LOS f: Discuss the security market line (SML), the beta coefficient, the market risk premium and the Sharpe ratio, and calculate the values of one of these variables given the values of the remaining variables.

Q1. The covariance of the market returns with the stock's returns is 0.005 and the standard deviation of the market’s returns is 0.05. What is the stock's beta?

A)   1.0.

B)   2.0.

C)   0.1.

Q2. Which of the following statements regarding beta is least accurate?

A)   The market portfolio has a beta of 1.

B)   A stock with a beta of zero will tend to move with the market.

C)   Beta is a measure of systematic risk.

Q3. What is the beta of Hamburg Corp.’s stock if the covariance of the stock with the market portfolio is 0.23, and the standard deviation of the market returns is 32%?

A)   2.25.

B)   1.65.

C)   0.72.

Q4. Jung Wu, CFA, uses the security market line to determine if stocks are undervalued or overvalued. Wu recently completed an analysis of Sang Tractor Supplies (STS) and derived the following forecasts for STS and for the broad market: 

• Forecasted return for STS: 10%
• Standard deviation forecasted for STS: 15%
• Expected return on the stock market index: 12%
• Standard deviation on the stock market index: 20%
• Correlation between STS and stock market index: 0.60
• Risk-free rate: 6%

To determine the fair value of STS, Wu should use the following risk value and should make the following valuation decision:

          Risk value                                  Valuation

A)    0.45                                      Undervalued

B)    0.15                                      Overvalued

C)    0.45                                      Overvalued

Q5. Janet Bellows, a portfolio manager, is attempting to explain asset valuation to a junior colleague, Bill Clay. Bellows explanation focuses on the capital asset pricing model (CAPM). Of particular interest is her discussion of the security market line (SML), and its use in security selection.

Bellows begins with a short review of the capital asset pricing model, including a discussion about its assumptions regarding transaction costs, taxes, holding periods, return requirements, and borrowing and lending at the risk-free rate.

Bellows then illustrates the SML, and explains how changes in the expected market return and the risk-free rate affect the line. In an effort to learn whether Clay understands the concepts she has explained to him, Bellows decides to test Clay’s knowledge of valuation using the CAPM.

Bellows provides the following information for Clay:

• The risk-free rate is 7%.
• The market risk premium during the previous year was 5.5%.
• The standard deviation of market returns is 35%.
• This year, the market risk premium is estimated to be 7%.
• Stock A has a beta of 1.30 and is expected to generate a 15.5% return.
• The covariance of Stock B with the market is 0.18.
• The standard deviation of Stock B’s returns is 41%.

Using this information, Clay must calculate expected stock returns and betas. Bellows especially wants to know Stock A’s required return, and whether or not the stock is a good buy.

Bellows then proposes a hypothetical situation to Clay: The stock market is expected to return 12.5% next year. Clay questions that return estimate in the context of the data listed above, and Bellows responds with four possible explanations for the estimate:

• The estimated risk premium is incorrect.
• Interest rates are likely to fall 1.5% over the next year.
• Given the data above, the return estimate is correct.
• The market beta is expected to rise over the next year.

Then Bellows provides Clay with the following information about Ohio Manufacturing, Texas Energy, and Montana Mining:

Clay has been tasked with providing an investment recommendation on the three stocks.

Based on the stock and market data provided above, which of the following data regarding Stock A is most accurate?

     Required 12-month return   Investment advice

A)        16.1%                               Sell

B)        16.1%                               Buy

C)        14.15%                             Buy

Q6. The beta of Stock B is closest to:

A)   1.47.

B)   1.07.

C)   0.51.

Q7. Which of the following represents the best investment advice?

A)   Buy Montana and Texas because their required return is lower than their expected return.

B)   Avoid Texas because its expected return is lower than its required return.

C)   Buy Montana because it is expected to return more than Texas, Ohio, and the market portfolio.

Q8. Assuming the market return estimate of 12.5% is accurate, which of the following statements is the best explanation for the estimate?

A)   Interest rates are likely to fall 1.5% over the next year.

B)   Given the data above, the return estimate is correct.

C)   The estimated risk premium is incorrect.

Q9. With regards to the capital asset pricing model, relaxing assumptions about:

A)   homogeneous expectations will result in the SML appearing more as a band instead of a line.

B)   risk free borrowing and lending rates results in a lower intercept and steeper slope.

C)   taxes will reduce differences between the capital market lines of different investors.

Q10. If the market risk premium decreases by 1%, while the risk-free rate remains the same, the security market line:

A)   becomes steeper.

B)   becomes flatter.

C)   parallel-shifts downward.

Q11. What is the expected rate of return for a stock that has a beta of 1.0 if the expected return on the market is 15%?

A)   15%.

B)   More than 15%.

C)   Cannot be determined without the risk-free rate.