Question 1

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/TSX composite index 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?

Accepted Answer

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 2

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

Accepted Answer

A) True 
 B)False

Question 3

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

Accepted Answer

A) True 
 B)False

Question 4

Under the following conditions, what are the expected returns for stocks X and Y?

$\begin{array}{ll}
\lambda^{0}=0.05 & b_{x, 1}=0.90 \
k_{1}=0.03 & b_{x, 2}=1.60 \
k_{2}=0.04 & b_{y, 1}=1.50 \
& b_{y, 2}=0.85
\end{array}$

Accepted Answer

A)  14.1% and 12.9% 
B)  12.5% and 19.5% 
C)  19.5% and 18.5% 
D)  21.2% and 18.5% 
E)  None of the above

Question 5

If the wrong benchmark (or market portfolio) is selected then

Accepted Answer

A)  Computed betas would be wrong. 
B)  The SML would be wrong. 
C)  Computed betas would be correct. 
D)  Choices a and b. 
E)  Choices b and c.

Question 6

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

Accepted Answer

A) True 
 B)False

Question 7

Exhibit 7-2
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
You expect the risk-free rate (RFR) to be 3% and the market return to be 8%. You also have the following information about three stocks. $$\begin{array} { c c c c c } 
\text { STOCK } & \text { BETA } & \begin{array} { c } 
\text { CURRENT } \
\text { PRICE }
\end{array} & \begin{array} { c } 
\text { EXPECTED } \
\text { PRICE }
\end{array} & \begin{array} { c } 
\text { EXIPECTED } \
\text { DIVIDEND }
\end{array} \
\hline \mathbf { X } & 1.25 & \$ 20 & \$ 23 & \$ 1.25 \
\mathbf { Y } & 1.50 & \$ 27 & \$ 29 & \$ 3.25 \
\mathbf { Z } & 0.90 & \$ 35 & \$ 38 & \$ 1.00
\end{array}$$
-Refer to Exhibit 7-2. What is your investment strategy concerning the three stocks?

Accepted Answer

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 8

Studies strongly suggest that the CAPM be abandoned and replaced with the APT.

Accepted Answer

A) True 
 B)False

Question 9

Consider an asset that has a beta of 1.5. The return on the risk-free asset is 6.5% and the expected return on the stock index is 15%. The estimated return on the asset is 20%. Calculate the alpha for the asset.

Accepted Answer

A)  19.25% 
B)  0.75% 
C)  -0.75% 
D)  9.75% 
E)  9.0%

Question 10

The variance of returns for a risky asset is 25%. The variance of the error term, Var(e) is 8%. What portion of the total risk of the asset, as measured by variance, is systematic?

Accepted Answer

A)  32% 
B)  8% 
C)  68% 
D)  25% 
E)  75%

Question 11

What does WRF = -0.50 mean?

Accepted Answer

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 12

In a macro-economic based risk factor model, which factor would be one of many appropriate factors?

Accepted Answer

A)  Confidence risk. 
B)  Maturity risk. 
C)  Expected inflation risk. 
D)  Call risk. 
E)  Return difference between small capitalization and large capitalization stocks.

Question 13

Exhibit 7-1
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S) $$\begin{array}{c}
\underline {\text { Rates of Return }}\
\begin{array} { c c c } 
\text { Year } & \text { RA Computer } & \text { Market Index } \
\hline 1 & 13 & 17 \
2 & 9 & 15 \
3 & - 11 & 6 \
4 & 10 & 8 \
5 & 11 & 10 \
6 & 6 & 12
\end{array}
\end{array}$$
-Refer to Exhibit 7-1. Compute the correlation coefficient between RA Computer and the Market Index.

Accepted Answer

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

Question 14

Exhibit 7-2
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
You expect the risk-free rate (RFR) to be 3% and the market return to be 8%. You also have the following information about three stocks. $$\begin{array} { c c c c c } 
\text { STOCK } & \text { BETA } & \begin{array} { c } 
\text { CURRENT } \
\text { PRICE }
\end{array} & \begin{array} { c } 
\text { EXPECTED } \
\text { PRICE }
\end{array} & \begin{array} { c } 
\text { EXIPECTED } \
\text { DIVIDEND }
\end{array} \
\hline \mathbf { X } & 1.25 & \$ 20 & \$ 23 & \$ 1.25 \
\mathbf { Y } & 1.50 & \$ 27 & \$ 29 & \$ 3.25 \
\mathbf { Z } & 0.90 & \$ 35 & \$ 38 & \$ 1.00
\end{array}$$
-Refer to Exhibit 7-2. What are the estimated rates of return for the three stocks (in the order X, Y, Z)?

Accepted Answer

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 15

Consider the following two factor APT model E(R) = λ₀ + λ₁b₁ + λ₂b₂?

Accepted Answer

A)  λ₁ is the expected return on the asset with zero systematic risk. 
B)  λ₁ is the expected return on asset 1. 
C)  λ₁ is the pricing relationship between the risk premium and the asset. 
D)  λ₁ is the risk premium. 
E)  λ₁ is the factor loading.

Question 16

Consider the following list of risk factors: 1. monthly growth in industrial production
2. return on high book to market value portfolio minus return on low book to market value portfolio
3. change in inflation
4. excess return on stock market portfolio
5. return on small cap portfolio minus return on big cap portfolio
6. unanticipated change in bond credit spread
Which of the following factors would you use to develop a macroeconomic-based risk factor model?

Accepted Answer

A)  1, 2, and 3. 
B)  1, 3, and 5. 
C)  2, 4, and 5. 
D)  1, 3, and 6. 
E)  4, 5, and 6.

Question 17

Exhibit 7-3
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S) $$\begin{array} { c c c c } 
\text { Period } & \begin{array} { c } 
\text { Return } \
\text { of Radtran } \
\text { (Percent) }
\end{array} & \begin{array} { c } 
\text { Ppecific Index } \
\text { (Percent) }
\end{array} & \begin{array} { c } 
\text { True } \
\text { General Index } \
\text { (Percent) }
\end{array} \
\hline 1 & 10 & 12 & 15 \
2 & 12 & 10 & 13 \
3 & - 10 & - 8 & - 8 \
4 & - 4 & - 10 & 0
\end{array}$$
-Refer to Exhibit 7-3. What is the average return for Radtron?

Accepted Answer

A)  1% 
B)  2% 
C)  3% 
D)  4% 
E)  5%

Question 18

Exhibit 7-8
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
Consider the three stocks, stock X, stock Y and stock Z, that have the following factor loadings (or factor betas) $$\begin{array} { c c c } 
\text { Stack } & \text { Factor 1 Loading } & \text { Factor 2 Loading } \
\hline \mathbf { X } & - 0.55 & 1.2 \
\mathbf { Y } & - 0.10 & 0.85 \
\mathbf { Z } & 0.35 & 0.5
\end{array}$$ 
The zero-beta return (λ₀) = 3%, and the risk premia are λ₁ = 10%, λ₂ = 8%. Assume that all three stocks are currently priced at $50.
-Refer to Exhibit 7-8. If you know that the actual prices one year from now are stock X $55, stock Y 52, and stock Z $57, then

Accepted Answer

A)  stock X is undervalued, stock Y is undervalued, stock Z is undervalued. 
B)  stock X is undervalued, stock Y is overvalued, stock Z is overvalued. 
C)  stock X is overvalued, stock Y is undervalued, stock Z is undervalued. 
D)  stock X is undervalued, stock Y is overvalued, stock Z is undervalued. 
E)  stock X is overvalued, stock Y is overvalued, stock Z is undervalued.

Question 19

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

Accepted Answer

A) True 
 B)False

Question 20

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.

Accepted Answer

A) True 
 B)False

Exam 7: Asset Pricing Models: Capm and Apt

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

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

Under the following conditions, what are the expected returns for stocks X and Y? $\begin{array}{ll}\lambda^{0}=0.05 & b_{x, 1}=0.90 \\k_{1}=0.03 & b_{x, 2}=1.60 \\k_{2}=0.04 & b_{y, 1}=1.50 \\& b_{y, 2}=0.85\end{array}$

If the wrong benchmark (or market portfolio) is selected then

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

Studies strongly suggest that the CAPM be abandoned and replaced with the APT.

Consider an asset that has a beta of 1.5. The return on the risk-free asset is 6.5% and the expected return on the stock index is 15%. The estimated return on the asset is 20%. Calculate the alpha for the asset.

The variance of returns for a risky asset is 25%. The variance of the error term, Var(e) is 8%. What portion of the total risk of the asset, as measured by variance, is systematic?

What does WRF = -0.50 mean?

In a macro-economic based risk factor model, which factor would be one of many appropriate factors?

Consider the following two factor APT model E(R) = λ₀ + λ₁b₁ + λ₂b₂?

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

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.