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Exam 6: Risk and Return

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Question 21

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Someone who is risk averse has a general dislike for risk and a preference for certainty.If risk aversion exists in the market, then investors in general are willing to accept somewhat lower returns on less risky securities.Different investors have different degrees of risk aversion, and the end result is that investors with greater risk aversion tend to hold securities with lower risk (and therefore a lower expected return) than investors who have more tolerance for risk.

A) True
B) False

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Question 22

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

A) True
B) False

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Question 23

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

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

The realized return on a stock portfolio is the weighted average of the expected returns on the stocks in the portfolio.

If investors become less averse to risk, the slope of the Security Market Line (SML) will increase.

If the price of money (e.g., interest rates and equity capital costs) increases due to an increase in anticipated inflation, the risk-free rate will also increase.If there is no change in investors' risk aversion, then the market risk premium (r_M − r_RF) will remain constant.Also, if there is no change in stocks' betas, then the required rate of return on each stock as measured by the CAPM will increase by the same amount as the increase in expected inflation.

A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions.

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

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

For a stock to be in equilibrium, two conditions are necessary: (1) The stock's market price must equal its intrinsic value as seen by the marginal investor and (2) the expected return as seen by the marginal investor must equal this investor's required return.

Since the market return represents the expected return on an average stock, the market return reflects a certain amount of risk.As a result, there exists a market risk premium, which is the amount over and above the risk-free rate, that is required to compensate stock investors for assuming an average amount of risk.

According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation.Thus, the relevant risk of a stock is the stock's contribution to the riskiness of a well-diversified portfolio.

It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm is negative.

Which of the following statements is CORRECT?

If you plotted the returns on a given stock against those of the market, and if 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 greater than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue into the future.

Portfolio A has but one security, while Portfolio B has 100 securities.Because of diversification effects, we would expect Portfolio B to have the lower risk.However, it is possible for Portfolio A to be less risky.

Under the CAPM, the required rate of return on a firm's common stock is determined only by the firm's market risk.If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm's required rate of return.

Brodkey Shoes has a beta of 1.30, the T-bill rate is 3.00%, and the T-bond rate is 6.5%.The annual return on the stock market during the past 3 years was 15.00%, but investors expect the annual future stock market return to be 13.00%.Based on the SML, what is the firm's required return?

"Risk aversion" implies that investors require higher expected returns on riskier than on less risky securities.