Question 1

Consider the CAPM. The expected return on the market is 18%. The expected return on a stock with a beta of 1.2 is 20%. What is the risk-free rate?
A) 2%
B) 6%
C) 8%
D) 12%

Accepted Answer

20% = rF + 1.2(18 - rF); rF = 8%

Question 2

Which of the following are assumptions of the simple CAPM model?
I. Individual trades of investors do not affect a stock's price.
II. All investors plan for one identical holding period.
III. All investors analyze securities in the same way and share the same economic view of the world.
IV. All investors have the same level of risk aversion.
A) I, II, and IV only
B) I, II, and III only
C) II, III, and IV only
D) I, II, III, and IV

Accepted Answer

I is an assumption of the efficient markets hypothesis, not the CAPM. II is an assumption of the CAPM, as it assumes all investors plan for the same holding period. III is also an assumption of the CAPM, as it assumes all investors analyze securities in the same way and share the same economic view of the world. IV is an assumption of the CAPM, as it assumes all investors have the same level of risk aversion. Therefore, choices II, III, and IV are assumptions of the simple CAPM model.

Question 3

In the context of the capital asset pricing model, the systematic measure of risk is captured by ________.
A) unique risk
B) beta
C) the standard deviation of returns
D) the variance of returns

Accepted Answer

In the context of the capital asset pricing model, the systematic (or market) risk is captured by beta. Beta measures the sensitivity of a security or portfolio's returns to changes in the overall market. Unique risk or company-specific risk is the risk that is specific to a particular company or industry and cannot be diversified away. The standard deviation and variance of returns are measures of total risk, which includes both systematic and unique risks.

Question 4

The market portfolio has a beta of ________.
A) -1
B) 0
C) .5
D) 1

Accepted Answer

Since the market portfolio is the "overall" portfolio of all stocks in the market, it has a beta of 1 by definition.

Question 5

The arbitrage pricing theory was developed by ________.
A) Henry Markowitz
B) Stephen Ross
C) William Sharpe
D) Eugene Fama

Accepted Answer

The arbitrage pricing theory was developed by Stephen Ross, a finance professor at the Massachusetts Institute of Technology (MIT), in the 1970s.

Question 6

According to the capital asset pricing model, a fairly priced security will plot ________.
A) above the security market line
B) along the security market line
C) below the security market line
D) at no relation to the security market line

Accepted Answer

The capital asset pricing model states that a fairly priced security will plot along the security market line, which represents the expected return of a security based on its level of risk. Securities that plot above the security market line are deemed undervalued, while those that plot below the line are considered overvalued. A security that has no relation to the security market line would be considered an anomaly in the model.

Question 7

When all investors analyze securities in the same way and share the same economic view of the world, we say they have ________.
A) heterogeneous expectations
B) equal risk aversion
C) asymmetric information
D) homogeneous expectations

Accepted Answer

Homogeneous expectations refer to a situation where all investors analyze securities in the same way and share the same economic view of the world. This means that they have similar expectations of future market developments, such as interest rates, inflation, and company earnings reports, which creates a more uniform and predictable investment environment.

Question 8

Consider the CAPM. The risk-free rate is 5%, and the expected return on the market is 15%. What is the beta on a stock with an expected return of 17%?
A) .5
B) .7
C) 1
D) 1.2

Accepted Answer

17% = 5% + β_s[15% - 5%]; β_s = 1.2

Question 9

Empirical results estimated from historical data indicate that betas ________.
A) are always close to zero
B) are constant over time
C) of all securities are always between zero and 1
D) seem to regress toward 1 over time

Accepted Answer

Empirical results suggest that betas tend to regress toward 1 over time, meaning they move closer to the market average. Betas can be greater than 1 or less than 0, but they tend to regress toward 1 in the long run. Betas are not always close to zero or constant over time, and they can be greater than 1 or less than 0.

Question 10

According to the capital asset pricing model, a security with a ________.
A) negative alpha is considered a good buy
B) positive alpha is considered overpriced
C) positive alpha is considered underpriced
D) zero alpha is considered a good buy

Accepted Answer

The capital asset pricing model (CAPM) suggests that the expected return on a security is equal to the risk-free rate plus a premium that is proportional to the security's beta (systematic risk). The alpha of a security is the excess return beyond what is predicted by the CAPM. A positive alpha indicates that the security is outperforming the market, and therefore considered underpriced. This would make it a good buy. Therefore, the best choice is C.

Question 11

In a well-diversified portfolio, ________ risk is negligible.
A) nondiversifiable
B) market
C) systematic
D) unsystematic

Accepted Answer

Unsystematic risk, also known as specific risk, can be reduced or eliminated through diversification. Therefore, in a well-diversified portfolio, unsystematic risk is negligible. Systematic risk, also known as market risk or nondiversifiable risk, cannot be eliminated through diversification and affects the entire market, not just specific assets.

Question 12

In a simple CAPM world which of the following statements is (are) correct?
I. All investors will choose to hold the market portfolio, which includes all risky assets in the world.
II. Investors' complete portfolio will vary depending on their risk aversion.
III. The return per unit of risk will be identical for all individual assets.
IV. The market portfolio will be on the efficient frontier, and it will be the optimal risky portfolio.
A) I, II, and III only
B) II, III, and IV only
C) I, III, and IV only
D) I, II, III, and IV

Accepted Answer

In the CAPM world, all investors will hold the market portfolio (I), their complete portfolio mix varies by risk aversion (II), the market portfolio is on the efficient frontier and is optimal (IV), and due to the CAPM assumptions, all assets are priced to have the same return per unit of risk (III).

Question 13

Fama and French claim that after controlling for firm size and the ratio of the firm's book value to market value, beta is:
I. Highly significant in predicting future stock returns
II. Relatively useless in predicting future stock returns
III. A good predictor of the firm's specific risk
A) I only
B) II only
C) I and III only
D) I, II, and III

Accepted Answer

Fama and French's research found that after controlling for firm size and the ratio of the firm's book value to market value, beta (a measure of market risk) is relatively useless in predicting future stock returns. This challenged the traditional Capital Asset Pricing Model (CAPM) which posits beta as a central determinant of expected return.

Question 14

If enough investors decide to purchase stocks, they are likely to drive up stock prices, thereby causing ________ and ________.
A) expected returns to fall; risk premiums to fall
B) expected returns to rise; risk premiums to fall
C) expected returns to rise; risk premiums to rise
D) expected returns to fall; risk premiums to rise

Accepted Answer

When investors buy stocks in large numbers, demand for those stocks increases, which drives up their prices. As prices rise, the future returns investors can expect from those stocks decrease because they are buying at higher prices. Similarly, as stock prices rise and become more expensive relative to their expected future cash flows, the additional return (or risk premium) investors require to invest in stocks over risk-free assets also falls, as the perceived risk decreases with higher prices and more investor interest.

Question 15

Investors require a risk premium as compensation for bearing ________.
A) unsystematic risk
B) alpha risk
C) residual risk
D) systematic risk

Accepted Answer

Investors require a risk premium as compensation for bearing systematic risk, which is the risk inherent in the overall market or a particular asset class. This type of risk cannot be diversified away and impacts all investments in a similar way. The other options (A, B, C) refer to types of unsystematic risk that can be reduced through diversification and are not typically compensated for with a risk premium.

Question 16

Arbitrage is based on the idea that ________.
A) assets with identical risks must have the same expected rate of return
B) securities with similar risk should sell at different prices
C) the expected returns from equally risky assets are different
D) markets are perfectly efficient

Accepted Answer

Arbitrage is the process of exploiting differences in the price of an asset in different markets to make a profit with no net cash flow. This idea is based on the principle that assets with identical risks must have the same expected rate of return. If there is any difference in expected returns, investors could buy the asset with the lower expected return and sell short the asset with the higher expected return. This would lead to an arbitrage opportunity, which would ultimately remove the price differential and restore equilibrium to the market.

Question 17

An adjusted beta will be ________ than the unadjusted beta.
A) lower
B) higher
C) closer to 1
D) closer to 0

Accepted Answer

Adjusted beta is calculated to account for the tendency of a security's beta to move towards the market average of 1 over time, making it closer to 1 than the unadjusted beta.

Question 18

Consider the CAPM. The risk-free rate is 6%, and the expected return on the market is 18%. What is the expected return on a stock with a beta of 1.3?
A) 6%
B) 15.6%
C) 18%
D) 21.6%

Accepted Answer

E[r_s] = 6% + 1.3[18% - 6%] = 21.6%

Question 19

The capital asset pricing model was developed by ________.
A) Kenneth French
B) Stephen Ross
C) William Sharpe
D) Eugene Fama

Accepted Answer

The Capital Asset Pricing Model (CAPM) was developed by William Sharpe. It is a model that describes the relationship between systematic risk and expected return for assets, particularly stocks.

Question 20

If all investors become more risk averse, the SML will ________ and stock prices will ________.
A) shift upward; rise
B) shift downward; fall
C) have the same intercept with a steeper slope; fall
D) have the same intercept with a flatter slope; rise

Accepted Answer

When investors become more risk-averse, they require a higher return for any given level of risk, which steepens the slope of the Security Market Line (SML). This reflects an increased price of risk. As a result, the required return on stocks increases, leading to a decrease in stock prices.

Quiz 7: Capital Asset Pricing and Arbitrage Pricing Theory

Consider the CAPM. The expected return on the market is 18%. The expected return on a stock with a beta of 1.2 is 20%. What is the risk-free rate?

In the context of the capital asset pricing model, the systematic measure of risk is captured by ________.

The market portfolio has a beta of ________.

The arbitrage pricing theory was developed by ________.

According to the capital asset pricing model, a fairly priced security will plot ________.

When all investors analyze securities in the same way and share the same economic view of the world, we say they have ________.

Consider the CAPM. The risk-free rate is 5%, and the expected return on the market is 15%. What is the beta on a stock with an expected return of 17%?

Empirical results estimated from historical data indicate that betas ________.

According to the capital asset pricing model, a security with a ________.

In a well-diversified portfolio, ________ risk is negligible.

Fama and French claim that after controlling for firm size and the ratio of the firm's book value to market value, beta is: I. Highly significant in predicting future stock returns II. Relatively useless in predicting future stock returns III. A good predictor of the firm's specific risk

If enough investors decide to purchase stocks, they are likely to drive up stock prices, thereby causing and .

Investors require a risk premium as compensation for bearing ________.

Arbitrage is based on the idea that ________.

An adjusted beta will be ________ than the unadjusted beta.

Consider the CAPM. The risk-free rate is 6%, and the expected return on the market is 18%. What is the expected return on a stock with a beta of 1.3?

The capital asset pricing model was developed by ________.

If all investors become more risk averse, the SML will and stock prices will .