2. 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) None of the above is a true statement.
6. 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) none of the above
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
11. 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 well-diversified portfolio is approximately __________.
A) 3.6%
B) 6.0%
C) 7.3%
D) 10.1%
E) none of the above
12. 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
well-diversified portfolio is approximately __________.
A) 0.80
B) 1.13
C) 1.25
D) 1.56
E) none of the above
14. 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) none of the above
15. 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) none of the above
17. 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) none of the above
18. 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) none of the above
20. 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) none of the above
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:
21. 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) none of the above
22. 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) none of the above
23. 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) none of the above
Consider the multifactor APT. There are two independent economic factors, F1 and F2. The
risk-free rate of return is 6%. The following information is available about two well-diversified
portfolios:
25. Assuming no arbitrage opportunities exist, the risk premium on the factor F1 portfolio
should be __________.
A) 3%
B) 4%
C) 5%
D) 6%
E) none of the above
27. 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) none of the above
28. 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) none of the above
30. 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) none of the above
34. 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.
36. A professional who searches for mispriced securities in specific areas such as merger-
target 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) none of the above.
I) the expected return-beta relationship is maintained for all but a small number of
well-diversified 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 IV
B) I and III
C) II and III
D) I, III, and IV
E) II, III, and IV
46. 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.
47. If arbitrage opportunities are to be ruled out, each well-diversified portfolio's expected
excess return must be
A) inversely proportional to the risk-free rate.
B) inversely proportional to its standard deviation.
C) proportional to its weight in the market portfolio.
D) proportional to its standard deviation.
E) proportional to its beta coefficient.
50. In a factor model, the return on a stock in a particular period will be related to
A) factor risk.
B) non-factor risk.
C) standard deviation of returns.
D) both A and B are true.
E) none of the above is true.
52. 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 the above factors were included in their model.
E) None of the above factors was included in their model.
53. Which of the following factors did Merton not suggest as a likely source of uncertainty
that might affect security returns?
A) uncertainties in labor income.
B) prices of important consumption goods.
C) book-to-market ratios.
D) changes in future investment opportunities.
E) All of the above are sources of uncertainty affecting security returns.
55. Multifactor models seek to improve the performance of the single-index model by
A) modeling the systematic component of firm returns in greater detail.
B) incorporating firm-specific components into the pricing model.
C) allowing for multiple economic factors to have differential effects
D) all of the above are true.
E) none of the above is true.
56. Multifactor models such as the one constructed by Chen, Roll, and Ross, can better
describe assets' returns by
A) expanding beyond one factor to represent sources of systematic risk.
B) using variables that are easier to forecast ex ante.
C) calculating beta coefficients by an alternative method.
D) using only stocks with relatively stable returns.
E) ignoring firm-specific risk.
58. Consider the multifactor APT. The risk premiums on the factor 1 and factor 2 portfolios
are 6% and 4%, respectively. The risk-free rate of return is 4%. Stock A has an
expected return of 16% and a beta on factor 1 of 1.3. Stock A has a beta on factor 2 of
________.
A) 1.33
B) 1.05
C) 1.67
D) 2.00
E) none of the above
61. Consider the single factor APT. Portfolio A has a beta of 0.5 and an expected return of
12%. Portfolio B has a beta of 0.4 and an expected return of 13%. The risk-free rate of
return is 5%. 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) none of the above
62. Consider the one-factor APT. The variance of returns on the factor portfolio is 9%.
The beta of a well-diversified portfolio on the factor is 1.25. The variance of returns on
the well-diversified portfolio is approximately __________.
A) 3.6%
B) 6.0%
C) 7.3%
D) 14.1%
E) none of the above
64. Consider the single-factor APT. Stocks A and B have expected returns of 12% and
14%, respectively. The risk-free rate of return is 5%. Stock B has a beta of 1.2. If
arbitrage opportunities are ruled out, stock A has a beta of __________.
A) 0.67
B) 0.93
C) 1.30
D) 1.69
E) none of the above
65. 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) none of the above
66. Discuss the advantages of arbitrage pricing theory (APT) over the capital asset pricing
model (CAPM) relative to diversified portfolios.
Difficulty: Moderate
Answer:
The APT does not require that the benchmark portfolio in the SML relationship be the
true market portfolio. Any well-diversified portfolio lying on the SML may serve as a
benchmark portfolio. Thus, the APT has more flexibility than the CAPM, as problems
associated with an unobservable market portfolio are not a concern with APT. In
addition, the APT provides further justification for the use of the index model for
practical implementation of the SML relationship. That is, if the index portfolio is not a
precise proxy for the true market portfolio, which is a cause of considerable concern in
the context of the CAPM, if an index portfolio is sufficiently diversified, the SML
relationship holds, according to APT.
This question is designed to determine if the student understands the basic advantages of
APT over the CAPM.
67. Discuss the advantages of the multifactor APT over the single factor APT and the
CAPM. What is one shortcoming of the multifactor APT and how does this
shortcoming compare to CAPM implications?
Difficulty: Moderate
Answer:
The single factor APT and the CAPM assume that there is only one systematic risk
factor affecting stock returns. However, obviously several factors may affect stock
returns. Some of these factors are: business cycles, interest rate fluctuations, inflation
rates, oil prices, etc. A multifactor model can accommodate these multiple sources of
risk.
One shortcoming of the multifactor APT is that the model provides no guidance
concerning the risk premiums on the factor portfolios. The CAPM implies that the risk
premium on the market is determined by the market's variance and the average degree of
risk aversion across investors.
68. Discuss arbitrage opportunities in the context of violations of the law of one price.
Difficulty: Easy
Answer:
The law of one price is violated when an asset is trading at different prices in two
markets. If the price differential exceeds the transactions costs, a simultaneous trade in
the two markets can produce a sure profit with a zero investment. That is, the investor
can sell short the asset in the high-priced market and buy the asset in the low-priced
market. The investor has been able to assume these positions with a zero investment
(using the proceeds of the short transaction to finance the long position). However, it
should be remembered that individual investors do not have access to the proceeds of a
short transaction until the position has been covered.
69. Discuss the similarities and the differences between the CAPM and the APT with
regard to the following factors: capital market equilibrium, assumptions about risk
aversion, risk-return dominance, and the number of investors required to restore
equilibrium.
Difficulty: Difficult
Answer:
Both the CAPM and the APT are market equilibrium models, which examine the factors
that affect securities' prices. In equilibrium, there are no overpriced or underpriced
securities. In both models, mispriced securities can be identified and purchased or sold
as appropriate to earn excess profits.
The CAPM is based on the idea that there are large numbers of investors who are
focused on risk-return dominance. Under the CAPM, when a mispricing occurs, many
individual investors make small changes in their portfolios, guided by their degrees of
risk aversion. The aggregate effect of their actions brings the market back into
equilibrium. Under the APT, each investor wants an infinite arbitrage position in the
mispriced asset. Therefore, it would not take many investors to identify the arbitrage
opportunity and act to bring the market back to equilibrium.
The student can compare the two models by focusing on the specific items.
70. Security A has a beta of 1.0 and an expected return of 12%. Security B has a beta of
0.75 and an expected return of 11%. The risk-free rate is 6%. Explain the arbitrage
opportunity that exists; explain how an investor can take advantage of it. Give specific
details about how to form the portfolio, what to buy and what to sell.
Difficulty: Moderate
Answer:
An arbitrage opportunity exists because it is possible to form a portfolio of security A
and the risk-free asset that has a beta of 0.75 and a different expected return than
security B. The investor can accomplish this by choosing .75 as the weight in A and .25
in the risk-free asset. This portfolio would have E(rp) = 0.75(12%) + 0.25(6%) =
10.5%, which is less than B's 11% expected return. The investor should buy B and
finance the purchase by short selling A and borrowing at the risk-free asset.
71. Name three variables that Chen, Roll, and Ross used to measure the impact of
macroeconomic factors on security returns. Briefly explain the reasoning behind their
model.
Difficulty: Difficult
Answer:
The factors they considered were IP (the % change in industrial production), EI (the %
change in expected inflation), UI (the % change in unanticipated inflation), CG (excess
return of long-term corporate bonds over long-term government bonds), and GB
(excess return of long-term government bonds over T-bills). The rational for their
model is that many different economic factors can combine to affect securities' returns.
Also, by including factors that are related to the business cycle, the estimation of beta
coefficients should be improved. Each beta will represent only the impact of the
corresponding variable on returns.
The student has some flexibility in remembering which variables were used in the study.
A general understanding of macroeconomic variables will be helpful in answering the
question. The question provides an opportunity to measure the student's understanding
of the types of risk that are relevant and how they can be explicitly considered in the
model.