Deck 12: An Alternative View of Risk and Return: the Arbitrage Pricing Theory

Question 1

A factor is a variable that:

A) affects the returns of risky assets in a systematic fashion.
B) affects the returns of risky assets in an unsystematic fashion.
C) correlates with risky asset returns in a unsystematic fashion.
D) does not correlate with the returns of risky assets in an systematic fashion.

Answer 1

affects the returns of risky assets in a systematic fashion.

Question 2

Which of the following statements is true?

A) A well-diversified portfolio has negligible systematic risk.
B) A well-diversified portfolio has negligible unsystematic risk.
C) An individual security has negligible systematic risk.
D) An individual security has negligible unsystematic risk.

Answer 2

A well-diversified portfolio has negligible unsystematic risk.

Question 3

Which of the following is true about the impact on market price of a security when a company makes an announcement and the market has discounted the news?

A) The price will change a great deal; even though the impact is primarily in the future, the future value is discounted to the present.
B) The price will change little, since the impact is primarily in the future.
C) The price will change little, since the market considers this information unimportant.
D) The price will change little, since the market considers this information untrue.
E) The price will change little, since the market has already included this information in the security's price.

Answer 3

The price will change little, since the market has already included this information in the security's price.

Question 4

Systematic risk is defined as:

A) a risk that specifically affects an asset or small group of assets.
B) any risk that affects a large number of assets.
C) any risk that has a huge impact on the return of a security.
D) the random component of return.

Question 5

The unexpected return on a security, U, is made up of:

A) market risk and systematic risk.
B) systematic risk and idiosyncratic risk.
C) idiosyncratic risk and unsystematic risk.
D) expected return and market risk.
E) expected return and idiosyncratic risk.

Question 6

If the expected rate of inflation was 3% and the actual rate was 6.2%; the systematic response coefficient from inflation, $\beta$ _I, would result in a change in any security return of:

A) 9.2%.
B) 3.2 $\beta$ _I%.
C) -3.2 $\beta$ _I%.
D) 3.0%.
E) 6.2 $\beta$ _I%.

Question 7

For a diversified portfolio including a large number of stocks,:

A) the weighted average expected return goes to zero.
B) the weighted average of the betas goes to zero.
C) the weighted average of the unsystematic risk goes to zero.
D) the return of the portfolio goes to zero.
E) the return on the portfolio equals the risk-free rate.

Question 8

If company A makes a new product discovery and their stock rises 5% this will have:

A) no effect on Company B's stock price because it is a systematic risk element.
B) no effect on Company B's stock price because it is an unsystematic risk element.
C) a large effect on Company B's stock price because it is a systematic risk element.
D) a large effect on Company B's stock price because it is an unsystematic risk element.

Question 9

Based on a multi-factor APT model, the concept of portfolio diversification is to minimize which one of the following?

A) weighted average of betas
B) weighted average of betas * F
C) F
D) weighted average of unsystematic risks
E) weighted average of expected returns

Question 10

The term Corr( $\varepsilon$ _R, $\varepsilon$ _T) = 0 tells us that:

A) the error terms of company R and T are 0.
B) the unsystematic risk of companies R and T is unrelated or uncorrelated.
C) the correlation between the returns of companies R and T is greater than zero.
D) the systematic risk companies R and T is unrelated.

Question 11

The single factor APT model that resembles the market model uses _____________ as the single factor.

A) arbitrage fees
B) GNP
C) the inflation rate
D) the market return
E) the risk-free return

Question 12

Both the APT and the CAPM imply a positive relationship between expected return and risk. The APT views risk:

A) very similarly to the CAPM via the beta of the security.
B) in terms of individual inter-security correlation versus the beta of the CAPM.
C) via the industry wide or market-wide factors creating correlation between securities versus the CAPM beta.
D) the standardized deviation of the covariance.

Question 13

In normal market conditions or when the market is rising if a security has a negative beta:

A) the security always has a positive return.
B) the security has an expected return above the risk-free return.
C) the security has an expected return less than the risk-free rate.
D) the security has an expected return equal to the market portfolio.

Question 14

Shareholders discount many corporate announcements because of their prior expectations. If an announcement causes the price to change it will mostly be driven by:

A) the expected part of the announcement.
B) market inefficiency.
C) the innovation or unexpected part of the announcement.
D) the systematic risk.

Question 15

In a portfolio of risky assets the response to a factor, F_i, can easily be determined by:

A) summing the weighted $\beta$ _is and multiplying by the innovation in F_i.
B) summing the F_is.
C) adding the average weighted expected returns.
D) Summing the weighted random errors.

Question 16

In the equation R = + U, the three symbols stand for:

A) average return, expected return, and unexpected return.
B) required return, expected return, and unbiased return.
C) actual return, expected return, and unexpected return.
D) required return, expected return, and unbiased risk.
E) risk, expected return, and unsystematic risk.
Blooms: Understand
Difficulty: Easy
Topic: 12-01 Factor Models: Announcements, Surprises, and Expected Returns

Question 17

Assume that the single factor APT model applies and a portfolio exists such that 2/3 of the funds are invested in Security Q and the rest in the risk-free asset. Security Q has a beta of 1.5. The portfolio has a beta of:

A) 0.00.
B) 0.50.
C) 0.75.
D) 1.00.
E) 1.50.

Question 18

The systematic response coefficient for productivity, $\beta$ _P, would produce an unexpected change in any security return of ________ if the expected rate of productivity was 1.5% and the actual rate was 2.25%.

A) 0.75( $\beta$ _P)%
B) -0.75( $\beta$ _P)%
C) 2.25( $\beta$ _P)%
D) -2.25%

Question 19

The betas along with the factors in the APT adjust the expected return for:

A) calculation errors.
B) unsystematic risks.
C) spurious correlations of factors.
D) differences between actual and expected levels of factors.

Question 20

In the One Factor (APT) Model, the characteristic line to estimate $\beta$ i passes through the origin, unlike the estimate used in the CAPM because:

A) the relationship is between the actual return on a security and the market index.
B) the relationship measures the change in the security return over time versus the change in the market return.
C) the relationship measures the change in excess return on a security versus GNP.
D) the relationship measures the change in excess return on a security versus the change in the factor about its mean of zero.

Question 21

Suppose that we have identified three important systematic risk factors given by exports, inflation, and industrial production. In the beginning of the year, growth in these three factors is estimated at -1%, 2.5%, and 3.5% respectively. However, actual growth in these factors turns out to be 1%, -2%, and 2%. The factor betas are given by $\beta$ EX = 1.8, $\beta$ I = 0.7, and $\beta$ IP = 1.0. What would the stock's total return be if the actual growth in each of the factors was equal to growth expected? Assume no unexpected news on the patent. Assume expected return on the stock is 6%.

A) 4%
B) 5%
C) 6%
D) 7%
E) 8%

Question 22

To estimate the required return for a security using APT or CAPM, it is necessary to have:

A) last period's return, beta, and the standard deviation.
B) last period's return, beta, and the risk-free rate.
C) beta, the market risk premium, and the risk-free rate.
D) beta, last period's return, and the standard deviation.
E) beta, last period's return, and the market risk premium.

Question 23

Explain the conceptual differences in the theoretical development of the CAPM and APT.

Question 24

Suppose the MiniCD Corporation's common stock has a return of 12%. Assume the risk-free rate is 4%, the expected market return is 9%, and no unsystematic influence affected Mini's return. The beta for MiniCD is:

A) 0.89.
B) 1.60.
C) 2.40.
D) 3.00.

Question 25

Financial models used to describe returns are based either on a theoretical construct or parametric methods. Parametric models rely on:

A) security betas explaining systematic factor relationships.
B) finding regularities and relations in past market data.
C) there being no true explanations of pricing relationships.
D) always being able to find the exception to the rule.

Question 26

The acronym CAPM stands for:

A) Capital Asset Pricing Model.
B) Certain Arbitrage Pressure Model.
C) Current Arbitrage Prices Model.
D) Cumulative Asset Price Model.

Question 27

A growth stock portfolio and a value portfolio might be characterized

A) each by their P/E relative to the index P/E; high P/E for growth and lower for value.
B) as earning a high rate of return for a growth security and a low rate of return for value security irrespective of risk.
C) low unsystematic risk and high systematic risk respectively.
D) moderate systematic risk and zero systematic risk respectively.

Question 28

An investor is considering the three stocks given below:

C. Demonstrate that holding stock A actually reduces risk by comparing the risk of a portfolio equally weighted between stock B and T-Bills with a portfolio equally weighted between stock B and
A.
Stock B and C: Rp = .5(13.3%) + .5(9.2%) = 11.25%
Stock B and C: $\beta$ p = .5(2.1) + .5(0.75) = 1.425
Stock B and T-bills: $\beta$ B&TBILL = .5(2.1) + .5(0) = 1.05
Stock's B and A: $\beta$ B&A = .5(2.1) + .5(-0.1) = 1.00

Question 29

An advantage of the APT over CAPM is:

A) APT can handle multiple factors.
B) if the factors can be properly identified, the APT may have more explanation/predictive power for returns.
C) the APT forces unsystematic risk to be negative to offset systematic risk; thus making the total portfolio risk free, allowing for an arbitrage opportunity for the astute investor.
D) APT can handle multiple factors; and if the factors can be properly identified, the APT may have more explanation/predictive power for returns.
E) All of these.

Question 30

Assuming that the single factor APT model applies, the beta for the market portfolio is:

A) zero.
B) one.
C) the average of the risk free beta and the beta for the highest risk security.
D) impossible to calculate without collecting sample data.

Question 31

A security that has a beta of zero will have an expected return of:

A) zero.
B) the market risk premium.
C) the risk free rate.
D) less than the risk free rate but not negative.
E) less than the risk free rate which can be negative.

Question 32

Which of the following statements is/are true?

A) Both APT and CAPM argue that expected excess return must be proportional to the beta(s).
B) APT and CAPM are the only approaches to measure expected returns in risky assets.
C) Both CAPM and APT are risk-based models.
D) Both APT and CAPM argue that expected excess return must be proportional to the beta(s); and APT and CAPM are the only approaches to measure expected returns in risky assets.
E) Both APT and CAPM argue that expected excess return must be proportional to the beta(s); and Both CAPM and APT are risk-based models.

Question 33

Suppose the JumpStart Corporation's common stock has a beta of 0.8. If the risk-free rate is 4% and the expected market return is 9%, the expected return for JumpStart's common stock is:

A) 3.2%.
B) 4.0%.
C) 7.2%.
D) 8.0%.
E) 9.0%.

Question 34

The acronym APT stands for:

A) Above Par Terms.
B) Absolute Profit Technique.
C) Arbitrage Pricing Theory.
D) Asset Puting Theory.
E) Assured Price Techniques.

Question 35

Suppose that we have identified three important systematic risk factors given by exports, inflation, and industrial production. In the beginning of the year, growth in these three factors is estimated at -1%, 2.5%, and 3.5% respectively. However, actual growth in these factors turns out to be 1%, -2%, and 2%. The factor betas are given by $\beta$ _EX = 1.8, $\beta$ _I = 0.7, and $\beta$ _IP = 1.0. Calculate the stock's total return if the company announces that they had an industrial accident and the operating facilities will close down for some time thus resulting in a loss by the company of 7% in return. Assume expected return on the stock is 6%.

A) -4.05%
B) -2.05%
C) 4.55%
D) 0.40%
E) 1.85%

Question 36

To estimate the cost of equity capital for a firm using APT or CAPM, it is necessary to have:

A) company financial leverage, beta, and the market risk premium.
B) company financial leverage, beta, and the risk-free rate.
C) beta, company financial leverage, and the industry beta.
D) beta, company financial leverage, and the market risk premium.
E) beta, the risk-free rate, and the market risk premium.

Question 37

A criticism of the CAPM is that it:

A) ignores the return on the market portfolio.
B) ignores the risk-free return.
C) requires a single measure of systematic risk.
D) utilizes too many factors.

Question 38

Three factors likely to occur in the APT model are:

A) unemployment, inflation, and current rates.
B) inflation, GNP, and interest rates.
C) current rates, inflation and change in housing prices.
D) unemployment, college tuition, and GNP.

Question 39

Style portfolios are characterized by:

A) their stock attributes; P/Es less than the market P/E are value funds.
B) their systematic factors, higher systematic factors are benchmark portfolios.
C) their stock attributes; higher stock attribute factors are benchmark portfolios.
D) their systematic factors, P/Es greater than the market are value portfolios.

Question 40

Suppose that we have identified three important systematic risk factors given by exports, inflation, and industrial production. In the beginning of the year, growth in these three factors is estimated at -1%, 2.5%, and 3.5% respectively. However, actual growth in these factors turns out to be 1%, -2%, and 2%. The factor betas are given by $\beta$ _EX = 1.8, $\beta$ _I = 0.7, and $\beta$ _IP = 1.0. If the expected return on the stock is 6%, and no unexpected news concerning the stock surfaces, calculate the stock's total return.

A) 2.95%
B) 4.95%
C) 6.55%
D) 7.40%
E) 8.85%

Question 41

Identify at least two accounting measures that are used in empirical asset pricing models and explain how these measures can be used to identify assets that are expected to have higher returns in the future.

Question 42

You have a 3 factor model to explain returns. Explain what a factor represents in the context of the APT? Each factor is multiplied by a $\beta$ what do these represent and how do they relate to the actual return?