File: Chap08, CHAPTER 8: INDEX MODELS AND THE

Multiple Choice Questions

1.
As diversification increases, the total variance of a portfolio approaches
____________.
A)
0
B)
1
C)
the variance of the market portfolio
D)
infinity
E)
none of the above
Answer:
C
Difficulty:
Easy
Response:
As more and more securities are added to the portfolio, unsystematic risk
decreases and most of the remaining risk is systematic, as measured by the variance of the
market portfolio.

2.
A)
B)
C)
D)
E)

The index model was first suggested by ____________.

Graham
Markowitz
Miller
Sharpe
none of the above

Answer:
D
Difficulty:
Easy
Response:
William Sharpe, building on the work of Harry Markowitz, developed the
index model.

3.
A)
B)
C)
D)
E)

A single-index model uses __________ as a proxy for the systematic risk factor.
a market index, such as the S&P 500 or the TSE 300
the current account deficit
the growth rate in GNP
the unemployment rate
none of the above

Answer:

Difficulty:
Easy
Response:
The single-index model uses a market index, such as the S&P 500 or TSE 300,
as a proxy for the market, and thus for systematic risk.

4.
The Security Risk Evaluation book published by Merrill Lynch relies on the
__________ most recent monthly observations to calculate regression parameters.
A)
12
B)
36
C)
60
D)
120
E)
none of the above
Answer:
C
Difficulty:
Easy
Response:
Most published betas and other regression parameters, including those
published by Merrill Lynch, are based on five years of monthly return data.

5.
To determine stock beta estimates, BMO Nesbitt Burns uses the __________ as a
proxy for the market portfolio.
A)
Dow Jones Industrial Average
B)
TSE 300 Index
C)
S&P 500 Index
D)
Wilshire 5000
E)
none of the above
Answer:
Difficulty:
Response:
proxy.

6.
A)
B)
C)
D)
E)

B
Easy
The BMO Nesbitt Burns data is based on the TSE 300 index as a market

According to the index model, covariances among security pairs are

due to the influence of a single common factor represented by the market index return
extremely difficult to calculate
related to industry-specific events
usually positive
a and d

Answer:
Difficulty:

E
Easy

Response:
Most securities move together most of the time, and move with a market index,
or market proxy.

7.
A)
B)
C)
D)
E)

The intercept calculated by BMO Nesbitt Burns in the regression equations is equal to
in the CAPM
+ rf(1 + )
+ rf(1 - )
1 -
none of the above

Answer:
C
Difficulty:
Moderate
Response:
The intercept that BMO Nesbitt Burns calls alpha is really, using the
parameters of the CAPM, an estimate of + rf (1 - ). The apparent justification for this
procedure is that, on a monthly basis, rf(1 - ) is small and is apt to be swamped by the
volatility of actual stock returns.

8.
Analysts may use regression analysis to estimate the index model for a stock. When
doing so, the slope of the regression line is an estimate of ______________.
A)
the of the asset
B)
the of the asset
C)
the of the asset
D)
the of the asset
E)
none of the above
Answer:
B
Difficulty:
Moderate
Response:
The slope of the regression line, , measures the volatility of the stock versus
the volatility of the market.

9.
In a factor model, the return on a stock in a particular period will be related to
_________.
A)
firm-specific events
B)
macroeconomic events
C)
the error term
D)
both a and b
E)
neither a nor b
Answer:

Difficulty:
Response:
events.

Moderate
The return on a stock is related to both firm-specific and macroeconomic

10.
If the index model is valid, _________ would be helpful in determining the covariance
between assets K and L.
A)
k
B)
L
C)
M
D)
all of the above
E)
none of the above
Answer:
D
Difficulty:
Moderate
Response:
If the index model is valid a, b, and c are determinants of the covariance
between K and L.

11.
If a firm's beta was calculated as 0.6 in a regression equation, Merrill Lynch would
state the adjusted beta at a number
A)
less than 0.6 but greater than zero.
B)
between 0.6 and 1.0.
C)
between 1.0 and 1.6.
D)
greater than 1.6.
E)
zero or less.
Answer:
B
Difficulty:
Moderate
Response:
Betas, on average, equal one; thus, betas over time regress toward the mean, or
1. Therefore, if historic betas are less than 1, adjusted betas are between 1 and the calculated
beta.

12.
The beta of Exxon stock has been estimated as 1.2 by Merrill Lynch using regression
analysis on a sample of historical returns. The Merrill Lynch adjusted beta of Exxon stock
would be ___________.
A)
1.20
B)
1.32
C)
1.13
D)
1.0
E)
none of the above

Answer:
Difficulty:
Response:

C
Moderate
Adjusted beta = 2/3 sample beta + 1/3(1); = 2/3(1.2) + 1/3 = 1.13.

13.
Assume that stock market returns do not resemble a single-index structure. An
investment fund analyzes 100 stocks in order to construct a mean-variance efficient portfolio
constrained by 100 investments. They will need to calculate _____________ expected returns
and ___________ variances of returns.
A)
100, 100
B)
100, 4950
C)
4950, 100
D)
4950, 4950
E)
none of the above
Answer:
A
Difficulty:
Moderate
Response:
The expected returns of each of the 100 securities must be calculated. In
addition, the 100 variances around these returns must be calculated.

14.
Assume that stock market returns do not resemble a single-index structure. An
investment fund analyzes 100 stocks in order to construct a mean-variance efficient portfolio
constrained by 100 investments. They will need to calculate ____________ covariances.
A)
45
B)
100
C)
4,950
D)
10,000
E)
none of the above
Answer:
Difficulty:
Response:

C
Moderate
(n2 - n)/2 = (1002 - 100)/2 = 4,950 covariances must be calculated.

15.
Assume that stock market returns do follow a single-index structure. An investment
fund analyzes 200 stocks in order to construct a mean-variance efficient portfolio constrained
by 200 investments. They will need to calculate ________ estimates of expected returns and
________ estimates of sensitivity coefficients to the macroeconomic factor.
A)
200; 19,900
B)
200; 200
C)
19,900; 200
D)
19,900; 19.900

E)

none of the above

Answer:
B
Difficulty:
Moderate
Response:
For a single-index model, n(200), expected returns and n(200) sensitivity
coefficients to the macroeconomic factor must be estimated.

16.
Assume that stock market returns do follow a single-index structure. An investment
fund analyzes 500 stocks in order to construct a mean-variance efficient portfolio constrained
by 500 investments. They will need to calculate ________ estimates of firm-specific
variances and ________ estimates for the variance of the macroeconomic factor.
A)
500; 1
B)
500; 500
C)
124,750; 1
D)
124,750; 500
E)
250,000; 500
Answer:
A
Difficulty:
Moderate
Response:
For the single-index model, n(500) estimates of firm-specific variances must
be calculated and 1 estimate for the variance of the common macroeconomic factor.

17.
Consider the single-index model. The alpha of a stock is 0%. The return on the
market index is 16%. The risk-free rate of return is 5%. The stock earns a return that exceeds
the risk-free rate by 11% and there are no firm-specific events affecting the stock
performance. The of the stock is _______.
A)
0.67
B)
0.75
C)
1.0
D)
1.33
E)
1.50
Answer:
Difficulty:
Response:

C
Moderate
11% = 0% + (11%); = 1.0.

18.
Suppose you held a well-diversified portfolio with a very large number of securities,
and that the single index model holds. If the of your portfolio was 0.20 and M was 0.16,
the of the portfolio would be approximately ________.
A)
0.64

B)
C)
D)
E)

0.80
1.25
1.56
none of the above

Answer:
Difficulty:
Response:

C
Difficult
2p / 2m = 2; (0.2)2/(0.16)2 = 1.56; = 1.25.

19.
Suppose the following equation best describes the evolution of over time:t = 0.25 +
0.75t-1If a stock had a of 0.6 last year, you would forecast the to be _______ in the
coming year.
A)
0.45
B)
0.60
C)
0.70
D)
0.75
E)
none of the above
Answer:
Difficulty:
Response:

C
Easy
0.25 + 0.75(0.6) = 0.70.

20.
BMO Nesbitt Burns estimates the index model for a stock using regression analysis
involving total returns. They estimated the intercept in the regression equation at 6% and the
at 0.5. The risk-free rate of return is 12%. The true of the stock is ________.
A)
0%
B)
3%
C)
6%
D)
9%
E)
none of the above
Answer:
Difficulty:
Response:

21.

A
Difficult
6% = + 12% ( 1 - 0.5); = 0%.

The index model for stock A has been estimated with the following result: RA = 0.01
+ 0.9RM + eAIf M = 0.25 and R2A = 0.25, the standard deviation of return of stock A is
_________.
A)
0.2025

B)
C)
D)
E)

0.2500
0.4500
0.8100
none of the above

Answer:
Difficulty:
Response:

C
Difficult
R2 = 22M / 2; 0.25 = [(0.81)(0.25)2]/2; = 0.4500.

22.

The index model for stock B has been estimated with the following result: RB = 0.01
+ 1.1RM + eBIf M = 0.20 and R2B = 0.50, the standard deviation of the return on stock B is
_________.
A)
0.1111
B)
0.2111
C)
0.3111
D)
0.4111
E)
none of the above
Answer:
Difficulty:
Response:

C
Difficult
R2 = 22M / 2; 0.5 = [(1.1)2(0.2)2]/2; = 0.3111.

23.
Suppose you forecast that the market index will earn a return of 15% in the coming
year. Treasury bills are yielding 6%. The unadjusted of Mobil stock is 1.30. A reasonable
forecast of the return on Mobil stock for the coming year is _________ if you use Merrill
Lynch adjusted betas.
A)
15.0%
B)
15.5%
C)
16.0%
D)
16.8%
E)
none of the above
Answer:
Difficulty:
Response:

D
Difficult
Adjusted beta = 2/3(1.3) + 1/3 = 1.20; E(rM) = 6% + 1.20(9%) = 16.8%.

24.
The index model has been estimated for stocks A and B with the following results: RA
= 0.01 + 0.5RM + eARB = 0.02 + 1.3RM + eBM = 0.25 (eA) = 0.20 (eB) = 0.10 The
covariance between the returns on stocks A and B is ___________.

A)
B)
C)
D)
E)

0.0384
0.0406
0.1920
0.0050
0.4000

Answer:
Difficulty:
Response:

B
Difficult
Cov(RA,RB) = AB2M = 0.5(1.3)(0.25)2 = 0.0406.

25.
The index model has been estimated for stocks A and B with the following results: RA
= 0.01 + 0.8RM + eARB = 0.02 + 1.2RM + eBM = 0.20 (eA) = 0.20 (eB) = 0.10
The standard deviation for stock A is __________.
A)
0.0656
B)
0.0676
C)
0.2561
D)
0.2600
E)
none of the above
Answer:
Difficulty:
Response:

C
Difficult
A = [(0.8)2(0.2)2 + (0.2)2]1/2 = 0.2561.

26.
The index model has been estimated for stock A with the following results: RA = 0.01
+ 0.8RM + eAM = 0.20
(eA) = 0.10The standard deviation of the return for stock A is
__________.
A)
0.0356
B)
0.1886
C)
0.1600
D)
0.6400
E)
none of the above
Answer:
Difficulty:
Response:

27.
A)
B)

B
Difficult
B = [(.8)2(0.2)2 + (0.1)2]1/2 = 0.1886.

Security returns
are based on both macro events and firm-specific events.
are based on firm-specific events only.

C)
D)
E)

are usually positively correlated with each other.

a and b.
a and c.

Answer:
E
Difficulty:
Easy
Response:
Stock returns are usually highly positively correlated with each other. Stock
returns are affected by both macro economic events and firm-specific events.

28.
The single-index model
A)
greatly reduces the number of required calculations, relative to those required by the
Markowitz model.
B)
enhances the understanding of systematic versus nonsystematic risk.
C)
greatly increases the number of required calculations, relative to those required by the
Markowitz model.
D)
a and b.
E)
b and c.
Answer:
D
Difficulty:
Easy
Response:
The single index model both greatly reduces the number of calculations and
enhances the understanding of the relationship between systematic and unsystematic risk on
security returns.

29.
A)
B)
C)
D)
E)

The Security Characteristic Line (SCL)

plots the excess return on a security as a function of the excess return on the market.
allows one to estimate the beta of the security.
allows one to estimate the alpha of the security.
all of the above.
none of the above.

Answer:
D
Difficulty:
Easy
Response:
The security characteristic line, which plots the excess return of the security as
a function of the excess return of the market allows one to estimate both the alpha and the
beta of the security.

30.
A)
B)

In a factor model, the return on a stock in a particular period will be related to

factor risk.
non-factor risk.

C)
D)
E)

standard deviation of returns.

both a and b are true.
none of the above are true.

Answer:
Difficulty:
Response:
risk.

D
Moderate
Factor models explain firm returns based on both factor risk and non-factor

31.
Which of the following factors did Chen, Roll and Ross not include in their
multifactor model?
A)
Change in industrial production
B)
Change in expected inflation
C)
Change in unanticipated inflation
D)
Excess return of long-term government bonds over T-bills
E)
All of the above factors were included in their model.
Answer:
E
Difficulty:
Moderate
Response:
Chen, 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.

32.
Which of the following factors was used by Fama and French in their multi-factor
model?
A)
Return on the market index
B)
Excess return of small stocks over large stocks
C)
Excess return of high book-to-market stocks over low book-to-market stocks
D)
All of the above factors were included in their model.
E)
None of the above factors were included in their model.
Answer:
Difficulty:
Response:

33.
A)
B)
C)
D)
E)

D
Moderate
Fama and French included all three of the factors listed.

The CAPM assumes that the only relevant source of risk arises from
industry factors
labor income
variations in stock returns
financial distress
firm return standard deviation

Answer:
C
Difficulty:
Easy
Response:
The CAPM presupposes that the only relevant source of risk is variations in
stock returns.

34.
A)
B)
C)
D)
E)

Multifactor models seek to improve the performance of the single-index model by

modeling the systematic component of firm returns in greater detail.
incorporating firm-specific components into the pricing model.
allowing for multiple economic factors to have differential effects
all of the above are true.
none of the above are true.

Answer:
Difficulty:
Response:

D
Easy
All three statements are true about multifactor models.

35.
The expected impact of unanticipated macroeconomic events on a security's return
during the period is
A)
included in the security's expected return.
B)
zero.
C)
equal to the risk free rate.
D)
proportional to the firm's beta.
E)
infinite.
Answer:
B
Difficulty:
Moderate
Response:
The expected value of unanticipated macroeconomic events is zero, because by
definition it must average to zero or it would be incorporated into the expected return.

36.
A)
B)
C)
D)
E)

Covariances between security returns tend to be

positive because of SEC regulations.
positive because of Exchange regulations.
positive because of economic forces that affect many firms.
negative because of SEC regulations
negative because of economic forces that affect many firms.

Answer:
Difficulty:

C
Moderate

Response:
Economic forces such as business cycles, interest rates, and technological
changes tend to have similar impacts on many firms.

37.
In the single-index model represented by the equation ri = E(ri) + iF + ei, the term ei
represents
A)
the impact of unanticipated macroeconomic events on security i's return.
B)
the impact of unanticipated firm-specific events on security i's return.
C)
the impact of anticipated macroeconomic events on security i's return.
D)
the impact of anticipated firm-specific events on security i's return.
E)
the impact of changes in the market on security i's return.
Answer:
B
Difficulty:
Moderate
Response:
The textbook discusses a model in which macroeconomic events are used as a
single index for security returns. The ei term represents the impact of unanticipated firmspecific events. The ei term has an expected value of zero. Only unanticipated events would
affect the return.

38.
Suppose you are doing a portfolio analysis that includes all of the stocks on the NYSE.
Using a single-index model rather than the Markowitz model _______ the number of inputs
needed from _______ to ________.
A)
increases, about 1,400, more than 1.4 million
B)
increases, about 10,000, more than 125,000
C)
reduces, more than 125,000, about 10,000
D)
reduces, more than 3.6 million, about 8,100
E)
increases, about 150, more than 1,500
Answer:
D
Difficulty:
Moderate
Response:
This example is discussed on pages 293-296 of the textbook. The main point
for the students to remember is that the single-index model drastically reduces the number of
inputs required.

39.
A)
B)
C)
D)
E)

One cost of the single-index model is that it

is virtually impossible to apply.
prohibits specialization of efforts within the security analysis industry.
requires forecasts of the money supply.
is legally prohibited by the SEC.
allows for only two kinds of risk macro risk and micro risk.

Answer:
E
Difficulty:
Moderate
Response:
The single-index model discussed in chapter 10 broke risk into macro and
micro portions. In this model other factors such as industry effects.

40.
The Security Characteristic Line (SCL) associated with the single-index model is a
plot of
A)
the security's returns on the vertical axis and the market index's returns on the
horizontal axis.
B)
the market index's returns on the vertical axis and the security's returns on the
horizontal axis.
C)
the security's excess returns on the vertical axis and the market index's excess returns
on the horizontal axis.
D)
the market index's excess returns on the vertical axis and the security's excess returns
on the horizontal axis.
E)
the security's returns on the vertical axis and Beta on the horizontal axis.
Answer:
C
Difficulty:
Moderate
Response:
The student needs to remember that it is the excess returns that are plotted and
that the security's returns are plotted as a dependent variable.

41.
A)
B)
C)
D)
E)

The idea that there is a limit to the reduction of portfolio risk due to diversification is
contradicted by both the CAPM and the single-index model.
contradicted by the CAPM.
contradicted by the single-index model.
supported in theory, but not supported empirically.
supported both in theory and by empirical evidence.

Answer:
E
Difficulty:
Moderate
Response:
The benefits of diversification are limited to the level of systematic risk. Both
the CAPM and the single-index model support this and empirical evidence has confirmed it.

42.
Multifactor models such as the one constructed by Chen, Roll, and Ross, can better
describe assets' returns by
A)
expanding beyond one factor to represent sources of systematic risk.
B)
using variables that are easier to forecast ex ante.
C)
calculating beta coefficients by an alternative method.
D)
using only stocks with relatively stable returns.

E)

ignoring firm-specific risk.

Answer:
A
Difficulty:
Moderate
Response:
The study used five different factors to explain security returns, allowing for
several sources of risk to affect the returns.

43.
A)
B)
C)
D)
E)

___________ a relationship between expected return and risk.

APT stipulates
CAPM stipulates
Both CAPM and APT stipulate
Neither CAPM nor APT stipulate
No pricing model has found

Answer:
Difficulty:
Response:

C
Easy
Both models attempt to explain asset pricing based on risk/return relationships.

44.
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)
None of the above is a true statement.
Answer:
B
Difficulty:
Moderate
Response:
The multifactor APT provides no guidance as to the determination of the risk
premium on the various factors. The CAPM assumes that the excess market return over the
risk-free rate is the market premium in the single factor CAPM.

45.
An arbitrage opportunity exists if an investor can construct a __________ investment
portfolio that will yield a sure profit.
A)
positive
B)
negative
C)
zero
D)
all of the above
E)
none of the above

Answer:
C
Difficulty:
Easy
Response:
If the investor can construct a portfolio without the use of the investor's own
funds and the portfolio yields a positive profit, arbitrage opportunities exist.

46.
A)
B)
C)
D)
E)

The APT was developed in 1976 by ____________.

Lintner
Modigliani and Miller
Ross
Sharpe
none of the above

Answer:
Difficulty:
Response:

C
Easy
Ross developed this model in 1976.

47.
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)
a and b
E)
a, b, and c
Answer:
Difficulty:
Response:
factors.

A
Easy
A factor model portfolio has a beta of 1 one factor, with zero betas on other

48.
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)
none of the above
Answer:
Difficulty:
Response:

A
Easy
Arbitrage is earning of positive profits with a zero (risk-free) investment.

49.
A)
B)
C)
D)
E)

In developing the APT, Ross assumed that uncertainty in asset returns was a result of
a common macroeconomic factor
firm-specific factors
pricing error
neither a nor b
both a and b

Answer:
E
Difficulty:
Moderate
Response:
Total risk (uncertainty) is assumed to be composed of both macroeconomic
and firm-specific factors.

50.
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)
none of the above
Answer:
C
Difficulty:
Moderate
Response:
The CAPM is an asset-pricing model based on the risk/return relationship of
all assets. The APT implies that this relationship holds for all well-diversified portfolios, and
for all but perhaps a few individual securities.

51.
Consider a single factor APT. Portfolio A has a beta of 1.0 and an expected return of
16%. Portfolio B has a beta of 0.8 and an expected return of 12%. The risk-free rate of return
is 6%. If you wanted to take advantage of an arbitrage opportunity, you should take a short
position in portfolio __________ and a long position in portfolio _______.
A)
A, A
B)
A, B
C)
B, A
D)
B, B
E)
A, the riskless asset
Answer:
Difficulty:

C
Moderate

Response:
A:
16% = 1.0F + 6%; F = 10%; B:12% = 0.8F + 6%: F = 7.5%; Thus,
short B and take a long position in A.

52.
Consider the single factor APT. Portfolio A has a beta of 0.2 and an expected return
of 13%. Portfolio B has a beta of 0.4 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 _________ .
A)
A, A
B)
A, B
C)
B, A
D)
B, B
E)
none of the above
Answer:
C
Difficulty:
Moderate
Response:
A:13% = 10% + 0.2F; F = 15%; B:15% = 10% + 0.4F; F = 12.5%; Therefore,
short B and take a long position in A.

53.
Consider the one-factor APT. The variance of returns on the factor portfolio is 6%.
The beta of a well-diversified portfolio on the factor is 1.1. The variance of returns on the
well-diversified portfolio is approximately __________.
A)
3.6%
B)
6.0%
C)
7.3%
D)
10.1%
E)
none of the above
Answer:
Difficulty:
Response:

C
Moderate
s2P = (1.1)2(6%) = 7.26%.

54.
Consider the one-factor APT. The standard deviation of returns on a well-diversified
portfolio is 18%. The standard deviation on the factor portfolio is 16%. The beta of the welldiversified portfolio is approximately __________.
A)
0.80
B)
1.13
C)
1.25
D)
1.56
E)
none of the above

Answer:
Difficulty:
Response:

B
Moderate
(18%)2 = (16%)2b2; b = 1.125.

55.
Consider the single-factor APT. Stocks A and B have expected returns of 15% and
18%, respectively. The risk-free rate of return is 6%. Stock B has a beta of 1.0. If arbitrage
opportunities are ruled out, stock A has a beta of __________.
A)
0.67
B)
1.00
C)
1.30
D)
1.69
E)
none of the above
Answer:
Difficulty:
Response:
0.75.

E
Moderate
A:15% = 6% + bF; B:18% = 6% + 1.0F; F = 12%; Thus, beta of A = 9/12 =

56.
Consider the multifactor APT with two factors. Stock A has an expected return of
16.4%, a beta of 1.4 on factor 1 and a beta of .8 on factor 2. The risk premium on the factor 1
portfolio is 3%. The risk-free rate of return is 6%. What is the risk-premium on factor 2 if no
arbitrage opportunities exit?
A)
2%
B)
3%
C)
4%
D)
7.75%
E)
none of the above
Answer:
Difficulty:
Response:

D
Difficult
16.4% = 1.4(3%) + .8x + 6%; x = 7.75.

57.
Consider the multifactor model APT with two factors. Portfolio A has a beta of 0.75
on factor 1 and a beta of 1.25 on factor 2. The risk premiums on the factor 1 and factor 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.
A)
13.5%
B)
15.0%
C)
16.5%
D)
23.0%

E)

none of the above

Answer:
Difficulty:
Response:

C
Moderate
7% + 0.75(1%) + 1.25(7%) = 16.5%.

58.
Consider the multifactor APT with two factors. The risk premiums on the factor 1 and
factor 2 portfolios are 5% and 6%, respectively. Stock A has a beta of 1.2 on factor 1, and a
beta of 0.7 on factor 2. The expected return on stock A is 17%. If no arbitrage opportunities
exist, the risk-free rate of return is ___________.
A)
6.0%
B)
6.5%
C)
6.8%
D)
7.4%
E)
none of the above
Answer:
Difficulty:
Response:

C
Moderate
17% = x% + 1.2(5%) + 0.7(6%); x = 6.8%.

59.
Consider a one-factor economy. Portfolio A has a beta of 1.0 on the factor and
portfolio B has a beta of 2.0 on the factor. The expected returns on portfolios A and B are
11% and 17%, respectively. Assume that the risk-free rate is 6% and that arbitrage
opportunities exist. Suppose you invested $100,000 in the risk-free asset, $100,000 in
portfolio B, and sold short $200,000 of portfolio A. Your expected profit from this strategy
would be ______________.
A)
-$1,000
B)
$0
C)
$1,000
D)
$2,000
E)
none of the above
Answer:
C
Difficulty:
Moderate
Response:
$100,000(0.06) = $6,000 (risk-free position); $100,000(0.17) = $17,000
(portfolio B); -$200,000(0.11) = -$22,000 (short position, portfolio A); 1,000 profit.

60.
Consider the one-factor APT. Assume that two portfolios, A and B, are well
diversified. The betas of portfolios A and B are 1.0 and 1.5, respectively. The expected

returns on portfolios A and B are 19% and 24%, respectively. Assuming no arbitrage
opportunities exist, the risk-free rate of return must be ____________ .
A)
4.0%
B)
9.0%
C)
14.0%
D)
16.5%
E)
none of the above
Answer:
B
Difficulty:
Moderate
Response:
A:19% = rf + 1(F); B:24% = rf + 1.5(F); 5% = .5(F); F = 10%; 24% = rf +
1.5(10); ff = 9%.

61.
Consider the multifactor APT. The risk premiums on the factor 1 and factor 2
portfolios are 5% and 3%, respectively. The risk-free rate of return is 10%. Stock A has an
expected return of 19% and a beta on factor 1 of 0.8. Stock A has a beta on factor 2 of
________.
A)
1.33
B)
1.50
C)
1.67
D)
2.00
E)
none of the above
Answer:
Difficulty:
Response:

C
Moderate
19% = 10% + 5%(0.8) + 3%(x); x = 1.67.

62.
Consider the single factor APT. Portfolios A and B have expected returns of 14% and
18%, respectively. The risk-free rate of return is 7%. Portfolio A has a beta of 0.7. If
arbitrage opportunities are ruled out, portfolio B must have a beta of __________.
A)
0.45
B)
1.00
C)
1.10
D)
1.22
E)
none of the above
Answer:
Difficulty:
Response:

C
Moderate
A:14% = 7% + 0.7F; F = 10; B:18% = 7% + 10b; b = 1.10.

Reference: Case 8-1

There are three stocks, A, 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; economic
growth may be strong, moderate, or weak. The returns for the upcoming year on stocks A, B,
and C for each of these states of nature are given below:

Stock
A
B
C

State of Nature
Strong Growth
39%
30%
6%

Moderate Growth
17%
15%
14%

Weak Growth
-5%
0%
22%

63.
If you invested in an equally weighted portfolio of stocks A and B, your portfolio
return would be ___________ if economic growth were moderate.
A)
3.0%
B)
14.5%
C)
15.5%
D)
16.0%
E)
none of the above
Refer to: Case 8-1
Answer:
Difficulty:
Response:

D
Easy
E(Rp) = 0.5(17%) + 0.5(15%) = 16%.

64.
If you invested in an equally weighted portfolio of stocks A and C, your portfolio
return would be ____________ if economic growth was strong.
A)
17.0%
B)
22.5%
C)
30.0%
D)
30.5%
E)
none of the above
Refer to: Case 8-1
Answer:
Difficulty:
Response:

B
Easy
0.5(39%) + 0.5(6%) = 22.5%.

65.
If you invested in an equally weighted portfolio of stocks B and C, your portfolio
return would be _____________ if economic growth was weak.
A)
-2.5%
B)
0.5%
C)
3.0%
D)
11.0%
E)
none of the above
Refer to: Case 8-1
Answer:
Difficulty:
Response:

D
Easy
0.5(0%) + 0.5(22%) = 11%.

66.
If you wanted to take advantage of a risk-free arbitrage opportunity, you should take a
short position in _________ and a long position in an equally weighted portfolio of _______.
A)
A, B&C
B)
B, A&C
C)
C, A&B
D)
A&B, C
E)
none of the above, none of the above
Refer to: Case 8-1
Answer:
C
Difficulty:
Difficult
Response:
E(RA) = (39% + 17% - 5%)/3 = 17%; E(RB) = (30% + 15% + 0%)/3 = 15%;
E(RC) = (22% + 14% + 6%)/3 = 14%; E(RP) = -0.5(14%) + 0.5[(17% + 15%)/2]; -7.0% +
8.0% = 1.0%.

Reference: Case 8-2

Consider the multifactor APT. There are two independent economic factors, F1 and F2. The
risk-free rate of return is 6%. The following information is available about two welldiversified portfolios:
Portfolio
A
B

on F1
1.0
2.0

on F2
2.0
0.0

Expected Return
19%
12%

67.
Assuming no arbitrage opportunities exist, the risk premium on the factor F1 portfolio
should be __________.
A)
3%
B)
4%
C)
5%
D)
6%
E)
none of the above
Refer to: Case 8-2
Answer:
A
Difficulty:
Difficult
Response:
2A:38% = 12% + 2.0(RP1) + 4.0(RP2); B: 12% = 6% + 2.0(RP1) +
0.0(RP2); 26% = 6% + 4.0(RP2); RP2 = 5; A:19% = 6% + RP1 + 2.0(5); RP1 = 3%.

68.
Assuming no arbitrage opportunities exist, the risk premium on the factor F2 portfolio
should be ___________.
A)
3%
B)
4%
C)
5%
D)
6%
E)
none of the above
Refer to: Case 8-2
Answer:
Difficulty:
Response:

69.
A)
B)
C)
D)
E)

C
Difficult
See solution to previous problem.

A zero-investment portfolio with a positive expected return arises when _________.

an investor has downside risk only
the law of prices is not violated
the opportunity set is not tangent to the capital allocation line
a risk-free arbitrage opportunity exists
none of the above

Answer:
D
Difficulty:
Easy
Response:
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, a risk-free arbitrage opportunity
exists.

70.
An investor will take as large a position as possible when an equilibrium price
relationship is violated. This is an example of _________.
A)
a dominance argument
B)
the mean-variance efficiency frontier
C)
a risk-free arbitrage
D)
the capital asset pricing model
E)
none of the above
Answer:
C
Difficulty:
Moderate
Response:
When the equilibrium price is violated, the investor will buy the lower priced
asset and simultaneously place an order to sell the higher priced asset. Such transactions
result in risk-free arbitrage. The larger the positions, the greater the risk-free arbitrage profits.

71.
A)
B)
C)
D)
E)

The APT differs from the CAPM because the APT _________.
places more emphasis on market risk
minimizes the importance of diversification
recognizes multiple unsystematic risk factors
recognizes multiple systematic risk factors
none of the above

Answer:
D
Difficulty:
Moderate
Response:
The CAPM assumes that market returns represent systematic risk. The APT
recognizes that other macroeconomic factors may be systematic risk factors.

72.
The feature of the APT that offers the greatest potential advantage over the CAPM is
the ______________.
A)
use of several factors instead of a single market index to explain the risk-return
relationship
B)
identification of anticipated changes in production, inflation and term structure as key
factors in explaining the risk-return relationship
C)
superior measurement of the risk-free rate of return over historical time periods
D)
variability of coefficients of sensitivity to the APT factors for a given asset over time
E)
none of the above
Answer:
Difficulty:

A
Easy

Response:
The advantage of the APT is the use of multiple factors, rather than a single
market index, to explain the risk-return relationship. However, APT does not identify the
specific factors.

73.
A)
B)
C)
D)
E)

In terms of the risk/return relationship

only factor risk commands a risk premium in market equilibrium.
only systematic risk is related to expected returns.
only nonsystematic risk is related to expected returns.
a and b.
a and c.

Answer:
D
Difficulty:
Easy
Response:
Nonfactor risk may be diversified away; thus, only factor risk commands a risk
premium in market equilibrium. Nonsystematic risk across firms cancels out in welldiversified portfolios; thus, only systematic risk is related to expected returns.

74.
A)
B)
C)
D)
E)

The following factors might affect stock returns:

the business cycle.
interest rate fluctuations.
inflation rates.
all of the above.
none of the above.

Answer:
Difficulty:
Response:

D
Easy
a, b, and c all are likely to affect stock returns.

75.
Advantage(s) of the APT is(are)
A)
that the model provides specific guidance concerning the determination of the risk
premiums on the factor portfolios.
B)
that the model does not require a specific benchmark market portfolio.
C)
that risk need not be considered.
D)
a and b.
E)
b and c.
Answer:
B
Difficulty:
Easy
Response:
The APT provides no guidance concerning the determination of the risk
premiums on the factor portfolios. Risk must considered in both the CAPM and APT. A

major advantage of APT over the CAPM is that a specific benchmark market portfolio is not
required.

76.
Portfolio A has expected return of 10% and standard deviation of 19%. Portfolio B
has expected return of 12% and standard deviation of 17%. Rational investors will
A)
Borrow at the risk free rate and buy A.
B)
Sell A short and buy B.
C)
Sell B short and buy A.
D)
Borrow at the risk free rate and buy B.
E)
Lend at the risk free rate and buy B.
Answer:
Difficulty:
Response:

B
Easy
Rational investors will arbitrage by selling A and buying B.

77.
An important difference between CAPM and APT is
A)
CAPM depends on risk-return dominance; APT depends on a no arbitrage condition.
B)
CAPM assumes many small changes are required to bring the market back to
equilibrium; APT assumes a few large changes are required to bring the market back to
equilibrium.
C)
implications for prices derived from CAPM arguments are stronger than prices derived
from APT arguments.
D)
all of the above are true.
E)
both a and b are true.
Answer:
E
Difficulty:
Difficult
Response:
Under the risk-return dominance argument of CAPM, when an equilibrium
price is violated many investors will make small portfolio changes, depending on their risk
tolerance, until equilibrium is restored. Under the no-arbitrage argument of APT, each
investor will take as large a position as possible so only a few investors must act to restore
equilibrium. Implications derived from APT are much stronger than those derived from
CAPM, making c an incorrect statement.

78.
A professional who searches for mispriced securities in specific areas such as mergertarget stocks, rather than one who seeks strict (risk-free) arbitrage opportunities is engaged in
A)
pure arbitrage.
B)
risk arbitrage.
C)
option arbitrage.
D)
equilibrium arbitrage.

E)

none of the above.

Answer:
B
Difficulty:
Moderate
Response:
Risk arbitrage involves searching for mispricings based on speculative
information that may or may not materialize.

79.
In the context of the Arbitrage Pricing Theory, as a well-diversified portfolio becomes
larger its nonsystematic risk approaches
A)
one.
B)
infinity.
C)
zero.
D)
negative one.
E)
none of the above.
Answer:
C
Difficulty:
Easy
Response:
As the number of securities, n, increases, the nonsystematic risk of a welldiversified portfolio approaches zero.

80.
A well-diversified portfolio is defined as
A)
one that is diversified over a large enough number of securities that the nonsystematic
variance is essentially zero.
B)
one that contains securities from at least three different industry sectors.
C)
a portfolio whose factor beta equals 1.0.
D)
a portfolio that is equally weighted.
E)
all of the above.
Answer:
A
Difficulty:
Moderate
Response:
A well-diversified portfolio is one that contains a large number of securities,
each having a small (but not necessarily equal) weight, so that nonsystematic variance is
negligible.

81.
A)
B)
C)
D)
E)

The APT requires a benchmark portfolio

that is equal to the true market portfolio.
that contains all securities in proportion to their market values.
that need not be well-diversified.
that is well-diversified and lies on the SML.
that is unobservable.

Answer:
D
Difficulty:
Moderate
Response:
Any well-diversified portfolio lying on the SML can serve as the benchmark
portfolio for the APT. The true (and unobservable) market portfolio is only a requirement for
the CAPM.

82.
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 welldiversified portfolios.
(II) the expected return-beta relationship is maintained for all well-diversified portfolios.
(III) the expected return-beta relationship is maintained for all but a small number of
individual securities.
(IV) the expected return-beta relationship is maintained for all individual securities.
A)
I and III are correct.
B)
I and IV are correct.
C)
II and III are correct.
D)
II and IV are correct.
E)
Only I is correct.
Answer:
C
Difficulty:
Moderate
Response:
The expected return-beta relationship must hold for all well-diversified
portfolios and for all but a few individual securities; otherwise arbitrage opportunities will be
available.

83.
Consider a well-diversified portfolio, A, in a two-factor economy. The risk-free rate is
6%, the risk premium on the first factor portfolio is 4% and the risk premium on the second
factor portfolio is 3%. If portfolio A has a beta of 1.2 on the first factor and .8 on the second
factor, what is its expected return?
A)
7.0%
B)
8.0%
C)
9.2%
D)
13.0%
E)
13.2%
Answer:
Difficulty:
Response:

E
Moderate
.06 + 1.2 (.04) + .8 (.03) = .132

84.
A)
B)
C)
D)
E)

The term arbitrage refers to

buying low and selling high.
short selling high and buying low.
earning risk-free economic profits.
negotiating for favorable brokerage fees.
hedging your portfolio through the use of options.

Answer:
C
Difficulty:
Easy
Response:
Arbitrage is exploiting security mispricings by the simultaneous purchase and
sale to gain economic profits without taking any risk. A capital market in equilibrium rules
out arbitrage opportunities.

85.
(I)
(II)
(III)
(IV)
A)
B)
C)
D)
E)

To take advantage of an arbitrage opportunity, an investor would

construct a zero investment portfolio that will yield a sure profit.
construct a zero beta investment portfolio that will yield a sure profit.
make simultaneous trades in two markets without any net investment.
short sell the asset in the low-priced market and buy it in the high-priced market.
I and IV
I and III
II and III
I, III, and IV
II, III, and IV

Answer:
B
Difficulty:
Difficult
Response:
Only I and III are correct. II is incorrect because the beta of the portfolio does
not need to be zero. IV is incorrect because the opposite is true.

86.
A)
B)
C)
D)
E)

The factor F in the APT model represents

firm-specific risk.
the sensitivity of the firm to that factor.
a factor that affects all security returns.
the deviation from its expected value of a factor that affects all security returns.
a random amount of return attributable to firm events.

Answer:
Difficulty:
Response:
returns.

D
Moderate
F measures the unanticipated portion of a factor that is common to all security

87.
In the APT model, what is the nonsystematic standard deviation of an equallyweighted 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%
Answer:
D
Difficulty:
Moderate
1 2
1
Response:
2 (e p ) (ei ) 252 12.5, (e p ) 12.5 3.54%
n
50

88.
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.
Answer:
D
Difficulty:
Moderate
Response:
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.

89.
If arbitrage opportunities are to be ruled out, each well-diversified portfolio's expected
excess return must be
A)
inversely proportional to the risk-free rate.
B)
inversely proportional to its standard deviation.
C)
proportional to its weight in the market portfolio.
D)
proportional to its standard deviation.
E)
proportional to its beta coefficient.
Answer:
E
Difficulty:
Moderate
Response:
For each well-diversified portfolio (P and Q, for example), it must be true that
[E(rp)-rf]/p = [E(rQ)-rf]/Q.

90.
Suppose you are working with two factor portfolios, Portfolio 1 and Portfolio 2. The
portfolios have expected returns of 15% and 6%, respectively. Based on this information,
what would be the expected return on well-diversified portfolio A, if A has a beta of 0.80 on
the first factor and 0.50 on the second factor? The risk-free rate is 3%.
A)
15.2%
B)
14.1%
C)
13.3%
D)
10.7%
E)
8.4%
Answer:
Difficulty:
Response:

B
Moderate
E(RA) = 3 +0.8*(15-3) + 0.5*(6-3) = 14.1

91.
Which of the following is (are) true regarding the APT?
(I) The Security Market Line does not apply to the APT.
(II) More than one factor can be important in determining returns.
(III) Almost all individual securities satisfy the APT relationship.
(IV) It doesn't rely on the market portfolio that contains all assets.
A)
II, III, and IV
B)
II and IV
C)
II and III
D)
I, II, and IV
E)
I, II, III, and IV
Answer:
A
Difficulty:
Moderate
Response:
All except the first item are true. There is a Security Market Line associated
with the APT.

Short Answer Questions

92.
Discuss the advantages of the single-index model over the Markowitz model in
terms of numbers of variable estimates required and in terms of understanding risk
relationships.
Answer:

For a 50 security portfolio, the Markowitz model requires the following parameter estimates:
n = 50 estimates of expected returns;
n = 50 estimates of variances;
(n2 - n)/2 = 1,225 estimates of covariances;
1,325 estimates.
For a 50 security portfolio, the single-index model requires the following parameter
estimates:
n = 50 estimates of expected excess returns, E(R);
n = 50 estimates of sensitivity coefficients, i;
n = 50 estimates of the firm-specific variances, 2(ei);
1 estimate for the variance of the common macroeconomic factor,2M;or (3n + 1) estimates.
In addition, the single-index model provides further insight by recognizing that different firms
have different sensitivities to macroeconomic events. The model also summarizes the
distinction between macroeconomic and firm-specific risk factors.
Difficulty:
Moderate
Response:
This question is designed to ascertain that the student understands the
significant simplifications and improvements offered by the single-index model over the
Markowitz model.

93.

Discuss the security characteristic line (SCL).

Answer:
The security characteristic line (SCL) is the result of estimating the
regression equation of the single-index model. The SCL is plot of the typical excess returns
on a security over the risk-free rate as a function of the excess return on the market. The
slope of the SCL is the beta of the security, and the y-intercept, alpha, is the excess return on
the security when the excess market return is zero.
Difficulty:
Moderate
Response:
This question is designed to ascertain that the student understands how the
SCL is obtained, as this relationship is the one that is most frequently used by published
information services for the estimation of the regression parameters, alpha and beta.

94.
Discuss the "adjusted betas" published by Merrill Lynch in Security Risk
Evaluation.
Answer:
Over time, security betas move toward 1, as the average beta of all securities is 1 and
variables regress toward the mean. Thus, if a historic beta has been greater than 1, the
chances are that in the future, this beta will be less than the historic beta. The opposite

relationship will be observed if the historic beta has been less than one. Merrill Lynch uses
the following relationship to calculate "adjusted betas".
Adjusted beta = 2/3 (sample beta) + 1/3 (1).
Difficulty:
Easy
Response:
This question is important, as many published sources quote an "adjusted beta"
with no explanation as to how such a number was obtained. The regression toward the mean
is a valid statistical concept and it is important that the student understands that this concept
represents the theory behind the possibly undocumented "adjusted betas".

95.
Discuss the similarities and the differences between the CAPM and the single-factor
model.
Answer:
Both models relate security returns to risk. The CAPM measures risk relative to the
security's covariance with the market portfolio, which includes all existing financial assets.
The security's beta coefficient is the risk measure in this context. The model yields a value
for the expected return on the asset. The equation for the CAPM is E(Ri) = rf + i [E(RM)rf]. The CAPM is subject to misspecification because the true market portfolio is empirically
unobservable.
The single-factor model also uses one variable to relate security returns to risk. In this
case, however, the variable represents a factor that captures the influence of macroeconomic
events on securities' returns. The equation for the single-factor model is ri = i + iF + ei.
As with the CAPM, amount of return overstated or understated by the equation is
assumed to be due to firm-specific factors.
Difficulty:
Difficult
Response:
This question gives the student a chance to clarify his understanding of the
similarities and differences between two of the models presented. The question can be
expanded by including additional comparisons with the single-index model and the market
model.

96.
Name three variables that Chen, Roll, and Ross used to measure the impact of
macroeconomic factors on security returns. Briefly explain the reasoning behind their model.
Answer:
The factors they considered were IP (the % change in industrial production), EI
(the % change in expected inflation), UI (the % change in unanticipated inflation), CG (excess
return of long-term corporate bonds over long-term government bonds), and GB (excess
return of long-term government bonds over T-bills). The rational for their model is that many
different economic factors can combine to affect securities' returns. Also, by including
factors that are related to the business cycle, the estimation of beta coefficients should be
improved. Each beta will represent only the impact of the corresponding variable on returns.
Difficulty:
Difficult

Response:
The student has some flexibility in remembering which variables were used in
the study. A general understanding of macroeconomic variables will be helpful in answering
the question. 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.

97.
Discuss the advantages of arbitrage pricing theory (APT) over the capital asset pricing
model (CAPM) relative to diversified portfolios.
Answer:
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. Thus, the APT has more flexibility than the CAPM, as
problems associated with an unobservable market portfolio are not a concern with APT. In
addition, the APT provides further justification for the use of the index model for practical
implementation of the SML relationship. That is, if the index portfolio is not a precise proxy
for the true market portfolio, which is a cause of considerable concern in the context of the
CAPM, if an index portfolio is sufficiently diversified, the SML relationship holds, according
to APT.
Difficulty:
Moderate
Response:
This question is designed to determine if the student understands the basic
advantages of APT over the CAPM.

98.
Discuss the advantages of the multifactor APT over the single factor APT and the
CAPM. What is one shortcoming of the multifactor APT and how does this shortcoming
compare to CAPM implications?
Answer:
The single factor APT and the CAPM assume that there is only one systematic risk
factor affecting stock returns. However, obviously several factors may affect stock returns.
Some of these factors are: business cycles, interest rate fluctuations, inflation rates, oil prices,
etc. A multifactor model can accommodate these multiple sources of risk.
One shortcoming of the multifactor APT is that the model provides no guidance
concerning the risk premiums on the factor portfolios. 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.
Difficulty:
Moderate

99.

Discuss arbitrage opportunities in the context of violations of the law of one price.

Answer:
The law of one price is violated when an asset is trading at different prices in
two markets. If the price differential exceeds the transactions costs, a simultaneous trade in

the two markets can produce a sure profit with a zero investment. That is, the investor can
sell short the asset in the high-priced market and buy the asset in the low-priced market. 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). However, it should be remembered that
individual investors do not have access to the proceeds of a short transaction until the position
has been covered.
Difficulty:
Easy

100. Discuss the similarities and the differences between the CAPM and the APT with
regard to the following factors: capital market equilibrium, assumptions about risk aversion,
risk-return dominance, and the number of investors required to restore equilibrium.
Answer:
Both the CAPM and the APT are market equilibrium models, which examine the
factors that affect securities' prices. In equilibrium, there are no overpriced or underpriced
securities. In both models, mispriced securities can be identified and purchased or sold as
appropriate to earn excess profits.
The CAPM is based on the idea that there are large numbers of investors who are
focused on risk-return dominance. Under the CAPM, when a mispricing occurs, many
individual investors make small changes in their portfolios, guided by their degrees of risk
aversion. The aggregate effect of their actions brings the market back into equilibrium.
Under the APT, each investor wants an infinite arbitrage position in the mispriced asset.
Therefore, it would not take many investors to identify the arbitrage opportunity and act to
bring the market back to equilibrium.
Difficulty:
Difficult
Response:
The student can compare the two models by focusing on the specific items.

101. Security A has a beta of 1.0 and an expected return of 12%. Security B has a beta of
0.75 and an expected return of 11%. The risk-free rate is 6%. Explain the arbitrage
opportunity that exists; explain how an investor can take advantage of it. Give specific details
about how to form the portfolio, what to buy and what to sell.
Answer:
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 0.75 and a different expected return than
security B. The investor can accomplish this by choosing .75 as the weight in A and .25 in
the risk-free asset. This portfolio would have E(rp) = 0.75(12%) + 0.25(6%) = 10.5%, which
is less than B's 11% expected return. The investor should buy B and finance the purchase by
short selling A and borrowing at the risk-free asset.
Difficulty:
Moderate
Response:
This question is similar to Concept Check question 6 in text.