1) The index model has been estimated for stocks A and B with the following results:

RA = 0.03 + 0.8RM + eA.

RB = 0.01 + 0.9RM + eB.
σM = 0.35; σ(eA) = 0.20; σ(eB) = 0.10.

The covariance between the returns on stocks A and B is

A) 0.0384.
B) 0.0406.
C) 0.0882.
D) 0.0772.
E) 0.4000.

Cov(RA, RB) = βA βB σM^2

Cov(RA, RB) = 0.8 *0.9*0.35^2

Cov(RA, RB)=0.07717

2) Analysts may use regression analysis to estimate the index model for a stock. When
doing so, the slope of the regression line is an estimate of

A) the α of the asset.

B) the β of the asset.
C) the σ of the asset.
D) the δ of the asset.
Slope of a regression line is an estimate of beta and it measures the volatility of the
stock and the volatility of the market.

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3) The return on a stock, in a factor model, in a given period will be related to

A) firm-specific events.
B) macroeconomic events.
C) the error term.
D) both firm-specific events and macroeconomic events.
E) neither firm-specific events nor macroeconomic events.

To find the return on a stock we consider a common factor that drives innovation in security
return that effects all firms which is represented as (m) and the firm’s specific uncertainty which
is represented as (ei).

4) Assume the index model is valid, what inputs will be required to determine covariance
between two assets?

A) βk
B) βL
C) σM
D) all of the options
E) None of the options are correct.

Formula for Covariance of two stocks is: Cov(RA, RB) = βA βB σM ^2

To find the covariance of two stocks we need to have beta coefficient of stock A and B which is
used to determine the systematic risk of the stocks and the ( σM ), the standard deviation of
common factor m which measures unanticipated macroeconomic surprises.

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5) Assume that stock market returns do not resemble a single-index structure. An
investment fund analyzes 150 stocks in order to construct a mean-variance efficient portfolio
constrained by 300 investments. They will need to calculate ____________ covariances.

A) 44,850
B) 150
C) 22,500
D) 11,175

(Number of investments^2 – number of investments)/2

(300^2 – 300)/2

44850

6) Assume that stock market returns do follow a single-index structure. An investment fund
analyzes 1000 stocks in order to construct a mean-variance efficient portfolio constrained by 500
investments. They will need to calculate ________ estimates of firm-specific variances and
________ estimate/estimates for the variance of the macroeconomic factor.

A) 500; 1
B) 1000; 1
C) 124,750; 1
D) 124,750; 500
E) 250,000; 500

500 firm specific variances must be calculated since we have 500 investments, and also the
macroeconomic surprises effect all firms so 1 macroeconomic factor must be estimated.

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7) The expected impact of unanticipated macroeconomic events on a security's return
during the period is

A) included in the security's expected return.

B) zero.
C) equal to the risk-free rate.
D) proportional to the firm's beta.
E) infinite.

Because Macroeconomic surprises usually effects all firms, therefore, the expected impact of
such events can be considered a zero.

8) What is the term ei in the single-index model equation ri = E(ri) + βiF + ei,

A) the impact of unanticipated macroeconomic events on security i's return.

B) the impact of unanticipated firm-specific events on security i's return.
C) the impact of anticipated macroeconomic events on security i's return.
D) the impact of anticipated firm-specific events on security i's return.
E) the impact of changes in the market on security i's return.

9)Consider the single-index model. The alpha of a stock is 0%. The return on the market index is
10%. The risk-free rate of return is 5%. The stock earns a return that exceeds the risk-free rate by
10%, and there are no firm-specific events affecting the stock performance. The β of the stock is

A) 0.67.
B) 0.75.
C) 1.0.
D) 1.33.
E) 2.0.

Required rate = Risk-free rate of return + [ β (Return on the market index - Risk-free rate of
return)]

10%= 0% +[ β (10%-5%)]

10%= β (5%)

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β =2

10) Using the single index model, what is the alpha of a stock with beta of 1.5, a market
return of 14%, risk free rate of 3% and the actual return of the stock is 19%?

A) −1.37%
B) 0.75%
C) 1.80%
D) 0.5%
E) −3.12%

Alpha = actual return- risk free rate- beta(market return -risk free rate)

Alpha = 19%-3%-1.5(14%-3%)

Alpha = 0.005  0.5%

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