Chapter 3

Multiple Choice Questions

1. Risk that can be eliminated through diversification is called ______ risk. 

A. unique
B. firm-specific
C. diversifiable
D. all of the above

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

7. Which of the following statistics cannot be negative? 

A. Covariance
B. Variance
C. E[r]
D. Correlation coefficient

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

9. Diversification is most effective when security returns are _________. 

A. high
B. negatively correlated
C. positively correlated
D. uncorrelated

10. The expected rate of return of a portfolio of risky securities is _________. 

A. the sum of the securities' covariances
B. the sum of the securities' variances
C. the weighted sum of the securities' expected returns
D. the weighted sum of the securities' variances

11. Beta is a measure of security responsiveness to _________. 

A. firm specific risk
B. diversifiable risk
C. market risk
D. unique risk

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

14. Market risk is also called __________ and _________. 

A. systematic risk, diversifiable risk
B. systematic risk, nondiversifiable risk
C. unique risk, nondiversifiable risk
D. unique risk, diversifiable risk

15. Firm specific risk is also called __________ and __________. 

A. systematic risk, diversifiable risk
B. systematic risk, non-diversifiable risk
C. unique risk, non-diversifiable risk
D. unique risk, diversifiable risk

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

20. The term "complete portfolio" refers to a portfolio consisting of

_________________. 
A. the risk-free asset combined with at least one risky asset
B. the market portfolio combined with the minimum variance portfolio
C. securities from domestic markets combined with securities from foreign
markets
D. common stocks combined with bonds

21. Rational risk-averse investors will always prefer portfolios _____________. 

A. located on the efficient frontier to those located on the capital market line
B. located on the capital market line to those located on the efficient frontier
C. at or near the minimum variance point on the efficient frontier
D. that are risk-free to all other asset choices

22 The optimal risky portfolio can be identified by finding ____________.

I. the minimum variance point on the efficient frontier
II. the maximum return point on the efficient frontier the minimum variance point
on the efficient frontier
III. the tangency point of the capital market line and the efficient frontier
IV. the line with the steepest slope that connects the risk free rate to the efficient
frontier 
A. I and II only
B. II and III only
C. III and IV only
D. I and IV only

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 =

24. A measure of the riskiness of an asset held in isolation is ____________. 

A. beta
B. standard deviation
C. covariance
D. semi-variance

25. The part of a stock's return that is systematic is a function of which of the

following variables?
I. Volatility in excess returns of the stock market
II. The sensitivity of the stock's returns to changes in the stock market
III. The variance in the stock's returns that is unrelated to the overall stock
market 
A. I only
B. I and II only
C. II and III only
D. I, II and III 

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

27. The term excess-return refers to ______________. 

A. returns earned illegally by means of insider trading
B. the difference between the rate of return earned and the risk-free rate
C. the difference between the rate of return earned on a particular security and
the rate of return earned on other securities of equivalent risk
D. the portion of the return on a security which represents tax liability and
therefore cannot be reinvested

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

=

30. The values of beta coefficients of securities are __________. 

A. always positive
B. always negative
C. always between positive 1 and negative 1
D. usually positive, but are not restricted in any particular way

31. A security's beta coefficient will be negative if ____________. 

A. its returns are negatively correlated with market index returns
B. its returns are positively correlated with market index returns
C. its stock price has historically been very stable
D. market demand for the firm's shares is very low

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

35. Some diversification benefits can be achieved by combining securities in a

portfolio as long as the correlation between the securities is _____________. 
A. 1
B. less than 1
C. between 0 and 1
D. less than or equal to 0
B

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.

38. Which of the following statements is true regarding time diversification?

I. The standard deviation of the average annual rate of return over several
years will be smaller than the one-year standard deviation.
II. For a longer time horizon, uncertainty compounds over a greater number
of years.
III. Time diversification does not reduce risk. 
A. I only
B. II only
C. II and III only
D. I, II and III
E. None of the statements are correct

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

40. Which of the following correlations coefficients will produce the least

diversification benefit? 
A. -0.6
B. -0.3
C. 0.0
D. 0.8

41. Which of the following correlation coefficients will produce the most

diversification benefits? 
A. -0.6
B. -0.9
C. 0.0
D. 0.4

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)

MULTIPLE CHOICE QUESTIONS

1 Which of the following is not an assumption of the Capital Market

Theory?

a) All investors are Markowitz efficient investors.

b) All investors have homogeneous expectations.
c) There are no taxes or transaction costs in buying or selling
assets.
d) There are no risk-free assets.
e) All investors have the same one period time horizon.

2 The market portfolio consists of all

f) New York Stock Exchange stocks.

g) International stocks and bonds.
h) Stocks and bonds.
i) U.S. and non-U.S. stocks and bonds.
j) Risky assets.
 E

3 The separation theorems divide decisions on from decisions on .

a) Lending, borrowing
b) Risk, return
c) Investing, financing
d) Risky assets, risk free assets
e) Buying stocks, buying bonds

4 When identifying undervalued and overvalued assets, which of the

following statements is false?

f) An asset is properly valued if its estimated rate of return is

equal to its required rate of return.
g) An asset is considered overvalued if its estimated rate of return
is below its required rate of return.
h) An asset is considered undervalued if its estimated rate of
return is above its required rate of return.
i) An asset is considered overvalued if its required rate of return is
below its estimated rate of return.
j) None of the above (that is, all are true statements)

5 Utilizing the security market line an investor owning a stock with a

beta of (-2) would expect the stock's return to in a market that
was expected to decline 10 percent.

a) Rise or fall an indeterminate amount

 b) Rise by 20.0%
c) Fall by 20.0%
d) Rise by 10.2%
e) Fall by 10.2%
B
6 The Capital Market Line (CML) refers to the efficient formed by
creating portfolios that

a) Invest solely in the market portfolio M.

b) Lend at the risk free asset and invest in the market portfolio.
c) Borrow at the risk free asset and invest in the market portfolio.
d) Lend and borrow at the risk free rate and invest in the market
portfolio.
e) Short sell the market portfolio.

(e) 7 As the number of stocks in a portfolio increases

a) The expected return of the portfolio increases because

systematic risk decreases.
b) The expected return of the portfolio increases because
unsystematic risk decreases.
c) The standard deviation of the portfolio increases because
systematic risk increases.
d) The standard deviation of the portfolio decreases because
systematic risk increases.
e) The standard deviation of the portfolio decreases because
unsystematic risk decreases.

E
 8 The Security Market Line (SML) represents the relation between

a) Risk and required return on an asset.

b) Systematic risk and required return on an asset.
c) Risk and return on a diversified portfolio of assets.
d) Unsystematic risk and required return on an asset
e) Systematic risk and required return on a diversified portfolio of
assets.

9 In a macro-economic based risk factor model the following factor

would be one of many appropriate factors

a) Confidence risk.
b) Maturity risk.
c) Expected inflation risk.
d) Call risk.
e) Return difference between small capitalization and large
capitalization stocks.

(d) 10 In a multifactor model, confidence risk represents

a) Unanticipated changes in the level of overall business activity.

b) Unanticipated changes in investors’ desired time to receive
payouts.
c) Unanticipated changes in short term and long term inflation
rates.
d) Unanticipated changes in the willingness of investors to take on
investment risk.
e) None of the above.
 D

11 In a multifactor model, time horizon risk represents

a) Unanticipated changes in the level of overall business activity.

b) Unanticipated changes in investors’ desired time to receive
payouts.
c) Unanticipated changes in short term and long term inflation
rates.
d) Unanticipated changes in the willingness of investors to take on
investment risk.
e) None of the above.

12 In a micro-economic based risk factor model the following factor

would be one of many appropriate factors

a) Confidence risk.
b) Maturity risk.
c) Expected inflation risk.
d) Call risk.
e) Return difference between small capitalization and large
capitalization stocks.

13 A less restrictive form of the Single Index Model is the:

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.

15 Which of the following is not one of the reasonable conclusions of the

CAPM reached by a consensus of the empirical results?

a. The intercept term is generally higher than the RF.

b. The SML appears to be non-linear.
c. The slope of the CAPM is generally less steep than suggested by
the theory.
d. All of the above are supported by empirical tests.

16 The arbitrage pricing theory (APT) and the CAPM both assume all except
which of the following?

a. Investors have homogeneous beliefs.

b. Investors are risk-averse utility maximizers.
c. Borrowing and lending can be done at the rate RF.
d. Markets are perfect.

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

18 Which of the following might be used as a factor in an APT factor

model?

a. The risk-free rate

b. Expected inflation
c. Unanticipated deviations from expected inflation
d. Loss by fire at a company’s manufacturing plant

19 The arbitrage pricing theory (APT)

a. considers only one factor and is a narrower model than the

CAPM.
b. considers more factors than the CAPM and is a broader model.
c. is useful only for well-diversified portfolios of common stock.
d. is easy to practice because the factors are readily observable.
A

20 The APT is based on the:

a. law of averages.
b. law of attraction.
c. law of accelerating return.
d. law of one price.

21 The Capital Asset Pricing Model:

a. has serious flaws because of its complexity.
 b. measures relevant risk of a security and shows the relationship
between risk and expected return.
c. was developed by Markowitz in the 1930s.
d. discounts almost all of the Markowitz portfolio theory.

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

Stock Beta Required Estimated Evaluation

U 0.85 0 .134 0.1250 Overvalued
N 1.25 0.150 0.1042 Overvalued
D - 0.20 0 .092 0.1149 Undervalued
If you believe the appropriateness of these estimated returns, you would buy stocks
D and sell stocks U and N.
Q.3. Based on five years of monthly data, you derive the following information for
the companies listed:
Company ai (Intercept) σi r iM
Intel 0.22 12.10% 0.72
Ford 0.10 14.60 0.33
Anheuser Busch 0.17 7.60 0.55
Merck 0.05 10.20 0.60
S&P 500 0.00 5.50 1.00
a. Compute the beta coefficient for each stock.
b. Assuming a risk-free rate of 8 percent and an expected return for the market
portfolio of 15 percent, compute the expected (required) return for all the stocks.

Solution.
a.
Cov i,m Cov i,m
βi = -------------- and ri,m = -------------
σ2m (σi) (σm)

then Cov i,m = (ri,m) (σi) (σm)

For Intel:
Cov i,m = (0.72)(0.1210)(0.0550) = 0.00479
Beta = 0.00479 / (0.055)2 = 0.00479/0.0030 = 1.597
For Ford:
COV i,m = (0.33)(0.1460)(0.0550) = 0.00265
Beta = 0.00265/ 0.0030 = 0.883
For Anheuser Busch:
COV i,m = (0.55)(0.0760)(0.0550) = 0.00230
Beta = 0.00230/ 0.0030 = 0.767
For Merck:
COV i,m = (0.60)(0.1020)(0.0550) = 0.00337
Beta = 0.00337/ 0.0030 = 1.123

b. E(Ri) = RFR + βi (RM - RFR)

= 0.08 + βi (0.15 - 0.08)
= 0.08 + 0.07 βi
Stock Beta E(Ri) = .08 + .07 βi
Intel 1.597 0.08 + 0.1118 = 0.1918
Ford 0.883 0.08 + 0.0618 = 0.1418
Anheuser Busch 0.767 0.08 + 0.0537 = 0.1337
Merck 1.123 0.08 + 0.0786 = 0.1586

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

Based on this information, compute the following:

a. The correlation coefficient between Chelle Computer and the General Index.
b. The standard deviation for the company and the index.
c. The beta for the Chelle Computer Company.
Solution.
Chelle Computer General (R1 -
E(R1) x
Year (R1) Index (RM) R1 - E(R1) RM - E(RM) RM -
E(RM)
1 37 15 27.33 6 163.98
2 9 13 -.67 4
-2.68
3 -11 14 -20.67 5
-103.35
4 8 -9 -1.67 -18
30.06
5 11 12 1.33 3
3.99
6 4 9 -5.67 0
0.00
∑ = 58 ∑= 54 ∑=
92.00
E(R1) = 58/6 E(M) = 54/6
E(R1) = 9.67 E(M) = 9
2
Var1 = [R1 - E(R1)] /N VarM = [RM - E(RM)]2/N
Var1 = 1211.33/6 = 201.89 VarM = 410/6 = 68.33
σ1 = √201.89 = 14.21 σM = √ 68.33 = 8.27
COV 1, M = 92.00/6 = 15.33
(a). The correlation coefficient can be computed as follows:
r1.M = COV 1, M / σ1 σM = 15.33/ (14.21) (8.27) = 15.33/117.52 = 0.13
(b). The standard deviations are: 14.21% for Chelle Computer and 8.27% for
index, respectively.
(c). Beta for Chelle Computer is computed as follows:
β1 = COV 1, M /VarM = 15.33/68.33 = 0.2244

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%

E (Price A) = SAR30(1.06) = SAR31.80

E(RB) = 0.7x0.04 + 0.6x0.02

= 0.28 + .012
= 0.04 or 4%

E (Price B) = SAR30(1.04) = SAR31.20

E(RC) = 0.3x0.04 + 0.4x0.02

= 0.12 + 0.008
= 0.02 or 2%

E (Price C) = SAR30(1.02) = SAR30.60