An analyst at ABC Securities is in the process of reviewing the following information on YoYo, Inc., a publicly traded toy manufacturer:
? Share price for the last 20 years
? 10-Q filings for the last 5 years
? 10-K filings for the last 15 years
? Website for YoYo, Inc.
The above collection of data is an example of which of the following?
Answer (A) is correct. Prices reflect all publicly available information, such as the share price, 10-Q filings, and 10-K filings for previous years as well as the company’s website in a
semi-strong efficient market.
The term “beta” can best be described as the
Answer (B) is correct. The investment return’s sensitivity to changes in the market’s returns is stated in terms of its beta coefficient.
The CFO of Clean Waterworks, a publicly traded company, is expecting to pay a dividend next year of $1.25 and projecting that the price of the company’s stock will be $45 in 1 year. The CFO has determined that the required rate of return for Clean Waterworks is 10%. Based on
the data available, what is the value of one share of Clean Waterworks stock today?
Answer (A) is correct. The value of one share of stock today is the price of the stock at the end of the year plus the dividend received, discounted back 1 year by the required rate of return. Thus, the value of the stock at the end of the year is $46.25 ($45 plus the $1.25 dividend). This must be discounted back to today to equal $42.05 ($46.25 ÷ 1.10).
Risk factors that cannot be eliminated through diversification include which of the following?
I. Interest-rate fluctuations
II. General price-level changes
III. New product development
IV. Management turnover
Answer (A) is correct. Unsystematic risk is sometimes referred to as diversifiable risk. Since individual securities are affected differently by economic conditions, this risk can be offset through portfolio diversification. Interest-rate fluctuations and general price-level changes are both examples of systematic risk and cannot be eliminated through diversification.
Yerxa Industries is considering expanding its international operations. Which one of the following conditions should Yerxa’s controller classify as political risk?
Answer (A) is correct. Political risk is the probability of loss from actions of governments, such as from changes in tax laws or environmental regulations or from expropriation of assets.
In the context of the capital asset pricing model (CAPM), the beta coefficient of a stock that has the same systematic risk as the market as a whole is equal to
Answer (C) is correct. A beta of 1 indicates that for every change in the market return, the stock return has an identical change; thus, they have the same systematic risk.
Systematic risk explains why
Answer (A) is correct. Systematic risk, also called market risk, is the risk faced by all firms. Changes in the economy as a whole, such as the business cycle, affect all players in the market. Since all firms are affected by systematic risk, all of their stock values move somewhat in the same direction.
Stock A and Stock B are combined into an equally weighted portfolio. If Stock A has a standard deviation of return of 30%, Stock B has a standard deviation of return of 30%, and the portfolio of the two stocks has a standard deviation of return of 30%, what is the correlation coefficient of the returns between the two stocks?
Answer (D) is correct. Since both stocks have the same standard deviation as the portfolio, they fluctuate together and are perfectly correlated. Perfect correlation implies a coefficient of 1.0. It can also be figured mathematically using the covariance formula: Covariance of two-stock portfolio = Correlation coefficient × Standard deviation of Stock A × Standard deviation of Stock B
(0.3)2 = Correlation coefficient × .3 × .3
0.09= Correlation coefficient × .09
Correlation coefficient = 1.0
A stock began the year with a stock price of $60 per share. In the middle of the year, it had a 3-for-2 stock split. The stock ended the year with a price of $50 per share. No dividends were paid. What total return did investors earn on the stock during this year?
Answer (C) is correct. The 3-for-2 stock split would revalue the beginning of the year stock price. There are now three shares at x stock price for every two at $60:
3x = 2 × $60
3x = $120
x = $40
The stock appreciated $10 to $50 by year end. Therefore, the return was 25% ($10 increase ÷ $40 beginning of year stock price).
An analyst uses the capital asset pricing model (CAPM) to measure the required return on two stocks, X and Y. The expected market rate of return is 12%, the risk-free rate of return is 4%, the beta (?) coefficient of stock X is 0.5, and the beta (?) coefficient of stock Y is 2.0. The required returns of the two stocks are
Answer (D) is correct. The formula for the required rate of return is the risk-free rate of return plus beta times the market risk premium. The market risk premium is the market rate of return minus the risk-free rate of return. Thus, the required rate of returns are calculated as follows:
Required rate of return for X = 4% + .5 × (12% – = 4% )
=4% + .5 × (8%)
=4% + 4%
Required rate of return for Y = 4% + 2.0 × (12% – 4%)
= 4% + 2.0 × (8%)
= 4% + 16%