Fin 311- CH 7

82. 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. 8.7% B. 11.2% C. 13.8% D. 15.2%

B. 11.2% Return = 3.5 + 9 - 1.3 = 11.2%

80. Using the index model, the alpha of a stock is 3%, the beta is 1.1, and the market return is 10%. What is the residual given an actual return of 15%? A. .0% B. 1% C. 2% D. 3%

B. 1% Residual = 15 - (3 + 1.1 × 10) = 1%

32. Consider the one-factor APT. The variance of the return on the factor portfolio is .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. .1152 B. .1270 C. .1521 D. .1342

A. .1152 = (.08)(1.2 squared) = 0.1152

83. The risk premium for exposure to exchange rates is 5%, and the firm has a beta relative to exchange rates of .4. The risk premium for exposure to the consumer price index is -6%, and the firm has a beta relative to the CPI of .8. If the risk-free rate is 3%, what is the expected return on this stock? A. .2% B. 1.5% C. 3.6% D. 4%

A. .2% Return = .03 + .4(.05) + .8(-.06) = .002

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 B. 0 C. -1 D. .5

A. 1

72. 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% B. 2% C. -1% D. -2%

A. 1% E[r]= [(28-25+1.5)/25](100%)= 18% Required return = 6% + (16% - 6%)(1.1) = 17% Abnormal return = 18% - 17% = 1%

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 .8, respectively. What is your portfolio beta? A. 1.048 B. 1.033 C. 1 D. 1.037

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

70. 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. Required return A = 5% + (13% - 5%)(1.5) = 17% Required return B = 5% + (13% - 5%)(1.2) = 14.6% αA = Actual return A - Required return A = 20% - 17% = 3% αB = Actual return B - Required return B = 15% - 14.6% = .4%

A. Advisor A was better because he generated a larger alpha Required return A = 5% + (13% - 5%)(1.5) = 17% Required return B = 5% + (13% - 5%)(1.2) = 14.6% αA = Actual return A - Required return A = 20% - 17% = 3% αB = Actual return B - Required return B = 15% - 14.6% = .4%

64. 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 _________. A. are in equilibrium B. offer an arbitrage opportunity C. are both underpriced D. are both fairly priced Thus, there are no arbitrage opportunities, and X and Y are in equilibrium.

A. are in equilibrium PremX= (14-8)/1= 6 PremY= (9.5-8)/.25=6

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

51. 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 mgmt

78. 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

47. 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

39. 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. measure the stock's contribution to the standard deviation of the market portfolio

59. 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

25. The beta of a security is equal to _________. A. the covariance between the security and market returns divided by the variance of the market's returns B. the covariance between the security and market returns divided by the standard deviation of the market's returns C. the variance of the security's returns divided by the covariance between the security and market returns D. the variance of the security's returns divided by the variance of the market's returns

A. the covariance between the security and market returns divided by the variance of the market's returns

60. 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

73. 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. .8 B. 1 C. 1.2 D. 1.5

B. 1 Market beta always equals 1 regardless of market volatility.

77. 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? A. 15.9% B. 12.9% C. 13.2% D. 12%

B. 12.9% E[rnew] = 12% + (5% - 3%)(1.2) + (-2% - 1%)(.5) = 12.9%

76. What is the expected return on a stock with a beta of .8, given a risk-free rate of 3.5% and an expected market return of 15.5%? A. 3.8% B. 13.1% C. 15.6% D. 19.1%

B. 13.1% Expected return = 3.5 + (.8)(15.5 - 3.5) = 13.1%

41. The variance of the return on the market portfolio is .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. .5 B. 2.5 C. 3.5 D. 5 A = (.20 - .10)/.04 = 2.5

B. 2.5 A = (.20 - .10)/.04 = 2.5

40. 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% Alpha= .12- [.05+1.1(.08-.05)]= .037

29. 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 .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 A=[(21-8)/1.3] < B=[(17-8)/.07] Short A;Buy B

10. 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

B. Beta

3. 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

B. I, II, and III only

49. 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 A. I and II only B. II and III only C. I and III only D. I, II, and III

B. II and III 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: 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

B. II only

52. Beta is a measure of ______________. A. total risk B. relative systematic risk C. relative nonsystematic risk D. relative business risk

B. Relative systematic risk

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

B. Stephen Ross

28. 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

58. A stock's alpha measures the stock's ____________________. A. expected return B. abnormal return C. excess return D. residual return

B. abnormal return

26. 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 mus lie on the security market line

20. 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

B. along the security market line

42. 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 _________. 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 E(rx) would normally be .04+.8(.11-.04)= .096

71. 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

34. 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

33. 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 In equilibrium, E(rX) = 5% + 1.15(15% - 5%) = 16.5%.

B. overpriced In equilibrium, E(rX) = 5% + 1.15(15% - 5%) = 16.5%.

57. Arbitrage is __________________________. A. an example of the law of one price B. the creation of riskless profits made possible by relative mispricing among securities C. a common opportunity in modern markets D. an example of a risky trading strategy based on market forecasting

B. the creation of riskless profits made possible by relative mispricing among securities

53. 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

38. 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 _________. A. 1.14 B. 1.2 C. 1.26 D. 1.5

C. 1.26 Bp= (600/1000)(1.5) + (400/1000)(.90) = 1.26

43. 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. .60 B. 1 C. 1.67 D. 3.20

C. 1.67 Bp= (.20/.12) = 1.67

37. 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 _________. A. 6.75% B. 9% C. 10.75% D. 12%

C. 10.75 E(rm)= .04+3(.0225)= 10.75

81. The risk premium for exposure to aluminum commodity prices is 4%, and the firm has a beta relative to aluminum commodity prices of .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% B. 11.5% C. 13.6% D. 14%

C. 13.6% Return = .04 + .6(.04) + 1.2(.06) = .136

31. 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. A. 13.5% B. 15% C. 16.25% D. 23%

C. 16.25% E(rA) = 7 + 0.5(1) + 1.25(7) = 16.25%

44. 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

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%

45. 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 .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% A= .10-[.05+1.2(.09-.05)]=.002 B= .14= [.05+1.8(.09-.05)]=.018

30. 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 _________. A. A; A B. A; B C. B; A D. B; B

C. B;A A= [(13-10)/.2] > B=[(15-10)/.4] Short B; Buy A

48. 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 A. I only B. I and II only C. I and III only D. I, II, and III

C. I and III only

27. 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

63. The expected return on the market portfolio is 15%. The risk-free rate is 8%. The expected return on SDA Corp. common stock is 16%. The beta of SDA Corp. common stock is 1.25. Within the context of the capital asset pricing model, _________. A. SDA Corp. stock is underpriced B. SDA Corp. stock is fairly priced C. SDA Corp. stock's alpha is -.75% D. SDA Corp. stock alpha is .75%

C. SDA Corp. stock's alpha is -.75% =.16-[.08+1.25(.15-.08)] = -.0075

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

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

C. closer to 1

46. 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

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

56. 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. recognize only one systematic risk factor

36. 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

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

D. 1

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. .5 B. .7 C. 1 D. 1.2

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

75. 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 × (MRP); MRP = 9%; Expected market return = 5 + 9 = 14%

84. 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. 11.6% B. 13% C. 15.3% D. 19.5%

D. 19.5% Return = 3.5 + 4 + 12 = 19.5%

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% B. 15.6% C. 18% D. 21.6%

D. 21.6% E[rs]= 6% + [18% - 6%](1.3) = 21.6%

74. 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% B. 4.8% C. 6.6% D. 8%

D. 8% 13.6 = 4 + 1.2 × (MRP); MRP = 8%

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

5. 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

D. I, II, III, and IV

55. 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

54. 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

85. 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

50. 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

35. 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

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

61. 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 macroeconomis variables in the risk-return relationship

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

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