Question 1

According to the APT model all securities should be priced such that riskless arbitrage is possible.

Accepted Answer

The Arbitrage Pricing Theory (APT) posits that the return on a portfolio or security is linearly related to various factors or indexes, and arbitrage should be impossible if the market is in equilibrium.

Question 2

The January Effect is an anomaly where returns in January are significantly smaller than in any other month.

Accepted Answer

The statement is incorrect. The January Effect refers to the phenomenon where stock prices tend to increase in the month of January, which is opposite to the statement given.

Question 3

Multifactor models of risk and return can be broadly grouped into models that use macroeconomic factors and models that use microeconomic factors.

Accepted Answer

Multifactor models of risk and return can be categorized into macroeconomic or microeconomic factors depending on the underlying set of factors used in the model.

Question 4

Arbitrage Pricing Theory (APT) specifies the exact number of risk factors and their identity

Accepted Answer

APT does not specify the exact number of risk factors or their identity, unlike the Capital Asset Pricing Model (CAPM). Instead, APT allows for multiple factors to influence asset pricing, and the number and identity of these factors are determined through statistical analysis.

Question 5

In the APT model, the identity of all the factors is known.

Accepted Answer

In the APT model, while the number of factors can be identified, their specific identities are not known.

Question 6

One method for estimating the parameters for the Capital Asset Pricing Model is to estimate a portfolio's characteristic line via regression techniques using the single-index market model.

Accepted Answer

This is a common method for estimating the parameters for the CAPM.

Question 7

A major advantage of the Arbitrage Pricing Theory is the risk factors are clearly universally identifiable.

Accepted Answer

The answer of A major advantage of the Arbitrage Pricing...

Question 8

Findings by Fama and French that stocks with high Book Value to Market Price ratios tended to produce larger risk adjusted returns than stocks with low Book Value to Market Price ratios challenge the efficacy of the CAPM.

Accepted Answer

The findings by Fama and French contradict the predictions of the CAPM, suggesting that other factors beyond market risk may be driving returns.

Question 9

Exhibit 9.1
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
(1)Capital markets are perfectly competitive.
(2)Quadratic utility function.
(3)Investors prefer more wealth to less wealth with certainty.
(4)Normally distributed security returns.
(5)Representation as a K factor model.
(6)A market portfolio that is mean-variance efficient.
-Refer to Exhibit 9.1. In the list above, which are not assumptions of the Arbitrage Pricing model?
A)(1) and (3)
B)(1), (2), and (3)
C)(1), (2), and (5)
D)(2), (4), and (6)
E)All six are assumptions

Accepted Answer

The answer of Exhibit 9.1
USE THE INFORMATION BELOW FOR THE...

Question 10

Findings by Basu that stocks with high P/E ratios tended to outperform stocks with low P/E ratios challenge the efficacy of the CAPM.

Accepted Answer

The Capital Asset Pricing Model (CAPM) is primarily concerned with assessing the expected return of an investment based on its risk relative to the market, not directly with the valuation metrics like P/E ratios. Basu's findings on P/E ratios relate more to market anomalies and stock valuation techniques rather than challenging the core principles of CAPM, which are about the relationship between risk and expected return.

Question 11

To date, the results of empirical tests of the Arbitrage Pricing Model have been
A)Clearly favorable.
B)Clearly unfavorable.
C)Mixed.
D)Unavailable.
E)Biased.

Accepted Answer

Empirical testing of the Arbitrage Pricing Model has produced mixed results, with some studies finding support for the model while others do not. This suggests that the model may have some limitations in accurately explaining asset returns.

Question 12

Studies strongly suggest that the CAPM be abandoned and replaced with the APT.

Accepted Answer

While some studies criticize the Capital Asset Pricing Model (CAPM) for its assumptions and limitations, it has not been universally suggested to be abandoned. The Arbitrage Pricing Theory (APT) is considered an alternative or complementary approach rather than a replacement, as both models have their own applications and advantages in finance.

Question 13

The APT does not require a market portfolio.

Accepted Answer

The APT does not require a market portfolio because it assumes that the systematic risk in an asset is captured by a number of risk factors, and the relationship between these factors and asset returns can be used to determine the expected return for that asset. The APT does not rely on the assumption of a single market portfolio representing all assets in the market.

Question 14

The APT assumes that capital markets are perfectly competitive.

Accepted Answer

The APT (Arbitrage Pricing Theory) assumes that capital markets are perfectly competitive. This means that investors have access to all relevant information about securities and that prices reflect this information accurately. In such a market, there are no market imperfections such as transaction costs, taxes, or restrictions on short-selling, and all investors have the same information and the same investment opportunities. The APT uses this assumption to develop a model that explains the relationship between the risk and return of an asset or portfolio.

Question 15

Exhibit 9.1
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
(1)Capital markets are perfectly competitive.
(2)Quadratic utility function.
(3)Investors prefer more wealth to less wealth with certainty.
(4)Normally distributed security returns.
(5)Representation as a K factor model.
(6)A market portfolio that is mean-variance efficient.
-Refer to Exhibit 9.1. In the list above which are assumptions of the Arbitrage Pricing Model?
A)(1) and (4)
B)(1), (2), and (3)
C)(1), (3), and (5)
D)(2), (3), (4), and (6)
E)All six are assumptions

Accepted Answer

The Arbitrage Pricing Model (APM) assumes perfectly competitive capital markets (1), investors' preferences can be represented by a quadratic utility function (2), investors prefer more wealth to less wealth with certainty (3), and returns are normally distributed (4). The APM also assumes a factor model (5), but does not specify that it must be a K factor model. Additionally, while the APM is often used in the context of mean-variance efficiency (6), this is not a specific assumption of the model. Therefore, only assumptions (1), (3), and (5) are included in the APM.

Question 16

Two approaches to defining factors for multifactor models are to use macroeconomic variables or individual characteristics of the securities.

Accepted Answer

This statement is true. Two common approaches to defining factors in multifactor models are macroeconomic variables or individual characteristics of the securities being analyzed.

Question 17

Fama and French suggest a four factor model approach that explains many prior market anomalies.

Accepted Answer

Fama and French's four-factor model includes market risk, size, value, and profitability factors that explain many previously observed market anomalies.

Question 18

Studies indicate that neither firm size nor the time interval used are important when computing beta.

Accepted Answer

Studies actually indicate that the time interval used is important when computing beta, as longer time intervals generally result in more stable estimates of beta. However, firm size has been found to have little impact on beta calculations.

Question 19

The APT assumes that security returns are normally distributed.

Accepted Answer

The Arbitrage Pricing Theory (APT) does not assume that security returns are normally distributed; it focuses on the relationship between a security's return and various macroeconomic factors or theoretical market indices.

Question 20

Empirical tests of the APT model have found that as the size of a portfolio increased so did the number of factors.

Accepted Answer

This is because larger portfolios are expected to be more diversified and therefore exposed to more systematic factors.

Quiz 9: Multifactor Models of Risk and Return