Arbitrage Pricing Model

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Arbitrage Pricing Model

© All Rights Reserved

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Chapter 10

Arbitrage Pricing Theory and Multifactor Models of Risk and Return

A. APT stipulates

B. CAPM stipulates

C. Both CAPM and APT stipulate

D. Neither CAPM nor APT stipulate

E. No pricing model has found

2. Consider the multifactor APT with two factors. Stock A has an expected return of 17.6%, a

beta of 1.45 on factor 1 and a beta of .86 on factor 2. The risk premium on the factor 1

portfolio is 3.2%. The risk-free rate of return is 5%. What is the risk-premium on factor 2 if

no arbitrage opportunities exit?

A. 9.26%

B. 3%

C. 4%

D. 7.75%

E. 9.75%

3. In a multi-factor APT model, the coefficients on the macro factors are often called ______.

A. systemic risk

B. factor sensitivities

C. idiosyncratic risk

D. factor betas

E. both factor sensitivities and factor betas

4. In a multi-factor APT model, the coefficients on the macro factors are often called ______.

A. systemic risk

B. firm-specific risk

C. idiosyncratic risk

D. factor betas

E. unique risk

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

5. In a multi-factor APT model, the coefficients on the macro factors are often called ______.

A. systemic risk

B. firm-specific risk

C. idiosyncratic risk

D. factor loadings

E. unique risk

6. 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. No pricing model currently exists that provides guidance concerning the determination of

the risk premium on any portfolio

portfolio that will yield a sure profit.

A. small positive

B. small negative

C. zero

D. large positive

E. large negative

A. Lintner

B. Modigliani and Miller

C. Ross

D. Sharpe

E. Fama

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

of the factors and a beta of 0 on any other factor.

A. factor

B. market

C. index

D. factor and market

E. factor, market, and index

10. 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. technical analysis

11. In developing the APT, 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 common macroeconomic factors nor firm-specific factors.

E. both common macroeconomic factors and firm-specific factors.

relationship for all assets, whereas the _____________ implies that this relationship holds for

all but perhaps a small number of securities.

A. APT; CAPM

B. APT; OPM

C. CAPM; APT

D. CAPM; OPM

E. APT and OPM; CAPM

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

13. Consider a single factor APT. Portfolio A has a beta of 1.0 and an expected return of 16%.

Portfolio B has a beta of 0.8 and an expected return of 12%. The risk-free rate of return is 6%.

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

E. A; the riskless asset

14. 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

E. No arbitrage opportunity exists.

15. Consider the one-factor APT. The variance of returns on the factor portfolio is 6%. The

beta of a well-diversified portfolio on the factor is 1.1. The variance of returns on the well-

diversified portfolio is approximately __________.

A. 3.6%

B. 6.0%

C. 7.3%

D. 10.1%

E. 8.6%

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

16. Consider the one-factor APT. The standard deviation of returns on a well-diversified

portfolio is 18%. The standard deviation on the factor portfolio is 16%. The beta of the well-

diversified portfolio is approximately __________.

A. 0.80

B. 1.13

C. 1.25

D. 1.56

E. 0.93

17. Consider the single-factor APT. Stocks A and B have expected returns of 15% and 18%,

respectively. The risk-free rate of return is 6%. Stock B has a beta of 1.0. If arbitrage

opportunities are ruled out, stock A has a beta of __________.

A. 0.67

B. 1.00

C. 1.30

D. 1.69

E. 0.75

18. Consider the multifactor APT with two factors. Stock A has an expected return of 16.4%,

a beta of 1.4 on factor 1 and a beta of .8 on factor 2. The risk premium on the factor 1

portfolio is 3%. The risk-free rate of return is 6%. What is the risk-premium on factor 2 if no

arbitrage opportunities exit?

A. 2%

B. 3%

C. 4%

D. 7.75%

E. 6.89%

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

19. Consider the multifactor model APT with two factors. Portfolio A has a beta of 0.75 on

factor 1 and a beta of 1.25 on factor 2. The risk premiums on the factor 1 and factor 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. 16.5%

D. 23.0%

E. 18.7%

20. Consider the multifactor APT with two factors. The risk premiums on the factor 1 and

factor 2 portfolios are 5% and 6%, respectively. Stock A has a beta of 1.2 on factor 1, and a

beta of 0.7 on factor 2. The expected return on stock A is 17%. If no arbitrage opportunities

exist, the risk-free rate of return is ___________.

A. 6.0%

B. 6.5%

C. 6.8%

D. 7.4%

E. 7.7%

21. Consider a one-factor economy. Portfolio A has a beta of 1.0 on the factor and portfolio B

has a beta of 2.0 on the factor. The expected returns on portfolios A and B are 11% and 17%,

respectively. Assume that the risk-free rate is 6% and that arbitrage opportunities exist.

Suppose you invested $100,000 in the risk-free asset, $100,000 in portfolio B, and sold short

$200,000 of portfolio A. Your expected profit from this strategy would be ______________.

A. $1,000

B. $0

C. $1,000

D. $2,000

E. $1,600

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

22. Consider the one-factor APT. Assume that two portfolios, A and B, are well diversified.

The betas of portfolios A and B are 1.0 and 1.5, respectively. The expected returns on

portfolios A and B are 19% and 24%, respectively. Assuming no arbitrage opportunities exist,

the risk-free rate of return must be ____________.

A. 4.0%

B. 9.0%

C. 14.0%

D. 16.5%

E. 8.2%

23. Consider the multifactor APT. The risk premiums on the factor 1 and factor 2 portfolios

are 5% and 3%, respectively. The risk-free rate of return is 10%. Stock A has an expected

return of 19% and a beta on factor 1 of 0.8. Stock A has a beta on factor 2 of ________.

A. 1.33

B. 1.50

C. 1.67

D. 2.00

E. 1.73

24. Consider the single factor APT. Portfolios A and B have expected returns of 14% and

18%, respectively. The risk-free rate of return is 7%. Portfolio A has a beta of 0.7. If arbitrage

opportunities are ruled out, portfolio B must have a beta of __________.

A. 0.45

B. 1.00

C. 1.10

D. 1.22

E. 1.33

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

There are three stocks, A, B, and C. You can either invest in these stocks or short sell them.

There are three possible states of nature for economic growth in the upcoming year; economic

growth may be strong, moderate, or weak. The returns for the upcoming year on stocks A, B,

and C for each of these states of nature are given below:

25. If you invested in an equally weighted portfolio of stocks A and B, your portfolio return

would be ___________ if economic growth were moderate.

A. 3.0%

B. 14.5%

C. 15.5%

D. 16.0%

E. 17.0%

26. If you invested in an equally weighted portfolio of stocks A and C, your portfolio return

would be ____________ if economic growth was strong.

A. 17.0%

B. 22.5%

C. 30.0%

D. 30.5%

E. 25.6%

27. If you invested in an equally weighted portfolio of stocks B and C, your portfolio return

would be _____________ if economic growth was weak.

A. 2.5%

B. 0.5%

C. 3.0%

D. 11.0%

E. 9.0%

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

28. If you wanted to take advantage of a risk-free arbitrage opportunity, you should take a

short position in _________ and a long position in an equally weighted portfolio of _______.

A. A; B and C

B. B; A and C

C. C; A and B

D. A and B; C

E. No arbitrage opportunity exists.

Consider the multifactor APT. There are two independent economic factors, F1and F2. The

risk-free rate of return is 6%. The following information is available about two well-

diversified portfolios:

29. Assuming no arbitrage opportunities exist, the risk premium on the factor F1portfolio

should be __________.

A. 3%

B. 4%

C. 5%

D. 6%

E. 2%

30. Assuming no arbitrage opportunities exist, the risk premium on the factor F2 portfolio

should be ___________.

A. 3%

B. 4%

C. 5%

D. 6%

E. 2%

10-9

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

31. A zero-investment portfolio with a positive expected return arises when _________.

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. a risk-free arbitrage opportunity does not exist

32. An investor will take as large a position as possible when an equilibrium price relationship

is violated. This is an example of _________.

A. a dominance argument

B. the mean-variance efficiency frontier

C. a risk-free arbitrage

D. the capital asset pricing model

E. the SML

33. The APT differs from the CAPM because the APT _________.

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. places more emphasis on systematic risk

34. The feature of the APT that offers the greatest potential advantage over the CAPM is the

______________.

A. use of several factors instead of a single market index to explain the risk-return

relationship

B. identification of anticipated changes in production, 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. superior measurement of the risk-free rate of return over historical time periods and

variability of coefficients of sensitivity to the APT factors for a given asset over time

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

A. only factor risk commands a risk premium in market equilibrium.

B. only systematic risk is related to expected returns.

C. only nonsystematic risk is related to expected returns.

D. only factor risk commands a risk premium in market equilibrium and only systematic risk

is related to expected returns.

E. only factor risk commands a risk premium in market equilibrium and only nonsystematic

risk is related to expected returns.

A. the business cycle.

B. interest rate fluctuations.

C. inflation rates.

D. the business cycle, interest rate fluctuations, and inflation rates.

E. the relationship between past FRED spreads.

A. that the model provides specific guidance concerning the determination of the risk

premiums on the factor portfolios.

B. that the model does not require a specific benchmark market portfolio.

C. that risk need not be considered.

D. that the model provides specific guidance concerning the determination of the risk

premiums on the factor portfolios and that the model does not require a specific benchmark

market portfolio.

E. that the model does not require a specific benchmark market portfolio and that risk need

not be considered.

38. Portfolio A has expected return of 10% and standard deviation of 19%. Portfolio B has

expected return of 12% and standard deviation of 17%. Rational investors will

A. borrow at the risk free rate and buy A.

B. sell A short and buy B.

C. sell B short and buy A.

D. borrow at the risk free rate and buy B.

E. lend at the risk free rate and buy B.

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

A. CAPM depends on risk-return dominance; APT depends on a no arbitrage condition.

B. CAPM assumes many small changes are required to bring the market back to equilibrium;

APT assumes a few large changes are required to bring the market back to equilibrium.

C. implications for prices derived from CAPM arguments are stronger than prices derived

from APT arguments.

D. CAPM depends on risk-return dominance; APT depends on a no arbitrage condition,

CAPM assumes many small changes are required to bring the market back to equilibrium;

APT assumes a few large changes are required to bring the market back to equilibrium,

implications for prices derived from CAPM arguments are stronger than prices derived from

APT arguments.

E. CAPM depends on risk-return dominance; APT depends on a no arbitrage condition and

assumes many small changes are required to bring the market back to equilibrium.

40. A professional who searches for mispriced securities in specific areas such as merger-

target stocks, rather than one who seeks strict (risk-free) arbitrage opportunities is engaged in

A. pure arbitrage.

B. risk arbitrage.

C. option arbitrage.

D. equilibrium arbitrage.

E. covered interest arbitrage.

41. In the context of the Arbitrage Pricing Theory, as a well-diversified portfolio becomes

larger its nonsystematic risk approaches

A. one.

B. infinity.

C. zero.

D. negative one.

E. None of these is correct.

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

A. one that is diversified over a large enough number of securities that the nonsystematic

variance is essentially zero.

B. one that contains securities from at least three different industry sectors.

C. a portfolio whose factor beta equals 1.0.

D. a portfolio that is equally weighted.

E. a portfolio that is equally weighted and contains securities from at least three different

industry sectors.

A. that is equal to the true market portfolio.

B. that contains all securities in proportion to their market values.

C. that need not be well-diversified.

D. that is well-diversified and lies on the SML.

E. that is unobservable.

44. 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.

II) the expected return-beta relationship is maintained for all well-diversified portfolios.

III) the expected return-beta relationship is maintained for all but a small number of

individual securities.

IV) the expected return-beta relationship is maintained for all individual securities.

A. I and III are correct.

B. I and IV are correct.

C. II and III are correct.

D. II and IV are correct.

E. Only I is correct.

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

45. Consider a well-diversified portfolio, A, in a two-factor economy. The risk-free rate is 6%,

the risk premium on the first factor portfolio is 4% and the risk premium on the second factor

portfolio is 3%. If portfolio A has a beta of 1.2 on the first factor and .8 on the second factor,

what is its expected return?

A. 7.0%

B. 8.0%

C. 9.2%

D. 13.0%

E. 13.2%

A. buying low and selling high.

B. short selling high and buying low.

C. earning risk-free economic profits.

D. negotiating for favorable brokerage fees.

E. hedging your portfolio through the use of options.

I) construct a zero investment portfolio that will yield a sure profit.

II) construct a zero beta investment portfolio that will yield a sure profit.

III) make simultaneous trades in two markets without any net investment.

IV) short sell the asset in the low-priced market and buy it in the high-priced market.

A. I and IV

B. I and III

C. II and III

D. I, III, and IV

E. II, III, and IV

A. firm-specific risk.

B. the sensitivity of the firm to that factor.

C. a factor that affects all security returns.

D. the deviation from its expected value of a factor that affects all security returns.

E. a random amount of return attributable to firm events.

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

49. In the APT model, what is the nonsystematic standard deviation of an equally-weighted

portfolio that has an average value of (ei) equal to 25% and 50 securities?

A. 12.5%

B. 625%

C. 0.5%

D. 3.54%

E. 14.59%

50. In the APT model, what is the nonsystematic standard deviation of an equally-weighted

portfolio that has an average value of (ei) equal to 20% and 20 securities?

A. 12.5%

B. 625%

C. 4.47%

D. 3.54%

E. 14.59%

51. In the APT model, what is the nonsystematic standard deviation of an equally-weighted

portfolio that has an average value of (ei) equal to 20% and 40 securities?

A. 12.5%

B. 625%

C. 0.5%

D. 3.54%

E. 3.16%

52. In the APT model, what is the nonsystematic standard deviation of an equally-weighted

portfolio that has an average value of (ei) equal to 18% and 250 securities?

A. 1.14%

B. 625%

C. 0.5%

D. 3.54%

E. 3.16%

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

53. Which of the following is true about the security market line (SML) derived from the

APT?

A. The SML has a downward slope.

B. The SML for the APT shows expected return in relation to portfolio standard deviation.

C. The SML for the APT has an intercept equal to the expected return on the market portfolio.

D. The benchmark portfolio for the SML may be any well-diversified portfolio.

E. The SML is not relevant for the APT.

54. Which of the following is false about the security market line (SML) derived from the

APT?

A. The SML has a downward slope.

B. The SML for the APT shows expected return in relation to portfolio standard deviation.

C. The SML for the APT has an intercept equal to the expected return on the market portfolio.

D. The benchmark portfolio for the SML may be any well-diversified portfolio.

E. The SML has a downward slope, the SML for the APT shows expected return in relation to

portfolio standard deviation, and the SML for the APT has an intercept equal to the expected

return on the market portfolio are all false.

55. If arbitrage opportunities are to be ruled out, each well-diversified portfolio's expected

excess return must be

A. inversely proportional to the risk-free rate.

B. inversely proportional to its standard deviation.

C. proportional to its weight in the market portfolio.

D. proportional to its standard deviation.

E. proportional to its beta coefficient.

56. Suppose you are working with two factor portfolios, Portfolio 1 and Portfolio 2. The

portfolios have expected returns of 15% and 6%, respectively. Based on this information,

what would be the expected return on well-diversified portfolio A, if A has a beta of 0.80 on

the first factor and 0.50 on the second factor? The risk-free rate is 3%.

A. 15.2%

B. 14.1%

C. 13.3%

D. 10.7%

E. 8.4%

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

I) The Security Market Line does not apply to the APT.

II) More than one factor can be important in determining returns.

III) Almost all individual securities satisfy the APT relationship.

IV) It doesn't rely on the market portfolio that contains all assets.

A. II, III, and IV

B. II and IV

C. II and III

D. I, II, and IV

E. I, II, III, and IV

58. In a factor model, the return on a stock in a particular period will be related to

A. factor risk.

B. non-factor risk.

C. standard deviation of returns.

D. both factor risk and non-factor risk.

E. There is no relationship between factor risk, risk premiums, and returns.

59. Which of the following factors did Chen, 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. Neither the change in industrial production, change in expected inflation, change in

unanticipated inflation, nor excess return of long-term government bonds over T-bills were

included in their model.

60. Which of the following factors did Chen, Roll and Ross include in their multifactor

model?

A. Change in industrial waste

B. Change in expected inflation

C. Change in unanticipated inflation

D. Change in expected inflation and Change in unanticipated inflation

E. All of these factors were included in their model

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

61. 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.

C. Excess return of high book-to-market stocks over low book-to-market stocks.

D. All of these factors were included in their model.

E. None of these factors were included in their model.

62. Consider the single-factor APT. Stocks A and B have expected returns of 12% and 14%,

respectively. The risk-free rate of return is 5%. Stock B has a beta of 1.2. If arbitrage

opportunities are ruled out, stock A has a beta of __________.

A. 0.67

B. 0.93

C. 1.30

D. 1.69

E. 1.27

63. Consider the one-factor APT. The standard deviation of returns on a well-diversified

portfolio is 19%. The standard deviation on the factor portfolio is 12%. The beta of the well-

diversified portfolio is approximately __________.

A. 1.58

B. 1.13

C. 1.25

D. 0.76

E. 1.42

64. Black argues that past risk premiums on firm-characteristic variables, such as those

described by Fama and French, are problematic because ________.

A. they may result from data snooping

B. they are sources of systematic risk

C. they can be explained by security characteristic lines

D. they are more appropriate for a single-factor model

E. they are macroeconomic factors

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

65. Multifactor models seek to improve the performance of the single-index model by

A. modeling the systematic component of firm returns in greater detail.

B. incorporating firm-specific components into the pricing model.

C. allowing for multiple economic factors to have differential effects.

D. modeling the systematic component of firm returns in greater detail, incorporating firm-

specific components into the pricing model, and allowing for multiple economic factors to

have differential effects.

E. none of these statements are true.

66. Multifactor models such as the one constructed by Chen, Roll, and Ross, can better

describe assets' returns by

A. expanding beyond one factor to represent sources of systematic risk.

B. using variables that are easier to forecast ex ante.

C. calculating beta coefficients by an alternative method.

D. using only stocks with relatively stable returns.

E. ignoring firm-specific risk.

67. Consider the multifactor model APT with three factors. Portfolio A has a beta of 0.8 on

factor 1, a beta of 1.1 on factor 2, and a beta of 1.25 on factor 3. The risk premiums on the

factor 1, factor 2, and factor 3 are 3%, 5% and 2%, respectively. The risk-free rate of return is

3%. The expected return on portfolio A is __________ if no arbitrage opportunities exist.

A. 13.5%

B. 13.4%

C. 16.5%

D. 23.0%

E. 11.6%

68. Consider the multifactor APT. The risk premiums on the factor 1 and factor 2 portfolios

are 6% and 4%, respectively. The risk-free rate of return is 4%. Stock A has an expected

return of 16% and a beta on factor 1 of 1.3. Stock A has a beta on factor 2 of ________.

A. 1.33

B. 1.05

C. 1.67

D. 2.00

E. .95

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

69. Consider a well-diversified portfolio, A, in a two-factor economy. The risk-free rate is 5%,

the risk premium on the first factor portfolio is 4% and the risk premium on the second factor

portfolio is 6%. If portfolio A has a beta of 0.6 on the first factor and 1.8 on the second factor,

what is its expected return?

A. 7.0%

B. 8.0%

C. 18.2%

D. 13.0%

E. 13.2%

70. Consider a single factor APT. Portfolio A has a beta of 2.0 and an expected return of 22%.

Portfolio B has a beta of 1.5 and an expected return of 17%. The risk-free rate of return is 4%.

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

E. A; the riskless asset

71. Consider the single factor APT. Portfolio A has a beta of 0.5 and an expected return of

12%. Portfolio B has a beta of 0.4 and an expected return of 13%. The risk-free rate of return

is 5%. 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

E. No arbitrage opportunity exists.

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

72. Consider the one-factor APT. The variance of returns on the factor portfolio is 9%. The

beta of a well-diversified portfolio on the factor is 1.25. The variance of returns on the well-

diversified portfolio is approximately __________.

A. 3.6%

B. 6.0%

C. 7.3%

D. 14.1%

E. 9.7%

73. Consider the one-factor APT. The variance of returns on the factor portfolio is 11%. The

beta of a well-diversified portfolio on the factor is 1.45. The variance of returns on the well-

diversified portfolio is approximately __________.

A. 23.1%

B. 6.0%

C. 7.3%

D. 14.1%

E. 11.4%

74. Consider the one-factor APT. The standard deviation of returns on a well-diversified

portfolio is 22%. The standard deviation on the factor portfolio is 14%. The beta of the well-

diversified portfolio is approximately __________.

A. 0.80

B. 1.13

C. 1.25

D. 1.57

E. 67

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Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

75. Discuss the advantages of arbitrage pricing theory (APT) over the capital asset pricing

model (CAPM) relative to diversified portfolios.

76. Discuss the advantages of the multifactor APT over the single factor APT and the CAPM.

What is one shortcoming of the multifactor APT and how does this shortcoming compare to

CAPM implications?

77. Discuss arbitrage opportunities in the context of violations of the law of one price.

78. Discuss the similarities and the differences between the CAPM and the APT with regard

to the following factors: capital market equilibrium, assumptions about risk aversion, risk-

return dominance, and the number of investors required to restore equilibrium.

10-22

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

79. Security A has a beta of 1.0 and an expected return of 12%. Security B has a beta of 0.75

and an expected return of 11%. The risk-free rate is 6%. Explain the arbitrage opportunity that

exists; explain how an investor can take advantage of it. Give specific details about how to

form the portfolio, what to buy and what to sell.

80. Name three variables that Chen, Roll, and Ross used to measure the impact of

macroeconomic factors on security returns. Briefly explain the reasoning behind their model.

10-23

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

Chapter 10 Arbitrage Pricing Theory and Multifactor Models of Risk and Return

Answer Key

A. APT stipulates

B. CAPM stipulates

C. Both CAPM and APT stipulate

D. Neither CAPM nor APT stipulate

E. No pricing model has found

AACSB: Analytic

Bloom's: Remember

Difficulty: Basic

Topic: APT and CAPM

2. Consider the multifactor APT with two factors. Stock A has an expected return of 17.6%, a

beta of 1.45 on factor 1 and a beta of .86 on factor 2. The risk premium on the factor 1

portfolio is 3.2%. The risk-free rate of return is 5%. What is the risk-premium on factor 2 if

no arbitrage opportunities exit?

A. 9.26%

B. 3%

C. 4%

D. 7.75%

E. 9.75%

AACSB: Analytic

Bloom's: Apply

Difficulty: Challenge

Topic: APT

10-24

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

3. In a multi-factor APT model, the coefficients on the macro factors are often called ______.

A. systemic risk

B. factor sensitivities

C. idiosyncratic risk

D. factor betas

E. both factor sensitivities and factor betas

The coefficients are called factor betas, factor sensitivities, or factor loadings.

AACSB: Analytic

Bloom's: Remember

Difficulty: Basic

Topic: APT

4. In a multi-factor APT model, the coefficients on the macro factors are often called ______.

A. systemic risk

B. firm-specific risk

C. idiosyncratic risk

D. factor betas

E. unique risk

The coefficients are called factor betas, factor sensitivities, or factor loadings.

AACSB: Analytic

Bloom's: Remember

Difficulty: Basic

Topic: APT

5. In a multi-factor APT model, the coefficients on the macro factors are often called ______.

A. systemic risk

B. firm-specific risk

C. idiosyncratic risk

D. factor loadings

E. unique risk

The coefficients are called factor betas, factor sensitivities, or factor loadings.

AACSB: Analytic

Bloom's: Remember

Difficulty: Basic

Topic: APT

10-25

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

6. 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. No pricing model currently exists that provides guidance concerning the determination of

the risk premium on any portfolio.

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.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT and CAPM

portfolio that will yield a sure profit.

A. small positive

B. small negative

C. zero

D. large positive

E. large negative

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.

AACSB: Analytic

Bloom's: Remember

Difficulty: Basic

Topic: APT

10-26

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

A. Lintner

B. Modigliani and Miller

C. Ross

D. Sharpe

E. Fama

AACSB: Analytic

Bloom's: Remember

Difficulty: Basic

Topic: APT

of the factors and a beta of 0 on any other factor.

A. factor

B. market

C. index

D. factor and market

E. factor, market, and index

A factor model portfolio has a beta of 1 one factor, with zero betas on other factors.

AACSB: Analytic

Bloom's: Remember

Difficulty: Basic

Topic: APT

10-27

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

10. 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. technical analysis

AACSB: Analytic

Bloom's: Remember

Difficulty: Basic

Topic: APT

11. In developing the APT, 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 common macroeconomic factors nor firm-specific factors.

E. both common macroeconomic factors and firm-specific factors

factors.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

10-28

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

relationship for all assets, whereas the _____________ implies that this relationship holds for

all but perhaps a small number of securities.

A. APT, CAPM

B. APT, OPM

C. CAPM, APT

D. CAPM, OPM

E. APT and OPM, CAPM

The CAPM is an asset-pricing model based on the risk/return relationship of all assets. The

APT implies that this relationship holds for all well-diversified portfolios, and for all but

perhaps a few individual securities.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT and CAPM

13. Consider a single factor APT. Portfolio A has a beta of 1.0 and an expected return of 16%.

Portfolio B has a beta of 0.8 and an expected return of 12%. The risk-free rate of return is 6%.

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

E. A, the riskless asset

A: 16% = 1.0F + 6%; F = 10%; B: 12% = 0.8F + 6%: F = 7.5%; thus, short B and take a long

position in A.

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

10-29

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

14. 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

E. No arbitrage opportunity exists.

A: 13% = 10% + 0.2F; F = 15%; B: 15% = 10% + 0.4F; F = 12.5%; therefore, short B and

take a long position in A.

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

15. Consider the one-factor APT. The variance of returns on the factor portfolio is 6%. The

beta of a well-diversified portfolio on the factor is 1.1. The variance of returns on the well-

diversified portfolio is approximately __________.

A. 3.6%

B. 6.0%

C. 7.3%

D. 10.1%

E. 8.6%

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

10-30

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

16. Consider the one-factor APT. The standard deviation of returns on a well-diversified

portfolio is 18%. The standard deviation on the factor portfolio is 16%. The beta of the well-

diversified portfolio is approximately __________.

A. 0.80

B. 1.13

C. 1.25

D. 1.56

E. 0.93

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

17. Consider the single-factor APT. Stocks A and B have expected returns of 15% and 18%,

respectively. The risk-free rate of return is 6%. Stock B has a beta of 1.0. If arbitrage

opportunities are ruled out, stock A has a beta of __________.

A. 0.67

B. 1.00

C. 1.30

D. 1.69

E. 0.75

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

10-31

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

18. Consider the multifactor APT with two factors. Stock A has an expected return of 16.4%,

a beta of 1.4 on factor 1 and a beta of .8 on factor 2. The risk premium on the factor 1

portfolio is 3%. The risk-free rate of return is 6%. What is the risk-premium on factor 2 if no

arbitrage opportunities exit?

A. 2%

B. 3%

C. 4%

D. 7.75%

E. 6.89%

AACSB: Analytic

Bloom's: Apply

Difficulty: Challenge

Topic: APT

19. Consider the multifactor model APT with two factors. Portfolio A has a beta of 0.75 on

factor 1 and a beta of 1.25 on factor 2. The risk premiums on the factor 1 and factor 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. 16.5%

D. 23.0%

E. 18.7%

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

10-32

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

20. Consider the multifactor APT with two factors. The risk premiums on the factor 1 and

factor 2 portfolios are 5% and 6%, respectively. Stock A has a beta of 1.2 on factor 1, and a

beta of 0.7 on factor 2. The expected return on stock A is 17%. If no arbitrage opportunities

exist, the risk-free rate of return is ___________.

A. 6.0%

B. 6.5%

C. 6.8%

D. 7.4%

E. 7.7%

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

21. Consider a one-factor economy. Portfolio A has a beta of 1.0 on the factor and portfolio B

has a beta of 2.0 on the factor. The expected returns on portfolios A and B are 11% and 17%,

respectively. Assume that the risk-free rate is 6% and that arbitrage opportunities exist.

Suppose you invested $100,000 in the risk-free asset, $100,000 in portfolio B, and sold short

$200,000 of portfolio A. Your expected profit from this strategy would be ______________.

A. $1,000

B. $0

C. $1,000

D. $2,000

E. $1,600

$200,000(0.11) = $22,000 (short position, portfolio A); 1,000 profit.

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

10-33

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

22. Consider the one-factor APT. Assume that two portfolios, A and B, are well diversified.

The betas of portfolios A and B are 1.0 and 1.5, respectively. The expected returns on

portfolios A and B are 19% and 24%, respectively. Assuming no arbitrage opportunities exist,

the risk-free rate of return must be ____________.

A. 4.0%

B. 9.0%

C. 14.0%

D. 16.5%

E. 8.2%

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

23. Consider the multifactor APT. The risk premiums on the factor 1 and factor 2 portfolios

are 5% and 3%, respectively. The risk-free rate of return is 10%. Stock A has an expected

return of 19% and a beta on factor 1 of 0.8. Stock A has a beta on factor 2 of ________.

A. 1.33

B. 1.50

C. 1.67

D. 2.00

E. 1.73

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

10-34

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

24. Consider the single factor APT. Portfolios A and B have expected returns of 14% and

18%, respectively. The risk-free rate of return is 7%. Portfolio A has a beta of 0.7. If arbitrage

opportunities are ruled out, portfolio B must have a beta of __________.

A. 0.45

B. 1.00

C. 1.10

D. 1.22

E. 1.33

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

There are three stocks, A, B, and C. You can either invest in these stocks or short sell them.

There are three possible states of nature for economic growth in the upcoming year; economic

growth may be strong, moderate, or weak. The returns for the upcoming year on stocks A, B,

and C for each of these states of nature are given below:

10-35

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

25. If you invested in an equally weighted portfolio of stocks A and B, your portfolio return

would be ___________ if economic growth were moderate.

A. 3.0%

B. 14.5%

C. 15.5%

D. 16.0%

E. 17.0%

AACSB: Analytic

Bloom's: Apply

Difficulty: Basic

Topic: APT

26. If you invested in an equally weighted portfolio of stocks A and C, your portfolio return

would be ____________ if economic growth was strong.

A. 17.0%

B. 22.5%

C. 30.0%

D. 30.5%

E. 25.6%

AACSB: Analytic

Bloom's: Apply

Difficulty: Basic

Topic: APT

10-36

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

27. If you invested in an equally weighted portfolio of stocks B and C, your portfolio return

would be _____________ if economic growth was weak.

A. 2.5%

B. 0.5%

C. 3.0%

D. 11.0%

E. 9.0%

AACSB: Analytic

Bloom's: Apply

Difficulty: Basic

Topic: APT

28. If you wanted to take advantage of a risk-free arbitrage opportunity, you should take a

short position in _________ and a long position in an equally weighted portfolio of _______.

A. A, B and C

B. B, A and C

C. C, A and B

D. A and B, C

E. No arbitrage opportunity exists.

E(RA) = (39% + 17% 5%)/3 = 17%; E(RB) = (30% + 15% + 0%)/3 = 15%; E(RC) = (22% +

14% + 6%)/3 = 14%; E(RP) = 0.5(14%) + 0.5[(17% + 15%)/2]; 7.0% + 8.0% = 1.0%.

AACSB: Analytic

Bloom's: Apply

Difficulty: Challenge

Topic: APT

Consider the multifactor APT. There are two independent economic factors, F1and F2. The

risk-free rate of return is 6%. The following information is available about two well-

diversified portfolios:

10-37

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

29. Assuming no arbitrage opportunities exist, the risk premium on the factor F1portfolio

should be __________.

A. 3%

B. 4%

C. 5%

D. 6%

E. 2%

4.0(RP2); RP2 = 5; A: 19% = 6% + RP1 + 2.0(5); RP1 = 3%.

AACSB: Analytic

Bloom's: Apply

Difficulty: Challenge

Topic: APT

30. Assuming no arbitrage opportunities exist, the risk premium on the factor F2 portfolio

should be ___________.

A. 3%

B. 4%

C. 5%

D. 6%

E. 2%

4.0(RP2); RP2 = 5; A: 19% = 6% + RP1 + 2.0(5); RP1 = 3%.

AACSB: Analytic

Bloom's: Apply

Difficulty: Challenge

Topic: APT

10-38

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

31. A zero-investment portfolio with a positive expected return arises when _________.

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. a risk-free arbitrage opportunity does not exist

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 risk-free arbitrage opportunity exists.

AACSB: Analytic

Bloom's: Remember

Difficulty: Basic

Topic: APT

32. An investor will take as large a position as possible when an equilibrium price relationship

is violated. This is an example of _________.

A. a dominance argument

B. the mean-variance efficiency frontier

C. a risk-free arbitrage

D. the capital asset pricing model

E. the SML

When the equilibrium price is violated, the investor will buy the lower priced asset and

simultaneously place an order to sell the higher priced asset. Such transactions result in risk-

free arbitrage. The larger the positions, the greater the risk-free arbitrage profits.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

10-39

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

33. The APT differs from the CAPM because the APT _________.

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. places more emphasis on systematic risk

The CAPM assumes that market returns represent systematic risk. The APT recognizes that

other macroeconomic factors may be systematic risk factors.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT and CAPM

34. The feature of the APT that offers the greatest potential advantage over the CAPM is the

______________.

A. use of several factors instead of a single market index to explain the risk-return

relationship

B. identification of anticipated changes in production, 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. superior measurement of the risk-free rate of return over historical time periods and

variability of coefficients of sensitivity to the APT factors for a given asset over time

The advantage of the APT is the use of multiple factors, rather than a single market index, to

explain the risk-return relationship. However, APT does not identify the specific factors.

AACSB: Analytic

Bloom's: Remember

Difficulty: Basic

Topic: APT

10-40

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

A. only factor risk commands a risk premium in market equilibrium.

B. only systematic risk is related to expected returns.

C. only nonsystematic risk is related to expected returns.

D. only factor risk commands a risk premium in market equilibrium and only systematic risk

is related to expected returns.

E. only factor risk commands a risk premium in market equilibrium and only nonsystematic

risk is related to expected returns.

Nonfactor risk may be diversified away; thus, only factor risk commands a risk premium in

market equilibrium. Nonsystematic risk across firms cancels out in well-diversified portfolios;

thus, only systematic risk is related to expected returns.

AACSB: Analytic

Bloom's: Remember

Difficulty: Basic

Topic: APT

A. the business cycle.

B. interest rate fluctuations.

C. inflation rates.

D. the business cycle, interest rate fluctuations, and inflation rates.

E. the relationship between past FRED spreads.

The business cycle, interest rate fluctuations, and inflation rates are likely to affect stock

returns.

AACSB: Analytic

Bloom's: Remember

Difficulty: Basic

Topic: APT

10-41

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

A. that the model provides specific guidance concerning the determination of the risk

premiums on the factor portfolios.

B. that the model does not require a specific benchmark market portfolio.

C. that risk need not be considered.

D. that the model provides specific guidance concerning the determination of the risk

premiums on the factor portfolios and that the model does not require a specific benchmark

market portfolio.

E. that the model does not require a specific benchmark market portfolio and that risk need

not be considered.

The APT provides no guidance concerning the determination of the risk premiums on the

factor portfolios. Risk must be considered in both the CAPM and APT. A major advantage of

APT over the CAPM is that a specific benchmark market portfolio is not required.

AACSB: Analytic

Bloom's: Remember

Difficulty: Basic

Topic: APT and CAPM

38. Portfolio A has expected return of 10% and standard deviation of 19%. Portfolio B has

expected return of 12% and standard deviation of 17%. Rational investors will

A. Borrow at the risk free rate and buy A.

B. Sell A short and buy B.

C. Sell B short and buy A.

D. Borrow at the risk free rate and buy B.

E. Lend at the risk free rate and buy B.

AACSB: Analytic

Bloom's: Understand

Difficulty: Basic

Topic: APT

10-42

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

A. CAPM depends on risk-return dominance; APT depends on a no arbitrage condition.

B. CAPM assumes many small changes are required to bring the market back to equilibrium;

APT assumes a few large changes are required to bring the market back to equilibrium.

C. implications for prices derived from CAPM arguments are stronger than prices derived

from APT arguments.

D. CAPM depends on risk-return dominance; APT depends on a no arbitrage condition,

CAPM assumes many small changes are required to bring the market back to equilibrium;

APT assumes a few large changes are required to bring the market back to equilibrium,

implications for prices derived from CAPM arguments are stronger than prices derived from

APT arguments.

E. CAPM depends on risk-return dominance; APT depends on a no arbitrage condition and

assumes many small changes are required to bring the market back to equilibrium.

Under the risk-return dominance argument of CAPM, when an equilibrium price is violated

many investors will make small portfolio changes, depending on their risk tolerance, until

equilibrium is restored. Under the no-arbitrage argument of APT, each investor will take as

large a position as possible so only a few investors must act to restore equilibrium.

Implications derived from APT are much stronger than those derived from CAPM, making C

an incorrect statement.

AACSB: Analytic

Bloom's: Remember

Difficulty: Challenge

Topic: APT

40. A professional who searches for mispriced securities in specific areas such as merger-

target stocks, rather than one who seeks strict (risk-free) arbitrage opportunities is engaged in

A. pure arbitrage.

B. risk arbitrage.

C. option arbitrage.

D. equilibrium arbitrage.

E. covered interest arbitrage.

Risk arbitrage involves searching for mispricings based on speculative information that may

or may not materialize.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

10-43

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

41. In the context of the Arbitrage Pricing Theory, as a well-diversified portfolio becomes

larger its nonsystematic risk approaches

A. one.

B. infinity.

C. zero.

D. negative one.

E. None of these is correct.

approaches zero.

AACSB: Analytic

Bloom's: Remember

Difficulty: Basic

Topic: APT

A. one that is diversified over a large enough number of securities that the nonsystematic

variance is essentially zero.

B. one that contains securities from at least three different industry sectors.

C. a portfolio whose factor beta equals 1.0.

D. a portfolio that is equally weighted.

E. a portfolio that is equally weighted and contains securities from at least three different

industry sectors

A well-diversified portfolio is one that contains a large number of securities, each having a

small (but not necessarily equal) weight, so that nonsystematic variance is negligible.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

10-44

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

A. that is equal to the true market portfolio.

B. that contains all securities in proportion to their market values.

C. that need not be well-diversified.

D. that is well-diversified and lies on the SML.

E. that is unobservable.

Any well-diversified portfolio lying on the SML can serve as the benchmark portfolio for the

APT. The true (and unobservable) market portfolio is only a requirement for the CAPM.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

44. 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.

II) the expected return-beta relationship is maintained for all well-diversified portfolios.

III) the expected return-beta relationship is maintained for all but a small number of

individual securities.

IV) the expected return-beta relationship is maintained for all individual securities.

A. I and III are correct.

B. I and IV are correct.

C. II and III are correct.

D. II and IV are correct.

E. Only I is correct.

The expected return-beta relationship must hold for all well-diversified portfolios and for all

but a few individual securities; otherwise arbitrage opportunities will be available.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

10-45

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

45. Consider a well-diversified portfolio, A, in a two-factor economy. The risk-free rate is 6%,

the risk premium on the first factor portfolio is 4% and the risk premium on the second factor

portfolio is 3%. If portfolio A has a beta of 1.2 on the first factor and .8 on the second factor,

what is its expected return?

A. 7.0%

B. 8.0%

C. 9.2%

D. 13.0%

E. 13.2%

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

A. buying low and selling high.

B. short selling high and buying low.

C. earning risk-free economic profits.

D. negotiating for favorable brokerage fees.

E. hedging your portfolio through the use of options.

Arbitrage is exploiting security mispricings by the simultaneous purchase and sale to gain

economic profits without taking any risk. A capital market in equilibrium rules out arbitrage

opportunities.

AACSB: Analytic

Bloom's: Remember

Difficulty: Basic

Topic: APT

10-46

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

I) construct a zero investment portfolio that will yield a sure profit.

II) construct a zero beta investment portfolio that will yield a sure profit.

III) make simultaneous trades in two markets without any net investment.

IV) short sell the asset in the low-priced market and buy it in the high-priced market.

A. I and IV

B. I and III

C. II and III

D. I, III, and IV

E. II, III, and IV

Only I and III are correct. II is incorrect because the beta of the portfolio does not need to be

zero. IV is incorrect because the opposite is true.

AACSB: Analytic

Bloom's: Understand

Difficulty: Challenge

Topic: APT

A. firm-specific risk.

B. the sensitivity of the firm to that factor.

C. a factor that affects all security returns.

D. the deviation from its expected value of a factor that affects all security returns.

E. a random amount of return attributable to firm events.

F measures the unanticipated portion of a factor that is common to all security returns.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

10-47

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

49. In the APT model, what is the nonsystematic standard deviation of an equally-weighted

portfolio that has an average value of (ei) equal to 25% and 50 securities?

A. 12.5%

B. 625%

C. 0.5%

D. 3.54%

E. 14.59%

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

50. In the APT model, what is the nonsystematic standard deviation of an equally-weighted

portfolio that has an average value of (ei) equal to 20% and 20 securities?

A. 12.5%

B. 625%

C. 4.47%

D. 3.54%

E. 14.59%

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

10-48

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

51. In the APT model, what is the nonsystematic standard deviation of an equally-weighted

portfolio that has an average value of (ei) equal to 20% and 40 securities?

A. 12.5%

B. 625%

C. 0.5%

D. 3.54%

E. 3.16%

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

52. In the APT model, what is the nonsystematic standard deviation of an equally-weighted

portfolio that has an average value of (ei) equal to 18% and 250 securities?

A. 1.14%

B. 625%

C. 0.5%

D. 3.54%

E. 3.16%

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

10-49

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

53. Which of the following is true about the security market line (SML) derived from the

APT?

A. The SML has a downward slope.

B. The SML for the APT shows expected return in relation to portfolio standard deviation.

C. The SML for the APT has an intercept equal to the expected return on the market portfolio.

D. The benchmark portfolio for the SML may be any well-diversified portfolio.

E. The SML is not relevant for the APT.

The benchmark portfolio does not need to be the (unobservable) market portfolio under the

APT, but can be any well-diversified portfolio. The intercept still equals the risk-free rate.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

54. Which of the following is false about the security market line (SML) derived from the

APT?

A. The SML has a downward slope.

B. The SML for the APT shows expected return in relation to portfolio standard deviation.

C. The SML for the APT has an intercept equal to the expected return on the market portfolio.

D. The benchmark portfolio for the SML may be any well-diversified portfolio.

E. The SML has a downward slope, the SML for the APT shows expected return in relation to

portfolio standard deviation, and the SML for the APT has an intercept equal to the expected

return on the market portfolio are all false.

The benchmark portfolio does not need to be the (unobservable) market portfolio under the

APT, but can be any well-diversified portfolio. The intercept still equals the risk-free rate.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

10-50

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

55. If arbitrage opportunities are to be ruled out, each well-diversified portfolio's expected

excess return must be

A. inversely proportional to the risk-free rate.

B. inversely proportional to its standard deviation.

C. proportional to its weight in the market portfolio.

D. proportional to its standard deviation.

E. proportional to its beta coefficient.

For each well-diversified portfolio (P and Q, for example), it must be true that [E(rp) rf]/p =

[E(rQ) rf]/ Q.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

56. Suppose you are working with two factor portfolios, Portfolio 1 and Portfolio 2. The

portfolios have expected returns of 15% and 6%, respectively. Based on this information,

what would be the expected return on well-diversified portfolio A, if A has a beta of 0.80 on

the first factor and 0.50 on the second factor? The risk-free rate is 3%.

A. 15.2%

B. 14.1%

C. 13.3%

D. 10.7%

E. 8.4%

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

10-51

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

I) The Security Market Line does not apply to the APT.

II) More than one factor can be important in determining returns.

III) Almost all individual securities satisfy the APT relationship.

IV) It doesn't rely on the market portfolio that contains all assets.

A. II, III, and IV

B. II and IV

C. II and III

D. I, II, and IV

E. I, II, III, and IV

All except the first item are true. There is a Security Market Line associated with the APT.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

58. In a factor model, the return on a stock in a particular period will be related to

A. factor risk.

B. non-factor risk.

C. standard deviation of returns.

D. both factor risk and non-factor risk.

E. There is no relationship between factor risk, risk premiums, and returns.

Factor models explain firm returns based on both factor risk and non-factor risk.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

10-52

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

59. Which of the following factors did Chen, 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. Neither the change in industrial production, change in expected inflation, change in

unanticipated inflation, nor excess return of long-term government bonds over T-bills were

included in their model.

Chen, 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.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

60. Which of the following factors did Chen, Roll and Ross include in their multifactor

model?

A. Change in industrial waste

B. Change in expected inflation

C. Change in unanticipated inflation

D. Change in expected inflation and Change in unanticipated inflation

E. All of these factors were included in their model.

Chen, Roll and Ross included the change in expected inflation and the change in

unanticipated inflation as well as the excess return of long-term corporate bonds over long-

term government bonds in their model.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

10-53

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

61. 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.

C. Excess return of high book-to-market stocks over low book-to-market stocks.

D. All of these factors were included in their model.

E. None of these factors were included in their model.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

62. Consider the single-factor APT. Stocks A and B have expected returns of 12% and 14%,

respectively. The risk-free rate of return is 5%. Stock B has a beta of 1.2. If arbitrage

opportunities are ruled out, stock A has a beta of __________.

A. 0.67

B. 0.93

C. 1.30

D. 1.69

E. 1.27

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

10-54

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

63. Consider the one-factor APT. The standard deviation of returns on a well-diversified

portfolio is 19%. The standard deviation on the factor portfolio is 12%. The beta of the well-

diversified portfolio is approximately __________.

A. 1.58

B. 1.13

C. 1.25

D. 0.76

E. 1.42

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

64. Black argues that past risk premiums on firm-characteristic variables, such as those

described by Fama and French, are problematic because ________.

A. they may result from data snooping

B. they are sources of systematic risk

C. they can be explained by security characteristic lines

D. they are more appropriate for a single-factor model

E. they are macroeconomic factors

Black argues that past risk premiums on firm-characteristic variables, such as those described

by Fama and French, are problematic because they may result from data snooping.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

10-55

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

65. Multifactor models seek to improve the performance of the single-index model by

A. modeling the systematic component of firm returns in greater detail.

B. incorporating firm-specific components into the pricing model.

C. allowing for multiple economic factors to have differential effects.

D. modeling the systematic component of firm returns in greater detail, incorporating firm-

specific components into the pricing model, and allowing for multiple economic factors to

have differential effects.

E. none of these statements are true.

Multifactor models seek to improve the performance of the single-index model by modeling

the systematic component of firm returns in greater detail, incorporating firm-specific

components into the pricing model., and allowing for multiple economic factors to have

differential effects.

AACSB: Analytic

Bloom's: Remember

Difficulty: Basic

Topic: APT

66. Multifactor models such as the one constructed by Chen, Roll, and Ross, can better

describe assets' returns by

A. expanding beyond one factor to represent sources of systematic risk.

B. using variables that are easier to forecast ex ante.

C. calculating beta coefficients by an alternative method.

D. using only stocks with relatively stable returns.

E. ignoring firm-specific risk.

The study used five different factors to explain security returns, allowing for several sources

of risk to affect the returns.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

10-56

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

67. Consider the multifactor model APT with three factors. Portfolio A has a beta of 0.8 on

factor 1, a beta of 1.1 on factor 2, and a beta of 1.25 on factor 3. The risk premiums on the

factor 1, factor 2, and factor 3 are 3%, 5% and 2%, respectively. The risk-free rate of return is

3%. The expected return on portfolio A is __________ if no arbitrage opportunities exist.

A. 13.5%

B. 13.4%

C. 16.5%

D. 23.0%

E. 11.6%

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

68. Consider the multifactor APT. The risk premiums on the factor 1 and factor 2 portfolios

are 6% and 4%, respectively. The risk-free rate of return is 4%. Stock A has an expected

return of 16% and a beta on factor 1 of 1.3. Stock A has a beta on factor 2 of ________.

A. 1.33

B. 1.05

C. 1.67

D. 2.00

E. .95

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

10-57

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

69. Consider a well-diversified portfolio, A, in a two-factor economy. The risk-free rate is 5%,

the risk premium on the first factor portfolio is 4% and the risk premium on the second factor

portfolio is 6%. If portfolio A has a beta of 0.6 on the first factor and 1.8 on the second factor,

what is its expected return?

A. 7.0%

B. 8.0%

C. 18.2%

D. 13.0%

E. 13.2%

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

70. Consider a single factor APT. Portfolio A has a beta of 2.0 and an expected return of 22%.

Portfolio B has a beta of 1.5 and an expected return of 17%. The risk-free rate of return is 4%.

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

E. A, the riskless asset

A: 22% = 2.0F + 4%; F = 9%; B: 17% = 1.5F + 4%: F = 8.67%; thus, short B and take a long

position in A.

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

10-58

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

71. Consider the single factor APT. Portfolio A has a beta of 0.5 and an expected return of

12%. Portfolio B has a beta of 0.4 and an expected return of 13%. The risk-free rate of return

is 5%. 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

E. No arbitrage opportunity exists.

A: 12% = 5% + 0.5F; F = 14%; B: 13% = 5% + 0.4F; F = 20%; therefore, short A and take a

long position in B.

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

72. Consider the one-factor APT. The variance of returns on the factor portfolio is 9%. The

beta of a well-diversified portfolio on the factor is 1.25. The variance of returns on the well-

diversified portfolio is approximately __________.

A. 3.6%

B. 6.0%

C. 7.3%

D. 14.1%

E. 9.7%

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

10-59

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

73. Consider the one-factor APT. The variance of returns on the factor portfolio is 11%. The

beta of a well-diversified portfolio on the factor is 1.45. The variance of returns on the well-

diversified portfolio is approximately __________.

A. 23.1%

B. 6.0%

C. 7.3%

D. 14.1%

E. 11.4%

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

74. Consider the one-factor APT. The standard deviation of returns on a well-diversified

portfolio is 22%. The standard deviation on the factor portfolio is 14%. The beta of the well-

diversified portfolio is approximately __________.

A. 0.80

B. 1.13

C. 1.25

D. 1.57

E. 67

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

10-60

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

75. Discuss the advantages of arbitrage pricing theory (APT) over the capital asset pricing

model (CAPM) relative to diversified portfolios.

The APT does not require that the benchmark portfolio in the SML relationship be the true

market portfolio. Any well-diversified portfolio lying on the SML may serve as a benchmark

portfolio. Thus, the APT has more flexibility than the CAPM, as problems associated with an

unobservable market portfolio are not a concern with APT. In addition, the APT provides

further justification for the use of the index model for practical implementation of the SML

relationship. That is, if the index portfolio is not a precise proxy for the true market portfolio,

which is a cause of considerable concern in the context of the CAPM, if an index portfolio is

sufficiently diversified, the SML relationship holds, according to APT.

Feedback: This question is designed to determine if the student understands the basic

advantages of APT over the CAPM.

Bloom's: Understand

Difficulty: Intermediate

Topic: APT and CAPM

76. Discuss the advantages of the multifactor APT over the single factor APT and the CAPM.

What is one shortcoming of the multifactor APT and how does this shortcoming compare to

CAPM implications?

The single factor APT and the CAPM assume that there is only one systematic risk factor

affecting stock returns. However, several factors may affect stock returns. Some of these

factors are: business cycles, interest rate fluctuations, inflation rates, oil prices, etc. A

multifactor model can accommodate these multiple sources of risk.

One shortcoming of the multifactor APT is that the model provides no guidance concerning

the factors or risk premiums on the factor portfolios. 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.

Feedback: This question is designed to determine if the student understands the basic

advantages of the multi-factor APT over the single-factor APT and CAPM.

Bloom's: Understand

Difficulty: Intermediate

Topic: APT and CAPM

10-61

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

77. Discuss arbitrage opportunities in the context of violations of the law of one price.

The law of one price is violated when an asset is trading at different prices in two markets. If

the price differential exceeds the transactions costs, a simultaneous trade in the two markets

can produce a sure profit with a zero investment. That is, the investor can sell short the asset

in the high-priced market and buy the asset in the low-priced market. 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). However, it should be remembered that individual

investors do not have access to the proceeds of a short transaction until the position has been

covered.

Feedback: This question is designed to determine if the student understands the basic concept

of arbitrage.

Bloom's: Understand

Difficulty: Basic

Topic: APT

78. Discuss the similarities and the differences between the CAPM and the APT with regard

to the following factors: capital market equilibrium, assumptions about risk aversion, risk-

return dominance, and the number of investors required to restore equilibrium.

Both the CAPM and the APT are market equilibrium models, which examine the factors that

affect securities' prices. In equilibrium, there are no overpriced or underpriced securities. In

both models, mispriced securities can be identified and purchased or sold as appropriate to

earn excess profits.

The CAPM is based on the idea that there are large numbers of investors who are focused on

risk-return dominance. Under the CAPM, when a mispricing occurs, many individual

investors make small changes in their portfolios, guided by their degrees of risk aversion. The

aggregate effect of their actions brings the market back into equilibrium. Under the APT, each

investor wants an infinite arbitrage position in the mispriced asset. Therefore, it would not

take many investors to identify the arbitrage opportunity and act to bring the market back to

equilibrium.

Feedback: The student can compare the two models by focusing on the specific items.

Bloom's: Understand

Difficulty: Challenge

Topic: APT and CAPM

10-62

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

79. Security A has a beta of 1.0 and an expected return of 12%. Security B has a beta of 0.75

and an expected return of 11%. The risk-free rate is 6%. Explain the arbitrage opportunity that

exists; explain how an investor can take advantage of it. Give specific details about how to

form the portfolio, what to buy and what to sell.

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 0.75 and a different expected return than security B. The

investor can accomplish this by choosing .75 as the weight in A and .25 in the risk-free asset.

This portfolio would have E(rp) = 0.75(12%) + 0.25(6%) = 10.5%, which is less than B's 11%

expected return. The investor should buy B and finance the purchase by short selling A and

borrowing at the risk-free asset.

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

80. Name three variables that Chen, Roll, and Ross used to measure the impact of

macroeconomic factors on security returns. Briefly explain the reasoning behind their model.

The factors they considered were IP (the % change in industrial production), EI (the % change

in expected inflation), UI (the % change in unanticipated inflation), CG (excess return of

long-term corporate bonds over long-term government bonds), and GB (excess return of long-

term government bonds over T-bills). The rational for their model is that many different

economic factors can combine to affect securities' returns. Also, by including factors that are

related to the business cycle, the estimation of beta coefficients should be improved. Each

beta will represent only the impact of the corresponding variable on returns.

Feedback: The student has some flexibility in remembering which variables were used in the

study. A general understanding of macroeconomic variables will be helpful in answering the

question. 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.

Bloom's: Understand

Difficulty: Challenge

Topic: APT

10-63

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