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(b, moderate)
(c, moderate)
a. Single investors can affect the market by their buying and selling
decisions.
b. There is no inflation.
c. Investors prefer capital gains over dividends.
d. Different investors have different probability distributions..
(b, moderate)
a. Investors recognize that all the assumptions of the CMT are unrealistic.
b. Investors recognize that all of the CMT assumptions are not unrealistic.
c. Investors are not aware of the assumptions of the CMT model.
d. Investors recognize the CMT is useless for individual investors.
(b, moderate)
a. savings account
b. certificate of deposit
c. Treasury bill
d. Treasury bond
(c, easy)
(b, difficult)
(b, moderate)
a. Ex post
b. When investors are risk-lovers
c. When the SML is upward sloping
d. When the risk premium for the market is very high
(a, difficult)
a. intercept of the CML is the origin while the intercept of the SML is RF.
b. CML consists of efficient portfolios, while the SML is concerned with all
portfolios or securities.
c. CML could be downward sloping while that is impossible for the SML.
d. CML and the SML are essentially the same except in terms of the
securities represented.
(b, difficult)
(c, moderate)
11 The SML can be used to analyze the relationship between risk and
required return for
a. all assets.
b. inefficient portfolios.
c. only efficient portfolios.
d. only individual securities.
(a, easy)
12. Which of the following is the correct calculation for the required rate of
return under the CAPM?
(c, moderate)
13. Under the CMT, the relevant risk to consider with any security is:
(b, difficult)
(b, moderate)
a. hold the same portfolio of risky assets and therefore have the same
risk/return combination.
b. have different optimal portfolios.
c. have the same portfolio of risky assets and achieve their own risk-return
combination through borrowing and lending.
d. hold the same portfolio of risky assets and the same expected return but at
different levels of risk
(d, difficult)
(b, moderate)
(c, easy)
(c, moderate)
(a, moderate)
20. The expected return on the market for next period is 16 percent. The risk
free rate of return is 7 percent, and Alpha Company has a beta of 1.1. The
market risk premium is
(b, easy)
21. The expected market return is 16 percent. The risk-free rate of return is 7
percent, and BC Co. has a beta of 1.1. Their required rate of return is
(c, moderate)
(b, moderate)
24. If a certain stock has a beta greater than 1.0, it means that
a. the stock's return is more volatile than that of the market portfolio.
b. an investor can eliminate the risk by combining it with another stock that
has a negative beta.
c. an investor will earn a higher return on his stock than that on the market
portfolio.
d. the stock is less risky than the market portfolio.
(a, easy)
a. Risk-free Model.
b. CAPM.
c. CML.
d. Market Model.
(d, easy)
a. SML.
b. CML.
c. characteristic line.
d. slope.
(c, easy)
27. Which of the following is not one of the reasonable conclusions of the
CAPM reached by a consensus of the empirical results?
(b, difficult)
28. The arbitrage pricing theory (APT) and the CAPM both assume all except
which of the following?
(c, difficult)
29. Risk factors in the APT must possess all of the following the
characteristics except:
(a, moderate)
(c, difficult)
a. considers only one factor and is a narrower model than the CAPM.
b. considers more factors than the CAPM and is a broader model.
c. is useful only for well-diversified portfolios of common stock.
d. is easy to practice because the factors are readily observable.
(b, moderate)
a. law of averages.
b. law of attraction.
c. law of accelerating return.
d. law of one price.
(d, easy)
True/False Questions
(T, easy)
(F, difficult)
3. The CML indicates the required return for each portfolio risk level.
(T, moderate)
4. A security that plots above the SML would be a good security to sell
short.
(F, difficult)
(F, easy)
6. The CML states that all investors should invest in the same portfolio of
risky assets.
(T, moderate)
7. Most analysts use the Dow Jones Industrial Average as proxy for the
market portfolio.
(F, easy)
8. Testing of the CAPM suggests the trade-off between expected return and
risk is an upward-sloping straight line.
(T, moderate)
(T, moderate)
10. Unlike the CAPM, the APT does not assume borrowing and lending at the
risk-free rate.
(T, moderate)
11. With the APT, risk is defined in terms of a stock's sensitivity to basic
economic factors.
(T, moderate)
12. Like the CAPM, the APT assumes a single-period investment horizon.
(F, moderate)
13. Both the CAPM and the APT assume that markets are perfect.
(T, moderate)
(T, easy)
Short-Answer Questions
1. How are securities chosen and in what proportions are they represented in
the market portfolio M?
(moderate)
2. What is the formula for the slope of the CML? What does it represent?
(moderate)
3. An analyst determined that for the past two quarters the risk-free rate has
exceeded the return on the market portfolio. Does this information
disprove the CML?
Answer: No, it merely shows that actual returns often diverge from
expected returns. The CML is founded on expected values, so that
proof or disproof does not lie in historical values.
(difficult)
Answer: One would expect the betas of defensive securities to be near zero
or even negative.
(moderate)
5. At a given point in time the SML dictates that a security with a beta of
1.10 should require a return of 18 percent. Analysts determine that a
particular stock with an observed beta of 1.10 has an expected return of 20
(difficult)
6. Two points define a straight line. What two points could be most readily
identified to estimate the SML?
Answer: The risk-free rate because the beta is defined as zero and the
expected market return because the beta is defined as 1.00.
(difficult)
7. Betas of individual securities are unstable over time. What are some
characteristics that could cause a companys beta to change over time?
(moderate)
8. What are the assumptions in the CAPM? Can these be relaxed without
destroying the conclusions of the model?
(difficult)
Answer: Suggest that investors are more averse to risk than before the shift.
They now require a risk premium of 11 percent (16 percent- 5
percent), whereas, they previously required 10 percent (15 percent
- 5 percent) on the market portfolio. A downward shift would
indicate less aversion to risk.
(difficult)
10. Why is market risk sometimes said to be the relevant risk for a portfolio
manager? What is the measure of market risk?
(moderate)
1. Compare the capital market line and the security market line.
Partial answer:
CML SML
efficient portfolios consisting of RF and M securities and
portfolios.
CML and SML both indicate an upward sloping expected return-risk
tradeoff.
2. Compare the security market line model and the arbitrage pricing theory.
Answer: SML is a one-factor model, the factor being the market risk
premium. The APT has more factors (often three to five),
such as unanticipated changes in inflation, industrial
production, etc. Unlike the CAPM, the APT does
not assume a single-period investment horizon, no
taxes, borrowing and lending at rate the RF, investor
selection on basis of expected return and variance. Both
CAPM and APT assume homogeneous beliefs, risk-averse utility
maximizers, perfect markets, and returns generated by a factor model.
(difficult)
1. The expected return for the market is 12 percent, with a standard deviation
of 20 percent. The expected risk-free rate is 8 percent. Information is
available for three mutual funds, all assumed to be efficient, as follows:
Solution:
(difficult)
(a) Calculate the required return for each stock using the SML.
(b) Assume that an analyst, using fundamental analysis, develops the
estimates labeled Ri for these stocks. Which stock would be
recommended for purchase?
Solution:
(difficult)
(moderate)