Question 1

Refer to the information in the previous question. 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

Comparing the actual prices with the fair values calculated in the previous question:
- Stock X's fair value = €50, which is below the actual price of €55. Therefore, stock X is overvalued.
- Stock Y's fair value = €55, which is above the actual price of €52. Therefore, stock Y is undervalued.
- Stock Z's fair value = €60, which is above the actual price of €57. Therefore, stock Z is undervalued.
Based on these comparisons, the correct choice is D, which states that stock X is undervalued, stock Y is overvalued, and stock Z is undervalued.

Question 2

The equation for the single-index market model is

Accepted Answer

The single-index market model equation is Rit = ai + bRmt + et, where Rit is the return on the asset i, Rmt is the return on the market portfolio, ai is the intercept, b is the slope coefficient, and et is the error term. The equation represents the linear relationship between the return on an asset and the return on the market portfolio. Option B correctly represents the equation.

Question 3

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 factors would you use to develop a microeconomic-based risk factor model?

Accepted Answer

C

Question 4

One approach for using multifactor models is to use factors that capture systematic risk. Which of the following is not a common factor used in this approach?

Accepted Answer

The answer of One approach for using multifactor models is...

Question 5

Refer to the following information. Consider the three stocks, stock X, stock Y and stock Z, that have the following factor loadings (or factor betas).
 The expected prices one year from now for stocks X, Y, and Z are

Accepted Answer

The answer of Refer to the following information. Consider the...

Question 6

In one of their empirical tests of the APT, Roll and Ross examined the relationship between a security's returns and its own standard deviation. A finding of a statistically significant relationship would indicate that

Accepted Answer

The finding of a statistically significant relationship between a security's returns and its own standard deviation would indicate that there is a significant unsystematic component in the security's returns. This would suggest that diversification is effective in reducing risk and therefore the APT would be invalidated as it assumes all non-diversifiable risk can be captured by factor sensitivities. Therefore, the correct answer is C.

Question 7

In a microeconomic (or characteristic) based risk factor model the following factor would be one of many appropriate factors:

Accepted Answer

In a microeconomic based risk factor model, factors should focus on specific characteristics that drive returns. The return difference between small capitalisation and large capitalisation stocks is a suitable factor as it captures the return potential associated with investing in smaller companies. Confidence risk, maturity risk, expected inflation risk, and call risk are not characteristic-based factors and are more appropriate for macroeconomic-based models.

Question 8

Assume that you are embarking on a test of the small-firm effect using APT. You form 10 size-based portfolios. The following finding would suggest there is evidence supporting APT:

Accepted Answer

The answer of Assume that you are embarking on a...

Question 9

To date, the results of empirical tests of the Arbitrage Pricing Model have been

Accepted Answer

Empirical tests of the Arbitrage Pricing Model have shown mixed results. While some studies have supported the model, others have found it to be less accurate in predicting stock returns. Therefore, option C is the best choice.

Question 10

Consider a two-factor APT model where the first factor is changes in the 30-year T-bond rate, and the second factor is the per cent growth in GNP. Based on historical estimates you determine that the risk premium for the interest rate factor is 0.02, and the risk premium on the GNP factor is 0.03. For a particular asset, the response coefficient for the interest rate factor is −1.2, and the response coefficient for the GNP factor is 0.80. The rate of return on the zero-beta asset is 0.03. Calculate the expected return for the asset.

Accepted Answer

E(R)= .03 + 0.02(-1.2)+ 0.03(0.80)= 3%

Question 11

In the APT model the idea of riskless arbitrage is to assemble a portfolio that

Accepted Answer

The APT model (Arbitrage Pricing Theory) suggests that it is possible to construct a portfolio that requires no initial wealth, bears no risk, and still earns a profit through riskless arbitrage. This is achieved by exploiting mispriced assets in the market.

Question 12

Refer to the following information. Stocks A, B, and C have two risk factors with the following beta coefficients. The zero-beta return (λ₀) = 0.025 and the risk premiums for the two factors are (λ₁) = 0.12 and (λ₀) = 0.10. Stock Factor 1 b_i1 Factor 2 b_i2 Calculate the expected returns for stocks A, B, C. A B C

Accepted Answer

The answer of Refer to the following information. Stocks A,...

Question 13

The table below provides factor risk sensitivities and factor risk premia for a three factor model for a particular asset where factor 1 is MP the growth rate in US industrial production, factor 2 is UI the difference between actual and expected inflation, and factor 3 is UPR the unanticipated change in bond credit spread.  Calculate the expected excess return for the asset.

Accepted Answer

The answer of The table below provides factor risk sensitivities...

Question 14

Refer to the following list. Which are not assumptions of the Arbitrage Pricing model? (1) Capital markets are perfectly competitive.
(2) Quadratic utility function.
(3) Investors prefer more wealth to less wealth with certainty.
(4) Normally distributed security returns.
(5) Representation as a K factor model.
(6) A market portfolio that is mean-variance efficient.

Accepted Answer

The assumptions of the Arbitrage Pricing model are (2), (5), and (6). Assumptions (1), (3), and (4) are not specific to this model and apply to other financial models.

Question 15

In a multifactor model, confidence risk represents

Accepted Answer

Confidence risk represents the unanticipated changes in the willingness of investors to take on investment risk. It is considered as one of the factors in a multifactor model that affects asset returns. A decrease in investors' confidence to take on risk will increase the required rate of return, which in turn will result in a decrease in the asset price.

Quiz 7: Multifactor Models of Risk and Return