FACTOR THEORY

Q. 2372 Risk Management and Investment Management

1) All the following with respect to the Capital Asset Pricing Model (CAPM) are true,
EXCEPT:

A
The CAPM states that there is a single factor driving the asset returns – the market
return in excess of T-bills

B
The CAPM defines 'market portfolio' as the portfolio where each stock is held in equal
weight

C
The CAPM states that individual assets are exposed to market factors and thus carry a
risk premium

D
The CAPM states that idiosyncratic risk is not rewarded by the market

The correct answer is: B).

The Capital Asset Pricing Model (CAPM) suggests that a single factor drives the asset returns.
The single factor is the market portfolio, which consists of each stock held in proportion to its
market capitalization. The CAPM also states that the investors must be compensated for taking
on the risk associated with an asset. Idiosyncratic risk is the risk which can be diversified away.
The CAPM states that such risk cannot be rewarded by way of a risk premium.

2) The following securities performed poorly in the 2007/2008 financial crisis, EXCEPT:
3) A
4) Government bonds
5) B
6) Corporate bonds (issued by banks)
7) C
8) Stocks issued by banks
9) D
10) Mortgage-backed securities

The correct answer is: A).

Options B, C, and D all give products whose performance actually ‘amplified’ that of the
market as a whole in the 20087/2008 financial crisis. This is because these assets had
high betas, meaning high systematic risk. Government bonds, on the other hand, are
low-beta securities, meaning they will always perform better than the market during times
of economic turmoil. Gold would be another good example of a security which tends to
pay off when the market crashes

3) Which of the following statements is (are) correct?

I. The CAPM is based on the assumption that investors have homogeneous expectations
 II. The CAPM is based on the assumption of market equilibrium
III. The CAPM is based on the assumption of diversified portfolio
IV. C

All statements are correct

The CAPM is based on the assumption that investors hold a combination of the market
portfolio and risk-free assets. Furthermore, it assumes that the set of means, volatilities,
and correlations are the same for all investors, i.e., the investors have homogeneous
expectations. In addition, the market is at equilibrium, where demand is equal to supply.
It also assumes investors do not hold concentrated portfolios. Rather, they hold well-
diversified portfolios that eliminate specific risks.

4) All the following are true about multifactor models, EXCEPT:

A
Multifactor models take into consideration multiple risk factors

B
Only linear dependency of the risk factors can be modeled

C
Multifactor models contain multiple betas

D
Idiosyncratic risk is diversified

The correct answer is: B).

A multifactor model takes into consideration multiple risk factors, unlike the CAPM which takes
into consideration only risk arising relative to the market portfolio. For the CAPM, only the linear
dependency of the risk factor can be modeled but in multiple factor models, the non-linear
dependency of the risk factors can also be modeled. Furthermore, multifactor models take into
consideration multiple risk factors, multiple betas each corresponding to a distinct risk. In both
the CAPM and multiple factor models, idiosyncratic risks are diversified away.

5) Country A, a developing economy, has recently witnessed government’s renewed interest and
effort in reforming the financial sector. A recent report published by a non-governmental
organization (NGO) indicates the presence of rampant insider trading. The report also points
towards the lack of depth in the financial market which poses significant problems for investors
and market participants. However, the presence of natural resources in the country makes it an
attractive destination for foreign investors.

A fund manager investing in country A utilizes the CAPM to compute the expected return. Which
of the following options is (are) correct?

I. Deviations from the CAPM will be observed due to insider trading

II. Deviations from the CAPM will be observed due to the developing economy
III. Deviations from the CAPM will be observed due to a lack of market depth
IV. Deviations from the CAPM will be observed due to the country's underdeveloped
corporate sector
V. C
I and III
Two of the assumptions of the CAPM state that:

a. Individual investors are price takers

b. Information is costless and available to all investors

In this case, these assumptions are violated: 

a) The absence of market depth would move market if the large trades are carried out, thus
moving the price significantly; and 
b) Insider trading makes information available to a select few, thus giving some investors an
advantage over others. In the absence of these two assumptions, the CAPM does not hold,
and there would be deviations.

6) Country A, a developing economy, has recently witnessed agovernment’s renewed interest

and effort in reforming the financial sector. A recent report published by a non-governmental
organization (NGO) indicates the presence of rampant insider trading. The report also points
towards the lack of depth in the financial market which poses significant problems for investors
and market participants. However, the presence of natural resources in the country makes it an
attractive destination for foreign investors.

A fund manager states that the risk premium as predicted by the CAPM will understate the actual
risk premium. Which of the following statements is correct?

A
The manager is incorrect, as the insider trading will reduce the risk premium

B
The manager is incorrect, as the absence of market depth will reduce the risk premium

C
The manager is correct, as information is not freely available to all investors

D
The manager is correct, as the market depth reduces the risk-free rate

The correct answer is: C).

As the information is not freely available and due to rampant insider trading, most investors will
demand an additional risk premium in order to invest in the market. Thus, the risk premium as
predicted by CAPM will be understated as compared to actual risk premium observed in the
market.

7) Country A is a developed economy with a vibrant financial sector. It witnessed a major

financial crisis around 15 years ago. The economy recovered quite well and has consistently
registered positive economic growth over the years. A recent survey conducted by an equity
research firm indicated that the country’s fund managers have built a well-diversified portfolio
inclusive of all the sectors of the economy. The survey also highlighted the fact that the fund
managers generally used historical data of the last 10 years and mean-variance utility to
determine the correlations between the different assets. Asked why they preferred data from the
last 10 years, most managers were of the view that recent data was the best estimator of the
correlation between the different assets.

Which of the following statements is accurate regarding the case?

A
 The correlation between the assets will be underestimated

B
The correlation between the assets will be overestimated

C
The correlation between the assets is independent of the time period

D
None of the above

he correct answer is: A).

During a financial crisis, returns on most assets move in the same direction i.e., the correlation
between different assets increases. The fund managers use data for the last 10 years to estimate
the correlation between the assets, effectively excluding figures from the financial crisis. Hence,
the correlation between the assets will be underestimated.

8) Country A is a developed economy with a vibrant financial sector. It witnessed a major

financial crisis around 15 years ago. The economy recovered quite well and has consistently
registered positive economic growth over the years. A recent survey conducted by an equity
research firm indicated that the country’s fund managers have built a well-diversified portfolio
inclusive of all the sectors of the economy. The survey also highlighted the fact that the fund
managers generally used historical data of the last 10 years and mean-variance utility to
determine the correlations between the different assets. Asked why they preferred data from the
last 10 years, most managers were of the view that recent data was the best estimator of the
correlation between the different assets.

Suppose the country faces a major economic crisis, which of the following is the most
appropriate statement?

A
The fund managers would not be affected as their portfolios are well diversified

B
Portfolio diversification would most likely fail and lead to losses

C
The returns from the fund would most likely beat other similar funds

D
None of the above

The correct answer is: B).

The correlation between various assets increases during a financial crisis, as happened in the
2007/2008 crisis. This means that the returns on various assets move in the same direction,
effectively eroding the benefits of diversification.

9) Country A is a developed economy with a vibrant financial sector. It witnessed a major

financial crisis around 15 years ago. The economy recovered quite well and has consistently
registered positive economic growth over the years. A recent survey conducted by an equity
research firm indicated that the country’s fund managers have built a well-diversified portfolio
inclusive of all the sectors of the economy. The survey also highlighted the fact that the fund
managers generally used historical data of the last 10 years and mean-variance utility to
determine the correlations between the different assets. Asked why they preferred data from the
last 10 years, most managers were of the view that recent data was the best estimator of the
correlation between the different assets.

The best model that can be applied to determine the behavior of assets during a crisis is:

A
The Capital Asset Pricing Model

B
A single-factor model

C
A multi-factor model

D
None of the above

The correct answer is: C).

Many risky assets registered a dismal performance during the 2007/2008 financial crisis, and this
ran in congruence with a multifactor model in which many assets were exposed to the same set
of risk factors. These factors include liquidity, slow economic growth rate, and uncertainty
regarding government/monetary policy.

10) Country A is a developed economy with a vibrant financial sector. It witnessed a major
financial crisis around 15 years ago. The economy recovered quite well and has
consistently registered positive economic growth over the years. A recent survey
conducted by an equity research firm indicated that the country’s fund managers have
built a well-diversified portfolio inclusive of all the sectors of the economy. The survey
also highlighted the fact that the fund managers generally used historical data of the last
10 years and mean-variance utility to determine the correlations between the different
assets. Asked why they preferred data from the last 10 years, most managers were of
the view that recent data was the best estimator of the correlation between the different
assets.

The major shortcoming of using mean-variance utility to implement diversification is that:

A
It assumes the correlation between assets classes is constant

B
It assumes the correlation between asset classes is not constant

C
It assumes the correlation between asset classes increases in a linear manner

D
It assumes the correlation between asset classes increases exponentially

The correct answer is: A).

The mean-variance utility assumes that the correlation between asset classes remains constant.
However, it has been observed that factor exposures vary through time giving rise to time-
varying correlations.

11) Country A has a well-developed financial market. Information is freely available and is
accessible by each market participant. A company involved in oil exploration recently
 discovered huge oil reserves. The stock price of the company after the disclosure of the
information is presented below. 

As indicated by the graph, the financial market of the country can most likely be
explained using:
A
The semi-strong form of market hypothesis
B
The strong form of Efficient market hypothesis
C
The weak form of efficient market hypothesis
D
None of the above

The correct answer is: B).

The stock market does not react to the new information regarding the discovery of huge oil
reserves by the company. This indicates that the share price reflects all information present in
the market, including other aspects. Hence, the market can most likely be described using the
strong form of the efficient market hypothesis.

An investment management firm situated in country A promises a return in excess of the market
return. Select the most appropriate statement:
A
Returns will not exceed the market return.
B
Active management may indeed result in excess return.
C
Passive management may indeed result in excess return.
D
None of the above
The correct answer is: A).

The stock market does not react to the new information regarding the discovery of huge oil
reserves by the company. This indicates that the share price reflects all information present in
the market. Furthermore, information is freely and easily accessible by every market participant.
In such markets, it would be impossible to beat the market. Actual returns can never exceed the
market return.

12) Consider the graph presented below. The line represents the security market line derived
from the Capital Asset Pricing Model (CAPM).A, B, C, M, O, X, and Y all represent different
stocks.

According to CAPM, stock A is:

A
Undervalued

B
Overvalued

C
Dependent on the financial market

D
Appropriately valued
The correct answer is: A).

Stock A lies above the SML. The return on the stock is more than its expected return as
predicted by the CAPM. As such, the stock is undervalued and therefore a good buy.

13) According to CAPM, stock C is:

A
Undervalued

B
Overvalued

C
Dependent on the financial market

D
Appropriately valued

The correct answer is: B).

Stock C lies below the SML, thus its return less than that predicted by the CAPM. As such, the
stock is overvalued and is therefore a good sell.

14) Stock X is subjected to a capital gain tax of 25%. What’s the most likely effect of taxes on
stock X?

A
The observed return of the stock will be as predicted by CAPM

B
The observed return of the stock will be more than that predicted by CAPM

C
The observed return of the stock will be less than that predicted by CAPM

D
None of the above

The correct answer is: B).

CAPM is based on the assumption that assets are not subject to taxation. However, when tax is
levied on the assets the expected return is in excess of that predicted by CAPM. Hence, the
observed return of stock X will be more than the CAPM predicted return.

15) Which statement is not true regarding the Capital Market Line (CML)?

A
The risk measure for the CML is standard deviation.

B
The CML is the line from the risk-free rate through the market portfolio.

C
 The CML is the best attainable capital allocation line.

D
The CML is also called the security market line.

The correct answer is: D).

Both the Capital Market Line and the Security Market Line depict risk/return relationships.
However, while the risk measure for the CML is standard deviation, the risk measure for the SML
is beta (thus d is not true; the other statements are true).

16) Assume that the economy faces a crisis which leads to a recession. In such a scenario, the
SML will most likely:

A
Shift downwards

B
Shift upwards

C
Remain the same

D
None of the above

The correct answer is: B).

As the economy faces a recession the risk premium demanded by the investors will increase. As
the risk premium increases, the expected return from each asset will increase thus shifting the
SML upwards.

Expected Return = Rf + β(Risk premium)

As the risk premium increases, the expected return also increases.

17) Which of the following reasons best explains why it is advisable for asset owners to hold the
market portfolio as compared to individual stocks?

A
The individual stocks are not only exposed to the market factor which carries the risk
premium, but they also have idiosyncratic risk, which is not rewarded by a risk premium

B
Individual stocks represent a systemic risk, and it is not passive since all risky assets
have risk premiums that are only determined by their exposure to the market portfolio

C
The market portfolio is not held by every investor, which has a strong implication that is
not outright rejected in the data

D
All of the above

The correct answer is: A).

As compared to individual stocks, asset owners are better off holding the factor. This can be
attributed to the fact that individual stocks are exposed to the market factor carrying the risk
premium. Furthermore, they have idiosyncratic (specificc) risk which is not rewarded by a risk
premium.
18) Which of the following best describes assets with the high beta?

A
High beta assets have lower volatility, or systemic risk, in comparison to the market and,
therefore, tend to move slowly in response to market changes

B
High beta assets are assets that tend to go up when the market goes up and goes down
when the market goes down

C
High beta assets are assets that have a tendency of going down when the market goes
up and moves up as the market goes down

D
High beta assets are assets whose prices are less volatile than the market portfolio

The correct answer is: B).

Theoretically, high beta assets have prices that are more volatile than the market, and these
assets have a tendency of going up as the market goes up, and down when the market moves
down.

19)