Management Notes

# Management Notes

Reference Notes for Management

# Capital Asset Pricing Model (CAPM) Quiz Questions and Answers – Multiple Choice Questions (MCQs) | Finance Quiz

## Capital Asset Pricing Model (CAPM) Quiz Questions and Answers

### 1. What does CAPM stand for?

a. Capital Asset Pricing Method
b. Comprehensive Asset Price Model
c. Capital Asset Pricing Model
d. Current Asset Price Measurement

Answer: c. Capital Asset Pricing Model
Explanation: CAPM stands for Capital Asset Pricing Model. It is a widely used financial model that establishes the relationship between the expected return on an investment and its systematic risk.

### 2. According to CAPM, what is the expected return on an investment primarily influenced by?

a. Company size
b. Market risk
c. Number of employees

Explanation: The expected return according to CAPM is primarily influenced by market risk, often measured by the beta coefficient, which reflects an investment’s sensitivity to overall market movements.

### 3. What is the risk-free rate in CAPM?

a. Rate with no investment risk
b. Rate with minimum market risk
c. Rate of return on government bonds
d. Rate of return on high-risk assets

Answer: c. Rate of return on government bonds
Explanation: The risk-free rate in CAPM represents the return on an investment with zero risk. It is often approximated by the rate of return on government bonds since they are considered to have minimal default risk.

### 4. How is beta related to an investment’s risk in CAPM?

a. Positive correlation
b. Negative correlation
c. No correlation
d. Random correlation

Explanation: Beta in CAPM measures the positive correlation between an investment’s returns and the market returns. A beta greater than 1 indicates higher volatility than the market, while a beta less than 1 suggests lower volatility.

### 5. In CAPM, what does the slope of the Security Market Line (SML) represent?

a. Risk-free rate
c. Expected market return
d. Standard deviation

Explanation: The slope of the Security Market Line (SML) in CAPM represents the market risk premium, which is the excess return investors require for taking on additional risk beyond the risk-free rate.

### 6. What does the intercept of the Security Market Line (SML) in CAPM represent?

a. Risk-free rate
c. Expected market return
d. Standard deviation

Explanation: The intercept of the Security Market Line (SML) in CAPM represents the risk-free rate, indicating the return investors would expect for an investment with zero risk.

### 7. According to CAPM, how is the expected return on an asset calculated?

a. Risk-free rate + Inflation rate
b. Risk-free rate + Beta
c. Risk-free rate + (Beta × Market risk premium)
d. Risk-free rate – Market risk premium

Explanation: According to CAPM, the expected return on an asset is calculated by adding the risk-free rate to the product of the asset’s beta and the market risk premium.

### 8. What happens to an asset’s expected return in CAPM if its beta increases?

a. Expected return increases
b. Expected return decreases
c. No change in expected return
d. Cannot be determined

Explanation: In CAPM, as the beta of an asset increases, its expected return also increases. This reflects the higher risk associated with the asset’s sensitivity to market movements.

### 9. What is the relationship between beta and systematic risk in CAPM?

a. Positive correlation
b. Negative correlation
c. No correlation
d. Inverse correlation

Explanation: Beta and systematic risk in CAPM have a positive correlation. Higher beta values indicate higher sensitivity to market movements, representing increased systematic risk.

### 10. How does CAPM account for unsystematic risk?

a. By including it in beta
b. By adjusting the risk-free rate
c. By excluding it from calculations
d. By incorporating it in the market risk premium

Answer: c. By excluding it from calculations
Explanation: CAPM assumes that unsystematic risk, also known as specific or diversifiable risk, can be eliminated through diversification. Therefore, it is excluded from the calculations in the model.

### 11. According to CAPM, what is the expected return of a risk-free asset?

a. Equal to the risk-free rate
b. Equal to the market risk premium
c. Equal to the expected market return
d. Equal to the inflation rate

Answer: a. Equal to the risk-free rate
Explanation: In CAPM, the expected return of a risk-free asset is equal to the risk-free rate, as it carries no systematic risk.

### 12. How does CAPM define systematic risk?

a. Risk that can be eliminated through diversification
b. Risk that affects only a specific industry
c. Risk that affects the entire market
d. Risk that is unpredictable

Answer: c. Risk that affects the entire market
Explanation: According to CAPM, systematic risk is the risk that affects the entire market and cannot be eliminated through diversification.

### 13. What is the purpose of the Capital Market Line (CML) in CAPM?

a. To represent the relationship between risk and return for individual securities
b. To represent the relationship between risk and return for a diversified portfolio
c. To measure the beta of individual securities
d. To calculate the risk-free rate

Answer: b. To represent the relationship between risk and return for a diversified portfolio
Explanation: The Capital Market Line (CML) in CAPM represents the relationship between risk and return for a fully diversified portfolio. It combines the risk-free rate with the market portfolio.

### 14. According to CAPM, what happens to the Security Market Line (SML) when the market risk premium increases?

a. SML shifts upward
b. SML shifts downward
c. No effect on SML
d. SML becomes steeper

Explanation: In CAPM, an increase in the market risk premium leads to a shift of the Security Market Line (SML) upward, reflecting the higher expected returns for all levels of systematic risk.

### 15. What is the role of the market risk premium in CAPM?

a. To represent the risk-free rate
b. To adjust the beta of individual securities
c. To quantify the excess return required for bearing systematic risk
d. To measure the standard deviation of the market

Answer: c. To quantify the excess return required for bearing systematic risk
Explanation: The market risk premium in CAPM quantifies the excess return that investors require for bearing systematic risk beyond the risk-free rate.

### 16. How does CAPM assume investors make decisions?

a. Based on past performance only
b. Based on expected returns only
c. Based on risk and return jointly
d. Based on company size

Answer: c. Based on risk and return jointly
Explanation: CAPM assumes that investors make decisions based on both risk and expected return, considering the trade-off between the two factors.

### 17. According to CAPM, what happens to an asset’s expected return if its beta is less than 1?

a. Expected return increases
b. Expected return decreases
c. No change in expected return
d. Cannot be determined

Explanation: In CAPM, if an asset’s beta is less than 1, its expected return decreases, indicating lower sensitivity to market movements and lower expected risk and return.

### 18. What is the significance of the market portfolio in CAPM?

a. Represents all individual securities in the market
b. Represents the average return of all individual securities
c. Represents the highest return in the market
d. Represents the lowest risk in the market

Answer: b. Represents the average return of all individual securities
Explanation: The market portfolio in CAPM represents the average return of all individual securities in the market, and it is used as a benchmark for evaluating the performance of individual investments.

### 19. How does CAPM consider the time value of money?

a. Discounts future cash flows
b. Ignores the time value of money
c. Assumes a constant discount rate
d. Uses a fixed interest rate

Answer: a. Discounts future cash flows
Explanation: CAPM considers the time value of money by discounting future cash flows to their present value using a discount rate that accounts for the risk-free rate and the risk associated with the investment.

### 20. In CAPM, what is the expected return of an asset with a beta of 1?

a. Equal to the risk-free rate
b. Equal to the market risk premium
c. Equal to the expected market return
d. Equal to the inflation rate

Answer: c. Equal to the expected market return
Explanation: In CAPM, an asset with a beta of 1 is expected to earn a return equal to the expected market return, reflecting average sensitivity to market movements and average systematic risk.