Chapter 10 – Arbitrage Pricing Theory and Multifactor Models of Risk and Return
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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
Difficulty: Easy
2. ___________ a relationship between expected return and risk.
A. APT stipulates
B. CAPM stipulates
Difficulty: Easy
Chapter 10 – Arbitrage Pricing Theory and Multifactor Models of Risk and Return
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3. In a multi-factor APT model, the coefficients on the macro factors are often called ______.
A. systemic risk
B. factor sensitivities
Difficulty: Easy
4. In a multi-factor APT model, the coefficients on the macro factors are often called ______.
A. systemic risk
B. firm-specific risk
Difficulty: Easy
5. In a multi-factor APT model, the coefficients on the macro factors on often called ______.
A. systemic risk
B. firm-specific risk
Difficulty: Easy
Chapter 10 – Arbitrage Pricing Theory and Multifactor Models of Risk and Return
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6. Which pricing model provides no guidance concerning the determination of the risk
premium on factor portfolios?
A. The CAPM
Difficulty: Moderate
7. An arbitrage opportunity exists if an investor can construct a __________ investment
portfolio that will yield a sure profit.
A. positive
B. negative
Difficulty: Easy
8. The APT was developed in 1976 by ____________.
A. Lintner
B. Modigliani and Miller
Difficulty: Easy
Chapter 10 – Arbitrage Pricing Theory and Multifactor Models of Risk and Return
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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.
E. A, B, and C
Difficulty: Easy
10. The exploitation of security mispricing in such a way that risk-free economic profits may
be earned is called ___________.
D. fundamental analysis
E. none of the above
Difficulty: Easy
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
Difficulty: Moderate
Chapter 10 – Arbitrage Pricing Theory and Multifactor Models of Risk and Return
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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
Difficulty: Moderate
13. 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
Difficulty: Moderate
Chapter 10 – Arbitrage Pricing Theory and Multifactor Models of Risk and Return
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14. 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
Difficulty: Moderate
15. 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%
Difficulty: Moderate
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16. 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 well-
diversified portfolio is approximately __________.
A. 0.80
Difficulty: Moderate
17. 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
Difficulty: Moderate
Chapter 10 – Arbitrage Pricing Theory and Multifactor Models of Risk and Return
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18. 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%
Difficulty: Difficult
19. 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%
Difficulty: Moderate
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20. 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%
Difficulty: Moderate
21. 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
Difficulty: Moderate
Chapter 10 – Arbitrage Pricing Theory and Multifactor Models of Risk and Return
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22. 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%
Difficulty: Moderate
23. 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
Difficulty: Moderate
Chapter 10 – Arbitrage Pricing Theory and Multifactor Models of Risk and Return
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24. 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
Difficulty: Moderate
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:
25. 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%
Difficulty: Easy
Chapter 10 – Arbitrage Pricing Theory and Multifactor Models of Risk and Return
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26. 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%
Difficulty: Easy
27. 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%
Difficulty: Easy
28. 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 and C
B. B, A and C
Difficulty: Difficult
Chapter 10 – Arbitrage Pricing Theory and Multifactor Models of Risk and Return
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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 well–
diversified portfolios:
29. Assuming no arbitrage opportunities exist, the risk premium on the factor F1 portfolio
should be __________.
D. 6%
E. none of the above
Difficulty: Difficult
30. Assuming no arbitrage opportunities exist, the risk premium on the factor F2 portfolio
should be ___________.
A. 3%
B. 4%
Difficulty: Difficult
Chapter 10 – Arbitrage Pricing Theory and Multifactor Models of Risk and Return
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31. A zero-investment portfolio with a positive expected return arises when _________.
A. an investor has downside risk only
B. the law of prices is not violated
Difficulty: Easy
32. 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
Difficulty: Moderate
33. The APT differs from the CAPM because the APT _________.
A. places more emphasis on market risk
B. minimizes the importance of diversification
Difficulty: Moderate
Chapter 10 – Arbitrage Pricing Theory and Multifactor Models of Risk and Return
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34. The feature of the APT that offers the greatest potential advantage over the CAPM is the
______________.
D. variability of coefficients of sensitivity to the APT factors for a given asset over time
E. none of the above
Difficulty: Easy
35. In terms of the risk/return relationship
A. only factor risk commands a risk premium in market equilibrium.
B. only systematic risk is related to expected returns.
Difficulty: Easy
36. The following factors might affect stock returns:
A. the business cycle.
Difficulty: Easy
Chapter 10 – Arbitrage Pricing Theory and Multifactor Models of Risk and Return
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37. 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.
Difficulty: Easy
38. 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.
Difficulty: Easy
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39. An important difference between CAPM and APT is
A. CAPM depends on risk-return dominance; APT depends on a no arbitrage condition.
Difficulty: Difficult
40. A professional who searches for mispriced securities in specific areas such as merger-
target stocks, rather than one who seeks strict (risk-free) arbitrage opportunities is engaged in
A. pure arbitrage.
Difficulty: Moderate
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41. In the context of the Arbitrage Pricing Theory, as a well-diversified portfolio becomes
larger its nonsystematic risk approaches
A. one.
B. infinity.
Difficulty: Easy
42. A well-diversified portfolio is defined as
D. a portfolio that is equally weighted.
E. all of the above.
Difficulty: Moderate
43. The APT requires a benchmark portfolio
A. that is equal to the true market portfolio.
B. that contains all securities in proportion to their market values.
Difficulty: Moderate