Investments Principles and Concepts International 12th Edition Jones Test Bank

Investments Principles and Concepts
International 12th Edition Jones Test

Bank
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File: Ch.09, Chapter 9: Asset Pricing Models
Multiple Choice Questions
1. The Capital Asset Pricing Model:
a. has serious flaws because of its complexity.

b. measures relevant risk of a security and shows the relationship between risk and
expected return.
c. was developed by Markowitz in the 1930s.
d. discounts almost all of the Markowitz portfolio theory.
Ans: b
Difficulty: Moderate
Ref: Capital Market Theory
2. Which of the following is not one of the assumptions of the CMT?
a. All investors have the same one-period time horizon.

b. There are no personal income taxes.
c. There is no interest rate charged on borrowing.
d. There are no transaction costs.
Ans: c
3. Which of the following is an assumption of the CMT?
a. Single investors can affect the market by their buying and selling decisions.
b. There is no inflation.
c. Investors prefer capital gains over dividends.
d. Different investors have different probability distributions..
Ans: b
4. Which of the following regarding investors and the CMT is true?
a. Investors recognize that all the assumptions of the CMT are unrealistic.
b. Investors recognize that all of the CMT assumptions are not unrealistic.
c. Investors are not aware of the assumptions of the CMT model.
d. Investors recognize the CMT is useless for individual investors.
Ans: b
Chapter Nine 105

Asset Pricing Models
5. Which of the following is generally used as a proxy for the risk-free rate of
return?
a. savings account
b. certificate of deposit
c. Treasury bill
d. Treasury bond
Ans: c
Difficulty: Easy
6. What does it mean when the CAPM is called "robust?"
a. The CAPM requires no assumptions.

b. Even if most of the assumptions of the CAPM are relaxed, most of the
conclusions will still hold.
c. The CAPM is based on realistic assumptions.
d. No other model can represent stock returns better than the CAPM.
Ans: b
Difficulty: Difficult
7. When markets are in equilibrium, the CML will be upward sloping
a. because it shows the optimum combination of risky securities.

b. because the price of risk must always be positive.
c. because it contains all securities weighted by their market values.
d. because the CML indicates the required return for each portfolio risk level.
Ans: b
Ref: The Equilibrium Return-Risk Tradeoff
8. __________, the CML can be downward sloping.
a. Ex post
b. When investors are risk-lovers
c. When the SML is upward sloping
d. When the risk premium for the market is very high
Ans: a
Chapter Nine 106

9. Which of the following statements about the difference between the SML and the
CML is TRUE?
a. The intercept of the CML is the origin while the intercept of the SML is RF.
b. CML consists of efficient portfolios, while the SML is concerned with all
portfolios or securities.
c. CML could be downward sloping while that is impossible for the SML.
d. CML and the SML are essentially the same except in terms of the
securities represented.
Ans: b
10. The separation theorem states that:
a. systematic risk is separate from unsystematic risk.

b. individual security risk is separate from portfolio risk.
c. the investment decision is separate from the financing decision.
d. borrowing portfolio is separate from the lending portfolio.
Ans: c
11 The SML can be used to analyze the relationship between risk and required return
for
a. all assets.
b. inefficient portfolios.
c. only efficient portfolios.
d. only individual securities.
Ans: a
Difficulty: Easy
12. Which of the following is the correct calculation for the required rate of return
under the CAPM?
a. beta (market risk premium)

b. beta + market risk premium
c. risk-free rate + risk premium
d. risk-free rate(market risk premium)
Ans: c
Chapter Nine 107

13. Under the CMT, the relevant risk to consider with any security is:
a. its correlation with other securities in the portfolio.

b. its covariance with the market portfolio.
c. its deviation from the portfolio required rate of return.
d. its variance from the risk-free rate of return.
Ans: b
14. Select the correct statement regarding the market portfolio. It:
a. is readily and precisely observable.

b. is a risky portfolio.
c. is the lowest point of tangency between the risk-free rate and the efficient
frontier.
d. should be composed of stocks or bonds.
Ans: b
15. Under the separation theorem, all investors should:
a. hold the same portfolio of risky assets and therefore have the same
risk/return combination.
b. have different optimal portfolios.
c. have the same portfolio of risky assets and achieve their own risk-return
combination through borrowing and lending.
d. hold the same portfolio of risky assets and the same expected return but at
different levels of risk
Ans: d
16. The slope of the CML is the:
a. standard deviation for efficient portfolios.

b. market price of risk for efficient portfolios.
c. risk-free rate.
d. risk premium for the market portfolio.
Ans: b
17. Securities with betas greater than l should have:
Chapter Nine 108

a. expected returns higher than the market.
b. required returns higher than the market return.
c. required returns lower than the market return.
d. no systematic risk.
Ans: b
Difficulty: Easy
18. The _________ is a plot of __________.
a. CML . . . individual stocks and efficient portfolios

b. CML . . . both efficient and inefficient portfolios, only
c. SML . . . individual securities and efficient portfolios
d. SML . . . individual securities, inefficient portfolios, and efficient portfolios.
Ans: c
19. Select the INCORRECT statement regarding the CML.
a. The CML is an equilibrium relationship for efficient portfolios and individual

securities.
b. The CML represents the risk-return tradeoff in equilibrium for efficient portfolios.
c. The intercept of the CML is the reward per unit of time available to investors for
deferring consumption.
d. Standard deviation is the measure of risk which determines a portfolio's
equilibrium return.
Ans: a
20. The expected return on the market for next period is 11 percent. The risk free rate
of return is 4 percent, and Alpha Company has a beta of 1.1. The market risk
premium is
a. 7.7 percent.
b. 7 percent.
c. 11 percent.
d. 12.1 percent.
Solution: Market risk premium = 11 – 4

= 7 percent
Ans: b
Difficulty: Easy
Chapter Nine 109

21. The expected market return is 16 percent. The risk-free rate of return is 7 percent,
and BC Co. has a beta of 1.1. Their required rate of return is
a. 17.6 percent.
b. 16.0 percent.
c. 16.9 percent.
d. 23.0 percent.
Solution: required return = 7 + 1.1(16 – 7)

= 16.9 percent
Ans: c
22. The expected market return is 9 percent. The risk-free rate of return is 1 percent,
and XYZ Co. has a beta of 1.4. The risk premium is
a. 8 percent.
b. 11.2 percent.
c. 12.2 percent.
d. 10.3 percent
Solution: risk premium = 1.4(9 – 1)

= 11.2 percent
Ans: b
23. If markets are truly efficient and in equilibrium
a. all securities would lie on the SML.

b. any security that plots below the SML would be considered undervalued.
c. any security that lies above the SML would be considered overvalued.
d. no security would lie on the SML..
Ans: a
24. If a certain stock has a beta greater than 1.0, it means that
a. the stock's return is more volatile than that of the market portfolio.
b. an investor can eliminate the risk by combining it with another stock that has a
negative beta.
c. an investor will earn a higher return on his stock than that on the market portfolio.
d. the stock is less risky than the market portfolio.
Ans: a
Difficulty: Easy
Chapter Nine 110

25. A less restrictive form of the Single Index Model is the:
a. Risk-free Model.
b. CAPM.
c. CML.
d. Market Model.
Ans: d
Difficulty: Easy
Ref: Estimating the SML
26. Under the Market Model, the regression line that results when the return of a
security is plotted against the market index return is the:
a. SML.
b. CML.
c. characteristic line.
d. slope.
Ans: c
Difficulty: Easy
27. Which of the following is not one of the reasonable conclusions of the CAPM
reached by a consensus of the empirical results?
a. The intercept term is generally higher than the RF.

b. The SML appears to be non-linear.
c. The slope of the CAPM is generally less steep than suggested by the theory.
d. CAPM is an imperfect model for the explanation of the cross section of security
returns.
Ans: b
Ref: Tests of the CAPM
28. The arbitrage pricing theory (APT) and the CAPM both assume all except the
following?
a. Investors have homogeneous beliefs.

b. Investors are risk-averse utility maximizers.
c. Borrowing and lending can be done at the rate RF.
d. Markets are perfect.
Ans: c
Ref: Abritrage Pricing Theory
Chapter Nine 111

29. Risk factors in the APT must possess all of the following the characteristics
except:
a. Factors must be readily observable in risk/return space.

b. Each factor must have a pervasive influence on stock returns
c. The factors must influence expected return.
d. Factors must be unpredictable.
Ans: a
30. Which of the following might be used as a factor in an APT factor model?
a. The risk-free rate

b. Expected inflation
c. Unanticipated deviations from expected inflation
d. Loss by fire at a company’s manufacturing plant
Ans: c
31. The arbitrage pricing theory (APT)
a. considers only one factor and is a narrower model than the CAPM.
b. considers more factors than the CAPM and is a broader model.
c. is useful only for well-diversified portfolios of common stock.
d. is Easy to practice because the factors are readily observable.
Ans: b
32. The APT is based on the:
a. law of averages.
b. law of attraction.
c. law of accelerating return.
d. law of one price.
Ans: d
Difficulty: Easy
Chapter Nine 112

33. Positive theory refers to a theory that
a. explains how economic participants should act

b. describes how economic participants act
c. is optimistic
d. has been shown to have high explanatory power as a result of empirical testing
Ans: b
Difficulty: Easy
True/False Questions
1. The most volatile stocks have beta’s near zero.
Ans: F
Difficulty: Easy
2. Using the separation theorem, it is necessary to match each investor's indifference

curves with a particular efficient portfolio.
Ans: F
3. The CML indicates the required return for each portfolio risk level.
Ans: T
4. A security that plots above the SML would be a good security to sell short.
Ans: F
5. Beta is a measure of systematic risk and relates one security's return to another
security's return.
Ans: F
Difficulty: Easy
6. The CML states that all investors should invest in the same portfolio of risky
assets.
Chapter Nine 113

Ans: T
7. Most professional investors use the S&P 500 as a general gauge of total market
performance.
Ans: T
Difficulty: Easy
8. Testing of the CAPM suggests the trade-off between expected return and risk is
an upward-sloping straight line.
Ans: T
9. In a declining market, a portfolio manager should attempt to increase the overall

beta of the portfolio.
Ans: F
Ref: Tests of the CAPM
10. Unlike the CAPM, the APT does not assume borrowing and lending at the risk-
free rate.
Ans: T
Ref: Arbitrage Pricing Theory
11. With the APT, risk is defined in terms of a stock's sensitivity to basic economic
factors.
Ans: T
12. Like the CAPM, the APT assumes a single-period investment horizon.
Ans: F
13. None of the asset-pricing models assume that the market is perfect.
Ans: F
Chapter Nine 114

14. The APT is based on the law of one price, which states two identical assets
cannot sell at different prices.
Ans: T
Difficulty: Easy
15. With the introduction of risk-free borrowing and lending changes the nature of the
original Markowitz efficient frontier by turning the efficient frontier into a
straight line.
Ans: T
Ref: Check Your Understanding
16. The characteristic line is the regression fitting total returns for a stock against total
returns for the market, and is sometimes calculated using excess returns.
Ans: T
17. Like CAPM, APT does not assume a single period investment horizon, no taxes,
borrowing and lending at the RF rate, and investors selecting portfolios based on
expected return and variance.
Ans: F
Short-Answer Questions
1. How are securities chosen and in what proportions are they represented in the
market portfolio M?
Answer: All assets are included in portfolio M in proportion to their market value.
In practice, the S&P 500 is often used as a proxy for the market
portfolio.
2. What is the formula for the slope of the CML? What does it represent?
Chapter Nine 115

Answer: The slope is [E(RM) – RF]/M. It represents the expected return- risk
tradeoff for efficient portfolios on the CML.
3. An analyst determined that for the past two quarters the risk-free rate has
exceeded the return on the market portfolio. Does this information disprove the
CML?
Answer: No, it merely shows that actual returns often diverge from expected
returns. The CML is founded on expected values, so that proof or
disproof does not lie in historical values.
4. Some securities are considered to be “defensive” in that they tend to hold their
value or increase in value when the majority of securities are losing value, such as
during a recession. What could one conclude about the betas of defensive
securities?
Answer: One would expect the betas of defensive securities to be near zero or even
negative.
5. At a given point in time the SML dictates that a security with a beta of 1.10
should require a return of 18 percent. Analysts determine that a particular stock
with an observed beta of 1.10 has an expected return of 20 percent. Outline the
scenario that will bring the security’s return into equilibrium.
Answer: Investors will recognize the security as a good buy (undervalued) and
will start buying it, increasing demand. The price will be bid up until the
return drops to 18 percent as required by the SML.
6. Two points define a straight line. What two points could be most readily
identified to estimate the SML?
Answer: The risk-free rate because the beta is defined as zero and the
expected market return because the beta is defined as 1.00.
7. Betas of individual securities are unstable over time. What are some
characteristics that could cause a company’s beta to change over time?
Answer: A few examples include earnings, cash flow, management, financial

leverage, and product mix.
Chapter Nine 116

8. What are the assumptions in the CAPM? Can these be relaxed without destroying
the conclusions of the model?
Answer: (1) homogeneous expectations, (2) one-period time horizon, (3)

borrow-lend at RF, (4) no transactions costs, (5) no personal
income taxes, (6) no inflation, (7) investor-price takers, and (8)
capital markets in equilibrium. Assumptions can be relaxed and
still reach most of the same general conclusions.
9. Suppose the SML has a risk-free rate of 5 percent and an expected market return
of 15 percent. Now suppose that the SML shifts, changing slope, so that kRF is
still 5 percent but kM is now 16 percent. What does this shift suggest about
investors’ risk aversion? If the slope were to change downward, what would that
suggest?
Answer: Suggest that investors are more averse to risk than before the shift. They
now require a risk premium of 11 percent (16 percent- 5 percent),
whereas, they previously required 10 percent (15 percent - 5 percent) on
the market portfolio. A downward shift would indicate less aversion
to risk.
10. Why is market risk sometimes said to be the “relevant” risk for a portfolio
manager? What is the measure of market risk?
Answer: Market risk, measured by beta, is nondiversifiable and must be dealt with
by the portfolio manager. Diversifiable risk should be diversified away
and should not pose a problem. Market risk, therefore, is considered to be
relevant to the portfolio manager’s job of balancing risk and return.
Critical Thinking/Essay Questions
1. Compare the capital market line and the security market line.
Answer:
CML SML
efficient portfolios consisting of RF and M securities and
portfolios.
CML and SML both indicate an upward sloping expected return-risk
tradeoff.
2. Compare the security market line model and the arbitrage pricing theory.
Answer: SML is a one-factor model, the factor being the market risk premium. The
APT has more factors (often three to five), such as unanticipated changes
Chapter Nine 117

in inflation, industrial production, etc. Unlike the CAPM, the APT does
not assume a single-period investment horizon, any taxes, borrowing and
lending at rate the RF, investor selection on basis of expected return and
variance. Both CAPM and APT assume homogeneous beliefs, risk-averse
utility maximizers, perfect markets, and returns generated by a factor
model.
3. If the risk free lending rate is lower than the borrowing rate, what would the shape
of the CML and efficient frontier look like?
Answer: The CML would go from the risk-free rate on the Y intercept to the point
tangent to the highest attainable point on the efficient frontier, and along a
line from the borrowing rate on the Y axis tangent to the highest attainable
point on the efficient frontier, but starting at that point of tangency and
running to the right. That portion of the efficient frontier that lies between
the two line segments would also be part of the new efficient frontier. The
resulting CML would consist of two line segments plus a curve between.
Problems
1. The expected return for the market is 12 percent, with a standard deviation of 20
percent. The expected risk-free rate is 8 percent. Information is available for
three mutual funds, all assumed to be efficient, as follows:
Mutual Funds SD(%)

Affiliated 15
Omega 17
Ivy 19
(a) Based on the CML, calculate the market price of risk.

(b) Calculate the expected return on each of these portfolios.
Solution:
(a) Slope of CML = (12 - 8)/20 = .20
(b) Affiliated 8 + .2(15) = 11 percent

Omega 8 + .2(17) = 11.4 percent
Ivy 8 + .2(19) = 11.8 percent
2. Given an expected return for the market of 12 percent, with a standard deviation
of 20 percent, and a risk-free rate of 8 percent, consider the following data:
Stock Beta Ri(%)
Chapter Nine 118

1 0.8 12
2 1.2 13
3 0.6 11
(a) Calculate the required return for each stock using the SML.
(b) Assume that an analyst, using fundamental analysis, develops the
estimates labeled Ri for these stocks. Which stock would be
recommended for purchase?
Solution:
(a) Stock 1 8 + 0.8(4) = 11.2 percent

Stock 2 8 + 1.2(4) = 12.8 percent
Stock 3 8 + 0.6(4) = 10.4 percent
(b) Stock 3 is undervalued because E(R) > RR.

3. The market has an expected return of 13 percent and the risk-free rate is 5.5
percent. If Merrill Lynch has a beta of 1.85, what is the required return for Merrill
Lynch?
Solution: .055 + 1.85 (.13-.055) = .055 + .1388 = .1938 = 19.38%

Chapter Nine 119


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Investments Principles and Concepts

International 12th Edition Jones Test

Multiple Choice Questions

1. The Capital Asset Pricing Model:

a. has serious flaws because of its complexity.

2. Which of the following is not one of the assumptions of the CMT?

a. All investors have the same one-period time horizon.

3. Which of the following is an assumption of the CMT?

4. Which of the following regarding investors and the CMT is true?

Chapter Nine 105

6. What does it mean when the CAPM is called "robust?"

a. The CAPM requires no assumptions.

7. When markets are in equilibrium, the CML will be upward sloping

a. because it shows the optimum combination of risky securities.

8. __________, the CML can be downward sloping.

Chapter Nine 106

10. The separation theorem states that:

a. systematic risk is separate from unsystematic risk.

a. beta (market risk premium)

Chapter Nine 107

a. its correlation with other securities in the portfolio.

a. is readily and precisely observable.

15. Under the separation theorem, all investors should:

16. The slope of the CML is the:

a. standard deviation for efficient portfolios.

17. Securities with betas greater than l should have:

Chapter Nine 108

18. The _________ is a plot of __________.

a. CML . . . individual stocks and efficient portfolios

19. Select the INCORRECT statement regarding the CML.

a. The CML is an equilibrium relationship for efficient portfolios and individual

Solution: Market risk premium = 11 – 4

Chapter Nine 109

Solution: required return = 7 + 1.1(16 – 7)

Solution: risk premium = 1.4(9 – 1)

23. If markets are truly efficient and in equilibrium

a. all securities would lie on the SML.

Chapter Nine 110

25. A less restrictive form of the Single Index Model is the:

a. The intercept term is generally higher than the RF.

a. Investors have homogeneous beliefs.

Chapter Nine 111

a. Factors must be readily observable in risk/return space.

a. The risk-free rate

31. The arbitrage pricing theory (APT)

32. The APT is based on the:

Chapter Nine 112

a. explains how economic participants should act

1. The most volatile stocks have beta’s near zero.

2. Using the separation theorem, it is necessary to match each investor's indifference

Chapter Nine 113

9. In a declining market, a portfolio manager should attempt to increase the overall

Chapter Nine 114

Chapter Nine 115

Answer: A few examples include earnings, cash flow, management, financial

Chapter Nine 116

Answer: (1) homogeneous expectations, (2) one-period time horizon, (3)

Critical Thinking/Essay Questions

18. The _ is a plot of __.