Chapter 09 The Capital Asset Pricing Model

Chapter 09 - The Capital Asset Pricing Model

20. According to the Capital Asset Pricing Model (CAPM), A. a security with a positive alpha is considered overpriced. B. a security with a zero alpha is considered to be a good buy. C. a security with a negative alpha is considered to be a good buy. D. a security with a positive alpha is considered to be underpriced. E. a security with a positive beta is considered to be underpriced.

A security with a positive alpha is one that is expected to yield an abnormal positive rate of return, based on the perceived risk of the security, and thus is underpriced.

AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: CAPM

21. According to the Capital Asset Pricing Model (CAPM), which one of the following statements is false?

A. The expected rate of return on a security increases in direct proportion to a decrease in the risk-free rate.

B. The expected rate of return on a security increases as its beta increases. C. A fairly priced security has an alpha of zero.

D. In equilibrium, all securities lie on the security market line. E. All of these are correct.

The statement that the expected rate of return on a security increases in direct proportion to a decrease in the risk-free rate is false.

AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: CAPM

9-33

Chapter 09 - The Capital Asset Pricing Model

22. In a well diversified portfolio A. market risk is negligible. B. systematic risk is negligible. C. unsystematic risk is negligible. D. nondiversifiable risk is negligible. E. risk does not exist.

Market, systematic, or nondiversifiable, risk is present in a diversified portfolio; the unsystematic risk has been eliminated.

AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: CAPM

23. Empirical results regarding betas estimated from historical data indicate that A. betas are constant over time.

B. betas of all securities are always greater than one. C. betas are always near zero.

D. betas appear to regress toward one over time. E. betas are always positive.

Betas vary over time, betas may be negative or less than one, betas are not always near zero; however, betas do appear to regress toward one over time.

AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: CAPM

9-34

Chapter 09 - The Capital Asset Pricing Model

24. Your personal opinion is that a security has an expected rate of return of 0.11. It has a beta of 1.5. The risk-free rate is 0.05 and the market expected rate of return is 0.09. According to the Capital Asset Pricing Model, this security is A. underpriced. B. overpriced. C. fairly priced.

D. cannot be determined from data provided.

E. can either be overpriced or underpriced but not fairly priced.

11% = 5% + 1.5(9% ? 5%) = 11.0%; therefore, the security is fairly priced.

AACSB: Analytic Bloom's: Apply

Difficulty: Intermediate Topic: CAPM

25. The risk-free rate is 7 percent. The expected market rate of return is 15 percent. If you expect a stock with a beta of 1.3 to offer a rate of return of 12 percent, you should A. buy the stock because it is overpriced.

B. sell short the stock because it is overpriced. C. sell the stock short because it is underpriced. D. buy the stock because it is underpriced. E. hold the stock because it is fairly priced.

12% < 7% + 1.3(15% ? 7%) = 17.40%; therefore, stock is overpriced and should be shorted.

AACSB: Analytic Bloom's: Apply

Difficulty: Intermediate Topic: CAPM

9-35

Chapter 09 - The Capital Asset Pricing Model

26. You invest $600 in a security with a beta of 1.2 and $400 in another security with a beta of 0.90. The beta of the resulting portfolio is A. 1.40 B. 1.00 C. 0.36 D. 1.08 E. 0.80

0.6(1.2) + 0.4(0.90) = 1.08.

AACSB: Analytic Bloom's: Apply

Difficulty: Intermediate Topic: CAPM

27. A security has an expected rate of return of 0.10 and a beta of 1.1. The market expected rate of return is 0.08 and the risk-free rate is 0.05. The alpha of the stock is A. 1.7%. B. -1.7%. C. 8.3%. D. 5.5%. E. -5.5%.

10% ? [5% + 1.1(8% ? 5%)] = 1.7%.

AACSB: Analytic Bloom's: Apply

Difficulty: Intermediate Topic: CAPM

9-36