Unit 10 (Ch.12) – Extra Problems - SOLUTIONS
1. According to CAPM, what two elements are represented in security returns?
a) a premium for market risk and for unique risk.
b) a premium for unique risk and a premium for firm-specific risk.
c) a premium for diversification and a premium for portfolio risk.
d) a premium for time value of money and a premium for market risk.
A security’s return is comprised of the risk free rate, which measures the time value of money (and includes the real
return in the economy plus an inflation component) plus a security premium which includes the security’s beta (a
measure of market risk).
i.e. Rj = Rf + β(Rm- Rf)
2. When the overall market experiences a decline of 8 percent, an investor with a portfolio of aggressive stocks will
a. negative portfolio returns of less than 8 percent.
b. negative portfolio returns of greater than 8 percent.
c. positive portfolio returns of less than 8 percent.
d. positive portfolio returns of greater than 8 percent.
Aggressive stocks have a beta of greater than 1.0 and are more sensitive to macroeconomic conditions (as
measured by the market portfolio). Therefore if the market goes down by 8%, an aggressive stock portfolio will most
likely decline by more than 8%.
3. The line plotted to fit observations of a stock's returns versus the market's returns determines the:
a. security market line.
b. beta of the stock.
c. market risk premium.
d. capital asset pricing model.
The beta of a stock is the percentage change in the stocks’ return divided by the percentage change in the market’s
4. Based on the following information, make an estimate of the stock's beta: Month 1 = Stock +1.5%, Market +1.1%;
Month 2 = Stock +2.0%, Market +1.4%; Month 3 = Stock -2.5%, Market -2.0%.
a. Beta is greater than 1.0.
b. Beta is less than 1.0.
c. Beta equals 1.0.
d. There is no consistent pattern of returns.
Month 1 beta = 1.5/1.1 = 1.36
Month 2 beta = 2.0/1.4 = 1.43
Month 3 beta = -2.5/-2.0 = 1.25 According to this data, the stock’s beta is greater than 1.
5. If a two-stock portfolio is equally invested in stocks with betas of 1.4 and 0.7, then the portfolio beta is:
Portfolio beta is just the weighted average of the betas of