Question 1

Arbitrage pricing theory is based on the premise that more than one factor affects stock returns, and the factors are specified to be (1) market returns, (2) dividend yields, and (3) changes in inflation.

Accepted Answer

Arbitrage Pricing Theory (APT) posits that multiple factors affect stock returns, but it does not specify which factors; instead, it allows for various economic, financial, and firm-specific factors beyond just market returns, dividend yields, and changes in inflation.

Question 2

In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are interested in ex ante (future) data.

Accepted Answer

This is true. While we cannot predict the future returns and risk of an asset, we can use historical data as a guide for our investment decisions. However, it is important to note that past performance may not necessarily reflect future performance.

Question 3

If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is
0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if stocks are held in portfolios, it is possible that the required return could be higher on the low standard deviation stock.

Accepted Answer

When stocks are held in portfolios, the investors can diversify their risks among multiple stocks, thus reducing the overall risk of their portfolio. In this case, the required return on a low standard deviation stock could be higher if it has a higher correlation with the other stocks in the portfolio, making it a more valuable diversifier. Therefore, it is possible that the required return could be higher on the low standard deviation stock in a portfolio context.

Question 4

Which of the following statements is CORRECT?
A) The typical R2 for a stock is about 0.3 and the typical R2 for a portfolio is also about 0.3.
B) The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is about 0.6.
C) The typical R2 for a stock is about 0.3 and the typical R2 for a large portfolio is about 0.94.
D) The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is also about 0.94.
E) The typical R2 for a stock is about 0.6 and the typical R2 for a portfolio is also about 0.6.

Accepted Answer

Individual stocks typically have lower R2 values due to higher idiosyncratic risk, while large portfolios have higher R2 values as diversification reduces unsystematic risk, making them more aligned with market movements.

Question 5

Which is the best measure of risk for an asset held in isolation, and which is the best measure for an asset held in a diversified portfolio?
A) Variance; correlation coefficient.
B) Standard deviation; correlation coefficient.
C) Beta; variance.
D) Coefficient of variation; beta.
E) Beta; beta.

Accepted Answer

The coefficient of variation is the best measure of risk for an asset held in isolation as it considers both risk and return. Beta is the best measure for an asset in a diversified portfolio as it measures the asset's sensitivity to market movements.

Question 6

We will almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.

Accepted Answer

The beta of a diversified portfolio is generally more stable over time compared to the beta of a single security because the diversification reduces the impact of individual security volatility.

Question 7

The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line can be influenced by managerial actions.

Accepted Answer

The slope of the SML is determined by the market risk premium, which is not directly influenced by managerial actions of individual firms. The SML reflects the relationship between systematic risk and expected return for all assets in the market, not the influence of individual firm actions.

Question 8

If the returns of two firms are negatively correlated, then one of them must have a negative beta.

Accepted Answer

The answer of If the returns of two firms are...

Question 9

You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B? A) $ b_{\mathrm{A}}>0 ; b_{\mathrm{B}}=1 $. B) $ b_{A}>+1 ; b_{B}=0 $. C) $ \mathrm{b}_{\mathrm{A}}=0 ; \mathrm{b}_{\mathrm{B}}=-1 $. D) $ \mathrm{b}_{\mathrm{A}}<0 ; \mathrm{b}_{\mathrm{B}}=0 $. E) $ b_{\mathrm{A}}<-1 ; b_{B}=1 $.

Accepted Answer

The answer of You have the following data on (1)...

Question 10

You have the following data on three stocks: 
 As a risk minimizer, you would choose Stock______ if it is to be held in isolation and Stock_________ if it is to be held as part of a well- diversified portfolio.
A) A; A.
B) A; B.
C) B; C.
D) C; A.
E) C; B.

Accepted Answer

The answer of You have the following data on three...

Question 11

If you plotted the returns of Selleck & Company against those of the market and found that the slope of your line was negative, the CAPM would indicate that the required rate of return on Selleck's stock should be less than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue in the future.

Accepted Answer

The answer of If you plotted the returns of Selleck...

Question 12

In a portfolio of three different stocks, which of the following could NOT be true? A) The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation. B) The riskiness of the portfolio is greater than the riskiness of one or two of the stocks. C) The beta of the portfolio is less than the betas of each of the individual stocks. D) The beta of the portfolio is greater than the beta of one or two of the individual stocks’ betas. E) The beta of the portfolio can not be equal to 1.

Accepted Answer

The answer of In a portfolio of three different stocks,...

Question 13

A stock with a beta equal to -1.0 has zero systematic (or market) risk.

Accepted Answer

A stock with a beta of -1.0 is perfectly negatively correlated with the market, meaning it moves in the opposite direction of the market but still has systematic risk, as its performance is related to market movements.

Question 14

Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true about these securities? (Assume market equilibrium.)
A) When held in isolation, Stock A has greater risk than Stock B.
B) Stock B must be a more desirable addition to a portfolio than Stock A.
C) Stock A must be a more desirable addition to a portfolio than Stock B.
D) The expected return on Stock A should be greater than that on Stock B.
E) The expected return on Stock B should be greater than that on Stock A.

Accepted Answer

In market equilibrium, a higher beta indicates higher systematic risk and thus a higher expected return according to the Capital Asset Pricing Model (CAPM). Therefore, Stock A with a beta of 1.5 should have a greater expected return than Stock B with a beta of 0.5.

Question 15

Which of the following is NOT a potential problem with beta and its estimation? A) Sometimes a security or project does not have a past history which can be used as a basis for calculating beta. B) Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different than the “true” or “expected future” beta. C) The beta of “the market,” can change over time, sometimes drastically. D) Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed. E) There is a wide confidence interval around a typical stock’s estimated beta.

Accepted Answer

The beta of "the market" is typically considered to be 1 and does not change over time, as it represents the average risk of the market.

Question 16

The Y-axis intercept of the SML indicates the return on an individual asset when the realized return on an average (b = 1) stock is zero.

Accepted Answer

The Y-axis intercept of the Security Market Line (SML) indicates the risk-free rate, which is the return expected from an asset with zero market risk, not the return on an individual asset when the realized return on an average stock is zero.

Question 17

The CAPM is a multi-period model which takes account of differences in securities' maturities, and it can be used to determine the required rate of return for any given level of systematic risk.

Accepted Answer

The Capital Asset Pricing Model (CAPM) is a single-period model that does not account for differences in securities' maturities. It is used to determine the required rate of return for a security based on its level of systematic risk, without considering the maturity of the security.

Question 18

Which of the following statements is CORRECT?
A) The Capital Market Line (CML) is a curved line that connects the risk-free rate and the market portfolio.
B) The slope of the CML is ( $ \hat{r} $ M - rRF)/bM.
C) All portfolios that lie on the CML to the right of $\sigma$M are inefficient.
D) All portfolios that lie on the CML to the left of $\sigma$M are inefficient.
E) The slope of the CML is ( $ \hat{r} $M - rRF)/$\sigma$M..

Accepted Answer

The slope of the Capital Market Line (CML) is calculated as the difference between the expected return of the market portfolio ($ \hat{r} $M) and the risk-free rate (rRF) divided by the standard deviation of the market portfolio ($\sigma$M).

Question 19

The slope of the SML is determined by the value of beta.

Accepted Answer

The slope of the Security Market Line (SML) is determined by the market risk premium, not by the value of beta. Beta measures the sensitivity of a security's returns to the returns of the market, but the slope of the SML is the difference between the expected return on the market portfolio and the risk-free rate, which represents the market risk premium.

Question 20

It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm are negative.

Accepted Answer

Beta measures a stock's volatility in relation to the broader market. A positive beta indicates that the stock tends to move in the same direction as the market while a negative beta indicates that the stock tends to move in the opposite direction of the market. The correlation between two firms' returns can be negative, indicating that they move in opposite directions. However, if the first firm has a beta that is positive with respect to the market, it means that it is more volatile than the market as a whole, regardless of its correlation with the second firm.

Quiz 24: Portfolio Theory, Asset Pricing Models, and Behavioral Finance

Arbitrage pricing theory is based on the premise that more than one factor affects stock returns, and the factors are specified to be (1) market returns, (2) dividend yields, and (3) changes in inflation.

In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are interested in ex ante (future) data.

Which of the following statements is CORRECT?

Which is the best measure of risk for an asset held in isolation, and which is the best measure for an asset held in a diversified portfolio?

We will almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.

The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line can be influenced by managerial actions.

If the returns of two firms are negatively correlated, then one of them must have a negative beta.

You have the following data on three stocks: As a risk minimizer, you would choose Stock if it is to be held in isolation and Stock___ if it is to be held as part of a well- diversified portfolio.

In a portfolio of three different stocks, which of the following could NOT be true?

A stock with a beta equal to -1.0 has zero systematic (or market) risk.

Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true about these securities? (Assume market equilibrium.)

Which of the following is NOT a potential problem with beta and its estimation?

The Y-axis intercept of the SML indicates the return on an individual asset when the realized return on an average (b = 1) stock is zero.

The CAPM is a multi-period model which takes account of differences in securities' maturities, and it can be used to determine the required rate of return for any given level of systematic risk.

Which of the following statements is CORRECT?

The slope of the SML is determined by the value of beta.

It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm are negative.

Quiz 24: Portfolio Theory, Asset Pricing Models, and Behavioral Finance

Arbitrage pricing theory is based on the premise that more than one factor affects stock returns, and the factors are specified to be (1) market returns, (2) dividend yields, and (3) changes in inflation.

In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are interested in ex ante (future) data.

Which of the following statements is CORRECT?

Which is the best measure of risk for an asset held in isolation, and which is the best measure for an asset held in a diversified portfolio?

We will almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.

The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line can be influenced by managerial actions.

If the returns of two firms are negatively correlated, then one of them must have a negative beta.

You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B?

You have the following data on three stocks: As a risk minimizer, you would choose Stock______ if it is to be held in isolation and Stock_________ if it is to be held as part of a well- diversified portfolio.

In a portfolio of three different stocks, which of the following could NOT be true?

A stock with a beta equal to -1.0 has zero systematic (or market) risk.

Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true about these securities? (Assume market equilibrium.)

Which of the following is NOT a potential problem with beta and its estimation?

The Y-axis intercept of the SML indicates the return on an individual asset when the realized return on an average (b = 1) stock is zero.

The CAPM is a multi-period model which takes account of differences in securities' maturities, and it can be used to determine the required rate of return for any given level of systematic risk.

Which of the following statements is CORRECT?

The slope of the SML is determined by the value of beta.

It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm are negative.

You have the following data on three stocks: As a risk minimizer, you would choose Stock if it is to be held in isolation and Stock___ if it is to be held as part of a well- diversified portfolio.