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Arbitrage Pricing Model

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Chapter 10

Arbitrage Pricing Theory and Multifactor Models of Risk and Return

Multiple Choice Questions

**1. ___________ a relationship between expected return and risk.
**

A. APT stipulates

B. CAPM stipulates

C. Both CAPM and APT stipulate

D. Neither CAPM nor APT stipulate

E. No pricing model has found

**2. Consider the multifactor APT with two factors. Stock A has an expected return of 17.6%, a
**

beta of 1.45 on factor 1 and a beta of .86 on factor 2. The risk premium on the factor 1

portfolio is 3.2%. The risk-free rate of return is 5%. What is the risk-premium on factor 2 if

no arbitrage opportunities exit?

A. 9.26%

B. 3%

C. 4%

D. 7.75%

E. 9.75%

**3. In a multi-factor APT model, the coefficients on the macro factors are often called ______.
**

A. systemic risk

B. factor sensitivities

C. idiosyncratic risk

D. factor betas

E. both factor sensitivities and factor betas

**4. In a multi-factor APT model, the coefficients on the macro factors are often called ______.
**

A. systemic risk

B. firm-specific risk

C. idiosyncratic risk

D. factor betas

E. unique risk

10-1

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

**5. In a multi-factor APT model, the coefficients on the macro factors are often called ______.
**

A. systemic risk

B. firm-specific risk

C. idiosyncratic risk

D. factor loadings

E. unique risk

**6. Which pricing model provides no guidance concerning the determination of the risk
**

premium on factor portfolios?

A. The CAPM

B. The multifactor APT

C. Both the CAPM and the multifactor APT

D. Neither the CAPM nor the multifactor APT

E. No pricing model currently exists that provides guidance concerning the determination of

the risk premium on any portfolio

**7. An arbitrage opportunity exists if an investor can construct a __________ investment
**

portfolio that will yield a sure profit.

A. small positive

B. small negative

C. zero

D. large positive

E. large negative

**8. The APT was developed in 1976 by ____________.
**

A. Lintner

B. Modigliani and Miller

C. Ross

D. Sharpe

E. Fama

10-2

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

**9. A _________ portfolio is a well-diversified portfolio constructed to have a beta of 1 on one
**

of the factors and a beta of 0 on any other factor.

A. factor

B. market

C. index

D. factor and market

E. factor, market, and index

**10. The exploitation of security mispricing in such a way that risk-free economic profits may
**

be earned is called ___________.

A. arbitrage

B. capital asset pricing

C. factoring

D. fundamental analysis

E. technical analysis

**11. In developing the APT, Ross assumed that uncertainty in asset returns was a result of
**

A. a common macroeconomic factor.

B. firm-specific factors.

C. pricing error.

D. neither common macroeconomic factors nor firm-specific factors.

E. both common macroeconomic factors and firm-specific factors.

**12. The ____________ provides an unequivocal statement on the expected return-beta
**

relationship for all assets, whereas the _____________ implies that this relationship holds for

all but perhaps a small number of securities.

A. APT; CAPM

B. APT; OPM

C. CAPM; APT

D. CAPM; OPM

E. APT and OPM; CAPM

10-3

2 and an expected return of 13%.0 and an expected return of 16%. A D. A. B. B E. you should take a short position in portfolio _________ and a long position in portfolio _________.6% B. 8.Chapter 10 . If you wanted to take advantage of an arbitrage opportunity. A. 15. A B.6% 10-4 . the riskless asset 14. Consider the one-factor APT. A. The variance of returns on the well- diversified portfolio is approximately __________. 10. 3. Portfolio A has a beta of 1.1% E. The variance of returns on the factor portfolio is 6%. If you wanted to take advantage of an arbitrage opportunity.4 and an expected return of 15%. B. The risk-free rate of return is 6%.3% D. The beta of a well-diversified portfolio on the factor is 1. B C. 7. A D. B. you should take a short position in portfolio __________ and a long position in portfolio _______. Consider the single factor APT. 6. B E. No arbitrage opportunity exists.0% C. A.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 13. Portfolio B has a beta of 0. A. Consider a single factor APT. Portfolio B has a beta of 0. B. A B. A. A. B C. Portfolio A has a beta of 0.8 and an expected return of 12%. The risk-free rate of return is 10%. A.1.

A.13 C. Stock A has an expected return of 16.93 17. 7.Chapter 10 .75% E.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 16. 3% C.4 on factor 1 and a beta of . Consider the single-factor APT.89% 10-5 . A.00 C. The risk-free rate of return is 6%. 1. Stocks A and B have expected returns of 15% and 18%. 1. Stock B has a beta of 1. 0. 1.69 E.25 D. a beta of 1. Consider the one-factor APT.30 D.75 18. Consider the multifactor APT with two factors. 0. 6. 1.0. The standard deviation of returns on a well-diversified portfolio is 18%. 4% D.67 B.4%.80 B. 0. respectively. The risk-free rate of return is 6%.8 on factor 2. 0. stock A has a beta of __________. What is the risk-premium on factor 2 if no arbitrage opportunities exit? A. 1. The standard deviation on the factor portfolio is 16%. The risk premium on the factor 1 portfolio is 3%. The beta of the well- diversified portfolio is approximately __________. 1. 2% B.56 E. If arbitrage opportunities are ruled out.

6. Portfolio A has a beta of 1. Consider the multifactor APT with two factors. Consider the multifactor model APT with two factors.2 on factor 1.7 on factor 2. The risk-free rate of return is 7%. 23. A. If no arbitrage opportunities exist. 15.5% C. A.000 D.5% D.0% B. respectively. $1.7% 20. 6. 6. 13. the risk-free rate of return is ___________. and sold short $200.0 on the factor and portfolio B has a beta of 2.000 E. $0 C.8% D. Portfolio A has a beta of 0.0 on the factor. The expected return on stock A is 17%. The expected return on portfolio A is __________ if no arbitrage opportunities exist. Assume that the risk-free rate is 6% and that arbitrage opportunities exist. The expected returns on portfolios A and B are 11% and 17%. −$1. Suppose you invested $100. 7. 16.Chapter 10 .4% E. A. 7. $100.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 19.0% C.0% E.75 on factor 1 and a beta of 1. respectively.600 10-6 .7% 21.25 on factor 2.5% B.000 B. The risk premiums on the factor 1 and factor 2 portfolios are 5% and 6%. respectively. Stock A has a beta of 1. $1.000 of portfolio A. $2.000 in the risk-free asset. Your expected profit from this strategy would be ______________. The risk premiums on the factor 1 and factor 2 portfolios are 1% and 7%. Consider a one-factor economy.000 in portfolio B. 18. and a beta of 0.

Consider the single factor APT. respectively. Assume that two portfolios.33 B. 9. 1.45 B.10 D. The expected returns on portfolios A and B are 19% and 24%. 1. 2.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 22. 0.7. The risk-free rate of return is 10%.00 E. 8. 1. The risk premiums on the factor 1 and factor 2 portfolios are 5% and 3%. A. If arbitrage opportunities are ruled out. 1. A and B. Consider the one-factor APT.Chapter 10 . the risk-free rate of return must be ____________.0% C. Assuming no arbitrage opportunities exist. A. Stock A has an expected return of 19% and a beta on factor 1 of 0. respectively. are well diversified. portfolio B must have a beta of __________. 1.22 E.50 C. Consider the multifactor APT.0% B.2% 23. respectively.33 10-7 .0 and 1.5% E. Portfolio A has a beta of 0.73 24.00 C. respectively. 4.8. 1. Portfolios A and B have expected returns of 14% and 18%.67 D. Stock A has a beta on factor 2 of ________.0% D. 1. 1. The betas of portfolios A and B are 1. 14. The risk-free rate of return is 7%. A. 16.5.

A. If you invested in an equally weighted portfolio of stocks B and C. You can either invest in these stocks or short sell them. There are three possible states of nature for economic growth in the upcoming year. 25.0% D. economic growth may be strong. A.0% 26. moderate.5% C.5% B. 15. 3. 17. 30. and C.Arbitrage Pricing Theory and Multifactor Models of Risk and Return There are three stocks.0% E.0% 10-8 .5% C.0% B. 16. B. your portfolio return would be ____________ if economic growth was strong. or weak. A. A. 30. 0.Chapter 10 . −2. 11.0% D.5% E.0% E. If you invested in an equally weighted portfolio of stocks A and B. and C for each of these states of nature are given below: 25. 14. B. 17.5% D.0% B. 3. 22. your portfolio return would be ___________ if economic growth were moderate. 9.6% 27.5% C. The returns for the upcoming year on stocks A. your portfolio return would be _____________ if economic growth was weak. If you invested in an equally weighted portfolio of stocks A and C.

Assuming no arbitrage opportunities exist. 5% D.Chapter 10 . A. A and C C. A and B. F1and F2. the risk premium on the factor F1portfolio should be __________.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 28. C. 5% D. Consider the multifactor APT. B. 6% E. The risk-free rate of return is 6%. 2% 30. 3% B. A and B D. the risk premium on the factor F2 portfolio should be ___________. A. 4% C. you should take a short position in _________ and a long position in an equally weighted portfolio of _______. B and C B. 4% C. 2% 10-9 . 3% B. A. Assuming no arbitrage opportunities exist. There are two independent economic factors. The following information is available about two well- diversified portfolios: 29. 6% E. No arbitrage opportunity exists. C E. A. If you wanted to take advantage of a risk-free arbitrage opportunity.

An investor will take as large a position as possible when an equilibrium price relationship is violated. A. A zero-investment portfolio with a positive expected return arises when _________. recognizes multiple unsystematic risk factors D. a risk-free arbitrage D. the capital asset pricing model E. superior measurement of the risk-free rate of return over historical time periods and variability of coefficients of sensitivity to the APT factors for a given asset over time 10-10 . A. places more emphasis on systematic risk 34. places more emphasis on market risk B. a risk-free arbitrage opportunity exists E. The APT differs from the CAPM because the APT _________. an investor has downside risk only B.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 31. and term structure as key factors in explaining the risk-return relationship C. This is an example of _________. a risk-free arbitrage opportunity does not exist 32. minimizes the importance of diversification C. variability of coefficients of sensitivity to the APT factors for a given asset over time E. superior measurement of the risk-free rate of return over historical time periods D. inflation. A. the mean-variance efficiency frontier C. A. the SML 33. identification of anticipated changes in production. the law of prices is not violated C. recognizes multiple systematic risk factors E. the opportunity set is not tangent to the capital allocation line D.Chapter 10 . The feature of the APT that offers the greatest potential advantage over the CAPM is the ______________. use of several factors instead of a single market index to explain the risk-return relationship B. a dominance argument B.

B. only factor risk commands a risk premium in market equilibrium and only systematic risk is related to expected returns. C. B. 36. interest rate fluctuations. only factor risk commands a risk premium in market equilibrium and only nonsystematic risk is related to expected returns. In terms of the risk/return relationship in the APT A. that risk need not be considered. that the model does not require a specific benchmark market portfolio and that risk need not be considered. 37. borrow at the risk free rate and buy B. sell A short and buy B.Chapter 10 . E.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 35. interest rate fluctuations. The following factors might affect stock returns: A. C. only factor risk commands a risk premium in market equilibrium. the business cycle. Portfolio A has expected return of 10% and standard deviation of 19%. lend at the risk free rate and buy B. D. that the model does not require a specific benchmark market portfolio. 10-11 . B. inflation rates. that the model provides specific guidance concerning the determination of the risk premiums on the factor portfolios. borrow at the risk free rate and buy A. C. sell B short and buy A. the business cycle. E. B. only systematic risk is related to expected returns. D. Rational investors will A. E. C. D. only nonsystematic risk is related to expected returns. that the model provides specific guidance concerning the determination of the risk premiums on the factor portfolios and that the model does not require a specific benchmark market portfolio. the relationship between past FRED spreads. E. Advantage(s) of the APT is(are) A. 38. and inflation rates. D. Portfolio B has expected return of 12% and standard deviation of 17%.

D. implications for prices derived from CAPM arguments are stronger than prices derived from APT arguments. pure arbitrage. APT depends on a no arbitrage condition.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 39. CAPM depends on risk-return dominance. option arbitrage. as a well-diversified portfolio becomes larger its nonsystematic risk approaches A. An important difference between CAPM and APT is A. E. CAPM assumes many small changes are required to bring the market back to equilibrium. covered interest arbitrage. one. equilibrium arbitrage. 40. CAPM depends on risk-return dominance. APT depends on a no arbitrage condition and assumes many small changes are required to bring the market back to equilibrium. CAPM depends on risk-return dominance. CAPM assumes many small changes are required to bring the market back to equilibrium.Chapter 10 . negative one. None of these is correct. APT assumes a few large changes are required to bring the market back to equilibrium. C. rather than one who seeks strict (risk-free) arbitrage opportunities is engaged in A. B. implications for prices derived from CAPM arguments are stronger than prices derived from APT arguments. APT assumes a few large changes are required to bring the market back to equilibrium. E. A professional who searches for mispriced securities in specific areas such as merger- target stocks. D. E. risk arbitrage. 10-12 . In the context of the Arbitrage Pricing Theory. B. C. 41. APT depends on a no arbitrage condition. infinity. D. zero. C. B.

B. that need not be well-diversified. B. that is well-diversified and lies on the SML. one that is diversified over a large enough number of securities that the nonsystematic variance is essentially zero. II and IV are correct. I and IV are correct. I and III are correct. II and III are correct. D. a portfolio whose factor beta equals 1. 44.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 42. III) the expected return-beta relationship is maintained for all but a small number of individual securities. B.Chapter 10 . 10-13 . D. II) the expected return-beta relationship is maintained for all well-diversified portfolios. a portfolio that is equally weighted. The APT requires a benchmark portfolio A. E. Only I is correct. a portfolio that is equally weighted and contains securities from at least three different industry sectors. that is unobservable. D. IV) the expected return-beta relationship is maintained for all individual securities.0. C. C. that contains all securities in proportion to their market values. A. E. A well-diversified portfolio is defined as A. E. one that contains securities from at least three different industry sectors. Imposing the no-arbitrage condition on a single-factor security market implies which of the following statements? I) the expected return-beta relationship is maintained for all but a small number of well- diversified portfolios. 43. C. that is equal to the true market portfolio.

a factor that affects all security returns.0% E.2 on the first factor and . III. II) construct a zero beta investment portfolio that will yield a sure profit. D. 13.8 on the second factor. buying low and selling high. C. Consider a well-diversified portfolio. a random amount of return attributable to firm events. C. an investor would I) construct a zero investment portfolio that will yield a sure profit.2% 46. II and III D. negotiating for favorable brokerage fees. E. hedging your portfolio through the use of options.0% C. II. 47. If portfolio A has a beta of 1. the deviation from its expected value of a factor that affects all security returns. and IV 48. 7. I and IV B. E. 10-14 . The term "arbitrage" refers to A.0% B. short selling high and buying low. firm-specific risk. The factor F in the APT model represents A.Chapter 10 . 13.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 45. what is its expected return? A. in a two-factor economy. and IV E. earning risk-free economic profits. III. 8. I and III C. The risk-free rate is 6%. IV) short sell the asset in the low-priced market and buy it in the high-priced market. A. I. the sensitivity of the firm to that factor. To take advantage of an arbitrage opportunity. D. B. 9. A. III) make simultaneous trades in two markets without any net investment. B. the risk premium on the first factor portfolio is 4% and the risk premium on the second factor portfolio is 3%.2% D.

1.5% B. what is the nonsystematic standard deviation of an equally-weighted portfolio that has an average value of (ei) equal to 18% and 250 securities? A.59% 51. 625% C. 3.59% 50. 0. 12.5% D. what is the nonsystematic standard deviation of an equally-weighted portfolio that has an average value of (ei) equal to 20% and 40 securities? A. In the APT model. 12. 3. 3. 625% C.5% B.54% E.47% D. 4. In the APT model.16% 52. what is the nonsystematic standard deviation of an equally-weighted portfolio that has an average value of (ei) equal to 20% and 20 securities? A.54% E. 625% C.5% B.54% E. 0. 0. 14. 12. 3.5% D. 3. 3.16% 10-15 .54% E.Chapter 10 .Arbitrage Pricing Theory and Multifactor Models of Risk and Return 49.14% B.5% D. In the APT model. what is the nonsystematic standard deviation of an equally-weighted portfolio that has an average value of (ei) equal to 25% and 50 securities? A. 625% C. In the APT model. 14.

if A has a beta of 0. B. proportional to its standard deviation. each well-diversified portfolio's expected excess return must be A. The SML for the APT shows expected return in relation to portfolio standard deviation.1% C. 15. 13. what would be the expected return on well-diversified portfolio A. E. D. D. inversely proportional to its standard deviation. 56. Portfolio 1 and Portfolio 2. The SML has a downward slope. 14. C. The SML has a downward slope. A. The SML has a downward slope. C. The benchmark portfolio for the SML may be any well-diversified portfolio.3% D. E. B.4% 10-16 . 8.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 53. The SML for the APT has an intercept equal to the expected return on the market portfolio.80 on the first factor and 0. proportional to its beta coefficient. Based on this information. the SML for the APT shows expected return in relation to portfolio standard deviation. The SML is not relevant for the APT. B. The SML for the APT shows expected return in relation to portfolio standard deviation. 10. E. D. 55. Which of the following is true about the security market line (SML) derived from the APT? A. Which of the following is false about the security market line (SML) derived from the APT? A. If arbitrage opportunities are to be ruled out.7% E. The portfolios have expected returns of 15% and 6%. C.50 on the second factor? The risk-free rate is 3%. The SML for the APT has an intercept equal to the expected return on the market portfolio. inversely proportional to the risk-free rate. 54.Chapter 10 . and the SML for the APT has an intercept equal to the expected return on the market portfolio are all false. proportional to its weight in the market portfolio.2% B. Suppose you are working with two factor portfolios. The benchmark portfolio for the SML may be any well-diversified portfolio. respectively.

II) More than one factor can be important in determining returns. Roll and Ross not include in their multifactor model? A. II and IV C. Change in industrial waste B. the return on a stock in a particular period will be related to A. and IV E. non-factor risk. E. Change in unanticipated inflation D. Excess return of long-term government bonds over T-bills E. Roll and Ross include in their multifactor model? A. A. Neither the change in industrial production. change in unanticipated inflation. and returns. B. Change in expected inflation C. I. 60. Which of the following factors did Chen. Which of the following is (are) true regarding the APT? I) The Security Market Line does not apply to the APT. risk premiums.Chapter 10 . II. D. factor risk. 59. and IV B. and IV 58. III. IV) It doesn't rely on the market portfolio that contains all assets. III) Almost all individual securities satisfy the APT relationship. I. In a factor model. nor excess return of long-term government bonds over T-bills were included in their model. Which of the following factors did Chen. C. change in expected inflation. II. Change in expected inflation and Change in unanticipated inflation E. Change in unanticipated inflation D. Change in expected inflation C.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 57. There is no relationship between factor risk. Change in industrial production B. All of these factors were included in their model 10-17 . II. II and III D. both factor risk and non-factor risk. standard deviation of returns. III.

27 63. 0. 1.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 61.76 E. Return on the market index. Excess return of high book-to-market stocks over low book-to-market stocks. 1. B. The risk-free rate of return is 5%. All of these factors were included in their model. they are macroeconomic factors 10-18 . they are sources of systematic risk C. 0.67 B. 1. Which of the following factors were used by Fama and French in their multi-factor model? A. 1.2. such as those described by Fama and French.30 D. Excess return of small stocks over large stocks. A. they can be explained by security characteristic lines D.58 B. The standard deviation on the factor portfolio is 12%. C. A. respectively.42 64.25 D. 1. If arbitrage opportunities are ruled out. The standard deviation of returns on a well-diversified portfolio is 19%. The beta of the well- diversified portfolio is approximately __________. stock A has a beta of __________. 1.13 C. A. Stock B has a beta of 1. 0.Chapter 10 . E. Consider the single-factor APT. are problematic because ________. 1. Consider the one-factor APT. D. None of these factors were included in their model.93 C. 62.69 E. Stocks A and B have expected returns of 12% and 14%. they may result from data snooping B. Black argues that past risk premiums on firm-characteristic variables. they are more appropriate for a single-factor model E.

8 on factor 1. expanding beyond one factor to represent sources of systematic risk. The risk premiums on the factor 1 and factor 2 portfolios are 6% and 4%. modeling the systematic component of firm returns in greater detail. C.Chapter 10 . 66.33 B. 67. Stock A has a beta on factor 2 of ________. 23.25 on factor 3. 1. Consider the multifactor APT. respectively. E. Multifactor models seek to improve the performance of the single-index model by A.0% E. incorporating firm- specific components into the pricing model. E.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 65. The risk-free rate of return is 3%. The risk premiums on the factor 1. Portfolio A has a beta of 0.6% 68. respectively. A. B.4% C. factor 2. Consider the multifactor model APT with three factors. The risk-free rate of return is 4%. ignoring firm-specific risk. incorporating firm-specific components into the pricing model. A.95 10-19 . Stock A has an expected return of 16% and a beta on factor 1 of 1. 11.00 E.05 C. can better describe assets' returns by A.67 D. 1.1 on factor 2.5% D.3. D. 13. 13. B. and Ross. a beta of 1. modeling the systematic component of firm returns in greater detail. using variables that are easier to forecast ex ante. 5% and 2%. allowing for multiple economic factors to have differential effects. C. The expected return on portfolio A is __________ if no arbitrage opportunities exist. using only stocks with relatively stable returns. Multifactor models such as the one constructed by Chen. and a beta of 1. Roll. calculating beta coefficients by an alternative method. D. none of these statements are true.5% B. 2. 16. and factor 3 are 3%. and allowing for multiple economic factors to have differential effects. 1. .

0% C. 7. B. what is its expected return? A. 13.2% D. The risk-free rate of return is 5%. B.0% B. 8. If you wanted to take advantage of an arbitrage opportunity.4 and an expected return of 13%. you should take a short position in portfolio _________ and a long position in portfolio _________.5 and an expected return of 12%.2% 70.0% E. A. A B. Portfolio A has a beta of 2. you should take a short position in portfolio __________ and a long position in portfolio _______. B E. B C. B C. Portfolio B has a beta of 1.5 and an expected return of 17%. A D. A. If portfolio A has a beta of 0. No arbitrage opportunity exists. B. the riskless asset 71. 13.8 on the second factor. Consider a single factor APT. Portfolio B has a beta of 0. The risk-free rate is 5%. B E. B. Consider a well-diversified portfolio. 10-20 . A D.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 69. Portfolio A has a beta of 0. A B. The risk-free rate of return is 4%.Chapter 10 . in a two-factor economy.6 on the first factor and 1. the risk premium on the first factor portfolio is 4% and the risk premium on the second factor portfolio is 6%. Consider the single factor APT. 18. A. A. If you wanted to take advantage of an arbitrage opportunity.0 and an expected return of 22%. A. A. A. A.

A. 0. 23. The variance of returns on the well- diversified portfolio is approximately __________. The standard deviation on the factor portfolio is 14%. Consider the one-factor APT.1% B.13 C. The beta of a well-diversified portfolio on the factor is 1.25. Consider the one-factor APT. 9.3% D. The variance of returns on the factor portfolio is 9%. The standard deviation of returns on a well-diversified portfolio is 22%.80 B.25 D.1% E. A. 7. The variance of returns on the factor portfolio is 11%.45. 7.7% 73.6% B. 67 10-21 . 1. 6.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 72.1% E. Consider the one-factor APT. 1. The variance of returns on the well- diversified portfolio is approximately __________. The beta of a well-diversified portfolio on the factor is 1.0% C.57 E. 14. 14. 1. A.3% D. The beta of the well- diversified portfolio is approximately __________.4% 74.Chapter 10 . 11. 3.0% C. 6.

10-22 . risk- return dominance. 78. and the number of investors required to restore equilibrium. 76. What is one shortcoming of the multifactor APT and how does this shortcoming compare to CAPM implications? 77.Chapter 10 . Discuss the similarities and the differences between the CAPM and the APT with regard to the following factors: capital market equilibrium. Discuss arbitrage opportunities in the context of violations of the law of one price. Discuss the advantages of arbitrage pricing theory (APT) over the capital asset pricing model (CAPM) relative to diversified portfolios.Arbitrage Pricing Theory and Multifactor Models of Risk and Return Short Answer Questions 75. Discuss the advantages of the multifactor APT over the single factor APT and the CAPM. assumptions about risk aversion.

Security B has a beta of 0. explain how an investor can take advantage of it. Roll.0 and an expected return of 12%.Chapter 10 . Explain the arbitrage opportunity that exists. 80. Name three variables that Chen.75 and an expected return of 11%. Security A has a beta of 1. Give specific details about how to form the portfolio.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 79. Briefly explain the reasoning behind their model. The risk-free rate is 6%. and Ross used to measure the impact of macroeconomic factors on security returns. 10-23 . what to buy and what to sell.

CAPM stipulates C.75% 17.Chapter 10 . APT stipulates B. 9. a beta of 1. A. 3% C. AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: APT and CAPM 2. AACSB: Analytic Bloom's: Apply Difficulty: Challenge Topic: APT 10-24 .6%. x = 9.86 on factor 2.86x + 5%. 7.Arbitrage Pricing Theory and Multifactor Models of Risk and Return Chapter 10 Arbitrage Pricing Theory and Multifactor Models of Risk and Return Answer Key Multiple Choice Questions 1. ___________ a relationship between expected return and risk.45(3.45 on factor 1 and a beta of . 9. Stock A has an expected return of 17. What is the risk-premium on factor 2 if no arbitrage opportunities exit? A. Consider the multifactor APT with two factors. Neither CAPM nor APT stipulate E. 4% D.2%) + . Both CAPM and APT stipulate D. The risk-free rate of return is 5%.26. No pricing model has found Both models attempt to explain asset pricing based on risk/return relationships. The risk premium on the factor 1 portfolio is 3.6% = 1.75% E.2%.26% B.

systemic risk B. factor sensitivities C. idiosyncratic risk D. factor sensitivities. factor betas E. or factor loadings. A. the coefficients on the macro factors are often called ______. firm-specific risk C. both factor sensitivities and factor betas The coefficients are called factor betas. systemic risk B. factor betas E. In a multi-factor APT model. the coefficients on the macro factors are often called ______. A. idiosyncratic risk D. In a multi-factor APT model. firm-specific risk C. systemic risk B. or factor loadings. AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: APT 10-25 . or factor loadings. idiosyncratic risk D. factor loadings E. In a multi-factor APT model. unique risk The coefficients are called factor betas.Chapter 10 . factor sensitivities. A. unique risk The coefficients are called factor betas. AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: APT 4. the coefficients on the macro factors are often called ______. AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: APT 5.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 3. factor sensitivities.

Chapter 10 . The multifactor APT provides no guidance as to the determination of the risk premium on the various factors. The multifactor APT C. The CAPM B. An arbitrage opportunity exists if an investor can construct a __________ investment portfolio that will yield a sure profit. large negative If the investor can construct a portfolio without the use of the investor's own funds and the portfolio yields a positive profit. No pricing model currently exists that provides guidance concerning the determination of the risk premium on any portfolio. large positive E. A. Neither the CAPM nor the multifactor APT E. The CAPM assumes that the excess market return over the risk-free rate is the market premium in the single factor CAPM. Which pricing model provides no guidance concerning the determination of the risk premium on factor portfolios? A. zero D. arbitrage opportunities exist. AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: APT 10-26 . AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: APT and CAPM 7.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 6. small positive B. small negative C. Both the CAPM and the multifactor APT D.

factor and market E. Fama Ross developed this model in 1976.Chapter 10 . market C. A. Modigliani and Miller C. A. Ross D. with zero betas on other factors. factor. A _________ portfolio is a well-diversified portfolio constructed to have a beta of 1 on one of the factors and a beta of 0 on any other factor. Sharpe E. Lintner B. index D.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 8. factor B. market. AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: APT 9. AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: APT 10-27 . and index A factor model portfolio has a beta of 1 one factor. The APT was developed in 1976 by ____________.

firm-specific factors C. neither common macroeconomic factors nor firm-specific factors.Chapter 10 . a common macroeconomic factor B. pricing error D. capital asset pricing C. both common macroeconomic factors and firm-specific factors Total risk (uncertainty) is assumed to be composed of both macroeconomic and firm-specific factors. In developing the APT. AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: APT 11. factoring D. E. AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: APT 10-28 . technical analysis Arbitrage is earning of positive profits with a zero (risk-free) investment. fundamental analysis E.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 10. arbitrage B. A. Ross assumed that uncertainty in asset returns was a result of A. The exploitation of security mispricing in such a way that risk-free economic profits may be earned is called ___________.

APT. OPM E. Portfolio A has a beta of 1. the riskless asset A: 16% = 1.5%. and for all but perhaps a few individual securities. Portfolio B has a beta of 0. B E. CAPM B. whereas the _____________ implies that this relationship holds for all but perhaps a small number of securities.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 12. you should take a short position in portfolio __________ and a long position in portfolio _______. APT D. CAPM. A B.8 and an expected return of 12%. The risk-free rate of return is 6%. The ____________ provides an unequivocal statement on the expected return-beta relationship for all assets. A. A. A D.8F + 6%: F = 7. APT and OPM.0 and an expected return of 16%. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 10-29 . A. The APT implies that this relationship holds for all well-diversified portfolios. A. B: 12% = 0. If you wanted to take advantage of an arbitrage opportunity. CAPM.Chapter 10 . short B and take a long position in A. OPM C. B. A. F = 10%.0F + 6%. B C. Consider a single factor APT. B. thus. CAPM The CAPM is an asset-pricing model based on the risk/return relationship of all assets. AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: APT and CAPM 13. APT.

0% C. 6. No arbitrage opportunity exists. B: 15% = 10% + 0.3% D. A D.Chapter 10 .1)2(6%) = 7. A. Consider the one-factor APT. A: 13% = 10% + 0. 3.5%.4 and an expected return of 15%. The variance of returns on the well- diversified portfolio is approximately __________.6% s2P = (1. B. Portfolio B has a beta of 0. B C. 7.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 14.2F. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 15. 8.6% B. F = 15%. A. B. A B. B E. A. you should take a short position in portfolio _________ and a long position in portfolio _________. The risk-free rate of return is 10%. The beta of a well-diversified portfolio on the factor is 1.26%. Portfolio A has a beta of 0. short B and take a long position in A. A. 10.2 and an expected return of 13%. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 10-30 . therefore. If you wanted to take advantage of an arbitrage opportunity. F = 12. Consider the single factor APT.1% E.1. The variance of returns on the factor portfolio is 6%.4F.

The standard deviation on the factor portfolio is 16%. If arbitrage opportunities are ruled out. respectively. 1.13 C. The risk-free rate of return is 6%.93 (18%)2 = (16%)2 b2. stock A has a beta of __________. 1. 0.75.0F. 0. 1.75 A: 18% = 6% + bF. The standard deviation of returns on a well-diversified portfolio is 18%. thus. 1. The beta of the well- diversified portfolio is approximately __________.56 E.69 E. 1.67 B. 1. Stocks A and B have expected returns of 15% and 18%. A.80 B. 0. B: 8% = 6% + 1.00 C. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 17. beta of A = 9/12 = 0.0.30 D. F = 12%. Stock B has a beta of 1.25 D.Chapter 10 . AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 10-31 .125. b = 1.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 16. Consider the single-factor APT. Consider the one-factor APT. 0. A.

The risk-free rate of return is 6%. 6. Stock A has an expected return of 16. 18.4%.8 on factor 2. 16. a beta of 1.75% E.7% 7% + 0. A. 2% B. AACSB: Analytic Bloom's: Apply Difficulty: Challenge Topic: APT 19. The risk premium on the factor 1 portfolio is 3%.4% = 1. 23. Portfolio A has a beta of 0. respectively.4(3%) + .75(1%) + 1. x = 7. The expected return on portfolio A is __________ if no arbitrage opportunities exist. 7.25(7%) = 16.0% C. The risk-free rate of return is 7%.5% B.75 on factor 1 and a beta of 1.8x + 6%. Consider the multifactor APT with two factors. 4% D.25 on factor 2.0% E. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 10-32 .Arbitrage Pricing Theory and Multifactor Models of Risk and Return 18.5%. Consider the multifactor model APT with two factors. What is the risk-premium on factor 2 if no arbitrage opportunities exit? A.75.89% 16. 3% C.4 on factor 1 and a beta of . 15. The risk premiums on the factor 1 and factor 2 portfolios are 1% and 7%. 13.5% D.Chapter 10 .

000 E. $100.000 D. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 21. and sold short $200. $1.000 B.000(0.7(6%). The risk premiums on the factor 1 and factor 2 portfolios are 5% and 6%. A. − $200. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 10-33 .000 profit.5% C.11) = −$22. 6.000(0. $2. The expected returns on portfolios A and B are 11% and 17%. respectively. Consider a one-factor economy.000 (risk-free position). $100. portfolio A).000 of portfolio A.0% B. Consider the multifactor APT with two factors. the risk-free rate of return is ___________. $1. The expected return on stock A is 17%.000(0.8% D. Your expected profit from this strategy would be ______________. If no arbitrage opportunities exist. 7.0 on the factor. x = 6. −$1.17) = $17.4% E.000 in portfolio B. Portfolio A has a beta of 1.06) = $6.000 (short position. 1. Suppose you invested $100. Assume that the risk-free rate is 6% and that arbitrage opportunities exist. Stock A has a beta of 1.600 $100.000 in the risk-free asset.Chapter 10 .Arbitrage Pricing Theory and Multifactor Models of Risk and Return 20.000 (portfolio B). respectively. 6. $0 C. and a beta of 0.2(5%) + 0.2 on factor 1.8%.0 on the factor and portfolio B has a beta of 2.7% 17% = x% + 1. 7. A.7 on factor 2. 6.

0% B. A.5(10).5(F). The expected returns on portfolios A and B are 19% and 24%. respectively. The betas of portfolios A and B are 1. are well diversified. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 23. 2. Stock A has an expected return of 19% and a beta on factor 1 of 0.5% E.5. 5% = . rf = 9%.2% A: 19% = rf + 1(F). 4. A. 24% = rf + 1. 14.Chapter 10 . The risk premiums on the factor 1 and factor 2 portfolios are 5% and 3%.67 D.8) + 3%(x). F = 10%. respectively. Assuming no arbitrage opportunities exist.00 E.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 22. 1. 16.73 19% = 10% + 5%(0.0% D.5(F). 1.8. The risk-free rate of return is 10%. 8. the risk-free rate of return must be ____________. Consider the multifactor APT.67. Stock A has a beta on factor 2 of ________. 1. Assume that two portfolios.33 B.0 and 1.50 C. B:24% = rf + 1. 9. 1. Consider the one-factor APT. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 10-34 . A and B.0% C. x = 1. respectively.

00 C. A. 1. There are three possible states of nature for economic growth in the upcoming year. 1. The returns for the upcoming year on stocks A. Portfolio A has a beta of 0. and C.7F. B: 18% = 7% + 10b. portfolio B must have a beta of __________. 1.7. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT There are three stocks. B. or weak. Portfolios A and B have expected returns of 14% and 18%. 1. A. 0. economic growth may be strong. moderate. B. If arbitrage opportunities are ruled out. and C for each of these states of nature are given below: 10-35 . respectively.45 B.Chapter 10 . You can either invest in these stocks or short sell them. The risk-free rate of return is 7%. F = 10. Consider the single factor APT.10.10 D. b = 1.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 24.33 A: 14% = 7% + 0.22 E.

22. your portfolio return would be ____________ if economic growth was strong. 25. 16.5(6%) = 22.5(17%) + 0.0% E. A. 3. AACSB: Analytic Bloom's: Apply Difficulty: Basic Topic: APT 26. 30.5% C. A.0% E(Rp) = 0.0% D.5(15%) = 16%.5% D. 17.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 25.5% C. 17.0% B.0% B. 30. If you invested in an equally weighted portfolio of stocks A and C.5% E. your portfolio return would be ___________ if economic growth were moderate.Chapter 10 . 14. If you invested in an equally weighted portfolio of stocks A and B.5%.5(39%) + 0. 15.6% 0. AACSB: Analytic Bloom's: Apply Difficulty: Basic Topic: APT 10-36 .

The risk-free rate of return is 6%. C.0% 0.0% + 8.0% = 1. your portfolio return would be _____________ if economic growth was weak.5(22%) = 11%. A and B. The following information is available about two well- diversified portfolios: 10-37 . 11. AACSB: Analytic Bloom's: Apply Difficulty: Basic Topic: APT 28. −7.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 27. A. E(RC) = (22% + 14% + 6%)/3 = 14%. B and C B.Chapter 10 . A and B D. A. B.0% E. 9. E(RA) = (39% + 17% − 5%)/3 = 17%. 3. There are two independent economic factors. 0.0% D.5(0%) + 0. E(RP) = −0. AACSB: Analytic Bloom's: Apply Difficulty: Challenge Topic: APT Consider the multifactor APT.5% B.5[(17% + 15%)/2].0%. −2. If you invested in an equally weighted portfolio of stocks B and C. you should take a short position in _________ and a long position in an equally weighted portfolio of _______. If you wanted to take advantage of a risk-free arbitrage opportunity. C E. A and C C. E(RB) = (30% + 15% + 0%)/3 = 15%. A.5% C. F1and F2.5(14%) + 0. No arbitrage opportunity exists.

A. 5% D. 2% 2A: 38% = 12% + 2.0(RP2). A: 19% = 6% + RP1 + 2.0(RP1) + 0. 3% B. RP1 = 3%.0(RP1) + 4. 26% = 6% + 4. 26% = 6% + 4. RP2 = 5. 2% 2A: 38% = 12% + 2. A. 5% D.0(RP1) + 0.0(RP2). Assuming no arbitrage opportunities exist.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 29. 4% C. 3% B. AACSB: Analytic Bloom's: Apply Difficulty: Challenge Topic: APT 30.0(5). B: 12% = 6% + 2.0(5). B: 12% = 6% + 2. A: 19% = 6% + RP1 + 2. 4% C. AACSB: Analytic Bloom's: Apply Difficulty: Challenge Topic: APT 10-38 . Assuming no arbitrage opportunities exist. RP1 = 3%. 6% E.0(RP2).0(RP2). the risk premium on the factor F2 portfolio should be ___________.0(RP2).Chapter 10 .0(RP2). 6% E. RP2 = 5. the risk premium on the factor F1portfolio should be __________.0(RP1) + 4.

a risk-free arbitrage D. Such transactions result in risk- free arbitrage. AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: APT 32. An investor will take as large a position as possible when an equilibrium price relationship is violated. the opportunity set is not tangent to the capital allocation line D. a risk-free arbitrage opportunity does not exist When an investor can create a zero-investment portfolio (by using none of the investor's own funds) with a possibility of a positive profit. the investor will buy the lower priced asset and simultaneously place an order to sell the higher priced asset.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 31. the greater the risk-free arbitrage profits. a risk-free arbitrage opportunity exists. AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: APT 10-39 . The larger the positions. a dominance argument B. A. A zero-investment portfolio with a positive expected return arises when _________. the capital asset pricing model E.Chapter 10 . the mean-variance efficiency frontier C. This is an example of _________. a risk-free arbitrage opportunity exists E. the SML When the equilibrium price is violated. an investor has downside risk only B. the law of prices is not violated C. A.

rather than a single market index. A. recognizes multiple unsystematic risk factors D. The APT recognizes that other macroeconomic factors may be systematic risk factors. use of several factors instead of a single market index to explain the risk-return relationship B. superior measurement of the risk-free rate of return over historical time periods D. places more emphasis on systematic risk The CAPM assumes that market returns represent systematic risk. superior measurement of the risk-free rate of return over historical time periods and variability of coefficients of sensitivity to the APT factors for a given asset over time The advantage of the APT is the use of multiple factors. variability of coefficients of sensitivity to the APT factors for a given asset over time E. to explain the risk-return relationship. recognizes multiple systematic risk factors E. and term structure as key factors in explaining the risk-return relationship C. AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: APT 10-40 .Arbitrage Pricing Theory and Multifactor Models of Risk and Return 33. APT does not identify the specific factors. inflation. identification of anticipated changes in production. AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: APT and CAPM 34. The feature of the APT that offers the greatest potential advantage over the CAPM is the ______________.Chapter 10 . The APT differs from the CAPM because the APT _________. places more emphasis on market risk B. A. minimizes the importance of diversification C. However.

C. The business cycle. B. E. In terms of the risk/return relationship in the APT A. interest rate fluctuations. only nonsystematic risk is related to expected returns. AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: APT 36. The following factors might affect stock returns: A. inflation rates. E. only factor risk commands a risk premium in market equilibrium. only systematic risk is related to expected returns. D. Nonsystematic risk across firms cancels out in well-diversified portfolios. and inflation rates. interest rate fluctuations.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 35. thus. C. D. thus. only factor risk commands a risk premium in market equilibrium and only systematic risk is related to expected returns. only factor risk commands a risk premium in market equilibrium and only nonsystematic risk is related to expected returns. B. the relationship between past FRED spreads.Chapter 10 . only factor risk commands a risk premium in market equilibrium. only systematic risk is related to expected returns. interest rate fluctuations. the business cycle. Nonfactor risk may be diversified away. the business cycle. and inflation rates are likely to affect stock returns. AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: APT 10-41 .

E. A major advantage of APT over the CAPM is that a specific benchmark market portfolio is not required. C. that risk need not be considered. Portfolio A has expected return of 10% and standard deviation of 19%. AACSB: Analytic Bloom's: Understand Difficulty: Basic Topic: APT 10-42 . B. that the model provides specific guidance concerning the determination of the risk premiums on the factor portfolios. that the model does not require a specific benchmark market portfolio and that risk need not be considered. Sell A short and buy B. Portfolio B has expected return of 12% and standard deviation of 17%. E. B. Advantage(s) of the APT is(are) A. The APT provides no guidance concerning the determination of the risk premiums on the factor portfolios. AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: APT and CAPM 38. Borrow at the risk free rate and buy B. that the model provides specific guidance concerning the determination of the risk premiums on the factor portfolios and that the model does not require a specific benchmark market portfolio. Sell B short and buy A. Rational investors will A. C. Lend at the risk free rate and buy B. D.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 37. Borrow at the risk free rate and buy A.Chapter 10 . D. that the model does not require a specific benchmark market portfolio. Risk must be considered in both the CAPM and APT. Rational investors will arbitrage by selling A and buying B.

A professional who searches for mispriced securities in specific areas such as merger- target stocks. C. E. C. option arbitrage.Chapter 10 . Implications derived from APT are much stronger than those derived from CAPM. APT depends on a no arbitrage condition. AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: APT 10-43 . CAPM depends on risk-return dominance. APT depends on a no arbitrage condition and assumes many small changes are required to bring the market back to equilibrium. APT depends on a no arbitrage condition. CAPM depends on risk-return dominance. CAPM assumes many small changes are required to bring the market back to equilibrium. pure arbitrage.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 39. APT assumes a few large changes are required to bring the market back to equilibrium. when an equilibrium price is violated many investors will make small portfolio changes. Under the no-arbitrage argument of APT. until equilibrium is restored. equilibrium arbitrage. each investor will take as large a position as possible so only a few investors must act to restore equilibrium. D. CAPM assumes many small changes are required to bring the market back to equilibrium. making C an incorrect statement. D. implications for prices derived from CAPM arguments are stronger than prices derived from APT arguments. CAPM depends on risk-return dominance. risk arbitrage. covered interest arbitrage. AACSB: Analytic Bloom's: Remember Difficulty: Challenge Topic: APT 40. B. depending on their risk tolerance. Under the risk-return dominance argument of CAPM. B. Risk arbitrage involves searching for mispricings based on speculative information that may or may not materialize. An important difference between CAPM and APT is A. rather than one who seeks strict (risk-free) arbitrage opportunities is engaged in A. implications for prices derived from CAPM arguments are stronger than prices derived from APT arguments. E. APT assumes a few large changes are required to bring the market back to equilibrium.

one that is diversified over a large enough number of securities that the nonsystematic variance is essentially zero. A well-diversified portfolio is defined as A. n. C. AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: APT 42. AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: APT 10-44 . B. C. a portfolio that is equally weighted. one that contains securities from at least three different industry sectors.Chapter 10 . D. increases.0. so that nonsystematic variance is negligible. a portfolio whose factor beta equals 1. E. B. each having a small (but not necessarily equal) weight. None of these is correct. negative one. the nonsystematic risk of a well-diversified portfolio approaches zero. D. E. As the number of securities. In the context of the Arbitrage Pricing Theory. zero. a portfolio that is equally weighted and contains securities from at least three different industry sectors A well-diversified portfolio is one that contains a large number of securities.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 41. one. as a well-diversified portfolio becomes larger its nonsystematic risk approaches A. infinity.

The expected return-beta relationship must hold for all well-diversified portfolios and for all but a few individual securities. Any well-diversified portfolio lying on the SML can serve as the benchmark portfolio for the APT. I and III are correct. IV) the expected return-beta relationship is maintained for all individual securities. that is unobservable. that need not be well-diversified. II and III are correct. C. AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: APT 10-45 . E. The APT requires a benchmark portfolio A.Chapter 10 . Only I is correct.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 43. otherwise arbitrage opportunities will be available. that is well-diversified and lies on the SML. III) the expected return-beta relationship is maintained for all but a small number of individual securities. II and IV are correct. AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: APT 44. D. II) the expected return-beta relationship is maintained for all well-diversified portfolios. I and IV are correct. B. The true (and unobservable) market portfolio is only a requirement for the CAPM. Imposing the no-arbitrage condition on a single-factor security market implies which of the following statements? I) the expected return-beta relationship is maintained for all but a small number of well- diversified portfolios. that is equal to the true market portfolio. C. A. E. that contains all securities in proportion to their market values. D. B.

8 on the second factor.0% B. The risk-free rate is 6%. E.2% .2 on the first factor and . 8.0% E.04) + .0% C.2% D.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 45. in a two-factor economy. Arbitrage is exploiting security mispricings by the simultaneous purchase and sale to gain economic profits without taking any risk. Consider a well-diversified portfolio. D. 9. B. A.03) = .2 (.8 (. 13. If portfolio A has a beta of 1. The term "arbitrage" refers to A.Chapter 10 . earning risk-free economic profits. negotiating for favorable brokerage fees. hedging your portfolio through the use of options. what is its expected return? A. C.06 + 1. short selling high and buying low. the risk premium on the first factor portfolio is 4% and the risk premium on the second factor portfolio is 3%.132 AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 46. AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: APT 10-46 . 7. A capital market in equilibrium rules out arbitrage opportunities. buying low and selling high. 13.

a random amount of return attributable to firm events. a factor that affects all security returns. I and IV B. C. III. To take advantage of an arbitrage opportunity. an investor would I) construct a zero investment portfolio that will yield a sure profit. III. II. III) make simultaneous trades in two markets without any net investment. and IV E. II) construct a zero beta investment portfolio that will yield a sure profit. F measures the unanticipated portion of a factor that is common to all security returns. the deviation from its expected value of a factor that affects all security returns. IV) short sell the asset in the low-priced market and buy it in the high-priced market. AACSB: Analytic Bloom's: Understand Difficulty: Challenge Topic: APT 48.Chapter 10 . I and III C. IV is incorrect because the opposite is true. AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: APT 10-47 . The factor F in the APT model represents A. B. the sensitivity of the firm to that factor. I. firm-specific risk. and IV Only I and III are correct. D. E.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 47. A. II is incorrect because the beta of the portfolio does not need to be zero. II and III D.

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

**49. In the APT model, what is the nonsystematic standard deviation of an equally-weighted
**

portfolio that has an average value of (ei) equal to 25% and 50 securities?

A. 12.5%

B. 625%

C. 0.5%

D. 3.54%

E. 14.59%

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

**50. In the APT model, what is the nonsystematic standard deviation of an equally-weighted
**

portfolio that has an average value of (ei) equal to 20% and 20 securities?

A. 12.5%

B. 625%

C. 4.47%

D. 3.54%

E. 14.59%

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

10-48

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

**51. In the APT model, what is the nonsystematic standard deviation of an equally-weighted
**

portfolio that has an average value of (ei) equal to 20% and 40 securities?

A. 12.5%

B. 625%

C. 0.5%

D. 3.54%

E. 3.16%

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

**52. In the APT model, what is the nonsystematic standard deviation of an equally-weighted
**

portfolio that has an average value of (ei) equal to 18% and 250 securities?

A. 1.14%

B. 625%

C. 0.5%

D. 3.54%

E. 3.16%

AACSB: Analytic

Bloom's: Apply

Difficulty: Intermediate

Topic: APT

10-49

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

53. Which of the following is true about the security market line (SML) derived from the

APT?

A. The SML has a downward slope.

B. The SML for the APT shows expected return in relation to portfolio standard deviation.

C. The SML for the APT has an intercept equal to the expected return on the market portfolio.

D. The benchmark portfolio for the SML may be any well-diversified portfolio.

E. The SML is not relevant for the APT.

**The benchmark portfolio does not need to be the (unobservable) market portfolio under the
**

APT, but can be any well-diversified portfolio. The intercept still equals the risk-free rate.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

54. Which of the following is false about the security market line (SML) derived from the

APT?

A. The SML has a downward slope.

B. The SML for the APT shows expected return in relation to portfolio standard deviation.

C. The SML for the APT has an intercept equal to the expected return on the market portfolio.

D. The benchmark portfolio for the SML may be any well-diversified portfolio.

E. The SML has a downward slope, the SML for the APT shows expected return in relation to

portfolio standard deviation, and the SML for the APT has an intercept equal to the expected

return on the market portfolio are all false.

**The benchmark portfolio does not need to be the (unobservable) market portfolio under the
**

APT, but can be any well-diversified portfolio. The intercept still equals the risk-free rate.

AACSB: Analytic

Bloom's: Remember

Difficulty: Intermediate

Topic: APT

10-50

8*(15 − 3) + 0. 13. it must be true that [E(rp) − rf]/p = [E(rQ) − rf]/ Q.80 on the first factor and 0. 15. proportional to its weight in the market portfolio.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 55.7% E. A.1 AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 10-51 . Portfolio 1 and Portfolio 2. if A has a beta of 0. E. proportional to its beta coefficient. D. For each well-diversified portfolio (P and Q.2% B. C. 10. inversely proportional to its standard deviation. The portfolios have expected returns of 15% and 6%. proportional to its standard deviation. AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: APT 56. If arbitrage opportunities are to be ruled out. Suppose you are working with two factor portfolios. respectively.3% D. what would be the expected return on well-diversified portfolio A.1% C. B. 8. for example).4% E(RA) = 3 + 0. inversely proportional to the risk-free rate. Based on this information. each well-diversified portfolio's expected excess return must be A. 14.Chapter 10 .50 on the second factor? The risk-free rate is 3%.5*(6 − 3) = 14.

and IV All except the first item are true. II and III D. III. IV) It doesn't rely on the market portfolio that contains all assets. In a factor model. AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: APT 58. risk premiums. III. standard deviation of returns. non-factor risk. Which of the following is (are) true regarding the APT? I) The Security Market Line does not apply to the APT. E. and returns. III) Almost all individual securities satisfy the APT relationship. AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: APT 10-52 . There is a Security Market Line associated with the APT. II. II. II) More than one factor can be important in determining returns. II. and IV B. C. B. Factor models explain firm returns based on both factor risk and non-factor risk. A. both factor risk and non-factor risk. factor risk.Chapter 10 . and IV E. There is no relationship between factor risk. D. the return on a stock in a particular period will be related to A. I.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 57. I. II and IV C.

Change in expected inflation and Change in unanticipated inflation E. Change in unanticipated inflation D. Roll and Ross not include in their multifactor model? A. All of these factors were included in their model. Change in unanticipated inflation D. AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: APT 60. AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: APT 10-53 . Neither the change in industrial production. Change in expected inflation C. Roll and Ross include in their multifactor model? A.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 59. nor excess return of long-term government bonds over T-bills were included in their model.Chapter 10 . Roll and Ross included the change in expected inflation and the change in unanticipated inflation as well as the excess return of long-term corporate bonds over long- term government bonds in their model. Which of the following factors did Chen. Change in industrial waste B. Change in expected inflation C. Chen. Change in industrial production B. Chen. change in expected inflation. Roll and Ross included the four listed factors as well as the excess return of long-term corporate bonds over long-term government bonds in their model. Which of the following factors did Chen. Excess return of long-term government bonds over T-bills E. change in unanticipated inflation.

Excess return of small stocks over large stocks. 1.30 D.93. Fama and French included all three of the factors listed. Thus. beta of A = 7/7.5 = 0. If arbitrage opportunities are ruled out. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 10-54 . The risk-free rate of return is 5%.27 A: 12% = 5% + bF. respectively.5%. 1. 1. 0. B. stock A has a beta of __________. E. None of these factors were included in their model. Return on the market index. Consider the single-factor APT. Excess return of high book-to-market stocks over low book-to-market stocks. AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: APT 62. B: 14% = 5% + 1. Which of the following factors were used by Fama and French in their multi-factor model? A.2. Stock B has a beta of 1. A.67 B. C.2F. Stocks A and B have expected returns of 12% and 14%.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 61.93 C. D.Chapter 10 . 0. F = 7. All of these factors were included in their model.69 E.

they may result from data snooping B. The beta of the well- diversified portfolio is approximately __________. such as those described by Fama and French. The standard deviation on the factor portfolio is 12%.58 B. Consider the one-factor APT. 1. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 64. A. they can be explained by security characteristic lines D.42 (19%)2 = (12%)2b2. they are macroeconomic factors Black argues that past risk premiums on firm-characteristic variables.13 C. 1. The standard deviation of returns on a well-diversified portfolio is 19%.58. are problematic because they may result from data snooping. such as those described by Fama and French.Chapter 10 .Arbitrage Pricing Theory and Multifactor Models of Risk and Return 63.25 D. A. are problematic because ________. 1. 1. they are sources of systematic risk C.76 E. Black argues that past risk premiums on firm-characteristic variables. b = 1. they are more appropriate for a single-factor model E. AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: APT 10-55 . 0.

expanding beyond one factor to represent sources of systematic risk. AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: APT 66. modeling the systematic component of firm returns in greater detail. and allowing for multiple economic factors to have differential effects. incorporating firm-specific components into the pricing model. using only stocks with relatively stable returns. can better describe assets' returns by A. allowing for several sources of risk to affect the returns. Multifactor models such as the one constructed by Chen. ignoring firm-specific risk. and allowing for multiple economic factors to have differential effects.. Roll. Multifactor models seek to improve the performance of the single-index model by modeling the systematic component of firm returns in greater detail. AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: APT 10-56 . incorporating firm- specific components into the pricing model. D. C. allowing for multiple economic factors to have differential effects. D. incorporating firm-specific components into the pricing model. C. and Ross.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 65. The study used five different factors to explain security returns. modeling the systematic component of firm returns in greater detail.Chapter 10 . using variables that are easier to forecast ex ante. none of these statements are true. calculating beta coefficients by an alternative method. B. Multifactor models seek to improve the performance of the single-index model by A. B. E. E.

4%. 1.25(2%) = 13. 13. Consider the multifactor model APT with three factors. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 10-57 .8(3%) + 1. Stock A has a beta on factor 2 of ________.3.3) + 4%(x). 5% and 2%. Consider the multifactor APT. respectively. x = 1. 13.05. 16. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 68. Portfolio A has a beta of 0.6% 3% + 0. The risk premiums on the factor 1 and factor 2 portfolios are 6% and 4%.8 on factor 1. and factor 3 are 3%.33 B.0% E. factor 2. Stock A has an expected return of 16% and a beta on factor 1 of 1. 11. 1.95 16% = 4% + 6%(1. A.00 E. and a beta of 1. . The expected return on portfolio A is __________ if no arbitrage opportunities exist.Chapter 10 .4% C.05 C. 23.25 on factor 3. A. a beta of 1.1 on factor 2. The risk premiums on the factor 1.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 67.67 D. 1. The risk-free rate of return is 4%. 2.1(5%) + 1.5% D.5% B. The risk-free rate of return is 3%. respectively.

6 on the first factor and 1. B. 18.06) = .0% B.5F + 4%: F = 8. If you wanted to take advantage of an arbitrage opportunity.0% C. The risk-free rate is 5%. A B. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 10-58 .04) + 1.6 (.0F + 4%. Portfolio B has a beta of 1. the riskless asset A: 22% = 2.8 on the second factor.8 (. in a two-factor economy. 8. 13. thus. what is its expected return? A. B.5 and an expected return of 17%. If portfolio A has a beta of 0.05 + .Chapter 10 . B C. A.182 AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 70. Consider a well-diversified portfolio. Consider a single factor APT. A.2% . Portfolio A has a beta of 2. A. B E.67%. F = 9%. A. short B and take a long position in A. you should take a short position in portfolio __________ and a long position in portfolio _______. 13.2% D. B: 17% = 1.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 69.0 and an expected return of 22%. A. 7. the risk premium on the first factor portfolio is 4% and the risk premium on the second factor portfolio is 6%. A D. The risk-free rate of return is 4%.0% E.

short A and take a long position in B. The variance of returns on the well- diversified portfolio is approximately __________. If you wanted to take advantage of an arbitrage opportunity. 7.06%. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 10-59 . F = 20%.4 and an expected return of 13%. 3. A B. 14. A: 12% = 5% + 0. A. B.7% s2P = (1. The beta of a well-diversified portfolio on the factor is 1. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 72.3% D. B E. Consider the one-factor APT.Chapter 10 . 9. F = 14%. A.25)2(9%) = 14. A D. The variance of returns on the factor portfolio is 9%.4F.0% C. you should take a short position in portfolio _________ and a long position in portfolio _________.6% B. Portfolio B has a beta of 0.25.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 71. Consider the single factor APT. A. B. 6. B C.5F. B: 13% = 5% + 0.1% E. The risk-free rate of return is 5%. No arbitrage opportunity exists. A. Portfolio A has a beta of 0.5 and an expected return of 12%. therefore.

The beta of a well-diversified portfolio on the factor is 1.80 B. The beta of the well- diversified portfolio is approximately __________.13 C. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 10-60 .13%.45)2(11%) = 23. The variance of returns on the well- diversified portfolio is approximately __________.4% s2P = (1.1% E. 23.Arbitrage Pricing Theory and Multifactor Models of Risk and Return 73. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Topic: APT 74. Consider the one-factor APT.Chapter 10 . The standard deviation on the factor portfolio is 14%.1% B.25 D. A. The variance of returns on the factor portfolio is 11%. 7. 0. A. b = 1. 1.45. 1. 1. 67 (22%)2 = (14%)2b2. 6. 11. Consider the one-factor APT.57.0% C.3% D. 14.57 E. The standard deviation of returns on a well-diversified portfolio is 22%.

etc. if the index portfolio is not a precise proxy for the true market portfolio. several factors may affect stock returns. In addition. if an index portfolio is sufficiently diversified. the APT has more flexibility than the CAPM. However. which is a cause of considerable concern in the context of the CAPM. The APT does not require that the benchmark portfolio in the SML relationship be the true market portfolio. Any well-diversified portfolio lying on the SML may serve as a benchmark portfolio. A multifactor model can accommodate these multiple sources of risk. Feedback: This question is designed to determine if the student understands the basic advantages of the multi-factor APT over the single-factor APT and CAPM. Feedback: This question is designed to determine if the student understands the basic advantages of APT over the CAPM. AACSB: Reflective Thinking Bloom's: Understand Difficulty: Intermediate Topic: APT and CAPM 76. That is.Chapter 10 . the APT provides further justification for the use of the index model for practical implementation of the SML relationship. AACSB: Reflective Thinking Bloom's: Understand Difficulty: Intermediate Topic: APT and CAPM 10-61 . inflation rates. the SML relationship holds. oil prices. Thus. as problems associated with an unobservable market portfolio are not a concern with APT. The CAPM implies that the risk premium on the market is determined by the market's variance and the average degree of risk aversion across investors. Discuss the advantages of the multifactor APT over the single factor APT and the CAPM. Discuss the advantages of arbitrage pricing theory (APT) over the capital asset pricing model (CAPM) relative to diversified portfolios. What is one shortcoming of the multifactor APT and how does this shortcoming compare to CAPM implications? The single factor APT and the CAPM assume that there is only one systematic risk factor affecting stock returns. One shortcoming of the multifactor APT is that the model provides no guidance concerning the factors or risk premiums on the factor portfolios. according to APT. Some of these factors are: business cycles. interest rate fluctuations.Arbitrage Pricing Theory and Multifactor Models of Risk and Return Short Answer Questions 75.

Arbitrage Pricing Theory and Multifactor Models of Risk and Return 77. Both the CAPM and the APT are market equilibrium models. The aggregate effect of their actions brings the market back into equilibrium. assumptions about risk aversion. risk- return dominance. In equilibrium. the investor can sell short the asset in the high-priced market and buy the asset in the low-priced market. it would not take many investors to identify the arbitrage opportunity and act to bring the market back to equilibrium. The investor has been able to assume these positions with a zero investment (using the proceeds of the short transaction to finance the long position). Under the CAPM. That is. Feedback: This question is designed to determine if the student understands the basic concept of arbitrage. when a mispricing occurs.Chapter 10 . Discuss arbitrage opportunities in the context of violations of the law of one price. AACSB: Reflective Thinking Bloom's: Understand Difficulty: Basic Topic: APT 78. it should be remembered that individual investors do not have access to the proceeds of a short transaction until the position has been covered. each investor wants an infinite arbitrage position in the mispriced asset. Feedback: The student can compare the two models by focusing on the specific items. If the price differential exceeds the transactions costs. which examine the factors that affect securities' prices. However. AACSB: Reflective Thinking Bloom's: Understand Difficulty: Challenge Topic: APT and CAPM 10-62 . The CAPM is based on the idea that there are large numbers of investors who are focused on risk-return dominance. The law of one price is violated when an asset is trading at different prices in two markets. guided by their degrees of risk aversion. Therefore. and the number of investors required to restore equilibrium. there are no overpriced or underpriced securities. a simultaneous trade in the two markets can produce a sure profit with a zero investment. many individual investors make small changes in their portfolios. Discuss the similarities and the differences between the CAPM and the APT with regard to the following factors: capital market equilibrium. In both models. mispriced securities can be identified and purchased or sold as appropriate to earn excess profits. Under the APT.

Chapter 10 . explain how an investor can take advantage of it. Roll. UI (the % change in unanticipated inflation). Name three variables that Chen. The question provides an opportunity to measure the student's understanding of the types of risk that are relevant and how they can be explicitly considered in the model. A general understanding of macroeconomic variables will be helpful in answering the question.0 and an expected return of 12%. Each beta will represent only the impact of the corresponding variable on returns. An arbitrage opportunity exists because it is possible to form a portfolio of security A and the risk-free asset that has a beta of 0.25(6%) = 10. The rational for their model is that many different economic factors can combine to affect securities' returns.25 in the risk-free asset. AACSB: Reflective Thinking Bloom's: Understand Difficulty: Challenge Topic: APT 10-63 .Arbitrage Pricing Theory and Multifactor Models of Risk and Return 79.75 and a different expected return than security B. The risk-free rate is 6%.75 as the weight in A and . The investor should buy B and finance the purchase by short selling A and borrowing at the risk-free asset. Also. which is less than B's 11% expected return. Explain the arbitrage opportunity that exists. what to buy and what to sell. Feedback: The student has some flexibility in remembering which variables were used in the study.5%. The investor can accomplish this by choosing . by including factors that are related to the business cycle. Security A has a beta of 1.75(12%) + 0. This portfolio would have E(rp) = 0. The factors they considered were IP (the % change in industrial production). and GB (excess return of long- term government bonds over T-bills). Feedback: The student can apply arbitrage principles. the estimation of beta coefficients should be improved. EI (the % change in expected inflation). AACSB: Reflective Thinking Bloom's: Apply Difficulty: Intermediate Topic: APT 80. Security B has a beta of 0. Briefly explain the reasoning behind their model. CG (excess return of long-term corporate bonds over long-term government bonds). and Ross used to measure the impact of macroeconomic factors on security returns.75 and an expected return of 11%. Give specific details about how to form the portfolio.

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