Question 1

An important characteristic of market equilibrium is ________.

Accepted Answer

The absence of arbitrage opportunities is an important characteristic of market equilibrium. This means that there are no opportunities for risk-free profit, as all prices are already appropriately adjusted to reflect all available information. The presence of arbitrage opportunities would indicate a market inefficiency, and market forces would eventually lead to prices adjusting to eliminate those opportunities, leading to market equilibrium.

Question 2

You have a $50,000 portfolio consisting of Intel, GE, and Con Edison. You put $20,000 in Intel, $12,000 in GE, and the rest in Con Edison. Intel, GE, and Con Edison have betas of 1.3, 1, and .8, respectively. What is your portfolio beta?

Accepted Answer

11eaaae8_8b63_3321_a4b8_c7bb79c81975_TB6474_11 (1.3) + 11eaaae8_8b63_5a32_a4b8_5bc2c3e28374_TB6474_11 (1.0) + 11eaaae8_8b63_5a33_a4b8_851342dc8610_TB6474_11 (0.8) = 1.048

Question 3

Consider the one-factor APT. The variance of the return on the factor portfolio is .08. The beta of a well-diversified portfolio on the factor is 1.2. The variance of the return on the well-diversified portfolio is approximately ________.

Accepted Answer

11eaaae8_8b63_cf68_a4b8_b3cea29ef7b5_TB6474_11 = (.08) (1.2)² = 0.1152

Question 4

According to the capital asset pricing model, fairly priced securities have ________.

Accepted Answer

According to the Capital Asset Pricing Model (CAPM), fairly priced securities have zero alphas. Alpha represents the abnormal rate of return on a security, relative to the expected return predicted by CAPM. A zero alpha indicates that the security is performing exactly as expected, given its risk (beta), and is therefore fairly priced.

Question 5

Consider the single factor APT. Portfolio A has a beta of 1.3 and an expected return of 21%. Portfolio B has a beta of .7 and an expected return of 17%. The risk-free rate of return is 8%. If you wanted to take advantage of an arbitrage opportunity, you should take a short position in portfolio ________ and a long position in portfolio ________.

Accepted Answer

11eaaae8_8b63_8144_a4b8_07091447dfcf_TB6474_11 < 11eaaae8_8b63_8145_a4b8_3545cf0ef279_TB6474_11 Short A; Buy B

Question 6

Security A has an expected rate of return of 12% and a beta of 1.1. The market expected rate of return is 8%, and the risk-free rate is 5%. The alpha of the stock is ________.

Accepted Answer

α = .12 - [.05 + 1.1(.08 - .05)] = .037

Question 7

In a world where the CAPM holds, which one of the following is not a true statement regarding the capital market line?

Accepted Answer

The capital market line is not the same as the security market line, which is the graphical representation of the CAPM. The capital market line is the line that connects the risk-free asset (usually a T-bill) to the efficient frontier, or the portfolio that offers the highest return for a given level of risk. The slope of the capital market line reflects the market risk premium, or the excess return that investors require for taking on the risk of the market portfolio. Therefore, choices A, C, and D are all true statements regarding the capital market line.

Question 8

The graph of the relationship between expected return and beta in the CAPM context is called the ________.

Accepted Answer

The graph of the relationship between expected return and beta in the CAPM context is called the Security Market Line (SML), not CML (Capital Market Line) or CAL (Characteristics Line) or SCL (Security Characteristic Line).

Question 9

Building a zero-investment portfolio will always involve ________.

Accepted Answer

A zero-investment portfolio involves taking equal but opposite positions in two or more securities, meaning the money received from the short positions is used to fund the long positions, resulting in a net investment of zero.

Question 10

According to the capital asset pricing model, in equilibrium ________.

Accepted Answer

According to the capital asset pricing model, in equilibrium, all securities' returns must lie on the security market line (SML), which measures the expected return of a security as a function of its beta (systematic risk). The SML is derived from the capital market line (CML), which represents the efficient frontier of risky assets. Therefore, choice B is correct as it aligns with the CAPM theory. Choices A, C, and D are incorrect as they contradict the CAPM theory.

Question 11

The variance of the return on the market portfolio is .04 and the expected return on the market portfolio is 20%. If the risk-free rate of return is 10%, the market degree of risk aversion, A, is ________.

Accepted Answer

A = (.20 - .10)/.04 = 2.5

Question 12

The possibility of arbitrage arises when ________.

Accepted Answer

Arbitrage opportunities arise when mispricing among securities creates an opportunity for riskless profits. This means that an investor can buy an underpriced security and simultaneously sell an overpriced security, making a profit without taking on any risk. The other choices do not accurately describe the conditions necessary for arbitrage to occur.

Question 13

Security X has an expected rate of return of 13% and a beta of 1.15. The risk-free rate is 5%, and the market expected rate of return is 15%. According to the capital asset pricing model, security X is ________.

Accepted Answer

In equilibrium, E(rX) = 5% + 1.15(15% - 5%) = 16.5%.

Question 14

You invest $600 in security A with a beta of 1.5 and $400 in security B with a beta of .90. The beta of this portfolio is ________.

Accepted Answer

β_p = (1.5) 11eaaae8_8b63_f679_a4b8_f93ca6873c86_TB6474_11 + (.90) 11eaaae8_8b63_f67a_a4b8_41319657cde4_TB6474_11 = 1.26

Question 15

Research has revealed that regardless of what the current estimate of a firm's beta is, beta will tend to move closer to ________ over time.

Accepted Answer

Beta is a measure of a stock's volatility compared to the market, and research has shown that over time, the volatility of a stock tends to approach the volatility of the market as a whole. Since the market beta is always 1 by definition, the answer is A) 1.

Question 16

In a single-factor market model the beta of a stock ________.

Accepted Answer

In a single-factor market model, the beta of a stock measures the stock's contribution to the standard deviation of the market portfolio. Beta is used to determine the systematic risk of a stock, which is the risk that cannot be diversified away. A beta of 1 indicates that the stock's price will move in line with the market, while a beta greater than 1 indicates that the stock is more volatile than the market, and a beta less than 1 indicates that the stock is less volatile than the market.

Question 17

According to the CAPM, which of the following is not a true statement regarding the market portfolio.

Accepted Answer

The market portfolio is not necessarily the minimum-variance portfolio; it is the tangency portfolio on the efficient frontier, which means it offers the highest expected return for a given level of risk.

Question 18

Consider the single factor APT. Portfolio A has a beta of .2 and an expected return of 13%. Portfolio B has a beta of .4 and an expected return of 15%. The risk-free rate of return is 10%. If you wanted to take advantage of an arbitrage opportunity, you should take a short position in portfolio ________ and a long position in portfolio ________.

Accepted Answer

11eaaae8_8b63_a856_a4b8_19ca20bced66_TB6474_11 < 11eaaae8_8b63_a857_a4b8_ef4a835ef667_TB6474_11 Short B; Buy A

Question 19

Consider the multifactor APT with two factors. Portfolio A has a beta of .5 on factor 1 and a beta of 1.25 on factor 2. The risk premiums on the factor 1 and 2 portfolios are 1% and 7%, respectively. The risk-free rate of return is 7%. The expected return on portfolio A is ________ if no arbitrage opportunities exist.

Accepted Answer

E(r_A) = 7 + 0.5(1) + 1.25(7) = 16.25%

Question 20

Consider the capital asset pricing model. The market degree of risk aversion, A, is 3. The risk premium is 2.25%. If the risk-free rate of return is 4%, the expected return on the market portfolio is ________.

Accepted Answer

E(r_m) = .04 + 3(0.0225) = .1075 = 10.75%

Quiz 7: Capital Asset Pricing and Arbitrage Pricing Theory