Deck 7: Capital Asset Pricing and Arbitrage Pricing Theory

Question 1

Which statement is true regarding the Capital Market Line (CML)?

A) The CML is the line from the risk-free rate through the market portfolio.
B) The CML is the best attainable capital allocation line.
C) The CML is also called the security market line.
D) The CML always has a positive slope.
E) The CML is the line from the risk-free rate through the market portfolio,is the best attainable capital allocation line,and it always has a positive slope.

Answer 1

E

Question 2

You invest $600 in security A with a beta of 1.2 and $400 in security B with a beta of 0.90.The beta of the resulting portfolio is

A) 1.40
B) 1.00
C) 0.36
D) 1.08
E) 0.80

Answer 2

D

Question 3

According to the Capital Asset Pricing Model (CAPM)a well diversified portfolio's rate of return is a function of

A) market risk
B) unsystematic risk
C) unique risk.
D) reinvestment risk.
E) none of these.

Answer 3

A

Question 4

According to the Capital Asset Pricing Model (CAPM),which one of the following statements is

A) The expected rate of return on a security decreases in direct proportion to a decrease in the risk-free rate.
B) The expected rate of return on a security increases as its beta increases.
C) A fairly priced security has an alpha of zero.
D) In equilibrium,all securities lie on the security market line.
E) All of these statements are true.

Question 5

According to the Capital Asset Pricing Model (CAPM),fairly priced securities

A) have positive betas.
B) have zero alphas.
C) have negative betas.
D) have positive alphas.
E) none of these.

Question 6

In a well diversified portfolio

A) market risk is negligible.
B) systematic risk is negligible.
C) unsystematic risk is negligible.
D) nondiversifiable risk is negligible.
E) none of these.

Question 7

The risk-free rate and the expected market rate of return are 0.06 and 0.12,respectively.According to the capital asset pricing model (CAPM),the expected rate of return on security X with a beta of 1.2 is equal to

A) 0.06.
B) 0.144.
C) 0.12.
D) 0.132
E) 0.18

Question 8

Which statement is not true regarding the market portfolio?

A) It includes all publicly traded financial assets.
B) It lies on the efficient frontier.
C) All securities in the market portfolio are held in proportion to their market values.
D) It is the tangency point between the capital market line and the indifference curve.
E) all of these are true.

Question 9

The market portfolio has a beta of

A) 0.
B) 1.
C) -1.
D) 0.5.
E) none of these

Question 10

Which statement is

A) The CML is the line from the risk-free rate through the market portfolio.
B) The CML is the best attainable capital allocation line.
C) The CML is also called the security market line.
D) The CML always has a positive slope.
E) All of these statements are true.

Question 11

According to the Capital Asset Pricing Model (CAPM),

A) a security with a positive alpha is considered overpriced.
B) a security with a zero alpha is considered to be a good buy.
C) a security with a negative alpha is considered to be a good buy.
D) a security with a positive alpha is considered to be underpriced.
E) none of these.

Question 12

The market risk,beta,of a security is equal to

A) the covariance between the security's return and the market return divided by the variance of the market's returns.
B) the covariance between the security and market returns divided by the standard deviation of the market's returns.
C) the variance of the security's returns divided by the covariance between the security and market returns.
D) the variance of the security's returns divided by the variance of the market's returns.
E) none of these.

Question 13

According to the Capital Asset Pricing Model (CAPM),the expected rate of return on any security is equal to

A) R_f + β[E(R_M)].
B) R_f + σ[E(R_M)- R_f].
C) R_f + β[E(R_M)- R_f].
D) E(R_M)+ R_f.
E) none of these.

Question 14

In the context of the Capital Asset Pricing Model (CAPM)the relevant measure of risk is

A) unique risk.
B) beta.
C) standard deviation of returns.
D) variance of returns.
E) none of these.

Question 15

The risk-free rate is 7 percent.The expected market rate of return is 15 percent.If you expect stock X with a beta of 1.3 to offer a rate of return of 12 percent,you should

A) buy stock X because it is overpriced.
B) sell short stock X because it is overpriced.
C) sell stock short X because it is underpriced.
D) buy stock X because it is underpriced.
E) none of these,as the stock is fairly priced.

Question 16

The Security Market Line (SML)is

A) the line that describes the expected return-beta relationship for well-diversified portfolios only.
B) also called the Capital Allocation Line.
C) the line that is tangent to the efficient frontier of all risky assets.
D) the line that represents the expected return-beta relationship.
E) the line that represents the relationship between an individual security's return and the market's return.

Question 17

Empirical results regarding betas estimated from historical data indicate that

A) betas are constant over time.
B) betas of all securities are always greater than one.
C) betas are always near zero.
D) betas appear to regress toward one over time.
E) betas are always positive.

Question 18

Assume that a security is fairly priced and has an expected rate of return of 0.13.The market expected rate of return is 0.13 and the risk-free rate is 0.04.The beta of the stock is

A) 1.25.
B) 1.7.
C) 1.
D) 0.95.
E) none of these

Question 19

Which statement is true regarding the market portfolio?

A) It includes all publicly traded financial assets.
B) It lies on the efficient frontier.
C) All securities in the market portfolio are held in proportion to their market values.
D) It is the tangency point between the capital market line and the indifference curve.
E) It includes all publicly traded financial assets,lies on the efficient frontier,and all securities in the market portfolio are held in proportion to their market values.

Question 20

Your personal opinion is that security X has an expected rate of return of 0.11.It has a beta of 1.5.The risk-free rate is 0.05 and the market expected rate of return is 0.09.According to the Capital Asset Pricing Model,this security is

A) underpriced.
B) overpriced.
C) fairly priced.
D) cannot be determined from data provided.
E) none of these.

Question 21

What is the expected return of a zero-beta security?

A) The market rate of return.
B) Zero rate of return.
C) A negative rate of return.
D) The risk-free rate.
E) None of these.

Question 22

In equilibrium,the marginal price of risk for a risky security must be

A) equal to the marginal price of risk for the market portfolio.
B) greater than the marginal price of risk for the market portfolio.
C) less than the marginal price of risk for the market portfolio.
D) adjusted by its degree of nonsystematic risk.
E) none of these are true.

Question 23

You invest 50% of your money in security A with a beta of 1.6 and the rest of your money in security B with a beta of 0.7.The beta of the resulting portfolio is

A) 1.40.
B) 1.15.
C) 0.36.
D) 1.08.
E) 0.80.

Question 24

The amount that an investor allocates to the market portfolio is negatively related to
I)the expected return on the market portfolio.
II)the investor's risk aversion coefficient.
III)the risk-free rate of return.
IV)the variance of the market portfolio

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

Question 25

The capital asset pricing model assumes

A) all investors are price takers.
B) all investors have the same holding period.
C) investors pay taxes on capital gains.
D) both a and b are true.
E) a,b and c are all true.

Question 26

The security market line (SML)

A) can be portrayed graphically as the expected return-beta relationship.
B) can be portrayed graphically as the expected return-standard deviation of market returns relationship.
C) provides a benchmark for evaluation of investment performance.
D) a and c.
E) b and c.

Question 27

The market price of risk

A) is the market risk premium divided by the standard deviation of the market returns.
B) has a reward-to-risk ratio of [E(r_M)- r_f]/σ²M.
C) is the price of a U.S.T-bill.
D) a and b.
E) a and c.

Question 28

Your opinion is that CSCO has an expected rate of return of 0.1375.It has a beta of 1.3.The risk-free rate is 0.04 and the market expected rate of return is 0.115.According to the Capital Asset Pricing Model,this security is

A) underpriced by 10%.
B) overpriced.
C) fairly priced.
D) cannot be determined from data provided.
E) underpriced by 5%.

Question 29

Studies of liquidity spreads in security markets have shown that

A) liquid stocks earn higher returns than illiquid stocks.
B) illiquid stocks earn higher returns than liquid stocks.
C) both liquid and illiquid stocks earn the same returns.
D) illiquid stocks are good investments for frequent,short-term traders.
E) None of these are true.

Question 30

If investors do not know their investment horizons for certain

A) the CAPM is no longer valid.
B) the CAPM underlying assumptions are not violated.
C) the implications of the CAPM are not violated as long as investors' liquidity needs are not priced.
D) the implications of the CAPM are no longer useful.
E) none of these are true.

Question 31

Research by Jeremy Stein of MIT resolves the dispute over whether beta is a sufficient pricing factor by suggesting that managers should use beta to estimate

A) long-term returns but not short-term returns.
B) short-term returns but not long-term returns.
C) both long-and short-term returns.
D) book-to-market ratios.
E) None of these was suggested by Stein.

Question 32

The risk premium on the market portfolio will be proportional to

A) the average degree of risk aversion of the investor population.
B) the risk of the market portfolio as measured by its variance.
C) the risk of the market portfolio as measured by its beta.
D) both a and b are true.
E) both a and c are true.

Question 33

Given the following two stocks A and B $$\begin{array} { l c c } \text { Security } & \text { Expected rate of return } & \text { Beta } \\\hline\text { A } & 0.12 & 1.2 \\\text { B } & 0.14 & 1.8\end{array}$$
If the expected market rate of return is 0.09 and the risk-free rate is 0.05,which security would be considered the better buy and why?

A) A because it offers an expected excess return of 1.2%.
B) B because it offers an expected excess return of 1.8%.
C) A because it offers an expected excess return of 2.2%.
D) B because it offers an expected return of 14%.
E) B because it has a higher beta.

Question 34

Standard deviation and beta both measure risk,but they are different in that

A) beta measures both systematic and unsystematic risk.
B) beta measures only systematic risk while standard deviation is a measure of total risk.
C) beta measures only unsystematic risk while standard deviation is a measure of total risk.
D) beta measures both systematic and unsystematic risk while standard deviation measures only systematic risk.
E) beta measures total risk while standard deviation measures only nonsystematic risk.

Question 35

Capital Asset Pricing Theory asserts that portfolio returns are best explained by:

A) economic factors.
B) specific risk.
C) systematic risk.
D) diversification.
E) none of these.

Question 36

The value of the market portfolio equals

A) the sum of the values of all equity securities.
B) the sum of the values of all equity and fixed income securities.
C) the sum the values of all equity,fixed income,and derivative securities.
D) the sum of the values of all equity,fixed income,and derivative securities plus the value of all mutual funds.
E) the entire wealth of the economy.

Question 37

An underpriced security will plot

A) on the Security Market Line.
B) below the Security Market Line.
C) above the Security Market Line.
D) either above or below the Security Market Line depending on its covariance with the market.
E) either above or below the Security Market Line depending on its standard deviation.

Question 38

The expected return-beta relationship

A) is the most familiar expression of the CAPM to practitioners.
B) refers to the way in which the covariance between the returns on a stock and returns on the market measures the contribution of the stock to the variance of the market portfolio,which is beta.
C) assumes that investors hold well-diversified portfolios
D) all of these are true.
E) none of these are true.

Question 39

Security A has an expected rate of return of 0.10 and a beta of 1.1.The market expected rate of return is 0.08 and the risk-free rate is 0.05.The alpha of the stock is

A) 1.7%.
B) -1.7%.
C) 8.3%.
D) 5.5%.
E) none of these.

Question 40

According to the CAPM,the risk premium an investor expects to receive on any stock or portfolio increases:

A) directly with alpha.
B) inversely with alpha.
C) directly with beta.
D) inversely with beta.
E) in proportion to its standard deviation.

Question 41

One of the assumptions of the CAPM is that investors exhibit myopic behavior.What does this mean?

A) They plan for one identical holding period.
B) The are price-takers who can't affect market prices through their trades.
C) They are mean-variance optimizers.
D) They have the same economic view of the world.
E) They pay no taxes or transactions costs.

Question 42

Your opinion is that Boeing has an expected rate of return of 0.0952.It has a beta of 0.92.The risk-free rate is 0.04 and the market expected rate of return is 0.10.According to the Capital Asset Pricing Model,this security is

A) underpriced by 7%.
B) overpriced.
C) fairly priced.
D) cannot be determined from data provided.
E) underpriced by 5%.

Question 43

List and discuss two of the assumptions of the CAPM.

Question 44

Discuss the assumptions of the capital asset pricing model,and how these assumptions relate to the "real world" investment decision process.

Question 45

A "fairly priced" asset lies

A) above the security market line.
B) on the security market line.
C) on the capital market line.
D) above the capital market line.
E) below the security market line.

Question 46

Discuss how the CAPM might be used in capital budgeting decisions and utility rate decisions.

Question 47

As a financial analyst,you are tasked with evaluating a capital budgeting project.You were instructed to use the IRR method and you need to determine an appropriate hurdle rate.The risk-free rate is 4 percent and the expected market rate of return is 11 percent.Your company has a beta of 1.0 and the project that you are evaluating is considered to have risk equal to the average project that the company has accepted in the past.According to CAPM,the appropriate hurdle rate would be ______%.

A) 4
B) 7
C) 15
D) 11
E) 1

Question 48

The CAPM applies to

A) portfolios of securities only.
B) individual securities only.
C) efficient portfolios of securities only.
D) efficient portfolios and efficient individual securities only.
E) all portfolios and individual securities.

Question 49

Discuss the mutual fund theorem.

Question 50

Which of the following statements about the mutual fund theorem is true?
I)It is similar to the separation property.
II)It implies that a passive investment strategy can be efficient.
III)It implies that efficient portfolios can be formed only through active strategies.
IV)It means that professional managers have superior security selection strategies.

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

Question 51

The expected return-beta relationship of the CAPM is graphically represented by

A) the security market line.
B) the capital market line.
C) the capital allocation line.
D) the efficient frontier with a risk-free asset.
E) the efficient frontier without a risk-free asset.

Question 52

For the CAPM that examines illiquidity premiums,if there is correlation among assets due to common systematic risk factors,the illiquidity premium on asset i is a function of

A) the market's volatility.
B) asset i's volatility.
C) the trading costs of security i.
D) the risk-free rate.
E) the money supply.

Question 53

Discuss the differences between the capital market line and the security market line.