LOS e: Explain the capital asset pricing model (CAPM), including its underlying assumptions and the resulting conclusions.

Q1. Which of the following is NOT an assumption necessary to derive the capital asset pricing model (CAPM)?

A)   Investors only need to know expected returns, variances, and covariances in order create optimal portfolios.

B)   Transactions costs are small for large investors.

C)   Investors are price takers whose buy and sell decisions don't affect asset prices.

Q2. Which of the following is NOT a prediction of the capital asset pricing model (CAPM)?

A)   All investors identify the same risky tangency portfolio and combine it with the risk-free asset to create their own optimal portfolios.

B)   The market price of risk is the slope of the capital market line.

C)   All investors hold an equally weighted market portfolio of all assets.

Q3. According to the capital asset pricing model (CAPM), if the expected return on an asset is too high given its beta, investors will:

A)   buy the stock until the price rises to the point where the expected return is again equal to that predicted by the security market line.

B)   sell the stock until the price falls to the point where the expected return is again equal to that predicted by the security market line.

C)   buy the stock until the price falls to the point where the expected return is again equal to that predicted by the security market line.

Q4. An investor is considering an investment. After a great deal of careful research he determines that the forecasted return on the investment is 15% and estimates the beta to be 2.0. The risk-free rate of interest is 3%, and the return on the market is 13%. Should the project be undertaken?

A)   No, the forecasted return is less than the expected return of 23%.

B)   Yes, the forecasted return is less than the expected return of 18%.

C)   Yes, the forecasted return is more than the expected return of 13%.

Q5. The market is expected to return 12% next year and the risk free rate is 6%. What is the expected rate of return on a stock with a beta of 0.9?

A)   13.0.

B)   10.8.

C)   11.4.

Q6. Figment, Inc., stock has a beta of 1.0 and a forecast return of 14%. The expected return on the market portfolio is 14%, and the long-run inflationary expectation is 3%. Which of the following statements is most accurate? Figment, Inc.’s stock:

A)   valuation relative to the market cannot be determined.

B)   is properly valued.

C)   is overvalued.

Q7. Callard Corp. stock has a beta of 1.5. If the current risk-free interest rate is 6%, and the expected return on the market is 14%, what is the expected rate of return for Callard Corp.’s stock?

A)   18%.

B)   20%.

C)   14%.

Q8. Howard Michaels, CFA, is an analyst for Donaldson Associates. Michaels is considering recommending a position in the retail sector for Donaldson’s institutional clients. Michaels has gathered the following information to help his guide his decision. Based on previous research, Michaels expects the market and Treasury bills to return 10% and 4%, respectively.

What would be the expected return for each investment, assuming the capital asset pricing model (CAPM) holds?

         Discount                            Everything

A)   19%                                      10%

B)   19%                                      14%

C)   13%                                      10%

Q9. According to the CAPM which investment is either underpriced, overpriced, or properly priced?

         Discount                                    Everything

A)  Overpriced                             Underpriced

B)  Underpriced                          Properly priced

C) Underpriced                             Overpriced

Q10. Harry Jordan, an associate of Michaels, recommends the $1 Discount Store investment because it has a higher forecasted return and lower risk. Is Jordan’s assertion correct?

A)   No, because according to the CAPM model it has been determined that Discount is overvalued.

B)   Yes, because from the table, we can confirm Jordan's statement that Discount has a higher return and lower risk than everything.

C)   No, since capital market theory states that the return on investment is based on the amount of total risk in the investment.

Q11. Which of the following is least likely an assumption that is necessary to derive the CAPM?

A)   Investors expectations are homogeneous.

B)   Markets are perfectly competitive.

C)   Limited risk-free borrowing.

Q12. According to the capital asset pricing model (CAPM), if the expected return on an asset is too low given its beta, investors will:

A)   sell the stock until the price rises to the point where the expected return is again equal to that predicted by the security market line.

B)   buy the stock until the price rises to the point where the expected return is again equal to that predicted by the security market line.

C)   sell the stock until the price falls to the point where the expected return is again equal to that predicted by the security market line.