Question 1

The risk-free rate is 4%.The expected market rate of return is 11%.If you expect stock X with a beta of .8 to offer a rate of return of 12 percent,then you should _________.

Accepted Answer

According to the Capital Asset Pricing Model (CAPM), the expected rate of return for a stock is equal to the risk-free rate plus the stock's beta (systematic risk) multiplied by the expected market rate of return minus the risk-free rate.

Using the formula, the expected rate of return for stock X is:
4% + 0.8(11% - 4%) = 10.2%

Since the expected rate of return for stock X is greater than the required rate of return (10.2% vs. 12%), stock X is considered underpriced and a good investment opportunity. Therefore, the correct choice is B- buy stock X because it is underpriced.

Question 2

Arbitrage is __________________________.

Accepted Answer

Arbitrage is the creation of riskless profits made possible by relative mispricing among securities, meaning you can buy an asset in one market and sell it simultaneously in another market at a higher price, making a profit without taking any market risk. It is not an example of the law of one price, which states that identical goods should have the same price in different markets, nor is it a common opportunity in modern markets. It is also not a risky trading strategy based on market forecasting.

Question 3

According to the CAPM,investors are compensated for all but which of the following?

Accepted Answer

According to the CAPM, investors are compensated for holding systematic risk or market risk, which is the risk that cannot be diversified away. They are not compensated for residual risk or unsystematic risk, which can be eliminated by diversification. However, investors are also compensated for expected inflation and the time value of money, which is the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity.

Question 4

Beta is a measure of ______________.

Accepted Answer

Beta measures the systematic risk of a security or a portfolio in relation to the overall market. It is a relative measure as it compares the security's volatility to that of the market, making it a useful tool for investors to assess the level of risk associated with an investment. Beta does not account for non-systematic risk, which is specific to a particular company or industry. Furthermore, it does not reflect total risk, which incorporates both systematic and non-systematic risk.

Question 5

The expected return of the risky asset portfolio with minimum variance is _________.

Accepted Answer

The expected return of the risky asset portfolio with minimum variance cannot be determined without additional information such as the specific assets in the portfolio and their expected returns.

Question 6

Consider the one-factor APT.The standard deviation of return on a well-diversified portfolio is 20%.The standard deviation on the factor portfolio is 12%.The beta of the well-diversified portfolio is approximately _________.

Accepted Answer

The one-factor APT model assumes that the return of an asset is generated by a single macroeconomic factor. The formula for the APT model is:

Ri = Rf + βiF + εi

where Ri is the return on asset i, Rf is the risk-free rate, βi is the sensitivity of asset i to the factor portfolio, F is the factor portfolio, and εi is the idiosyncratic risk.

Given that the standard deviation of the well-diversified portfolio is 20%, the idiosyncratic risk can be assumed to be small, which means that most of the risk comes from the systematic factor (F).

Using the formula for the variance of the well-diversified portfolio:

σ^2p = β^2σ^2F

where σ^2p is the variance of the well-diversified portfolio and β is the asset's beta, we can solve for β:

β = σp/σF = 20%/12% = 1.67

Therefore, the beta of the well-diversified portfolio is approximately 1.67.

Question 7

Liquidity is a risk factor that __________.

Accepted Answer

Liquidity risk refers to the risk associated with the ease of converting an asset into cash without significantly affecting its market price. It is a complex factor that has been challenging to measure accurately and incorporate into portfolio management strategies. Trading mechanisms, market conditions, and various asset characteristics can influence liquidity, making it a significant consideration across different types of investments, including both stocks and bonds.

Question 8

In a study conducted by Jagannathan and Wang,it was found that the performance of beta in explaining security returns could be considerably enhanced by _____________.
I.including the unsystematic risk of a stock
II.including human capital in the market portfolio
III.allowing for changes in beta over time

Accepted Answer

Including human capital in the market portfolio and allowing for changes in beta over time were found to enhance the performance of beta in explaining security returns.

Question 9

According to capital asset pricing theory,the key determinant of portfolio returns is _________.

Accepted Answer

According to capital asset pricing theory, portfolio returns are primarily determined by the systematic risk of the portfolio, which is measured by beta. Firm-specific or idiosyncratic risk can be diversified away, so it is not a key determinant of portfolio returns. Economic factors may also affect portfolio returns, but they are not the primary determinant.

Question 10

Consider the following two stocks,A and B.Stock A has an expected return of 10% and a beta of 1.20.Stock B has an expected return of 14% and a beta of 1.80.The expected market rate of return is 9% and the risk-free rate is 5%.Security __________ would be considered a good buy because _________.

Accepted Answer

The answer of Consider the following two stocks,A and B.Stock...

Question 11

The most significant conceptual difference between the arbitrage pricing theory (APT)and the capital asset pricing model (CAPM)is that the CAPM _____________.

Accepted Answer

The most significant conceptual difference between the APT and the CAPM is that the CAPM recognizes only one systematic risk factor (beta), while the APT recognizes multiple systematic risk factors. The CAPM places a heavy emphasis on market risk and assumes that it is the only systematic risk factor that matters, while the APT allows for the possibility of multiple systematic factors affecting asset prices. The CAPM does not account for unsystematic risk factors, while the APT allows for the inclusion of multiple unsystematic risk factors.

Question 12

The risk-free rate and the expected market rate of return are 6% and 16% respectively.According to the capital asset pricing model,the expected rate of return on security X with a beta of 1.2 is equal to _________.

Accepted Answer

E(r_x) = .06 + .1.2(.16 - .06) = .18

Question 13

In his famous critique of the CAPM,Roll argued that the CAPM ______________.

Accepted Answer

Roll's critique of the CAPM is that it is not testable because the true market portfolio, which should include all assets, can never be observed or accurately measured.

Question 14

Standard deviation of portfolio returns is a measure of ___________.

Accepted Answer

Standard deviation of portfolio returns is a measure of total risk, which includes both systematic and non-systematic risk.

Question 15

A stock's alpha measures the stock's ____________________.

Accepted Answer

Alpha is the excess return of a stock compared to its expected return. Therefore, it measures the abnormal return of a stock rather than just the expected or residual return.

Question 16

The SML is valid for _______________ and the CML is valid for ______________.

Accepted Answer

The SML (Security Market Line) is valid for well-diversified portfolios and individual assets, while the CML (Capital Market Line) is only valid for well-diversified portfolios. This is because the CML takes into account the risk-free rate of return, which would not apply to individual assets that have unique risk characteristics. Therefore, only option D is entirely accurate.

Question 17

The variance of the return on the market portfolio is .0400 and the expected return on the market portfolio is 20%.If the risk-free rate of return is 10%,the market degree of risk aversion,A,is _________.

Accepted Answer

The market degree of risk aversion is calculated as the ratio of the variance of the return on the market portfolio to the square of the expected return on the market portfolio. In this case, the variance of the return on the market portfolio is .0400 and the expected return on the market portfolio is 20%. Therefore, the market degree of risk aversion is .0400 / (0.20)^2 = 2.5.

Question 18

Which of the following variables do Fama and French claim do a better job explaining stock returns than beta?
I.Book to market ratio
II.Unexpected change in industrial production
III.Firm size

Accepted Answer

Fama and French claim that the variables of book to market ratio and firm size do a better job explaining stock returns than beta. Unexpected change in industrial production is not mentioned by Fama and French as a variable that explains stock returns better than beta.

Question 19

The measure of unsystematic risk can be found from an index model as _________.

Accepted Answer

The residual standard deviation, also known as the standard error of the estimate, represents the measure of unsystematic risk in an index model. It measures the deviation of each data point from the regression line, which is not explained by the model. Therefore, option A is the correct choice. R-square, degrees of freedom, and the sum of squares of the regression are all measures of the goodness of fit of the model and do not specifically measure the unsystematic risk.

Question 20

According to the CAPM,the risk premium an investor expects to receive on any stock or portfolio is _______________.

Accepted Answer

According to the CAPM, the risk premium an investor expects to receive on any stock or portfolio is directly related to the beta of the stock. Beta is a measure of systematic risk, or the extent to which a security's returns are correlated with market returns. Therefore, the higher the beta, the higher the expected risk premium an investor is likely to demand.

Quiz 7: Capital Asset Pricing and Arbitrage Pricing Theory