Multiple Choice Questions: A. B. C. D
Multiple Choice Questions: A. B. C. D
2. The _______ decision should take precedence over the _____ decision.
A. asset allocation, stock selection
B. bond selection, mutual fund selection
C. stock selection, asset allocation
D. stock selection, mutual fund selection
3. Based on the outcomes in the table below choose which of the statements
is/are correct:
I. The covariance of Security A and Security B is zero
II. The correlation coefficient between Security A and C is negative
III. The correlation coefficient between Security B and C is positive
A. I only
B. I and II only
C. II and III only
D. I, II and III
B
4. Adding additional risky assets to the investment opportunity set will generally
move the efficient frontier _____ and to the ______.
A. up, right
B. up, left
C. down, right
D. down, left
5. An investor's degree of risk aversion will determine his or her ______.
A. optimal risky portfolio
B. risk-free rate
C. optimal mix of the risk-free asset and risky asset
D. capital allocation line
6. The ________ is equal to the square root of the systematic variance divided by
the total variance.
A. covariance
B. correlation coefficient
C. standard deviation
D. reward-to-variability ratio
B
8. The correlation coefficient between two assets equals to _________.
A. their covariance divided by the product of their variances
B. the product of their variances divided by their covariance
C. the sum of their expected returns divided by their covariance
D. their covariance divided by the product of their standard deviations
C
12. The risk that can be diversified away is __________.
A. beta
B. firm specific risk
C. market risk
D. systematic risk
13. Consider an investment opportunity set formed with two securities that are
perfectly negatively correlated. The global minimum variance portfolio has a
standard deviation that is always _________.
A. equal to the sum of the securities standard deviations
B. equal to -1
C. equal to 0
D. greater than 0
D
16. Which one of the following stock return statistics fluctuates the most over
time?
A. Covariance of returns
B. Variance of returns
C. Average return
D. Correlation coefficient
17. Harry Markowitz is best known for his Nobel prize winning work on
_____________.
A. strategies for active securities trading
B. techniques used to identify efficient portfolios of risky assets
C. techniques used to measure the systematic risk of securities
D. techniques used in valuing securities options
18. Suppose that a stock portfolio and a bond portfolio have a zero correlation.
This means that ______.
A. the returns on the stock and bond portfolio tend to move inversely
B. the returns on the stock and bond portfolio tend to vary independently of each
other
C. the returns on the stock and bond portfolio tend to move together
D. the covariance of the stock and bond portfolio will be positive
19. On a standard expected return vs. standard deviation graph investors will
prefer portfolios that lie to the _____________ of the current investment
opportunity set.
A. left and above
B. left and below
C. right and above
D. right and below
A
C
23. The standard deviation of return on investment A is .10 while the standard
deviation of return on investment B is .05. If the covariance of returns on A and B
is .0030, the correlation coefficient between the returns on A and B is _________.
A. .12
B. .36
C. .60
D. .77
Correlation =
B
26. Which risk can be diversified away as additional securities are added to a
portfolio?
I. Total risk
II. Systematic risk
III. Firm specific risk
A. I only
B. I and II only
C. I, II, and III
D. I and III
28. You are recalculating the risk of ACE stock in relation to the market index and
you find the ratio of the systematic variance to the total variance has risen. You
must also find that the ____________.
A. covariance between ACE and the market has fallen
B. correlation coefficient between ACE and the market has fallen
C. correlation coefficient between ACE and the market has risen
D. unsystematic risk of ACE has risen
C
29. A stock has a correlation with the market of 0.45. The standard deviation of
the market is 21% and the standard deviation of the stock is 35%. What is the
stock's beta?
A. 1.00
B. 0.75
C. 0.60
D. 0.55
=
A
32. The market value weighted average beta of firms included in the market
index will always be _____________.
A. 0
B. between 0 and 1
C. 1
D. There is no particular rule concerning the average beta of firms included in the
market index
C
33. Diversification can reduce or eliminate __________ risk.
A. all
B. systematic
C. non-systematic
D. only an insignificant
34. In order to construct a riskless portfolio using two risky stocks, one would
need to find two stocks with a correlation coefficient of ________.
A. 1.0
B. 0.5
C. 0
D. -1.0
36. If an investor does not diversify their portfolio and instead puts all of their
money in one stock, the appropriate measure of security risk for that investor is
the ________.
A. stock's standard deviation
B. variance of the market
C. stock's beta
D. covariance with the market index
37. Which of the following provides the best example of a systematic risk event?
A. A strike by union workers hurts a firm's quarterly earnings.
B. Mad Cow disease in Montana hurts local ranchers and buyers of beef.
C. The Federal Reserve increases interest rates 50 basis points.
D. A senior executive at a firm embezzles $10 million and escapes to South
America.
C
39. Decreasing the number of stocks in a portfolio from 50 to 10 would likely
_________________________.
A. increase the systematic risk of the portfolio
B. increase the unsystematic risk of the portfolio
C. increase the return of the portfolio
D. decrease the variation in returns the investor faces in any one year
42. What is the most likely correlation coefficient between a stock index mutual
fund and the S&P 500?
A. -1.0
B. 0.0
C. 1.0
D. 0.5
C
43. Investing in two assets with a correlation coefficient of -0.5 will reduce what
kind of risk?
A. Market risk
B. Non-diversifiable risk
C. Systematic risk
D. Unique risk
44. Investing in two assets with a correlation coefficient of 1.0 will reduce which
kind of risk?
A. Market risk
B. Unique risk
C. Unsystematic risk
D. With a correlation of 1.0, no risk will be reduced
D
45. A portfolio of stocks fluctuates when the treasury yields change. Since this risk
cannot be eliminated through diversification, it is called __________.
A. firm specific risk
B. systematic risk
C. unique risk
D. none of the above
B
46. As you lengthen the time horizon of your investment period and decide to
invest for multiple years you will find that ________.
I. the average risk per year may be smaller over longer investment horizons
II. the overall risk of your investment will compound over time
III. your overall risk on the investment will fall
A. I only
B. I and II only
C. III only
D. I, II and III
47. You are considering adding a new security to your portfolio. In order to decide
whether you should add the security you need to know the security's _______.
I. expected return
II. standard deviation
III. correlation with your portfolio
A. I only
B. I and II only
C. I and III only
D. I, II and III
D
Chapter 4
An introduction to asset pricing models
TRUE/FALSE QUESTIONS
1 One of the assumptions of Capital Market Theory is that investors
can borrow or lend at the risk-free rate. (T)
2 An assumption of Capital Market Theory is that buying or selling
of assets entails no taxes, but entails significant transaction costs.
(F)
3 A risky asset is an asset with uncertain future returns, and
uncertainty (or risk) is measured by the variance or standard
deviation of returns. (T)
4 The standard deviation of a portfolio that combines the risk-free
asset with risky assets is the linear proportion of the standard
deviation of the risky asset portfolio. (T)
5 The Capital Market Line (CML) is the line from the intercept point
that represents the risk-free rate tangent to the original efficient
frontier. (T)
6 The market portfolio consists of all risky assets. (T)
7 All portfolios on the CML are perfectly negatively correlated,
which means that all portfolios on the CML are perfectly
negatively correlated with the completely diversified market
portfolio since it lies on the CML. (F)
8 Diversification reduces the unsystematic risk in a portfolio. (T)
9 The Capital Asset Pricing Model (CAPM) is a technique for
determining the expected risk on an asset. (F)
10 Beta is a standardized measure of systematic risk. (T)
11 Multifactor models of risk and return can be broadly grouped into
models that use macroeconomic factors and models that use
microeconomic factors. (T)
12 Arbitrage Pricing Theory (APT) specifies the exact number of risk
factors and their identity (F)
13. Betas for defensive portfolios are generally less than one. (T)
14. Using the separation theorem, it is necessary to match each
investor's indifference curves with a particular efficient
portfolio. (F)
15. The CML indicates the required return for each portfolio risk
level. (T)
16. A security that plots above the SML would be a good security to
sell short. (F)
17. Beta is a measure of systematic risk and relates one security's
return to another security's return. (F)
18. The CML states that all investors should invest in the same
portfolio of risky assets. (T)
19. Most analysts use the Dow Jones Industrial Average as proxy for
the market portfolio. (F)
20. Testing of the CAPM suggests the trade-off between expected return
and risk is an upward-sloping straight line. (T)
21. If the overall market is expected to rise, a portfolio manager
should increase the beta of the portfolio. (T)
22. Unlike the CAPM, the APT does not assume borrowing and
lending at the risk-free rate. (T)
23. With the APT, risk is defined in terms of a stock's sensitivity to
basic economic factors. (T)
24. Like the CAPM, the APT assumes a single-period investment
horizon. (F)
25. Both the CAPM and the APT assume that markets are perfect.
(T)
26. The APT is based on the law of one price, which states two
identical assets cannot sell at different prices. (T)
a) Lending, borrowing
b) Risk, return
c) Investing, financing
d) Risky assets, risk free assets
e) Buying stocks, buying bonds
E
8 The Security Market Line (SML) represents the relation between
a) Confidence risk.
b) Maturity risk.
c) Expected inflation risk.
d) Call risk.
e) Return difference between small capitalization and large
capitalization stocks.
a) Confidence risk.
b) Maturity risk.
c) Expected inflation risk.
d) Call risk.
e) Return difference between small capitalization and large
capitalization stocks.
a. Risk-free Model.
b. CAPM.
c. CML.
d. Market Model.
D
14 Under the Market Model, the regression line that results when the return
of a security is plotted against the market index return is the:
a. SML.
b. CML.
c. characteristic line.
d. slope.
16 The arbitrage pricing theory (APT) and the CAPM both assume all except
which of the following?
17 Risk factors in the APT must possess all of the following the characteristics
except:
a. Factors must be readily observable in risk/return space.
b. Each factor must have a pervasive influence on stock returns
c. The factors must influence expected return.
d. Factors must be unpredictable.
A
a. law of averages.
b. law of attraction.
c. law of accelerating return.
d. law of one price.
B
Chapter 4 (CAPM & APT)
Questions of CAPM
Q.1. You expect an RFR of 10 percent and the market return (RM) of 14 percent.
Compute the expected(required) return for the following stocks.
Stock Beta E(Ri)
U 0.85
N 1.25
D –0.20
Solution. E(Ri) = RFR + βi(RM - RFR)
= .10 + βi (.14 - .10)
= .10 + .04βi
Stock Beta (Required Return) E(Ri) = .10 + .04βi
U 85 .10 + .04(0.85) = .10 + .034 = .134
N 1.25 .10 + .04(1.25) = .10 + .05 = .150
D -.20 .10 + .04(-.20) = .10 - .008 = .092
Q.2. You ask a stockbroker what the firm’s research department expects for these
stocks. The broker responds with the following information:
Stock Current Price Expected Price Expected Dividend
U 22 24 0.75
N 48 51 2.00
D 37 40 1.25
Indicate what actions you would take with regard to these stocks. Discuss your
decisions.
Solution.
Stock Current Price Expected Price Expected Dividend Estimated
Return
U 22 24 0.75 24 - 22 + 0.75
-----------------= .
1250
22
N 48 51 2.00 51 - 48 + 2.00
--------------- =
0.1042
48
D 37 40 1.25 40 - 37 + 1.25
------------------ =
0.1149
37
Solution.
a.
Cov i,m Cov i,m
βi = -------------- and ri,m = -------------
σ2m (σi) (σm)
Q.4. The following are the historic returns for the Chelle Computer Company:
Year Chelle Computer General Index
1 37 15
2 9 13
3 −11 14
4 8 −9
5 11 12
6 4 9
Questions of APT
Q.1. Consider the following data for two risk factors (1 and 2) and two securities (J
and L):
λ0 = 0.05 bJ1 = 0.80
λ1 = 0.02 bJ2 = 1.40
λ2 = 0.04 bL1 = 1.60
bL2 = 2.25
a. Compute the expected returns for both securities.
b. Suppose that Security J is currently priced at SAR 22.50 while the price of
Security L is SAR 15.00. Further, it is expected that both securities will pay a
dividend of SAR 0.75 during the coming year. What is the expected price of each
security one year from now?
Solution.
1(a). In general, for the APT, E(Rq) = λ0 + λ1bq1 + λ2bq2
For security J:
E(RJ) = 0.05 + 0.02x0.80 + 0.04x1.40
= 0.05 + 0.016 + 0.056
= .1220 or 12.20%
For Security L:
E(RL) = 0.05 +0.02x1.60 + 0.04x2.25
= 0.05 + 0.032 + 0.09
= .172 or 17.20%
1(b). Total return = dividend yield + capital gain yield
For security J, the dividend yield is SAR0.75/SAR22.50 = 0.033 or 3.33%
For security L, the dividend yield is SAR0.75/SAR15.00 = 0.05 or 5%
For security J, the expected capital gain is therefore 12.20%– 3.33% = 8.87%
For security L the expected capital gain is therefore 17.20% - 5.00% = 12.20%
Therefore:
The expected price for security J is SAR22.50x (1.0887) = SAR25.50
The expected price for security L is SAR15.00x (1.1220) = SAR16.83
Q.2. You have been assigned the task of estimating the expected returns for three
different stocks: QRS, TUV, and WXY. Your preliminary analysis has established
the historical risk premiums associated with three risk factors that could potentially
be included in your calculations: the excess return on a proxy for the market
portfolio (MKT), and two variables capturing general macroeconomic exposures
(MACRO1 and MACRO2). These values are: λMKT = 7.5%, λMACRO1 = −0.3%, and
λMACRO2 = 0.6%. You have also estimated the following factor betas (i.e., loadings)
for all three stocks with respect to each of these potential risk factors:
FACTOR LOADING
Stock MKT MACRO1 MACRO2
QRS 1.24 −0.42 0.00
TUV 0.91 0.54 0.23
WXY 1.03 −0.09 0.00
a. Calculate expected returns for the three stocks using just the MKT risk factor.
Assume a risk-free rate of 4.5%.
b. Calculate the expected returns for the three stocks using all three risk factors and
the same 4.5% risk-free rate.
c. Discuss the differences between the expected return estimates from the single-
factor model and those from the multifactor model. Which estimates are most
likely to be more useful in practice?
Solution.
for the APT, E(Rq) = λ0 + λ1bq1
(a). RQRS = 4.5 +7.5x1.24
= 4.5 + 9.3
= 13.8%
RTUV = 4.5 + 7.5x0.91
= 4.5 + 6.825
= 11.325%
RWXY = 4.5 + 7.5x1.03
= 4.5 +7.725
= 12.225%
(b). for the APT, E(Rq) = λ0 + λ1bq1 + λ2bq2
RQRS = 4.5 + 7.5x1.24 + (-0.3) x (-0.42) + 0.6x0.00
= 4.5 + 9.30 + 0.126 +0.00
= 13.926%
RTUV = 4.5 + 7.5x0.91 + (-0.3) x (0.54) + 0.6x0.23
= 4.5 + 6.825 – 0.162 + 0.138
= 11.301%
RWXY = 4.5 + 7.5x1.03 + (-0.3) x (-0.09) +0.6x0.00
= 4.5 + 7.725 + 0.027 + 0.00
= 12.252%
(c). Assuming that the factor loadings are significant the three factor model should
be more useful to the extent that the non-market factors pick up movements in
returns not captured by the market return.
Q.3. Suppose that three stocks (A, B, and C) and two common risk factors (1 and
2) have the following relationship:
E(RA) = (1.1) λ1 + (0.8) λ2
E(RB) = (0.7) λ1 + (0.6) λ2
E(RC) = (0.3) λ1 + (0.4) λ2
a. If λ1 = 4% and λ2 = 2%, what are the prices expected next year for each of the
stocks? Assume that all three stocks currently sell for SAR30 and will not pay a
dividend in the next year.
Solution.
(a). Because no stock pays a dividend, all return is due to price appreciation.
E(RA) = 1.1x0.04 + 0.8x0.02
= 0.044 + 0.016
= 0.06 or 6%