Chapter 8.pdf

Chapter 08 - Portfolio Theory and the Capital Asset Pricing Model

Chapter 08 Portfolio Theory and the Capital Asset Pricing Model Multiple Choice Questions

1. Portfolio Theory was first developed by: A. Merton Miller B. Richard Brealey C. Franco Modigliani D. Harry Markowitz

2. The distribution of returns, measured over a short interval of time, like daily returns, can be approximated by: A. Normal distribution B. Lognormal distribution C. Binomial distribution D. none of the above

3. The distribution of returns, measured over long intervals, like annual returns, can be approximated by A. Normal distribution B. Binomial distribution C. Lognormal distribution D. none of the above

4. Normal and lognormal distributions are completely specified by: I) mean II) standard deviation III) third moment A. I only B. I and II only C. II only D. III only

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5. Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. Calculate the mean of returns for each company. A. FC: 12%, MC: 6% B. FC: 10%, MC: 12% C. FC: 20%, MC: 32% D. None of the above

6. Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: -5%, 15%, 20%; MC: 8%, 8%, 20%. Calculate the variances of return for FC and MC. A. FC: 100 MC: 256 B. FC: 350 MC: 96 C. FC: 175 MC: 48 D. None of the above

7. Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. Calculate the covariance between the returns of FC and MC. A. 60 B. 80 C. 40 D. None of the above

8. Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. Calculate the standard deviation (S.D.) of return for FC and MC. A. FC: 10% MC: 12% B. FC: 18.7% MC: 9.8% C. FC: 13.2% MC: 6.9% D. None of the above

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9. Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. Calculate the correlation coefficient between the return of FC and MC. A. 0.0 B. -0.655 C. +0.655 D. None of the above

10. Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. If FC and MC are combined in a portfolio with 50% of the funds invested in each, calculate the expected return on the portfolio. A. 12% B. 10% C. 11% D. None of the above.

11. Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. What is the variance of the portfolio with 50% of the funds invested in FC and 50% in MC (approximately)? A. 85.75 B. 111.50 C. 55.75 D. None of the above

12. Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. What is the standard deviation of the portfolio with 50% of the funds invested in FC and 50% in MC? A. 10.6% B. 14.4% C. 9.3% D. None of the above

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13. Investments A and B both offer an expected rate of return of 12%. If the standard deviation of A is 20% and that of B is 30%, then investors would: A. Prefer A to B B. Prefer B to A C. Prefer a portfolio of A and B D. Cannot answer without knowing investor's risk preferences

14. Investments B and C both have the same standard deviation of 20%. If the expected return on B is 15% and that of C is 18%, then the investors would A. Prefer B to C B. Prefer C to B C. Reject both B and C D. None of the above

15. The efficient portfolios: I) have only unique risk II) provide highest returns for a given level of risk III) provide the least risk for a given level of returns IV) have no risk at all A. I only B. II and III only C. IV only D. II only

16. In practice, efficient portfolios are generated using: A. regression analysis B. quadratic programming C. trial and error method D. graphical method

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17. By combining lending and borrowing at the risk-free rate with the efficient portfolios, we can I) extend the range of investment possibilities II) change efficient set of portfolios from being curvilinear to a straight line. III) provide a higher expected return for any level of risk except the tangential portfolio A. I only B. I and II only C. I, II, and III D. none of the above

18. Suppose you invest equal amounts in a portfolio with an expected return of 16% and a standard deviation of returns of 20% and a risk-free asset with an interest rate of 4%; calculate the expected return on the resulting portfolio: A. 10% B. 4% C. 12% D. none of the above

19. Suppose you invest equal amounts in a portfolio with an expected return of 16% and a standard deviation of returns of 20% and a risk-free asset with an interest rate of 4%; calculate the standard deviation of the returns on the resulting portfolio: A. 8% B. 10% C. 20% D. none of the above

20. Suppose you borrow at the risk-free rate an amount equal to your initial wealth and invest in a portfolio with an expected return of 16% and a standard deviation of returns of 20%. The risk-free asset has an interest rate of 4%; calculate the expected return on the resulting portfolio: A. 20% B. 32% C. 28% D. none of the above

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21. Suppose you borrow at the risk-free rate an amount equal to your initial wealth and invest in a portfolio with an expected return of 20% and a standard deviation of returns of 16%. The risk-free asset has an interest rate of 4%; calculate standard deviation of the resulting portfolio: A. 28% B. 40% C. 32% D. none of the above

22. If the covariance of Stock A with Stock B is - 100, what is the covariance of Stock B with Stock A? A. +100 B. -100 C. 1/100 D. Need additional information

23. The correlation measures the: A. Rate of movements of the return of individual stocks B. Direction of movement of the return of individual stocks C. Direction of movement between the returns of two stocks D. Stock market volatility

24. If the correlation coefficient between Stock A and Stock B is +0.6, what is the correlation between Stock B with Stock A? A. +0.6 B. -0.6 C. +0.4 D. -0.4

25. The correlation between the efficient portfolio and the risk-free asset is: A. +1 B. -1 C. 0 D. cannot be calculated

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26. In the presence of a risk-free asset, the investor's job is to: I) invest in the market portfolio II) find an interior portfolio using quadratic programming III) borrow or lend at the risk-free rate IV) read and understand Markowitz's portfolio theory A. I and II only B. I and III only C. II and IV only D. IV only

27. Sharpe ratio is defined as: A. (rP - rf)/σP B. (rP - rM)/σP C. (rP - rf)/bP D. none of the above

28. Beta of Treasury bills is: A. +1.0 B. +0.5 C. -1.0 D. 0

29. Beta of the market portfolio is: A. Zero B. +0.5 C. -1.0 D. +1.0

30. The capital asset pricing model (CAPM) states that: A. The expected risk premium on an investment is proportional to its beta B. The expected rate of return on an investment is proportional to its beta C. The expected rate of return on an investment depends on the risk-free rate and the market rate of return D. The expected rate of return on an investment is dependent on the risk-free rate

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31. The graphical representation of CAPM (Capital Asset Pricing Model) is called: A. Capital Market Line B. Characteristic Line C. Security Market Line D. None of the above

32. Beta measure indicates: A. The ability to diversify risk B. The change in the rate of return on an investment for a given change in the market return C. The actual return on an asset D. A and C

33. The security market line (SML) is the graph of: A. Expected rate on investment (Y-axis) vs. variance of return B. Expected return on investment vs. standard deviation of return C. Expected rate of return on investment vs. beta D. A and B

34. If the beta of Microsoft is 1.13, risk-free rate is 3% and the market risk premium is 8%, calculate the expected return for Microsoft. A. 12.04% B. 15.66% C. 13.94% D. 8.65%

35. If the beta of Amazon.com is 2.2, risk-free rate is 5.5% and the market risk premium is 8%, calculate the expected rate of return for Amazon.com stock: A. 15.8% B. 14.3% C. 35.2% D. 23.1%

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36. If the beta of Exxon Mobil is 0.65, risk-free rate is 4% and the market rate of return is 14%, calculate the expected rate of return from Exxon: A. 12.6% B. 10.5% C. 13.1% D. 6.5%

37. A stock with a beta of zero would be expected to: A. Have a rate of return equal to zero B. Have a rate of return equal to the market risk premium C. Have a rate of return equal to the risk-free rate D. Have a rate of return equal to the market rate of return

38. A stock with a beta of 1. 25 would be expected to: A. Increase in returns 25% faster than the market in up markets B. Increase in returns 25% faster than the market in down markets C. Increase in returns 125% faster than the market in up markets D. Increase in returns 125% faster than the market in down markets

39. If the market risk premium is (rm - rf) is 8%, then according to the CAPM, the risk premium of a stock with beta value of 1.7 must be: A. less than 12% B. 12% C. greater than 12% D. cannot be determined

40. The main shortcoming of CAPM is that it A. ignores the return on the market portfolio B. uses too many factors C. requires a single risk measure of systematic risk D. ignores risk-free rate of return

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41. If a stock is overpriced it would plot: A. Above the security market line B. Below the security market line C. On the security market line D. On the Y-axis

42. If a stock is under priced it would plot: A. Above the security market line B. Below the security market line C. On the security market line D. On the Y-axis

43. Given the following data for a stock: beta = 1.5; risk-free rate = 4%; market rate of return = 12%; and Expected rate of return on the stock = 15%. Then the stock is: A. overpriced B. under priced C. correctly priced D. cannot be determined



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46. A "factor" in APT is a variable that: A. is pure "noise" B. correlates with risky asset returns in an unsystematic manner C. affects the return of risky assets in a systematic manner D. affects the return of a risky asset in a random manner

47. Given the following data for a stock: risk-free rate = 4%; factor-1 beta = 1.5; factor-2 beta = 0.5; factor-1 risk-premium = 8%; factor-2 risk-premium = 2%. Calculate the expected rate of return on the stock using the two-factor APT model. A. 13% B. 17% C. 10% D. none of the above

48. The three factors in the Three-Factor Model are: I) Market factor II) Size factor III) Book-to-market factor A. I only B. I and II only C. I,II, and III D. III only

49. Given the following data for the a stock: risk-free rate = 5%; beta (market) = 1.5; beta (size) = 0.3; beta (book-to-market) = 1.1; market risk premium = 7%; size risk premium = 3.7%; and book-to-market risk premium = 5.2%. Calculate the expected return on the stock using the Fama-French three-factor model. A. 22.3% B. 7.8% C. 11.5% D. none of the above

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50. Given the following data for the a stock: risk-free rate = 5%; beta (market) = 1.4; beta (size) = 0.4; beta (book-to-market) = -1.1; market risk premium = 7%; size risk premium = 3.7%; and book-to-market risk premium = 5.2%. Calculate the expected return on the stock using the Fama-French three-factor model. A. 22.3% B. 7.8% C. 10.6% D. none of the above

51. How does an investor earn more than the return generated by the tangency portfolio and still stay on the security market line? A. Borrow at the risk free rate and invest in the tangency portfolio. B. Add high risk/return assets to the portfolio. C. Adjust the weight of stock in the portfolio to include more high return stocks. D. It cannot be done.

52. For a company like Alcoa, what is likely to be the major factor when developing an arbitrage pricing model? A. Asset price of stocks B. Commodity price of aluminum C. GDP D. Inflation

True / False Questions

53. The distribution of daily returns for a stock would be closely related to the lognormal distribution. True False

54. The distribution of annual returns for a stock would be closely related to the normal distribution. True False

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55. If the expected return of stock A is 12% and that of stock B is 14% and both have the same variance, then investors would prefer stock B to stock A. True False

56. If two investments offer the same expected return, most investors would prefer the one with higher variance. True False

57. Portfolios that offer the highest expected return for a given variance or standard deviation are known as efficient portfolios. True False

58. Investors are mainly concerned with those risks that can be eliminated through diversification. True False

59. Beta measures the marginal contribution of a stock to the risk of a well-diversified portfolio. True False

60. According to CAPM, all investments plot along the security market line. True False

61. In theory, the CAPM requires that the market portfolio consist of all common stocks. True False

62. According to the CAPM, market portfolio is a risky portfolio. True False

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63. Tests of CAPM have confirmed that Capital Asset Pricing Model holds good under all circumstances. True False

64. The arbitrage pricing theory (APT) implies that the market portfolio is efficient. True False

65. Both the CAPM and the APT stress that expected return is not affected by unique risk. True False

66. It is not possible to earn a return that is outside the efficient frontier without the existence of a risk free asset or some other asset that is uncorrelated with your portfolio assets. True False

67. The addition of investment grade baseball trading cards is likely to expand the efficient frontier to a better risk return trade off.

True False

Essay Questions

68. Explain the term efficient portfolios.

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69. Briefly explain the effect of introducing borrowing and lending at the risk-free rate on the efficient portfolios.

70. Briefly explain the term "risk-free rate of interest"

71. Briefly explain the term "market portfolio."

72. Explain the term market risk.

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73. Briefly explain the term "security market line."

74. Briefly explain the "capital asset pricing model."

75. Where would under priced and overpriced securities plot on the SML (security market line)?

76. Briefly explain the Fama-French Three-Factor Model.

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77. Briefly discuss how you would use Fama-French three-factor model to estimate the cost of equity for a firm.

78. Explain why growth mutual funds are worse investments than taking out a second mortgage on a home and investing in the market index.

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Chapter 08 Portfolio Theory and the Capital Asset Pricing Model Answer Key

Multiple Choice Questions

1. Portfolio Theory was first developed by: A. Merton Miller B. Richard Brealey C. Franco Modigliani D. Harry Markowitz

Type: Easy

2. The distribution of returns, measured over a short interval of time, like daily returns, can be approximated by: A. Normal distribution B. Lognormal distribution C. Binomial distribution D. none of the above

Type: Medium

3. The distribution of returns, measured over long intervals, like annual returns, can be approximated by A. Normal distribution B. Binomial distribution C. Lognormal distribution D. none of the above

Type: Medium

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4. Normal and lognormal distributions are completely specified by: I) mean II) standard deviation III) third moment A. I only B. I and II only C. II only D. III only

Type: Difficult

5. Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. Calculate the mean of returns for each company. A. FC: 12%, MC: 6% B. FC: 10%, MC: 12% C. FC: 20%, MC: 32% D. None of the above R(FC) = ( - 5 + 15 + 20)/3 = 10%; R(MC) = (8 + 8 + 20)/3 = 12%

Type: Medium

6. Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: -5%, 15%, 20%; MC: 8%, 8%, 20%. Calculate the variances of return for FC and MC. A. FC: 100 MC: 256 B. FC: 350 MC: 96 C. FC: 175 MC: 48 D. None of the above Var(FC) = [( -5 - 10)^2 + (15 - 10)^2 + (20 - 10)^2]/(3 - 1) = 175 Var(MC) = [(8 - 12)^2 + (8 - 12)^2 + (20 - 12)^2]/(3 - 1) = 48

Type: Difficult

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7. Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. Calculate the covariance between the returns of FC and MC. A. 60 B. 80 C. 40 D. None of the above [( -5 - 10)(8 - 12) + (15 - 10)(8 - 12) + (20 - 10)(20 - 12)]/(3 - 1) = 60

Type: Medium

8. Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. Calculate the standard deviation (S.D.) of return for FC and MC. A. FC: 10% MC: 12% B. FC: 18.7% MC: 9.8% C. FC: 13.2% MC: 6.9% D. None of the above Standard Deviation(FC) = 175^0.5 = 13.2%; Standard Deviation(MC) = 48 ^0.5 = 6.9%.

Type: Medium

9. Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. Calculate the correlation coefficient between the return of FC and MC. A. 0.0 B. -0.655 C. +0.655 D. None of the above Correlation Coefficient = Covariance/[(S.D.(FC)) * (S.D.(MC))] = 60/(13.2 * 6.9) = +0.655

Type: Medium

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10. Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. If FC and MC are combined in a portfolio with 50% of the funds invested in each, calculate the expected return on the portfolio. A. 12% B. 10% C. 11% D. None of the above. Rp = (10)(0.5) + (12)(0.5) = 11%

Type: Medium

11. Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. What is the variance of the portfolio with 50% of the funds invested in FC and 50% in MC (approximately)? A. 85.75 B. 111.50 C. 55.75 D. None of the above Var(P) = (0.5^2)(175) + (0.5^2)(48) + (2)(0.5)(0.5)(60) = 85.75

Type: Difficult

12. Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. What is the standard deviation of the portfolio with 50% of the funds invested in FC and 50% in MC? A. 10.6% B. 14.4% C. 9.3% D. None of the above S.D. = (85.75)^0.5 = 9.3%

Type: Medium

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13. Investments A and B both offer an expected rate of return of 12%. If the standard deviation of A is 20% and that of B is 30%, then investors would: A. Prefer A to B B. Prefer B to A C. Prefer a portfolio of A and B D. Cannot answer without knowing investor's risk preferences

Type: Medium

14. Investments B and C both have the same standard deviation of 20%. If the expected return on B is 15% and that of C is 18%, then the investors would A. Prefer B to C B. Prefer C to B C. Reject both B and C D. None of the above

Type: Medium

15. The efficient portfolios: I) have only unique risk II) provide highest returns for a given level of risk III) provide the least risk for a given level of returns IV) have no risk at all A. I only B. II and III only C. IV only D. II only

Type: Easy

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16. In practice, efficient portfolios are generated using: A. regression analysis B. quadratic programming C. trial and error method D. graphical method

Type: Difficult

17. By combining lending and borrowing at the risk-free rate with the efficient portfolios, we can I) extend the range of investment possibilities II) change efficient set of portfolios from being curvilinear to a straight line. III) provide a higher expected return for any level of risk except the tangential portfolio A. I only B. I and II only C. I, II, and III D. none of the above

Type: Difficult

18. Suppose you invest equal amounts in a portfolio with an expected return of 16% and a standard deviation of returns of 20% and a risk-free asset with an interest rate of 4%; calculate the expected return on the resulting portfolio: A. 10% B. 4% C. 12% D. none of the above Expected return = 0.5(16) + 0.5(4) = 10%

Type: Medium

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19. Suppose you invest equal amounts in a portfolio with an expected return of 16% and a standard deviation of returns of 20% and a risk-free asset with an interest rate of 4%; calculate the standard deviation of the returns on the resulting portfolio: A. 8% B. 10% C. 20% D. none of the above Standard deviation = 0.5(20) = 10%

Type: Medium

20. Suppose you borrow at the risk-free rate an amount equal to your initial wealth and invest in a portfolio with an expected return of 16% and a standard deviation of returns of 20%. The risk-free asset has an interest rate of 4%; calculate the expected return on the resulting portfolio: A. 20% B. 32% C. 28% D. none of the above Expected return = 2(16) - (4) = 28%

Type: Medium

21. Suppose you borrow at the risk-free rate an amount equal to your initial wealth and invest in a portfolio with an expected return of 20% and a standard deviation of returns of 16%. The risk-free asset has an interest rate of 4%; calculate standard deviation of the resulting portfolio: A. 28% B. 40% C. 32% D. none of the above Standard Deviation = 2(20) = 40%

Type: Medium

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22. If the covariance of Stock A with Stock B is - 100, what is the covariance of Stock B with Stock A? A. +100 B. -100 C. 1/100 D. Need additional information

Type: Easy

23. The correlation measures the: A. Rate of movements of the return of individual stocks B. Direction of movement of the return of individual stocks C. Direction of movement between the returns of two stocks D. Stock market volatility

Type: Medium

24. If the correlation coefficient between Stock A and Stock B is +0.6, what is the correlation between Stock B with Stock A? A. +0.6 B. -0.6 C. +0.4 D. -0.4

Type: Easy

25. The correlation between the efficient portfolio and the risk-free asset is: A. +1 B. -1 C. 0 D. cannot be calculated

Type: Difficult

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26. In the presence of a risk-free asset, the investor's job is to: I) invest in the market portfolio II) find an interior portfolio using quadratic programming III) borrow or lend at the risk-free rate IV) read and understand Markowitz's portfolio theory A. I and II only B. I and III only C. II and IV only D. IV only

Type: Difficult

27. Sharpe ratio is defined as: A. (rP - rf)/σP B. (rP - rM)/σP C. (rP - rf)/bP D. none of the above

Type: Medium

28. Beta of Treasury bills is: A. +1.0 B. +0.5 C. -1.0 D. 0

Type: Easy

29. Beta of the market portfolio is: A. Zero B. +0.5 C. -1.0 D. +1.0

Type: Easy

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30. The capital asset pricing model (CAPM) states that: A. The expected risk premium on an investment is proportional to its beta B. The expected rate of return on an investment is proportional to its beta C. The expected rate of return on an investment depends on the risk-free rate and the market rate of return D. The expected rate of return on an investment is dependent on the risk-free rate

Type: Medium

31. The graphical representation of CAPM (Capital Asset Pricing Model) is called: A. Capital Market Line B. Characteristic Line C. Security Market Line D. None of the above

Type: Medium

32. Beta measure indicates: A. The ability to diversify risk B. The change in the rate of return on an investment for a given change in the market return C. The actual return on an asset D. A and C

Type: Medium

33. The security market line (SML) is the graph of: A. Expected rate on investment (Y-axis) vs. variance of return B. Expected return on investment vs. standard deviation of return C. Expected rate of return on investment vs. beta D. A and B

Type: Medium

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34. If the beta of Microsoft is 1.13, risk-free rate is 3% and the market risk premium is 8%, calculate the expected return for Microsoft. A. 12.04% B. 15.66% C. 13.94% D. 8.65% E(R) = 3 + 1.13(8) = 12.04%

Type: Medium

35. If the beta of Amazon.com is 2.2, risk-free rate is 5.5% and the market risk premium is 8%, calculate the expected rate of return for Amazon.com stock: A. 15.8% B. 14.3% C. 35.2% D. 23.1% Beta = 5.5 + (2.2)(8) = 23.1%

Type: Medium

36. If the beta of Exxon Mobil is 0.65, risk-free rate is 4% and the market rate of return is 14%, calculate the expected rate of return from Exxon: A. 12.6% B. 10.5% C. 13.1% D. 6.5% Beta = 4 + 0.65(14 - 4) = 8.7%

Type: Medium

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37. A stock with a beta of zero would be expected to: A. Have a rate of return equal to zero B. Have a rate of return equal to the market risk premium C. Have a rate of return equal to the risk-free rate D. Have a rate of return equal to the market rate of return

Type: Medium

38. A stock with a beta of 1. 25 would be expected to: A. Increase in returns 25% faster than the market in up markets B. Increase in returns 25% faster than the market in down markets C. Increase in returns 125% faster than the market in up markets D. Increase in returns 125% faster than the market in down markets

Type: Medium

39. If the market risk premium is (rm - rf) is 8%, then according to the CAPM, the risk premium of a stock with beta value of 1.7 must be: A. less than 12% B. 12% C. greater than 12% D. cannot be determined

Type: Medium

40. The main shortcoming of CAPM is that it A. ignores the return on the market portfolio B. uses too many factors C. requires a single risk measure of systematic risk D. ignores risk-free rate of return

Type: Medium

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41. If a stock is overpriced it would plot: A. Above the security market line B. Below the security market line C. On the security market line D. On the Y-axis

Type: Difficult

42. If a stock is under priced it would plot: A. Above the security market line B. Below the security market line C. On the security market line D. On the Y-axis

Type: Difficult

43. Given the following data for a stock: beta = 1.5; risk-free rate = 4%; market rate of return = 12%; and Expected rate of return on the stock = 15%. Then the stock is: A. overpriced B. under priced C. correctly priced D. cannot be determined r = 4 + (1.5) * (12 - 4) = 16%; the expected rate of return is less than the required rate of return. The stock is overpriced.

Type: Difficult

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44. Given the following data for a stock: beta = 0.5; risk-free rate = 4%; market rate of return = 12%; and Expected rate of return on the stock = 10%. Then the stock is: A. overpriced B. under priced C. correctly priced D. cannot be determined r = 4 + (0.5) * (12 - 4) = 8%; the expected rate of return is more than the required rate of return. The stock is under priced.

Type: Difficult

45. Given the following data for a stock: beta = 0.9; risk-free rate = 4%; market rate of return = 14%; and Expected rate of return on the stock = 13%. Then the stock is: A. overpriced B. under priced C. correctly priced D. cannot be determined r = 4 + (0.9) * (14 - 4) = 13%; the expected rate of return is equal to the required rate of return. The stock is correctly priced.

Type: Difficult

46. A "factor" in APT is a variable that: A. is pure "noise" B. correlates with risky asset returns in an unsystematic manner C. affects the return of risky assets in a systematic manner D. affects the return of a risky asset in a random manner

Type: Medium

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47. Given the following data for a stock: risk-free rate = 4%; factor-1 beta = 1.5; factor-2 beta = 0.5; factor-1 risk-premium = 8%; factor-2 risk-premium = 2%. Calculate the expected rate of return on the stock using the two-factor APT model. A. 13% B. 17% C. 10% D. none of the above r = 4 + (1.5) * (8) + (0.5) * (2) = 17%

Type: Medium

48. The three factors in the Three-Factor Model are: I) Market factor II) Size factor III) Book-to-market factor A. I only B. I and II only C. I,II, and III D. III only

Type: Easy

49. Given the following data for the a stock: risk-free rate = 5%; beta (market) = 1.5; beta (size) = 0.3; beta (book-to-market) = 1.1; market risk premium = 7%; size risk premium = 3.7%; and book-to-market risk premium = 5.2%. Calculate the expected return on the stock using the Fama-French three-factor model. A. 22.3% B. 7.8% C. 11.5% D. none of the above Expected return = 5 + (1.5) * (7) + (0.3) * (3.7) + (1.1) * (5.2) = 22.3%

Type: Difficult

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50. Given the following data for the a stock: risk-free rate = 5%; beta (market) = 1.4; beta (size) = 0.4; beta (book-to-market) = -1.1; market risk premium = 7%; size risk premium = 3.7%; and book-to-market risk premium = 5.2%. Calculate the expected return on the stock using the Fama-French three-factor model. A. 22.3% B. 7.8% C. 10.6% D. none of the above Expected return = 5 + (1.4) * (7) + (0.4) * (3.7) + ( - 1.1) * (5.2) = 10.6%

Type: Difficult

51. How does an investor earn more than the return generated by the tangency portfolio and still stay on the security market line? A. Borrow at the risk free rate and invest in the tangency portfolio. B. Add high risk/return assets to the portfolio. C. Adjust the weight of stock in the portfolio to include more high return stocks. D. It cannot be done.

Type: Medium

52. For a company like Alcoa, what is likely to be the major factor when developing an arbitrage pricing model? A. Asset price of stocks B. Commodity price of aluminum C. GDP D. Inflation

Type: Difficult

True / False Questions

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53. The distribution of daily returns for a stock would be closely related to the lognormal distribution. FALSE

Type: Medium

54. The distribution of annual returns for a stock would be closely related to the normal distribution. FALSE

Type: Medium

55. If the expected return of stock A is 12% and that of stock B is 14% and both have the same variance, then investors would prefer stock B to stock A. TRUE

Type: Easy

56. If two investments offer the same expected return, most investors would prefer the one with higher variance. FALSE

Type: Easy

57. Portfolios that offer the highest expected return for a given variance or standard deviation are known as efficient portfolios. TRUE

Type: Easy

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58. Investors are mainly concerned with those risks that can be eliminated through diversification. FALSE

Type: Medium

59. Beta measures the marginal contribution of a stock to the risk of a well-diversified portfolio. TRUE

Type: Difficult

60. According to CAPM, all investments plot along the security market line. TRUE

Type: Medium

61. In theory, the CAPM requires that the market portfolio consist of all common stocks. FALSE

Type: Medium

62. According to the CAPM, market portfolio is a risky portfolio. TRUE

Type: Difficult

63. Tests of CAPM have confirmed that Capital Asset Pricing Model holds good under all circumstances. FALSE

Type: Difficult

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64. The arbitrage pricing theory (APT) implies that the market portfolio is efficient. FALSE

Type: Medium

65. Both the CAPM and the APT stress that expected return is not affected by unique risk. TRUE

Type: Difficult

66. It is not possible to earn a return that is outside the efficient frontier without the existence of a risk free asset or some other asset that is uncorrelated with your portfolio assets. TRUE

Type: Medium

67. The addition of investment grade baseball trading cards is likely to expand the efficient frontier to a better risk return trade off.

TRUE

Type: Medium

Essay Questions

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68. Explain the term efficient portfolios. By investing in various securities in different proportions, investors can for infinitely different portfolios with different risk return characteristics. As small portion of these portfolios provide the highest return for a given level of risk or the least risk for a given level of return. These portfolios are called efficient portfolios. They can be generated using quadratic programming.

Type: Medium

69. Briefly explain the effect of introducing borrowing and lending at the risk-free rate on the efficient portfolios. Borrowing and lending extend the range of investment possibilities by providing a new set of efficient portfolios except for the tangential point. This new set of efficient portfolios offers higher expected return for any level of risk than just investing in common stocks.

Type: Medium

70. Briefly explain the term "risk-free rate of interest" Theoretically, risk-free rate of interest has zero risk and hence plots on the y-axis of riskexpected return graph. In practice, Treasury bill rates are used as risk-free rate.

Type: Easy

71. Briefly explain the term "market portfolio." Market portfolio is a risky portfolio that has the average risk for the economy. The beta of this portfolio is one. Market-index portfolios represent it in practice.

Type: Medium

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72. Explain the term market risk. Market risk is that part of the risk that is associated with market-wide variations. Investors cannot eliminate market risk. All the risk in a well-diversified portfolio is market risk. Beta is a measure of market risk.

Type: Medium

73. Briefly explain the term "security market line." Security market line (SML) is the straight-line plot of "beta" on the x-axis and expected return on investment on y-axis. This straight line joins two benchmark investments: Risk-free rate on the y-axis and the market portfolio, which has a beta of one. It provides the risk-return tradeoff for any security. In equilibrium all securities should plot on SML. It is used for comparing investments with different risk characteristics.

Type: Medium

74. Briefly explain the "capital asset pricing model." The relationship, that in a competitive market, the expected risk premium on a security varies in direct proportion to beta is called the capital asset pricing model (CAPM). It is expressed as: (r - rf) = β (rm- rf). Where: (r - rf) = expected risk premium on any security (rm - rf) = market risk premium b = security risk It is used for comparing investments with different risk characteristics. CAPM is also written in this form: (r) = rf + β (rm - rf).

Type: Medium

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75. Where would under priced and overpriced securities plot on the SML (security market line)? Under priced securities would plot above the SML and overpriced securities would plot below the SML. These conditions do not last long in a competitive market. As investors start buying the under priced securities, their prices will increase and would be forced to move towards the SML. Investors would sell the overpriced securities thereby forcing their prices down and again these securities would move towards the SML. In equilibrium all securities will plot on the SML.

Type: Medium

76. Briefly explain the Fama-French Three-Factor Model. The three-factor model was developed by Fama and French and is an empirical model.

They have identified three factors that explain the security risk premium better. The three factors are: Market factor, Size factor, and Book-to-market factor.

Type: Medium

77. Briefly discuss how you would use Fama-French three-factor model to estimate the cost of equity for a firm. • The three factors considered are: (1) market factor, (2) size factor, and (3) book-to-market value factor. • Estimate the risk premiums for each factor. • Estimate the factor sensitivities. Use the following model to estimate the expected equity returns on the stock.

Type: Difficult

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78. Explain why growth mutual funds are worse investments than taking out a second mortgage on a home and investing in the market index. The growth mutual fund is usually riskier than the market portfolio. It is well below the security market line and is not producing an efficient risk return trade off. While difficult to accept, a second mortgage permits the investor to create a leveraged investment in the tangency portfolio. This generates a return that is on the security market line and has a higher return given the same level of risk as the growth fund. As such, the investor can earn a better risk return trade off than with the growth fund. True, this is a very risky investment, but it is better than the growth fund. Investors often fail to realize the risk of the growth fund.

Type: Difficult

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Chapter 8.pdf

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