Investments Practice for Exam II

You believe that you can earn 2% more on your portfolio if you engage in full-time stock research. However, the additional trading costs and tax liability from active management will cost you about .5%. You have an $800,000 stock portfolio. What is the most you can afford to spend on your research?

(.02-.005)(800000) = $12,000

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%?

E(Ri) = Rf + Bi [E(Rm)-Rf] .17 = .05 + Bi(.15-.05) .12/.10 = 1.2 = beta

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?

E(Ri) = Rf + Bi [E(Rm)-Rf] .20 = Rf + 1.2(.18-Rf) .20 = Rf + .2160 - 1.2Rf -.016 = -.2RF .08 = Rf

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?

E(Ri) = Rf + Bi [E(Rm)-Rf] E(Ri) = .06 + 1.3(.18-.06)

You invest $600 in security A with a beta of 1.5 and $400 in security B with a beta of .90. The beta of this portfolio is _________.

Find weights and multiple by the respective betas and then add. (600/1000)(1.5) + (400/1000)(.90) = Bp

The possibility of arbitrage arises when ____________.

mispricing among securities creates opportunities for riskless profits

The four-factor model used to construct performance benchmarks for mutual funds uses the three Fama and French factors and one additional factor related to _________.

momentum

The tendency of poorly performing stocks and well-performing stocks in one period to continue their performance into the next period is called the ________________.

momentum effect

An implication of the efficient market hypothesis is that __________.

nonzero alphas will quickly disappear

Investors gravitate toward the latest hot stock even though it has never paid a dividend. Even though net income is projected to fall over the current and next several years, the price of the stock continues to rise. What behavioral concept may explain this price pattern?

overconfidence

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

positive alpha is considered underpriced

Market anomaly refers to _______.

price behavior that differs from the behavior predicted by the efficient market hypothesis

Conventional finance theory assumes investors are _______, and behavioral finance assumes investors are _______.

rational; irrational

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

recognizes only one systematic risk factor

Which of the following is not a method employed by fundamental analysts? - analyzing the Fed's next interest rate move - relative strength analysis - earnings forecasting - estimating the economic growth rate

relative strength analysis

Beta is a measure of ______________.

relative systematic risk

If investors overweight recent performance in forecasting the future, they are exhibiting _______.

representative bias

Your two best friends each tell you about a person they know who successfully started a small business. That's it, you decide; if they can do it, so can you. This is an example of _____________.

representative bias

According to the CAPM, investors are compensated for all but which of the following? - Expected inflation - Systematic risk - time value of money - residual risk

residual risk

A _________ is a value above which it is difficult for the market to rise.

resistance level

An investor should do what for stocks with negative alphas?

sell short

Evidence suggests that there may be _______ momentum and ________ reversal patterns in stock price behavior.

short-run; long-run

Which of the following beliefs would not preclude charting as a method of portfolio management?

stock prices follow recurring patterns

The term random walk is used in investments to refer to ______________.

stock prices that are random and unpredictable

Most people would readily agree that the stock market is not _________.

strong-form efficient

The price of a stock fluctuates between $43 and $60. If the time frame referenced encompasses the primary trend, the $43 price may be considered the ___________.

support level

One can profit from an arbitrage opportunity by

taking a long position in the cheaper market and a short position in the expensive market

Choosing stocks by searching for predictable patterns in stock prices is called ________.

technical analysis

Random price movements indicate ________.

that markets are functioning efficiently

Which of the following is not an issue that is central to the debate regarding market efficiency? - the magnitude issue - the tax-loss selling issue - the lucky event issue - the selection bias issue

the tax-loss selling issue

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

unsystematic

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 _________.

using the CAPM equation you find: .13 = .1650 so the security is overpriced

Fama and French have suggested that many market anomalies can be explained as manifestations of ____________.

varying risk premiums

The tendency when the ______ performing stocks in one period are the best performers in the next and the current ________ performers are lagging the market later is called the reversal effect.

worst; best

According to the capital asset pricing model, fairly priced securities have _________.

zero alphas

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.

1

The market portfolio has a beta of _________.

1

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?

1. Find real return using HPR * 100% 2. Find CAPM return 3. Compare the two and that is your abnormal return

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 .8, respectively. What is your portfolio beta?

1. Find relative weights of each investment (e.g. amount in each category / total invested): 20000/50000 2. Multiple step 1 by the beta for the respective investment: 20000/50000(1.3) 3. Do this for all investments and add them: Beta of Portfolio = 1.048

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%, then you should _________.

1. Find the Market Risk Premium: E(Rm) - Rf 2. Find CAPM: Rf + Bi (Rm - Rf) 3. Compare the two and since price and return move in opposite directions this stock is underpriced or compare to CAPM Market risk premium = .07 CAPM = .096 (against the offer rate of 12% you can see that it is underpriced)

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 _________.

1. Solve CAPM with alpha 2. Compare CAPM return to E(R) of the stock 3. Choose whichever has a larger alpha (abnormal return) A: 9.8% to 10% (.02 difference) B: 12.2% to 14% (1.8% difference)

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 .25. In this situation, you would conclude that portfolios X and Y _________.

1. Solve for E(Rm) using CAPM 2. You'll see that E(Rm) is equal to the E(Ri) in both instances and is therefore fairly priced and at equilibrium

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 .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?

1. Solve for alpha using: E(Rm) = alpha + E(R1)(B1) + E(R2)(B2) 2. Start with found alpha and 'what-if' dimensions and use same formula as above but solve for E(Rm): alpha + .05(1.2) + -.02(.5) E(Rm) = 12.9%

Consider the single factor APT. Portfolio A has a beta of .2 and an expected return of 13%. Portfolio B has a beta of .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 _________.

B;A

Consider the multifactor APT with two factors. Portfolio A has a beta of .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.

Basically just CAPM, just remember risk premium is the E(Rm)-Rf part of CAPM. Also, you are adding mroe factors so you just add more of the last part of the CAPM equation. So: .07 + .5(.01) + 1.25 (.07)

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.

I, II, III only

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.

I, II, III, and IV

Among the important characteristics of market efficiency is (are) that: I. There are no arbitrage opportunities. II. Security prices react quickly to new information. III. Active trading strategies will not consistently outperform passive strategies.

I, II, and III

Value stocks may provide investors with better returns than growth stocks if: I. Value stocks are out of favor with investors. II. Prices of growth stocks include premiums for overly optimistic growth levels. III. Value stocks are likely to generate positive-earnings surprises.

I, II, and III

According to the CAPM, which of the following is not a true statement regarding the market portfolio.

It is always the minimum-variance portfolio on the efficient frontier

The small-firm effect is strongest in which month?

January

Consider the capital asset pricing model. The market degree of risk aversion, A, is 3. The variance of return on the market portfolio is .0225. If the risk-free rate of return is 4%, the expected return on the market portfolio is _________.

Rf + Risk Aversion(Return on Market Portfolio) So: E(Rm) = .04 + 3(.0225) 10.75%

The graph of the relationship between expected return and beta in the CAPM context is called the _________.

SML

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 _________.

Solve for CAPM with alpha: .12 = .05 + 1.1(.08-.05) + alpha alpha = 3.7%

In a world where the CAPM holds, which one of the following is not a true statement regarding the capital market line? - the capital market line always has a + slope - the capital market line is also called the SML - the capital market line is the best-attainable capital allocation line - the capital market line is the line from the risk-free rate through the market portfolio

The capital market line is also called the SML

What is the expected return on the market? 15% - return; 2 - beta 10% - return; 1 - beta

Where beta = 1 so 10%

A support level is ___________________.

a level below which the market is unlikely to fall

Proponents of the EMH typically advocate __________.

a passive investment strategy

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

abnormal return

__________ is the return on a stock beyond what would be predicted from market movements alone.

abnormal return

The strong form of the EMH states that ________ must be reflected in the current stock price.

all information, including inside information

The weak form of the EMH states that ________ must be reflected in the current stock price.

all past information, including security price and volume data

The semistrong form of the EMH states that ________ must be reflected in the current stock price.

all publicly available information

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

along the SML

Arbitrage is based on the idea that _________.

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

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

beta

If you believed in the reversal effect, you should __________.

buy stocks this period that performed poorly last period

If investors are too slow to update their beliefs about a stock's future performance when new evidence arises, they are exhibiting _______.

conservatism

Behaviorists point out that even if market prices are ____________, there may be _______________.

distorted; limited arbitrage opportunities

In an efficient market and for an investor who believes in a passive approach to investing, what is the primary duty of a portfolio manager?

diversification

Basu found that firms with high P/E ratios __________.

earned higher average returns than firms with low P/E ratios

Which of the following is not a method employed by followers of technical analysis? - charting - relative strength analysis - earnings forecasting - trading around support and resistance levels

earnings forecasting

The Fama and French evidence that high book-to-market firms outperform low book-to-market firms even after adjusting for beta means that _________.

either high book-to-market firms are underpriced or the book-to-market ratio is a proxy for a systematic risk factor

When the market risk premium rises, stock prices will ________.

fall

An investor has her money segregated into checking, savings, and investments. The allocation among the categories is subjective, yet the investor spends freely from the checking account and not the others. This behavior can be explained as _______________.

mental accounting

What is the expected return for a portfolio with a beta of .5? 15% - return; 2 - beta 10% - return; 1 - beta

half of beta 1 so 7.5%

What is the beta for a portfolio with an expected return of 12.5%? 15% - return; 2 - beta 10% - return; 1 - beta

half-way between 10 and 15 is 12.5% so 1.5 beta

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

have the same intercept with a steeper slope; fall

A mutual fund that attempts to hold quantities of shares in proportion to their representation in the market is called an __________ fund.

index

One type of passive portfolio management is ________.

investing in a well-diversified portfolio without attempting to search out mispriced securities

What is the alpha of a portfolio with a beta of 2 and actual return of 15%? 15% - return; 2 - beta 10% - return; 1 - beta

it matches the beta so therefore there is no abnormal return; 0%

The primary objective of fundamental analysis is to identify __________.

mispriced stocks