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Please answer the following questions by selecting the best possible answer on the
Scantron sheet provided to you.
1
. Which of the following statements is most correct? (Assume that the risk-free
rate remains constant.)
a. If the market risk premium increases by 1 percentage point, then the required
return on all stocks will rise by 1 percentage point.
b. If the market risk premium increases by 1 percentage point, then the required
return will increase for stocks that have a beta greater than 1.0, but it will
decrease for stocks that have a beta less than 1.0.
c. If the market risk premium increases by 1 percentage point, then the required
return will increase by 1 percentage point for a stock that has a beta equal to
1.0.
d. Statements a and c are correct.
e. None of the statements above is correct.
2
. Which of the following statements best describes what would be expected to
happen as you randomly add stocks to your portfolio?
a. Adding more stocks to your portfolio reduces the portfolios company-specific
risk.
b. Adding more stocks to your portfolio reduces the beta of your portfolio.
c. Adding more stocks to your portfolio increases the portfolios expected return.
d. Statements a and c are correct.
e. All of the statements above are correct.
3
. Which of the following statements is most correct?
a. The slope of the security market line is beta.
b. The slope of the security market line is the market risk premium, (r M r R F ).
c. If you double a companys beta its required return more than doubles.
d. Statements a and c are correct.
e. Statements b and c are correct.
4
. You have developed the following data on three stocks:
State Pi rJ
1 0.2 10%
2 0.6 15
3 0.2 20
a. 15%; 6.50%
b. 12%; 5.18%
c. 15%; 3.16%
d. 15%; 10.00%
e. 20%; 5.00%
12
. You have been scouring The Wall Street Journal looking for stocks that are good
values and have calculated expected returns for five stocks. Assume the risk-free
rate (rRF) is 7 percent and the market risk premium (r M - rRF) is 2 percent. Which
security would be the best investment? (Assume you must choose just one.)
Returns
Probability X Y
0.1 -20% 10%
0.8 20 15
0.1 40 20
If you form a 50-50 portfolio of the two stocks, what is the portfolios standard
deviation? (Hint: Calculate the portfolio return for each state and then compute
the expected return and standard deviation for the portfolio.)
a. 8.1%
b. 10.5%
c. 13.4%
d. 16.5%
e. 20.0%
14
. For the foreseeable future, the real risk-free rate of interest, k*, is expected to
remain at 3 percent. Inflation is expected to steadily increase over time. The
maturity risk premium equals 0.1(t - 1)%, where t represents the bonds maturity.
On the basis of this information, which of the following statements is most correct?
a. The yield on 10-year Treasury securities must exceed the yield on
2-year Treasury securities.
b. The yield on 10-year Treasury securities must exceed the yield on
5-year corporate bonds.
c. The yield on 10-year corporate bonds must exceed the yield on 8-year Treasury
securities.
d. Statements a and b are correct.
e. Statements a and c are correct.
15
. Which of the following factors are likely to lead to an increase in nominal interest
rates?
a. Households increase their savings rate.
b. Companies see an increase in their production opportunities that leads to an
increase in the demand for funds.
c. There is an increase in expected inflation.
d. Statements b and c are correct.
e. All of the statements above are correct.
16
. Assume that the expectations theory describes the term structure of interest rates.
Which of the following statements is most correct?
a. In equilibrium long-term rates equal short term rates.
b. An upward-sloping yield curve implies that interest rates are expected to
decline in the years ahead.
c. The maturity risk premium is zero.
d. Statements a and b are correct.
e. None of the statements above is correct.
17
. Assume that the expectations theory holds. Which of the following statements
about Treasury bill rates is most correct? (2-year rates apply to bonds that will
mature in two years, 3-year rates apply to bonds that will mature in 3 years, and so
on).
a. If 2-year rates exceed 1-year rates, then the market expects interest rates to rise.
b. If 2-year rates are 7 percent, and 3-year rates are 7 percent, then
5-year rates must also be 7 percent.
c. If 1-year rates are 6 percent and 2-year rates are 7 percent, then the market
expects 1-year rates to be 6.5 percent in one year.
d. Statements a and c are correct.
e. Statements b and c are correct.
18
. The real risk-free rate of interest is 3 percent. Inflation is expected to be 4 percent
this coming year, jump to 5 percent next year, and increase to 6 percent the year
after (Year 3). According to the expectations theory, what should be the interest rate
on 3-year, risk-free securities today?
a. 18%
b. 12%
c. 6%
d. 8%
e. 10%
19
. One-year government bonds yield 6 percent and 2-year government bonds yield 5.5
percent. Assume that the expectations theory holds. What does the market believe
the rate on 1-year government bonds will be one year from today?
a. 5.00%
b. 5.50%
c. 5.75%
d. 6.00%
e. 7.00%
20
. One-year Treasury securities yield 5 percent, 2-year Treasury securities yield 5.5
percent, and 3-year Treasury securities yield 6 percent. Assume that the
expectations theory holds. What does the market expect will be the yield on 1-year
Treasury securities two years from now?
a. 6.0%
b. 6.5%
c. 7.0%
d. 7.5%
e. 8.0%
21
. You observe the following yield curve for Treasury securities:
Maturity Yield
1 year 5.5%
2 years 5.8
3 years 6.0
4 years 6.3
5 years 6.5
Assume that the pure expectations hypothesis holds. What does the market expect
will be the yield on 4-year securities, 1 year from today?
a. 6.00%
b. 6.30%
c. 6.40%
d. 6.75%
e. 7.30%
22
. Given the following data, find the expected rate of inflation during the next year.
a. 3.5%
b. 4.5%
c. 5.5%
d. 6.5%
e. 7.5%
23
. Drongo Corporations 4-year bonds currently yield 7.4 percent and have an inflation
premium of 3.5%. The real risk-free rate of interest, r*, is 2.7 percent and is assumed
to be constant. The maturity risk premium (MRP) is estimated to be 0.1%(t - 1),
where t is equal to the time to maturity. The default risk and liquidity premiums for
this companys bonds total 0.9 percent and are believed to be the same for all bonds
issued by this company. If the average inflation rate is expected to be 5 percent for
years 5, 6, and 7, what is the yield on a 7-year bond for Drongo Corporation?
a. 8.70%
b. 8.34%
c. 7.40%
d. 9.20%
e. 8.54%
1. Market risk premium Answer: c Diff: E
Statements b and c are false. Randomly adding more stocks will have no
effect on the portfolios beta or expected return.
Step 1: We must determine the market risk premium using the CAPM equation with data
inputs for Stock A:
rA = rRF + (rM rRF)bA
11%= 5% + (rM rRF)1.0
6% = (rM rRF).
Step 2: We can now find the required return of Stock B using the CAPM equation with data
inputs for Stock B:
rB = rRF + (rM rRF)bB
rB = 5% + (6%)1.4
rB = 13.4%.
rRF = r* + IP = 3% + 5% = 8%.
rs = 8% + (5%)2.0 = 18%.
12.25% = 5% + (RPM)1.15
7.25% = (RPM)1.15
RPM = 6.3043% 6.30%.
10. Portfolio beta Answer: b Diff: E
Fill in the columns for XY and product, and then use the formula to
calculate the standard deviation. We did each (k - k )2P calculation with a
calculator, stored the value, did the next calculation and added it to the
first one, and so forth. When all three calculations had been done, we
recalled the stored memory value, took its square root, and had XY = 8.1%.
Yield
Corporate
Treasury
Maturity
8 10
Since we know that the corporate bond has to have a higher yield than the
Treasury bond for all bonds of the same maturity, we know the yield curve for
the corporate bond must be higher than the yield curve for the Treasury bond.
We also know that the yield curve is upward sloping because inflation steadily
increases over time. If you look at the graph, its obvious that statement c
must be true. Since statements a and c are both true, then statement e is the
correct choice.
Statement a is correct; the other statements are false. Knowing 2-year rates
and 3-year rates permits no inference regarding 5-year rates. However, knowing
2-year rates and 3-year rates beginning in two years would permit applying the
expectations theory to infer 5-year rates. Given the data concerning one- and
2-year rates in statement c, the market expects 1-year rates in one year to be
8%.
4% + 5% + 6%
Average inflation = = 5%.
3
rRF = r* + IP = 3% + 5% = 8%.
19. Expected interest rates Answer: a Diff: E
Answer: c Diff: E
The MRP for the 4-year bond is 0.1%(4 - 1) = 0.3%. Find the 4-year IP as 7.4% =
2.7% + 0.3% + 0.9% + IP4, or IP4 = 3.5%. Calculate the 7-year IP as [3.5%(4) +
5%(3)]/7 = 4.14%. The MRP for the 7-year bond is 0.1%(7 - 1) = 0.6%. Finally, the
yield on the 7-year bond is 2.7% + 0.6% + 0.9% + 4.14% = 8.34%.