Capital Market Theory

C is correct. CAPM states that only systematic risk (market risk) is rewarded with higher expected returns. This is because systematic risk cannot be diversified away and affects all securities in the market. Investors receive compensation only for risk they cannot eliminate through diversification.

A (Business risk), B (Credit risk), and D (Liquidity risk) are all forms of unsystematic (company-specific) risk that can be reduced through diversification. According to CAPM, investors receive no risk premium for holding diversifiable risks because they can eliminate these risks by building a well-diversified portfolio.

B is correct. Using the CAPM formula: Expected Return = Rf + β(Rm - Rf) = 3% + 1.5(10% - 3%) = 3% + 1.5(7%) = 3% + 10.5% = 13.5%. The equity risk premium is 7% (market return minus risk-free rate), and the stock's beta of 1.5 means it captures 1.5 times that premium.

A (10.5%) incorrectly adds only the equity risk premium adjustment without the risk-free rate. C (15.0%) incorrectly multiplies the beta by the market return instead of the equity risk premium. D (18.0%) incorrectly multiplies beta by the market return and then adds the risk-free rate.

A is correct. The weak form of EMH states that all past price information is already reflected in current prices, making technical analysis (chart patterns, historical prices) ineffective. If weak form efficiency holds, you cannot beat the market by studying historical trading data.

B (Quarterly earnings reports), C (Meeting with management), and D (SEC filings) all represent fundamental analysis using public information. These strategies could potentially be effective under weak form EMH because weak form only claims past prices are reflected in current prices, not all public information. However, these methods would be ineffective under semi-strong form EMH, which incorporates all public information.

B is correct. The efficient frontier shows the set of optimal portfolios offering the highest expected return for each level of risk (or equivalently, the lowest risk for each level of return). These portfolios represent the best risk-return combinations available.

A is incorrect because diversification can only eliminate unsystematic (company-specific) risk, not systematic (market) risk. MPT explicitly recognizes that market risk remains even in fully diversified portfolios. C is incorrect because correlation is critical to diversification benefits. Lower correlation provides greater risk reduction. D is incorrect because adding highly correlated securities provides minimal risk reduction. The diversification benefit diminishes as you add securities beyond approximately 30 to 40 holdings.

B is correct. When a security plots above the SML, it means the security is offering a higher expected return than CAPM predicts for its level of systematic risk (beta). This indicates the security is undervalued because investors are receiving more return than necessary to compensate for the risk, making it an attractive purchase.

A is incorrect because securities above the SML are undervalued, not overvalued. Overvalued securities plot below the SML. C is incorrect because fairly valued securities plot on the SML itself, where actual returns match expected returns. D is incorrect because the position above the SML indicates valuation status, not absolute risk level. A security with low beta can plot above the SML and still be appropriate for conservative investors.

B is correct. First, calculate the expected return using CAPM: Expected Return = Rf + β(Rm - Rf) = 3% + 1.2(11% - 3%) = 3% + 1.2(8%) = 3% + 9.6% = 12.6%. Then calculate alpha: Alpha = Actual Return - Expected Return = 14% - 12.6% = 1.4%. The positive alpha indicates the manager outperformed expectations by 1.4%.

A (0.4%) makes an error in the beta adjustment calculation. C (3.0%) incorrectly subtracts the risk-free rate from the actual return instead of calculating expected return first. D (5.6%) incorrectly calculates alpha as the difference between actual return and risk-free rate, ignoring the beta-adjusted market risk premium.

D is correct. A correlation of -0.8 (negative correlation) provides the greatest diversification benefit. When securities move in opposite directions, combining them significantly reduces portfolio volatility. Perfect negative correlation (-1.0) would provide maximum theoretical benefit, but -0.8 is still highly beneficial.

A (+1.0) provides no diversification benefit because perfectly correlated securities move together identically. B (+0.5) provides some diversification benefit, but positive correlation means securities still tend to move together. C (0.0) provides moderate benefit since the securities move independently, but negative correlation is more powerful for risk reduction.

C is correct. Research shows that portfolios containing approximately 30 to 40 securities eliminate most unsystematic (company-specific) risk. Beyond this point, additional diversification provides diminishing marginal benefits. The remaining risk is systematic risk that cannot be diversified away.

A (5 to 10 securities) is insufficient to achieve adequate diversification. While it provides some risk reduction, significant unsystematic risk remains. B (15 to 20 securities) provides substantial diversification but research indicates more holdings are optimal. D (100 or more securities) is unnecessary. While not harmful, adding securities beyond 40 provides minimal additional risk reduction and may increase costs and complexity.

B is correct. A beta of 0.7 means the stock is less volatile than the market. When the market moves up or down by 10%, this stock would typically move only 7% in the same direction. Stocks with beta less than 1.0 are considered defensive because they provide some cushion during market declines.

A is incorrect because stocks with beta greater than 1.0 are more volatile and aggressive, not less. C is incorrect because equally volatile stocks have a beta of 1.0. D is incorrect because negative beta indicates negative correlation with the market. This stock's positive beta of 0.7 means it moves in the same direction as the market, just with less magnitude.

A is correct. The Security Market Line uses beta (systematic risk only) on the x-axis, while the Capital Market Line uses standard deviation (total risk) on the x-axis. Both show expected return on the y-axis, but they measure risk differently. SML applies to all assets and portfolios, while CML applies only to efficient portfolios.

B is incorrect because both SML and CML can apply to various asset types. The key difference is the risk measure used, not the asset coverage. C is incorrect because both SML and CML deal with expected returns, not the distinction between historical and expected. D is incorrect because the active versus passive distinction is not what differentiates these lines. CML applies to efficient portfolios regardless of whether they're actively or passively managed.