FINANCE 634
Fall 1999 Exam 2
Part 1
1. The realized return on a share of common stock is the sum of the dividend yield and the capital gain yield.
2. The "variance" of a rate of return in the ex ante sense is the squared difference between the highest and the lowest expected returns, other things equal.
3. The standard deviation of the rate of return is the appropriate measure of risk in the pricing of all common stock.
4. While the covariance can vary between very large positive and negative numbers, the correlation coefficient can vary only between +1 and -1.
5. The larger the standard deviation, the larger the expected return - other things equal.
6. According to capital market theory, the market portfolio is the only risky investment that would be held by rational risk-averse investors if they have the option of borrowing and lending at the risk-free rate.
7. According to capital market theory, all efficiently priced risky portfolios are equally desirable to investors.
8. According to capital market theory, the choice of which risky asset to invest in is determined by the investor's degree of risk aversion only if there is no riskless asset.
9. When two risky assets are combined in a portfolio, all risk can be eliminated from the portfolio only if the assets have a correlation with each other of -1.
10. Rational risk-averse investors will always prefer less risk to more risk in their investments.
11. The slope of the security market line (SML) is Beta.
12. A company that is in a risky business like oil exploration will always have a higher beta than will a company that is in a safer business like an airline.
13. The risk premium for a stock will increase as the beta for the stock increases, other things equal.
14. The risk premium for a stock will increase as the real rate of interest increases, other things equal.
15. The risk premium for common stock will increase as the expected return on the market portfolio increases, other things equal.
16. An increase in the level of risk aversion for the average investor will result in an increase in all required rates of return, other things equal.
17. A strike in a company's work force would be an example of a type of risk that would not affect the company's beta.
18. An increase in the debt/assets ratio for a company will cause an increase in the company's beta, other things equal.
19. A stock with a beta of 2.0 has twice as high a standard deviation as does a stock with a beta of 1.0.
20. Beta is estimated as the slope of a linear regression line relating the monthly returns on the Dow Jones Industrial Average to the monthly returns on a given stock, usually over a 5-year time period.
21. According to capital market theory, investors who hold high-beta stocks will make a higher-than-average annual return.
22. An analyst who has used ratio analysis of financial statement information to compose a portfolio that earned a 15% average annual rate of return over the last 10 years while the S&P 500 Index has made an average annual return of 12% would be evidence that the market is not semi-strong-form efficient.
23. According to most research, the market is at least semi-strong-form efficient for most stocks most of the time.
24. An efficient portfolio has the highest possible expected return at a given level of risk and the lowest possible risk at a given level of expected return as compared to all other risky portfolios.
25. The crux of the CAPM is that he market only compensates investors for taking undiversifiable risks.
PROBLEMS
1. You have estimated the following subjective distributions of returns for the assets shown for the coming year in three possible states of the economy.
| Asset A | Asset B | T-Bills | |
| Bad (Prob = .30) | 6% | 2% | 6% |
| Normal (Prob = .50) | 9% | 12% | 6% |
| Good (Prob = .20) | 20% | 25% | 6% |
Asset A is a well-diversified portfolio composed of 100 stocks. Asset B is a portfolio
of a few risky investments.
| ASSET--> | A | B | T-Bills |
| Expected Return | |||
| Standard Dev. of Return | |||
| Correlation with Asset A | |||
| Correlation with T-Bills | |||
| Beta Coefficient |
[10] Wt in A: _________ Wt. in B: ___________ Wt. in T-Bills: __________
c. Suppose you want to form a portfolio from any or all of the assets listed above such that
your portfolio has an expected return of 9.0%. What would be the rational composition
of your portfolio?
[10] Wt in A: _________ Wt. in B: ___________ Wt. in T-Bills: __________
d. Suppose you plan to invest $20,000 in asset A and $25,000 in Asset B. You also intend
to invest $25,000 in Treasury Bills. What will be the beta coefficient of your position?
[5]
e. Suppose you plan to invest $50,000 in asset A and $25,000 in asset B. You intend to
finance this position by borrowing $30,000 at the riskfree rate and using $45,000 of
your own money. What will be the expected return of this position?
[5]
1=T, 2=F, 3=F, 4=T, 5=F, 6=T, 7=F, 8=T, 9=T, 10=F, 11=F, 12=F, 13=T, 14=F, 15=T, 16=F, 17=T, 18=T, 19=F, 20=F, 21=F, 22=F, 23=T, 24=T, 25=T
E(R) of A = 10.3%, E(R) of B = 11.6%, E(R) of T-Bills = 5%
SD of A = 5.02%, SD of B = 7.98%, SD of T-Bills = 0%
Corr(A,B) = .9517
Corr of T-bills with anything = 0
Beta of A = 1, Beta of B = 1.512, Beta of T-Bills = 0
b. Wt(A) = 2 Wt(B) = 0 Wt(T) = -1
c. Wt(A) = .7542 Wt(B) = 0 Wt(T) = .2453
d. .878
e. 14.56%