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

Chapter 10 Arbitrage Pricing Theory and Multifactor Models of Risk and Return Multiple Choice Questions

1. ___________ a relationship between expected return and risk. A. APT stipulates B. CAPM stipulates C. Both CAPM and APT stipulate D. Neither CAPM nor APT stipulate E. No pricing model has found

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

7. An arbitrage opportunity exists if an investor can construct a __________ investment portfolio that will yield a sure profit. A. small positive B. small negative C. zero D. large positive E. large negative

8. The APT was developed in 1976 by ____________. 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

9. A _________ portfolio is a well-diversified portfolio constructed to have a beta of 1 on one of the factors and a beta of 0 on any other factor. A. factor B. market C. index D. 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.

12. The ____________ provides an unequivocal statement on the expected return-beta 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 welldiversified 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 welldiversified 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 welldiversified 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%

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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

35. In terms of the risk/return relationship in the APT 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.

36. The following factors might affect stock 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.

37. Advantage(s) of the APT is(are) A. that the model provides specific guidance concerning the determination of the risk premiums on the factor portfolios. 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

39. An important difference between CAPM and APT is 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 mergertarget 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

42. A well-diversified portfolio is defined as A. one that is diversified over a large enough number of securities that the nonsystematic variance is essentially zero. 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.

43. The APT requires a benchmark portfolio 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 welldiversified 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%

46. The term "arbitrage" refers to 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.

47. To take advantage of an arbitrage opportunity, an investor would 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

48. The factor F in the APT model represents 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 b...