Deck 8: The Efficient Market Hypothesis

Question 1

The beta of Exxon stock has been estimated as 1.2 by Merrill Lynch using regression analysis on a sample of historical returns.The Merrill Lynch adjusted beta of Exxon stock would be ___________.

A) 1.20
B) 1.32
C) 1.13
D) 1.0
E) none of these

Answer 1

C

Question 2

If a firm's beta was calculated as 1.3 in a regression equation,a commonly used adjustment technique would provide an adjusted beta of

A) less than 1.0 but greater than zero.
B) between 0.3 and 0.9.
C) between 1.0 and 1.3.
D) greater than 1.3.
E) zero or less.

Answer 2

C

Question 3

As diversification increases,the total variance of a portfolio approaches ____________.

A) 0
B) 1
C) the variance of the market portfolio
D) infinity
E) none of these

Answer 3

C

Question 4

Assume that stock market returns do not resemble a single-index structure.An investment fund analyzes 100 stocks in order to construct a mean-variance efficient portfolio constrained by 100 investments.They will need to calculate ____________ covariances.

A) 45
B) 100
C) 4,950
D) 10,000
E) none of these

Question 5

If a firm's beta was calculated as 0.6 in a regression equation,Merrill Lynch would state the adjusted beta at a number

A) less than 0.6 but greater than zero.
B) between 0.6 and 1.0.
C) between 1.0 and 1.6.
D) greater than 1.6.
E) zero or less.

Question 6

In a factor model,the return on a stock in a particular period will be related to _________.

A) firm-specific events
B) macroeconomic events
C) the error term
D) both a and b
E) neither a nor b

Question 7

Assume that stock market returns do not resemble a single-index structure.An investment fund analyzes 100 stocks in order to construct a mean-variance efficient portfolio constrained by 100 investments.They will need to calculate _____________ expected returns and ___________ variances of returns.

A) 100,100
B) 100,4950
C) 4950,100
D) 4950,4950
E) none of these

Question 8

Assume that stock market returns do follow a single-index structure.An investment fund analyzes 500 stocks in order to construct a mean-variance efficient portfolio constrained by 500 investments.They will need to calculate ________ estimates of firm-specific variances and ________ estimates for the variance of the macroeconomic factor.

A) 500;1
B) 500;500
C) 124,750;1
D) 124,750;500
E) 250,000;500

Question 9

The intercept calculated by BMO Nesbitt Burns in the regression equations is equal to

A) α in the CAPM
B) α + r_f(1 + β)
C) α + r_f(1 - β)
D) 1 - α
E) none of these

Question 10

Assume that stock market returns do not resemble a single-index structure.An investment fund analyzes 150 stocks in order to construct a mean-variance efficient portfolio constrained by 150 investments.They will need to calculate ____________ covariances.

A) 12
B) 150
C) 22,500
D) 11,175
E) 300

Question 11

To determine stock beta estimates,BMO Nesbitt Burns uses the __________ as a proxy for the market portfolio.

A) Dow Jones Industrial Average
B) S&P/TSX Composite Index
C) S&P 500 Index
D) Wilshire 5000
E) none of these

Question 12

Consider the single-index model.The alpha of a stock is 0%.The return on the market index is 16%.The risk-free rate of return is 5%.The stock earns a return that exceeds the risk-free rate by 11% and there are no firm-specific events affecting the stock performance.The β of the stock is _______.

A) 0.67
B) 0.75
C) 1.0
D) 1.33
E) 1.50

Question 13

The index model was first suggested by ____________.

A) Graham
B) Markowitz
C) Miller
D) Sharpe
E) none of these

Question 14

Suppose you held a well-diversified portfolio with a very large number of securities,and that the single index model holds.If the σ of your portfolio was 0.20 and σ_M was 0.16,the β of the portfolio would be approximately ________.

A) 0.64
B) 0.80
C) 1.25
D) 1.56
E) none of these

Question 15

Analysts may use regression analysis to estimate the index model for a stock.When doing so,the slope of the regression line is an estimate of ______________.

A) the α of the asset
B) the β of the asset
C) the σ of the asset
D) the δ of the asset
E) none of these

Question 16

Assume that stock market returns do follow a single-index structure.An investment fund analyzes 200 stocks in order to construct a mean-variance efficient portfolio constrained by 200 investments.They will need to calculate ________ estimates of expected returns and ________ estimates of sensitivity coefficients to the macroeconomic factor.

A) 200;19,900
B) 200;200
C) 19,900;200
D) 19,900;19.900
E) none of these

Question 17

If the index model is valid,_________ would be helpful in determining the covariance between assets K and L.

A) β_k
B) β_L
C) σ_M
D) all of these
E) none of these

Question 18

The Security Risk Evaluation book published by Merrill Lynch relies on the _________ most recent monthly observations to calculate regression parameters.

A) 12
B) 36
C) 60
D) 120
E) none of these

Question 19

A single-index model uses ___________ as a proxy for the systematic risk factor.

A) a market index,such as the S&P 500 or the S&P/TSX Composite
B) the current account deficit
C) the growth rate in GNP
D) the unemployment rate
E) none of these

Question 20

According to the index model,covariances among security pairs are

A) due to the influence of a single common factor represented by the market index return
B) extremely difficult to calculate
C) related to industry-specific events
D) usually positive
E) a and d

Question 21

The index model has been estimated for stocks A and B with the following results:
R_A = 0.01 + 0.5R_M + e_A
R_B = 0.02 + 1.3R_M + e_B
Σ_M = 0.25 σ(e_A)= 0.20 σ(e_B)= 0.10
The covariance between the returns on stocks A and B is ___________.

A) 0.0384
B) 0.0406
C) 0.1920
D) 0.0050
E) 0.4000

Question 22

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 these are true.
E) none of these are true.

Question 23

BMO Nesbitt Burns estimates the index model for a stock using regression analysis involving total returns.They estimated the intercept in the regression equation at 6% and the β at 0.5.The risk-free rate of return is 12%.The true α of the stock is ________.

A) 0%
B) 3%
C) 6%
D) 9%
E) none of these

Question 24

The single-index model

A) greatly reduces the number of required calculations,relative to those required by the Markowitz model.
B) enhances the understanding of systematic versus nonsystematic risk.
C) greatly increases the number of required calculations,relative to those required by the Markowitz model.
D) a and b.
E) b and c.

Question 25

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 these are true.

Question 26

The index model for stock A has been estimated with the following result:
R_A = 0.01 + 0.9R_M + e_A
If σ_M = 0.25 and R²_A = 0.25,the standard deviation of return of stock A is _________.

A) 0.2025
B) 0.2500
C) 0.4500
D) 0.8100
E) none of these

Question 27

Suppose the following equation best describes the evolution of β over time:
Βt= 0.25 + 0.75βt-1
If a stock had a β of 0.6 last year,you would forecast the β to be _______ in the coming year.

A) 0.45
B) 0.60
C) 0.70
D) 0.75
E) none of these

Question 28

Covariances between security returns tend to be

A) positive because of SEC regulations.
B) positive because of Exchange regulations.
C) positive because of economic forces that affect many firms.
D) negative because of SEC regulations
E) negative because of economic forces that affect many firms.

Question 29

The index model has been estimated for stock A with the following results:
R_A = 0.01 + 0.8R_M + e_A
Σ_M = 0.20 σ(e_A)= 0.10
The standard deviation of the return for stock A is __________.

A) 0.0356
B) 0.1886
C) 0.1600
D) 0.6400
E) none of these

Question 30

The expected impact of unanticipated macroeconomic events on a security's return during the period is

A) included in the security's expected return.
B) zero.
C) equal to the risk free rate.
D) proportional to the firm's beta.
E) infinite.

Question 31

In the single-index model represented by the equation ri= E(r_i)+ β_iF + e_i,the term e_i represents

A) the impact of unanticipated macroeconomic events on security i's return.
B) the impact of unanticipated firm-specific events on security i's return.
C) the impact of anticipated macroeconomic events on security i's return.
D) the impact of anticipated firm-specific events on security i's return.
E) the impact of changes in the market on security i's return.

Question 32

The Security Characteristic Line (SCL)

A) plots the excess return on a security as a function of the excess return on the market.
B) allows one to estimate the beta of the security.
C) allows one to estimate the alpha of the security.
D) all of these.
E) none of these.

Question 33

The CAPM assumes that the only relevant source of risk arises from

A) industry factors
B) labor income
C) variations in stock returns
D) financial distress
E) firm return standard deviation

Question 34

Suppose you forecast that the market index will earn a return of 15% in the coming year.Treasury bills are yielding 6%.The unadjusted β of Mobil stock is 1.30.A reasonable forecast of the return on Mobil stock for the coming year is _________ if you use Merrill Lynch adjusted betas.

A) 15.0%
B) 15.5%
C) 16.0%
D) 16.8%
E) none of these

Question 35

Which of the following factors did Chen,Roll and Ross not include in their multifactor model?

A) Change in industrial production
B) Change in expected inflation
C) Change in unanticipated inflation
D) Excess return of long-term government bonds over T-bills
E) All of these factors were included in their model.

Question 36

The index model has been estimated for stocks A and B with the following results:
R_A = 0.01 + 0.8R_M + e_A
R_B = 0.02 + 1.2R_M + e_B
Σ_M = 0.20 σ(e_A)= 0.20 σ(e_B)= 0.10
The standard deviation for stock A is __________.

A) 0.0656
B) 0.0676
C) 0.2561
D) 0.2600
E) none of these

Question 37

Which of the following factors was 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 these factors were included in their model.
E) None of these factors were included in their model.

Question 38

Security returns

A) are based on both macro events and firm-specific events.
B) are based on firm-specific events only.
C) are usually positively correlated with each other.
D) a and b.
E) a and c.

Question 39

Suppose you held a well-diversified portfolio with a very large number of securities,and that the single index model holds.If the σ of your portfolio was 0.18 and σ_Mwas 0.24,the b of the portfolio would be approximately ________.

A) 0.75
B) 0.56
C) 0.07
D) 1.03
E) 0.86

Question 40

The index model for stock B has been estimated with the following result:
R_B = 0.01 + 1.1R_M + e_B
If σ_M = 0.20 and R²_B = 0.50,the standard deviation of the return on stock B is _________.

A) 0.1111
B) 0.2111
C) 0.3111
D) 0.4111
E) none of these

Question 41

An arbitrage opportunity exists if an investor can construct a _________ investment portfolio that will yield a sure profit.

A) positive
B) negative
C) zero
D) all of these
E) none of these

Question 42

The Security Characteristic Line (SCL)associated with the single-index model is a plot of

A) the security's returns on the vertical axis and the market index's returns on the horizontal axis.
B) the market index's returns on the vertical axis and the security's returns on the horizontal axis.
C) the security's excess returns on the vertical axis and the market index's excess returns on the horizontal axis.
D) the market index's excess returns on the vertical axis and the security's excess returns on the horizontal axis.
E) the security's returns on the vertical axis and Beta on the horizontal axis.

Question 43

The APT was developed in 1976 by ____________.

A) Lintner
B) Modigliani and Miller
C) Ross
D) Sharpe
E) none of these

Question 44

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 these

Question 45

A _________ portfolio is a well-diversified portfolio constructed to have a beta of 1 on one of the factors and a beta of 0 on any other factor.

A) factor
B) market
C) index
D) a and b
E) a,b,and c

Question 46

Assume that stock market returns do not resemble a single-index structure.An investment fund analyzes 125 stocks in order to construct a mean-variance efficient portfolio constrained by 125 investments.They will need to calculate _____________ expected returns and ___________ variances of returns.

A) 125,125
B) 125,15,625
C) 15,625,125
D) 15,625,15,625
E) 250,250

Question 47

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 these

Question 48

One "cost" of the single-index model is that it

A) is virtually impossible to apply.
B) prohibits specialization of efforts within the security analysis industry.
C) requires forecasts of the money supply.
D) is legally prohibited by the SEC.
E) allows for only two kinds of risk-macro risk and micro risk.

Question 49

In developing the APT,Ross assumed that uncertainty in asset returns was a result of

A) a common macroeconomic factor
B) firm-specific factors
C) pricing error
D) neither a nor b
E) both a and b

Question 50

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 these

Question 51

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 these are true statements.

Question 52

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 these

Question 53

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.

Question 54

Suppose you are doing a portfolio analysis that includes all of the stocks on the NYSE.Using a single-index model rather than the Markowitz model _______ the number of inputs needed from _______ to ________.

A) increases,about 1,400,more than 1.4 million
B) increases,about 10,000,more than 125,000
C) reduces,more than 125,000,about 10,000
D) reduces,more than 3.6 million,about 8,100
E) increases,about 150,more than 1,500

Question 55

The idea that there is a limit to the reduction of portfolio risk due to diversification is

A) contradicted by both the CAPM and the single-index model.
B) contradicted by the CAPM.
C) contradicted by the single-index model.
D) supported in theory,but not supported empirically.
E) supported both in theory and by empirical evidence.

Question 56

Assume that stock market returns do not resemble a single-index structure.An investment fund analyzes 40 stocks in order to construct a mean-variance efficient portfolio constrained by 40 investments.They will need to calculate _____________ expected returns and ___________ variances of returns.

A) 100,100
B) 40,40
C) 4950,100
D) 4950,4950
E) 80,80

Question 57

Consider the single-factor APT.Stocks A and B have expected returns of 15% and 18%,respectively.The risk-free rate of return is 6%.Stock B has a beta of 1.0.If arbitrage opportunities are ruled out,stock A has a beta of __________.

A) 0.67
B) 1.00
C) 1.30
D) 1.69
E) none of these

Question 58

___________ a relationship between expected return and risk.

A) APT stipulates
B) CAPM stipulates
C) Both CAPM and APT stipulate
D) Neither CAPM nor APT stipulate
E) No pricing model has found

Question 59

The ____________ provides an unequivocal statement on the expected return-beta relationship for all assets,whereas the _____________ implies that this relationship holds for all but perhaps a small number of securities.

A) APT,CAPM
B) APT,OPM
C) CAPM,APT
D) CAPM,OPM
E) none of these

Question 60

If a firm's beta was calculated as 1.6 in a regression equation,a commonly used adjustment technique would provide an adjusted beta of

A) less than 0.6 but greater than zero.
B) between 0.6 and 1.0.
C) between 1.0 and 1.6.
D) greater than 1.6.
E) zero or less.

Question 61

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 these

Question 62

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: $$\begin{array}{l}\begin{array} { l l l l } \text { portfolio}&\beta \text { on F?}&\beta \text { on F?}&\text { expected return}\\A&1.0&2.0&19\%\\B&2.0&0.0&12\%\end{array}\end{array}$$
Assuming no arbitrage opportunities exist,the risk premium on the factor F₂ portfolio should be ___________.

A) 3%
B) 4%
C) 5%
D) 6%
E) none of these

Question 63

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 these

Question 64

Advantage(s)of the APT is(are)

A) that the model provides specific guidance concerning the determination of the risk premiums on the factor portfolios.
B) that the model does not require a specific benchmark market portfolio.
C) that risk need not be considered.
D) a and b.
E) b and c.

Question 65

The APT differs from the CAPM because the APT _________.

A) places more emphasis on market risk
B) minimizes the importance of diversification
C) recognizes multiple unsystematic risk factors
D) recognizes multiple systematic risk factors
E) none of these

Question 66

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 these

Question 67

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 these

Question 68

In the context of the Arbitrage Pricing Theory,as a well-diversified portfolio becomes larger its nonsystematic risk approaches

A) one.
B) infinity.
C) zero.
D) negative one.
E) none of these.

Question 69

The APT requires a benchmark portfolio

A) that is equal to the true market portfolio.
B) that contains all securities in proportion to their market values.
C) that need not be well-diversified.
D) that is well-diversified and lies on the SML.
E) that is unobservable.

Question 70

A well-diversified portfolio is defined as

A) one that is diversified over a large enough number of securities that the nonsystematic variance is essentially zero.
B) one that contains securities from at least three different industry sectors.
C) a portfolio whose factor beta equals 1.0.
D) a portfolio that is equally weighted.
E) all of these.

Question 71

Consider the multifactor APT with two factors.The risk premiums on the factor 1 and factor 2 portfolios are 5% and 6%,respectively.Stock A has a beta of 1.2 on factor 1,and a beta of 0.7 on factor 2.The expected return on stock A is 17%.If no arbitrage opportunities exist,the risk-free rate of return is ______________.

A) 6.0%
B) 6.5%
C) 6.8%
D) 7.4%
E) none of these

Question 72

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 these

Question 73

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 these

Question 74

Consider the multifactor APT.The risk premiums on the factor 1 and factor 2 portfolios are 5% and 3%,respectively.The risk-free rate of return is 10%.Stock A has an expected return of 19% and a beta on factor 1 of 0.8.Stock A has a beta on factor 2 of ________.

A) 1.33
B) 1.50
C) 1.67
D) 2.00
E) none of these

Question 75

Imposing the no-arbitrage condition on a single-factor security market implies which of the following statements?
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 III are correct.
B) I and IV are correct.
C) II and III are correct.
D) II and IV are correct.
E) Only I is correct.

Question 76

In terms of the risk/return relationship

A) only factor risk commands a risk premium in market equilibrium.
B) only systematic risk is related to expected returns.
C) only nonsystematic risk is related to expected returns.
D) a and b.
E) a and c.

Question 77

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: $$\begin{array}{l}\begin{array} { l l l l } \text { portfolio}&\beta \text { on F?}&\beta \text { on F?}&\text { expected return}\\A&1.0&2.0&19\%\\B&2.0&0.0&12\%\end{array}\end{array}$$
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 these

Question 78

An important difference between CAPM and APT is

A) CAPM depends on risk-return dominance;APT depends on a no arbitrage condition.
B) CAPM assumes many small changes are required to bring the market back to equilibrium;APT assumes a few large changes are required to bring the market back to equilibrium.
C) implications for prices derived from CAPM arguments are stronger than prices derived from APT arguments.
D) all of these are true.
E) both a and b are true.

Question 79

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 these.

Question 80

The following factors might affect stock returns:

A) the business cycle.
B) interest rate fluctuations.
C) inflation rates.
D) all of these.
E) none of these.