Deck 8: The Capital Asset Pricing Model and Multi-Factor Models

Question 1

What are the two variables whose relationship is represented by the Security Market Line?

A) Diversification and correlation
B) Risk and diversification
C) Beta and risk
D) Beta and expected returns

Answer 1

D

Question 2

Which one of the following statements does Arnold consider to be controversial?

A) Shareholders demand a higher return for riskier assets.
B) Systematic risk is measured by beta.
C) Risk- averters are wise to diversify.
D) Investors will not be rewarded for bearing unsystematic risk.

Answer 2

B

Question 3

What return would you expect if the risk- free rate of return was 5 per cent, the beta risk is 1.5, and the historical risk premium has been 6 per cent? (Base you calculation on the capital asset pricing model.)

A) 14%
B) 13.5%
C) 11%
D) 16.5%

Answer 3

A

Question 4

The cost of ordinary equity may be estimated by using the

A) discounted payback method.
B) capital asset pricing model.
C) internal rate of return.
D) yield curve.

Question 5

An increase in the beta of a firm indicates , and, all else being the same, results in .

A) an increase in risk; a higher required rate of return and hence a lower share price.
B) a decrease in risk; a higher required rate of return and hence a lower share price.
C) a decrease in risk; a lower required rate of return and hence a higher share price.
D) an increase in risk; a lower required rate of return and hence a higher share price.

Question 6

What is the basic predication of the CAPM?

A) Investment risk increases with asset value.
B) The average return on a financial asset decreases with risk.
C) The average return on a financial asset increases with risk.
D) Investment risk decreases with asset value.

Question 7

In the capital asset pricing model, the general risk preferences of investors in the marketplace are reflected by

A) the risk- free rate.
B) the difference between the security market line and the risk- free rate.
C) the level of the security market line.
D) the slope of the security market line.

Question 8

Asset Y has a beta of 1.2. The risk- free rate of return is 6%, while the return on the market portfolio of assets is 12%. The asset's market risk premium is

A) 10 %
B) 6.0%
C) 7.2%
D) 13.2%

Question 9

For a particular share, a 1 per cent change in the market index generally leads to a return of less than 1 per cent on the company's share. What can be concluded about the value of beta (fi)?

A) fi > 1
B) fi = - 1
C) fi < 1
D) fi = 1

Question 10

Which two of the statements accurately relate to unsystematic risk?

A) Unsystematic risk can be accurately measured using beta.
B) Unsystematic risk highlights risks common to all firms.
C) An efficient market will not reward unsystematic risk.
D) Unsystematic risk can be eliminated by diversification.

Question 11

Asset P has a beta of 0.9. The risk- free rate of return is 8%, while the return on the market portfolio of assets is 14%. The asset's required rate of return is

A) 13.4%
B) 5.4%
C) 10%
D) 6%

Question 12

Shares in a company are perfectly correlated with the market return. The risk free rate of return is 5 per cent and the risk premium is 6 per cent. What is the expected return?

A) 30%
B) 11%
C) 1%
D) 1.2%

Question 13

Using the capital asset pricing model, the cost of ordinary stock equity is the return required by investors as compensation for

A) the specific risk of the firm.
B) price volatility of the stock.
C) the firm's diversifiable risk.
D) the firm's nondiversifiable risk.

Question 14

If the beta of a specific share is 1, what is the likely result of a 2 per cent increase in the market index return?

A) A 2 per cent increase in the return on the share
B) A 0.5 per cent decrease in the return on the share
C) A 2 per cent decrease in the return on the share
D) A 0.5 per cent increase in the return on the share

Question 15

Which two of the following highlight technical problems with the CAPM?

A) The market portfolio is unobservable.
B) It is a one- period model estimated at one point in time.
C) It can be used to assess levels of risk.

Question 16

Which of the following gives the best definition of the CAPM approach?

A) Unsystematic risk, as measured by beta, is the only factor affecting the level of return required on a share for a completely diversified investor.
B) Systematic risk, as measured by beta, is the only factor affecting the level of return required on a share for a completely diversified investor.
C) Unsystematic risk, as measured by beta, is one of the key factors affecting the level of return required on a share for a completely diversified investor.
D) Systematic risk, as measured by beta, is one of the key factors affecting the level of return required on a share for a completely diversified investor.

Question 17

Which three of the following are common applications of the CAPM?

A) Assessing the required rate of return on a firm's projects
B) Portfolio selection
C) Identifying incorrect ex ante assumptions in a firm's accession policy
D) Identifying mispriced shares

Question 18

In the formula E(ri) = rf + fi E(rm - rf), what does the term E(rm - rf) represent?

A) The change in share value
B) The average risk premium for shares
C) The risk free rate
D) The increase in share value

Question 19

A firm has a beta of 1.2. The market return equals 14% and the risk- free rate of return equals 6 %. The estimated cost of ordinary equity is

A) 6%
B) 15.6%
C) 14%
D) 7.2%

Question 20

What is represented by the symbol rf in the formula ri = rf + fi (rm - rf) ?

A) Risk free rate of return
B) Market rate of return
C) Free market rate of return
D) Fundamental rate of return

Question 21

The value of zero for beta coefficient of the risk- free asset reflects not only its absence of risk but also the fact that the asset's return is unaffected by movements in the market return.

Question 22

The difference between the return on the market portfolio of assets and the risk- free rate of return represents the premium the investor must receive for taking the average amount of risk associated with holding the market portfolio of assets.

Question 23

What does beta measure?

A) The level of risk associated with a market segment
B) Covariance between returns on a particular share with the returns of the market as a whole
C) The positive variance between returns on a particular share with the returns of a segment of the market
D) Covariance between two shares

Question 24

Use of the Capital Asset Pricing Model (CAPM) in measuring the cost of ordinary equity differs from the constant dividend growth valuation model in that it directly considers the firm's risk as reflected by beta.

Question 25

The cost of ordinary equity for a firm would be 18% if the risk- free return is 5%, the market risk premium is 10%, and the firm's beta is 1.3.

Question 26

Using the Capital Asset Pricing Model (CAPM), the cost of ordinary equity is the return required by investors as compensation for the firm's nondiversifiable risk.

Question 27

The security market line (SML) reflects the required return in the marketplace for each level of nondiversifiable risk (beta).

Question 28

The capital asset pricing model describes the relationship between the required return, or the cost of common stock equity capital, and the nonsystematic risk of the firm as measured by the beta coefficient.

Question 29

The cost of ordinary equity for a firm would be 18% if the risk- free return is 5%, the market return is 10%, and the firm's beta is 1.3.

Question 30

Which model would you be adopting if you used the formula E(ri) = rf + fi[E (rm)- rf) ?

A) Portfolio Expected Returns
B) Capital Asset Pricing
C) Security Market Line
D) Risk Removal by Diversification