Deck 13: Empirical Evidence on Security Returns

Question 1

Fama and MacBeth (1973) found that the relationship between average excess returns and betas was

A) linear.
B) nonexistent.
C) as expected, based on earlier studies.
D) linear and as expected, based on earlier studies.
E) Fama and MacBeth did not examine the relationship between excess returns and beta.

Answer 1

D
Explanation: The Fama and MacBeth study validated earlier studies of the excess returns/beta relationship.

Question 2

The expected return/beta relationship is used

A) by regulatory commissions in determining the costs of capital for regulated firms.
B) in court rulings to determine discount rates to evaluate claims of lost future incomes.
C) to advise clients as to the composition of their portfolios.
D) All of the options are correct.
E) None of the options are correct.

Answer 2

D
Explanation: The risk/return relationship is appropriate for all of the uses cited above.

Question 3

Given the results of the early studies by Lintner (1965) and Miller and Scholes (1972), one would conclude that

A) high beta stocks tend to outperform the predictions of the CAPM.
B) low beta stocks tend to outperform the predictions of the CAPM.
C) there is no relationship between beta and the predictions of the CAPM.
D) high beta stocks and low beta stocks tend to outperform the predictions of the CAPM.
E) None of the options are correct.

Answer 3

B
Explanation: The results of these studies are exactly the opposite of what one would expect.

Question 4

In the results of the earliest estimations of the security market line by Miller and Scholes (1972), it was found that the average difference between a stock's return and the risk free rate was ________ to its beta.

A) positively related
B) negatively related
C) unrelated
D) inversely related
E) not proportional

Question 5

If a market proxy portfolio consistently beats all professionally managed portfolios on a risk adjusted basis, it may be concluded that

A) the CAPM is valid.
B) the market proxy is mean/variance efficient.
C) the CAPM is invalid.
D) the CAPM is valid and the market proxy is mean/variance efficient.
E) the market proxy is mean/variance efficient and the CAPM is invalid.

Question 6

In the 1972 empirical study by Black, Jensen, and Scholes, they found that the risk adjusted returns of high beta portfolios were _____________ the risk adjusted returns of low beta portfolios.

A) greater than
B) equal to
C) less than
D) unrelated to
E) More information is necessary to answer this question.

Question 7

In the results of the earliest estimations of the security market line by Miller and Scholes (1972), it was found that the average difference between a stock's return and the risk free rate was ________ to its nonsystematic risk and ________ to its beta.

A) positively related; negatively related
B) negatively related; positively related
C) positively related; positively related
D) negatively related; negatively related
E) not related; not related

Question 8

The research by Fama and French suggesting that CAPM is invalid has generated which of the following responses?

A) Better econometrics should be used in the test procedure.
B) Estimates of asset betas need to be improved.
C) Theoretical sources and implications of research that contradicts CAPM needs to be reconsidered.
D) The single index model needs to account for nontraded assets and the cyclical behavior of asset betas.
E) All of the options are correct.

Question 9

Consider the regression equation: r_i r_f = g₀ + g₁b₁ + g₂s²(e_i) + e_it
Where:
R_i r_f = the average difference between the monthly return on stock i and the monthly risk free rate
B_i = the beta of stock i
S²(e_i) = a measure of the nonsystematic variance of the stock i
If you estimated this regression equation and the CAPM was valid, you would expect the estimated coefficient, g₀, has to be

A) 0.
B) 1.
C) equal to the risk free rate of return.
D) equal to the average difference between the monthly return on the market portfolio and the monthly risk free rate.
E) None of the options are correct.

Question 10

__________ argued in his famous critique that tests of the expected return/beta relationship are invalid and that it is doubtful that the CAPM can ever be tested.

A) Kim
B) Markowitz
C) Modigliani
D) Roll
E) None of the options are correct.

Question 11

In the results of the earliest estimations of the security market line by Lintner (1965) and by Miller and Scholes (1972), it was found that the average difference between a stock's return and the risk free rate was ________ to its nonsystematic risk.

A) positively related
B) negatively related
C) unrelated
D) related in a nonlinear fashion
E) None of the options are correct.

Question 12

Kandel and Stambaugh (1995) expanded Roll's critique of the CAPM by arguing that tests rejecting a positive relationship between average return and beta are demonstrating

A) the inefficiency of the market proxy used in the tests.
B) that the relationship between average return and beta is not linear.
C) that the relationship between average return and beta is negative.
D) the need for a better way of explaining security returns.
E) None of the options are correct.

Question 13

In developing their test of a multifactor model, Chen, Roll, and Ross hypothesized that __________ might be a proxy for systematic factors.

A) the monthly growth rate in industrial production
B) unexpected inflation
C) expected inflation
D) the monthly growth rate in industrial production and unexpected inflation
E) the monthly growth rate in industrial production, unexpected inflation, and expected inflation

Question 14

The expected return/beta relationship is not used

A) by regulatory commissions in determining the costs of capital for regulated firms.
B) in court rulings to determine discount rates to evaluate claims of lost future incomes.
C) to advise clients as to the composition of their portfolios.
D) by regulatory commissions in determining the costs of capital for regulated firms and to advise clients as to the composition of their portfolios.
E) None of the options are correct.

Question 15

In the 1972 empirical study by Black, Jensen, and Scholes, they found that the estimated slope of the security market line was _______ what the CAPM would predict.

A) flatter than
B) equal to
C) steeper than
D) one half as much as
E) None of the options are correct.

Question 16

If a professionally managed portfolio consistently outperforms the market proxy on a risk adjusted basis and the market is efficient, it should be concluded that

A) the CAPM is invalid.
B) the proxy is inadequate.
C) either the CAPM is invalid or the proxy is inadequate.
D) the CAPM is valid and the proxy is adequate.
E) None of the options are correct.

Question 17

In the 1972 empirical study by Black, Jensen, and Scholes, they found that the estimated slope of the security market line was _______ what the CAPM would predict.

A) higher than
B) equal to
C) less than
D) twice as much as
E) More information is required to answer this question.

Question 18

Consider the regression equation: r_it r_ft = a_i + b_i(r_mt r_ft) + e_it
Where:
R_it = return on stock i in month t
R_ft = the monthly risk free rate of return in month t
R_mt = the return on the market portfolio proxy in month t
This regression equation is used to estimate

A) the security characteristic line.
B) benchmark error.
C) the capital market line.
D) All of the options are correct.
E) None of the options are correct.

Question 19

In the empirical study of a multifactor model by Chen, Roll, and Ross, a factor (the factors) that appeared to have significant explanatory power in explaining security returns was (were)

A) the change in the expected rate of inflation.
B) the risk premium on corporate bonds.
C) the unexpected change in the rate of inflation.
D) industrial production.
E) the risk premium on corporate bonds, the unexpected change in the rate of inflation, and industrial production.

Question 20

In the empirical study of a multifactor model by Chen, Roll, and Ross, a factor that did not appear to have significant explanatory power in explaining security returns was

A) the change in the expected rate of inflation.
B) the risk premium on corporate bonds.
C) the unexpected change in the rate of inflation.
D) industrial production.

Question 21

Consider the regression equation: r_i r_f = g₀ + g₁b_i + e_it
where:
R_i r_f = the average difference between the monthly return on stock i and the monthly risk free rate
B_i = the beta of stock i
This regression equation is used to estimate

A) the benchmark error.
B) the security market line.
C) the capital market line.
D) the benchmark error and the security market line.
E) the benchmark error, the security market line, and the capital market line.

Question 22

Which of the following would be required for tests of the multifactor CAPM and APT?

A) Specification of risk factors
B) Identification of portfolios that hedge these fundamental risk factors
C) Tests of the explanatory power and risk premiums of the hedge portfolios
D) All of the options are correct.
E) None of the options are correct.

Question 23

Tests of the CAPM that use regression techniques are subject to inaccuracies because

A) the statistical results used are almost always incorrect.
B) the slope coefficient of the regression equation is biased downward.
C) the slope coefficient of the regression equation is biased upward.
D) the intercept of the regression equation is biased downward.
E) the intercept of the regression equation is equal to the risk free rate.

Question 24

Fama and French (2002) studied the equity premium puzzle by breaking their sample into subperiods and found that

A) the equity premium was largest throughout the entire 1872 1999 period.
B) the equity premium was largest during the 1872 1949 subperiod.
C) the equity premium was largest during the 1950 1999 subperiod.
D) the differences in equity premiums for the three time periods were statistically insignificant.
E) the constant growth dividend discount model never works.

Question 25

In their multifactor model, Chen, Roll, and Ross found

A) that two market indexes, the equally weighted NYSE and the value weighted NYSE, were not significant predictors of security returns.
B) that the value weighted NYSE index had the incorrect sign, implying a negative market risk premium.
C) expected changes in inflation predicted security returns.
D) that two market indexes, the equally weighted NYSE and the value weighted NYSE, were not significant predictors of security returns and that the value weighted NYSE index had the incorrect sign, implying a negative market risk premium.
E) All of the options are correct.

Question 26

Which of the following statements is true about models that attempt to measure the empirical performance of the CAPM?

A) The conventional CAPM works better than the conditional CAPM with human capital.
B) The conventional CAPM works about the same as the conditional CAPM with human capital.
C) The conditional CAPM with human capital yields a better fit for empirical returns than the conventional CAPM.
D) Adding firm size to the model specification dramatically improves the fit.
E) Adding firm size to the model specification worsens the fit.

Question 27

Early tests of the CAPM involved

A) establishing sample data.
B) estimating the security characteristic line.
C) estimating the security market line.
D) All of the options are correct.
E) None of the options are correct.

Question 28

Strongest evidence in support of the CAPM has come from demonstrating that

A) the market beta is equal to 1.0.
B) nonsystematic risk has significant explanatory power in estimating security returns.
C) the average return beta relationship is highly significant.
D) the intercept in tests of the excess returns beta relationship is exactly zero.
E) professional investors do not generally outperform market indexes, demonstrating that the market is efficient.

Question 29

Consider the regression equation: r_i r_f = g₀ + g₁b_i + g₂s²(e_i) + e_it
Where:
R_i r_t = the average difference between the monthly return on stock i and the monthly risk free rate
B_i = the beta of stock i
S²(e_i) = a measure of the nonsystematic variance of the stock i
If you estimated this regression equation and the CAPM was valid, you would expect the estimated coefficient, g₂, to be

A) 0.
B) 1.
C) equal to the risk free rate of return.
D) equal to the average difference between the monthly return on the market portfolio and the monthly risk free rate.
E) None of the options are correct.

Question 30

Benchmark error

A) refers to the use of an incorrect market proxy in tests of the CAPM.
B) can result in inconclusive tests of the CAPM.
C) can result in incorrect evaluation measures for portfolio managers.
D) refers to the use of an incorrect market proxy in tests of the CAPM and can result in inconclusive tests of the CAPM.
E) All of the options are correct.

Question 31

The CAPM is not testable unless

A) the exact composition of the true market portfolio is known and used in the tests.
B) all individual assets are included in the market proxy.
C) the market proxy and the true market portfolio are highly negatively correlated.
D) the exact composition of the true market portfolio is known and used in the tests, and all individual assets are included in the market proxy.
E) all individual assets are included in the market proxy and the market proxy, and the true market portfolio are highly negatively correlated.

Question 32

One way that Black, Jensen and Scholes overcame the problem of measurement error was to

A) group securities into portfolios.
B) use a two stage regression methodology.
C) reduce the precision of beta estimates.
D) set alpha equal to one.
E) None of the options are correct.

Question 33

Equity premium puzzle studies may be subject to survivorship bias because

A) the time period covered was not long enough.
B) an inappropriate index was used.
C) the indexes used did not exist for the whole period of the study.
D) both U.S. and foreign data were used.
E) only U.S. data was used.

Question 34

Which of the following statements is false about models that attempt to measure the empirical performance of the CAPM? I) The conventional CAPM works better than the conditional CAPM with human capital.
II) The conventional CAPM works about the same as the conditional CAPM with human capital.
III) The conditional CAPM with human capital yields a better fit for empirical returns than the conventional CAPM.

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

Question 35

Consider the regression equation: r_i r_f = g₀ + g₁b_i + g₂s²(e_i) + e_it
where:
R_i r_t = the average difference between the monthly return on stock i and the monthly risk free rate
B_i = the beta of stock i
S²(e_i) = a measure of the nonsystematic variance of the stock i
If you estimated this regression equation and the CAPM was valid, you would expect the estimated coefficient, g₁, to be

A) 0.
B) 1.
C) equal to the risk free rate of return.
D) equal to the average difference between the monthly return on the market portfolio and the monthly risk free rate.
E) equal to the average monthly return on the market portfolio.

Question 36

According to Roll, the only testable hypothesis associated with the CAPM is

A) the number of ex post mean variance efficient portfolios.
B) the exact composition of the market portfolio.
C) whether the market portfolio is mean variance efficient.
D) the SML relationship.
E) None of the options are correct.

Question 37

A study by Mehra and Prescott (1985) found that historical average excess returns

A) have been too small to be consistent with rational security pricing.
B) have been too large to be consistent with rational security pricing.
C) have been too small to be consistent with fractional security pricing.
D) prove CAPM is incorrect.
E) prove the market is efficient.

Question 38

Which of the following is a (are) result(s) of the Fama and French (2002) study of the equity premium puzzle? I) Average realized returns during 1950 1999 exceeded the internal rate of return (IRR) for corporate investments.
II) The statistical precision of average historical returns is far higher than the precision of estimates from the dividend discount model (DDM).
III) The reward to variability ratio (Sharpe) derived from the DDM is far more stable than that derived from realized returns.
IV) There is no difference between DDM estimates and actual returns with regard to IRR, statistical precision, or the Sharpe measure.

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

Question 39

Tests of multifactor models indicate

A) the single factor model has better explanatory power in estimating security returns.
B) macroeconomic variables have no explanatory power in estimating security returns.
C) it may be possible to hedge some economic factors that affect future consumption risk with appropriate portfolios.
D) multifactor models do not work.
E) None of the options are correct.

Question 40

Fama and French (1992) found that

A) firm size had better explanatory power than beta in describing portfolio returns.
B) beta had better explanatory power than firm size in describing portfolio returns.
C) beta had better explanatory power than book to market ratios in describing portfolio returns.
D) macroeconomic factors had better explanatory power than beta in describing portfolio returns.
E) None of the options are correct.

Question 41

Which of the following must be done to test the multifactor CAPM or the APT? I) Specify the risk factors
II) Identify portfolios that hedge the risk factors
III) Test the explanatory power of hedge portfolios
IV) Test the risk premiums of hedge portfolios

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

Question 42

Liew and Vassalou (2000) show that returns on style portfolios (SMB and HML)

A) seem like statistical flukes.
B) seem to predict GDP growth.
C) may be proxies for business cycle risk.
D) seem to predict GDP growth and may be proxies for business cycle risk.
E) None of the options are correct.

Question 43

An extension of the Fama French three factor model includes a fourth factor to measure

A) default spread.
B) term spread.
C) momentum.
D) industrial production.
E) inflation.

Question 44

A major finding by Heaton and Lucas (2000) is that

A) the market rate of return does not help explain the rate of return of individual securities, and CAPM must be rejected.
B) the market rate of return does explain the rate of return of individual securities.
C) the change in proprietary wealth helps explain the rate of return of individual securities.
D) the market rate of return does not help explain the rate of return of individual securities, and CAPM must be rejected, but the change in proprietary wealth helps explain the rate of return of individual securities.
E) None of the options are correct.

Question 45

Petkova and Zhang (2005) examine the relationship between beta and the market risk premium and find

A) a countercyclical beta is negative in good economies and positive in bad economies.
B) the beta of the HML portfolio is negative in good economies and positive in bad economies.
C) a cyclical beta is positive in good economies and negative in bad economies.
D) the beta of the HML portfolio is positive in good economies and negative in bad economies.
E) a countercyclical beta and the beta of the HML portfolio are negative in good economies and positive in bad economies.

Question 46

The Fama French model I) is a useful tool for benchmarking performance against a well defined set of factors.
II) premia are determined by market irrationality.
III) premia are determined by rational risk factors.
IV) is the reason that the premia is unsettled.
V) is not a useful tool for benchmarking performance against a well defined set of factors.

A) I only
B) V only
C) I and II
D) I and IV
E) II and V

Question 47

The Fama and French three factor model uses ___, ___, and ___ as factors.

A) industrial production; term spread; default spread
B) industrial production; inflation; default spread
C) firm size; book to market ratio; market index
D) firm size; book to market ratio; default spread
E) None of the options are correct.

Question 48

An extension of the Fama French three factor model was introduced by

A) Black.
B) Scholes.
C) Carhart.
D) Jensen.
E) Miller.

Question 49

Liquidity embodies several characteristics, such as

A) trading costs.
B) ease of sale.
C) market depth.
D) necessary price concessions to effect a quick transaction.
E) All of the options are correct.

Question 50

Studies by Chan, Karceski, and Lakonishok (2003) and La Porta, Lakonishok, Shleifer, and Vishny (1997) report that

A) the value premium is a manifestation of market irrationality.
B) the value premium is a rational risk premia.
C) the value premium is a statistical artifact found only in the U.S.
D) All of the options are correct.
E) None of the options are correct.

Question 51

Jagannathan and Wang (2006) find that the CCAPM explains returns ______ the Fama French three factor model, and that the Fama French three factor model explains returns ______ the traditional CAPM.

A) worse than; worse than
B) worse than; better than
C) better than; better than
D) better than; worse than
E) equally as well as; equally as well as

Question 52

The Fama and French three factor model does not use ___ as one of the explanatory factors.

A) industrial production
B) inflation
C) firm size
D) book to market ratio
E) industrial production or inflation