Tutorial work - week 5 PDF

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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 Both models attempt to explain asset pricing based on risk/return relationships. 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% 17.6% = 1.45(3.2%) + .86x + 5%; x = 9.26. 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. 4. 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.

5. 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 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. 6. The APT was developed in 1976 by ____________. A. Lintner B. Modigliani and Miller C. Ross D. Sharpe E. Fama Ross developed this model in 1976. 7. 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 Arbitrage is earning of positive profits with a zero (risk-free) investment. 8. 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 Total risk (uncertainty) is assumed to be composed of both macroeconomic and firm-specific factors. 9. 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. 10. 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% s2P = (1.1)2(6%) = 7.26%. 11. 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 A: 18% = 6% + bF; B: 8% = 6% + 1.0F; F = 12%; thus, beta of A = 9/12 = 0.75. 12. 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% 17% = x% + 1.2(5%) + 0.7(6%); x = 6.8%. 13. 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 riskfree arbitrage. The larger the positions, the greater the risk-free arbitrage profits.

14. 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. 15. 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. 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. 16. 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. As the number of securities, n, increases, the nonsystematic risk of a well-diversified portfolio approaches zero. 17. 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 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.

18. 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. F measures the unanticipated portion of a factor that is common to all security returns. 19. 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. Fama and French included all three of the factors listed....