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Chapter 07

Capital Asset Pricing and Arbitrage Pricing Theory
STUDY
PLAY
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
2. Fama and French claim that after controlling for firm size and the ratio of book value to market value, beta is insignificant in explaining stock returns. This claim
I. is supported by their analysis of historical stock return data
II. is based on a well developed theoretical model
III. implies that unsystematic risk is actually priced
A. I only
b. I and II only
c. II and III only
d. I, II and III
A. I only
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
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
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%
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 12%?
a. .5
B. .7
c. 1.2
d. 1.4
B. .7
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%
9. The arbitrage pricing theory was developed by __________.
a. Henry Markowitz
B. Stephen Ross
c. William Sharpe
d. Eugene Fama
B. Stephen Ross
10. In the context of the capital asset pricing model, the systematic measure of risk is __________.
a. Unique risk
B. Beta
c. Standard deviation of returns
d. Variance of returns
B. Beta
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 one
D. Seem to regress toward one over time
D. Seem to regress toward one over time
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
13. The market portfolio has a beta of __________.
a. -1.0
b. 0
c. 0.5
D. 1.0
D. 1.0
14. In a well diversified portfolio, __________ risk is negligible.
a. Nondiversifiable
b. Market
c. Systematic
D. Unsystematic
D. Unsystematic
15. The capital asset pricing model was developed by __________.
a. Kenneth French
b. Stephen Ross
C. William Sharpe
d. Eugene Fama
C. William Sharpe
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
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
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
20. 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
21. 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, 1.0 and 0.8 respectively. What is your portfolio beta?
A. 1.048
b. 1.033
c. 1.000
d. 1.037
A. 1.048
22. The graph of the expected return beta relationship in the CAPM context is called the __________.
a. CML
b. CAL
C. SML
d. Term Structure
C. SML
23. Research has revealed that regardless of what the current estimate of a firm's beta is, it will tend to move closer to ______ over time.
A. 1
b. 0
c. -1
d. 0.5
A. 1
24. 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
25. According to the capital asset pricing model, __________.
a. All securities' returns must lie on 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
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
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
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
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
30. Consider the multi-factor 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 factors 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. 15.0%
C. 16.25%
d. 23.0%
C. 16.25%
31. 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 __________.0810.
A. .1152
b. .1270
c. .1521
d. .1342
A. .1152
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 the above
B. Overpriced
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. Mis-pricing among securities creates opportunities for riskless profits
c. Two identically risky securities carry the same expected returns
d. Investors do not diversify
B. Mis-pricing among securities creates opportunities for riskless profits
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
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 a lack of liquidity in the market
C. The absence of arbitrage opportunities
36. 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. 9.0%
C. 10.75%
d. 12.0%
C. 10.75%
37. 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. 1.20
C. 1.26
d. 2.40
C. 1.26
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
39. Security A has an expected rate of return of 12% and a beta of 1.10. 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%
40. The variance of the return on the market portfolio is .0400 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. 5.0
B. 2.5
41. 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 percent, 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
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. 1.00
C. 1.67
d. 3.20
C. 1.67
43. The risk-free rate and the expected market rate of return are 5% and 15% 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%
B. 17%
44. Consider the following two stocks, A and B. Stock A has an expected return of 10% and a beta of 1.20. Stock B has an expected return of 14% and a beta of 1.80. The expected market rate of return is 9% and the risk-free rate is 5%. Security __________ would be considered a good buy because __________.
a. A, it offers an expected excess return of 0.8%
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%
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
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 3 factor model
A. Is not testable because the true market portfolio can never be observed
47. 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
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 ______________.
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
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
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
51. Beta is a measure of _______________.
a. Total risk
B. Relative systematic risk
c. Relative non-systematic 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
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. There is not enough information to answer this question
D. There is not enough information to answer this question
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
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
56. Arbitrage is ___________________________.
a. Is an example of the law of one price
B. The creation of riskless profits made possible by relative mispricing among securities
c. Is 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
57. A stock's alpha measures the stock's ________________________________.
a. Expected return
B. Abnormal return
c. Excess return
d. Residual return
B. Abnormal return
58. The measure of unsystematic risk can be found from an index model as
A. Standard error
b. Multiple R
c. Degrees of freedom
d. Sum of squares of the regression
A. Standard error
59. Standard deviation is a measure of ____________.
A. Total risk
b. Relative systematic risk
c. Relative non-systematic risk
d. Relative business risk
A. Total 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 non-systematic risk as a key factor in the risk-return relationship
c. That the APT requires an even larger number of unrealistic assumptions than the CAPM
D. The model fails to identify the key macro-economic variables in the risk-return relationship
D. The model fails to identify the key macro-economic variables in the risk-return relationship
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 could be anything between 0.6541 and 1.465 inclusive
d. Has no systematic risk
C. Has a beta that could be anything between 0.6541 and 1.465 inclusive
62. 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 -0.75%
d. SDA Corp. stock alpha is 0.75%
C. SDA Corp. stock's alpha is -0.75%
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 1.00. 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
64. In estimating beta many analysts use _________ returns over _______ years.
a. Daily; 10
B. Monthly; 5
c. Weekly; 25
d. Monthly; 10
B. Monthly; 5
65. What is the expected return on the market?
a. 0%
b. 5%
C. 10%
d. 15%
C. 10%
66. What is the beta for a portfolio with an expected return of 12.5%?
a. 0
b. 1
C. 1.5
d. 2
C. 1.5
67. What is the expected return for a portfolio with a beta of 0.5?
a. 5%
B. 7.5%
c. 12.5%
d. 15%
B. 7.5%
68. 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%
69. If the simple CAPM is valid and all portfolios are priced correctly, which of the situations below are possible? Consider each situation independently and assume the risk free rate is 5%.
a.
b.
c.
D.
d. market 30%
70. Two investment advisors are comparing performance. Advisor A averaged a 20% return with a portfolio beta of 1.5 and Advisor 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 advisor was the better stock picker?
A. Advisor A was better because he generated a larger alpha
b. Advisor B was better because he generated a larger alpha
c. Advisor A was better because he generated a higher return
d. Advisor B was better because he achieved a good return with a lower beta
A. Advisor A was better because he generated a larger alpha
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
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 one 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%
73. If the beta of the market index is 1.0 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
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 4.0%?
a. 4.0%
b. 4.8%
c. 6.6%
D. 8.0%
D. 8.0%
75. According to the CAPM, what is the expected market return given an expected return on a security of 14.6%, a stock beta of 1.2, and a risk free interest rate of 5.0%?
a. 4.0%
b. 8.0%
C. 13.0%
d. 16.0%
C. 13.0%
76. 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 15.6%?
a. 3.8%
B. 13.2%
c. 15.6%
d. 19.1%
B. 13.2%
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% and based on this data You are analyzing a stock is 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. 15.9%
B. 12.9%
c. 13.2%
d. 12.0%
B. 12.9%
78. A stock has a beta of 1.3. The unsystematic 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
79. There are two independent economic factors M1 and M2. The risk-free rate is 5% and all stocks have independent firm-specific components with a standard deviation of 25%. Portfolios A and B are well diversified. Given the data below which equation provides the correct pricing model?


a. E(rP) = 5 + 1.12bP1 + 11.86bP2
b. E(rP) = 5 + 4.96bP1 + 13.26bP2
c. E(rP) = 5 + 3.23bP1 + 8.46bP2
D. E(rP) = 5 + 8.71bP1 + 9.68bP2
D. E(rP) = 5 + 8.71bP1 + 9.68bP2
81. 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 4.0%, what is the expected return on this stock?
a. 10.0%
b. 11.5%
C. 13.6%
d. 14.0%
C. 13.6%
82. The two factor model on a stock provides a risk premium for exposure to market risk of 8%, a risk premium for exposure to interest rate of (-2.3%), and a risk free rate of 3.0%. What is the expected return on the stock?
A. 8.7%
b. 11.0%
c. 13.3%
d. 15.2%
A. 8.7%
82. The two factor model on a stock provides a risk premium for exposure to market risk of 8%, a risk premium for exposure to interest rate of (-2.3%), and a risk free rate of 3.0%. What is the expected return on the stock?
A. 8.7%
b. 11.0%
c. 13.3%
d. 15.2%
A. 8.7%
83. The risk premium for exposure to exchange rates is 5% and the firm has a beta relative to exchanges 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 3.0%, what is the expected return on this stock?
A. 0.2%
b. 1.5%
c. 3.6%
d. 4.0%
A. 0.2%
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 4.0%. What is the expected return on the stock?
a. 11.6%
b. 13.0%
c. 15.3%
D. 19.5%
D. 19.5%
85. Since the APT does not specify which factors should be used to determine risk premiums, how should we decide which factors to investigate?
a. Researchers should focus on factors that affect firms and industries
b. Researchers should look for the most important unsystematic factors
c. Researchers should concentrate on better defining the market portfolio
D. Researchers should consider factors that correlate highly with uncertainty in consumption and investment opportunities
D. Researchers should consider factors that correlate highly with uncertainty in consumption and investment opportunities