CHAPTER 5

RISK AND RATES OF RETURN

(Difficulty: E = Easy, M = Medium, and T = Tough)

Multiple Choice: Conceptual

Easy:
Risk concepts Answer: e Diff: E
1. Which of the following statements is most correct?

a. Risk refers to the chance that some unfavorable event will occur, and
a probability distribution is completely described by a listing of the
likelihood of unfavorable events.
b. Portfolio diversification reduces the variability of returns on an
individual stock.
c. When company-specific risk has been diversified the inherent risk that
remains is market risk, which is constant for all securities in the
market.
d. A stock with a beta of -1.0 has zero market risk.
e. The SML relates required returns to firms’ market risk. The slope and
intercept of this line cannot be controlled by the financial manager.

Risk measures Answer: a Diff: E

2. You observe the following information regarding Company X and Company Y:

 Company X has a higher expected mean return than Company Y.

 Company X has a lower standard deviation than Company Y.
 Company X has a higher beta than Company Y.

Given this information, which of the following statements is most correct?

a. Company X has a lower coefficient of variation than Company Y.

b. Company X has more company-specific risk than Company Y.
c. Company X is a better stock to buy than Company Y.
d. Statements a and b are correct.
e. Statements a, b, and c are correct.

Chapter 5 - Page 1
Market risk premium Answer: c Diff: E
3. Which of the following statements is most correct? (Assume that the risk-
free rate remains constant.)

a. If the market risk premium increases by 1 percentage point, then the

required return on all stocks will rise by 1 percentage point.
b. If the market risk premium increases by 1 percentage point, then the
required return will increase for stocks that have a beta greater than
1.0, but it will decrease for stocks that have a beta less than 1.0.
c. If the market risk premium increases by 1 percentage point, then the
required return will increase by 1 percentage point for a stock that
has a beta equal to 1.0.
d. Statements a and c are correct.
e. None of the statements above is correct.

Standard deviation Answer: b Diff: E

4. A highly risk-averse investor is considering the addition of an asset to
a 10-stock portfolio. The two securities under consideration both have
an expected return, k , 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 equal to 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.

Beta coefficient Answer: d Diff: E

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

a. When held in isolation, Stock A has greater risk than Stock B.

b. Stock B would be a more desirable addition to a portfolio than Stock A.
c. Stock A would be a more desirable addition to a portfolio than Stock B.
d. The expected return on Stock A will be greater than that on Stock B.
e. The expected return on Stock B will be greater than that on Stock A.

Chapter 5 - Page 2
Beta coefficient Answer: c Diff: E
6. Stock X has a beta of 0.5 and Stock Y has a beta of 1.5. Which of the
following statements is most correct?

a. Stock Y’s return this year will be higher than Stock X’s return.
b. Stock Y’s return has a higher standard deviation than Stock X.
c. If expected inflation increases (but the market risk premium is
unchanged), the required returns on the two stocks will increase by
the same amount.
d. If the market risk premium declines (leaving the risk-free rate
unchanged), Stock X will have a larger decline in its required return
than will Stock Y.
e. If you invest $50,000 in Stock X and $50,000 in Stock Y, your portfolio
will have a beta less than 1.0, provided the stock returns on the two
stocks are not perfectly correlated.

Required return Answer: b Diff: E

7. In the years ahead the market risk premium, (kM - kRF), is expected to
fall, while the risk-free rate, kRF, is expected to remain at current
levels. Given this forecast, which of the following statements is most
correct?

a. The required return for all stocks will fall by the same amount.
b. The required return will fall for all stocks but will fall more for
stocks with higher betas.
c. The required return will fall for all stocks but will fall less for
stocks with higher betas.
d. The required return will increase for stocks with a beta less than 1.0
and will decrease for stocks with a beta greater than 1.0.
e. The required return on all stocks will remain unchanged.

Risk and return Answer: a Diff: E N

8. Over the past 75 years, we have observed that investments with higher
average annual returns also tend to have the highest standard deviations
in their annual returns. This observation supports the notion that there
is a positive correlation between risk and return. Which of the following
lists correctly ranks investments from having the highest returns and
risk to those with the lowest returns and risk?

a. Small-company stocks, large-company stocks, long-term corporate bonds,

long-term government bonds, U.S. Treasury bills.
b. Small-company stocks, long-term corporate bonds, large-company stocks,
long-term government bonds, U.S. Treasury bills.
c. Large-company stocks, small-company stocks, long-term corporate bonds,
U.S. Treasury bills, long-term government bonds.
d. U.S. Treasury bills, long-term government bonds, long-term corporate
bonds, small-company stocks, large-company stocks.
e. Large-company stocks, small-company stocks, long-term corporate bonds,
long-term government bonds, U.S. Treasury bills.

Chapter 5 - Page 3
Portfolio risk Answer: b Diff: E
9. Stock A and Stock B both have an expected return of 10 percent and a
standard deviation of 25 percent. Stock A has a beta of 0.8 and Stock B
has a beta of 1.2. The correlation coefficient, r, between the two stocks
is 0.6. Portfolio P is a portfolio with 50 percent invested in Stock A
and 50 percent invested in Stock B. Which of the following statements is
most correct?

a. Portfolio P has a coefficient of variation equal to 2.5.

b. Portfolio P has more market risk than Stock A but less market risk
than Stock B.
c. Portfolio P has a standard deviation of 25 percent and a beta of 1.0.
d. All of the statements above are correct.
e. None of the statements above is correct.

Portfolio risk, return, and beta Answer: e Diff: E

10. Which of the following statements is most correct?

a. A two-stock portfolio will always have a lower standard deviation than

a one-stock portfolio.
b. A two-stock portfolio will always have a lower beta than a one-stock
portfolio.
c. If portfolios are formed by randomly selecting stocks, a 10-stock
portfolio will always have a lower beta than a one-stock portfolio.
d. All of the statements above are correct.
e. None of the statements above is correct.

Portfolio risk and return Answer: a Diff: E

11. Which of the following statements best describes what would be expected
to happen as you randomly add stocks to your portfolio?

a. Adding more stocks to your portfolio reduces the portfolio’s company-

specific risk.
b. Adding more stocks to your portfolio reduces the beta of your
portfolio.
c. Adding more stocks to your portfolio increases the portfolio’s expected
return.
d. Statements a and c are correct.
e. All of the statements above are correct.

Chapter 5 - Page 4
Portfolio risk and return Answer: e Diff: E
12. Bob has a $50,000 stock portfolio with a beta of 1.2, an expected return
of 10.8 percent, and a standard deviation of 25 percent. Becky has a
$50,000 portfolio with a beta of 0.8, an expected return of 9.2 percent,
and a standard deviation of 25 percent. The correlation coefficient, r,
between Bob’s and Becky’s portfolios is 0. Bob and Becky are engaged to
be married. Which of the following best describes their combined $100,000
portfolio?

a. The combined portfolio’s expected return is a simple average of the

expected returns of the two individual portfolios (10%).
b. The combined portfolio’s beta is a simple average of the betas of the
two individual portfolios (1.0).
c. The combined portfolio’s standard deviation is less than a simple
average of the two portfolios’ standard deviations (25%), even though
there is no correlation between the returns of the two portfolios.
d. Statements a and b are correct.
e. All of the statements above are correct.

Portfolio risk and return Answer: a Diff: E

13. Your portfolio consists of $50,000 invested in Stock X and $50,000
invested in Stock Y. Both stocks have an expected return of 15 percent,
a beta of 1.6, and a standard deviation of 30 percent. The returns of
the two stocks are independent--the correlation coefficient, r, is zero.
Which of the following statements best describes the characteristics of
your portfolio?

a. Your portfolio has a beta equal to 1.6 and its expected return is 15
percent.
b. Your portfolio has a standard deviation of 30 percent and its expected
return is 15 percent.
c. Your portfolio has a standard deviation less than 30 percent and its
beta is greater than 1.6.
d. Your portfolio has a standard deviation greater than 30 percent and a
beta equal to 1.6.
e. Your portfolio has a beta greater than 1.6 and an expected return
greater than 15 percent.

Portfolio risk and return Answer: b Diff: E

14. In general, which of the following will tend to occur if you randomly add
additional stocks to your portfolio, which currently consists of only
three stocks?

a. The expected return of your portfolio will usually decline.

b. The company-specific risk of your portfolio will usually decline, but
the market risk will tend to remain the same.
c. Both the company-specific risk and the market risk of your portfolio
will decline.
d. The market risk and expected return of the portfolio will decline.
e. The company-specific risk will remain the same, but the market risk
will tend to decline.

Chapter 5 - Page 5
Portfolio risk and return Answer: b Diff: E
15. Stock X has a beta of 0.7 and Stock Y has a beta of 1.3. The standard
deviation of each stock’s returns is 20 percent. The returns are
independent of each other. (In other words, the correlation coefficient,
r, between Stock X and Stock Y is zero.) Portfolio P has 50 percent of
its wealth invested in Stock X and the other 50 percent is invested in
Stock Y. Given this information, which of the following statements is
most correct?

a. Portfolio P has a standard deviation of 20 percent.

b. The required return on Portfolio P is the same as the required return
on the market (kM).
c. The required return on Portfolio P is equal to the market risk premium
(kM – kRF).
d. Statements a and b are correct.
e. Statements a and c are correct.

Portfolio risk and return Answer: e Diff: E

16. Jane has randomly selected a portfolio of 20 stocks, and Dick has randomly
selected a portfolio of two stocks. Which of the following statements is
most correct?

a. The required return on Jane’s portfolio must be higher than the

required return on Dick’s portfolio because Jane is more diversified.
b. If the two portfolios have the same beta, Jane’s portfolio will have
less market risk but the same amount of company-specific risk as Dick’s
portfolio.
c. If the two portfolios have the same beta, their required returns will
be the same but Jane’s portfolio will have more company-specific risk
than Dick’s.
d. All of the statements above are correct.
e. None of the statements above is correct.

Portfolio risk and return Answer: d Diff: E

17. Stock A and Stock B each have an expected return of 12 percent, a beta of
1.2, and a standard deviation of 25 percent. The returns on the two
stocks have a correlation of 0.6. Portfolio P has half of its money
invested in Stock A and half in Stock B. Which of the following statements
is most correct?

a. Portfolio P has an expected return of 12 percent.

b. Portfolio P has a standard deviation of 25 percent.
c. Portfolio P has a beta of 1.2.
d. Statements a and c are correct.
e. All of the statements above are correct.

Chapter 5 - Page 6
Portfolio risk and return Answer: e Diff: E
18. Stocks A, B, and C all have an expected return of 10 percent and a standard
deviation of 25 percent. Stocks A and B have returns that are independent
of one another. (Their correlation coefficient, r, equals zero.) Stocks
A and C have returns that are negatively correlated with one another (that
is, r < 0). Portfolio AB is a portfolio with half its money invested in
Stock A and half invested in Stock B. Portfolio AC is a portfolio with
half its money invested in Stock A and half invested in Stock C. Which
of the following statements is most correct?

a. Portfolio AB has an expected return of 10 percent.

b. Portfolio AB has a standard deviation of 25 percent.
c. Portfolio AC has a standard deviation that is less than 25 percent.
d. Statements a and b are correct.
e. Statements a and c are correct.

Portfolio risk and return Answer: a Diff: E

19. Stock A and Stock B each have an expected return of 15 percent, a standard
deviation of 20 percent, and a beta of 1.2. The returns of the two stocks
are not perfectly correlated; the correlation coefficient is 0.6. You
have put together a portfolio that consists of 50 percent Stock A and 50
percent Stock B. Which of the following statements is most correct?

a. The portfolio’s expected return is 15 percent.

b. The portfolio’s beta is less than 1.2.
c. The portfolio’s standard deviation is 20 percent.
d. Statements a and b are correct.
e. All of the statements above are correct.

Portfolio risk and return Answer: d Diff: E N

20. Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a
beta of 1.2. Portfolio P has equal amounts invested in each of the three
stocks. Each of the stocks has a standard deviation of 25 percent. The
returns of the three stocks are independent of one another (i.e., the
correlation coefficients all equal zero). Which of the following
statements is most correct?

a. Portfolio P’s expected return is less than the expected return of Stock
C.
b. Portfolio P’s standard deviation is less than 25 percent.
c. Portfolio P’s realized return will always exceed the realized return of
Stock A.
d. Statements a and b are correct.
e. Statements b and c are correct.

Chapter 5 - Page 7
CAPM Answer: b Diff: E
21. The risk-free rate is 6 percent. Stock A has a beta of 1.0, while Stock
B has a beta of 2.0. The market risk premium (kM – kRF) is positive. Which
of the following statements is most correct?

a. Stock B’s required rate of return is twice that of Stock A.

b. If Stock A’s required return is 11 percent, the market risk premium is
5 percent.
c. If the risk-free rate increases (but the market risk premium stays
unchanged), Stock B’s required return will increase by more than Stock
A’s.
d. Statements b and c are correct.
e. All of the statements above are correct.

CAPM and required return Answer: c Diff: E

22. In recent years, both expected inflation and the market risk premium
(kM – kRF) have declined. Assume that all stocks have positive betas.
Which of the following is likely to have occurred as a result of these
changes?

a. The average required return on the market, kM, has remained constant,
but the required returns have fallen for stocks that have betas greater
than 1.0.
b. The required returns on all stocks have fallen by the same amount.
c. The required returns on all stocks have fallen, but the decline has
been greater for stocks with higher betas.
d. The required returns on all stocks have fallen, but the decline has
been greater for stocks with lower betas.
e. The required returns have increased for stocks with betas greater than
1.0 but have declined for stocks with betas less than 1.0.

CAPM and required return Answer: c Diff: E N

23.Assume that the risk-free rate is 5 percent. Which of the following
statements is most correct?

a. If a stock’s beta doubles, the stock’s required return will also

double.
b. If a stock’s beta is less than 1.0, the stock’s required return is
less than 5 percent.
c. If a stock has a negative beta, the stock’s required return is less
than 5 percent.
d. All of the statements above are correct.
e. None of the statements above is correct.

Chapter 5 - Page 8
CAPM and required return Answer: e Diff: E N
24. Stock X has a beta of 1.5 and Stock Y has a beta of 0.5. The market is
in equilibrium (that is, required returns equal expected returns). Which
of the following statements is most correct?

a. Since the market is in equilibrium, the required returns of the two

stocks should be the same.
b. If both expected inflation and the market risk premium (k M - kRF)
increase, the required returns of both stocks will increase by the
same amount.
c. If expected inflation remains constant but the market risk premium (k M
- kRF) declines, the required return of Stock X will decline but the
required return of Stock Y will increase.
d. All of the statements above are correct.
e. None of the statements above is correct.

CAPM and required return Answer: b Diff: E N

25. Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a
beta of 1.2. Portfolio P has equal amounts invested in each of the three
stocks. Each of the stocks has a standard deviation of 25 percent. The
returns of the three stocks are independent of one another (i.e., the
correlation coefficients all equal zero). Assume that there is an increase
in the market risk premium, but that the risk-free rate remains unchanged.
Which of the following statements is most correct?

a. The required return of all three stocks will increase by the amount of
the increase in the market risk premium.
b. The required return on Stock A will increase by less than the increase
in the market risk premium, while the required return on Stock C will
increase by more than the increase in the market risk premium.
c. The required return of all stocks will remain unchanged since there
was no change in their betas.
d. The required return of the average stock will remain unchanged, but
the returns of riskier stocks (such as Stock C) will decrease while
the returns of safer stocks (such as Stock A) will increase.
e. The required return of the average stock will remain unchanged, but
the returns of riskier stocks (such as Stock C) will increase while
the returns of safer stocks (such as Stock A) will decrease.

CAPM, beta, and required return Answer: c Diff: E

26. Currently, the risk-free rate is 6 percent and the market risk premium is
5 percent. On the basis of this information, which of the following
statements is most correct?

a. If a stock has a negative beta, its required return must also be

negative.
b. If a stock’s beta doubles, its required return must also double.
c. An index fund with beta = 1.0 has a required return of 11 percent.
d. Statements a and c are correct.
e. Statements b and c are correct.

Chapter 5 - Page 9
SML Answer: a Diff: E
27. Which of the following statements is incorrect?

a. The slope of the security market line is measured by beta.

b. Two securities with the same stand-alone risk can have different betas.
c. Company-specific risk can be diversified away.
d. The market risk premium is affected by attitudes about risk.
e. Higher beta stocks have a higher required return.

SML Answer: b Diff: E

28. Which of the following statements is most correct?

a. The slope of the security market line is beta.

b. The slope of the security market line is the market risk premium, ( k M
– k R F ).
c. If you double a company’s beta its required return more than doubles.
d. Statements a and c are correct.
e. Statements b and c are correct.

SML Answer: c Diff: E

29. Stock A has a beta of 1.2 and a standard deviation of 20 percent. Stock
B has a beta of 0.8 and a standard deviation of 25 percent. Portfolio P
is a $200,000 portfolio consisting of $100,000 invested in Stock A and
$100,000 invested in Stock B. Which of the following statements is most
correct? (Assume that the required return is determined by the Security
Market Line.)

a. Stock B has a higher required rate of return than Stock A.

b. Portfolio P has a standard deviation of 22.5 percent.
c. Portfolio P has a beta equal to 1.0.
d. Statements a and b are correct.
e. Statements a and c are correct.

SML Answer: e Diff: E

30. Nile Foods’ stock has a beta of 1.4 and Elbe Eateries’ stock has a beta of
0.7. Assume that the risk-free rate, kRF, is 5.5 percent and the market
risk premium, (kM – kRF), equals 4 percent. Which of the following statements
is most correct?

a. Since Nile’s beta is twice that of Elbe’s, its required rate of return
will also be twice that of Elbe’s.
b. If the risk-free rate increases but the market risk premium remains
unchanged, the required return will increase for both stocks but the
increase will be larger for Nile since it has a higher beta.
c. If the market risk premium increases but the risk-free rate remains
unchanged, Nile’s required return will increase (since it has a beta
greater than 1.0) but Elbe’s will decline (since it has a beta less than
1.0).
d. All of the statements above are correct.
e. None of the statements above is correct.

Chapter 5 - Page 10
SML Answer: c Diff: E
31. Stock X has a beta of 0.6, while Stock Y has a beta of 1.4. Which of the
following statements is most correct?

a. Stock Y must have a higher expected return and a higher standard deviation
than Stock X.
b. A portfolio consisting of $50,000 invested in Stock X and $50,000 invested
in Stock Y will have a required return that exceeds that of the overall
market.
c. If the market risk premium decreases (but expected inflation is
unchanged), the required return on both stocks will decrease but the
decrease will be greater for Stock Y.
d. If expected inflation increases (but the market risk premium is
unchanged), the required return on both stocks will decrease by the same
amount.
e. If expected inflation decreases (but the market risk premium is
unchanged), the required return on both stocks will decrease but the
decrease will be greater for Stock Y.

SML Answer: b Diff: E

32. Stock A has a beta of 0.8 and Stock B has a beta of 1.2. 50 percent of
Portfolio P is invested in Stock A and 50 percent is invested in Stock B.
If the market risk premium (kM – kRF) were to increase but the risk-free rate
(kRF) remained constant, which of the following would occur?

a. The required return will decrease by the same amount for both Stock A
and Stock B.
b. The required return will increase for both stocks but the increase will
be greater for Stock B than for Stock A.
c. The required return will increase for Stock A but will decrease for Stock
B.
d. The required return will increase for Stock B but will decrease for Stock
A.
e. The required return on Portfolio P will remain unchanged.

SML Answer: e Diff: E

33. Stock A has a beta of 0.7, whereas Stock B has a beta of 1.3. Portfolio
P has 50 percent invested in both Stocks A and B. Which of the following
would occur if the market risk premium increased by
1 percentage point? (Assume that the risk-free rate remains constant.)

a. The required return for Stock A would fall but the required return for
Stock B would increase.
b. The required return for Portfolio P would remain unchanged.
c. The required return for both stocks would increase by 1 percentage point.
d. The required return for Stock A would increase by more than
1 percentage point, while the return for Stock B would increase by
less than 1 percentage point.
e. The required return for Portfolio P would increase by 1 percentage
point.

Chapter 5 - Page 11
SML Answer: b Diff: E N
34. Assume that the risk-free rate remains constant, but that the market risk
premium declines. Which of the following is likely to occur?

a. The required return on a stock with a beta = 1.0 will remain the same.
b. The required return on a stock with a beta < 1.0 will decline.
c. The required return on a stock with a beta > 1.0 will increase.
d. Statements b and c are correct.
e. All of the statements above are correct.

SML, CAPM, and beta Answer: e Diff: E

35. Which of the following statements is most correct?

a. The slope of the security market line is beta.

b. A stock with a negative beta must have a negative required rate of
return.
c. If a stock’s beta doubles its required rate of return must double.
d. If a stock has a beta equal to 1.0, its required rate of return will
be unaffected by changes in the market risk premium.
e. None of the statements above is correct.

Risk analysis and portfolio diversification Answer: d Diff: E

36. Which of the following statements is most correct?

a. Portfolio diversification reduces the variability of the returns on

the individual stocks held in the portfolio.
b. If an investor buys enough stocks, he or she can, through
diversification, eliminate virtually all of the nonmarket (or company-
specific) risk inherent in owning stocks. Indeed, if the portfolio
contained all publicly traded stocks, it would be riskless.
c. The required return on a firm’s common stock is determined by its
systematic (or market) risk. If the systematic risk is known, and if
that risk is expected to remain constant, then no other information is
required to specify the firm’s required return.
d. A security’s beta measures its nondiversifiable (systematic, or
market) risk relative to that of an average stock.
e. A stock’s beta is less relevant as a measure of risk to an investor
with a well-diversified portfolio than to an investor who holds only
that one stock.

Chapter 5 - Page 12
Miscellaneous risk concepts Answer: c Diff: E N
37. Consider the following information for three stocks, Stock A, Stock B, and
Stock C. The returns on each of the three stocks are positively correlated,
but they are not perfectly correlated. (That is, all of the correlation
coefficients are between 0 and 1.)

Expected Standard
Stock Return Deviation Beta
Stock A 10% 20% 1.0
Stock B 10 20 1.0
Stock C 12 20 1.4

Portfolio P has half of its funds invested in Stock A and half invested
in Stock B. Portfolio Q has one third of its funds invested in each of
the three stocks. The risk-free rate is 5 percent, and the market is in
equilibrium. (That is, required returns equal expected returns.) Which
of the following statements is most correct?

a. Portfolio P has a standard deviation of 20 percent.

b. Portfolio P’s coefficient of variation is greater than 2.0.
c. Portfolio Q’s expected return is 10.67 percent.
d. Portfolio Q has a standard deviation of 20 percent.
e. Portfolio P’s required return is greater than the required return on
Stock A.

Medium:
Risk aversion Answer: b Diff: M
38. You have developed the following data on three stocks:

Stock Standard Deviation Beta

A 0.15 0.79
B 0.25 0.61
C 0.20 1.29

If you are a risk minimizer, you should 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.

a. A; A
b. A; B
c. B; A
d. C; A
e. C; B

Chapter 5 - Page 13
SML and risk aversion Answer: e Diff: M
39. Assume that investors become increasingly risk averse, so that the market
risk premium increases. Also, assume that the risk-free rate and expected
inflation remain the same. Which of the following is most likely to
occur?

a. The required rate of return will decline for stocks that have betas
less than 1.0.
b. The required rate of return on the market, kM, will remain the same.
c. The required rate of return for each stock in the market will increase
by an amount equal to the increase in the market risk premium.
d. Statements a and b are correct.
e. None of the statements above is correct.

Portfolio risk and return Answer: c Diff: M

40. In a portfolio of three different stocks, which of the following could
not be true?

a. The riskiness of the portfolio is less than the riskiness of each of

the stocks if each 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 less than the beta of each of the
individual stocks.
d. The beta of the portfolio is greater than the beta of one or two of
the individual stocks’ betas.
e. None of the above (that is, they all could be true, but not necessarily
at the same time).

Portfolio risk and return Answer: d Diff: M N

41. Stock A has an expected return of 10 percent and a standard deviation of
20 percent. Stock B has an expected return of 12 percent and a standard
deviation of 30 percent. The risk-free rate is 5 percent and the market
risk premium, kM - kRF, is 6 percent. Assume that the market is in
equilibrium. Portfolio P has 50 percent invested in Stock A and 50 percent
invested in Stock B. The returns of Stock A and Stock B are independent
of one another. (That is, their correlation coefficient equals zero.)
Which of the following statements is most correct?

a. Portfolio P’s expected return is 11 percent.

b. Portfolio P’s standard deviation is less than 25 percent.
c. Stock B’s beta is 1.25.
d. Statements a and b are correct.
e. All of the statements above are correct.

Chapter 5 - Page 14
Portfolio risk and return Answer: d Diff: M N
42. Stock A has a beta of 1.2 and a standard deviation of 25 percent. Stock B
has a beta of 1.4 and a standard deviation of 20 percent. Portfolio P was
created by investing in a combination of Stocks A and B. Portfolio P has
a beta of 1.25 and a standard deviation of 18 percent. Which of the
following statements is most correct?

a. Portfolio P has the same amount of money invested in each of the two
stocks.
b. The returns of the two stocks are perfectly positively correlated (r =
1.0).
c. Stock A has more market risk than Stock B but less stand-alone risk.
d. Portfolio P’s required return is greater than Stock A’s required return.
e. Stock A has more market risk than Portfolio P.

Portfolio risk Answer: e Diff: M

43. Which of the following statements is most correct?

a. Market participants are able to eliminate virtually all market risk if

they hold a large diversified portfolio of stocks.
b. Market participants are able to eliminate virtually all company-
specific risk if they hold a large diversified portfolio of stocks.
c. It is possible to have a situation where the market risk of a single
stock is less than that of a well diversified portfolio.
d. Statements a and c are correct.
e. Statements b and c are correct.

Portfolio risk and beta Answer: c Diff: M

44. Stock A has a beta = 0.8, while Stock B has a beta = 1.6. Which of the
following statements is most correct?

a. Stock B’s required return is double that of Stock A’s.

b. An equally weighted portfolio of Stock A and Stock B will have a beta
less than 1.2.
c. If market participants become more risk averse, the required return on
Stock B will increase more than the required return for Stock A.
d. All of the statements above are correct.
e. Statements a and c are correct.

Chapter 5 - Page 15
Portfolio risk and beta Answer: e Diff: M
45. Which of the following statements is most correct?

a. If you add enough randomly selected stocks to a portfolio, you can

completely eliminate all the market risk from the portfolio.
b. If you formed a portfolio that included a large number of low-beta
stocks (stocks with betas less than 1.0 but greater than -1.0), the
portfolio would itself have a beta coefficient that is equal to the
weighted average beta of the stocks in the portfolio, so the portfolio
would have a relatively low degree of risk.
c. If you were restricted to investing in publicly traded common stocks,
yet you wanted to minimize the riskiness of your portfolio as measured
by its beta, then according to the CAPM theory you should invest some
of your money in each stock in the market. That is, if there were
10,000 traded stocks in the world, the least risky portfolio would
include some shares in each of them.
d. Diversifiable risk can be eliminated by forming a large portfolio, but
normally even highly-diversified portfolios are subject to market risk.
e. Statements b and d are correct.

Market risk Answer: b Diff: M

46. Inflation, recession, and high interest rates are economic events that
are characterized as

a. Company-specific risk that can be diversified away.

b. Market risk.
c. Systematic risk that can be diversified away.
d. Diversifiable risk.
e. Unsystematic risk that can be diversified away.

Beta coefficient Answer: a Diff: M

47. Which of the following statements is most correct?

a. The beta coefficient of a stock is normally found by running a

regression of past returns on the stock against past returns on a stock
market index. One could also construct a scatter diagram of returns
on the stock versus those on the market, estimate the slope of the
line of best fit, and use it as beta.
b. It is theoretically possible for a stock to have a beta of 1.0. If a
stock did have a beta of 1.0, then, at least in theory, its required
rate of return would be equal to the risk-free (default-free) rate of
return, kRF.
c. If you found a stock with a zero beta and held it as the only stock in
your portfolio, you would by definition have a riskless portfolio.
Your 1-stock portfolio would be even less risky if the stock had a
negative beta.
d. The beta of a portfolio of stocks is always larger than the betas of
any of the individual stocks.
e. All of the statements above are correct.

Chapter 5 - Page 16
Beta coefficient Answer: d Diff: M
48. You have developed data that give (1) the average annual returns on the
market for the past five years, and (2) similar information on Stocks A
and B. If these data are as follows, which of the possible answers best
describes the historical betas for A and B?

Years Market Stock A Stock B

1 0.03 0.16 0.05
2 -0.05 0.20 0.05
3 0.01 0.18 0.05
4 -0.10 0.25 0.05
5 0.06 0.14 0.05

a. bA > 0; bB = 1
b. bA > +1; bB = 0
c. bA = 0; bB = -1
d. bA < 0; bB = 0
e. bA < -1; bB = 1

Beta coefficient Answer: a Diff: M

49. Which of the following statements is most correct?

a. Suppose the returns on two stocks are negatively correlated. One has a
beta of 1.2 as determined in a regression analysis, while the other has
a beta of -0.6. The returns on the stock with the negative beta will be
negatively correlated with returns on most other stocks in the market.
b. Suppose you are managing a stock portfolio, and you have information that
leads you to believe the stock market is likely to be very strong in the
immediate future. That is, you are confident the market is about to rise
sharply. You should sell your high-beta stocks and buy low-beta stocks
in order to take advantage of the expected market move.
c. Collections Inc. is in the business of collecting past-due accounts for
other companies; that is, it is a collection agency. Collections’
revenues, profits, and stock price tend to rise during recessions. This
suggests that Collections Inc.’s beta should be quite high, say 2.0,
because it does so much better than most other companies when the economy
is weak.
d. Statements a and b are correct.
e. Statements a and c are correct.

Chapter 5 - Page 17
Beta coefficient Answer: c Diff: M
50. Which of the following is not a difficulty concerning beta and its
estimation?

a. Sometimes a security or project does not have a past history that 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 an “average stock,” or “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.

Beta coefficient Answer: d Diff: M N

51. Certain firms and industries are characterized by consistently low or high
betas, depending on the particular situation. On the basis of that notion,
which of the following companies seems out of place with its stated beta?
(That is, one of the following companies definitely could not have the
indicated beta, while the other companies seem well matched with their
stated betas.)

a. Sun Microsystems, Beta = 1.59.

b. Amazon.com, Beta = 1.70.
c. Ford Motor Company, Beta = 0.92.
d. Florida Power & Light, Beta = 1.52.
e. Wal-Mart, Beta = 1.15.

SML Answer: e Diff: M

52. Which of the following statements is most correct?

a. The SML relates required returns to firms’ market risk. The slope and
intercept of this line cannot be controlled by the financial manager.
b. The slope of the SML is determined by the value of beta.
c. If 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
that the observed relationship is expected to continue on into the
future.
d. If investors become less risk averse, the slope of the Security Market
Line will increase.
e. Statements a and c are correct.

Chapter 5 - Page 18
SML Answer: a Diff: M
53. Other things held constant, (1) if the expected inflation rate decreases,
and (2) investors become more risk averse, the Security Market Line would
shift

a. Down and have a steeper slope.

b. Up and have a less steep slope.
c. Up and keep the same slope.
d. Down and keep the same slope.
e. Down and have a less steep slope.

SML Answer: b Diff: M

54. Which of the following statements is most correct about a stock that has a
beta = 1.2?

a. If the stock’s beta doubles its expected return will double.

b. If expected inflation increases 3 percent, the stock’s expected return
will increase by 3 percent.
c. If the market risk premium increases by 3 percent the stock’s expected
return will increase by less than 3 percent.
d. All of the statements above are correct.
e. Statements b and c are correct.

SML Answer: b Diff: M N

55. Assume that the risk-free rate, kRF, increases but the market risk premium,
(kM – kRF) declines. The net effect is that the overall expected return on
the market, kM, remains constant. Which of the following statements is
most correct?

a. The required return will decline for stocks that have a beta less than
1.0 but will increase for stocks that have a beta greater than 1.0.
b. The required return will increase for stocks that have a beta less than
1.0 but will decline for stocks that have a beta greater than 1.0.
c. The required return of all stocks will fall by the amount of the decline
in the market risk premium.
d. The required return of all stocks will increase by the amount of the
increase in the risk-free rate.
e. Since the overall return on the market stays constant, the required
return on all stocks will remain the same.

Chapter 5 - Page 19
SML, CAPM, and portfolio risk Answer: a Diff: M
56. Which of the following statements is most correct?

a. An increase in expected inflation could be expected to increase the

required return on a riskless asset and on an average stock by the same
amount, other things held constant.
b. A graph of the SML would show required rates of return on the vertical
axis and standard deviations of returns on the horizontal axis.
c. If two “normal” or “typical” stocks were combined to form a 2-stock
portfolio, the portfolio’s expected return would be a weighted average
of the stocks’ expected returns, but the portfolio’s standard deviation
would probably be greater than the average of the stocks’ standard
deviations.
d. If investors became more risk averse, then (1) the slope of the SML would
increase and (2) the required rate of return on low-beta stocks would
increase by more than the required return on high-beta stocks.
e. The CAPM has been thoroughly tested, and the theory has been confirmed
beyond any reasonable doubt.

Portfolio return, CAPM, and beta Answer: e Diff: M

57. Which of the following statements is most correct?

a. If the returns from two stocks are perfectly positively correlated (that
is, the correlation coefficient is +1) and the two stocks have equal
variance, an equally weighted portfolio of the two stocks will have a
variance that is less than that of the individual stocks.
b. If a stock has a negative beta, its expected return must be negative.
c. According to the CAPM, stocks with higher standard deviations of returns
will have higher expected returns.
d. A portfolio with a large number of randomly selected stocks will have
less market risk than a single stock that has a beta equal to 0.5.
e. None of the statements above is correct.

CAPM and required return Answer: d Diff: M

58. Which of the following statements is most correct?

a. We would observe a downward shift in the required returns of all stocks

if investors believed that there would be deflation in the economy.
b. If investors became more risk averse, then the new security market line
would have a steeper slope.
c. If the beta of a company doubles, then the required rate of return will
also double.
d. Statements a and b are correct.
e. All of the statements above are correct.

Chapter 5 - Page 20
Risk analysis and portfolio diversification Answer: e Diff: M
59. Which of the following statements is most correct?

a. If you add enough randomly selected stocks to a portfolio, you can

completely eliminate all the market risk from the portfolio.
b. If you form a large portfolio of stocks each with a beta greater than
1.0, this portfolio will have more market risk than a single stock with
a beta = 0.8.
c. Company-specific (or unsystematic) risk can be reduced by forming a large
portfolio, but normally even highly-diversified portfolios are subject
to market (or systematic) risk.
d. All of the statements above are correct.
e. Statements b and c are correct.

Portfolio diversification Answer: c Diff: M

60. Jane holds a large diversified portfolio of 100 randomly selected stocks
and the portfolio’s beta = 1.2. Each of the individual stocks in her
portfolio has a standard deviation of 20 percent. Jack has the same amount
of money invested in a single stock with a beta equal to 1.6 and a standard
deviation of 20 percent. Which of the following statements is most correct?

a. Jane’s portfolio has a larger amount of company-specific risk since she

is holding more stocks in her portfolio.
b. Jane has a higher required rate of return, since she is more diversified.
c. Jane’s portfolio has less market risk since it has a lower beta.
d. Statements b and c are correct.
e. None of the statements above is correct.

Portfolio risk and SML Answer: e Diff: M

61. Which of the following statements is most correct?

a. It is possible to have a situation in which the market risk of a single

stock is less than the market risk of a portfolio of stocks.
b. The market risk premium will increase if, on average, market participants
become more risk averse.
c. If you selected a group of stocks whose returns are perfectly positively
correlated, then you could end up with a portfolio for which none of the
unsystematic risk is diversified away.
d. Statements a and b are correct.
e. All of the statements above are correct.

Chapter 5 - Page 21
Tough:
CAPM Answer: c Diff: T
62. Which of the following statements is most correct?

a. According to CAPM theory, the required rate of return on a given stock

can be found by use of the SML equation:

ki = kRF + (kM - kRF)bi.

Expectations for inflation are not reflected anywhere in this equation,

even indirectly, and because of that the text notes that the CAPM may
not be strictly correct.
b. If the required rate of return is given by the SML equation as set forth
in Statement a, there is nothing a financial manager can do to change
his or her company’s cost of capital, because each of the elements in
the equation is determined exclusively by the market, not by the type of
actions a company’s management can take, even in the long run.
c. Assume that the required rate of return on the market is currently
kM = 15%, and that kM remains fixed at that level. If the yield curve
has a steep upward slope, the calculated market risk premium would be
larger if the 30-day T-bill rate were used as the risk-free rate than if
the 30-year T-bond rate were used as kRF.
d. Statements a and b are correct.
e. Statements a and c are correct.

SML Answer: d Diff: T

63. Which of the following statements is most correct?

a. If investors become more risk averse but kRF remains constant, the
required rate of return on high-beta stocks will rise, the required
return on low-beta stocks will decline, but the required return on an
average-risk stock will not change.
b. 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.
c. An investor who holds just one stock will 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. Assume that the required rate of return on the market, k M, is given
and fixed. 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 kRF.
e. None of the statements above is correct.

Chapter 5 - Page 22
Multiple Choice: Problems

Easy:
Required return Answer: d Diff: E N
64. The risk-free rate of interest, kRF, is 6 percent. The overall stock market
has an expected return of 12 percent. Hazlett, Inc. has a beta of 1.2.
What is the required return of Hazlett, Inc. stock?

a. 12.0%
b. 12.2%
c. 12.8%
d. 13.2%
e. 13.5%

Required return Answer: b Diff: E N

65. The risk-free rate is 5 percent. Stock A has a beta = 1.0 and Stock B
has a beta = 1.4. Stock A has a required return of 11 percent. What is
Stock B’s required return?

a. 12.4%
b. 13.4%
c. 14.4%
d. 15.4%
e. 16.4%

CAPM and required return Answer: d Diff: E

66. Calculate the required rate of return for Mercury Inc., assuming that
investors expect a 5 percent rate of inflation in the future. The real
risk-free rate is equal to 3 percent and the market risk premium is
5 percent. Mercury has a beta of 2.0, and its realized rate of return
has averaged 15 percent over the last 5 years.

a. 15%
b. 16%
c. 17%
d. 18%
e. 20%

Chapter 5 - Page 23
CAPM and market risk premium Answer: c Diff: E N
67. Consider the following information for three stocks, Stock A, Stock B, and
Stock C. The returns on each of the three stocks are positively correlated,
but they are not perfectly correlated. (That is, all of the correlation
coefficients are between 0 and 1.)

Expected Standard
Stock Return Deviation Beta
Stock A 10% 20% 1.0
Stock B 10 20 1.0
Stock C 12 20 1.4

Portfolio P has half of its funds invested in Stock A and half invested
in Stock B. Portfolio Q has one third of its funds invested in each of
the three stocks. The risk-free rate is 5 percent, and the market is in
equilibrium. (That is, required returns equal expected returns.) What
is the market risk premium (kM - kRF)?

a. 4.0%
b. 4.5%
c. 5.0%
d. 5.5%
e. 6.0%

Market risk premium Answer: d Diff: E

68. A stock has an expected return of 12.25 percent. The beta of the stock
is 1.15 and the risk-free rate is 5 percent. What is the market risk
premium?

a. 1.30%
b. 6.50%
c. 15.00%
d. 6.30%
e. 7.25%

Beta coefficient Answer: b Diff: E

69. Given the following information, determine which beta coefficient for
Stock A is consistent with equilibrium:

k̂A = 11.3%; kRF = 5%; kM = 10%

a. 0.86
b. 1.26
c. 1.10
d. 0.80
e. 1.35

Chapter 5 - Page 24
Beta coefficient Answer: a Diff: E
70. Assume that the risk-free rate is 5 percent and that the market risk
premium is 7 percent. If a stock has a required rate of return of 13.75
percent, what is its beta?

a. 1.25
b. 1.35
c. 1.37
d. 1.60
e. 1.96
Portfolio beta Answer: b Diff: E
71. You hold a diversified portfolio consisting of a $10,000 investment in
each of 20 different common stocks (that is, your total investment is
$200,000). The portfolio beta is equal to 1.2. You have decided to sell
one of your stocks that has a beta equal to 0.7 for $10,000. You plan to
use the proceeds to purchase another stock that has a beta equal to 1.4.
What will be the beta of the new portfolio?

a. 1.165
b. 1.235
c. 1.250
d. 1.284
e. 1.333
Portfolio return Answer: a Diff: E
72. An investor is forming a portfolio by investing $50,000 in stock A that
has a beta of 1.50, and $25,000 in stock B that has a beta of 0.90. The
return on the market is equal to 6 percent and Treasury bonds have a yield
of 4 percent. What is the required rate of return on the investor’s
portfolio?

a. 6.6%
b. 6.8%
c. 5.8%
d. 7.0%
e. 7.5%
Portfolio return Answer: b Diff: E

73. You are an investor in common stocks, and you currently hold a well-
diversified portfolio that has an expected return of 12 percent, a beta
of 1.2, and a total value of $9,000. You plan to increase your portfolio
by buying 100 shares of AT&E at $10 a share. AT&E has an expected return
of 20 percent with a beta of 2.0. What will be the expected return and
the beta of your portfolio after you purchase the new stock?

a. k̂p = 20.0%; bp = 2.00

b. k̂p = 12.8%; bp = 1.28
c. k̂p = 12.0%; bp = 1.20
d. k̂p = 13.2%; bp = 1.40

Chapter 5 - Page 25
 e. k̂p = 14.0%; bp = 1.32
Portfolio risk and return Answer: a Diff: E N
74. Stock A has an expected return of 12 percent, a beta of 1.2, and a standard
deviation of 20 percent. Stock B has an expected return of 10 percent, a
beta of 1.2, and a standard deviation of 15 percent. Portfolio P has $900,000
invested in Stock A and $300,000 invested in Stock B. The correlation
between Stock A’s returns and Stock B’s returns is zero (that is, r = 0).
Which of the following statements is most correct?

a. Portfolio P’s expected return is 11.5 percent.

b. Portfolio P’s standard deviation is 18.75 percent.
c. Portfolio P’s beta is less than 1.2.
d. Statements a and b are correct.
e. Statements a and c are correct.

Coefficient of variation Answer: b Diff: E

75. Below are the stock returns for the past five years for Agnew Industries:

Year Stock Return

2002 22%
2001 33
2000 1
1999 -12
1998 10

What was the stock’s coefficient of variation during this 5-year period?
(Use the population standard deviation to calculate the coefficient of
variation.)

a. 10.80
b. 1.46
c. 15.72
d. 0.69
e. 4.22

Chapter 5 - Page 26
Medium:
Expected return Answer: e Diff: M
76. Assume a new law is passed that restricts investors to holding only one
asset. A risk-averse investor is considering two possible assets as the
asset to be held in isolation. The assets’ possible returns and related
probabilities (that is, the probability distributions) are as follows:

Asset X Asset Y
P k P k
0.10 -3% 0.05 -3%
0.10 2 0.10 2
0.25 5 0.30 5
0.25 8 0.30 8
0.30 10 0.25 10
Which asset should be preferred?

a. Asset X, since its expected return is higher.

b. Asset Y, since its beta is probably lower.
c. Either one, since the expected returns are the same.
d. Asset X, since its standard deviation is lower.
e. Asset Y, since its coefficient of variation is lower and its expected
return is higher.

Expected return Answer: c Diff: M

77. Given the following probability distribution, what are the expected return
and the standard deviation of returns for Security J?

State Pi kJ
1 0.2 10%
2 0.6 15
3 0.2 20

a. 15%; 6.50%
b. 12%; 5.18%
c. 15%; 3.16%
d. 15%; 10.00%
e. 20%; 5.00%

Required return Answer: c Diff: M

78. You are holding a stock that has a beta of 2.0 and is currently in
equilibrium. The required return on the stock is 15 percent, and the
return on an average stock is 10 percent. What would be the percentage
change in the return on the stock, if the return on an average stock
increased by 30 percent while the risk-free rate remained unchanged?

a. +20%
b. +30%
c. +40%
d. +50%
e. +60%

Chapter 5 - Page 27
Required return Answer: c Diff: M
79. Oakdale Furniture Inc. has a beta coefficient of 0.7 and a required rate of
return of 15 percent. The market risk premium is currently 5 percent. If
the inflation premium increases by 2 percentage points, and Oakdale acquires
new assets that increase its beta by 50 percent, what will be Oakdale’s new
required rate of return?

a. 13.50%
b. 22.80%
c. 18.75%
d. 15.25%
e. 17.00%

Required return Answer: e Diff: M

80. Partridge Plastic’s stock has an estimated beta of 1.4, and its required
rate of return is 13 percent. Cleaver Motors’ stock has a beta of 0.8,
and the risk-free rate is 6 percent. What is the required rate of return
on Cleaver Motors’ stock?

a. 7.0%
b. 10.4%
c. 12.0%
d. 11.0%
e. 10.0%

Expected and required returns Answer: c Diff: M

81. The realized returns for the market and Stock J for the last four years
are given below:

Year Market Stock J

1 10% 5%
2 15 0
3 -5 14
4 0 10

An average stock has an expected return of 12 percent and the market risk
premium is 4 percent. If Stock J’s expected rate of return as viewed by
a marginal investor is 8 percent, what is the difference between J’s
expected and required rates of return?

a. 0.66%
b. 1.25%
c. 2.64%
d. 3.72%
e. 5.36%

Chapter 5 - Page 28
Expected and required returns Answer: b Diff: M
82. You have been scouring The Wall Street Journal looking for stocks that
are “good values” and have calculated expected returns for five stocks.
Assume the risk-free rate (kRF) is 7 percent and the market risk premium
(kM - kRF) is 2 percent. Which security would be the best investment?
(Assume you must choose just one.)

Expected Return Beta

a. 9.01% 1.70
b. 7.06% 0.00
c. 5.04% -0.67
d. 8.74% 0.87
e. 11.50% 2.50

CAPM and required return Answer: e Diff: M

83. HR Corporation has a beta of 2.0, while LR Corporation’s beta is 0.5. The
risk-free rate is 10 percent, and the required rate of return on an
average stock is 15 percent. Now the expected rate of inflation built
into kRF falls by 3 percentage points, the real risk-free rate remains
constant, the required return on the market falls to 11 percent, and the
betas remain constant. When all of these changes are made, what will be
the difference in the required returns on HR’s and LR’s stocks?

a. 1.0%
b. 2.5%
c. 4.5%
d. 5.4%
e. 6.0%

CAPM and required return Answer: a Diff: M N

84. Bradley Hotels has a beta of 1.3, while Douglas Farms has a beta of 0.7.
The required return on an index fund that holds the entire stock market
is 12 percent. The risk-free rate of interest is 7 percent. By how much
does Bradley’s required return exceed Douglas’ required return?

a. 3.0%
b. 6.5%
c. 5.0%
d. 6.0%
e. 7.0%

Chapter 5 - Page 29
CAPM and required return Answer: d Diff: M
85. Company X has a beta of 1.6, while Company Y’s beta is 0.7. The risk-
free rate is 7 percent, and the required rate of return on an average
stock is 12 percent. Now the expected rate of inflation built into k RF
rises by 1 percentage point, the real risk-free rate remains constant,
the required return on the market rises to 14 percent, and betas remain
constant. After all of these changes have been reflected in the data, by
how much will the required return on Stock X exceed that on Stock Y?

a. 3.75%
b. 4.20%
c. 4.82%
d. 5.40%
e. 5.75%

CAPM and required return Answer: e Diff: M

86. Historical rates of return for the market and for Stock A are given below:

Year Market Stock A

1 6.0% 8.0%
2 -8.0 3.0
3 -8.0 -2.0
4 18.0 12.0

If the required return on the market is 11 percent and the risk-free rate
is 6 percent, what is the required return on Stock A, according to CAPM/SML
theory?

a. 6.00%
b. 6.57%
c. 7.25%
d. 7.79%
e. 8.27%

Chapter 5 - Page 30
CAPM and required return Answer: a Diff: M
87. Some returns data for the market and for Countercyclical Corp. are given
below:

Year Market Countercyclical

1999 -2.0% 8.0%
2000 12.0 3.0
2001 -8.0 18.0
2002 21.0 -7.0

The required return on the market is 14 percent and the risk-free rate is
8 percent. What is the required return on Countercyclical Corp. according
to CAPM/SML theory?

a. 3.42%
b. 4.58%
c. 8.00%
d. 11.76%
e. 14.00%

Portfolio return Answer: c Diff: M

88. Stock X, Stock Y, and the market have had the following returns over the
past four years.

Year Market X Y
1999 11% 10% 12%
2000 7 4 -3
2001 17 12 21
2002 -3 -2 -5

The risk-free rate is 7 percent. The market risk premium is 5 percent.

What is the required rate of return for a portfolio that consists of
$14,000 invested in Stock X and $6,000 invested in Stock Y?

a. 9.94%
b. 10.68%
c. 11.58%
d. 12.41%
e. 13.67%

Chapter 5 - Page 31
Portfolio return Answer: b Diff: M
89. The risk-free rate, kRF, is 6 percent and the market risk premium,
(kM – kRF), is 5 percent. Assume that required returns are based on the
CAPM. Your $1 million portfolio consists of $700,000 invested in a stock
that has a beta of 1.2 and $300,000 invested in a stock that has a beta of
0.8. Which of the following statements is most correct?

a. The portfolio’s required return is less than 11 percent.

b. If the risk-free rate remains unchanged but the market risk premium
increases by 2 percentage points, the required return on your portfolio
will increase by more than 2 percentage points.
c. If the market risk premium remains unchanged but expected inflation
increases by 2 percentage points, the required return on your portfolio
will increase by more than 2 percentage points.
d. If the stock market is efficient, your portfolio’s expected return should
equal the expected return on the market, which is 11 percent.
e. None of the statements above is correct.
Portfolio return Answer: c Diff: M
90. A portfolio manager is holding the following investments:

Stock Amount Invested Beta

X $10 million 1.4
Y 20 million 1.0
Z 40 million 0.8

The manager plans to sell his holdings of Stock Y. The money from the sale
will be used to purchase another $15 million of Stock X and another $5
million of Stock Z. The risk-free rate is 5 percent and the market risk
premium is 5.5 percent. How many percentage points higher will the required
return on the portfolio be after he completes this transaction?

a. 0.07%
b. 0.18%
c. 0.39%
d. 0.67%
e. 1.34%

Portfolio return Answer: b Diff: M N

91. Assume that the risk-free rate is 5.5 percent and the market risk premium
is 6 percent. A money manager has $10 million invested in a portfolio that
has a required return of 12 percent. The manager plans to sell $3 million
of stock with a beta of 1.6 that is part of the portfolio. She plans to
reinvest this $3 million into another stock that has a beta of 0.7. If she
goes ahead with this planned transaction, what will be the required return
of her new portfolio?

a. 10.52%
b. 10.38%
c. 11.31%
d. 10.90%

Chapter 5 - Page 32
e. 8.28%

Chapter 5 - Page 33
Portfolio return Answer: a Diff: M N
92. The current risk-free rate is 6 percent and the market risk premium is
5 percent. Erika is preparing to invest $30,000 in the market and she
wants her portfolio to have an expected return of 12.5 percent. Erika is
concerned about bearing too much stand-alone risk; therefore, she will
diversify her portfolio by investing in three different assets (two mutual
funds and a risk-free security). The three assets she will be investing
in are an aggressive growth mutual fund that has a beta of 1.6, an S&P
500 index fund with a beta of 1, and a risk-free security that has a beta
of 0. She has already decided that she will invest 10 percent of her
money in the risk-free asset. In order to achieve the desired expected
return of 12.5 percent, what proportion of Erika’s portfolio must be
invested in the S&P 500 index fund?

a. 23.33%
b. 33.33%
c. 53.33%
d. 66.66%
e. 76.66%

CAPM and portfolio return Answer: d Diff: M

93. Your portfolio consists of $100,000 invested in a stock that has a beta =
0.8, $150,000 invested in a stock that has a beta = 1.2, and $50,000 invested
in a stock that has a beta = 1.8. The risk-free rate is
7 percent. Last year this portfolio had a required rate of return of 13
percent. This year nothing has changed except for the fact that the market
risk premium has increased by 2 percent (two percentage points). What is
the portfolio’s current required rate of return?

a. 5.14%
b. 7.14%
c. 11.45%
d. 15.33%
e. 16.25%

CAPM and portfolio return Answer: b Diff: M

94. Currently, the risk-free rate is 5 percent and the market risk premium is
6 percent. You have your money invested in three assets: an index fund
that has a beta of 1.0, a risk-free security that has a beta of 0, and an
international fund that has a beta of 1.5. You want to have 20 percent
of your portfolio invested in the risk-free asset, and you want your
overall portfolio to have an expected return of 11 percent. What portion
of your overall portfolio should you invest in the inter-national fund?

a. 0%
b. 40%
c. 50%
d. 60%
e. 80%

CAPM and portfolio return Answer: c Diff: M

Chapter 5 - Page 34
95. A money manager is holding a $10 million portfolio that consists of the
following five stocks:

Stock Amount Invested Beta

A $4 million 1.2
B 2 million 1.1
C 2 million 1.0
D 1 million 0.7
E 1 million 0.5

The portfolio has a required return of 11 percent, and the market risk
premium, kM – kRF, is 5 percent. What is the required return on Stock C?

a. 7.2%
b. 10.0%
c. 10.9%
d. 11.0%
e. 11.5%

CAPM and portfolio return Answer: c Diff: M

96. You have been managing a $1 million portfolio. The portfolio has a beta
of 1.6 and a required rate of return of 14 percent. The current risk-
free rate is 6 percent. Assume that you receive another $200,000. If
you invest the money in a stock that has a beta of 0.6, what will be the
required return on your $1.2 million portfolio?

a. 12.00%
b. 12.25%
c. 13.17%
d. 14.12%
e. 13.67%

CAPM and portfolio return Answer: c Diff: M

97. Currently, the risk-free rate, kRF, is 5 percent and the required return
on the market, kM, is 11 percent. Your portfolio has a required rate of
return of 9 percent. Your sister has a portfolio with a beta that is
twice the beta of your portfolio. What is the required rate of return on
your sister’s portfolio?

a. 12.0%
b. 12.5%
c. 13.0%
d. 17.0%
e. 18.0%

Chapter 5 - Page 35
CAPM and portfolio return Answer: b Diff: M N
98. Stock A has an expected return of 10 percent and a beta of 1.0. Stock B
has a beta of 2.0. Portfolio P is a two-stock portfolio, where part of
the portfolio is invested in Stock A and the other part is invested in
Stock B. Assume that the risk-free rate is 5 percent, that required returns
are determined by the CAPM, and that the market is in equilibrium so that
expected returns equal required returns. Portfolio P has an expected
return of 12 percent. What proportion of Portfolio P consists of Stock B?

a. 20%
b. 40%
c. 50%
d. 60%
e. 80%

Portfolio beta Answer: b Diff: M

99. You hold a diversified portfolio consisting of a $5,000 investment in
each of 20 different common stocks. The portfolio beta is equal to 1.15.
You have decided to sell one of your stocks, a lead mining stock whose b
is equal to 1.0, for $5,000 net and to use the proceeds to buy $5,000 of
stock in a steel company whose b is equal to 2.0. What will be the new
beta of the portfolio?

a. 1.12
b. 1.20
c. 1.22
d. 1.10
e. 1.15

Portfolio beta Answer: c Diff: M

100. A mutual fund manager has a $200,000,000 portfolio with a beta = 1.2.
Assume that the risk-free rate is 6 percent and that the market risk
premium is also 6 percent. The manager expects to receive an additional
$50,000,000 in funds soon. She wants to invest these funds in a variety
of stocks. After making these additional investments she wants the fund’s
expected return to be 13.5 percent. What should be the average beta of
the new stocks added to the portfolio?

a. 1.10
b. 1.33
c. 1.45
d. 1.64
e. 1.87

Chapter 5 - Page 36
Portfolio beta Answer: e Diff: M
101. Walter Jasper currently manages a $500,000 portfolio. He is expecting to
receive an additional $250,000 from a new client. The existing portfolio
has a required return of 10.75 percent. The risk-free rate is 4 percent
and the return on the market is 9 percent. If Walter wants the required
return on the new portfolio to be 11.5 percent, what should be the average
beta for the new stocks added to the portfolio?

a. 1.50
b. 2.00
c. 1.67
d. 1.35
e. 1.80

Portfolio return and beta Answer: a Diff: M

102. A portfolio manager is holding the following investments in her portfolio:

Stock Amount Invested Beta

1 $300 million 0.7
2 200 million 1.0
3 500 million 1.6

The risk-free rate, kRF, is 5 percent and the portfolio has a required return
of 11.655 percent. The manager is thinking about selling all of her holdings
of Stock 3, and instead investing the money in Stock 4, which has a beta of
0.9. If she were to do this, what would be the new portfolio’s required
return?

a. 9.73%
b. 11.09%
c. 9.91%
d. 7.81%
e. 10.24%

Portfolio return and beta Answer: e Diff: M

103. A fund manager is holding the following stocks:

Stock Amount Invested Beta

1 $300 million 1.2
2 560 million 1.4
3 320 million 0.7
4 230 million 1.8

The risk-free rate is 5 percent and the market risk premium is also
5 percent. If the manager sells half of her investment in Stock 2 ($280
million) and puts the money in Stock 4, by how many percentage points will
her portfolio’s required return increase?

a. 0.36%
b. 0.22%
c. 2.00%

Chapter 5 - Page 37
 d. 0.20%
e. 0.40%
Portfolio return and beta Answer: e Diff: M N
104. A portfolio manager is managing a $10 million portfolio. Currently the
portfolio is invested in the following manner:

Investment Dollar Amount Invested Beta

Stock 1 $2 million 0.6
Stock 2 3 million 0.8
Stock 3 3 million 1.2
Stock 4 2 million 1.4

Currently, the risk-free rate is 5 percent and the portfolio has an expected
return of 10 percent. Assume that the market is in equilibrium so that
expected returns equal required returns. The manager is willing to take
on additional risk and wants to instead earn an expected return of 12
percent on the portfolio. Her plan is to sell Stock 1 and use the proceeds
to buy another stock. In order to reach her goal, what should be the beta
of the stock that the manager selects to replace Stock 1?

a. 1.40
b. 1.75
c. 2.05
d. 2.40
e. 2.60

Portfolio standard deviation Answer: a Diff: M

105. Here are the expected returns on two stocks:

Returns
Probability X Y
0.1 -20% 10%
0.8 20 15
0.1 40 20

If you form a 50-50 portfolio of the two stocks, what is the portfolio’s
standard deviation?

a. 8.1%
b. 10.5%
c. 13.4%
d. 16.5%
e. 20.0%

Chapter 5 - Page 38
Coefficient of variation Answer: e Diff: M N
106. The CFO of Brady Boots has estimated the rates of return to Brady’s stock,
depending on the state of the economy. He has also compiled analysts’
expectations for the economy.

Economy Probability Return

Recession 0.1 -23%
Below average 0.1 -8
Average 0.4 6
Above average 0.2 17
Boom 0.2 24

Given this data, what is the company’s coefficient of variation? (Use the
population standard deviation, not the sample standard deviation when
calculating the coefficient of variation.)

a. 1.94
b. 25.39
c. 2.26
d. 5.31
e. 1.84

Coefficient of variation Answer: b Diff: M

107. Ripken Iron Works faces the following probability distribution:

Stock’s Expected
State of Probability of Return if this
the Economy State Occurring State Occurs
Boom 0.25 25%
Normal 0.50 15
Recession 0.25 5

What is the coefficient of variation on the company’s stock?

a. 0.06
b. 0.47
c. 0.54
d. 0.67
e. 0.71

Chapter 5 - Page 39
Coefficient of variation Answer: c Diff: M
108. An analyst has estimated how a particular stock’s return will vary depending
on what will happen to the economy:

Stock’s Expected
State of Probability of Return if this
the Economy State Occurring State Occurs
Recession 0.10 -60%
Below Average 0.20 -10
Average 0.40 15
Above Average 0.20 40
Boom 0.10 90

What is the coefficient of variation on the company’s stock?

a. 2.121
b. 2.201
c. 2.472
d. 3.334
e. 3.727

Coefficient of variation Answer: c Diff: M

109. The following probability distributions of returns for two stocks have been
estimated:

Returns
Probability Stock A Stock B
0.3 12% 5%
0.4 8 4
0.3 6 3

What is the coefficient of variation for the stock that is less risky,
assuming you use the coefficient of variation to rank riskiness?

a. 3.62
b. 0.28
c. 0.19
d. 0.66
e. 5.16

Chapter 5 - Page 40
Coefficient of variation Answer: d Diff: M
110. A financial analyst is forecasting the expected return for the stock of
Himalayan Motors. The analyst estimates the following probability
distribution of returns:

Probability Return
20% -5%
40 10
20 20
10 25
10 50

On the basis of this analyst’s forecast, what is the stock’s coefficient

of variation?

a. 0.80
b. 0.91
c. 0.96
d. 1.04
e. 1.10

Coefficient of variation Answer: b Diff: M

111. A stock market analyst estimates that there is a 25 percent chance the
economy will be weak, a 50 percent chance the economy will be average, and
a 25 percent chance the economy will be strong. The analyst estimates that
Hartley Industries’ stock will have a 5 percent return if the economy is
weak, a 15 percent return if the economy is average, and a 30 percent return
if the economy is strong. On the basis of this estimate, what is the
coefficient of variation for Hartley Industries’ stock?

a. 0.61644
b. 0.54934
c. 0.75498
d. 3.62306
e. 0.63432

Coefficient of variation Answer: b Diff: M

112. An analyst has estimated Williamsport Equipment’s returns under the
following economic states:

Economic State Probability Expected Return

Recession 0.20 -24%
Below average 0.30 -3
Above average 0.30 +15
Boom 0.20 +50

What is Williamsport’s estimated coefficient of variation?

a. 0.36
b. 2.80
c. 2.86
d. 2.95

Chapter 5 - Page 41
 e. 3.30
Coefficient of variation Answer: e Diff: M
113. Stock Z has had the following returns over the past five years:

Year Return
1998 10%
1999 12
2000 27
2001 -15
2002 30

What is the company’s coefficient of variation (CV)? (Use the population

standard deviation to calculate CV.)

a. 99.91
b. 35.76
c. 9.88
d. 2.79
e. 1.25

Beta coefficient Answer: a Diff: M

114. An investor has $5,000 invested in a stock that has an estimated beta of
1.2, and another $15,000 invested in the stock of the company for which
she works. The risk-free rate is 6 percent and the market risk premium
is also 6 percent. The investor calculates that the required rate of
return on her total ($20,000) portfolio is 15 percent. What is the beta
of the company for which she works?

a. 1.6
b. 1.7
c. 1.8
d. 1.9
e. 2.0

Beta coefficient Answer: e Diff: M

115. Portfolio P has 30 percent invested in Stock X and 70 percent in Stock Y.
The risk-free rate of interest is 6 percent and the market risk premium is
5 percent. Portfolio P has a required return of 12 percent and
Stock X has a beta of 0.75. What is the beta of Stock Y?

a. 0.21
b. 1.20
c. 0.96
d. 1.65
e. 1.39

Chapter 5 - Page 42
CAPM and beta coefficient Answer: d Diff: M
116. A money manager is managing the account of a large investor. The investor
holds the following stocks:
Stock Amount Invested Estimated Beta
A $2,000,000 0.80
B 5,000,000 1.10
C 3,000,000 1.40
D 5,000,000 ????

The portfolio’s required rate of return is 17 percent. The risk-free

rate, kRF, is 7 percent and the return on the market, kM, is 14 percent.
What is Stock D’s estimated beta?

a. 1.256
b. 1.389
c. 1.429
d. 2.026
e. 2.154
Market return Answer: d Diff: M
117. The returns of United Railroad Inc. (URI) are listed below, along with
the returns on “the market”:

Year URI Market

1 -14% -9%
2 16 11
3 22 15
4 7 5
5 -2 -1

If the risk-free rate is 9 percent and the required return on URI’s stock
is 15 percent, what is the required return on the market? Assume the
market is in equilibrium. (Hint: Think rise over run.)

a. 4%
b. 9%
c. 10%
d. 13%
e. 16%

Chapter 5 - Page 43
Tough:
Portfolio required return Answer: a Diff: T
118. A money manager is holding the following portfolio:

Stock Amount Invested Beta

1 $300,000 0.6
2 300,000 1.0
3 500,000 1.4
4 500,000 1.8

The risk-free rate is 6 percent and the portfolio’s required rate of

return is 12.5 percent. The manager would like to sell all of her holdings
of Stock 1 and use the proceeds to purchase more shares of Stock 4. What
would be the portfolio’s required rate of return following this change?

a. 13.63%
b. 10.29%
c. 11.05%
d. 12.52%
e. 14.33%

Multiple Part:
(The following information applies to the next two problems.)

A portfolio manager has a $10 million portfolio, which consists of $1 million

invested in 10 separate stocks. The portfolio beta is 1.2. The risk-free rate
is 5 percent and the market risk premium is 6 percent.

CAPM and portfolio return Answer: d Diff: E N

119. What is the portfolio’s required return?

a. 6.20%
b. 9.85%
c. 12.00%
d. 12.20%
e. 12.35%

CAPM and portfolio return Answer: c Diff: M N

120. The manager sells one of the stocks in her portfolio for $1 million. The
stock she sold has a beta of 0.9. She takes the $1 million and uses the
money to purchase a new stock that has a beta of 1.6. What is the required
return of her portfolio after purchasing this new stock?

a. 10.75%
b. 12.35%
c. 12.62%
d. 13.35%
e. 14.60%

Chapter 5 - Page 44
 Web Appendix 5A
Multiple Choice: Conceptual

Medium:
Beta calculation Answer: b Diff: M
5A-1. Which of the following statements is most correct?

a. The CAPM is an ex ante model, which means that all of the variables
should be historical values that can reasonably be projected into
the future.
b. The beta coefficient used in the SML equation should reflect the
expected volatility of a given stock’s return versus the return on
the market during some future period.
c. The general equation: Y = a + bX + e, is the standard form of a
simple linear regression where b = beta, and X equals the independent
return on an individual security being compared to Y, the return on
the market, which is the dependent variable.
d. The rise-over-run method is not a legitimate method of estimating
beta because it measures changes in an individual security’s return
regressed against time.

Multiple Choice: Problems

Easy:
Beta calculation Answer: c Diff: E
5A-2. Given the following returns on Stock J and “the market” during the last
three years, what is the beta coefficient of Stock J? (Hint: Think
rise over run.)

Year Stock J Market

1 -13.85% -8.63%
2 22.90 12.37
3 35.15 19.37

a. 0.92
b. 1.10
c. 1.75
d. 2.24
e. 1.45

Chapter 5 - Page 45
Medium:
Beta and base year sensitivity Answer: a Diff: M
5A-3. Given the following returns on Stock Q and “the market” during the last
three years, what is the difference in the calculated beta coefficient
of Stock Q when Year 1-Year 2 data are used as compared to Year 2-Year
3 data? (Hint: Think rise over run.)

Year Stock Q Market

1 6.30% 6.10%
2 -3.70 12.90
3 21.71 16.20

a. 9.17
b. 1.06
c. 6.23
d. 0.81
e. 0.56

Beta calculation Answer: b Diff: M

5A-4. Stock X, and “the market” have had the following rates of returns over
the past four years.

Year Stock X Market

1999 12% 14%
2000 5 2
2001 11 14
2002 -7 -3

60 percent of your portfolio is invested in Stock X, and the remaining

40 percent is invested in Stock Y. The risk-free rate is 6 percent and
the market risk premium is also 6 percent. You estimate that 14 percent
is the required rate of return on your portfolio. What is the beta of
Stock Y?

a. 1.33
b. 1.91
c. 2.00
d. 2.15
e. 2.33

Chapter 5 - Page 46
Beta calculation Answer: c Diff: E
5A-5. Hanratty Inc.’s stock and the stock market have generated the following
returns over the past five years:
Year Hanratty Market (kM)
1 13% 9%
2 18 15
3 -5 -2
4 23 19
5 6 12

On the basis of these historical returns, what is the estimated beta of

Hanratty Inc.’s stock?

a. 0.7839
b. 0.9988
c. 1.2757
d. 1.3452
e. 1.5000

Beta calculation Answer: a Diff: E

5A-6. Below are the returns for the past five years for Stock S and for the
overall market:

Year Stock S Market (kM)

1998 12% 8%
1999 34 28
2000 -29 -20
2001 -11 -4
2002 45 30

What is Stock S’s estimated beta?

a. 1.43
b. 0.69
c. 0.91
d. 1.10
e. 1.50

Chapter 5 - Page 47
Multiple Part:

(The following information applies to the next two problems.)

You have been asked to use a CAPM analysis to choose between Stocks R and S, with
your choice being the one whose expected rate of return exceeds its required rate
of return by the widest margin. The risk-free rate is 6 percent, and the required
return on an average stock (or “the market”) is 10 percent. Your security analyst
tells you that Stock S’s expected rate of return, k̂ , is equal to 11 percent,
while Stock R’s expected rate of return, k̂ , is equal to 12 percent. The CAPM
is assumed to be a valid method for selecting stocks, but the expected return
for any given investor (such as you) can differ from the required rate of return
for a given stock. The following past rates of return are to be used to calculate
the two stocks’ beta coefficients, which are then to be used to determine the
stocks’ required rates of return:

Year Stock R Stock S Market

1 -15% 0% -5%
2 5 5 5
3 25 10 15

Note: The averages of the historical returns are not needed, and they are
generally not equal to the expected future returns.

Beta calculation Answer: c Diff: M

5A-7. Calculate both stocks’ betas. What is the difference between the betas?
That is, what is the value of betaR - betaS? (Hint: The graphical method of
calculating the rise over run, or (Y2 – Y1) divided by (X2 – X1) may aid you.)

a. 0.0
b. 1.0
c. 1.5
d. 2.0
e. 2.5

Required rate of return Answer: e Diff: M

5A-8. Set up the SML equation and use it to calculate both stocks’ required
rates of return, and compare those required returns with the expected
returns given above. You should invest in the stock whose expected
return exceeds its required return by the widest margin. What is the
widest margin, or greatest excess return ( k - k)?

a. 0.0%
b. 0.5%
c. 1.0%
d. 2.0%
e. 3.0%

Chapter 5 - Page 48
 CHAPTER 5
ANSWERS AND SOLUTIONS

1. Risk concepts Answer: e Diff: E

2. Risk measures Answer: a Diff: E

Statement a is correct, since the coefficient of variation is equal to the

standard deviation divided by the mean. The remaining statements are false.

3. Market risk premium Answer: c Diff: E

CAPM equation: ks = kRF + (kM - kRF)b

If the market risk premium (measured by kM - kRF) goes up by 1.0, then the
required return for each stock will change by its beta times 1.0.
Therefore, a stock with a beta of 0.5 will see its required return go up
by 0.5 percentage point. Therefore, statement a is false. As just shown
in statement a, a stock with a beta of 0.5 will see its required return
increase by 0.5 percentage point. All stocks with positive betas will
see their required returns increase. Therefore, statement b is false.
If the market risk premium increases by 1 percentage point, then the
required return increases by 1.0 times the stock’s beta. Therefore, the
required return of a stock with a beta coefficient equal to 1.0 will
increase by 1 percentage point, and statement c is correct.

4. Standard deviation Answer: b Diff: E

5. Beta coefficient Answer: d Diff: E

6. Beta coefficient Answer: c Diff: E

Statement a is false; Y has a higher required return because it is more

risky, but it may still end up actually earning a lower return than X.
Statement b is false; beta tells us about the covariance of the stock with
the market. It tells us nothing about the stocks’ individual standard
deviations. Statement c is correct from the CAPM: ks = kRF + (kM – kRF)b.
Statement d is false from the CAPM. Statement e is false; the portfolio
beta, bp, is calculated as (0.5  0.5) + (0.5  1.5) = 1.0.

7. Required return Answer: b Diff: E

The easiest way to see this is to write out the CAPM: ks = kRF + (kM – kRF)b.
Clearly, a change in the market risk premium is going to have the most effect
on firms with high betas. Consequently, statement b is the correct choice.

8. Risk and return Answer: a Diff: E N

The correct answer is statement a. Stocks are riskier than bonds, with
stocks in small companies being riskier than stocks in larger companies.

Chapter 5 - Page 49
 From there, corporate bonds are riskier than government bonds, and longer-
term government bonds are riskier than shorter-term ones.
9. Portfolio risk Answer: b Diff: E

The standard deviation of the portfolio will be less than the weighted
average of the two stocks’ standard deviations because the correlation
coefficient is less than one. Therefore, although the expected return on
the portfolio will be the weighted average of the two returns (10
percent), the CV will not be equal to 25%/10%. Therefore, statement a is
false. Remember, market risk is measured by beta. The beta of the
portfolio will be the weighted average of the two betas; therefore, it
will be less than the beta of the high-beta stock (B), but more than the
beta of the low-beta stock (A). Therefore, the market risk of the
portfolio will be higher than A’s, but lower than B’s. Therefore,
statement b is correct. Because the correlation between the two stocks
is less than one, the portfolio’s standard deviation will be less than 25
percent. Therefore, statement c is false.

10. Portfolio risk, return, and beta Answer: e Diff: E

The trick here is to notice the word always in each of the answers. If
you can find even one exception to the statement, then the statement will
not “always” be true.

The exception to statement a is if the correlation coefficient, r, = 1.0.

While this is unlikely to ever happen, theoretically it is still possible.
Therefore, there is an exception, so we cannot necessarily say always.
Therefore, statement a is false. Beta has nothing to do with the number of
stocks in a portfolio. You can take a stock with a beta of 0.4, and a stock
with a beta of 1.6, and combine them (with equal weights) in a portfolio.
The portfolio beta will now be 1.0, which is higher than a portfolio of just
the first stock. Therefore, statement b is false. Statement c is false
for the same reason that statement b is false. Consequently, the correct
choice is statement e.

11. Portfolio risk and return Answer: a Diff: E

Statements b and c are false. Randomly adding more stocks will have no
effect on the portfolio’s beta or expected return.

12. Portfolio risk and return Answer: e Diff: E

13. Portfolio risk and return Answer: a Diff: E

The portfolio will have an expected return equal to the weighted average of
the individual stock returns. The portfolio’s beta will also be equal to
the weighted average of the individual stock betas. The standard deviation
of the portfolio will be less than 30 percent, because the stocks have a
correlation coefficient of less than one. Therefore, the portfolio’s beta
will equal 1.6, its standard deviation is less than 30 percent, and its
expected return is 15 percent. The correct answer must be statement a.

Chapter 5 - Page 50
14. Portfolio risk and return Answer: b Diff: E

Since we are randomly adding stocks, eventually your portfolio will have
the same expected return as the market, on average. Therefore, unless we
are told that the current expected return is higher than the market average,
we have no reason to believe that the expected return will decline.
Therefore, statement a is false. If we randomly add stocks to the portfolio,
the company-specific risk will decline because the standard deviation of
the portfolio will be declining. However, the market risk (as measured by
beta) will tend to remain the same, for the same reason that in statement a
the expected return was unlikely to change. Therefore, statement b is
correct. As in statement a, we know there is no reason to believe that the
market risk of the portfolio (as measured by beta) will decline. Therefore,
statement c is false. Neither the market risk nor the expected return on
the portfolio are expected to decline (see above), so statement d is false.
The company-specific risk (as measured by the standard deviation of the
portfolio) will decline and market risk is not expected to change.
Therefore, statement e is false.
15. Portfolio risk and return Answer: b Diff: E

Statement a is false. Since the correlation coefficient is less than one,

there is a benefit from diversification so the portfolio’s standard
deviation is less than 20 percent. Statement b is correct. The beta of
the portfolio is the weighted average of the two betas. So the portfolio’s
beta is calculated as: 0.5  0.7 + 0.5  1.3 = 1.0. Since the beta of the
portfolio is equal to 1.0 and the beta of the market is equal to 1.0, the
portfolio must have the same return as the market. Statement c is false.
The required return would be equal to: kp = kRF + (kM - kRF)bp.
16. Portfolio risk and return Answer: e Diff: E

A portfolio of randomly-selected stocks should, on average, have a beta of

1.0. Therefore, both portfolios should have the same required return.
Therefore, statement a is false. Beta is the measure of market risk, while
standard deviation is the measure of diversifiable risk. Since both portfolios
have the same beta, they will have the same market risk. Since Jane has more
stocks in her portfolio, she is more diversified and will have less company-
specific risk than Dick. Therefore, statement b is false. Jane has more
stocks in her portfolio, so she is more diversified and will have less
company-specific risk than Dick. Therefore, statement c is false. Since
statements a, b, and c are false, the correct choice is statement e.
17. Portfolio risk and return Answer: d Diff: E

Remember, for portfolios you can take averages of betas and returns, but not
standard deviations. So, the portfolio will have a return of 12 percent
(because both stocks have returns of 12 percent) and a beta of 1.2 (both
stocks have betas of 1.2). However, since the correlation coefficient is
less than 1.0, the portfolio’s standard deviation will be less than the
average of the two stocks’ standard deviations. (That is, the portfolio’s
standard deviation will be less than 25 percent.) So, statements a and c are
correct; therefore, the correct choice is statement d.
Chapter 5 - Page 51
18. Portfolio risk and return Answer: e Diff: E

Remember, you can always find the portfolio required return by finding
the weighted average return of the stocks in the portfolio. You can
always find the portfolio beta by finding the weighted average beta of
the stocks in the portfolio. You cannot find the standard deviation by
finding the weighted average standard deviation of the stocks in the
portfolio, unless r = 1.0. The portfolio standard deviation is not a
weighted average of the individual stocks’ standard deviations. How-
ever, since the 2 correlation coefficients are less than 1, we know the
portfolio’s standard deviation will be less than 25 percent. Since
statements a and c are correct, the correct choice is statement e.

19. Portfolio risk and return Answer: a Diff: E

Statement a is true; the others are false. Since both stocks’ betas are
equal to 1.2, the portfolio beta will equal 1.2. Because the stocks’
correlation coefficient is less than one, the portfolio’s standard
deviation will be lower than 20 percent.

20. Portfolio risk and return Answer: d Diff: E N

The correct answer is statement d. Statement a is correct; Stock C has a

higher beta than Portfolio P. Statement b is correct; the stocks are less
than perfectly correlated (r  1), hence the portfolio standard deviation
must be less than 25%. Statement c is incorrect; the expected returns of
Portfolio P are greater than the expected returns of Stock A, but the
realized returns cannot be known ex ante. Therefore statement d is the
correct choice.

21. CAPM Answer: b Diff: E

The CAPM is written as: ks = kRF + (kM – kRF)b. Statement a is false based
on the CAPM equation. Statement b is correct on the basis of the CAPM
equation. Statement c is false; the required returns will increase by
the same amount.

22. CAPM and required return Answer: c Diff: E

You need to think about the CAPM to answer this question: ks = kRF + (kM – kRF)b.
From the statement in the question kRF and (kM – kRF) have both declined.
Statement a is false; the average required return on the market must have
declined too. Statement b is false; the size of the decline depends on the
beta of the stock. Statement c is correct. Statement d is false. This must
be, if statement c is correct. Statement e is false because the required
returns will have fallen for all stocks.

Chapter 5 - Page 52
23. CAPM and required return Answer: c Diff: E N

The correct answer is statement c. Here, the required rate is ks = 5% + b  RPM.

If a stock’s beta doubles, b becomes 2b. So, ks = 5% + 2b  RPM. But doubling
its required return would require the equation to be 2(5% + b  RPM) = 10% +
2b  RPM. So, statement a is incorrect. Statement b would be correct only
if the beta coefficient were negative. Therefore, statement b is incorrect.
Statement c is correct. If b < 0 and RPM > 0, then (b  RPM) < 0. So, ks < 5%.

24. CAPM and required return Answer: e Diff: E N

The correct answer is statement e. Since Stock X is riskier, its required

return should be higher, so statement a is incorrect. Since the betas of
Stock A and Stock B are different, statement b will be incorrect in most
circumstances. Although some situations exist where this holds, in
general, it will not be true. So, statement b is not always correct.
Statement c is always incorrect. The required return for both stocks will
decline. So, statement e is the correct choice.

25. CAPM and required return Answer: b Diff: E N

The correct answer is statement b. Remember, the market risk premium is

the slope of the Security Market Line. This means high-beta stocks
experience greater increases in their required returns, while low-beta
stocks experience smaller increases in their required returns. Statement
a is incorrect. Statement b is correct; stocks with a beta less than 1
increase by less than the increase in the market risk premium, and vice
versa. Statement c is incorrect; since the market risk premium is changing,
required returns must change too. Statements d and e are incorrect for
the same reason that statement c is incorrect.

26. CAPM, beta, and required return Answer: c Diff: E

kRF = 6%; RPM = 5%; CAPM equation: ks = kRF + (kM - kRF)b.

Statement a is false. Just because a stock has a negative beta does not
mean its return is also negative. For example, if its beta were -0.5,
its return would be as follows:
k = kRF + RPM(b)
= 6% + 5%(-0.5)
= 6% + (-2.5%)
= 3.5%.

Statement b is also false. If the beta doubles, the second term in the CAPM
equation above will double; however, kRF will not double, so the overall
return will not double. Statement c is correct. If b = 1.0, then:
k = kRF + RPM(b)
= 6% + 5%(1.0)
= 11%.

27. SML Answer: a Diff: E

Chapter 5 - Page 53
 The slope of the SML is determined by the size of the market risk premium,
kM - kRF, which depends on investor risk aversion.

28. SML Answer: b Diff: E

Statement b is correct. Statement a is false, since the slope of the SML

is kM – kRF. Statement c is false, since ks = kRF + (kM – kRF)b. The
remaining statements are false.

29. SML Answer: c Diff: E

Statement c is correct; the others are false. Stock A will have a higher
required rate of return than B because A has the higher beta.
The standard deviation of a portfolio is not the average of the standard
deviations of the component stocks. The portfolio beta is a weighted
average of the component stocks’ betas; therefore, bp = 1.0.

30. SML Answer: e Diff: E

The CAPM states ks = kRF + (kM - kRF)b. Working through each statement, it
is apparent that none of the statements is consistent with the formula.
Therefore, statement e is the best choice.

31. SML Answer: c Diff: E

Stock Y will have a higher expected return than Stock X does (because its
beta is higher), but we are told nothing about its standard deviation.
Remember, beta has nothing to do with standard deviation. Therefore,
statement a is false. The expected return of a portfolio of $50,000 in each
stock will have a required return that is the weighted average of the returns
on both stocks. Since each one has a weight of ½, it will be a simple
average. The portfolio’s beta will be the average of the two betas ((0.6 +
1.4)/2 = 1.0). The portfolio has the same beta that the market portfolio
does and, therefore, the same required return that the market has. Therefore,
statement b is false. If the market risk premium decreases, the slope of
the SML will decrease. Therefore, the required returns of stocks with
higher betas will decrease more. Therefore, Stock Y’s required return will
fall by more than Stock X’s. Therefore, statement c is correct. If the
expected inflation increases, the SML will have a parallel shift up, and
the required returns on all stocks will increase by the same amount, not
decrease. Therefore, statement d is false. If expected inflation decreases,
the SML will have a parallel shift down, and the required returns on all
stocks will decrease by the same amount. Therefore, statement e is false.

32. SML Answer: b Diff: E

Remember, the market risk premium is the slope of the line in the SML
Chapter 5 - Page 54
 diagram. The line is anchored at the y-axis, and when the market risk
premium changes, the line “rotates” around that point. Also remember the
SML equation is ks = kRF + (kM - kRF)b. Statement a is implying a “parallel
shift” of the line, and that is incorrect. A review of the equation shows
that, because beta is multiplied by the market risk premium, changes in the
market risk premium will affect stocks with different betas differently.
Statement b is correct. The slope of the line will increase, so required
returns on stocks with betas closer to 0 will increase by less than returns
on stocks with higher betas. A review of the equation shows that if the
beta were higher, a change in the market risk premium would have more effect
on ks than if the beta were lower. Statement c is false because it is the
reverse of statement b, which we have already stated is true. Statement d
is false because an increase in the market risk premium will increase the
required return on all stocks with positive betas. Statement e is false.
The portfolio beta is the weighted average of the individual stocks’ betas.
In this case, the portfolio beta will be 1.0. It is clear from the SML
equation that a portfolio with a beta of 1.0 will be affected by changes in
the market risk premium.

33. SML Answer: e Diff: E

If the market risk premium (kM - kRF) increases, the required return on
all stocks with positive betas would increase. Therefore, statement a is
false. Since the required return for all positive beta stocks will
increase, the return for Portfolio P must increase as well. Therefore,
statement b is false. The required return on Stock A will increase by
0.7 percent, and the required return on Stock B will increase by 1.3
percent. Therefore, statement c is false. Statement d is the opposite of
what would actually happen, so statement d is false. The beta for
Portfolio P is 1.0[(50%  0.7) + (50%  1.3)]. Therefore, the change in
the portfolio’s required return will be b  (kM - kRF) = 1.0  1% = 1%.
Therefore, statement e is correct.

34. SML Answer: b Diff: E N

The correct answer is statement b. If the risk premium declines, then

the slope of the SML declines.
Chapter 5 - Page 55
 k
A

1.0 beta

At first, the line could be drawn at A. Then when the risk premium
declines, it will look more like B. Statements a and c are incorrect.
The required return on all stocks will fall. Therefore, statement b is
correct.

35. SML, CAPM, and beta Answer: e Diff: E

Statement e is correct; the others are false. The market risk premium is
the slope of the SML. If a stock has a negative beta, this does not mean
its required return is negative. A doubling of a stock’s beta doesn’t
mean that its required return will double. The required return is a
function of kRF, kM, and beta. The required return is affected by the
market risk premium.

36. Risk analysis and portfolio diversification Answer: d Diff: E

A security’s beta does indeed measure market risk relative to that of an

average stock. Diversification reduces the variability of the port-
folio’s return. An investor, through diversification, can eliminate
company-specific risk; however, a portfolio containing all publicly-
traded stocks would still be exposed to market risk. The CAPM specifies
a stock’s required return as: ks = kRF + (kM - kRF)b. Thus, the risk-free
rate and the market risk premium are needed along with a stock’s beta to
determine its required return. A stock’s beta is more relevant as a
measure of risk to an investor with a well-diversified portfolio than to
an investor who holds only that one stock.

37. Miscellaneous risk concepts Answer: c Diff: E N

The correct answer is statement c. Statement a is incorrect. Since the

correlation is not 1.00, the standard deviation of the portfolio is less

Chapter 5 - Page 56
 than 20%. For the same reason, Statement d is also incorrect. Since
Portfolio P’s standard deviation is less than 20%, its CV (/ X ) is less
than 2.0. So, statement b is incorrect. And, statement e is incorrect
since Portfolio P’s required return equals that of Stock A. Portfolio Q’s
required return = (10% + 10% + 12%)/3 = 10.67%. So, statement c is the
correct choice.

38. Risk aversion Answer: b Diff: M

39. SML and risk aversion Answer: e Diff: M

40. Portfolio risk and return Answer: c Diff: M

41. Portfolio risk and return Answer: d Diff: M N

The correct answer is statement d. Statement a is correct; the expected

return of a portfolio is a weighted average of the returns of each of the
component stocks. Hence, kP = wAkA + wBkB = 0.5(10%) + 0.5(12%) = 11%.
Statement b is also correct; since the correlation coefficient is zero, the
standard deviation of the portfolio must be less than the weighted average
of the standard deviations of each of the component stocks. Statement c is
incorrect; Stock B’s beta can be calculated using: kB = kRF + (kM – kRF)b.
12% = 5% + (6%)b. Therefore, Stock B’s beta is 1.16. So statement d is
the correct choice.

42. Portfolio risk and return Answer: d Diff: M N

The correct answer is statement d. If the same amount were invested in Stocks
A and B, the portfolio beta would be (1/2)  1.2 + (1/2)  1.4 = 1.30. This
is not the beta of the portfolio, so statement a is incorrect. Since the
standard deviation of the portfolio is less than the standard deviation of
both Stock A and Stock B, they cannot be perfectly correlated. If they were,
the standard deviation of the portfolio would be between 20% and 25%,
inclusive. So, statement b is incorrect. Since the beta of Stock B is higher
than that of Stock A, Stock B has more market risk; so, statement c is
incorrect. Since the beta of the portfolio is higher than the beta of Stock
A, the portfolio has a higher required return than Stock A; therefore,
statement d is true. Statement e is incorrect; since the beta of Stock A is
less than the beta of the portfolio, Stock A has less market risk than the
portfolio.

43. Portfolio risk Answer: e Diff: M

44. Portfolio risk and beta Answer: c Diff: M

45. Portfolio risk and beta Answer: e Diff: M

46. Market risk Answer: b Diff: M

47. Beta coefficient Answer: a Diff: M

48. Beta coefficient Answer: d Diff: M

Chapter 5 - Page 57
49. Beta coefficient Answer: a Diff: M

50. Beta coefficient Answer: c Diff: M

51. Beta coefficient Answer: d Diff: M N

The correct answer is statement d. Except for Florida Power & Light (FP&L),
the remaining four companies and betas are all in line with the nature of
the firms and their industries. However, FP&L (a utility company) is out
of place. Its indicated beta of 1.52 puts it in the same league as technology
frontrunners Sun Microsystems and Amazon.com. A more reasonable beta
estimate for FP&L would be somewhere between 0.50 and 0.70.

52. SML Answer: e Diff: M

53. SML Answer: a Diff: M

54. SML Answer: b Diff: M

55. SML Answer: b Diff: M N

The correct answer is statement b. A simple example helps here. Assume

kRF is originally 5%. And the RPM is 3%. Then, ks = 5% + (3%)b. Recall
that the market has a beta of 1.0. So, the market requires a return of
8%. Let kRF now be 6%, and the RPM fall to 2%. The market still has a
required return of 8%.

Statement a is incorrect; for any beta between zero and one, you can see
that the new required return is higher. For example, a stock with a beta
of 0.5 had an original required return of 6.5%, but now has a required
return of 7%. Just the opposite happens for stocks with a beta greater
than one. Statement b is correct, for just the opposite reason. For
example, a stock with a beta of 2.0 originally had a required return =
5% + (3%)2.0 = 11%, but now has a required return of 6% + (2%)2.0 = 10%.
It has fallen. A beta between zero and one will yield just the opposite
result. From the explanations above, both statements c and d are clearly
incorrect. For some stocks, the required return will rise; for others,
the required return will fall.

56. SML, CAPM, and portfolio risk Answer: a Diff: M

An increase in expected inflation would lead to an increase in k RF, the

intercept of the SML. If risk aversion were unchanged, then the slope of
the SML would remain constant. Therefore, there would be a parallel
upward shift in the SML, which would result in an increase in kM that is
equal to the expected increase in inflation.

57. Portfolio return, CAPM, and beta Answer: e Diff: M

Statement e is correct because none of the statements are correct. Statement

a is false because if the returns of 2 stocks were perfectly positively
Chapter 5 - Page 58
 correlated the portfolio’s variance would equal the variance of each of the
stocks. Statement b is false. A stock can have a negative beta and still
have a positive return because ks = kRF + (kM – kRF)b. Statement c is false.
According to the CAPM, stocks with higher betas have higher expected returns.
Betas are a measure of market risk, while standard deviation is a measure
of stand-alone risk--but not a good measure. The coefficient of variation
is a better measure of stand-alone risk. The portfolio’s beta (the measure
of market risk) will be dependent on the beta of each of the randomly
selected stocks in the portfolio. However, the portfolio’s beta would
probably approach bM = 1, which would indicate higher market risk than a
stock with a beta equal to 0.5.

58. CAPM and required return Answer: d Diff: M

59. Risk analysis and portfolio diversification Answer: e Diff: M

60. Portfolio diversification Answer: c Diff: M

Statement c is correct; the others are false. Holding a portfolio of

stocks reduces company-specific risk. Diversification lowers risk;
consequently, it reduces the required rate of return. Beta measures
market risk, the lower the beta the lower the market risk.

61. Portfolio risk and SML Answer: e Diff: M

62. CAPM Answer: c Diff: T

63. SML Answer: d Diff: T

64. Required return Answer: d Diff: E N

ks = kRF + (kM - kRF)b

= 6% + (12% - 6%)1.2
= 13.2%.

65. Required return Answer: b Diff: E N

Step 1: We must determine the market risk premium using the CAPM equation
with data inputs for Stock A:
kA = kRF + (kM – kRF)bA
11% = 5% + (kM – kRF)1.0
6% = (kM – kRF).

Step 2: We can now find the required return of Stock B using the CAPM
equation with data inputs for Stock B:
kB = kRF + (kM – kRF)bB
kB = 5% + (6%)1.4
kB = 13.4%.

66. CAPM and required return Answer: d Diff: E

kRF = k* + IP = 3% + 5% = 8%.
ks = 8% + (5%)2.0 = 18%.
Chapter 5 - Page 59
67. CAPM and market risk premium Answer: c Diff: E N

Using Stock A (or any stock),

10% = kRF + (kM – kRF)bA
10% = 5% + (kM – kRF)1.0
(kM – kRF) = 5%.

68. Market risk premium Answer: d Diff: E

12.25% = 5% + (RPM)1.15
7.25% = (RPM)1.15
RPM = 6.3043%  6.30%.

69. Beta coefficient Answer: b Diff: E

In equilibrium
kA = k A = 11.3%.
kA = kRF + (kM - kRF)b
11.3% = 5% + (10% - 5%)b
b = 1.26.
70. Beta coefficient Answer: a Diff: E

13.75% = 5% + (7%)b
8.75% = 7%b
b = 1.25.
71. Portfolio beta Answer: b Diff: E

1.2 = 1/20(0.7) + (19/20)b

b is average beta for other 19 stocks.
1.165 = (19/20)b.
New Beta = 1.165 + 1/20(1.4) = 1.235.
72. Portfolio return Answer: a Diff: E

The portfolio’s beta is a weighted average of the individual security

betas as follows:

($50,000/$75,000)1.5 + ($25,000/$75,000)0.9 = 1.3. The required rate of

return is then simply: 4% + (6% - 4%)1.3 = 6.6%.

73. Portfolio return Answer: b Diff: E

k p = 0.9(12%) + 0.1(20%) = 12.8%.

bp = 0.9(1.2) + 0.1(2.0) = 1.28.

74. Portfolio risk and return Answer: a Diff: E N

The correct answer is statement a. Remember, you can take the weighted
average of the beta, and the weighted average of the returns, but you can

Chapter 5 - Page 60
 only take the weighted average of the standard deviations if r = 1.0.

The total portfolio value will be $900,000 + $300,000 = $1,200,000.

Expected return:
$900,000 $300,000
 12% +  10% = 11.5%.
$1,200,000 $1,200,000

Beta:
$900,000 $300,000
 1.2 +  1.2 = 1.2.
$1,200,000 $1,200,000

 = [0.75(12% - 11.5%)2 + 0.25(10% - 11.5%)2]½

= [0.1875% + 0.56250%]½
= [0.75%]½
= 0.86603%.

75. Coefficient of variation Answer: b Diff: E

Using your financial calculator you find the mean to be 10.8% and the
population standard deviation to be 15.715%. The coefficient of variation
is just the standard deviation divided by the mean, or 15.715%/10.8% =
1.4551  1.46.

76. Expected return Answer: e Diff: M

k̂X = 0.10(-3%) + 0.10(2%) + 0.25(5%) + 0.25(8%) + 0.30(10%) = 6.15%.

k̂Y = 0.05(-3%) + 0.10(2%) + 0.30(5%) + 0.30(8%) + 0.25(10%) = 6.45%.

2X = 0.10(-3% - 6.15%)2 + 0.10(2% - 6.15%)2 + 0.25(5% - 6.15%)2

+ 0.25(8% - 6.15%)2 + 0.30(10% - 6.15%)2
X = 15.73%; X = 3.97%.
2

CVX = 3.97%/6.15% = 0.645.

2Y = 0.05(-3% - 6.45%)2 + 0.10(2% - 6.45%)2 + 0.30(5% - 6.45%)2

+ 0.30(8% - 6.45%)2 + 0.25(10% - 6.45%)2
Y = 10.95%; Y = 3.31%.
2

CVY = 3.31%/6.45% = 0.513.

Therefore, Asset Y has a higher expected return and lower coefficient of

variation and hence it would be preferred.

77. Expected return Answer: c Diff: M

k̂J = (0.2)(0.10) + (0.6)(0.15) + (0.2)(0.20) = 0.15 = 15.0%.

Expected return = 15.0%.
Chapter 5 - Page 61
 J2 = (0.2)(0.10 - 0.15)2 + 0.6(0.15 - 0.15)2 + (0.2)(0.20 - 0.15)2 = 0.001.
Standard deviation = 0.001 = 0.0316 = 3.16%.

78. Required return Answer: c Diff: M

Step 1: Solve for risk-free rate

15% = kRF + (10% - kRF)2.0
15% = kRF + 20% - 2kRF
kRF = 5%.

Step 2: Calculate new market return

kM increases by 30%, so kM = 1.3(10%) = 13%.

Step 3: Calculate new required return on stock

ks = 5% + (13% - 5%)2 = 21%.

Step 4: Calculate percentage change in return on stock

21% - 15%
= 40%.
15%

79. Required return Answer: c Diff: M

Before: ks = 15% = kRF + (5%)0.7; kRF = 15% - 3.5%; kRF = 11.5%.

New kRF = 11.5% + 2.0% = 13.5%.
New beta = 0.7  1.5 = 1.05.

After: New required rate of return:

ks = 13.5% + (5%)1.05 = 18.75%.

80. Required return Answer: e Diff: M

Step 1: Calculate the market risk premium (kM - kRF) using the
information for Partridge:
13%= 6% + (kM - kRF)1.4
kM - kRF= 5%.

Step 2: Now calculate the required return for Cleaver:

ks = 6% + (5%)0.8 = 10%.
81. Expected and required returns Answer: c Diff: M

Use the calculator’s regression function to find betaj. It is -0.6600.

Find kRF. Note that RPM = kM - kRF, so
4% = 12% - kRF
kRF = 8%.

Find kJ = 8% + 4%(-0.66) = 5.36%.

 = 8.00% - 5.36% = 2.64%.
82. Expected and required returns Answer: b Diff: M

By calculating the required returns on each of the securities and comparing

required and expected returns, we can identify which security is the best
Chapter 5 - Page 62
 investment alternative; that is, the security for which the expected return
exceeds the required return by the largest amount. The expected and required
returns and the differences between them are shown below:

Security Expected Return Required Return Expected-

Required
A 9.01% 7% + 2%(1.7) = 10.40% -1.39%
B 7.06% 7% + 2%(0.0) = 7.00% 0.06%
C 5.04% 7% + 2%(-0.67) = 5.66% -0.62%
D 8.74% 7% + 2%(0.87) = 8.74% 0.00%
E 11.50% 7% + 2%(2.50) = 12.00% -0.50%

Clearly, security B is the best alternative.

83. CAPM and required return Answer: e Diff: M

bHR = 2.0; bLR = 0.5. No changes occur.

kRF = 10%. Decreases by 3% to 7%.
kM = 15%. Falls to 11%.
Now SML: ki = kRF + (kM - kRF)bi.
kHR = 7% + (11% - 7%)2 = 7% + 4%(2) = 15%
kLR = 7% + (11% - 7%)0.5 = 7% + 4%(0.5) = 9
Difference 6%
84. CAPM and required return Answer: a Diff: M N

An index fund will have a beta of 1.0. If kM is 12 percent (given in the

problem) and the risk-free rate is 7 percent, you can calculate the market
risk premium (RPM).

ks = kRF + (RPM)b
12% = 7% + (RPM)1.0
5% = RPM.

Now, you can use the RPM, the kRF, and the two stock’s betas to calculate
their required returns.

Bradley:
ks = kRF + (RPM)b
= 7% + (5%)1.3
= 7% + 6.5%
= 13.5%.

Douglas:
ks = kRF + (RPM)b
= 7% + (5%)0.7
= 7% + 3.5%
= 10.5%.

The difference in their required returns is:

13.5% - 10.5% = 3.0%.
85. CAPM and required return Answer: d Diff: M

bX = 1.6; bY = 0.7; kRF = 7%; kM = 12%.

Chapter 5 - Page 63
 Inflation increases by 1%, but k* remains constant. kRF increases by 1%;
kM rises to 14%.

Before inflation change:

kX = 7% + 5%(1.6) = 15%.
kY = 7% + 5%(0.7) = 10.5%.

After inflation change:

kX = 8% + (14% - 8%)1.6 = 17.6%.
kY = 8% + (14% - 8%)0.7 = 12.2%.

kX - kY = 17.6% - 12.2% = 5.4%.

86. CAPM and required return Answer: e Diff: M

kA = 6% + (11% - 6%)bA.
Calculate bA as follows using a financial calculator:
6 Input 8 +
-8 Input 3 +
-8 Input -2 +
18 Input 12 +

0  y ,m
 swap bA = 0.4534.
kA = 6% + 5%(0.4534) = 8.2669%  8.27%

87. CAPM and required return Answer: a Diff: M

With your financial calculator input the following:

-2 Input 8 +
12 Input 3 +
-8 Input 18 +
21 Input -7 +

0  y ,m
 swap bC = -0.76.
kC = 8% + (14% - 8%)(-0.76) = 8% - 4.58% = 3.42%.

88. Portfolio return Answer: c Diff: M

Calculate bX and bY for the stocks using the regression function of a

calculator.

bX = 0.7358; bY = 1.3349.
kX = 7% + 5%(0.7358) = 10.679%.
kY = 7% + 5%(1.3349) = 13.6745%.
kp = 14/20(10.679%) + 6/20(13.6745%) = 11.58%.

89. Portfolio return Answer: b Diff: M

Chapter 5 - Page 64
 Statement b is correct; all the other statements are false. If the market
risk premium increases by 2 percent and kRF remains unchanged, then the
portfolio’s return will increase by 2%(1.08) = 2.16%. Statement a is false,
since kp = 6% + (5%)bp. The portfolio’s beta is calculated as 0.7(1.2) +
0.3(0.8) = 1.08. Therefore, kp = 6% + 5%(1.08) = 11.4%. Statement c is
false. If kRF increases by 2 percent, but RPM remains unchanged, the
portfolio’s return will increase by 2 percent. Statement d is false. Market
efficiency states that the expected return should equal the required return;
therefore, k̂p = kp = 11.4%.

90. Portfolio return Answer: c Diff: M

Find the initial portfolio’s beta and its required return. Then, find
the new beta and new required return. Then subtract the two.

Step 1: The portfolio beta is the weighted average beta of the stocks in the
portfolio. The total invested is $70 million ($10 + $20 + $40).
 $10   $20   $40 
bOld =   (1.4) +   (1.0) +   (0.8)
 $70   $70   $70 
bOld = 0.9429.

kOld = kRF + (kM – kRF)b

= 5% + (5.5%)(0.9429)
= 10.1857%.

Step 2: Now, change the weights. The amount of X owned is now $25
million ($10 + $15), the amount of Y owned is now $0 million,
and the amount of Z owned is $45 million ($40 + $5).
 $25   $0   $45 
bNew =   (1.4) +   (1.0) +   (0.8)
 $70   $70   $70 
bNew = 1.0143.

kNew = kRF + (kM – kRF)b

= 5% + (5.5%)(1.0143)
= 10.5786%.

Step 3: Now subtract the two returns:

10.5786% - 10.1857% = 0.3929%.

Chapter 5 - Page 65
91. Portfolio return Answer: b Diff: M N

Data given:
kRF = 5.5% Current portfolio = $10 million
RPM = 6% kp = 12%

Step 1: Calculate the portfolio’s current beta.

ks = kRF + (RPM)b
12% = 5.5% + (6%)b
1.0833 = b.

The portfolio beta is the weighted average of the betas of the individual
stocks in the portfolio. If you sell $3 million of a stock that has a
beta of 1.6, what will be the beta of the remaining stocks?

Step 2: Calculate the beta of the remaining stocks in the portfolio.

1.0833 = ($3/$10)(1.6) + ($7/$10)X
0.6033 = ($7/$10)X
0.8619 = X.

0.8619 is the beta of the $7 million of stocks that remain. Now what
happens to the portfolio beta when the new stock is added?

Step 3: Calculate the new portfolio’s beta.

b = ($7/$10)(0.8619) + ($3/$10)(0.7)
= 0.6033 + 0.21
= 0.8133.

Step 4: Calculate the new portfolio’s required return.

ks = kRF + (RPM)b
= 5.5% + (6%)0.8133
= 5.5% + 4.88%
= 10.38%.
92. Portfolio return Answer: a Diff: M N

The aggressive growth mutual fund has an expected return of:

kAGMF = 6% + (5%)1.6 = 14%.

The S&P 500 index fund has an expected return of:

kSP500 = 6% + 1.0(5%) = 11%.

So, to get the return she desires, Erika must solve for X, the percentage
of her portfolio invested in the S&P 500 index fund:

12.5% = 0.10(6%) + (0.90 – X)(14%) + X(11%)

11.9% = 12.6% - 14%X + 11%X
-0.7% = -3%X
0.2333 = X.

So invest 23.33% in the S&P 500 index fund, invest 66.67% in the aggressive
growth fund, and invest 10.00% in the risk-free asset. (Note that the
percentage totals must add up so that 100% of the funds are invested.)

93. CAPM and portfolio return Answer: d Diff: M

Chapter 5 - Page 66
 $100,000 $150,000 $50,000
bp = (0.8) + (1.2) + (1.8)
$300,000 $300,000 $300,000
bp = 1.1667.

Last year: k = 13%

13% = 7% + RPM(1.1667)
6% = RPM(1.1667)
RPM = 5.1429%.

This year:
k = 7% +(5.1429% + 2%)1.1667
k = 15.33%.

94. CAPM and portfolio return Answer: b Diff: M

Step 1: Determine the returns on each of the 3 assets:

kRF = 5%; kM - kRF = 6%.
kRF = 5%.

kIndex = kRF + (kM - kRF)b

= 5% + (6%)(1.0)
= 11%.

kInt'l = 5% + (6%)(1.5)
= 14%.

Step 2: Let X be the portion of the portfolio invested in the

international fund, and let (0.8 – X) be the portion invested in
the index fund:
11% = 0.2(kRF) + (X)(kInt'l) + (0.8 - X)(kIndex)
11% = 0.2(5%) + (14%)X + (0.8)(11%) - (11%)X
11% = 1% + 14%X + 8.8% – 11%X
11% - 1% - 8.8% = (14% - 11%)X
1.2% = 3%X
X = 0.4.
Therefore, 40 percent should be invested in the international fund.

95. CAPM and portfolio return Answer: c Diff: M

Chapter 5 - Page 67
 You are given the required return on the portfolio, the RP M, and enough
information to calculate the beta of the original portfolio. With this
information you can find kRF. Once you have kRF, you can find the required
return on Stock C.

Step 1: Find the portfolio beta:

Take a weighted average of the individual stocks’ betas to find the
portfolio beta. The total amount invested in the portfolio is:
$4 million + $2 million + $2 million + $1 million + $1 million
= $10 million.
The weighted average portfolio beta is:
 $4   $2   $2   $1   $1 
bp   (1.2)   (1.1)   (1.0)   (0.7)   (0.5)
 $10   $10   $10   $10   $10 
bp  1.02.

Step 2: Use the CAPM and the portfolio’s required return to calculate
kRF, the risk-free rate:
kp = kRF + RPM(bp)
11% = kRF + 5%(1.02)
5.9% = kRF.

Step 3: Use the CAPM to calculate the required return on Stock C:

kC = kRF + RPM(bC)
kC = 5.9% + 5%(1.0)
kC = 10.9%.

96. CAPM and portfolio return Answer: c Diff: M

Step 1: Determine the market risk premium from the CAPM:

0.14 = 0.06 + (kM - kRF)1.6
(kM - kRF) = 0.05.

Step 2: Calculate the beta of the new portfolio:

The beta of the new portfolio is ($200,000/$1,200,000)(0.6) +
($1,000,000/$1,200,000)(1.6) = 1.4333.

Step 3: Calculate the required return on the new portfolio:

The required return on the new portfolio is:
6% + (5%)(1.4333) = 13.16667%  13.17%.

97. CAPM and portfolio return Answer: c Diff: M

Step 1: Determine the beta of your portfolio:

9% = 5% + (11% - 5%)b
b = 0.66667.
Step 2: Determine the beta of your sister’s portfolio:
Sister’s beta = 0.66667  2 = 1.3333.

Step 3: Determine the required return of your sister’s portfolio:

5% + (11% - 5%)(1.3333) = 13%.
98. CAPM and portfolio return Answer: b Diff: M N

Chapter 5 - Page 68
 kA = 10%; bA = 1.0; bB = 2.0; kRF = 5%; kP = 12%; X = % of Stock B in
portfolio.

Step 1: Determine market risk premium, RPM.

kA = 0.05 + RPM(1.0)
0.10 = 0.05 + RPM(1.0)
RPM = 0.05.

Step 2: Calculate expected return of Stock B.

kB = 0.05 + 0.05(2.0) = 0.15.

Let X% of Portfolio P be in Stock B, so (1 - X)% is in Stock A. The

expected return of Portfolio P is the weighted average of the expected
returns of the two stocks.

0.12 = 0.15X + (1 - X)(0.10).

0.12 = 0.15X + 0.10 – 0.10X
0.02 = 0.05X
X = 0.40 = 40%.

99. Portfolio beta Answer: b Diff: M

Before: 1.15 = 0.95(bR) + 0.05(1.0)

0.95(bR) = 1.10
bR = 1.1579.

After: bp = 0.95(bR) + 0.05(2.0) = 1.10 + 0.10 = 1.20.

100. Portfolio beta Answer: c Diff: M

After additional investments are made, for the entire fund to have an
expected return of 13.5%, the portfolio must have a beta of 1.25 as shown
by 13.5% = 6% + (6%)b. Since the fund’s beta is a weighted average of
the betas of all the individual investments, we can calculate the required
beta on the additional investment as follows:

($200,000,000  1.2) ($50,000,000  X)

1.25 = +
$250,000,000 $250,000,000
1.25 = 0.96 + 0.2X
0.29 = 0.2X
X = 1.45.

101. Portfolio beta Answer: e Diff: M

Chapter 5 - Page 69
 Find the beta of the original portfolio (bOld) as 10.75% = 4% + (9% - 4%)bOld
or bOld = 1.35. To achieve an expected return of 11.5%, the new portfolio
must have a beta (bNew) of 11.5% = 4% + (9% - 4%) bNew or bNew = 1.5. To
construct a portfolio with a bNew = 1.5, the added stocks must have an average
beta (bAvg) such that:
1.5 = ($250,000/$750,000)bAvg + ($500,000/$750,000)1.35
1.5 = 0.333bAvg + 0.90
0.6 = 0.333bAvg
bAvg = 1.8.

102. Portfolio return and beta Answer: a Diff: M

Step 1: Calculate the beta of the original portfolio:

Right now, the total dollars invested in the portfolio is:
$300 + $200 + $500 = $1,000 million. The portfolio’s beta is:
b = 0.7($300/$1,000) + 1.0($200/$1,000) + 1.6($500/$1,000)
= 1.21.

Step 2: Calculate the market risk premium using the CAPM, given the
original beta calculated in Step 1:
kp = kRF + (kM - kRF)b
11.655% = 5% + (kM - kRF)1.21
6.655% = 1.21(kM - kRF)
5.5% = kM - kRF.

Step 3: Calculate the new portfolio’s beta:

Now, if she changes her portfolio and gets rid of Stock 3 (with
a beta of 1.6) and replaces it with Stock 4 (with a beta of 0.9),
the new portfolio’s beta will be:
b = 0.7($300/$1,000) + 1.0($200/$1,000) + 0.9($500/$1,000)
= 0.86.

Step 4: Calculate the new portfolio’s required return:

The required return will be:
kp = 5.0% + 5.5%(0.86)
kp = 9.73%.

103. Portfolio return and beta Answer: e Diff: M

Chapter 5 - Page 70
 You need to find the beta of the portfolio now and after the change. Then,
use the betas in the CAPM to find the two different returns.

Step 1: Determine the betas of the two portfolios:

The total amount invested in the portfolios is: $300 + $560 + $320
+ $230 = $1,410 million. (Note that the 2nd portfolio changes only
in the composition of the stocks, not the amount invested.)
bOld = ($300/$1,410)1.2 + ($560/$1,410)1.4 + ($320/$1,410)0.7 +
($230/$1,410)1.8
= 1.2638.

Now, create the new portfolio by selling $280 million of Stock 2

and reinvesting it in Stock 4. The new portfolio’s beta will be:
bNew = ($300/$1,410)1.2 + [($560 - $280)/$1,410]1.4 +
($320/$1,410)0.7 + [($230 + $280)/$1,410]1.8
= 1.3433.

Step 2: Determine the returns of the two portfolios:

kpOld = kRF + (kM - kRF)b
= 5% + (5%)1.2638
= 11.3190%.

kpNew = kRF + (kM - kRF)b

= 5% + (5%)1.3433
= 11.7165%.

The difference is: 11.7165% – 11.3190% = 0.3975%  0.40%.

104. Portfolio return and beta Answer: e Diff: M N

The total portfolio is worth $10,000,000 so the beta of the portfolio is:
(2/10)  0.6 + (3/10)  0.8 + (3/10)  1.2 + (2/10)  1.4 = 1.0.

kp = 10%; bp = 1. With this, we can determine the market risk premium (RPM):

10% = kRF + (RPM)bp

10% = 5% + (RPM)1.0
5% = RPM.

The manager wants an expected return kp = 12%. So, the manager needs a
portfolio with a beta of 1.4. To check this:

kp = kRF + (RPM)bp
= 5% + (5%)1.4 = 12%.

The manager has $2,000,000 to invest in a stock with a beta of X. With

this stock, the new portfolio beta is:

(2/10)X + (3/10)  0.8 + (3/10)  1.2 + (2/10)  1.4 = 1.4.

0.2X + 0.24 + 0.36 + 0.28 = 1.4
0.2X = 0.52
X = 2.60.
bX = 2.60.
105. Portfolio standard deviation Answer: a Diff: M

Chapter 5 - Page 71
 Fill in the columns for “XY” and “product,” and then use the formula to
calculate the standard deviation. We did each (k - k )2P calculation with
a calculator, stored the value, did the next calculation and added it to
the first one, and so forth. When all three calculations had been done,
we recalled the stored memory value, took its square root, and had XY =
8.1%.

Probability Portfolio XY Product

0.1 -5.0% -0.5%
0.8 17.5 14.0
0.1 30.0 3.0
k = 16.5%

XY = ((k - k )2P)½ = 8.07%  8.1%.

106. Coefficient of variation Answer: e Diff: M N

k̂ = (0.1)(-23%) + (0.1)(-8%) + (0.4)(6%) + (0.2)(17%) + (0.2)(24%)

= -2.3% + -0.8% + 2.4% + 3.4% + 4.8%
= 7.5%.

 = [0.1(-23% - 7.5%)2 + 0.1(-8% - 7.5%)2 + 0.4(6% - 7.5%)2 +

0.2(17% - 7.5%)2 + 0.2(24% - 7.5%)2]½
 = [93.025% + 24.025% + 0.9% + 18.05% + 54.45%]½
 = 13.80036%.

CV = / k̂
= 13.80036%/7.5%
= 1.84.

107. Coefficient of variation Answer: b Diff: M

The expected rate of return will equal 0.25(25%) + 0.5(15%) + 0.25(5%) = 15%.
The variance of the expected return is:
0.25(25% - 15%)2 + 0.5(15% -15%)2 + 0.25(5% - 15%)2 = 0.0050.
The standard deviation is the square root of 0.0050 = 0.0707.
And, CV = 0.0707/0.15 = 0.47.

108. Coefficient of variation Answer: c Diff: M

CV = Standard deviation/Expected return.

Expected return = 0.1(-60%) + 0.2(-10%) + 0.4(15%) + 0.2(40%) + 0.1(90%)

= 15%.

Standard
deviation = [0.1(-60% - 15%) + 0.2(-10% - 15%) + 0.4(15% -15%)
2 2 2

+ 0.2(40% - 15%)2 + 0.1(90% - 15%)2]1/2

= 37.081%.

CV = 37.081%/15% = 2.4721.
109. Coefficient of variation Answer: c Diff: M

Chapter 5 - Page 72
 Expected return for stock A is 0.3(12%) + 0.4(8%) + 0.3(6%) = 8.6%.
Expected return for stock B is 0.3(5%) + 0.4(4%) + 0.3(3%) = 4%.

Standard deviation for stock A is:

[0.3(12% - 8.6%)2 + 0.4(8% - 8.6%)2 + 0.3(6% - 8.6%)2]1/2 = 2.3749%.

Similarly, the standard deviation for stock B is 0.7746%.

CVA = 2.3749%/8.6% = 0.28.
CVB = 0.7746%/4% = 0.19.

110. Coefficient of variation Answer: d Diff: M

k̂ = 0.2(-5%) + 0.4(10%) + 0.2(20%) + 0.1(25%) + 0.1(50%)

= -1% + 4% + 4% + 2.5% + 5%
= 14.5%.

 = [0.2(-5% - 14.5%)2 + 0.4(10% - 14.5%)2 + 0.2(20% - 14.5%)2 + 0.1(25% - 14.5%)2 +

0.1(50% - 14.5%)2]1/2
 = (0.0076 + 0.0008 + 0.0006 + 0.0011 + 0.0126)1/2
 = 0.1507.

CV = / k̂
= 0.1507/0.145
= 1.039  1.04.

111. Coefficient of variation Answer: b Diff: M

Step 1: Calculate the mean for the data:

k̂ = 0.25(5%) + 0.50(15%) + 0.25(30%)
= 16.25%.

Step 2: Calculate the population standard deviation for the data:

 = [0.25(5% - 16.25%)2 + 0.5(15% - 16.25%)2 + 0.25(30% - 16.25%)2]1/2
= (0.003164 + 0.000078 + 0.004727)1/2
= (0.007969)1/2 = 0.089268 = 8.9268%.

The coefficient of variation is 8.9268%/16.25% = 0.54934.

112. Coefficient of variation Answer: b Diff: M

E(ROE) = (0.2  -24%) + (0.3  -3%) + (0.3  15%) + (0.2  50%)

E(ROE) = -4.8% - 0.9% + 4.5% + 10%
E(ROE) = 8.8%.

ROE = [0.2(-24% - 8.8%)2 + 0.3(-3% - 8.8%)2 + 0.3(15% - 8.8%)2 + 0.2(50% - 8.8%)2]1/2

ROE = [215.168% + 41.772% + 11.532% + 339.488%]1/2
ROE = [607.960%]1/2 = 24.6568%.

24.6568%
CV = = 2.80.
8.8%
113. Coefficient of variation Answer: e Diff: M

Chapter 5 - Page 73
 CV is equal to the standard deviation divided by the average return.

Step 1: Determine the population standard deviation using your

calculator:
10 +
12 +
27 +
15 +/- +
30 +
Then select  x,y to find 15.9925%.

Step 2: Determine the mean return using your calculator:

 x , y to find x = 12.8%.

Step 3: Determine the coefficient of variation:

CV = 15.9925%/12.8%
= 1.2494  1.25.

114. Beta coefficient Answer: a Diff: M

First find the portfolio’s beta:

15% = 6% + (6%)bp
9% = 6%bp
bp = 1.5.

Let bc be the beta of the company for which she works. The portfolio’s
beta is a weighted average of the individual betas of the stocks in the
portfolio.

Therefore, 1.5 = ($5,000/$20,000)1.2 + ($15,000/$20,000)bC.

1.5 = 0.3 + 0.75bC
1.2 = 0.75bC
bC = 1.6.

115. Beta coefficient Answer: e Diff: M

Chapter 5 - Page 74
 Step 1: Determine the portfolio’s beta:
The portfolio’s beta is the weighted average of the betas of the
individual stocks in the portfolio.
bp = 0.3(bX) + 0.7(bY)
bp = 0.3(0.75) + 0.7(bY)

We have two unknowns. However, we can solve for the portfolio’s

beta by using the CAPM:
kp = kRF + (kM - kRF)bp.

For the portfolio, we have:

12% = 6% + (5%)bp
6% = (5%)bp
1.2 = bp.

Step 2: Solve for Stock Y’s beta:

bp = 0.3(0.75) + 0.7(bY)
1.2 = 0.225 + 0.7(bY)
0.975 = 0.7(bY)
bY = 1.3929  1.39.

116. CAPM and beta coefficient Answer: d Diff: M

Portfolio beta is found from the CAPM:

17% = 7% + (14% - 7%)bp
bp = 1.4286.

The portfolio beta is a weighted average of the betas of the stocks within
the portfolio.
1.4286 = ($2/$15)(0.8) + ($5/$15)(1.1) + ($3/$15)(1.4) + ($5/$15)bD
1.4286 = 0.1067 + 0.3667 + 0.2800 + (5/15)bD
0.6752 = 5/15bD
bD = 2.026.

117. Market return Answer: d Diff: M

Rise  Y 22 - 16 6
b = = = = = 1.5.
Run  X 15 - 11 4

ks = 15% = 9% + (kM - 9%)1.5

6% = (kM - 9%)1.5
4% = kM - 9%
kM = 13%.

Chapter 5 - Page 75
118. Portfolio required return Answer: a Diff: T

Step 1: Find the beta of the original portfolio by taking a weighted average
of the individual stocks’ betas. We calculate a beta of 1.3.
 $300,000   $300,000   $500,000   $500,000  
  (0.6)    (1)    (1.4)    (1.8)
 $1,600,000  $1,600,000  $1,600,000  $1,600,000 
Step 2: Find the market risk premium using the original portfolio.
ks = 0.125 = 0.06 + (kM - kRF)1.3. If you substitute for all the
values you know, you calculate a market risk premium of 0.05.

Step 3: Calculate the new portfolio’s beta.

The question asks for the new portfolio’s required rate of
return. We have all of the necessary information except the new
portfolio’s beta. Now, Stock 1 has 0 weight (we sold it) and
Stock 4 has a weight of $800,000/$1,600,000 = 0.5. The
portfolio’s new beta is:
 $300,000   $500,000   $800,000 
  (1)    (1.4)    (1.8)  1.525.
 $1,600,000  $1,600,000  $1,600,000

Step 4: Find the portfolio’s required return.

Thus, ks = 0.06 + (0.05)1.525 = 13.625%  13.63%.

119. CAPM and portfolio return Answer: d Diff: E N

This is a straight-forward application of the CAPM. We are given the risk-

free rate, the market risk premium, and the portfolio beta.

kp = kRF + (kM – kRF)bp

kp = 5% + (6%)1.2
kp = 12.2%.

Chapter 5 - Page 76
120. CAPM and portfolio return Answer: c Diff: M N

We must calculate the beta of the new portfolio. From the definition of
beta, we can solve for the new portfolio beta:

10


i1
bi
Portfolio beta = . bi is the beta for the 10 individual stocks.
10
10


i1
bi
1.2 =
10
10
12 = 
i1
bi .

So, if the portfolio manager sells a stock that has a beta of 0.9 and
replaces it with a stock with a beta of 1.6, that means the sum of the
betas for the new portfolio is 0.7 higher than before. Dividing the new
sum of betas by 10 gives us the new portfolio beta.

12.7/10 = bp
1.27 = bp.

Alternatively, you can calculate the portfolio’s new beta as follows:

1.2 = 0.9br + 0.1(0.9)
1.11 = 0.9br
1.2333 = br; beta of remaining stocks in portfolio.

bp = 0.9(1.2333) + 0.1(1.6)
= 1.11 + 0.16
= 1.27. (beta of new portfolio)

Now, we can calculate the required return of the new portfolio.

kp = kRF + (kM – kRF)bp
kp = 5% + 6%(1.27)
kp = 12.62%.

Chapter 5 - Page 77
 WEB APPENDIX 5A SOLUTIONS

5A-1. Beta calculation Answer: b Diff: M

5A-2. Beta calculation Answer: c Diff: E

Rise/Run = (Y1 – Y0)/(X1 – X0) = (JYear 2 – JYear 1)/(MYear 2 – MYear 1)

= (22.90% – (-13.85%))/(12.37% – (-8.63%)) = 36.75%/21.0%
beta = 1.75.

5A-3. Beta and base year sensitivity Answer: a Diff: M

Year 1–Year 2 data:

Rise/Run = (Y1 – Y0)/(X1 – X2)
= (-3.7% – 6.30%)/(12.90% – 6.10%) = -10.0%/6.8%
beta = -1.47.

Year 2 – Year 3 data:

beta = (21.71% – (-3.70%))/(16.20% – 12.90%) = 25.41%/3.3% = 7.70.

Difference:
betaY2 – Y3 – betaY1 – Y2 = 7.70 – (-1.47) = 9.17.

5A-4. Beta calculation Answer: b Diff: M

Calculate beta of stock X:

Enter into 10-B market return first!
bx = 0.9484.

k = kRF + (kM - kRF)bp

14% = 6% + 6%bp
8% = 6%b
bp = 1.333.

bp = 0.6(bX) + 0.4(bY)
1.333 = 0.6(0.9484) + 0.4bY
0.7643 = 0.4bY
bY = 1.9107  1.91.

Chapter 5 - Page 78
5A-5. Beta calculation Answer: c Diff: E

Using the linear regression function of the HP 10-B calculator, enter

the market return and the corresponding stock return and find the slope
of the predicted regression line. Slope = b = 1.2757.
5A-6. Beta calculation Answer: a Diff: E

Enter the following input data in the calculator:

8 INPUT 12 +
28 INPUT 34 +
20 +/- INPUT 29 +/- +
4 +/- INPUT 11 +/- +
30 INPUT 45 +
Press 0  ŷ ,m  SWAP to find beta = 1.432  1.43.

5A-7. Beta calculation Answer: c Diff: M

a. Plot the returns of Stocks R and S and the market.

Return on Stock
(%)
StockR
25

StockS

Return on Market (%)

- 15 15

-15

b. Calculate beta using the rise over run method or calculator

regression function.

Y2 - Y1 25 - 5 20
= beta StockR: = = 2.0 = betaR.
X2 - X1 15 - 5 10
10 - 5 5
StockS: = = 0.5 = betaS.
15 - 5 10

Chapter 5 - Page 79
 c. The difference in betas is: BetaR - BetaS = 2.0 - 0.5 = 1.5.

5A-8. Required rate of return Answer: e Diff: M

a. Draw SML.

Required Rate
of Return (%)

16

kR = 14 SML

12 k̂R  12%
k̂S  11%
kM = 10
k̂R  kR
kS = 8
k̂S  kS
kRF = 6

| | | | | | | | | |
0.2 1.0 2.0 Risk, beta
b. Calculate required returns for Stocks R and S.
kR = 6% + (10% - 6%)2.0 = 14%.
kS = 6% + (10% - 6%)0.5 = 8%.

c. Calculate the difference between the expected and required returns.

k̂R  kR = 12% - 14% = -2.0%.
k̂S  kS = 11% - 8% = 3.0%.

d. Widest margin = k̂S  kS = 3.0%.

Chapter 5 - Page 80