Question 1

Standard deviation of portfolio returns is a measure of ________.

Accepted Answer

Standard deviation of portfolio returns is a measure of total risk, which includes both systematic and unsystematic risk.

Question 2

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

Accepted Answer

Roll's critique of the Capital Asset Pricing Model (CAPM) is that it is not testable in a true sense because the actual market portfolio, which should include all assets in the world (not just traded financial assets but also things like human capital and real estate), can never be fully observed or replicated.

Question 3

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

Accepted Answer

Alpha measures the abnormal return of a stock, which is the difference between the actual return and the expected return based on the stock's beta coefficient.

Question 4

Liquidity is a risk factor that ________.

Accepted Answer

Liquidity risk refers to the risk associated with the ease of converting an asset into cash without significantly affecting its market price. It is a complex factor that has been challenging to measure accurately and incorporate into portfolio management strategies. Trading mechanisms, market conditions, and various asset characteristics can influence liquidity, making it a significant consideration across different types of investments, including both stocks and bonds.

Question 5

Consider two stocks, A and B. Stock A has an expected return of 10% and a beta of 1.2. Stock B has an expected return of 14% and a beta of 1.8. The expected market rate of return is 9% and the risk-free rate is 5%. Security ________ would be considered the better buy because ________.

Accepted Answer

α_A = .10 − [.05 + 1.20(.09) - .05] = .002 α_B = .14 − [.05 + 1.80(.09) - .05] = .018

Question 6

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

Accepted Answer

The Security Market Line (SML) applies to both individual assets and well-diversified portfolios, while the Capital Market Line (CML) is valid only for well-diversified portfolios.

Question 7

Beta is a measure of ________.

Accepted Answer

Beta measures the relative systematic risk of a stock or portfolio compared to the overall market. It indicates how much a stock's price will move in relation to the overall market. Beta less than 1 indicates less systematic risk and beta greater than 1 indicates higher systematic risk. Therefore, option B is the correct answer.

Question 8

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

Accepted Answer

E(r_x) would normally be .04 + .8(.11 - .04) = .096

Question 9

The risk-free rate and the expected market rate of return are 6% and 16%, respectively. According to the capital asset pricing model, the expected rate of return on security X with a beta of 1.2 is equal to ________.

Accepted Answer

E(r_x) = .06 + .1.2(.16 - .06) = .18

Question 10

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

Accepted Answer

The most significant conceptual difference between APT and CAPM is that APT recognizes multiple systematic risk factors while CAPM only recognizes one systematic risk factor (market risk).

Question 11

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

Accepted Answer

The arbitrage pricing theory (APT) does not specify which macroeconomic factors should be used, making it difficult to identify the key variables affecting the risk-return relationship.

Question 12

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

Accepted Answer

Fama and French claim that the book-to-market ratio and firm size are better variables than beta in explaining stock returns, but they do not consider the unexpected change in industrial production as a relevant factor. Therefore, the correct choice is option C, which includes variables I and III only.

Question 13

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

Accepted Answer

According to CAPM, the risk premium is directly related to the beta of the stock. Beta measures the systematic risk of the stock, which is the risk that affects the entire market. The higher the beta of a stock, the higher the risk premium that investors expect to receive as compensation for taking on the additional risk. Choice A and B are incorrect because risk aversion is not directly related to the expected risk premium in the CAPM. Choice D is incorrect because alpha is not a measure of systematic risk and, therefore, is not used in the CAPM to determine the expected risk premium.

Question 14

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

Accepted Answer

According to capital asset pricing theory, the key determinant of portfolio returns is the systematic risk of the portfolio, which is measured by beta. This is because investors are assumed to be rational and risk-averse and will only be compensated for taking on systematic risk, which cannot be diversified away through diversification. Firm-specific risk, economic factors, and degree of diversification are important factors to consider, but they do not have as much impact on portfolio returns as the systematic risk.

Question 15

Consider the one-factor APT. The standard deviation of return on a well-diversified portfolio is 20%. The standard deviation on the factor portfolio is 12%. The beta of the well-diversified portfolio is approximately ________.

Accepted Answer

β = 11eaaae8_8b64_1d8b_a4b8_41b45d9e42f5_TB6474_11 = 1.67

Question 16

In a study conducted by Jagannathan and Wang, it was found that the performance of beta in explaining security returns could be considerably enhanced by:
I. Including the unsystematic risk of a stock
II. Including human capital in the market portfolio
III. Allowing for changes in beta over time

Accepted Answer

Jagannathan and Wang's study found that including human capital in the market portfolio and allowing for changes in beta over time could significantly improve the performance of beta in explaining security returns. They did not suggest that including the unsystematic risk of a stock would enhance beta's explanatory power, as unsystematic risk is diversifiable and not typically considered in models like the CAPM, which focuses on systematic risk.

Question 17

Arbitrage is ________.

Accepted Answer

Arbitrage is the practice of buying and selling securities or assets in different markets to take advantage of price discrepancies and earn riskless profits. It involves exploiting market inefficiencies to generate profit without taking on any additional risk. Therefore, the best answer is B.

Question 18

The expected return of the risky-asset portfolio with minimum variance is ________.

Accepted Answer

The expected return of the risky-asset portfolio with minimum variance cannot be determined from the information given, as it depends on the specific assets and their returns in the portfolio.

Question 19

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

Accepted Answer

The residual standard deviation, also known as the residual standard error, is a measure of the variability of the residuals in a regression model. Since unsystematic risk is the risk that is specific to individual assets and cannot be diversified away, it can be represented by the residual variability in the index model. Therefore, the measure of unsystematic risk can be found from an index model as the residual standard deviation.

Question 20

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

Accepted Answer

According to the CAPM, investors are compensated for systematic risk which is measured by beta. This compensation is called the risk premium. In addition, time value of money and expected inflation are also factors that impact investors' compensation. However, residual risk is not compensated for because it is considered unsystematic and can be diversified away by holding a portfolio of stocks.

Quiz 7: Capital Asset Pricing and Arbitrage Pricing Theory