Asset Pricing Models - Review Questions

Question 1

Which of the following assets cannot lie on the efficient frontier?

Asset A: return = 14%, standard deviation = 19%
Asset B: return = 10%, standard deviation = 10%
Asset C: return = 16%, standard deviation = 20%
Asset D: return = 11%, standard deviation = 15%
Asset E: return = 15%, standard deviation = 18%

Choose the best answer.

1) Asset A and C
2) Asset B and E
3) Asset A and D
4) Asset C and D
5) Asset B and C

Answer 1

3) Asset A and D

Another approach is to look at the actual data points relative to one another. The basic principle of risk /return is that for higher returns you expect higher risk levels. Points B, C, D, and E all have increased risk amounts relative to increased returns. Moreover, there are not any conflicts when you compare these to each other. On the other hand, when you compare portfolio A to E, it should be clear that portfolio A is suboptimal compared to portfolio E, in that E has a higher return and LESS risk versus portfolio A. Portfolio D is also suboptimal compared to the projected efficient frontier from points B to E to C.

Question 2

Emma is evaluating a stock. She notes that the market is generating a return of 8%. The risk-free rate is at 2.5%. The investment has a beta of 0.9. How much should the stock yield for a return?

Answer 2

The return of the stock = 2.5 + 0.9(8 - 2.5) = 7.45%.

Question 3

Which variable represents the market risk premium?

ri=rf+Bi[rm−rf]
Choose the best answer.

1) ri
2) rf
3) Bi
4) [rm−rf]

Answer 3

4) [rm−rf]

The risk premium is the difference between the market return and the risk free rate. This is the premium given to investors for taking on systematic risk. When multiplied to Beta, it becomes the risk premium of the security.

Question 4

Cheri is trying to determine the return for a security that has a zero factor of 4%, expected return from economic growth of 8% with sensitivity to the growth of 0.8. If the error term is 0, what is the return of this security?

Choose the best answer.

1) 12%
2) 10.4%
3) 13.6%
4) 8%

Answer 4

2) 10.4%

The one factor model for this security is r = .04 + (.8)(.08) = 10.4%

Question 5

If the average stock return is 8%, and the risk-free rate of return is 5%, what should a stock with a beta of 1.2 yield, according to the Capital Asset Pricing Model (CAPM)?

1) 9.7%
2) 8.6%
3) 8.2%
4) 9.2%

Answer 5

2) 8.6%

To calculate the required return:
5% + ((8% - 5%) x 1.2)
5% + 3.6%= 8.6%

Question 6

All of the following are reasons to question the validity of the Capital Asset Pricing Model (CAPM), EXCEPT:

1) There can be substantial difficulties in calculating betas.
2) The Model is better at predicting returns than analyzing historical trends.
3) Non-market risk may affect investment security prices.
4) The capital markets may not be as efficient as the Model implies.

Answer 6

2) The Model is better at predicting returns than analyzing historical trends.

The CAPM model is better at evaluating past performance of securities than predicting future performance.

Question 7

What is the market premium if the market is expected to return 17% on average for the next year, the risk-free rate is 4%, and Company X has a beta coefficient of 1.5 and a past annual return of 25%?

1) 21%
2) 14.8%
3) 31.2%
4) 13%

Answer 7

4) 13%

Market return (17%) minus the risk-free rate (4%) equals the market risk premium by definition.

Question 8

In analyzing the position of a portfolio in terms of risk/return on the capital market line (CML), superior performance exists if the fund’s position is ________ the CML, inferior performance exists if the fund’s position is __________ the CML, and equilibrium position if it is ________ the CML.

1) Above; on; below
2) On; above; below
3) Below; above; on
4) Above; below; on

Answer 8

4) Above; below; on

Superior performance exists if the fund’s position is above the capital market line. Inferior position exists if the fund’s position is below the capital market line. Since less than optimal return is being earned for the risk being taken.

Question 9

If the market risk premium were to increase, the current value of common stock, everything else being equal, would:

1) Not change because this does not affect stock values.
2) Decrease due to lower risk-free rates.
3) Increase due to higher risk-free rates
4) Decrease in order to compensate the investor for higher expected return

Answer 9

4) Decrease in order to compensate the investor for higher expected return

As expected return increases, the discount rate applied to earnings becomes larger, and market price decreases to compensate a new investor based on these expectations. The riskiness of an average security has risen if the market risk premium increases. Note, expected return will increase with market risk premium increases given the formula of (Rm-Rf)=Market Risk Premium.

Question 10

Which of the following are assumptions of The Capital Asset Pricing Model (CAPM)?

1) Investors can borrow and lend at the risk free rate
2) Investors have access to all information
3) Investors make rational decisions
4) Each investor has different risk and return expectations

Choose the best answer

1, 4
1, 2, 3
2, 3, 4
All of the above

Answer 10

1, 2, 3

1, 2, & 3 are correct. CAPM assumes each investor has the SAME risk and return expectations.