Deck 12: An Alternative View of Risk and Return: The Arbitrage Pricing Theory

Question 1

The single factor APT model that resembles the market model uses _________ as the single factor.

A) arbitrage fees
B) GNP
C) the inflation rate
D) the market return
E) the risk-free return

Answer 1

the market return

Question 2

The acronym CAPM stands for:

A) Capital Asset Pricing Model.
B) Certain Arbitrage Pressure Model.
C) Current Arbitrage Prices Model.
D) Cumulative Asset Price Model.
E) None of these.

Answer 2

Capital Asset Pricing Model.

Question 3

Which of the following is true about the impact on market price of a security when a company makes an announcement and the market has discounted the news?

A) The price will change a great deal; even though the impact is primarily in the future, the future value is discounted to the present.
B) The price will change little, if at all, since the impact is primarily in the future.
C) The price will change little, if at all, since the market considers this information unimportant.
D) The price will change little, if at all, since the market considers this information untrue.
E) The price will change little, if at all, since the market has already included this information in the security's pricE.

Answer 3

The price will change little, if at all, since the market has already included this information in the security's pricE.

Question 4

What would not be true about a GNP beta?

A) If a stock's β GNP = 1.5, the stock will experience a 1.5% increase for every 1% surprise increase in GNP.
B) If a stock's β GNP = -1.5, the stock will experience a 1.5% decrease for every 1% surprise increase in GNP.
C) It is a measure of risk.
D) It measures the impact of systematic risk associated with GNP.
E) None of these.

Question 5

Which of the following statements is true?

A) A well-diversified portfolio has negligible systematic risk.
B) A well-diversified portfolio has negligible unsystematic risk.
C) An individual security has negligible systematic risk.
D) An individual security has negligible unsystematic risk.
E) Both A well-diversified portfolio has negligible systematic risk; and An individual security has negligible unsystematic risk.

Question 6

In the one factor (APT) model,the characteristic line to estimate β_i passes through the origin,unlike the estimate used in the CAPM because:

A) the relationship is between the actual return on a security and the market index.
B) the relationship measures the change in the security return over time versus the change in the market return.
C) the relationship measures the change in excess return on a security versus GNP.
D) the relationship measures the change in excess return on a security versus the return on the factor about its mean of zero.
E) Cannot be determined without actual data.

Question 7

Systematic risk is defined as:

A) a risk that specifically affects an asset or small group of assets.
B) any risk that affects a large number of assets.
C) any risk that has a huge impact on the return of a security.
D) the random component of return.
E) None of these.

Question 8

In a portfolio of risky assets,the response to a factor,F_i,can be determined by:

A) summing the weighted β_i s and multiplying by the factor F_i.
B) summing the F_i s.
C) adding the average weighted expected returns.
D) summing the weighted random errors.
E) All of

Question 9

A company owning gold mines will probably have a _____ inflation beta because an ___ increase in inflation is usually associated with an increase in gold prices.

A) negative; anticipated
B) positive; anticipated
C) negative; unanticipated
D) positive; unanticipated
E) None of these.

Question 10

Shareholders discount many corporate announcements because of their prior expectations. If an announcement causes the price to change it will mostly be driven by:

A) the expected part of the announcement.
B) market inefficiency.
C) the unexpected part of the announcement.
D) the systematic risk.
E) None of these.

Question 11

If company A,a medical research company,makes a new product discovery and their stock rises 5%,this will have:

A) no effect on Company B's, a newspaper, stock price because it is a systematic risk element.
B) no effect on Company B's, a newspaper, stock price because it is an unsystematic risk element.
C) a large effect on Company B's, a newspaper, stock price because it is a systematic risk element.
D) a large effect on Company B's, a newspaper, stock price because it is an unsystematic risk element.
E) None of these.

Question 12

In the equation R = + U,the three symbols stand for:

A) average return, expected return, and unexpected return.
B) required return, expected return, and unbiased return.
C) actual total return, expected return, and unexpected return.
D) required return, expected return, and unbiased risk.
E) risk, expected return, and unsystematic risk.

Question 13

The acronym APT stands for:

A) Arbitrage Pricing Techniques.
B) Absolute Profit Theory.
C) Arbitrage Pricing Theory.
D) Asset Pricing Theory.
E) Assured Price Techniques.

Question 14

If the expected rate of inflation was 3% and the actual rate was 6.2%; the systematic response coefficient from inflation,β_I,would result in a change in any security return of ___ β_I.

A) 9.2
B) 3.2
C) -3.2
D) 3.0
E) 6.2

Question 15

A security that has a beta of zero will have an expected return of:

A) zero.
B) the market risk premium.
C) the risk free rate.
D) less than the risk free rate but not negative.
E) less than the risk free rate which can be negativE.

Question 16

A factor is a variable that:

A) affects the returns of risky assets in a systematic fashion.
B) affects the returns of risky assets in an unsystematic fashion.
C) correlates with risky asset returns in a unsystematic fashion.
D) does not correlate with the returns of risky assets in a systematic fashion.
E) None of these.

Question 17

The term Corr (ε R,ε T) = 0 tells us that:

A) all error terms of company R and T are 0.
B) the unsystematic risk of companies R and T is unrelated or uncorrelated.
C) the correlation between the returns of companies R and T is -1.
D) the systematic risk of companies R and T is unrelated.
E) None of these.

Question 18

The unexpected return on a security,U,is made up of:

A) market risk and systematic risk.
B) systematic risk and unsystematic risk.
C) idiosyncratic risk and unsystematic risk.
D) expected return and market risk.
E) expected return and idiosyncratic risk.

Question 19

For a diversified portfolio including a large number of stocks,the:

A) weighted average expected return goes to zero.
B) weighted average of the betas goes to zero.
C) weighted average of the unsystematic risk goes to zero.
D) return of the portfolio goes to zero.
E) return on the portfolio equals the risk-free ratE.

Question 20

The betas along with the factors in the APT adjust the expected return for:

A) calculation errors.
B) unsystematic risks.
C) spurious correlations of factors.
D) differences between actual and expected levels of factors.
E) All of

Question 21

A growth stock portfolio and a value portfolio might be characterized:

A) each by their P/E relative to the index P/E; high P/E for growth and lower for value.
B) as earning a high rate of return for a growth security and a low rate of return for value security irrespective of risk.
C) low unsystematic risk and high systematic risk respectively.
D) moderate systematic risk and zero systematic risk respectively.
E) None of these.

Question 22

Assuming that the single factor APT model applies,the beta for the market portfolio is:

A) zero.
B) one.
C) the average of the risk free beta and the beta for the highest risk security.
D) impossible to calculate without collecting sample data.
E) None of these.

Question 23

Suppose the JumpStart Corporation's common stock has a beta of 0.8. If the risk-free rate is 4% and the expected market return is 9%,the expected return for JumpStart's common stock is:

A) 3.2%.
B) 4.0%.
C) 7.2%.
D) 8.0%.
E) 9.0%.

Question 24

The most realistic APT model would likely include:

A) multiple factors.
B) only one factor.
C) a factor to measure inflation.
D) Both multiple factors; and a factor to measure inflation.
E) Both only one factor; and a factor to measure inflation.

Question 25

The Fama-French three factor model includes the following factors:

A) beta, expected return on the market, risk free rate of interest, a size factor, and a value factor.
B) the market risk premium, a volume factor, and a size factor.
C) beta, expected return on the market, risk free rate of interest, a volume factor, and a value factor.
D) the yield on corporate bonds, a size factor, and a market factor.
E) None of these.

Question 26

The Fama-French three factor model predicts the expected return on a portfolio increases:

A) linearly with its factor loading of the size factor.
B) linearly with its factor loading of the volume.
C) exponentially with its factor loading of the size factor.
D) exponentially with its factor loading of the volume factor.
E) None of these.

Question 27

Assume that the single factor APT model applies and a portfolio exists such that 2/3 of the funds are invested in Security Q and the rest in the risk-free asset. Security Q has a beta of 1.5. The portfolio has a beta of:

A) 0.00.
B) 0.50.
C) 0.75.
D) 1.00.
E) 1.50.

Question 28

Three factors likely to occur in the APT model are:

A) unemployment, inflation, and current rates.
B) inflation, GNP, and interest rates.
C) current rates, inflation and change in housing prices.
D) unemployment, college tuition, and GNP.
E) This cannot be determined or even estimated.

Question 29

To estimate the cost of equity capital for a firm using the CAPM,it is necessary to have:

A) company financial leverage, beta, and the market risk premium.
B) company financial leverage, beta, and the risk-free rate.
C) beta, company financial leverage, and the industry beta.
D) beta, company financial leverage, and the market risk premium.
E) beta, the risk-free rate, and the market risk premium.

Question 30

Which of the following statements is/are true?

A) Both APT and CAPM argue that expected excess return must be proportional to the beta(s).
B) APT and CAPM are the only approaches to measure expected returns in risky assets.
C) Both CAPM and APT are risk-based models.
D) Both APT and CAPM argue that expected excess return must be proportional to the beta(s); and APT and CAPM are the only approaches to measure expected returns in risky assets.
E) Both APT and CAPM argue that expected excess return must be proportional to the beta(s); and Both CAPM and APT are risk-based models.

Question 31

Style portfolios are characterized by:

A) their stock attributes; P/Es less than the market P/E are value funds.
B) their systematic factors, higher systematic factors are benchmark portfolios.
C) their stock attributes; higher stock attribute factors are benchmark portfolios.
D) their systematic factors, P/Es greater than the market are value portfolios.
E) There is no difference between systematic factors and stock attributes.

Question 32

Suppose the MiniCD Corporation's common stock has a return of 12%. Assume the risk-free rate is 4%,the expected market return is 9%,and no unsystematic influence affected Mini's return. The beta for MiniCD is:

A) 0.89.
B) 1.60.
C) 2.40.
D) 3.00.
E) It is impossible to calculate beta without the inflation ratE. 12 = 4 + β(9 - 4); 8 = 5β; β = 8/5 = 1.60

Question 33

The systematic response coefficient for productivity,β_p,would produce an unexpected change in any security return of ____ β_P if the expected rate of productivity was 1.5% and the actual rate was 2.25%.

A) 0.75%
B) -0.75%
C) 2.25%
D) -2.25%
E) 1.5%

Question 34

A criticism of the CAPM is that it:

A) ignores the return on the market portfolio.
B) ignores the risk-free return.
C) requires a single measure of systematic risk.
D) utilizes too many factors.
E) None of these.

Question 35

Suppose that we have identified three important systematic risk factors given by exports,inflation,and industrial production. In the beginning of the year,growth in these three factors is estimated at -1%,2.5%,and 3.5% respectively. However,actual growth in these factors turns out to be 1%,-2%,and 2%. The factor betas are given by β_EX = 1.8,β_I = 0.7,and β_IP = 1.0. If the expected return on the stock is 6%,and no unexpected news concerning the stock surfaces,calculate the stock's total return.

A) 2.95%
B) 4.95%
C) 6.55%
D) 7.40%
E) 8.85%

Question 36

A value company is defined as one that:

A) tends to have a lower average return than a growth company.
B) tends to have higher average return than a growth company.
C) has a high ratio of book equity to market equity.
D) tends to have a lower average return than a growth company and tends to have higher average return than a growth company.
E) tends to have a lower average return than a growth company and has a high ratio of book equity to market equity.

Question 37

Parametric or empirical models rely on:

A) security betas explaining systematic factor relationships.
B) finding regularities and relations in past market data.
C) there being no true explanations of pricing relationships.
D) always being able to find the exception to the rule.
E) None of these.

Question 38

In normal market conditions if a security has a negative beta:

A) the security always has a positive return.
B) the security has an expected return above the risk-free return.
C) the security has an expected return less than the risk-free rate.
D) the security has an expected return equal to the market portfolio.
E) Both the security always has a positive return; and the security has an expected return above the risk-free return.

Question 39

An advantage of the APT over CAPM is:

A) APT can handle multiple factors.
B) if the factors can be properly identified, the APT may have more explanation/predictive power for returns.
C) the APT forces unsystematic risk to be negative to offset systematic risk; thus making the total portfolio risk free, allowing for an arbitrage opportunity for the astute investor.
D) Both APT can handle multiple factors; and if the factors can be properly identified, the APT may have more explanation/predictive power for returns.
E) All of

Question 40

Both the APT and the CAPM imply a positive relationship between expected return and risk. The APT views risk:

A) very similarly to the CAPM via the beta of the security.
B) in terms of individual intersecurity correlation versus the beta of the CAPM.
C) via the industry wide or marketwide factors creating correlation between securities.
D) as the standardized deviation of the covariance.
E) None of these.

Question 41

Suppose that we have identified three important systematic risk factors given by exports,inflation,and industrial production. In the beginning of the year,growth in these three factors is estimated at -1%,2.5%,and 3.5% respectively. However,actual growth in these factors turns out to be 1%,-2%,and 2%. The factor betas are given by β_EX = 1.8,β_I = 0.7,and β_IP = 1.0. Calculate the stock's total return if the company announces that they had an industrial accident and the operating facilities will close down for some time thus resulting in a loss by the company of 7% in return.

A) -4.05%
B) -2.05%
C) 4.55%
D) 0.40%
E) 1.85%

Question 42

Suppose the Carz Corporation's common stock has a beta of 0.9. If the risk-free rate is 3.5% and the expected market return is 9%,the expected return for JumpStart's common stock is:

A) 3.5%.
B) 8.45%.
C) 9.00%.
D) 9.15%.
E) 9.24%.

Question 43

An investor is considering the three stocks given below:
Calculate the expected return and beta of a portfolio equally weighted between stocks B and C. Demonstrate that holding stock A actually reduces risk by comparing the risk of a portfolio equally weighted between stock B and T-Bills with a portfolio equally weighted between stocks B and A.

Question 44

Assume that the single factor APT model applies and a portfolio exists such that 1/2 of the funds are invested in Security Q and the rest in the risk-free asset. Security Q has a beta of 1.8. The portfolio has a beta of:

A) 0.0.
B) 0.8.
C) 0.9.
D) 1.0.
E) 1.8.

Question 45

The systematic response coefficient for productivity,β_p,would produce an unexpected change in any security return of __ β_P if the expected rate of productivity was 1.8% and the actual rate was 2.3%.

A) 0.5%
B) -0.5%
C) 2.3%
D) -2.3%
E) 1.8%

Question 46

Explain the conceptual differences in the theoretical development of the CAPM and APT.

Question 47

You have a 3 factor model to explain returns. Explain what a factor represents in the context of the APT?
Each factor is multiplied by a beta. What do these represent and how do they relate to the actual return?

Question 48

Suppose the Binder Corporation's common stock has a return of 17%. Assume the risk-free rate is 5%,the expected market return is 8%,and no unsystematic influence affected Binder's return. The beta for Binder is:

A) 0.
B) 2.
C) 3.
D) 4.
E) It is impossible to calculate beta without the inflation ratE. 17 = 5 + β(8 - 5); β = 4

Question 49

Suppose that we have identified three important systematic risk factors given by exports,inflation,and industrial production. In the beginning of the year,growth in these three factors is estimated at -1%,2.5%,and 3.5% respectively. However,actual growth in these factors turns out to be 1%,-2%,and 2%. The factor betas are given by β_EX = 1.8,β_I = 0.7,and β_IP = 1.0. Calculate the stock's total return if the company announces that an important patent filing has been granted sooner than expected and will earn the company 5% more in return.

A) 7.95%
B) 9.95%
C) 11.55%
D) 7.90%
E) 9.35%

Question 50

Discuss the Fama-French three factor model; both what it means and the factors of the model.

Question 51

Suppose that we have identified three important systematic risk factors given by exports,inflation,and industrial production. In the beginning of the year,growth in these three factors is estimated at -1%,2.5%,and 3.5% respectively. However,actual growth in these factors turns out to be 1%,-2%,and 2%. The factor betas are given by β_EX = 1.8,β_I = 0.7,and β_IP = 1.0. What would the stock's total return be if the actual growth in each of the factors was equal to growth expected?
Assume no unexpected news on the patent.

A) 4%
B) 5%
C) 6%
D) 7%
E) 8%