Deck 7: Capital Pricing and Arbitrage Pricing Theory

Question 1

Security X has an expected rate of return of 13% and a beta of 1.15. The risk-free rate is 5% and the market expected rate of return is 15%. According to the capital asset pricing model, security X is ________.

A)fairly priced
B)overpriced
C)underpriced
D)None of the above

Answer 1

B

Question 2

Consider the CAPM. The risk-free rate is 6% and the expected return on the market is 18%. What is the expected return on a share with a beta of 1.3?

A)6%
B)15.6%
C)18%
D)21.6%

Answer 2

D

Question 3

According to the capital asset pricing model, fairly priced securities have ________.

A)negative betas
B)positive alphas
C)positive betas
D)zero alphas

Answer 3

D

Question 4

Consider the CAPM. The risk-free rate is 5% and the expected return on the market is 15%. What is the beta on a share with an expected return of 17%?

A).5
B).7
C)1
D)1.2

Question 5

Consider the single factor APT. Portfolio A has a beta of 1.3 and an expected return of 21%. Portfolio B has a beta of 0.7 and an expected return of 17%. The risk-free rate of return is 8%. If you wanted to take advantage of an arbitrage opportunity, you should take a short position in portfolio ________ and a long position in portfolio ________.

A)A, A
B)A, B
C)B, A
D)B, B

Question 6

In a well-diversified portfolio, ________ risk is negligible.

A)nondiversifiable
B)market
C)systematic
D)unsystematic

Question 7

In the context of the capital asset pricing model, the systematic measure of risk is captured by ________.

A)unique risk
B)beta
C)standard deviation of returns
D)variance of returns

Question 8

Consider the single factor APT. Portfolio A has a beta of 0.2 and an expected return of 13%. Portfolio B has a beta of 0.4 and an expected return of 15%. The risk-free rate of return is 10%. If you wanted to take advantage of an arbitrage opportunity, you should take a short position in portfolio ________ and a long position in portfolio ________.

A)A, A
B)A, B
C)B, A
D)B, B

Question 9

Consider the multi-factor APT with two factors. Portfolio A has a beta of 0.5 on factor 1 and a beta of 1.25 on factor 2. The risk premiums on the factors 1 and 2 portfolios are 1% and 7% respectively. The risk-free rate of return is 7%. The expected return on portfolio A is ________ if no arbitrage opportunities exist.

A)13.5%
B)15.0%
C)16.25%
D)23.0%

Question 10

The arbitrage pricing theory was developed by ________.

A)Henry Markowitz
B)Stephen Ross
C)William Sharpe
D)Eugene Fama

Question 11

In a simple CAPM world which of the following statements is/are correct?
I) All investors will choose to hold the market portfolio, which includes all risky assets in the world
II) Investors' complete portfolio will vary depending on their risk aversion
III) The return per unit of risk will be identical for all individual assets
IV) The market portfolio will be on the efficient frontier and it will be the optimal risky portfolio

A)I, II and III only
B)II, III and IV only
C)I, III and IV only
D)I, II, III and IV

Question 12

If all investors become more risk averse the SML will ________ and share prices will ________.

A)shift upward; rise
B)shift downward; fall
C)have the same intercept with a steeper slope; fall
D)have the same intercept with a flatter slope; rise

Question 13

The graph of the relationship between expected return and beta in the CAPM context is called the ________.

A)CML
B)CAL
C)SML
D)SCL

Question 14

Consider the one-factor APT. The variance of the return on the factor portfolio is .08. The beta of a well-diversified portfolio on the factor is 1.2. The variance of the return on the well-diversified portfolio is approximately ________.

A).1152
B).1270
C).1521
D).1342

Question 15

Which of the following are assumptions of the simple CAPM model?
I) Individual trades of investors do not affect a share's price
II) All investors plan for one identical holding period
III) All investors analyse securities in the same way and share the same economic view of the world
IV) All investors have the same level of risk aversion

A)I, II and IV only
B)I, II and III only
C)II, III and IV only
D)I, II, III and IV

Question 16

You have a $50 000 portfolio consisting of Intel, GE and Con Edison. You put $20 000 in Intel, $12 000 in GE and the rest in Con Edison. Intel, GE and Con Edison have betas of 1.3, 1.0 and 0.8 respectively. What is your portfolio beta?

A)1.048
B)1.033
C)1.000
D)1.037

Question 17

According to the capital asset pricing model, ________.

A)all securities' returns must lie on the capital market line
B)all securities' returns must lie on the security market line
C)the slope of the security market line must be less than the market risk premium
D)any security with a beta of 1 must have an excess return of zero

Question 18

If enough investors decide to purchase shares they are likely to drive up share prices thereby causing ________ and ________.

A)expected returns to fall; risk premiums to fall
B)expected returns to rise; risk premiums to fall
C)expected returns to rise; risk premiums to rise
D)expected returns to fall; risk premiums to rise

Question 19

Investors require a risk premium as compensation for bearing ________.

A)unsystematic risk
B)alpha risk
C)residual risk
D)systematic risk

Question 20

The possibility of arbitrage arises when ________.

A)there is no consensus among investors regarding the future direction of the market, and thus trades are made arbitrarily
B)mis-pricing among securities creates opportunities for riskless profits
C)two identically risky securities carry the same expected returns
D)investors do not diversify

Question 21

The risk-free rate is 4%. The expected market rate of return is 11%. If you expect share X with a beta of .8 to offer a rate of return of 12 per cent, then you should ________.

A)buy share X because it is overpriced
B)buy share X because it is underpriced
C)sell short share X because it is overpriced
D)sell short share X because it is underpriced

Question 22

The SML is valid for ________ and the CML is valid for ________.

A)only individual assets; well diversified portfolios only
B)only well diversified portfolios; only individual assets
C)both well diversified portfolios and individual assets; both well diversified portfolios and individual assets
D)both well diversified portfolios and individual assets; well diversified portfolios only

Question 23

In his famous critique of the CAPM, Roll argued that the CAPM ________.

A)is not testable because the true market portfolio can never be observed
B)is of limited use because systematic risk can never be entirely eliminated
C)should be replaced by the APT
D)should be replaced by the Fama French 3 factor model

Question 24

Standard deviation of portfolio returns is a measure of ________.

A)total risk
B)relative systematic risk
C)relative non-systematic risk
D)relative business risk

Question 25

In a single factor market model the beta of a share ________.

A)measures the share's contribution to the standard deviation of the market portfolio
B)measures the share's unsystematic risk
C)changes with the variance of the residuals
D)measures the share's contribution to the standard deviation of the share

Question 26

One of the main problems with the arbitrage pricing theory is ________.

A)its use of several factors instead of a single market index to explain the risk-return relationship
B)the introduction of non-systematic risk as a key factor in the risk-return relationship
C)that the APT requires an even larger number of unrealistic assumptions than the CAPM
D)the model fails to identify the key macroeconomic variables in the risk-return relationship

Question 27

Security A has an expected rate of return of 12% and a beta of 1.10. The market expected rate of return is 8% and the risk-free rate is 5%. The alpha of the share is ________.

A)-1.7%
B)3.7%
C)5.5%
D)8.7%

Question 28

An important characteristic of market equilibrium is ________.

A)the presence of many opportunities for creating zero-investment portfolios
B)all investors exhibiting the same degree of risk aversion
C)the absence of arbitrage opportunities
D)the a lack of liquidity in the market

Question 29

You run a regression of a share's returns versus a market index and find the following: Based on the data you know that the share

A)earned a positive alpha that is statistically significantly different from zero
B)has a beta precisely equal to 0.890
C)has a beta that could be anything between 0.6541 and 1.465 inclusive
D)has no systematic risk

Question 30

The variance of the return on the market portfolio is .0400 and the expected return on the market portfolio is 20%. If the risk-free rate of return is 10%, the market degree of risk aversion, A, is ________.

A)0.5
B)2.5
C)3.5
D)5.0

Question 31

The measure of unsystematic risk can be found from an index model as ________.

A)residual standard deviation
B)R-square
C)degrees of freedom
D)sum of squares of the regression

Question 32

Arbitrage is ________.

A)is an example of the law of one price
B)the creation of riskless profits made possible by relative mispricing among securities
C)is a common opportunity in modern markets
D)an example of a risky trading strategy based on market forecasting

Question 33

According to the CAPM, investors are compensated for all but which of the following?

A)Expected inflation
B)Systematic risk
C)Time value of money
D)Residual risk

Question 34

The most significant conceptual difference between the arbitrage pricing theory (APT) and the capital asset pricing model (CAPM) is that the CAPM ________.

A)places less emphasis on market risk
B)recognises multiple unsystematic risk factors
C)recognises only one systematic risk factor
D)recognises multiple systematic risk factors

Question 35

Beta is a measure of ________.

A)total risk
B)relative systematic risk
C)relative non-systematic risk
D)relative business risk

Question 36

According to capital asset pricing theory, the key determinant of portfolio returns is ________.

A)the degree of diversification
B)the systematic risk of the portfolio
C)the firm specific risk of the portfolio
D)economic factors

Question 37

According to the CAPM, the risk premium an investor expects to receive on any share or portfolio is ________.

A)directly related to the risk aversion of the particular investor
B)inversely related to the risk aversion of the particular investor
C)directly related to the beta of the share
D)inversely related to the alpha of the share

Question 38

Liquidity is a risk factor that ________.

A)has yet to be accurately measured and incorporated into portfolio management
B)is unaffected by trading mechanisms on various stock exchanges
C)has no effect on the market value of an asset
D)affects bond prices but not share prices

Question 39

A share's alpha measures the share's ________.

A)expected return
B)abnormal return
C)excess return
D)residual return

Question 40

Which of the following variables do Fama and French claim do a better job explaining share returns than beta?
I) Book to market ratio
II) Unexpected change in industrial production
III) Firm size

A)I only
B)I and II only
C)I and III only
D)I, II and III

Question 41

The expected return on the market is the risk-free rate plus the ________.

A)diversified returns
B)equilibrium risk premium
C)historical market return
D)unsystematic return

Question 42

What is the expected return on a share with a beta of 0.8, given a risk-free rate of 3.5% and an expected market return of 15.5%?

A)3.8%
B)13.1%
C)15.6%
D)19.1%

Question 43

The two factor model on a share provides a risk premium for exposure to market risk of 12%, a risk premium for exposure to silver commodity prices of 3.5% and a risk-free rate of 4.0%. What is the expected return on the share?

A)11.6%
B)13.0%
C)15.3%
D)19.5%

Question 44

If the beta of the market index is 1.0 and the standard deviation of the market index increases from 12% to 18%, what is the new beta of the market index?

A)0.8
B)1.0
C)1.2
D)1.5

Question 45

A share has a beta of 1.3. The unsystematic risk of this share is ________ the stock market as a whole.

A)higher than
B)lower than
C)equal to
D)indeterminable compared to

Question 46

The two factor model on a share provides a risk premium for exposure to market risk of 9%, a risk premium for exposure to interest rate of (-1.3%), and a risk-free rate of 3.5%. What is the expected return on the share?

A)8.7%
B)11.2%
C)13.8%
D)15.2%

Question 47

According to the CAPM, what is the expected market return given an expected return on a security of 15.8%, a share beta of 1.2, and a risk-free interest rate of 5.0%?

A)5.0%
B)9.0%
C)13.0%
D)14.0%

Question 48

The expected return on the market portfolio is 15%. The risk-free rate is 8%. The expected return on SDA Corp. common shares is 16%. The beta of SDA Corp. common shares is 1.25. Within the context of the capital asset pricing model, ________.

A)SDA Corp. shares are underpriced
B)SDA Corp. shares are fairly priced
C)SDA Corp. shares' alpha is -0.75%
D)SDA Corp. shares' alpha is 0.75%

Question 49

There are two independent economic factors M1 and M2. The risk-free rate is 5% and all shares have independent firm-specific components with a standard deviation of 25%. Portfolios A and B are well diversified. Given the data below which equation provides the correct pricing model?

A)E(r_P) = 5 + 1.12β_P1 + 11.86β_P2
B)E(r_P) = 5 + 4.96β_P1 + 13.26β_P2
C)E(r_P) = 5 + 3.23β_P1 + 8.46β_P2
D)E(r_P) = 5 + 8.71β_P1 + 9.68β_P2

Question 50

The measure of risk used in the Capital Asset Pricing Model is ________.

A)specific risk
B)the standard deviation of returns
C)reinvestment risk
D)beta

Question 51

You consider buying a share at a price of $25. The share is expected to pay a dividend of $1.50 next year and your advisory service tells you that you can expect to sell the share in one year for $28. The share's beta is 1.1, rf is 6% and E[rm] = 16%. What is the share's abnormal return?

A)1%
B)2%
C)-1%
D)-2%

Question 52

If the simple CAPM is valid and all portfolios are priced correctly, which of the situations below are possible?
Consider each situation independently and assume the risk-free rate is 5%.

A)Option A
B)Option B
C)Option C
D)Option D

Question 53

The risk premium for exposure to exchange rates is 5% and the firm has a beta relative to exchanges rates of 0.4. The risk premium for exposure to the consumer price index is -6% and the firm has a beta relative to the CPI of 0.8. If the risk-free rate is 3.0%, what is the expected return on this share?

A)0.2%
B)1.5%
C)3.6%
D)4.0%

Question 54

According to the CAPM, what is the market risk premium given an expected return on a security of 13.6%, a share beta of 1.2, and a risk-free interest rate of 4.0%?

A)4.0%
B)4.8%
C)6.6%
D)8.0%

Question 55

Research has identified two systematic factors that affect US stock (share) returns. The factors are growth in industrial production and changes in long term interest rates. Industrial production growth is expected to be 3% and long term interest rates are expected to increase by 1%. You are analysing a share that has a beta of 1.2 on the industrial production factor and 0.5 on the interest rate factor. It currently has an expected return of 12%. However, if industrial production actually grows 5% and interest rates drop 2% what is your best guess of the share's return?

A)15.9%
B)12.9%
C)13.2%
D)12.0%

Question 56

The risk premium for exposure to aluminum commodity prices is 4% and the firm has a beta relative to aluminum commodity prices of 0.6. The risk premium for exposure to GDP changes is 6% and the firm has a beta relative to GDP of 1.2. If the risk-free rate is 4.0%, what is the expected return on this share?

A)10.0%
B)11.5%
C)13.6%
D)14.0%

Question 57

Using the index model, the alpha of a share is 3.0%, the beta if 1.1 and the market return is 10%. What is the residual given an actual return of 15%?

A)0.0%
B)1.0%
C)2.0%
D)3.0%

Question 58

Assume that both X and Y are well-diversified portfolios and the risk-free rate is 8%. Portfolio X has an expected return of 14% and a beta of 1.00. Portfolio Y has an expected return of 9.5% and a beta of 0.25. In this situation, you would conclude that portfolios X and Y ________.

A)are in equilibrium
B)offer an arbitrage opportunity
C)are both underpriced
D)are both fairly priced

Question 59

Two investment advisors are comparing performance. Advisor A averaged a 20% return with a portfolio beta of 1.5 and Advisor B averaged a 15% return with a portfolio beta of 1.2. If the T-bond rate was 5% and the market return during the period was 13%, which advisor was the better share picker?

A)Advisor A was better because he generated a larger alpha
B)Advisor B was better because he generated a larger alpha
C)Advisor A was better because he generated a higher return
D)Advisor B was better because he achieved a good return with a lower beta