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

Question 1

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 intersecurity correlation versus the beta of the CAPM.
C) via the industry wide or marketwide factors creating correlation between securities versus the CAPM beta.
D) the standardized deviation of the covariance.

Answer 1

via the industry wide or marketwide factors creating correlation between securities versus the CAPM beta.

Question 2

The term Corr(å _R, ε _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 zero.
D) the systematic risk companies R and T is unrelated.

Answer 2

the unsystematic risk of companies R and T is unrelated or uncorrelated.

Question 3

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.

Answer 3

no effect on Company B's stock price because it is an unsystematic risk element.

Question 4

In the One Factor (APT) Model, the characteristic line to estimate βi 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 5

In normal market conditions 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 6

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

A) summing the weighted β_i s and multiplying by the innovation in F_i.
B) summing the F_i s.
C) adding the average weighted expected returns.
D) Summing the weighted random errors.

Question 7

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 8

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 9

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 10

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 11

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.

Question 12

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 13

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

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

Question 14

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.

Question 15

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 16

In the equation R = 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 required return, expected return, and unexpected return.
D) required return, expected return, and unbiased risk.
E) risk, expected return, and unsystematic risk.

Question 17

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 18

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

A) 9.2%
B) 3.2 β_I.
C) -3.2 β_I
D) 3.0%
E) 6.2 β_I

Question 19

The systematic response coefficient for productivity, β_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%
B) -0.75(β_P)%
C) 2.25(β_P)%
D) -2.25%

Question 20

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.

Question 21

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 β what do these represent and how do they relate to the actual return?

Question 22

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 23

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 24

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

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

In normal market conditions 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 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

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 29

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 30

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 is:

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

Question 31

An investor is considering the three stocks given below:
Calculate the expected return and beta of a portfolio equally weighted between stocks B and 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.

Question 32

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 33

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 34

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 35

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 36

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.