Chapter 9 ASSET PRICING MODELS Multiple Choice Questions

Capital Market Theory 1. a. b. c. d. The Capital Asset Pricing Model: has serious flaws because of its complexity. measures relevant risk of a security and shows the relationship between risk and expected return. was developed by Markowitz in the 1930s. discounts almost all of the Markowitz portfolio theory.

(b, moderate) 2. a. b. c. d. Which of the following is not one of the assumptions of the CMT? All investors have the same one-period time horizon. There are no personal income taxes. There is no interest rate charged on borrowing. There are no transaction costs.

(c, moderate) 3. a. b. c. d. Which of the following is an assumption of the CMT? Single investors can affect the market by their buying and selling decisions. There is no inflation. Investors prefer capital gains over dividends. Different investors have different probability distributions..

(b, moderate) 4. a. b. c. d. Which of the following regarding investors and the CMT is true? Investors recognize that all the assumptions of the CMT are unrealistic. Investors recognize that all of the CMT assumptions are not unrealistic. Investors are not aware of the assumptions of the CMT model. Investors recognize the CMT is useless for individual investors.

(b, moderate)

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5. a. b. c. d.

The _______ is typically taken to be the risk-free rate. savings account certificate of deposit Treasury bill Treasury bond

(c, easy) 6. a. b. c. d. What does it mean when the CAPM is called "robust?" The CAPM requires no assumptions. Even if most of the assumptions of the CAPM are relaxed, most of the conclusions will still hold. The CAPM is based on realistic assumptions. No other model can represent stock returns better than the CAPM.

(b, difficult) The Equilibrium Return-Risk Tradeoff 7. a. b. c. d. When markets are in equilibrium, the CML will be upward sloping because it shows the optimum combination of risky securities. because the price of risk must always be positive. because it contains all securities weighted by their market values. because the CML indicates the required return for each portfolio risk level.

(b, moderate) 8. a. b. c. d. __________, the CML can be downward sloping. Ex post When investors are risk-lovers When the SML is upward sloping When the risk premium for the market is very high

(a, difficult)

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9. a. b. c. d.

Which of the following statements about the difference between the SML and the CML is TRUE? The intercept of the CML is the origin while the intercept of the SML is RF. CML consists of efficient portfolios, while the SML is concerned with all portfolios or securities. CML could be downward sloping while that is impossible for the SML. CML and the SML are essentially the same except in terms of the securities represented.

(b, difficult) 10. a. b. c. d. The separation theorem states that: systematic risk is separate from unsystematic risk. individual security risk is separate from portfolio risk. the investment decision is separate from the financing decision. borrowing portfolio is separate from the lending portfolio.

(c, moderate) 11 a. b. c. d. The SML can be used to analyze the relationship between risk and required return for all assets. inefficient portfolios. only efficient portfolios. only individual securities.

(a, easy) 12. a. b. c. d. Which of the following is the correct calculation for the required rate of return under the CAPM? beta (market risk premium) beta + market risk premium risk-free rate + risk premium risk-free rate(market risk premium)

(c, moderate) 13. a. b. c. d. Under the CMT, the relevant risk to consider with any security is: its correlation with other securities in the portfolio. its covariance with the market portfolio. its deviation from the portfolio required rate of return. its variance from the risk-free rate of return.

(b, difficult)
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14. a. b. c. d.

Select the correct statement regarding the market portfolio. It: is readily and precisely observable. is a risky portfolio. is the lowest point of tangency between the risk-free rate and the efficient frontier. should be composed of stocks or bonds.

(b, moderate) 15. a. b. c. d. Under the separation theorem, all investors should: hold the same portfolio of risky assets and therefore have the same risk/return combination. have different optimal portfolios. have the same portfolio of risky assets and achieve their own risk-return combination through borrowing and lending. hold the same portfolio of risky assets and the same expected return but at different levels of risk

(d, difficult) 16. a. b. c. d. The slope of the CML is the: standard deviation for efficient portfolios. market price of risk for efficient portfolios. risk-free rate. risk premium for the market portfolio.

(b, moderate) 17. a. b. c. d. Securities with betas less than l should have: expected returns higher than the market. required returns higher than the market return. required returns lower than the market return. no systematic risk.

(c, easy)

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18. a. b. c. d.

The _________ is a plot of __________. CML . . . individual stocks and efficient portfolios CML . . . both efficient and inefficient portfolios, only SML . . . individual securities and efficient portfolios SML . . . individual securities, inefficient portfolios, and efficient portfolios.

(c, moderate) 19. a. b. c. d. Select the INCORRECT statement regarding the CML. The CML is an equilibrium relationship for efficient portfolios and individual securities. The CML represents the risk-return tradeoff in equilibrium for efficient portfolios. The intercept of the CML is the reward per unit of time available to investors for deferring consumption. Standard deviation is the measure of risk which determines a portfolio's equilibrium return.

(a, moderate) 20. The expected return on the market for next period is 16 percent. The risk free rate of return is 7 percent, and Alpha Company has a beta of 1.1. The market risk premium is 9.9 percent. 9 percent. 16 percent. 16.9 percent. Answer: Market risk premium = 16 - 7 = 9 percent

a. b. c. d.

(b, easy) 21. a. b. c. d. The expected market return is 16 percent. The risk-free rate of return is 7 percent, and BC Co. has a beta of 1.1. Their required rate of return is 17.6 percent. 16.0 percent. 16.9 percent. 23.0 percent. Answer: required return = 7 + 1.1(16 7) = 16.9 percent

(c, moderate)

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22. a. b. c. d.

The expected market return 16 percent. The risk-free rate of return is 7 percent, and AB Co. has a beta of 1.1. The risk premium is 7 percent. 9.9 percent. 9 percent. 10.3 percent Answer: risk premium = 1.1(16 7) = 9.9 percent

(b, moderate) 23. a. b. c. d. If markets are truly efficient and in equilibrium all securities would lie on the SML. any security that plots below the SML would be considered undervalued. any security that lies above the SML would be considered overvalued. no security would lie on the SML..

(a, moderate, p. 9-21) 24. a. b. c. d. If a certain stock has a beta greater than 1.0, it means that the stock's return is more volatile than that of the market portfolio. an investor can eliminate the risk by combining it with another stock that has a negative beta. an investor will earn a higher return on his stock than that on the market portfolio. the stock is less risky than the market portfolio.

(a, easy) Estimating the SML 25. a. b. c. d. A less restrictive form of the Single Index Model is the: Risk-free Model. CAPM. CML. Market Model.

(d, easy)

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26. a. b. c. d.

Under the Market Model, the regression line that results when the return of a security is plotted against the market index return is the: SML. CML. characteristic line. slope.

(c, easy) Tests of the CAPM 27. a. b. c. d. Which of the following is not one of the reasonable conclusions of the CAPM reached by a consensus of the empirical results? The intercept term is generally higher than the RF. The SML appears to be non-linear. The slope of the CAPM is generally less steep than suggested by the theory. All of the above are supported by empirical tests.

(b, difficult) Abritrage Pricing Theory 28. a. b. c. d. The arbitrage pricing theory (APT) and the CAPM both assume all except which of the following? Investors have homogeneous beliefs. Investors are risk-averse utility maximizers. Borrowing and lending can be done at the rate RF. Markets are perfect.

(c, difficult) 29. a. b. c. d. Risk factors in the APT must possess all of the following the characteristics except: Factors must be readily observable in risk/return space. Each factor must have a pervasive influence on stock returns The factors must influence expected return. Factors must be unpredictable.

(a, moderate)

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30. a. b. c. d.

Which of the following might be used as a factor in an APT factor model? The risk-free rate Expected inflation Unanticipated deviations from expected inflation Loss by fire at a companys manufacturing plant

(c, difficult) 31. a. b. c. d. The arbitrage pricing theory (APT) considers only one factor and is a narrower model than the CAPM. considers more factors than the CAPM and is a broader model. is useful only for well-diversified portfolios of common stock. is easy to practice because the factors are readily observable.

(b, moderate) 32. a. b. c. d. The APT is based on the: law of averages. law of attraction. law of accelerating return. law of one price.

(d, easy)

True/False Questions
The Equilibrium Return-Risk Tradeoff 1. (T, easy) 2. Using the separation theorem, it is necessary to match each investor's indifference curves with a particular efficient portfolio. Betas for defensive portfolios are generally less than one.

(F, difficult) 3. The CML indicates the required return for each portfolio risk level.

(T, moderate) 4. A security that plots above the SML would be a good security to sell short.

(F, difficult)

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5.

Beta is a measure of systematic risk and relates one security's return to another security's return.

(F, easy) 6. The CML states that all investors should invest in the same portfolio of risky assets.

(T, moderate) 7. Most analysts use the Dow Jones Industrial Average as proxy for the market portfolio.

(F, easy) Estimating the SML 8. Testing of the CAPM suggests the trade-off between expected return and risk is an upward-sloping straight line.

(T, moderate) Tests of the CAPM 9. If the overall market is expected to rise, a portfolio manager should increase the beta of the portfolio.

(T, moderate) Arbitrage Pricing Theory 10. Unlike the CAPM, the APT does not assume borrowing and lending at the risk-free rate.

(T, moderate) 11. With the APT, risk is defined in terms of a stock's sensitivity to basic economic factors.

(T, moderate) 12. Like the CAPM, the APT assumes a single-period investment horizon.

(F, moderate) 13. Both the CAPM and the APT assume that markets are perfect.

(T, moderate)

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14.

The APT is based on the law of one price, which states two identical assets cannot sell at different prices.

(T, easy)

Short-Answer Questions
1. How are securities chosen and in what proportions are they represented in the market portfolio M? All assets are included in portfolio M in proportion to their market value. In practice, the S&P 500 is often used as a proxy for the market portfolio.

Answer:

(moderate) 2. What is the formula for the slope of the CML? What does it represent? The slope is [E(RM) RF]/M. It represents the expected returnrisk tradeoff for efficient portfolios on the CML.

Answer: (moderate) 3.

An analyst determined that for the past two quarters the risk-free rate has exceeded the return on the market portfolio. Does this information disprove the CML? No, it merely shows that actual returns often diverge from expected returns. The CML is founded on expected values, so that proof or disproof does not lie in historical values.

Answer:

(difficult) 4. Some securities are considered to be defensive in that they tend to hold their value or increase in value when the majority of securities are losing value, such as during a recession. What could one conclude about the betas of defensive securities? One would expect the betas of defensive securities to be near zero or even negative.

Answer: (moderate) 5.

At a given point in time the SML dictates that a security with a beta of 1.10 should require a return of 18 percent. Analysts determine that a particular stock with an observed beta of 1.10 has an expected return of 20 percent. Outline the scenario that will bring the securitys return into equilibrium.

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Answer:

Investors will recognize the security as a good buy (undervalued) and will start buying it, increasing demand. The price will be bid up until the return drops to 18 percent as required by the SML.

(difficult) 6. Two points define a straight line. What two points could be most readily identified to estimate the SML? The risk-free rate because the beta is defined as zero and the expected market return because the beta is defined as 1.00.

Answer: (difficult) 7.

Betas of individual securities are unstable over time. What are some characteristics that could cause a companys beta to change over time? A few examples include earnings, cash flow, management, financial leverage, and product mix.

Answer: (moderate) 8.

What are the assumptions in the CAPM? Can these be relaxed without destroying the conclusions of the model? (1) homogeneous expectations, (2) one-period time horizon, (3) borrow-lend at RF, (4) no transactions costs, (5) no personal income taxes, (6) no inflation, (7) investor-price takers, and (8) capital markets in equilibrium. Assumptions can be relaxed and still reach most of the same general conclusions.

Answer:

(difficult)

9.

Suppose the SML has a risk-free rate of 5 percent and an expected market return of 15 percent. Now suppose that the SML shifts, changing slope, so that kRF is still 5 percent but kM is now 16 percent. What does this shift
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suggest about investors risk aversion? If the slope were to change downward, what would that suggest? Answer: Suggest that investors are more averse to risk than before the shift. They now require a risk premium of 11 percent (16 percent- 5 percent), whereas, they previously required 10 percent (15 percent - 5 percent) on the market portfolio. A downward shift would indicate less aversion to risk.

(difficult) 10. Why is market risk sometimes said to be the relevant risk for a portfolio manager? What is the measure of market risk? Market risk, measured by beta, is nondiversifiable and must be dealt with by the portfolio manager. Diversifiable risk should be diversified away and should not pose a problem. Market risk, therefore, is considered to be relevant to the portfolio managers job of balancing risk and return.

Answer:

(moderate)

Critical Thinking/Essay Questions

1. Compare the capital market line and the security market line. Partial answer: CML efficient portfolios consisting of RF and M SML securities and portfolios. CML and SML both indicate an upward sloping expected return-risk tradeoff. 2. Compare the security market line model and the arbitrage pricing theory. Answer: SML is a one-factor model, the factor being the market risk premium. The APT has more factors (often three to five), such as unanticipated changes in inflation, industrial production, etc. Unlike the CAPM, the APT does assume a single-period investment horizon, no taxes, borrowing and lending at rate the RF, investor basis of expected return and variance. Both APT assume homogeneous beliefs, risk-averse utility perfect markets, and returns generated by a factor model.

not selection on CAPM and maximizers, (difficult)

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Problems
1. The expected return for the market is 12 percent, with a standard deviation of 20 percent. The expected risk-free rate is 8 percent. Information is available for three mutual funds, all assumed to be efficient, as follows: Mutual Funds Affiliated Omega Ivy (a) (b) SD(%) 15 17 19

Based on the CML, calculate the market price of risk. Calculate the expected return on each of these portfolios.

Solution: (a) Omega Ivy (difficult) 2. Given an expected return for the market of 12 percent, with a standard deviation of 20 percent, and a risk-free rate of 8 percent, consider the following data: Stock 1 2 3 (a) (b) Beta 0.8 1.2 0.6 Ri(%) 12 13 11 Slope of CML = (12 - 8)/20 = .20 (b) Affiliated 8 + .2(15) = 11 percent 8 + .2(17) = 11.4 percent 8 + .2(19) = 11.8 percent

Calculate the required return for each stock using the SML. Assume that an analyst, using fundamental analysis, develops the estimates labeled Ri for these stocks. Which stock would be recommended for purchase? Solution: (a) Stock 1 8 + 0.8(4) = 11.2 percent Stock 2 8 + 1.2(4) = 12.8 percent Stock 3 8 + 0.6(4) = 10.4 percent (b) (difficult) Stock 3 is undervalued because E(R) > RR.

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3.

The market has an expected return of 13 percent and the risk-free rate is 5.5 percent. If Merrill Lynch has a beta of 1.85, what is the required return for Merrill Lynch? .055 + 1.85 (.13-.055) = .055 + .1388 = .1938 = 19.38%

Solution: (moderate)

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