Ch. 7 Problem Sets

67) <p> What is the alpha of a portfolio with a beta of 2 and actual return of 15%? A) 0% B) 13% C) 15% D) 17%

A) 0% 15%-15%= 0%

84) One extensive study found that about __________ of financial managers use CAPM to estimate cost of capital. A) one-third B) one-half C) seventy five percent D) ninety percent

C) seventy five percent

4) 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

D) homogeneous expectations

11) 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

D) seem to regress toward 1 over time

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

D) systematic risk

60) One of the main problems with the arbitrage pricing theory is __________. A) its use of several factors instead of a single market index to explain the risk-return relationship B) the introduction of nonsystematic risk as a key factor in the risk-return relationship C) that the APT requires an even larger number of unrealistic assumptions than does the CAPM D) the model fails to identify the key macroeconomic variables in the risk-return relationship

D) the model fails to identify the key macroeconomic variables in the risk-return relationship

41) The risk-free rate is 4%. The expected market rate of return is 11%. If you expect stock X with a beta of 0.8 to offer a rate of return of 12%, then you should __________. A) buy stock X because it is overpriced B) buy stock X because it is underpriced C) sell short stock X because it is overpriced D) sell short stock X because it is underpriced

B) buy stock X because it is underpriced

85) Compensation of money managers is __________ based on alpha or other appropriate risk-adjusted measures. A) never B) rarely C) almost always D) always

B) rarely

36) Consider the capital asset pricing model. The market degree of risk aversion, A, is 3. The risk premium is 2.25%. If the risk-free rate of return is 4%, the expected return on the market portfolio is __________. A) 6.75% B) 9.25% C) 10.75% D) 12.00%

C) 10.75% rm-0.04=3*(0.0225) rm= 0.1075 10.75%

43) 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 __________. A) 12% B) 17% C) 18% D) 23%

C) 18% E(rx)=.06+1.2(.16-.06)=.18

1) The measure of risk used in the capital asset pricing model is __________. A) specific risk B) the standard deviation of returns C) reinvestment risk D) beta

D. beta

71) You consider buying a share of stock at a price of $25. The stock is expected to pay a dividend of $1.50 next year, and your advisory service tells you that you can expect to sell the stock in 1 year for $28. The stock's beta is 1.1, rf is 6%, and E( rm) = 16%. What is the stock's abnormal return? A) 1.00% B) 2.05% C) −1.00% D) −2.05%

A) 1.00% (28+1.50)/25-1-6%-1.1*(16%-6%) = 1.00%

22) You have a $50,000 portfolio consisting of Intel, GE, and Con Edison. You put $20,000 in Intel, $12,000 in GE, and the rest in Con Edison. Intel, GE, and Con Edison have betas of 1.3, 1, and 0.8, respectively. What is your portfolio beta? A) 1.048 B) 1.033 C) 1.000 D) 1.037

A) 1.048 (20/50)(1.3)+(12/50)(1.0)+(18/50)(0.8)=1.048

69) Two investment advisers are comparing performance. Adviser A averaged a 20% return with a portfolio beta of 1.5, and adviser B averaged a 15% return with a portfolio beta of 1.2. If the T-bill rate was 5% and the market return during the period was 13%, which adviser was the better stock picker? A) Advisor A was better because he generated a larger alpha. B) Advisor B was better because she generated a larger alpha. C) Advisor A was better because he generated a higher return. D) Advisor B was better because she achieved a good return with a lower beta.

A) Advisor A was better because he generated a larger alpha.

63) Assume that both X and Y are well-diversified portfolios and the risk-free rate is 8%. Portfolio X has an expected return of 14% and a beta of 1. Portfolio Y has an expected return of 9.5% and a beta of 0.25. In this situation, you would conclude that portfolios X and Y ________. A) are in equilibrium B) offer an arbitrage opportunity C) are both underpriced D) are both fairly priced

A) are in equilibrium Rx = Rf + Beta of X * (Rm - Rf) 14% = 8% + 1 * (Rm - 8%) Rm = 14% Ry = Rf + Beta of Y * (Rm - Rf) 9.5% = 8% + 0.25*(Rm - Rf) Rm - Rf = 1.5%/0.25 Rm = 6% + 8% = 14%

18) 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

A) assets with identical risks must have the same expected rate of return

12) 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

A) expected returns to fall; risk premiums to fall

50) Liquidity is a risk factor that __________. A) has yet to be accurately measured and incorporated into portfolio management B) is unaffected by trading mechanisms on various stock exchanges C) has no effect on the market value of an asset D) affects bond prices but not stock prices

A) has yet to be accurately measured and incorporated into portfolio management

77) A stock has a beta of 1.3. The systematic risk of this stock is __________ the stock market as a whole. A) higher than B) lower than C) equal to D) indeterminable compared to

A) higher than

46) In his famous critique of the CAPM, Roll argued that the CAPM __________. A) is not testable because the true market portfolio can never be observed B) is of limited use because systematic risk can never be entirely eliminated C) should be replaced by the APT D) should be replaced by the Fama-French three-factor model

A) is not testable because the true market portfolio can never be observed

38) In a single-factor market model the beta of a stock ________. A) measures the stock's contribution to the standard deviation of the market portfolio B) measures the stock's unsystematic risk C) changes with the variance of the residuals D) measures the stock's contribution to the standard deviation of the stock

A) measures the stock's contribution to the standard deviation of the market portfolio

58) The measure of unsystematic risk can be found from an index model as __________. A) residual standard deviation B) R-square C) degrees of freedom D) sum of squares of the regression

A) residual standard deviation

83) One can profit from an arbitrage opportunity by: A) taking a long position in the cheaper market and a short position in the expensive market. B) taking a short position in the cheaper market and a long position in the expensive market. C) taking a long position in both markets. D) taking a short position in both markets.

A) taking a long position in the cheaper market and a short position in the expensive market.

59) Standard deviation of portfolio returns is a measure of __________. A) total risk B) relative systematic risk C) relative nonsystematic risk D) relative business risk

A) total risk

79) The two-factor model on a stock provides a risk premium for exposure to market risk of 9%, a risk premium for exposure to interest rate risk of −1.3%, and a risk-free rate of 3.5%. The beta for exposure to market risk is 1, and the beta for exposure to interest rate risk is also 1. What is the expected return on the stock? A) 8.70% B) 11.20% C) 13.85% D) 15.25%

B) 11.20% 3.5%+((1*9%)+(1*(-1.3%)) = ​ 11.2%.

76) Research has identified two systematic factors that affect U.S. stock returns. The factors are growth in industrial production and changes in long-term interest rates. Industrial production growth is expected to be 3%, and long-term interest rates are expected to increase by 1%. You are analyzing a stock that has a beta of 1.2 on the industrial production factor and 0.5 on the interest rate factor. It currently has an expected return of 12%. However, if industrial production actually grows 5% and interest rates drop 2%, what is your best guess of the stock's return? A) 15.90% B) 12.90% C) 13.20% D) 12.00%

B) 12.90% 12% + (5% - 3%)(1.2) + (-2% - 1%)(.5) = 12% + 2.4% - 1.5% = 12.9%

75) What is the expected return on a stock with a beta of 0.8, given a risk-free rate of 3.5% and an expected market return of 15.5%? A) 3.80% B) 13.10% C) 15.65% D) 19.10%

B) 13.10% 3.5 + 0.8(15.5-3.5) = 13.1%

48) 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: 1. Including the unsystematic risk of a stock 2. Including human capital in the market portfolio 3. Allowing for changes in beta over time A) 1 and 2 only B) 2 and 3 only C) 1 and 3 only D) 1, 2, and 3

B) 2 and 3 only

2) Fama and French claim that after controlling for firm size and the ratio of the firm's book value to market value, beta is: 1. Highly significant in predicting future stock returns 2. Relatively useless in predicting future stock returns 3. A good predictor of the firm's specific risk A) 1 only B) 2 only C) 1 and 3 only D) 1, 2, and 3

B) 2 only

40) The variance of the return on the market portfolio is 0.04 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 __________. A) 0.5 B) 2.5 C) 3.5 D) 5.5

B) 2.5 (0.20-0.10)/0.04=2.5

39) Security A has an expected rate of return of 12% and a beta of 1.1. The market expected rate of return is 8%, and the risk-free rate is 5%. The alpha of the stock is __________. A) −1.7% B) 3.7% C) 5.5% D) 8.7%

B) 3.7% 0.12 - [0.05 + 1.1 *(0.08-0.05)]

66) <p> What is the expected return for a portfolio with a beta of 0.5? A) 5.5% B) 7.5% C) 12.5% D) 15.0%

B) 7.5% 5+(5*0.5)= 7.5%

28) Consider the single factor APT. Portfolio A has a beta of 1.3 and an expected return of 21%. Portfolio B has a beta of 0.7 and an expected return of 17%. The risk-free rate of return is 8%. If you wanted to take advantage of an arbitrage opportunity, you should take a short position in portfolio __________ and a long position in portfolio __________. A) A; A B) A; B C) B; A D) B; B

B) A; B

56) An investor should do which of the following for stocks with negative alphas? A) Go long B) Sell short C) Hold D) Do nothing

B) Sell short

27) In a world where the CAPM holds, which one of the following is not a true statement regarding the capital market line? A) The capital market line always has a positive slope. B) The capital market line is also called the security market line. C) The capital market line is the best-attainable capital allocation line. D) The capital market line is the line from the risk-free rate through the market portfolio

B) The capital market line is also called the security market line.

57) A stock's alpha measures the stock's __________. A) expected return B) abnormal return C) excess return D) residual return

B) abnormal return

25) According to the capital asset pricing model, in equilibrium __________. A) all securities' returns must lie below the capital market line B) all securities' returns must lie on the security market line C) the slope of the security market line must be less than the market risk premium D) any security with a beta of 1 must have an excess return of zero

B) all securities' returns must lie on the security market line

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

B) beta

70) The expected return on the market is the risk-free rate plus the __________. A) diversified returns B) equilibrium risk premium C) historical market return D) unsystematic return

B) equilibrium risk premium

33) The possibility of arbitrage arises when __________. A) there is no consensus among investors regarding the future direction of the market, and thus trades are made arbitrarily B) mispricing among securities creates opportunities for riskless profits C) two identically risky securities carry the same expected returns D) investors do not diversify

B) mispricing among securities creates opportunities for riskless profits

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

B) on the security market line

32) Security X has an expected rate of return of 13% and a beta of 1.15. The risk-free rate is 5%, and the market expected rate of return is 15%. According to the capital asset pricing model, security X is __________. A) fairly priced B) overpriced C) underpriced D) None of these answers are correct.

B) overpriced

51) Beta is a measure of __________. A) total risk B) relative systematic risk C) relative nonsystematic risk D) relative business risk

B) relative systematic risk

52) According to capital asset pricing theory, the key determinant of portfolio returns is __________. A) the degree of diversification B) the systematic risk of the portfolio C) the firm-specific risk of the portfolio D) economic factors

B) the systematic risk of the portfolio

78) The risk premium for exposure to aluminum commodity prices is 4%, and the firm has a beta relative to aluminum commodity prices of 0.6. The risk premium for exposure to GDP changes is 6%, and the firm has a beta relative to GDP of 1.2. If the risk-free rate is 4%, what is the expected return on this stock? A) 10.0% B) 11.5% C) 13.6% D) 14.0%

C) 13.6% 4%+(4%*0.6) +(6%*1.2)= 13.6%

30) Consider the multifactor APT with two factors. Portfolio A has a beta of 0.5 on factor 1 and a beta of 1.25 on factor 2. The risk premiums on the factor 1 and 2 portfolios are 1% and 7%, respectively. The risk-free rate of return is 7%. The expected return on portfolio A is __________ if no arbitrage opportunities exist. A) 13.50% B) 15.00% C) 16.25% D) 23.25%

C) 16.25% 7+0.5*1+1.25*7=16.25%

8) 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%

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

29) Consider the single factor APT. Portfolio A has a beta of 0.2 and an expected return of 13%. Portfolio B has a beta of 0.4 and an expected return of 15%. The risk-free rate of return is 10%. If you wanted to take advantage of an arbitrage opportunity, you should take a short position in portfolio __________ and a long position in portfolio __________. A) A; A B) A; B C) B; A D) B; B

C) B; A

44) Consider two stocks, A and B. Stock A has an expected return of 10% and a beta of 1.2. Stock B has an expected return of 14% and a beta of 1.8. The expected market rate of return is 9% and the risk-free rate is 5%. Security __________ would be considered the better buy because __________. A) A; it offers an expected excess return of 0.2% B) A; it offers an expected excess return of 2.2% C) B; it offers an expected excess return of 1.8% D) B; it offers an expected return of 2.4%

C) B; it offers an expected excess return of 1.8% 1. Capm Return of Stock A = Rf + beta * Risk Premium = 5% + 1.20 * (9% - 5%) = 9.80% 2. Alpha = Expected Return - CAPM Return = 10% - 9.80% = 0.20% 3. Capm Return of Stock B = Rf + beta * Risk Premium = 5% + 1.80 * (9% - 5%) = 12.20% 4. Alpha = Expected Return - CAPM Return = 14% - 12.20% = 1.80%

26) According to the CAPM, which of the following is not a true statement regarding the market portfolio. A) All securities in the market portfolio are held in proportion to their market values. B) It includes all risky assets in the world, including human capital. C) It is always the minimum-variance portfolio on the efficient frontier. D) It lies on the efficient frontier.

C) It is always the minimum-variance portfolio on the efficient frontier.

62) The expected return on the market portfolio is 15%. The risk-free rate is 8%. The expected return on SDA Corporation common stock is 16%. The beta of SDA Corporation common stock is 1.25. Within the context of the capital asset pricing model, __________. A) SDA Corporation stock is underpriced B) SDA Corporation stock is fairly priced C) SDA Corporation stock's alpha is −0.75% D) SDA Corporation stock alpha is 0.75%

C) SDA Corporation stock's alpha is −0.75% Alpha = Ri - (Rf + beta * (Rm - Rf ) ) -0.75% = 16% - (8% + 1.25 * (15% - 8% ))

23) The graph of the relationship between expected return and beta in the CAPM context is called the __________. A) CML B) CAL C) SML D) SCL

C) SML

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

C) William Sharpe

45) According to the CAPM, the risk premium an investor expects to receive on any stock or portfolio is __________. A) directly related to the risk aversion of the particular investor B) inversely related to the risk aversion of the particular investor C) directly related to the beta of the stock D) inversely related to the alpha of the stock

C) directly related to the beta of the stock

61) You run a regression of a stock's returns versus a market index and find the following: Coefficients Lower 95% Upper 95% Intercept 0.789 −1.556 3.457 Slope 0.890 0.6541 1.465 Based on the data, you know that the stock __________. A) earned a positive alpha that is statistically significantly different from zero B) has a beta precisely equal to 0.890 C) has a beta that is likely to be anything between 0.6541 and 1.465 inclusive D) has no systematic risk

C) has a beta that is likely to be anything between 0.6541 and 1.465 inclusive

16) 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

C) have the same intercept with a steeper slope; fall

17) 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

C) positive alpha is considered underpriced

55) The most significant conceptual difference between the arbitrage pricing theory (APT) and the capital asset pricing model (CAPM) is that the CAPM __________. A) places less emphasis on market risk B) recognizes multiple unsystematic risk factors C) recognizes only one systematic risk factor D) recognizes multiple systematic risk factors

C) recognizes only one systematic risk factor

35) An important characteristic of market equilibrium is __________. A) the presence of many opportunities for creating zero-investment portfolios B) all investors exhibit the same degree of risk aversion C) the absence of arbitrage opportunities D) the lack of liquidity in the market

C) the absence of arbitrage opportunities

68) If the simple CAPM is valid and all portfolios are priced correctly, which of the situations below is possible? Consider each situation independently, and assume the risk-free rate is 5%. A) Portfolio Expected Return Beta A 15% 1.2 Market 15% 1.0 B) Portfolio Expected Return Beta A 20% 12% Market 15% 20 C) Portfolio Expected Return Beta A 20% 1.2 Market 15% 1.0 D) Portfolio Expected Return Beta A 30% 2.5 Market 15% 1.0 A) Option A B) Option B C) Option C D) Option D

D) Option D D) Portfolio Expected Return Beta

54) According to the CAPM, investors are compensated for all but which of the following? A) Expected inflation B) Systematic risk C) Time value of money D) Residual risk

D) Residual risk

53) The expected return of the risky-asset portfolio with minimum variance is __________. A) the market rate of return B) zero C) the risk-free rate D) The answer cannot be determined from the information given.

D) The answer cannot be determined from the information given.

49) The SML is valid for __________, and the CML is valid for __________. A) only individual assets; well-diversified portfolios only B) only well-diversified portfolios; only individual assets C) both well-diversified portfolios and individual assets; both well-diversified portfolios and individual assets D) both well-diversified portfolios and individual assets; well-diversified portfolios only

D) both well-diversified portfolios and individual assets; well-diversified portfolios only

34) Building a zero-investment portfolio will always involve __________. A) an unknown mixture of short and long positions B) only short positions C) only long positions D) equal investments in a short and a long position

D) equal investments in a short and a long position

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

D) unsystematic

21) According to the capital asset pricing model, fairly priced securities have __________. A) negative betas B) positive alphas C) positive betas D) zero alphas

D) zero alphas

31) Consider the one-factor APT. The variance of the return on the factor portfolio is 0.08. The beta of a well-diversified portfolio on the factor is 1.2. The variance of the return on the well-diversified portfolio is approximately __________. A) 0.1152 B) 0.1270 C) 0.1521 D) 0.1342

A) 0.1152 (1.2)^2 * 0.08 = 0.1152 11.52%

80) The risk premium for exposure to exchange rates is 5%, and the firm has a beta relative to exchange rates of 0.4. The risk premium for exposure to the consumer price index is −6%, and the firm has a beta relative to the CPI of 0.8. If the risk-free rate is 3%, what is the expected return on this stock? A) 0.20% B) 1.55% C) 3.69% D) 4.04%

A) 0.20% 3%+0.4*5%+0.8*-6% = 0.2%

24) Research has revealed that regardless of what the current estimate of a firm's beta is, beta will tend to move closer to __________ over time. A) 1.0 B) 0.0 C) −1.0 D) 0.5

A) 1.0

7) 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) 0.5 B) 0.7 C) 1.0 D) 1.2

D) 1.2 17% = 5% + [15% - 5%]βs βs = 1.2

42) 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 __________. A) 0.60 B) 1 C) 1.67 D) 3.20

C) 1.67 20%/12%= 1.67

64) <p> What is the expected return on the market? A) 0% B) 5% C) 10% D) 15%

C) 10% Since Beta is always 1

47) Which of the following variables do Fama and French claim do a better job explaining stock returns than beta? 1. Book-to-market ratio 2. Unexpected change in industrial production 3. Firm size A) 1 only B) 1 and 2 only C) 1 and 3 only D) 1, 2, and 3

C) 1 and 3 only

3) Which of the following are assumptions of the simple CAPM model? 1. Individual trades of investors do not affect a stock's price. 2. All investors plan for one identical holding period. 3. All investors analyze securities in the same way and share the same economic view of the world. 4. All investors have the same level of risk aversion. A) 1, 2, and 4 only B) 1, 2, and 3 only C) 2, 3, and 4 only D) 1, 2, 3, and 4

B) 1, 2, and 3 only

72) If the beta of the market index is 1 and the standard deviation of the market index increases from 12% to 18%, what is the new beta of the market index? A) 0.8 B) 1.0 C) 1.2 D) 1.5

B) 1.0

37) You invest $600 in security A with a beta of 1.5 and $400 in security B with a beta of 0.90. The beta of this portfolio is __________. A) 1.14 B) 1.20 C) 1.26 D) 1.55

C) 1.26 $600/$1000= 0.6 $400/$1000= 0.4 (0.6*1.5)+(0.4*0.9)= 1.26

65) <p> What is the beta for a portfolio with an expected return of 12.5%? A) 0.5 B) 1.0 C) 1.5 D) 2.5

C) 1.5 12*5 = 5+(5*Beta) (7*5)

5) In a simple CAPM world which of the following statements is (are) correct? 1. All investors will choose to hold the market portfolio, which includes all risky assets in the world. 2. Investors' complete portfolio will vary depending on their risk aversion. 3. The return per unit of risk will be identical for all individual assets. 4. The market portfolio will be on the efficient frontier, and it will be the optimal risky portfolio. A) 1, 2, and 3 only B) 2, 3, and 4 only C) 1, 3, and 4 only D) 1, 2, 3, and 4

D) 1, 2, 3, and 4

13) The market portfolio has a beta of __________. A) −1.0 B) 0.0 C) 0.5 D) 1.0

D) 1.0

74) According to the CAPM, what is the expected market return given an expected return on a security of 15.8%, a stock beta of 1.2, and a risk-free interest rate of 5%? A) 5% B) 9% C) 13% D) 14%

D) 14% 15.8% = 5% + 1.2 * (market return - 5%) market return = 14%

81) The two-factor model on a stock provides a risk premium for exposure to market risk of 12%, a risk premium for exposure to silver commodity prices of 3.5%, and a risk-free rate of 4%. The beta for exposure to market risk is 1, and the beta for exposure to commodity prices is also 1. What is the expected return on the stock? A) 11.64% B) 13.05% C) 15.35% D) 19.50%

D) 19.50% 4 + 1(12) + 1(3.5) =19.50%

6) 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) 6.00% B) 15.60% C) 18.00% D) 21.60%

D) 21.60% CAPM = 6%+1.3(18%-6%)=21.6%

73) According to the CAPM, what is the market risk premium given an expected return on a security of 13.6%, a stock beta of 1.2, and a risk-free interest rate of 4%? A) 4.00% B) 4.80% C) 6.65% D) 8.00%

D) 8.00% (0.136-0.04)/1.2

82) The CAPM __________. A) predicts the relationship between risk and expected return of an asset B) provides a benchmark rate of return for evaluating possible investments C) helps us make an educated guess as to expected return on assets that have not yet traded in the marketplace D) All of the options are correct.

D) All of the options are correct.