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LOS h: Calculate an adjusted beta, and discuss the use of adjusted and historical betas as predictors of future betas. fficeffice" />

Q1. Adjusted betas were developed in an effort to compensate for:

A)   inaccurate forecasts for the efficient frontier based on traditional beta.

B)   traditional beta’s limitations in assessing the risk of extremely volatile stocks.

C)   the weaknesses of standard deviation as a risk measurement.

Correct answer is A)

Adjusted beta was developed to compensate for the beta instability problem, or the tendency of historical betas to generate inaccurate forecasts. Extreme volatility is not an issue; nor is standard deviation.

 

Q2. Conner Cans shares have a beta of 0.8. Assuming α₁ is 40%, Conner’s adjusted beta is closest to:

A)   1.12.

B)   0.88.

C)   0.92.

Correct answer is C)

Adjusted beta = α₀ + α₁ × beta where α₀ and α₁ must sum to 1, so α₀ = 60%.
Adjusted beta = 60% + 40% × 0.8 = 0.92.

 

Q3. Martz & Withers Enterprises has a beta of 1.6. We can most likely assume that:

A)   calculating an adjusted beta will ease the downward pressure on the forecasted beta.

B)   the future beta will be less than 1.6 but greater than 1.0.

C)   the standard error on the future beta forecast is positive.

Correct answer is B)

The standard error is always expected to be zero, and the beta has nothing to do with that estimate. In the case of Martz & Withers, adjusted beta will almost certainly be lower than the current beta. Most adjusted beta calculations are as follows: adjusted beta = 2/3 + (1/3 × historical beta). In this case, adjusted beta is 1.2. Not everyone will use the two-thirds/one-third relationship, but any adjusted-beta equation will result in a value between 1.0 and 1.6.

 

Q4. Analysts attempting to compensate for instability in the minimum-variance frontier will find which of the following strategies least effective?

A)   Reducing the frequency of portfolio rebalancing.

B)   Eliminating short sales.

C)   Gathering more accurate historical data.

Correct answer is C)

Constraining portfolio weights through the elimination of short sales and avoiding rebalancing until significant changes occur in the efficient frontier can be effective strategies for limiting instability. However, even the best historical data is often of limited use in forecasting future values. Gathering more accurate historical data would help, compensate for instability, but not as much as the other two options.