Multiple Choice Questions 1. ___________ a relationship between expected return and risk.

A) APT stipulates B) CAPM stipulates C) Both CAPM and APT stipulate D) Neither CAPM nor APT stipulate E) No pricing model has found Answer: C Difficulty: Easy Rationale: Both models attempt to explain asset pricing based on risk/return relationships. 2. Which pricing model provides no guidance concerning the determination of the risk premium on factor portfolios? A) The CAPM B) The multifactor APT C) Both the CAPM and the multifactor APT D) Neither the CAPM nor the multifactor APT E) None of the above is a true statement. Answer: B Difficulty: Moderate Rationale: The multifactor APT provides no guidance as to the determination of the risk premium on the various factors. The CAPM assumes that the excess market return over the risk-free rate is the market premium in the single factor CAPM. 3. An arbitrage opportunity exists if an investor can construct a __________ investment portfolio that will yield a sure profit. A) positive B) negative C) zero D) all of the above E) none of the above Answer: C Difficulty: Easy Rationale: If the investor can construct a portfolio without the use of the investor's own funds and the portfolio yields a positive profit, arbitrage opportunities exist.

4. The APT was developed in 1976 by ____________. A) Lintner B) Modigliani and Miller C) Ross D) Sharpe E) none of the above Answer: C Difficulty: Easy Rationale: Ross developed this model in 1976. 5. A _________ portfolio is a well-diversified portfolio constructed to have a beta of 1 on one of the factors and a beta of 0 on any other factor. A) factor B) market C) index D) A and B E) A, B, and C Answer: A Difficulty: Easy Rationale: A factor model portfolio has a beta of 1 one factor, with zero betas on other factors. 6. The exploitation of security mispricing in such a way that risk-free economic profits may be earned is called ___________. A) arbitrage B) capital asset pricing C) factoring D) fundamental analysis E) none of the above Answer: A Difficulty: Easy Rationale: Arbitrage is earning of positive profits with a zero (risk-free) investment.

CAPM B) APT. Portfolio B has a beta of 0. B: 12% = 0. short B and take a long position in A.0F + 6%. B C) B. A B) A. The risk-free rate of return is 6%. The ____________ provides an unequivocal statement on the expected return-beta relationship for all assets. 9. A) APT.7.0 and an expected return of 16%. If you wanted to take advantage of an arbitrage opportunity. Ross assumed that uncertainty in asset returns was a result of A) a common macroeconomic factor B) firm-specific factors C) pricing error D) neither A nor B E) both A and B Answer: E Difficulty: Moderate Rationale: Total risk (uncertainty) is assumed to be composed of both macroeconomic and firm-specific factors. F = 10%. The APT implies that this relationship holds for all well-diversified portfolios. and for all but perhaps a few individual securities. APT D) CAPM.5%.8 and an expected return of 12%. Portfolio A has a beta of 1. In developing the APT. OPM E) none of the above Answer: C Difficulty: Moderate Rationale: The CAPM is an asset-pricing model based on the risk/return relationship of all assets. you should take a short position in portfolio __________ and a long position in portfolio _______. A D) B. thus. OPM C) CAPM.8F + 6%: F = 7. the riskless asset Answer: C Difficulty: Moderate Rationale: A: 16% = 1. A) A. whereas the _____________ implies that this relationship holds for all but perhaps a small number of securities. . Consider a single factor APT. 8. B E) A.

80 B) 1. you should take a short position in portfolio _________ and a long position in portfolio _________.25 D) 1.1)2(6%) = 7.0% C) 7.10. The risk-free rate of return is 10%. Consider the one-factor APT. Consider the one-factor APT.6% B) 6.2F. short B and take a long position in A.4 and an expected return of 15%. . 12. F = 12. A) 0.56 E) none of the above Answer: B Difficulty: Moderate Rationale: (18%)2 = (16%)2 b2. B C) B. F = 15%. b = 1. A D) B.1% E) none of the above Answer: C Difficulty: Moderate Rationale: s2P = (1. therefore.1.3% D) 10. Portfolio B has a beta of 0. A B) A. B: 15% = 10% + 0. The beta of a well-diversified portfolio on the factor is 1. The standard deviation of returns on a well-diversified portfolio is 18%. B E) none of the above Answer: C Difficulty: Moderate Rationale: A: 13% = 10% + 0. The variance of returns on the factor portfolio is 6%.26%. The variance of returns on the well-diversified portfolio is approximately __________.13 C) 1. If you wanted to take advantage of an arbitrage opportunity. Portfolio A has a beta of 0.125.4F. A) A. The standard deviation on the factor portfolio is 16%. The beta of the well-diversified portfolio is approximately __________.2 and an expected return of 13%.5%. A) 3. Consider the single factor APT. 11.

x = 7. beta of A = 9/12 = 0. respectively. A) 13. A) 0. What is the risk-premium on factor 2 if no arbitrage opportunities exit? A) 2% B) 3% C) 4% D) 7. thus. a beta of 1. The risk-free rate of return is 6%.0% C) 16. Stock A has an expected return of 16.25 on factor 2. Stock B has a beta of 1. respectively. 15. The expected return on portfolio A is __________if no arbitrage opportunities exist.4(3%) + .4% = 1. Consider the multifactor model APT with two factors.25(7%) = 16. The risk-free rate of return is 6%. Consider the single-factor APT. If arbitrage opportunities are ruled out. stock A has a beta of __________.67 B) 1.5% B) 15.30 D) 1.5% D) 23.0. 14. . B: 8% = 6% + 1.75.75% E) none of the above Answer: D Difficulty: Difficult Rationale: 16. The risk premium on the factor 1 portfolio is 3%.75. Stocks A and B have expected returns of 15% and 18%.75(1%) + 1. The risk premiums on the factor 1 and factor 2 portfolios are 1% and 7%. Portfolio A has a beta of 0.75 on factor 1 and a beta of 1. F = 12%.4%.69 E) none of the above Answer: E Difficulty: Moderate Rationale: A: 15% = 6% + bF.00 C) 1.5%. The risk-free rate of return is 7%.0F.8x + 6%. Consider the multifactor APT with two factors.0% E) none of the above Answer: C Difficulty: Moderate Rationale: 7% + 0.8 on factor 2.4 on factor 1 and a beta of .13.

The betas of portfolios A and B are 1.0% B) 6.000(0. 5% = . Assume that two portfolios. If no arbitrage opportunities exist. A) 4. The risk premiums on the factor 1 and factor 2 portfolios are 5% and 6%. The expected returns on portfolios A and B are 11% and 17%.5(F).7(6%).000 B) $0 C) $1.000 (risk-free position). Assuming no arbitrage opportunities exist.16.000 (portfolio B).4% E) none of the above Answer: C Difficulty: Moderate Rationale: 17% = x% + 1. Consider a one-factor economy.000 of portfolio A. -$200. respectively.17) = $17. Stock A has a beta of 1.2(5%) + 0. A and B.000 (short position.0% B) 9. the risk-free rate of return must be ____________.000(0. B:24% = rf + 1. and a beta of 0.8%.000 in portfolio B. A) 6. Portfolio A has a beta of 1.11) = -$22. 18. the risk-free rate of return is ___________. Suppose you invested $100.000 E) none of the above Answer: C Difficulty: Moderate Rationale: $100.5(F). F = 10%. respectively. 24% = rf + . respectively.000 profit.5. are well diversified. portfolio A). and sold short $200. 1.7 on factor 2. Assume that the risk-free rate is 6% and that arbitrage opportunities exist.0% C) 14.000 in the risk-free asset.06) = $6. respectively. x = 6. Your expected profit from this strategy would be ______________.5% C) 6.0% D) 16. Consider the multifactor APT with two factors. 17.5% E) none of the above Answer: B Difficulty: Moderate Rationale: A: 19% = rf + 1(F).8% D) 7.000 D) $2.000(0. $100.0 and 1. Consider the one-factor APT.0 on the factor and portfolio B has a beta of 2. A) -$1. The expected return on stock A is 17%.0 on the factor. $100.2 on factor 1. The expected returns on portfolios A and B are 19% and 24%.

ff = 9%. .5(10).1.

The risk-free rate of return is 7%. economic growth may be strong.50 C) 1.19.8) + 3%(x). x = 1. 20. B. Consider the single factor APT. B.45 B) 1.7F. or weak. If arbitrage opportunities are ruled out. B: 18% = 7% + 10b. A) 0. moderate.22 E) none of the above Answer: C Difficulty: Moderate Rationale: A: 14% = 7% + 0.8. You can either invest in these stocks or short sell them. respectively. portfolio B must have a beta of __________. A) 1. Portfolio A has a beta of 0. A. Stock A has a beta on factor 2 of ________. There are three possible states of nature for economic growth in the upcoming year. Consider the multifactor APT.10 D) 1. The risk premiums on the factor 1 and factor 2 portfolios are 5% and 3%. Stock A has an expected return of 19% and a beta on factor 1 of 0.10.7.67 D) 2. Use the following to answer questions 21-24: There are three stocks.00 E) none of the above Answer: C Difficulty: Moderate Rationale: 19% = 10% + 5%(0. and C. b = 1. The returns for the upcoming year on stocks A. and C for each of these states of nature are given below: .67.33 B) 1.00 C) 1. The risk-free rate of return is 10%. respectively. Portfolios A and B have expected returns of 14% and 18%. F = 10.

5% C) 15.5(17%) + 0.5%. your portfolio return would be _____________ if economic growth was weak. A) -2.0% B) 14.0% D) 11.5(39%) + 0. your portfolio return would be ___________ if economic growth were moderate. If you invested in an equally weighted portfolio of stocks B and C.5% B) 0. If you invested in an equally weighted portfolio of stocks A and B.0% D) 30.0% E) none of the above Answer: D Difficulty: Easy Rationale: E(Rp) = 0.5(15%) = 16%. If you invested in an equally weighted portfolio of stocks A and C. .0% B) 22. your portfolio return would be ____________ if economic growth was strong.5% C) 3. A) 17.5(22%) = 11%.5(0%) + 0. A) 3.5% C) 30. 23. 22.0% E) none of the above Answer: D Difficulty: Easy Rationale: 0.5% D) 16.5% E) none of the above Answer: B Difficulty: Easy Rationale: 0.21.5(6%) = 22.

5(14%) + 0.0% = 1. If you wanted to take advantage of a risk-free arbitrage opportunity. E(RC) = (22% + 14% + 6%)/3 = 14%. B and C B) B. -7. B: 12% = 6% + 2. 26% = 6% + 4.0(5). E(RB) = (30% + 15% + 0%)/3 = 15%. F1 and F2.24. A and B D) A and B.0(RP1) + 0. Use the following to answer questions 25-26: Consider the multifactor APT. Assuming no arbitrage opportunities exist. you should take a short position in _________ and a long position in an equally weighted portfolio of _______. RP1 = 3%.0%. none of the above Answer: C Difficulty: Difficult Rationale: E(RA) = (39% + 17% . C E) none of the above. E(RP) = -0. RP2 = 5.5[(17% + 15%)/ 2].5%)/3 = 17%. . The risk-free rate of return is 6%. A: 19% = 6% + RP1 + 2. A) 3% B) 4% C) 5% D) 6% E) none of the above Answer: A Difficulty: Difficult Rationale: 2A: 38% = 12% + 2. There are two independent economic factors.0% + 8. the risk premium on the factor F1 portfolio should be __________.0(RP2).0(RP1) + 4. A) A.0(RP2).0 (RP2). A and C C) C. The following information is available about two well-diversified portfolios: 25.

the investor will buy the lower priced asset and simultaneously place an order to sell the higher priced asset. This is an example of _________. Assuming no arbitrage opportunities exist. A) an investor has downside risk only B) the law of prices is not violated C) the opportunity set is not tangent to the capital allocation line D) a risk-free arbitrage opportunity exists E) none of the above Answer: D Difficulty: Easy Rationale: When an investor can create a zero-investment portfolio (by using none of the investor's own funds) with a possibility of a positive profit. A) a dominance argument B) the mean-variance efficiency frontier C) a risk-free arbitrage D) the capital asset pricing model E) none of the above Answer: C Difficulty: Moderate Rationale: When the equilibrium price is violated. A) 3% B) 4% C) 5% D) 6% E) none of the above Answer: C Difficulty: Difficult Rationale: See solution to previous problem. the greater the risk-free arbitrage profits. a risk-free arbitrage opportunity exists.26. 27. An investor will take as large a position as possible when an equilibrium price relationship is violated. The larger the positions. A zero-investment portfolio with a positive expected return arises when _________. 28. the risk premium on the factor F2 portfolio should be ___________. . Such transactions result in risk-free arbitrage.

to explain the risk-return relationship. thus. 30. rather than a single market index. The APT recognizes that other macroeconomic factors may be systematic risk factors. only systematic risk is related to expected returns. thus. A) places more emphasis on market risk B) minimizes the importance of diversification C) recognizes multiple unsystematic risk factors D) recognizes multiple systematic risk factors E) none of the above Answer: D Difficulty: Moderate Rationale: The CAPM assumes that market returns represent systematic risk. However. Nonsystematic risk across firms cancels out in well-diversified portfolios. In terms of the risk/return relationship A) only factor risk commands a risk premium in market equilibrium. inflation and term structure as key factors in explaining the risk-return relationship C) superior measurement of the risk-free rate of return over historical time periods D) variability of coefficients of sensitivity to the APT factors for a given asset over time E) none of the above Answer: A Difficulty: Easy Rationale: The advantage of the APT is the use of multiple factors. 31.29. only factor risk commands a risk premium in market equilibrium. D) A and B. . A) use of several factors instead of a single market index to explain the risk-return relationship B) identification of anticipated changes in production. B) only systematic risk is related to expected returns. The APT differs from the CAPM because the APT _________. C) only nonsystematic risk is related to expected returns. Answer: D Difficulty: Easy Rationale: Nonfactor risk may be diversified away. The feature of the APT that offers the greatest potential advantage over the CAPM is the ______________. APT does not identify the specific factors. E) A and C.

Risk must considered in both the CAPM and APT. D) all of the above. E) none of the above. D) A and B. Portfolio B has expected return of 12% and standard deviation of 17%. E) Lend at the risk free rate and buy B. D) Borrow at the risk free rate and buy B. C) Sell B short and buy A. B) interest rate fluctuations. Advantage(s) of the APT is(are) A) that the model provides specific guidance concerning the determination of the risk premiums on the factor portfolios. and C all are likely to affect stock returns. Portfolio A has expected return of 10% and standard deviation of 19%. B) Sell A short and buy B. Answer: B Difficulty: Easy Rationale: The APT provides no guidance concerning the determination of the risk premiums on the factor portfolios. . Answer: D Difficulty: Easy Rationale: A. Answer: B Difficulty: Easy Rationale: Rational investors will arbitrage by selling A and buying B. C) inflation rates. 33. A major advantage of APT over the CAPM is that a specific benchmark market portfolio is not required. C) that risk need not be considered. B) that the model does not require a specific benchmark market portfolio. Rational investors will A) Borrow at the risk free rate and buy A.32. E) B and C. 34. The following factors might affect stock returns: A) the business cycle. B.

36. Answer: E Difficulty: Difficult Rationale: Under the risk-return dominance argument of CAPM. Answer: B Difficulty: Moderate Rationale: Risk arbitrage involves searching for mispricings based on speculative information that may or may not materialize. rather than one who seeks strict (risk-free) arbitrage opportunities is engaged in A) pure arbitrage. . E) none of the above. depending on their risk tolerance. C) option arbitrage. B) risk arbitrage. C) implications for prices derived from CAPM arguments are stronger than prices derived from APT arguments. when an equilibrium price is violated many investors will make small portfolio changes. B) CAPM assumes many small changes are required to bring the market back to equilibrium.35. making C an incorrect statement. D) all of the above are true. each investor will take as large a position as possible so only a few investors must act to restore equilibrium. D) equilibrium arbitrage. APT assumes a few large changes are required to bring the market back to equilibrium. E) both A and B are true. An important difference between CAPM and APT is A) CAPM depends on risk-return dominance. APT depends on a no arbitrage condition. Under the no-arbitrage argument of APT. until equilibrium is restored. Implications derived from APT are much stronger than those derived from CAPM. A professional who searches for mispriced securities in specific areas such as mergertarget stocks.

37. D) that is well-diversified and lies on the SML. . 38. The true (and unobservable) market portfolio is only a requirement for the CAPM. E) that is unobservable. the nonsystematic risk of a welldiversified portfolio approaches zero. Answer: D Difficulty: Moderate Rationale: Any well-diversified portfolio lying on the SML can serve as the benchmark portfolio for the APT. C) that need not be well-diversified.0. The APT requires a benchmark portfolio A) that is equal to the true market portfolio. 39. each having a small (but not necessarily equal) weight. as a well-diversified portfolio becomes larger its nonsystematic risk approaches A) one. C) a portfolio whose factor beta equals 1. D) negative one. so that nonsystematic variance is negligible. B) one that contains securities from at least three different industry sectors. A well-diversified portfolio is defined as A) one that is diversified over a large enough number of securities that the nonsystematic variance is essentially zero. increases. n. B) that contains all securities in proportion to their market values. Answer: A Difficulty: Moderate Rationale: A well-diversified portfolio is one that contains a large number of securities. B) infinity. E) none of the above. Answer: C Difficulty: Easy Rationale: As the number of securities. E) all of the above. C) zero. In the context of the Arbitrage Pricing Theory. D) a portfolio that is equally weighted.

Answer: C Difficulty: Moderate Rationale: The expected return-beta relationship must hold for all well-diversified portfolios and for all but a few individual securities. Imposing the no-arbitrage condition on a single-factor security market implies which of the following statements? I) the expected return-beta relationship is maintained for all but a small number of well-diversified portfolios. A. what is its expected return? A) 7. If portfolio A has a beta of 1. otherwise arbitrage opportunities will be available.0% B) 8.04) + .132 . the risk premium on the first factor portfolio is 4% and the risk premium on the second factor portfolio is 3%. III) the expected return-beta relationship is maintained for all but a small number of individual securities.06 + 1. II) the expected return-beta relationship is maintained for all well-diversified portfolios. II and III are correct. IV) the expected return-beta relationship is maintained for all individual securities.2 on the first factor and . in a two-factor economy.8 (. The risk-free rate is 6%.2% Answer: E Difficulty: Moderate Rationale: . Consider a well-diversified portfolio. II and IV are correct.03) = .2% D) 13. Only I is correct.2 (.40. A) B) C) D) E) I and III are correct. I and IV are correct.0% E) 13.8 on the second factor. 41.0% C) 9.

short sell the asset in the low-priced market and buy it in the high-priced market. B) short selling high and buying low.42. To take advantage of an arbitrage opportunity. construct a zero beta investment portfolio that will yield a sure profit. B) the sensitivity of the firm to that factor. 44. and IV Answer: B Difficulty: Difficult Rationale: Only I and III are correct. . III. 43. The term “arbitrage” refers to A) buying low and selling high. A capital market in equilibrium rules out arbitrage opportunities. Answer: C Difficulty: Easy Rationale: Arbitrage is exploiting security mispricings by the simultaneous purchase and sale to gain economic profits without taking any risk. an investor would I) II) III) IV) A) B) C) D) E) construct a zero investment portfolio that will yield a sure profit. C) a factor that affects all security returns. II is incorrect because the beta of the portfolio does not need to be zero. and IV II. Answer: D Difficulty: Moderate Rationale: F measures the unanticipated portion of a factor that is common to all security returns. make simultaneous trades in two markets without any net investment. IV is incorrect because the opposite is true. I and IV I and III II and III I. C) earning risk-free economic profits. D) the deviation from its expected value of a factor that affects all security returns. D) negotiating for favorable brokerage fees. E) hedging your portfolio through the use of options. III. E) a random amount of return attributable to firm events. The factor F in the APT model represents A) firm-specific risk.

what is the nonsystematic standard deviation of an equally-weighted portfolio that has an average value of ó(ei) equal to 25% and 50 securities? A) 12. In the APT model. 47. but can be any well-diversified portfolio. E) proportional to its beta coefficient. B) The SML for the APT shows expected return in relation to portfolio standard deviation. Answer: D Difficulty: Moderate Rationale: The benchmark portfolio does not need to be the (unobservable) market portfolio under the APT. D) proportional to its standard deviation.5% B) 625% C) 0.54% E) 14. E) The SML is not relevant for the APT. . If arbitrage opportunities are to be ruled out. B) inversely proportional to its standard deviation. D) The benchmark portfolio for the SML may be any well-diversified portfolio. C) proportional to its weight in the market portfolio. C) The SML for the APT has an intercept equal to the expected return on the market portfolio.5% D) 3. it must be true that [E(rp)-rf]/βp = [E(rQ)-rf]/ βQ. each well-diversified portfolio's expected excess return must be A) inversely proportional to the risk-free rate.45.59% Answer: D Difficulty: Moderate Rationale: 46. Answer: E Difficulty: Moderate Rationale: For each well-diversified portfolio (P and Q. for example). The intercept still equals the risk-free rate. Which of the following is true about the security market line (SML) derived from the APT? A) The SML has a downward slope.

More than one factor can be important in determining returns. Portfolio 1 and Portfolio 2. the return on a stock in a particular period will be related to A) factor risk. III.5*(6-3) = 14. C) standard deviation of returns. III.2% B) 14. what would be the expected return on well-diversified portfolio A. Almost all individual securities satisfy the APT relationship. .48.1% C) 13. Based on this information. The portfolios have expected returns of 15% and 6%. II. and IV Answer: A Difficulty: Moderate Rationale: All except the first item are true. B) non-factor risk. D) both A and B are true. It doesn't rely on the market portfolio that contains all assets. Which of the following is (are) true regarding the APT? I) II) III) IV) A) B) C) D) E) The Security Market Line does not apply to the APT.7% E) 8. and IV I. There is a Security Market Line associated with the APT. 49.1. II. Answer: D Difficulty: Moderate Rationale: Factor models explain firm returns based on both factor risk and non-factor risk. and IV II and IV II and III I. 50.3% D) 10.80 on the first factor and 0. E) none of the above is true.4% Answer: B Difficulty: Moderate Rationale: E(RA) = 3 +0. A) 15. if A has a beta of 0. II.8*(15-3) + 0. respectively. Suppose you are working with two factor portfolios. In a factor model.50 on the second factor? The risk-free rate is 3%.

Which of the following factors were used by Fama and French in their multi-factor model? A) Return on the market index B) Excess return of small stocks over large stocks. 52. Answer: D Difficulty: Moderate Rationale: Fama and French included all three of the factors listed.51. E) All of the above are sources of uncertainty affecting security returns. Roll and Ross included the four listed factors as well as the excess return of long-term corporate bonds over long-term government bonds in their model. E) None of the above factors was included in their model. C) Excess return of high book-to-market stocks over low book-to-market stocks. Answer: C Difficulty: Moderate Rationale: Merton did not suggest book-to-market ratios as an ICAPM pricing factor. Which of the following factors did Merton not suggest as a likely source of uncertainty that might affect security returns? A) uncertainties in labor income. . 53. B) prices of important consumption goods. C) book-to-market ratios. Which of the following factors did Chen. the other three were suggested. Roll and Ross not include in their multifactor model? A) Change in industrial production B) Change in expected inflation C) Change in unanticipated inflation D) Excess return of long-term government bonds over T-bills E) All of the above factors were included in their model. Answer: E Difficulty: Moderate Rationale: Chen. D) All of the above factors were included in their model. D) changes in future investment opportunities.

A) they may result from data snooping. C) they can be explained by security characteristic lines. Roll. Black argues that past risk premiums on firm-characteristic variables. and Ross. Answer: A Difficulty: Moderate Rationale: The study used five different factors to explain security returns. . B) they are sources of systematic risk. Answer: A Difficulty: Moderate 55. allowing for several sources of risk to affect the returns. Answer: D Difficulty: Easy 56. Multifactor models seek to improve the performance of the single-index model by A) modeling the systematic component of firm returns in greater detail. E) none of the above is true. E) they are macroeconomic factors.54. C) allowing for multiple economic factors to have differential effects D) all of the above are true. Multifactor models such as the one constructed by Chen. D) they are more appropriate for a single-factor model. are problematic because. E) ignoring firm-specific risk. B) using variables that are easier to forecast ex ante. can better describe assets' returns by A) expanding beyond one factor to represent sources of systematic risk. D) using only stocks with relatively stable returns. B) incorporating firm-specific components into the pricing model. C) calculating beta coefficients by an alternative method. such as those described by Fama and French.

8 (.6 on the first factor and 1. A) 13.2% D) 13. 5% and 2%.0% E) none of the above Answer: B Difficulty: Moderate Rationale: 3% + 0.0% C) 18.8(3%) + 1.2% Answer: C Difficulty: Moderate Rationale: .25 on factor 3.182 . and a beta of 1. respectively.06) = .3. The risk-free rate is 5%. The risk-free rate of return is 3%.33 B) 1. Portfolio A has a beta of 0. The expected return on portfolio A is __________if no arbitrage opportunities exist. The risk-free rate of return is 4%. The risk premiums on the factor 1.04) + 1.8 on the second factor. If portfolio A has a beta of 0.8 on factor 1. Consider the multifactor APT.05. Stock A has a beta on factor 2 of ________. respectively. The risk premiums on the factor 1 and factor 2 portfolios are 6% and 4%. Stock A has an expected return of 16% and a beta on factor 1 of 1. Consider a well-diversified portfolio.3) + 4%(x). x = 1. 58.05 C) 1.67 D) 2. 59.5% B) 13.05 + .4%. what is its expected return? A) 7.6 (.25(2%) = 13.5% D) 23. the risk premium on the first factor portfolio is 4% and the risk premium on the second factor portfolio is 6%.1(5%) + 1.4% C) 16.0% E) 13. A) 1.57.1 on factor 2.0% B) 8.00 E) none of the above Answer: B Difficulty: Moderate Rationale: 16% = 4% + 6%(1. A. factor 2. a beta of 1. and factor 3 are 3%. in a two-factor economy. Consider the multifactor model APT with three factors.

short A and take a long position in B. Portfolio B has a beta of 0. therefore. Consider the single factor APT. Portfolio B has a beta of 1.1% E) none of the above Answer: D Difficulty: Moderate Rationale: s2P = (1.25)2(9%) = 14. If you wanted to take advantage of an arbitrage opportunity. The risk-free rate of return is 5%. F = 20%. A D) B. the riskless asset Answer: C Difficulty: Moderate Rationale: A: 22% = 2.0F + 4%.3% D) 14. 61. A) A. F = 9%. A B) A. A) 3. A D) B. B C) B. B E) none of the above Answer: B Difficulty: Moderate Rationale: A: 12% = 5% + 0. A B) A. B: 17% = 1. B: 13% = 5% + 0. A) A.4F.0% C) 7. B E) A.5F + 4%: F = 8. B C) B. F = 14%. thus. you should take a short position in portfolio __________ and a long position in portfolio _______.5 and an expected return of 12%.06%.5F. Consider the one-factor APT. 62. Portfolio A has a beta of 2. Portfolio A has a beta of 0.25.67%. you should take a short position in portfolio _________ and a long position in portfolio _________.60.5 and an expected return of 17%. The beta of a well-diversified portfolio on the factor is 1. The risk-free rate of return is 4%. Consider a single factor APT. If you wanted to take advantage of an arbitrage opportunity.4 and an expected return of 13%. short B and take a long position in A. . The variance of returns on the factor portfolio is 9%. The variance of returns on the well-diversified portfolio is approximately __________.0 and an expected return of 22%.6% B) 6.

What is the risk-premium on factor 2 if no arbitrage opportunities exit? A) 9. b = 1.57. stock A has a beta of __________.69 E) none of the above Answer: B Difficulty: Moderate Rationale: A: 12% = 5% + bF.25 D) 1.93. The standard deviation on the factor portfolio is 14%. respectively.67 B) 0.13 C) 1. Stock A has an expected return of 17.2%) + . a beta of 1.45(3. 64.26. The risk-free rate of return is 5%.5 = 0. Consider the one-factor APT. Stock B has a beta of 1. A) 0. Thus. The risk premium on the factor 1 portfolio is 3. B: 14% = 5% + 1.6%.30 D) 1.5%.63.2. 65. If arbitrage opportunities are ruled out.6% = 1.86x + 5%.93 C) 1. x = 9. A) 0. Consider the single-factor APT. The risk-free rate of return is 5%.2%. The beta of the well-diversified portfolio is approximately __________. The standard deviation of returns on a well-diversified portfolio is 22%.45 on factor 1 and a beta of .2F.26% B) 3% C) 4% D) 7. F = 7. Consider the multifactor APT with two factors.80 B) 1. Stocks A and B have expected returns of 12% and 14%. beta of A = 7/7.75% E) none of the above Answer: A Difficulty: Difficult Rationale: 17. .57 E) none of the above Answer: D Difficulty: Moderate Rationale: (22%)2 = (14%)2b2.86 on factor 2.

the SML relationship holds. oil prices. That is. as problems associated with an unobservable market portfolio are not a concern with APT. which is a cause of considerable concern in the context of the CAPM. according to APT. Any well-diversified portfolio lying on the SML may serve as a benchmark portfolio. 67. if the index portfolio is not a precise proxy for the true market portfolio. if an index portfolio is sufficiently diversified. Discuss the advantages of the multifactor APT over the single factor APT and the CAPM. obviously several factors may affect stock returns. Some of these factors are: business cycles. Thus. One shortcoming of the multifactor APT is that the model provides no guidance concerning the risk premiums on the factor portfolios. . the APT has more flexibility than the CAPM. interest rate fluctuations. This question is designed to determine if the student understands the basic advantages of APT over the CAPM. Difficulty: Moderate Answer: The APT does not require that the benchmark portfolio in the SML relationship be the true market portfolio. etc. However. In addition. the APT provides further justification for the use of the index model for practical implementation of the SML relationship. What is one shortcoming of the multifactor APT and how does this shortcoming compare to CAPM implications? Difficulty: Moderate Answer: The single factor APT and the CAPM assume that there is only one systematic risk factor affecting stock returns. A multifactor model can accommodate these multiple sources of risk. inflation rates. Discuss the advantages of arbitrage pricing theory (APT) over the capital asset pricing model (CAPM) relative to diversified portfolios.Essay Questions 66. The CAPM implies that the risk premium on the market is determined by the market's variance and the average degree of risk aversion across investors.

That is. 69. The aggregate effect of their actions brings the market back into equilibrium. a simultaneous trade in the two markets can produce a sure profit with a zero investment. Therefore. If the price differential exceeds the transactions costs. it should be remembered that individual investors do not have access to the proceeds of a short transaction until the position has been covered. Difficulty: Difficult Answer: Both the CAPM and the APT are market equilibrium models. risk-return dominance. The investor has been able to assume these positions with a zero investment (using the proceeds of the short transaction to finance the long position). assumptions about risk aversion. . Discuss the similarities and the differences between the CAPM and the APT with regard to the following factors: capital market equilibrium. The CAPM is based on the idea that there are large numbers of investors who are focused on risk-return dominance. the investor can sell short the asset in the high-priced market and buy the asset in the low-priced market. In equilibrium. it would not take many investors to identify the arbitrage opportunity and act to bring the market back to equilibrium. The student can compare the two models by focusing on the specific items. However. Difficulty: Easy Answer: The law of one price is violated when an asset is trading at different prices in two markets. which examine the factors that affect securities' prices. each investor wants an infinite arbitrage position in the mispriced asset. Discuss arbitrage opportunities in the context of violations of the law of one price. mispriced securities can be identified and purchased or sold as appropriate to earn excess profits. Under the APT. In both models. and the number of investors required to restore equilibrium. when a mispricing occurs. guided by their degrees of risk aversion. there are no overpriced or underpriced securities. many individual investors make small changes in their portfolios.68. Under the CAPM.

by including factors that are related to the business cycle. what to buy and what to sell. The question provides an opportunity to measure the student's understanding of the types of risk that are relevant and how they can be explicitly considered in the model. explain how an investor can take advantage of it. CG (excess return of long-term corporate bonds over long-term government bonds). Roll. Give specific details about how to form the portfolio. The student has some flexibility in remembering which variables were used in the study. EI (the % change in expected inflation). Difficulty: Difficult Answer: The factors they considered were IP (the % change in industrial production). .75 and a different expected return than security B. Difficulty: Moderate Answer: An arbitrage opportunity exists because it is possible to form a portfolio of security A and the risk-free asset that has a beta of 0. 71. Briefly explain the reasoning behind their model.0 and an expected return of 12%. the estimation of beta coefficients should be improved. Also. A general understanding of macroeconomic variables will be helpful in answering the question. which is less than B's 11% expected return. The rational for their model is that many different economic factors can combine to affect securities' returns. The risk-free rate is 6%. Security A has a beta of 1.70.75(12%) + 0. The investor should buy B and finance the purchase by short selling A and borrowing at the risk-free asset. The investor can accomplish this by choosing .5%. Each beta will represent only the impact of the corresponding variable on returns.25(6%) = 10. and Ross used to measure the impact of macroeconomic factors on security returns. Security B has a beta of 0. Explain the arbitrage opportunity that exists. Name three variables that Chen.75 as the weight in A and .75 and an expected return of 11%. UI (the % change in unanticipated inflation). This portfolio would have E(rp) = 0.25 in the risk-free asset. and GB (excess return of long-term government bonds over T-bills).

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