Chapter 7- APM

which are assumptions of the Arbitrage Pricing Model

(1) Capital markets are perfectly competitive. 2. Investors prefer more wealth to less wealth with certainty 3. representation as a K factor model

In one of their empirical tests of the APT, Roll and Ross examined the relationship between a security's returns and its own standard deviation. A finding of a statistically significant relationship would indicate that

APT is invalid because a security's unsystematic component would be eliminated by diversification.

The error caused by NOT using the true market portfolio has become known as the

Benchmark error

Which of the following is a major difference between the capital market line (CML) and the capital asset pricing model (CAPM)?

Definitions of portfolio risk are based on systematic and total risk, The number of calculations to determine risk is significantly greater for one method. One requires a tangency point on the efficient frontier, and the other does not. CML measures total risk by the standard deviation of the investment, while the SML considers only the systematic component of an investment's volatility.

The betas for the market portfolio and risk-free security are:

Market: 1 rf: 0

Refer to Exhibit 7.6. How does Jonathan Crowley's portfolio compare to the market portfolio?

On a risk-adjusted basis Crowley's portfolio performed similar to the market portfolio.

Which of the following is NOT a major difference between the capital market line (CML) and the capital asset pricing model (CAPM)?

One is related to the market portfolio, and the other is not.

The excess return form of the single-index market model is

Rit - RFRt = a + b(Rmt - RFRt) + eit.

The equation for the single-index market model is

Rit = ai + bRmt + et.

APT

Ross devised an alternative asset pricing model. Thus makes few assumptions than CAPM and does not specifically require the designation of a market portfolio. Instead the APT posits that expected security returns are related in a linear fashion to multiple common risk factors. The theory does not specify how many factors exist or what their identities might be. The results from the empirical tests of the apt have thus far been mixed.

Assume that you are embarking on a test of the small-firm effect using APT. You form 10 size-based portfolios. Which of the following finding would suggest that there is evidence supporting APT?

The ten portfolios must have excess returns not significantly different from zero.

In the presence of transactions costs, the SML will be

a set of lines rather than a single straight line.

Which of the following is a relaxation of the assumptions for the CAPM?

a. differential lending and borrowing rates b. a zero-beta model c. transaction costs d. taxes

Dhrymes, Friend, and Gultekin, in their study of the APT, found that

as the number of securities used to form portfolios increased, the number of factors that characterized the return generating process increased.

If the assumption that there are no transaction costs is relaxed, the SML will be a

band of securities.

challenge confronting CAPM

benchmark error problem that results from improperly specifying a proxy for the market portfolio.

A portfolio manager uses two different proxies for the market portfolio, the S&P 500 index, and the MSCI World index. Differences in the manager's portfolio performance resulting from the different market portfolios is referred to as

benchmark error.

Which of the following is not a step required for a multifactor risk model to estimate expected return for an individual stock position?

calculate the expected returns using linear programming analysis

in a macroeconomic-based risk factor model, the following factor would be one of many appropriate factors:

confidence risk.

Beta is a measure of

diversifiable risk

CAPM testing

early test subtantiated the positive relationship between returns and measures of systematic risk, although subsequent studies indicated that the single beta model needed to be supplemented with additional dimensions of risk (skewness, firm size, P/E, book value/market value)

A completely diversified portfolio would have a correlation with the market portfolio that is

equal to one because it has only systematic risk.

Fama and French suggest a three-factor model approach. Which of the following is NOT included in their approach?

excess returns to a broad market index, return differences between small-cap and large-cap portfolios, return differences between value and growth stocks, return differences between foreign stocks

. Cho, Elton, and Gruber tested the APT by examining the number of factors in the return generating process and found that

five factors were required using Roll-Ross procedures. six factors were present when using historical beta. fundamental betas indicated a need for three factors.

CAPM

generalizes the risk return trade off in the CML to allow for a consideration of individual securiteis as well as entire portfolios. To make this extension, The capm redefines the relevant measures of risk as beta, which is a systematic component of a securitys voltality relative to that of the market portfolio. Like the CML, the SML shows the relationship between risk and expected return is a straight line with a positive slope. The SML provides investors with a tool for judging whther secutiries are undervalued or overvalued given their level of systematic (beta) risk.

A 1994 study by Burmeister, Roll, and Ross defined all of the following risk factors

inflation risk. market-timing risk. business cycle risk. confidence risk

The ____ the number of stocks in a portfolio and the ____ the time period, the ____ the portfolio beta.

larger, longer, more stabl

To date, the results of empirical tests of the Arbitrage Pricing Model have been

mixed

Which of the following factors would you use to develop a macroeconomic-based risk factor model?

monthly growth in industrial production, change in inflation, unanticipated change in bond credit spread

In the APT model the idea of riskless arbitrage is to assemble a portfolio that

requires no initial wealth, will bear no risk, and still earn a profit.

In a microeconomic (or characteristic)-based risk factor model, the following factor would be one of many appropriate factors:

return difference between small capitalization and large capitalization stocks.

Which of the following factors would you use to develop a microeconomic-based risk factor model?

return on high book to market value portfolio minus return on low book to market value portfolio, excess return on stock market portfolio, return on small cap portfolio minus return on big cap portfolio

. If an individual owns only one security the most appropriate measure of risk is

standard deviation

The capital market line (CML) uses ____ as a risk measurement, whereas the capital asset pricing model (CAPM) uses ____.

standard deviation; systematic risk

A study by Chen, Roll, and Ross in 1986 examined all of the following factors in applying the Arbitrage Pricing Theory (APT) EXCEPT

the expected change in the bond credit spread.

Unlike the capital asset pricing model, the arbitrage pricing theory requires only the following assumption

the stochastic process generating asset returns can be represented by a factor model.

In a multifactor model, time horizon risk represents

unanticipated changes in investors' desired time to receive payouts.

In a multifactor model, confidence risk represents

unanticipated changes in the willingness of investors to take on investment risk.

One approach for using multifactor models is to use factors that capture systematic risk. Which of the following is a common factor used in this approach?

unexpected changes in inflation consumer confidence yield curve shifts unexpected changes in real GDP

The fact that tests have shown the CAPM intercept to be greater than the RFR is consistent with a(n)

zero beta model or a higher borrowing rate.