Foundations of Financial Markets and Institutions, 4e (Fabozzi/Modigliani/Jones)

Chapter 12 Risk/Return and Asset Pricing Models

Multiple Choice Questions

1 Portfolio Theory

1) In designing a portfolio, investors seek to maximize the expected return from their investment,
given some level of risk they are willing to accept. Portfolios that satisfy this requirement are
A) magnificent (or maximal)
B) sufficient (or minimal)
C) efficient (or optimal)
D) inefficient (or suboptimal)
Answer: C

2) Which of the below is the equation for the return on a portfolio where V0 = the portfolio
market value at the beginning of the interval, V1 = the portfolio market value at the end of the
interval, and D1 = the cash distributions to the investor during the interval?
V  V0  D1
A) Rp = 1
V0
V  V0  D1
B) Rp = 1
V0
V  V0  D1
C) Rp = 1
V0
D) Rp = (V1 -V0 + D1) × V0
Answer: A

3) What is the return on a portfolio if the portfolio market value at the beginning of the interval is
$1,250, the portfolio market value at the end of the interval is $1,385, and the cash distributions
to the investor during the interval is $55.52?
A) 15.12%
B) 15.24%
C) 15.36%
D) 15.48%
Answer: B
V  V0  D1
Comment: Inserting into our equation the given values, we have: Rp = Rp = 1 = Rp
V0
$1,385  $1,250  $55.52
= $1,250
= 0.152416 or about 15.24%.
4) What is the return on a portfolio on a portfolio if the portfolio market value at the beginning of
the interval is $1,350, the portfolio market value at the end of the interval is $1,185, and the cash
distributions to the investor during the interval is $115.52?
kA) 12.85%
B) 5.24%
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C) -1.78%
D) -3.67%
Answer: D
V1  V0  D1
Comment: Inserting into our equation the given values, we have: Rp = Rp = = Rp
V0
$1,185  $1,350  $115 .52
= $1,350
= -0.036652 or about -3.67%.
5) A problem with a portfolio return computation is: ________.
A) the underlying assumption is that all cash payments and inflows are made and received at the
beginning of the period
B) we have to rely on the formula that is able to adjust portfolio returns with the same time
horizon.
C) if two investments have the same return, but one investment makes a cash payment early and
the other late, the one with early payment will be overstated
D) we cannot rely on the formula to compare return on a one-month investment with that on a
10-year return portfolio.
Answer: D
Comment: In principle, a portfolio calculation of returns could be carried out for any interval of
time, say, for one month or 10 years. Yet, there are several problems with this approach. First, it
is apparent that a calculation made over a long period of time, say, more than a few months,
would not be very reliable because of the underlying assumption that all cash payments and
inflows are made and received at the end of the period. Clearly, if two investments have the
same return as calculated from the formula above, but one investment makes a cash payment
early and the other late, the one with early payment will be understated. Second, we cannot
rely on the formula to compare return on a one-month investment with that on a 10-year return
portfolio. For purposes of comparison, the return must be expressed per unit of time–say, per
year. In practice, we handle these two problems by first computing the return over a reasonably
short unit of time, perhaps a quarter of a year or less. The return over the relevant horizon,
consisting of several unit periods, is computed by averaging the return over the unit intervals.

6) Which of the below statements is TRUE?

A) A particularly useful way to quantify the uncertainty about the portfolio return is to specify
the probability associated with each of the possible future returns.
B) The expected return is simply the mean or average of possible outcomes without regard to
each outcome's probability or weight.
C) One measure of risk is the extent to which possible future portfolio values are likely to
diverge from the last value.
D) If risk is defined as the chance of achieving returns lower than expected, it would seem
logical to measure risk by the dispersion of the possible returns above the expected value.
Answer: A
Comment: One measure of risk is the extent to which possible future portfolio values are likely
to diverge from the expected or predicted value.
The expected return is simply the weighted average of possible outcomes.
If risk is defined as the chance of achieving returns lower than expected, it would seem logical to
measure risk by the dispersion of the possible returns below the expected value.

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7) Empirically, a comparison of the distribution of historical returns for a large portfolio of
randomly selected stocks (say, 50 stocks) with the distribution of historical returns for an
individual stock in the portfolio has indicated a curious relationship in that it can be common to
find ________.
A) that the standard deviation of return for the individual stocks in the portfolio is considerably
smaller than that of the portfolio.
B) that the average return of an individual stock is less than the portfolio return.
C) that the return for all individual stocks in the portfolio is each considerably larger than that of
the portfolio itself.
D) that the standard deviation of return for the portfolio is always zero.
Answer: B
Comment: Empirically, a comparison of the distribution of historical returns for a large portfolio
of randomly selected stocks (say, 50 stocks) with the distribution of historical returns for an
individual stock in the portfolio has indicated a curious relationship in that it can be common to
find that (1) the standard deviation of return for the individual stocks in the portfolio is
considerably larger than that of the portfolio, and (2) the average return of an individual stock is
less than the portfolio return.

8) ________ will not systematically affect the portfolio return, but it will reduce the variability
(standard deviation) of return with this variability reduced when there is ________ among
security returns.
A) Diversification; more variance
B) Differentiation; less correlation
C) Diversification; less correlation
D) Diversification; less variance
Answer: C

9) We can distinguish between a security's ________, which can be washed away by mixing the
security with other securities in a diversified portfolio, and its ________, which cannot be
eliminated by diversification.
A) systematic risk; unsystematic risk
B) portfolio risk; systematic risk
C) unsystematic risk; T-Bill risk
D) unsystematic risk; systematic risk
Answer: D

10) A security's return in equal to its systematic return plus its unsystematic return where
________.
A) the security return, R, may be expressed as R = βRm + ε'.
B) the systematic return is proportional to the market return and it can be expressed as the
symbol beta (or β) times the market return, Rm.
C) unsystematic return, which is independent of market returns, is usually represented by the
symbol epsilon (ε').
D) All of these
Answer: D
Comment: Since the systematic return is proportional to the market return, it can be expressed as

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the symbol beta (or β) times the market return, Rm. The proportionality factor of beta is a market
sensitivity index, indicating how sensitive the security return is to changes in the market level.
The unsystematic return, which is independent of market returns, is usually represented by the
symbol epsilon (ε’). Thus, the security return, R, may be expressed as R = βRm + ε’. For
example, if a security has a β factor of 2.0, then a 10% market return will generate a 20%
systematic return for the stock. The security return for the period would be the 20% plus the
unsystematic component.

11) Which of the below statements is FALSE?

A) The systematic risk of a portfolio is simply the market value-weighted average of the
systematic risk of the individual securities.
B) The beta (β) for a portfolio consisting of all stocks is 1.00.
C) The beta of a security or portfolio can be estimated using statistical analysis.
D) There will be no difference in the calculated beta depending on the length of time over which
a return is calculated and the number of observations used
Answer: D
Comment: There will be a difference in the calculated beta depending on the length of time
over which a return is calculated and the number of observations used.

2 The Capital Asset Pricing Model

1) The two major standards of risk are: ________.

A) total risk and the relative index of systematic or nondiversifiable risk.
B) standard deviation and unsystematic risk.
C) total risk and the standard deviation.
D) beta and the relative index of systematic or nondiversifiable risk (beta).
Answer: A
Comment: The two major standards of risk are: (i) one is a measure of total risk (standard
deviation) and (ii) the other a relative index of systematic or nondiversifiable risk (beta).

2) Returns expected by investors logically should be related to ________ as opposed to total risk
A) unsystematic
B) systematic risk
C) diversifiable
D) the standard deviation
Answer: B

3) Consider an investor who holds a risky portfolio that has the same risk as the market portfolio.
If the beta is one then the investor should expect to earn ________. Consider another investor
who holds a riskless portfolio such as Treasury bills. If the beta is zero then the investor should
earn ________.
A) the riskless rate of return; the market portfolio rate of return.
B) the risky return; the riskless rate of return.
C) the market portfolio rate of return; the riskless rate of return.
D) the market portfolio rate of return; the corporate bond rate of return.
Answer: C

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4) Consider an investor who owns three assets: asset 1, asset 2, and asset 3 and invests equally in
each of the three assets. If the beta of asset 1 is 1.2, the beta of asset 2 is 1.5 and the Beta of asset
3 is zero, then what is the beta of the investor's portfolio.
A) 0.75
B) 0.90
C) 1.10
D) 1.25
Answer: B
Comment: The beta of a portfolio is a simple weighted average of the individual betas where the
weights add up to one. Thus, we have:
1  1  1 
βp = X1β1 + X2β2 + X3β3 =   1.2     1.5     0  = 0.4 + 0.5 + 0 = 0.9.
3  3  3 
NOTE. Since the weights are all equal, it is easier to add up the betas and divide by three:
   2   3 1.2  1.5  0 2.7
βp = 1   = 0.9.
3 3 3
5) Consider an investor who owns two assets: the risky market portfolio where the investor puts
two-thirds of her money and a riskless asset where the investor puts one-third of her money.
What is the beta of her portfolio?
A) zero
B) 0.33
C) 0.50
D) 0.67
Answer: D
Comment: The beta of a portfolio is a simple weighted average of the individual betas where the
weights add up to one. Thus, we have: βp = X1β1 + X2β2 where 1 refers to the riskless assets
(which has a beta of zero) and 2 refers to the risky asset (which has a beta of one). Inserting in
our given values, we have:
2  1 
βp = X1β1 + X2β2 =   1.0     0  = 0.6667 + 0 = 0.6667 or about 0.67.
3  3 

6) The riskless rate is 5.00% and the return on the market is 10.00%. If you form a portfolio with
a beta of 0.8, what should be your rate of return according to the CAPM?
A) 8.00%
B) 8.50%
C) 9.00%
D) 9.50%
Answer: C
Comment: The CAPM asserts: Rp = Rf + [βp × (Rm - Rf)] = 5.00% + [0.8 × (10.00% - 5.00%)]
= 5.00% + [0.8×(5.00%)] = 5.00% + 4.00% = 9.00%.

7) The Treasury bill rate is 4.50% and the return on the market is estimated to be 9.50%. If you
form a portfolio with a beta of 1.2, what should be your rate of return according to the CAPM?
A) 9.00%
B) 9.50%

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C) 9.75%
D) 10.50%
Answer: D
Comment: The CAPM asserts: Rp = Rf + [βp × (Rm - Rf)] = 4.50% + [1.2 × (9.50% - 4.50%)] =
4.50% + [1.2 × (5.00%)] = 4.50% + 6.00% = 10.50%.

8) Which of the below statements is FALSE?

A) The major difficulty in testing the CAPM is that the model is stated in terms of investors'
expectations and not in terms of realized returns.
B) The expected risk premium should be equal to the quantity of risk (as measured by beta) and
the market price of risk (as measured by the expected market risk premium).
C) Empirical tests find a significant positive relationship between realized returns and systematic
risk as measured by beta but the estimate of the average market risk premium is usually less than
that predicted by the CAPM.
D) Empirical tests find evidence of significant curvature in the risk/return relationship.
Answer: D
Comment: Empirical tests find that the relationship between risk and return appears to be linear.
The studies give no evidence of significant curvature in the risk/return relationship.

True/False Questions

1 Portfolio Theory

1) Risk aversion means that investors want to minimize risk for any given level of expected
return, or want to maximize return, for any given level of risk.
Answer: TRUE

2) The index of the sensitivity of a security's returns to movement in the market is the security's
standard deviation, which can be estimated with regression techniques from historical data.
Answer: FALSE

3) The market model is the hypothesis that a security's return may be attributed to two forces, the
returns on securities in general, and events related to the market itself.
Answer: FALSE
Comment: The market model is the hypothesis that a security’s return may be attributed to two
forces, the returns on securities in general or the market, and events related to the firm itself.

4) The relevant risk of any individual security is not total variability in returns but rather
systematic variability, which is that portion of total variability that cannot be eliminated by
combining it with other securities in a diversified portfolio.
Answer: TRUE

2 The Capital Asset Pricing Model

1) The capital asset pricing model (or CAPM) hypothesizes that assets with the same level of
systematic risk should experience the same level of returns.

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Answer: TRUE

2) The level of returns expected from any asset (which may be an individual security or a
portfolio of securities) is an exponential function of the risk-free rate, the asset's beta, and the
returns expected on the market portfolio of risky assets.
Answer: FALSE
Comment: The level of returns expected from any asset (which may be an individual security or
a portfolio of securities) is a linear function of the risk-free rate, the asset’s beta, and the returns
expected on the market portfolio of risky assets.

3) Some reservations about the CAPM are inevitable because it makes many assumptions about
investors' behavior and the structure of the market where assets are traded.
Answer: TRUE

4) A major strength of the CAPM is that it is basically testable because the true market portfolio
is an attainable portfolio diversified across all risky assets in the world.
Answer: FALSE
Comment: A major criticism of the CAPM is that it is basically untestable because the true or
relevant market portfolio is an unobservable or unattainable portfolio diversified across all risky
assets in the world.

3 The Multifactor CAPM

1) The multifactor CAPM says that investors want to be compensated only for market risk.
Answer: FALSE
Comment: The multifactor CAPM says that investors want to be compensated for the risk
associated with each source of extra-market risk, in addition to market risk.

2) The multifactor CAPM posits that extra-market factors influence expected returns on
securities or portfolios.
Answer: TRUE

4 Arbitrage Pricing Theory Model

1) The arbitrage pricing theory (or APT) model postulates that a security's return is a function of
several factors and the security's sensitivity to changes in each of them.
Answer: TRUE

3) An repelling feature of the APT model is that it makes few assumptions about investors and
the structure of the market.
Answer: FALSE
Comment: An appealing feature of the APT model is that it makes few assumptions about
investors and the structure of the market.
Essay Questions

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1 Portfolio Theory

1) Explain how diversification can help investors realize their investment goal of maximizing
return while minimizing risk. In your answer give an estimate of how many stocks are needed to
achieve your investment goal.
Answer: Diversification is valuable because much of the total risk (which equals standard
deviation of return) is diversifiable. That is, if an investment in an individual stock is combined
with other securities, a portion of the variation in its returns can be smoothed or canceled by
complementary variation in the other securities. In fact, the portfolio standard deviation is lower
than that of the typical security in the portfolio. Diversification results from combining securities
whose returns are less than perfectly correlated in order to reduce portfolio risk. The portfolio
return is simply a weighted average of the individual security returns, no matter the number of
securities in the portfolio. Therefore, diversification will not systematically affect the portfolio
return, but it will reduce the variability (standard deviation) of return. In general, the less the
correlation among security returns, the greater the impact of diversification on reducing
variability. This is true no matter how risky the securities of the portfolio are when considered in
isolation. On the average, Wagner and Lau find that approximately 40% of the risk of an
individual common stock is eliminated by forming randomly selected portfolios of 20 stocks.
They also find (1) additional diversification yields rapidly diminishing reduction in risk, with the
improvement only slight when the number of securities held is increased beyond, say, 10, and (2)
a rapid decline in total portfolio risk as the portfolios were expanded from one to 10 securities.

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