Deck 8: An Introduction to Asset Pricing Models

Question 1

The portfolios on the capital market line are combinations of the risk-free asset and the market portfolio.

Answer 1

True

Question 2

If you borrow money at the RFR and invest the money in the market portfolio, the rate of return on your portfolio will be higher than the market rate of return.

Answer 2

True

Question 3

Beta is a measure of unsystematic risk.

Answer 3

False

Question 4

The capital market line is the tangent line between the risk free rate of return and the efficient frontier.

Question 5

Using the S&P index as the proxy market portfolio when evaluating a portfolio manager relative to the SML will tend to underestimate the manager's performance.

Question 6

The market portfolio consists of all risky assets.

Question 7

Studies have shown the beta is more stable for portfolios than for individual securities.

Question 8

Studies have shown that a well-diversified investor needs as few as five stocks.

Question 9

Correlation of the market portfolio and the zero-beta portfolio will be linear.

Question 10

Securities with returns that lie above the security market line are undervalued.

Question 11

If the market portfolio is mean-variance efficient it has the lowest risk for a given level of return among the attainable set of portfolios.

Question 12

One of the assumptions of capital market theory is that investors can borrow or lend at the risk free rate.

Question 13

Since many of the assumptions made by the capital market theory are unrealistic, the theory is not applicable in the real world.

Question 14

Securities with returns that lie below the security market line are undervalued.

Question 15

The existence of transaction costs indicates that at some point the additional cost of diversification relative to its benefit would be excessive for most investors.

Question 16

The introduction of lending and borrowing severely limits the available risk/return opportunities.

Question 17

The betas of those companies compiled by Value Line Investment Services tend to be almost identical to those compiled by Merrill Lynch.

Question 18

There can be only one zero-beta portfolio.

Question 19

A risk-free asset is one in which the return is completely guaranteed; there is no uncertainty.

Question 20

Under the CAPM framework, the introduction of lending and borrowing at differential rates leads to a non-linear capital market line.

Question 21

The standard deviation for the risk-free security is equal to zero.

Question 22

More recent studies done in 2001 suggest more securities are needed than historically to create a well-diversified portfolio.

Question 23

The usefulness of CAPM theory is limited in practice due to benchmark error.

Question 24

When identifying undervalued and overvalued assets, which of the following statements is false?

A)An asset is properly valued if its estimated rate of return is equal to its required rate of return.
B)An asset is considered overvalued if its estimated rate of return is below its required rate of return.
C)An asset is considered undervalued if its estimated rate of return is above its required rate of return.
D)An asset is considered overvalued if its required rate of return is below its estimated rate of return.
E)None of the above (that is, all are true statements)

Question 25

The "true" market portfolio is unknown.

Question 26

Tobin's separation theory states that the market is a separate investment from the risk-free security.

Question 27

The market portfolio consists of all

A)New York Stock Exchange stocks.
B)High grade stocks and bonds.
C)Stocks and bonds.
D)U.S. and non-U.S. stocks and bonds.
E)Risky assets.

Question 28

The Capital Market Line (CML) refers only to those portfolios that lie on the line segment that extends from the risk-free asset to the point of tangency on the efficient frontier known as the market portfolio.

Question 29

If an incorrect proxy market portfolio such as the S&P index is used when developing the security market line, the slope of the line will tend to be underestimated.

Question 30

Since the market portfolio is reasonable in theory, it is easy to implement when testing or using the CAPM.

Question 31

The separation theorem divides 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

Question 32

Overall the correlation coefficients of industries to the market portfolio vary widely, which is expected due to the wide variance of industry Betas.

Question 33

The only way to estimate a beta for a security is to calculate the covariance of the security with the market.

Question 34

The line of best fit for a scatter diagram showing the rates of return of an individual risky asset and the market portfolio of risky assets over time is called the

A)Security market line.
B)Capital asset pricing model.
C)Characteristic line.
D)Line of least resistance.
E)Market line.

Question 35

What does W_RF = -0.50 mean?

A)The investor can borrow money at the risk-free rate.
B)The investor can lend money at the current market rate.
C)The investor can borrow money at the current market rate.
D)The investor can borrow money at the prime rate of interest.
E)The investor can lend money at the prime rate of interest.

Question 36

The planning period for the CAPM is the same length of time for every investor.

Question 37

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)All investments are indivisible so it is impossible to buy or sell fractional shares.
E)All investors have the same one period time horizon.

Question 38

The rate of return on a risk free asset should equal the

A)Long run real growth rate of the economy.
B)Long run nominal growth rate of the economy.
C)Short run real growth rate of the economy.
D)Short run nominal growth rate of the economy.
E)Prime rate of interest.

Question 39

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 15 percent.

A)Rise or fall an indeterminate amount
B)Fall by 3%
C)Fall by 30%
D)Rise by 13%
E)Rise by 30%

Question 40

The Capital Market Line (CML) can be thought of as the new Efficient Frontier.

Question 41

In the presence of transactions costs, the SML will be

A)A single straight line.
B)A kinked line.
C)A set of lines rather than a single straight line.
D)A curve rather than a single straight line.
E)Impossible to determine.

Question 42

Beta is a measure of:

A)Company specific risk
B)Industry risk
C)Diversifiable risk
D)Systematic risk
E)Unique risk

Question 43

All of the following questions remain to be answered in the real world except

A)What is a good proxy for the market portfolio?
B)What happens when you cannot borrow or lend at the risk free rate?
C)How good is the capital asset model as a predictor?
D)What is the beta of the market portfolio of risky assets?
E)What is the stability of beta for individual stocks?

Question 44

The error caused by not using the true market portfolio has become known as the

A)Portfolio deviation.
B)CAPM shift.
C)Benchmark error.
D)Market error.
E)Beta error.

Question 45

If an individual owns only one security the most appropriate measure of risk is:

A)Standard deviation
B)Correlation
C)Beta
D)Covariance
E)All of the above are equally important

Question 46

Which of the following variables were found to be important in explaining return based upon a study of Fama and French (covering the period 1963 to 1990)?

A)Size
B)Book-to-market value
C)Beta
D)Choices a and b only
E)All of the above

Question 47

All portfolios on the capital market line are

A)Perfectly positively correlated.
B)Perfectly negatively correlated.
C)Unique from each other.
D)Weakly correlated.
E)Unrelated except that they contain the risk free asset.

Question 48

A portfolio manager uses two different proxies for the market portfolio, the S&P 500 index and the MSCI World index. Differences in the manager's portfolio performance resulting from the different market portfolios is referred to as

A)The size effect
B)The market effect
C)Measurement error
D)Benchmark error
E)Manager's performance error

Question 49

All of the following are assumptions of the Capital Asset Pricing Model (CAPM) except

A)Investors can borrow and lend any amount at the risk-free rate.
B)Investors all have homogeneous expectations regarding expected returns.
C)Investors can have different time horizons, daily, weekly, annual, or some other period.
D)All investments are infinitely divisible.
E)Capital markets are in equilibrium.

Question 50

A completely diversified portfolio would have a correlation with the market portfolio that is

A)Equal to zero because it has only unsystematic risk.
B)Equal to one because it has only systematic risk.
C)Less than zero because it has only systematic risk.
D)Less than one because it has only unsystematic risk.
E)Less than one because it has only systematic risk.

Question 51

The Efficient Frontier refers to a set of portfolios that

A)Have the highest expected return for a given level of risk.
B)Have the lowest risk for a given level of return.
C)Are dominant to all other portfolios.
D)a, b, and c above are correct.
E)None of the answers above are correct.

Question 52

Which of the following would most closely resemble the true market portfolio?

A)Stocks
B)Stocks and bonds
C)Stocks, bonds and foreign securities
D)Stocks, bonds, foreign securities and options
E)Stocks, bonds, foreign securities options and coins

Question 53

Theoretically, the correlation coefficient between a completely diversified portfolio and the market portfolio should be

A)-1.0.
B)+1.0.
C)0.0.
D)-0.5.
E)+0.5.

Question 54

The correlation coefficient between the market return and a risk-free asset would

A)be + $\infty$ .
B)be - $\infty$ .
C)be +1.
D)be -1.
E)be Zero.

Question 55

If the assumption that there are no transaction costs is relaxed, the SML will be a

A)Straight line.
B)Band of securities.
C)Convex curve.
D)Concave curve.
E)Parabolic curve.

Question 56

The betas for the market portfolio and risk-free security are:

Question 57

As the number of securities in a portfolio increases, the amount of systematic risk

A)Remains constant.
B)Decreases.
C)Increases.
D)Changes.
E)None of the above

Question 58

The ____ the number of stocks in a portfolio and the ____ the time period the ____ the portfolio beta.

A)Larger, longer, less stable
B)Larger, longer, more stable
C)Larger, shorter, less stable
D)Larger, shorter, more stable
E)Smaller, longer, more stable

Question 59

Which of the following is not a relaxation of the assumptions for the CAPM?

A)Differential lending and borrowing rates
B)A zero beta model
C)Transaction costs
D)Taxes
E)Homogeneous expectations and fixed planning periods

Question 60

The fact that tests have shown the CAPM intercept to be greater than the RFR is consistent with a(n)

A)Zero beta model.
B)unstable beta or a higher borrowing rate.
C)Zero beta model or a higher borrowing rate.
D)higher borrowing rate.
E)unstable beta.

Question 61

Exhibit 8.1
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) $$\begin{array}{l}\quad\quad\quad\quad\quad\quad\quad\quad\text { Rates of Return }\\\begin{array} { c c c } \text { Year } & \text { RA Computer } & \text { Market Index } \\\hline 1 & 13 & 17 \\2 & 9 & 15 \\3 & - 11 & 6 \\4 & 10 & 8 \\5 & 11 & 10 \\6 & 6 & 12\end{array}\end{array}$$

-Refer to Exhibit 8.1. Compute the beta for RA Computer using the historic returns presented above.

A)0.7715
B)1.2195
C)1.3893
D)1.1023
E)-0.7715

Question 62

Exhibit 8.1
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) $$\begin{array}{l}\quad\quad\quad\quad\quad\quad\quad\quad\text { Rates of Return }\\\begin{array} { c c c } \text { Year } & \text { RA Computer } & \text { Market Index } \\\hline 1 & 13 & 17 \\2 & 9 & 15 \\3 & - 11 & 6 \\4 & 10 & 8 \\5 & 11 & 10 \\6 & 6 & 12\end{array}\end{array}$$

-Refer to Exhibit 8.1. If you expected the return on the Market Index to be 12%, what would you expect the return on RA Computer to be?

A)7.26%
B)6.75%
C)8.00%
D)9.37%
E)-3.29%

Question 63

Recently you have received a tip that the stock of Buttercup Industries is going to rise from $76.00 to $85.00 per share over the next year. You know that the annual return on the S&P 500 has been 13% and the 90-day T-bill rate has been yielding 3% per year over the past 10 years. If beta for Buttercup is 1.0, will you purchase the stock?

A)Yes, because it is overvalued.
B)Yes, because it is undervalued.
C)No, because it is undervalued.
D)No, because it is overvalued.
E)Yes, because the expected return equals the estimated return.

Question 64

Exhibit 8.2
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
You expect the risk-free rate (RFR) to be 3 percent and the market return to be 8 percent. You also have the following information about three stocks. $$\begin{array} { c c c c c } \text { Stock } & \text { Beta } & \begin{array} { c } \text { Current } \\\text { Price }\end{array} & \begin{array} { c } \text { Expected } \\\text { Price }\end{array} & \begin{array} { c } \text { Expected } \\\text { Dividend }\end{array} \\\hline \mathrm { X } & 1.25 & \$ 20 & \$ 23 & \$ 1.25 \\\mathrm { Y } & 1.50 & \$ 27 & \$ 29 & \$ 0.25 \\\mathrm { Z } & 0.90 & \$ 35 & \$ 38 & \$ 1.00\end{array}$$

-Refer to Exhibit 8.2. What is your investment strategy concerning the three stocks?

A)Buy X and Y, sell Z.
B)Sell X, Y and Z.
C)Sell X and Z, buy Y.
D)Buy X, Y and Z.
E)Buy X and Z, sell Y.

Question 65

Your broker has advised you that he believes that the stock of Brat Inc. is going to rise from $20 to $22.15 per share over the next year. You know that the annual return on the S&P 500 has been 11.25% and the 90-day T-bill rate has been yielding 4.75% per year over the past 10 years. If beta for Brat is 1.25, will you purchase the stock?

A)Yes, because it is overvalued
B)No, because it is overvalued
C)No, because it is undervalued
D)Yes, because it is undervalued
E)Yes, because the expected return equals the estimated return

Question 66

Which of the following is not a major difference between the capital market line (CML) and the capital asset pricing model (CAPM)?

A)Definitions of portfolio risk are based on systematic and total risk
B)One is related to the market portfolio, the other does not
C)The number of calculations to determine risk is significantly greater for one method
D)One requires a tangency point on the efficient frontier, the other does not
E)All of the above

Question 67

Exhibit 8.1
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) $$\begin{array}{l}\quad\quad\quad\quad\quad\quad\quad\quad\text { Rates of Return }\\\begin{array} { c c c } \text { Year } & \text { RA Computer } & \text { Market Index } \\\hline 1 & 13 & 17 \\2 & 9 & 15 \\3 & - 11 & 6 \\4 & 10 & 8 \\5 & 11 & 10 \\6 & 6 & 12\end{array}\end{array}$$

-Refer to Exhibit 8.1. Compute the intercept of the characteristic line for RA Computer.

A)-9.41
B)11.63
C)4.92
D)-4.92
E)-7.98

Question 68

Exhibit 8.1
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) $$\begin{array}{l}\quad\quad\quad\quad\quad\quad\quad\quad\text { Rates of Return }\\\begin{array} { c c c } \text { Year } & \text { RA Computer } & \text { Market Index } \\\hline 1 & 13 & 17 \\2 & 9 & 15 \\3 & - 11 & 6 \\4 & 10 & 8 \\5 & 11 & 10 \\6 & 6 & 12\end{array}\end{array}$$

-Refer to Exhibit 8.1. The equation of the characteristic line for RA is

A)R_RA = 11.63 + 1.2195R_MI
B)R_RA = -7.98 + 1.1023R_MI
C)R_RA = -9.41 + 1.3893R_MI
D)R_RA = -4.92 - 0.7715R_MI
E)R_RA = 4.92 + 0.7715R_MI

Question 69

Recently you have received a tip that the stock of Bubbly Incorporated is going to rise from $57 to $61 per share over the next year. You know that the annual return on the S&P 500 has been 9.25% and the 90-day T-bill rate has been yielding 3.75% per year over the past 10 years. If beta for Bubbly is 0.85, will you purchase the stock?

A)Yes, because it is overvalued.
B)No, because it is overvalued.
C)No, because it is undervalued.
D)Yes, because it is undervalued.
E)Yes, because the expected return equals the estimated return.

Question 70

Exhibit 8.1
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) $$\begin{array}{l}\quad\quad\quad\quad\quad\quad\quad\quad\text { Rates of Return }\\\begin{array} { c c c } \text { Year } & \text { RA Computer } & \text { Market Index } \\\hline 1 & 13 & 17 \\2 & 9 & 15 \\3 & - 11 & 6 \\4 & 10 & 8 \\5 & 11 & 10 \\6 & 6 & 12\end{array}\end{array}$$

-Refer to Exhibit 8.1. Compute the correlation coefficient between RA Computer and the Market Index.

A)-0.32
B)0.78
C)0.66
D)0.58
E)0.32

Question 71

A friend has some reliable information that the stock of Puddles Company is going to rise from $43.00 to $50.00 per share over the next year. You know that the annual return on the S&P 500 has been 11% and the 90-day T-bill rate has been yielding 5% per year over the past 10 years. If beta for Puddles is 1.5, will you purchase the stock?

A)Yes, because it is overvalued.
B)Yes, because it is undervalued.
C)No, because it is undervalued.
D)No, because it is overvalued.
E)Yes, because the expected return equals the estimated return.

Question 72

Exhibit 8.2
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
You expect the risk-free rate (RFR) to be 3 percent and the market return to be 8 percent. You also have the following information about three stocks. $$\begin{array} { c c c c c } \text { Stock } & \text { Beta } & \begin{array} { c } \text { Current } \\\text { Price }\end{array} & \begin{array} { c } \text { Expected } \\\text { Price }\end{array} & \begin{array} { c } \text { Expected } \\\text { Dividend }\end{array} \\\hline \mathrm { X } & 1.25 & \$ 20 & \$ 23 & \$ 1.25 \\\mathrm { Y } & 1.50 & \$ 27 & \$ 29 & \$ 0.25 \\\mathrm { Z } & 0.90 & \$ 35 & \$ 38 & \$ 1.00\end{array}$$

-Refer to Exhibit 8.2. What are the estimated rates of return for the three stocks (in the order X, Y, Z)?

A)21.25%, 8.33%, 11.43%
B)6.20%, 2.20%, 8.20%
C)16.50%, 5.50%, 22.00%
D)9.25%, 10.5%, 7.5%
E)15.00%, 3.50%, 7.30%

Question 73

Calculate the expected return for D Industries which has a beta of 1.0 when the risk free rate is 0.03 and you expect the market return to be 0.13.

A)8.6%
B)9.2%
C)11.0%
D)12.0%
E)13.0%

Question 74

Calculate the expected return for E Services which has a beta of 1.5 when the risk free rate is 0.05 and you expect the market return to be 0.11.

A)10.6%
B)12.1%
C)13.6%
D)14.0%
E)16.2%

Question 75

The capital market line (CML) uses ____ as a risk measurement, whereas the capital asset pricing model (CAPM) uses ____.

A)Beta; total risk
B)Standard deviation; total risk
C)Standard deviation; systematic risk
D)Unsystematic risk; total risk
E)Systematic risk; beta

Question 76

Calculate the expected return for A Industries which has a beta of 1.75 when the risk free rate is 0.03 and you expect the market return to be 0.11.

A)11.13%
B)14.97%
C)16.25%
D)22.25%
E)17.0%

Question 77

Calculate the expected return for B Services which has a beta of 0.83 when the risk free rate is 0.05 and you expect the market return to be 0.12.

A)14.96%
B)16.15%
C)10.81%
D)17.00%
E)15.25%

Question 78

Calculate the expected return for C Inc. which has a beta of 0.8 when the risk free rate is 0.04 and you expect the market return to be 0.12.

A)8.10%
B)9.60%
C)10.40%
D)11.20%
E)12.60%

Question 79

Exhibit 8.2
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
You expect the risk-free rate (RFR) to be 3 percent and the market return to be 8 percent. You also have the following information about three stocks. $$\begin{array} { c c c c c } \text { Stock } & \text { Beta } & \begin{array} { c } \text { Current } \\\text { Price }\end{array} & \begin{array} { c } \text { Expected } \\\text { Price }\end{array} & \begin{array} { c } \text { Expected } \\\text { Dividend }\end{array} \\\hline \mathrm { X } & 1.25 & \$ 20 & \$ 23 & \$ 1.25 \\\mathrm { Y } & 1.50 & \$ 27 & \$ 29 & \$ 0.25 \\\mathrm { Z } & 0.90 & \$ 35 & \$ 38 & \$ 1.00\end{array}$$

-Refer to Exhibit 8.2. What are the expected (required) rates of return for the three stocks (in the order X, Y, Z)?

A)16.50%, 5.50%, 22.00%
B)9.25%, 10.5%, 7.5%
C)21.25%, 8.33%, 11.43%
D)6.20%, 2.20%, 8.20%
E)15.00%, 3.50%, 7.30%

Question 80

Calculate the expected return for F Inc. which has a beta of 1.3 when the risk free rate is 0.06 and you expect the market return to be 0.125.

A)12.65%
B)13.55%
C)14.45%
D)15.05%
E)16.34%