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

Question 1

Based on a multifactor model,systematic risk arises from:

A)a common factor,F.
B)negative betas.
C)the lack of market liquidity.
D)the variable,ε.
E)a positive covariance between securities.

Answer 1

a common factor,F.

Question 2

A beta coefficient reflects the response of a security's return to:

A)the risk-free rate.
B)an unsystematic risk.
C)a systematic risk.
D)the market rate of return.
E)idiosyncratic risk.

Answer 2

a systematic risk.

Question 3

Company A is a medical research company that develops and tests new drugs.Company B is in the news industry and publishes multiple newspapers.If Company A discovers a new product and its stock rises in value by 5 percent as a result,this will most likely have ________ effect on Company B's stock price because the discovery would be classified as ________ risk.

A)no; a systematic
B)no; an unsystematic
C)a large; a systematic
D)a large; an unsystematic
E)an indeterminate; market

Answer 3

no; an unsystematic

Question 4

A three-factor model would most likely include factors such as:

A)tax rates,inflation,and profit margin.
B)PE ratio,price-to-book ratio,and firm size.
C)firm size,inflation,and GNP.
D)inflation,GNP,and interest rates.
E)GNP,interest rates,and PE ratios.

Question 5

The symbol "F_I" is best defined as the:

A)indicated GNP value.
B)first and primary source of unexpected returns.
C)initial expected rate of return.
D)actual inflation rate minus the expected inflation rate.
E)surprise change in interest rates.

Question 6

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

A)multiplying the portfolio weighted average β_i by the factor F_i.
B)computing the portfolio weighted average F_i.
C)multiplying the CAPM beta times the factor.
D)summing the weighted random errors.
E)dividing the percentage change in the factor,F_i,by the total number of factors affecting the portfolio.

Question 7

The unexpected return on a security is made up of:

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

Question 8

If an investor plans to add a stock to a well-diversified portfolio,the investor should first consider the ________ risks of that additional stock.

A)expected total
B)historical total
C)systematic
D)idiosyncratic
E)firm-specific

Question 9

The stock of a silver mining company most likely has a:

A)zero inflation beta.
B)positive inflation beta.
C)beta that exactly matches the market beta.
D)negative inflation beta.
E)beta equal to the risk-free beta.

Question 10

Assume a security has no unsystematic risk.Given this,the excess return on that security will be the highest if the factor,F,________ and the beta for that factor is ________.

A)increases in value; high
B)increases in value; low
C)remains constant; zero
D)decreases in value; high
E)decreases in value; low

Question 11

If the expected rate of GNP growth was 3 percent and the actual rate was .2 percent higher than the expectation,the total return on a stock would change by ________ based on a multifactor model.

A)3.2β_GNP
B).2β_GNP
C)−.2β_GNP
D)−3.2β_GNP
E)3β_GNP

Question 12

A security held in a large,well-diversified portfolio that has a beta of zero in a one-factor model will have an actual return:

A)of zero.
B)closely equal to the market risk premium.
C)closely equal to the expected return.
D)that is positive and less than the risk-free rate.
E)that is less than the risk-free rate and can be negative.

Question 13

Which one 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.
E)Both a well-diversified portfolio and an individual security have negligible unsystematic risk.

Question 14

As used in the market model,the symbol "ε" represents:

A)unsystematic risk.
B)beta.
C)systematic risk.
D)a stock's response to systematic risk.
E)the expected change in GNP.

Question 15

If a security has a GNP beta of 1.5,then the security's total rate of return will:

A)increase by 1.5 percent for every 1 percent decrease in GNP.
B)increase by 1.5 percent every time the GNP increases by 1.5 percent.
C)change by an amount equal to 1.5 times the percentage amount of any unexpected change in GNP.
D)change by an amount equal to the unexpected percentage change in GNP divided by a factor of 1.5.
E)increase by 1.5 percent whenever the GNP increases by 1.5 percent.

Question 16

If a large number of diverse securities are added to a portfolio comprised of three stocks,then the:

A)weighted average expected return goes to zero.
B)weighted average of the factor betas goes to zero.
C)weighted average of the unsystematic risk goes to zero.
D)return of the portfolio must equal the market rate of return.
E)return of the portfolio will equal the risk-free rate.

Question 17

In the equation R = E(R)+ U,the three symbols,from left to right,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)required return,expected return,and unsystematic risk.

Question 18

Which type of risk is unaffected by portfolio diversification?

A)Unsystematic risk
B)Idiosyncratic risk
C)Total risk
D)Systematic risk
E)All types of risk are affected by portfolio diversification.

Question 19

Consider the security market line (SML)under the one-factor model.Assume Point C lies on the SML but an investor would prefer a point that also lies on the SML but is lower and to the left of Point C.How can this investor obtain that point for their portfolio?

A)Replace the lower beta stocks in the portfolio with higher beta stocks
B)Sell a portion of the portfolio and use the proceeds to purchase undervalued stocks
C)Sell the higher beta stocks in the portfolio and replace them with undervalued stocks
D)Replace the portfolio with undervalued stocks and risk-free assets
E)Replace the portfolio with a combination of a higher beta portfolio that lies on the SML and risk-free assets

Question 20

If an announcement by a firm causes the price of that firm's stock to suddenly change,that price change will most likely be driven by:

A)the expected part of the announcement.
B)market inefficiency.
C)the unexpected part of the announcement.
D)systematic risk.
E)expectations of a revised announcement in the near term.

Question 21

Parametric or empirical models rely:

A)on security betas explaining systematic factor relationships.
B)on finding regularities and relations in past market data.
C)on security returns always being located on the capital market line.
D)solely on factors within the security's issuing firm's realm of control.
E)primarily on financial market models and theories.

Question 22

The single-factor model generally uses ________ as the single factor.

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

Question 23

Assume the single-factor model is applied to a security that has a negative factor beta.The security will:

A)always have a positive rate of return.
B)have an expected return greater than the risk-free rate.
C)have an actual return that equals the risk-free rate.
D)have an expected return equal to the market rate of return.
E)have an actual rate of return that can be positive,negative,or zero.

Question 24

Outdoor Products stock has an expected return of 12.6 percent and betas of: β_GNP = 1.52; β_I = 1.06; and β_Ex = 1.28.This expectation is based on a three-factor model with expected values of: GNP growth of 3.2 percent; inflation of 2.9 percent; and export growth of 2.2 percent.However,actual growth in these factors turns out to be 3.6 percent,3.2 percent,and 2.5 percent,respectively.Calculate the stock's total return if the company unexpectedly announces they had an industrial accident and the operating facilities will close down temporarily which will reduce the return by 7 percent (from 10 percent down to 3 percent).

A)−4.05 percent
B)6.91 percent
C)3.57 percent
D)7.42 percent
E)−1.85 percent

Question 25

The slope of the security market line represents the:

A)risk-premium for an individual security.
B)risk-free rate of return.
C)market rate of return.
D)total return per unit of beta.
E)market risk premium.

Question 26

Alpha stock has an expected return of 8.2 percent and betas of: β_GNP = 1.23; β_I = .97; and β_Ex = 1.08.This expectation is based on a three-factor model with expected values of: GNP growth of −1 percent; inflation of 2.4 percent; and export growth of 3.5 percent.However,actual growth in these factors turns out to be .55 percent,1.8 percent,and 2.6 percent,respectively.Assuming there was no unexpected news related specifically to the stock,what was the stock's total rate of return?

A)8.04 percent
B)8.55 percent
C)8.47 percent
D)7.85 percent
E)8.85 percent

Question 27

The general purpose of identifying multiple factors in the APT model is to:

A)identify the top three factors that have the largest impact on the market rate of return.
B)identify and eliminate all systematic risks from a portfolio.
C)identify the quantity of each factor that is needed to reduce a portfolio's risk,as measured by beta,to a level equal to that of the overall market.
D)reduce the unsystematic risk to a level where the unsystematic risk of one security is unrelated to the unsystematic risk of any other security.
E)reduce the slope of the security market line,thereby reducing portfolio risk.

Question 28

A criticism of the CAPM is that it:

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

Question 29

Which one of the following statements is 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 quantitative approaches to measure expected returns in risky assets.
C)The factors to be used in the APT are easier to identify than the factor used in the CAPM.
D)CAPM provides the means for a more-detailed estimate of a security's expected return than does APT.
E)CAPM assigns a beta of 1 to the market while APT assigns the market a beta of zero.

Question 30

Estimating the rate of return for any portfolio lying on the security market line requires which of the following?

A)Market rate of return and the portfolio beta
B)Market rate of return,market beta,and the risk-free rate
C)Risk-free rate,factor beta,and the industry beta
D)Factor beta and the market risk premium
E)Portfolio beta,the risk-free rate,and the market risk premium

Question 31

A factor,as used in APT,is a variable that:

A)represents a nondiversifiable risk.
B)affects the returns of risky assets in an unsystematic fashion.
C)correlates the returns of a risky asset with those of a risk-free asset.
D)measures the response of a specific asset to a systematic risk.
E)represents a firm-specific risk.

Question 32

The acronym APT stands for:

A)arbitrage pricing techniques.
B)absolute profit theory.
C)arbitrage pricing theory.
D)asset pricing theory.
E)assured price techniques.

Question 33

When using the empirical approach,rather than a risk-based model,to compute an expected rate of return on a security,the beta values are replaced with:

A)the ratio of the market rate of return to the risk-free rate.
B)a singular value equal to the market-to-book value of the firm.
C)the firm's various attributes.
D)the ratio of the firm's historical average return to the risk-free rate.
E)the average standard deviation of the security's historical returns.

Question 34

The systematic response coefficient for productivity,β_p,would produce an unexpected change in any security return of (β_P × ________)if the expected rate of productivity was 1.5 percent and the actual rate was 2.25 percent.

A).75 percent
B)−.75 percent
C)2.25 percent
D)− 2.25 percent
E)1.5 percent

Question 35

When selecting a benchmark,it is important to match the security or portfolio that will be evaluated to securities:

A)that have an opposing style.
B)that have identical factor betas for all factors in the pricing model being utilized.
C)that closely mimic the overall market.
D)with the same PE ratios.
E)of similar style that are available for purchase.

Question 36

Overton Markets stock has an expected return of 7.8 percent and betas of: β_GNP = 1.06; β_I = 1.01; and β_Ex = .52.This expectation is based on a three-factor model with expected values of: GNP growth of 2.6 percent; inflation of 3.1 percent; and export growth of 1.4 percent.However,actual growth in these factors turns out to be 3.1 percent,2.6 percent,and .2 percent,respectively.Calculate the stock's total return if the company unexpectedly announces that an important patent filing has been granted sooner than expected and will earn the company 5 percent more in return,(i.e.from 10 percent up to 15 percent).

A)16.02 percent
B)12.20 percent
C)11.55 percent
D)10.90 percent
E)11.02 percent

Question 37

Assuming the single-factor model applies,the factor 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 in the portfolio.
D)impossible to calculate without collecting sample data.
E)irrelevant to the model.

Question 38

If you were to consider the CAPM as a one-factor model,then the factor would be the:

A)rate of inflation.
B)market risk premium.
C)GNP.
D)risk-free rate.
E)individual beta of each security or portfolio.

Question 39

A growth-stock portfolio is probably best characterized as having a:

A)high PE ratio as compared to the overall market.
B)lower risk premium than the overall market.
C)low level of systematic risk and a high level of unsystematic risk.
D)low PE ratio as compared to the overall market.
E)a lower beta than the overall market.

Question 40

The Fama-French three-factor model seems to support the notion that higher returns can best be earned over time on:

A)large,growth stocks.
B)large,value stocks.
C)small,value stocks.
D)small,growth stocks.
E)the overall stock market.

Question 41

Verbally describe a graph that illustrates the one-factor model.

Question 42

In a multifactor model,explain what a factor represents and the role that beta plays in relation to factors.How do factors and betas affect the actual return?

Question 43

The systematic response coefficient for productivity,β_p,would produce an unexpected change in any security return of [β_P × ________] if the expected rate of productivity was 1.8 percent and the actual rate was 2.2 percent.

A).4 percent
B)−.4 percent
C)2.2 percent
D)−2.2 percent
E)1.8 percent

Question 44

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

Question 45

Suppose ABC's common stock has a return of 12.87 percent,the risk-free rate is 2.65 percent,the market return is 13.46 percent,and there is currently no unsystematic influence affecting ABC's return.Given a one-factor APT model,what is the factor beta?

A).896
B).945
C)1.003
D).962
E).979

Question 46

Explain the concept of a benchmark and why benchmarks provide value when evaluating the performance of a security or portfolio.

Question 47

Assume a one-factor model where the factor is associated with the overall market.Suppose JSC's common stock has a factor beta of .8,the risk-free rate is 3.2 percent,and the expected market rate of return is 11.2 percent.What is the expected return for JSC stock?

A)10.25 percent
B)6.40 percent
C)7.20 percent
D)9.60 percent
E)12.16 percent

Question 48

Suppose Binder Corporation's common stock has an actual return of 12.34 percent compared to its expected return of 12.6 percent.The risk-free rate was expected to be 4.3 percent,which it was.The beta of F_i is .9 and the beta of F_GNP is 1.1.If inflation unexpectedly increased by 1.4 percent,what was the unexpected change in GNP?

A)2.02 percent
B)1.38 percent
C)−.82 percent
D)−1.38 percent
E)−2.02 percent

Question 49

Suppose you identified three important systematic risk factors given by exports,inflation,and industrial production.At the beginning of the year,a firm's stock return is estimated at 9.6 percent and the growth in the three factors is estimated at −1 percent,2.5 percent,and 3.5 percent,respectively.The factor betas are: β_EX = 1.8,β_I = .7,and β_IP = 1.What would be the stock's total return if the actual growth in each of the factors was equal to the expected growth and no unexpected company news occurred?

A)4.6 percent
B)5.9 percent
C)9.6 percent
D)14.6 percent
E)8.7 percent

Question 50

Suppose a sizeable,fully diversified portfolio has an F₁ beta of .9,an F₂ beta of 1.4,and an expected return of 11.6 percent.If F₁ turns out to be 1.1 percent and F₂ is −.8 percent,what will be the actual rate of return based on a two-factor arbitrage pricing model?

A)12.05 percent
B)11.47 percent
C)11.72 percent
D)12.32 percent
E)12.58 percent

Question 51

Assume the single-factor APT model applies and a portfolio exists such that half of the funds are invested in risky Security Q and the rest in a risk-free asset.Security Q has a beta of 1.8.The portfolio has a factor beta of:

A)0.
B).8.
C).9.
D)1.
E)1.8.

Question 52

Assume the single-factor model applies and a portfolio exists such that 65 percent of the funds are invested in risky 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)1.500.
B).925.
C).650.
D).975.
E)1.000.