25 Lecture - Stock betas & risk, SML and return and stock prices in efficient markets

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25 Lecture

MGT201

Midterm & Final Term Short Notes

Stock betas & risk, SML and return and stock prices in efficient markets

Stock betas are a measure of a stock's sensitivity to market risk. SML is a graphical representation of the relationship between risk and return for individual stocks. Efficient market hypothesis (EMH) suggests that stock prices fully reflect al


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  1. Which of the following is not true regarding beta? A. Beta measures the sensitivity of a stock's return to changes in the market. B. A beta of 1 indicates that the stock's return is perfectly correlated with the market return. C. A beta of 0 indicates that the stock's return is uncorrelated with the market return. D. A beta of less than 1 indicates that the stock is less volatile than the market. Answer: D

  2. The Security Market Line (SML) is a graphical representation of: A. the relationship between expected returns and beta for individual securities. B. the relationship between risk and return for individual securities. C. the relationship between the market risk premium and the risk-free rate. D. the relationship between the risk-free rate and beta for individual securities. Answer: A

  3. In an efficient market, which of the following statements is true? A. All stocks have the same expected return. B. All stocks have the same risk. C. All stocks have the same price. D. None of the above. Answer: D

  4. Which of the following statements is true regarding the Capital Asset Pricing Model (CAPM)? A. It is used to estimate the expected return of a security. B. It assumes that investors are risk averse. C. It assumes that the market is inefficient. D. It assumes that all investors have the same expectations and information. Answer: A

  5. If the risk-free rate increases, what happens to the Security Market Line (SML)? A. It shifts upward. B. It shifts downward. C. It remains unchanged. D. It becomes steeper. Answer: A

  6. Which of the following factors can affect a stock's beta? A. The stock's industry. B. The stock's size. C. The stock's financial leverage. D. All of the above. Answer: D

  7. Which of the following statements is true regarding the relationship between beta and required return? A. The higher the beta, the lower the required return. B. The higher the beta, the higher the required return. C. Beta has no effect on required return. D. There is an inverse relationship between beta and required return. Answer: B

  8. Which of the following is not a limitation of the CAPM? A. It assumes that investors are rational. B. It assumes that all investors have the same expectations and information. C. It assumes that markets are always efficient. D. It does not take into account other factors that can affect a stock's return. Answer: C

  9. Which of the following is true regarding efficient portfolios? A. They are portfolios that have the highest possible return for a given level of risk. B. They are portfolios that have the lowest possible risk for a given level of return. C. They are portfolios that have the highest possible return and the lowest possible risk. D. They are portfolios that have an expected return of zero. Answer: A

  10. Which of the following statements is true regarding the relationship between risk and return in efficient markets? A. There is a direct relationship between risk and return. B. There is an inverse relationship between risk and return. C. There is no relationship between risk and return. D. The relationship between risk and return is different for each individual security. Answer: A



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Midterm & Finalterm Prepration
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  1. Define stock beta and explain its relevance in risk analysis of individual stocks. Answer: Beta is a measure of a stock's volatility in relation to the overall market. It is used to analyze the risk of a stock and is a critical component of the Capital Asset Pricing Model (CAPM). A beta of 1.0 indicates that the stock's price will move with the market, while a beta greater than 1.0 means the stock will be more volatile than the market, and a beta less than 1.0 means it will be less volatile.

  2. What is the Security Market Line (SML) and how is it used to determine the expected return of a stock? Answer: The Security Market Line (SML) is a graphical representation of the relationship between risk and expected return of stocks. The SML is used to determine the expected return of a stock by comparing its beta to the market risk premium. The SML is a line that connects the risk-free rate of return to the market rate of return and represents the minimum required return that investors should expect for a given level of risk.

  3. How do efficient markets impact the pricing of stocks? Answer: Efficient markets are characterized by the rapid and accurate dissemination of information, leading to prices that quickly reflect all available information. In such markets, stock prices are determined by the fundamental values of the companies, and stocks are priced such that the expected return on a stock is equal to its risk-adjusted required return.

  4. What is portfolio beta, and how is it calculated? Answer: Portfolio beta is the weighted average of the betas of the individual stocks held in a portfolio. It is calculated by multiplying the beta of each stock by its proportionate weight in the portfolio and adding up the results.

  5. How does the SML relate to the Capital Asset Pricing Model (CAPM)? Answer: The SML is a key component of the Capital Asset Pricing Model (CAPM), which is a widely used model to estimate the expected return of an asset based on its risk. The CAPM uses the SML to determine the required rate of return for a given level of risk and the expected return of a stock.

  6. What is the risk-free rate, and how is it used in the SML? Answer: The risk-free rate is the rate of return an investor can earn with certainty, such as from a government bond. It is used as the starting point for the SML, as it represents the minimum expected return an investor should receive for taking on any amount of risk.

  7. What is the market risk premium, and how is it used in the SML? Answer: The market risk premium is the additional return investors require to invest in a risky asset over and above the risk-free rate. It is used in the SML to determine the required return for a given level of risk.

  8. How do changes in market conditions, such as interest rates and inflation, impact the SML? Answer: Changes in market conditions, such as interest rates and inflation, can impact the SML by shifting the line up or down. An increase in interest rates or inflation will result in an increase in the risk-free rate, which will shift the SML up. Conversely, a decrease in interest rates or inflation will shift the SML down.

  9. How is the expected return of a stock determined using the SML? Answer: The expected return of a stock is determined by finding the point where the stock's beta intersects with the SML. The expected return is equal to the risk-free rate plus the stock's beta multiplied by the market risk premium.

  10. How does the SML relate to the concept of efficient portfolios? Answer: Efficient portfolios are those that offer the highest expected return for a given level of risk

Stock betas measure a stock's sensitivity to market risk. A beta greater than one implies that the stock is more volatile than the market, while a beta less than one indicates that it is less volatile. The Security Market Line (SML) is a graphical representation of the relationship between expected returns and systematic risk, as measured by beta. The SML provides a benchmark to evaluate a stock's performance and determine if it is overvalued or undervalued relative to its expected return given its level of risk. Efficient markets theory suggests that stock prices always reflect all available information, making it difficult to achieve returns above the market average. Therefore, investors can only achieve higher returns by assuming more risk, as measured by beta. The SML offers investors a tool to determine whether a stock is overvalued or undervalued based on its beta and expected return. In an efficient market, investors cannot earn higher returns without assuming more risk, which means that all securities will lie on the SML. Stocks that lie above the SML are expected to earn higher returns than the market average, while stocks below the SML are expected to earn lower returns. Investors can use the SML to identify undervalued stocks, which are those that lie above the SML, and overvalued stocks, which are those that lie below the SML. Overall, understanding stock betas, the SML, and efficient markets is crucial for investors to make informed investment decisions and assess the risk and return tradeoff of their portfolio.

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