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CHAPTER 8—AN INTRODUCTION TO ASSET PRICING MODELS
TRUE/FALSE
1. One of the assumptions of capital market theory is that investors can borrow or lend at the risk free
rate.
ANS: T PTS: 1
2. Since many of the assumptions made by the capital market theory are unrealistic, the theory is not
applicable in the real world.
ANS: F PTS: 1
3. A risk-free asset is one in which the return is completely guaranteed; there is no uncertainty.
ANS: T PTS: 1
4. The market portfolio consists of all risky assets.
ANS: T PTS: 1
5. The introduction of lending and borrowing severely limits the available risk/return opportunities.
ANS: F PTS: 1
6. The capital market line is the tangent line between the risk free rate of return and the efficient frontier.
ANS: T PTS: 1
7. The portfolios on the capital market line are combinations of the risk-free asset and the market
portfolio.
ANS: T PTS: 1
8. If you borrow money at the RFR and invest the money in the market portfolio, the rate of return on
your portfolio will be higher than the market rate of return.
ANS: T PTS: 1
9. Studies have shown that a well-diversified investor needs as few as five stocks.
ANS: F PTS: 1
10. Beta is a measure of unsystematic risk.
ANS: F PTS: 1
11. The betas of those companies compiled by Value Line Investment Services tend to be almost identical
to those compiled by Merrill Lynch.
ANS: F PTS: 1
12. Securities with returns that lie above the security market line are undervalued.
ANS: T PTS: 1
13. Securities with returns that lie below the security market line are undervalued.
ANS: F PTS: 1
14. Under the CAPM framework, the introduction of lending and borrowing at differential rates leads to a
non-linear capital market line.
ANS: T PTS: 1
15. Correlation of the market portfolio and the zero-beta portfolio will be linear.
ANS: T PTS: 1
16. There can be only one zero-beta portfolio.
ANS: F PTS: 1
17. The existence of transaction costs indicates that at some point the additional cost of diversification
relative to its benefit would be excessive for most investors.
ANS: T PTS: 1
18. Studies have shown the beta is more stable for portfolios than for individual securities.
ANS: T PTS: 1
19. If the market portfolio is mean-variance efficient it has the lowest risk for a given level of return
among the attainable set of portfolios.
ANS: T PTS: 1
20. Using the S&P index as the proxy market portfolio when evaluating a portfolio manager relative to the
SML will tend to underestimate the manager's performance.
ANS: F PTS: 1
21. If an incorrect proxy market portfolio such as the S&P index is used when developing the security
market line, the slope of the line will tend to be underestimated.
ANS: T PTS: 1
22. Since the market portfolio is reasonable in theory, it is easy to implement when testing or using the
CAPM.
ANS: F PTS: 1
23. The planning period for the CAPM is the same length of time for every investor.
ANS: F PTS: 1
24. The only way to estimate a beta for a security is to calculate the covariance of the security with the
market.
ANS: F PTS: 1
25. The "true" market portfolio is unknown.
ANS: T PTS: 1
26. More recent studies done in 2001 suggest more securities are needed than historically to create a
well-diversified portfolio.
ANS: T PTS: 1
27. Tobin's separation theory states that the market is a separate investment from the risk-free security.
ANS: F PTS: 1
28. The standard deviation for the risk-free security is equal to zero.
ANS: T PTS: 1
29. The Capital Market Line (CML) can be thought of as the new Efficient Frontier.
ANS: T PTS: 1
30. The usefulness of CAPM theory is limited in practice due to benchmark error.
ANS: T PTS: 1
31. Overall the correlation coefficients of industries to the market portfolio vary widely, which is expected
due to the wide variance of industry Betas.
ANS: F PTS: 1
32. The Capital Market Line (CML) refers only to those portfolios that lie on the line segment that extends
from the risk-free asset to the point of tangency on the efficient frontier known as the market portfolio.
ANS: F PTS: 1
MULTIPLE CHOICE
1. Which of the following is not an assumption of the Capital Market Theory?

a. All investors are Markowitz efficient investors.
b. All investors have homogeneous expectations.
c. There are no taxes or transaction costs in buying or selling assets.
d. All investments are indivisible so it is impossible to buy or sell fractional shares.
e. All investors have the same one period time horizon.
ANS: D PTS: 1 OBJ: Multiple Choice
2. The rate of return on a risk free asset should equal the

a. Long run real growth rate of the economy.
b. Long run nominal growth rate of the economy.
c. Short run real growth rate of the economy.
d. Short run nominal growth rate of the economy.
e. Prime rate of interest.
ANS: A PTS: 1 OBJ: Multiple Choice
3. Which of the following statements about the risk-free asset is correct?

a. The risk-free asset is defined as an asset for which there is uncertainty regarding the
expected rate of return.
b. The standard deviation of return for the risk-free asset is equal to zero.
c. The standard deviation of return for the risk-free asset cannot be zero, since division by
zero is undefined.
d. Choices a and b.
e. Choices a and c.
ANS: B PTS: 1 OBJ: Multiple Choice
4. What does WRF = −0.50 mean?

a. The investor can borrow money at the risk-free rate.
b. The investor can lend money at the current market rate.
c. The investor can borrow money at the current market rate.
d. The investor can borrow money at the prime rate of interest.
e. The investor can lend money at the prime rate of interest.
5. The market portfolio consists of all

a. New York Stock Exchange stocks.
b. High grade stocks and bonds.
c. Stocks and bonds.
d. U.S. and non-U.S. stocks and bonds.
e. Risky assets.
ANS: E PTS: 1 OBJ: Multiple Choice
6. The separation theorem divides decisions on ____ from decisions on ____.

a. Lending, borrowing
b. Risk, return
c. Investing, financing
d. Risky assets, risk free assets
e. Buying stocks, buying bonds
ANS: C PTS: 1 OBJ: Multiple Choice
7. When identifying undervalued and overvalued assets, which of the following statements is false?
a. An asset is properly valued if its estimated rate of return is equal to its required rate of
return.
b. An asset is considered overvalued if its estimated rate of return is below its required rate
of return.
c. An asset is considered undervalued if its estimated rate of return is above its required rate
of return.
d. An asset is considered overvalued if its required rate of return is below its estimated rate
of return.
e. None of the above (that is, all are true statements)
8. The line of best fit for a scatter diagram showing the rates of return of an individual risky asset and the
market portfolio of risky assets over time is called the
a. Security market line.
b. Capital asset pricing model.
c. Characteristic line.
d. Line of least resistance.
e. Market line.
9. Utilizing the security market line an investor owning a stock with a beta of −2 would expect the stock's
return to ____ in a market that was expected to decline 15 percent.
a. Rise or fall an indeterminate amount
b. Fall by 3%
c. Fall by 30%
d. Rise by 13%
e. Rise by 30%
10. All of the following questions remain to be answered in the real world except
a. What is a good proxy for the market portfolio?
b. What happens when you cannot borrow or lend at the risk free rate?
c. How good is the capital asset model as a predictor?
d. What is the beta of the market portfolio of risky assets?
e. What is the stability of beta for individual stocks?
11. The correlation coefficient between the market return and a risk-free asset would
a. be +.
b. be −.
c. be +1.
d. be −1.
e. be Zero.
12. As the number of securities in a portfolio increases, the amount of systematic risk
a. Remains constant.
b. Decreases.
c. Increases.
d. Changes.
e. None of the above
13. Theoretically, the correlation coefficient between a completely diversified portfolio and the market
portfolio should be
a. −1.0.
b. +1.0.
c. 0.0.
d. −0.5.
e. +0.5.
14. All portfolios on the capital market line are

a. Perfectly positively correlated.
b. Perfectly negatively correlated.
c. Unique from each other.
d. Weakly correlated.
e. Unrelated except that they contain the risk free asset.
15. The fact that tests have shown the CAPM intercept to be greater than the RFR is consistent with a(n)
a. Zero beta model.
b. unstable beta or a higher borrowing rate.
c. Zero beta model or a higher borrowing rate.
d. higher borrowing rate.
e. unstable beta.
16. If the assumption that there are no transaction costs is relaxed, the SML will be a
a. Straight line.
b. Band of securities.
c. Convex curve.
d. Concave curve.
e. Parabolic curve.
17. Which of the following is not a relaxation of the assumptions for the CAPM?
a. Differential lending and borrowing rates
b. A zero beta model
c. Transaction costs
d. Taxes
e. Homogeneous expectations and fixed planning periods
18. Which of the following variables were found to be important in explaining return based upon a study
of Fama and French (covering the period 1963 to 1990)?
a. Size
b. Book-to-market value
c. Beta
d. Choices a and b only
e. All of the above
19. Which of the following would most closely resemble the true market portfolio?
a. Stocks
b. Stocks and bonds
c. Stocks, bonds and foreign securities
d. Stocks, bonds, foreign securities and options
e. Stocks, bonds, foreign securities options and coins
20. The error caused by not using the true market portfolio has become known as the
a. Portfolio deviation.
b. CAPM shift.
c. Benchmark error.
d. Market error.
e. Beta error.
21. The ____ the number of stocks in a portfolio and the ____ the time period the ____ the portfolio beta.
a. Larger, longer, less stable
b. Larger, longer, more stable
c. Larger, shorter, less stable
d. Larger, shorter, more stable
e. Smaller, longer, more stable
22. A completely diversified portfolio would have a correlation with the market portfolio that is
a. Equal to zero because it has only unsystematic risk.
b. Equal to one because it has only systematic risk.
c. Less than zero because it has only systematic risk.
d. Less than one because it has only unsystematic risk.
e. Less than one because it has only systematic risk.
23. In the presence of transactions costs, the SML will be

a. A single straight line.
b. A kinked line.
c. A set of lines rather than a single straight line.
d. A curve rather than a single straight line.
e. Impossible to determine.
24. If the wrong benchmark (or market portfolio) is selected then

a. Computed betas would be wrong.
b. The SML would be wrong.
c. Computed betas would be correct.
d. a and b.
e. b and c.
25. All of the following are assumptions of the Capital Asset Pricing Model (CAPM) except
a. Investors can borrow and lend any amount at the risk-free rate.
b. Investors all have homogeneous expectations regarding expected returns.
c. Investors can have different time horizons, daily, weekly, annual, or some other period.
d. All investments are infinitely divisible.
e. Capital markets are in equilibrium.
26. Beta is a measure of:

a. Company specific risk
b. Industry risk
c. Diversifiable risk
d. Systematic risk
e. Unique risk
27. The Efficient Frontier refers to a set of portfolios that

a. Have the highest expected return for a given level of risk.
b. Have the lowest risk for a given level of return.
c. Are dominant to all other portfolios.
d. a, b, and c above are correct.
e. None of the answers above are correct.
28. If an individual owns only one security the most appropriate measure of risk is:
a. Standard deviation
b. Correlation
c. Beta
d. Covariance
e. All of the above are equally important
29. The betas for the market portfolio and risk-free security are:
Market Risk-free
a. 0 1
b. 1 0
c. −1 1
d. 1 −1
e. 2 1
30. A portfolio manager uses two different proxies for the market portfolio, the S&P 500 index and the
MSCI World index. Differences in the manager's portfolio performance resulting from the different
market portfolios is referred to as
a. The size effect
b. The market effect
c. Measurement error
d. Benchmark error
e. Manager's performance error
31. The capital market line (CML) uses ____ as a risk measurement, whereas the capital asset pricing
model (CAPM) uses ____.
a. Beta; total risk
b. Standard deviation; total risk
c. Standard deviation; systematic risk
d. Unsystematic risk; total risk
e. Systematic risk; beta
32. Which of the following is not a major difference between the capital market line (CML) and the
capital asset pricing model (CAPM)?
a. Definitions of portfolio risk are based on systematic and total risk
b. One is related to the market portfolio, the other does not
c. The number of calculations to determine risk is significantly greater for one method
d. One requires a tangency point on the efficient frontier, the other does not
e. All of the above
33. Calculate the expected return for A Industries which has a beta of 1.75 when the risk free rate is 0.03
and you expect the market return to be 0.11.
a. 11.13%
b. 14.97%
c. 16.25%
d. 22.25%
e. 17.0%
ANS: E
k = 0.03 + 1.75 (0.11 − 0.03) = 0.17
PTS: 1 OBJ: Multiple Choice Problem
34. Calculate the expected return for B Services which has a beta of 0.83 when the risk free rate is 0.05
a. 14.96%
b. 16.15%
c. 10.81%
d. 17.00%
e. 15.25%
ANS: C
k = 0.05 + 0.83 (0.12 − 0.05) = 0.1081
35. Calculate the expected return for C Inc. which has a beta of 0.8 when the risk free rate is 0.04 and you
expect the market return to be 0.12.
a. 8.10%
b. 9.60%
c. 10.40%
d. 11.20%
e. 12.60%
ANS: C
k = 0.04 + 0.8 (0.12 − 0.04) = 0.1040 = 10.40%

36. Calculate the expected return for D Industries which has a beta of 1.0 when the risk free rate is 0.03
a. 8.6%
b. 9.2%
c. 11.0%
d. 12.0%
e. 13.0%
ANS: E
k = 0.03 + 1.0 (0.13 − 0.03) = 0.1300 = 13.00%
37. Calculate the expected return for E Services which has a beta of 1.5 when the risk free rate is 0.05 and
you expect the market return to be 0.11.
a. 10.6%
b. 12.1%
c. 13.6%
d. 14.0%
e. 16.2%
ANS: D
k = 0.05 + 1.5 (0.11 − 0.05) = 0.1400 = 14.00%
38. Calculate the expected return for F Inc. which has a beta of 1.3 when the risk free rate is 0.06 and you
expect the market return to be 0.125.
a. 12.65%
b. 13.55%
c. 14.45%
d. 15.05%
e. 16.34%
ANS: C
k = 0.06 + 1.3 (0.125 − 0.06) = 0.1445 = 14.45%
Exhibit 8.1
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Rates of Return
Year RA Computer Market Index
1 13 17
2 9 15
3 −11 6
4 10 8
5 11 10
6 6 12
39. Refer to Exhibit 8.1. Compute the beta for RA Computer using the historic returns presented above.
a. 0.7715
b. 1.2195
c. 1.3893
d. 1.1023
e. −0.7715
ANS: C
(1) (2) (3) (4) (5) (6) (7) (8)
RA Market RA Market (6)  (7)
Year RA Market (R−E(R))2 (R−E(R))2 R−E(R) R−E(R)
1 13 17 44.44 32.11 6.67 5.67 37.78
2 9 15 7.11 13.44 2.67 3.67 9.78
3 −11 6 300.44 28.44 −17.33 −5.33 92.44
4 10 8 13.44 11.11 3.67 −3.33 −12.22
5 11 10 21.78 1.78 4.67 −1.33 −6.22
6 6 12 0.11 0.44 −0.33 0.67 −0.22
Total 38 68 387.33 87.33 121.33
Average 6.3333 11.33333
Variance 77.47 17.47
Std. Dev. 8.80 4.18
Covariance 24.27
Correlation 0.66
Beta 1.3893
alpha −9.41221
Exp Ret on mkt 12
Exp ret on stock 7.259542
COVRA,MI = 121.33  5 = 24.27
MI2 = 87.33  5 = 17.47  MI = 4.18
Beta for RA is (RA) = COVRA,MI  MI2 = 24.27  17.47 = 1.3893
RA2 = 387.33  5 = 77.47  RA = 8.8
40. Refer to Exhibit 8.1. Compute the correlation coefficient between RA Computer and the Market Index.
a. −0.32
b. 0.78
c. 0.66
d. 0.58
e. 0.32
ANS: C
(1) (2) (3) (4) (5) (6) (7) (8)
1 13 17 44.44 32.11 6.67 5.67 37.78
2 9 15 7.11 13.44 2.67 3.67 9.78
3 −11 6 300.44 28.44 −17.33 −5.33 92.44
4 10 8 13.44 11.11 3.67 −3.33 −12.22
5 11 10 21.78 1.78 4.67 −1.33 −6.22
6 6 12 0.11 0.44 −0.33 0.67 −0.22
Total 38 68 387.33 87.33 121.33
Average 6.3333 11.33333
Std. Dev. 8.80 4.18
Covariance 24.27
Correlation 0.66
Beta 1.3893
alpha −9.41221
Exp Ret on mkt 12
The correlation coefficient between the returns of RA and the Market Index is:
rRA,MI = COVRA,MI  RAMI = (24.27)  (8.8)(4.18) = 0.66
41. Refer to Exhibit 8.1. Compute the intercept of the characteristic line for RA Computer.
a. −9.41
b. 11.63
c. 4.92
d. −4.92
e. −7.98
ANS: A
(1) (2) (3) (4) (5) (6) (7) (8)
1 13 17 44.44 32.11 6.67 5.67 37.78
2 9 15 7.11 13.44 2.67 3.67 9.78
3 −11 6 300.44 28.44 −17.33 −5.33 92.44
4 10 8 13.44 11.11 3.67 −3.33 −12.22
5 11 10 21.78 1.78 4.67 −1.33 −6.22
6 6 12 0.11 0.44 −0.33 0.67 −0.22
Total 38 68 387.33 87.33 121.33
Average 6.3333 11.33333
Std. Dev. 8.80 4.18
Covariance 24.27
Correlation 0.66
Beta 1.3893
alpha −9.41221
Exp Ret on mkt 12
The equation for the intercept () of the characteristic line is:
= MEAN(RA) − RAMEAN(MI) = 6.3333 + (1.3893)(11.3333) = −9.4122
42. Refer to Exhibit 8.1. The equation of the characteristic line for RA is
a. RRA = 11.63 + 1.2195RMI
b. RRA = −7.98 + 1.1023RMI
c. RRA = −9.41 + 1.3893RMI
d. RRA = −4.92 − 0.7715RMI
e. RRA = 4.92 + 0.7715RMI
ANS: C
(1) (2) (3) (4) (5) (6) (7) (8)
1 13 17 44.44 32.11 6.67 5.67 37.78
2 9 15 7.11 13.44 2.67 3.67 9.78
3 −11 6 300.44 28.44 −17.33 −5.33 92.44
4 10 8 13.44 11.11 3.67 −3.33 −12.22
5 11 10 21.78 1.78 4.67 −1.33 −6.22
6 6 12 0.11 0.44 −0.33 0.67 −0.22
Total 38 68 387.33 87.33 121.33
Average 6.3333 11.33333
Std. Dev. 8.80 4.18
Covariance 24.27
Correlation 0.66
Beta 1.3893
alpha −9.41221
Exp Ret on mkt 12
The equation for the of the characteristic line for RA is:

RRA =  + RARMI = −9.4122 + 1.3893RMI
43. Refer to Exhibit 8.1. If you expected the return on the Market Index to be 12%, what would you expect
the return on RA Computer to be?
a. 7.26%
b. 6.75%
c. 8.00%
d. 9.37%
e. −3.29%
ANS: A
(1) (2) (3) (4) (5) (6) (7) (8)
1 13 17 44.44 32.11 6.67 5.67 37.78
2 9 15 7.11 13.44 2.67 3.67 9.78
3 −11 6 300.44 28.44 −17.33 −5.33 92.44
4 10 8 13.44 11.11 3.67 −3.33 −12.22
5 11 10 21.78 1.78 4.67 −1.33 −6.22
6 6 12 0.11 0.44 −0.33 0.67 −0.22
Total 38 68 387.33 87.33 121.33
Average 6.3333 11.33333
Std. Dev. 8.80 4.18
Covariance 24.27
Correlation 0.66
Beta 1.3893
alpha −9.41221
Exp Ret on mkt 12
Return (RA) = −9.4122 + 1.3893(12) = 7.26%
Exhibit 8.2
You expect the risk-free rate (RFR) to be 3 percent and the market return to be 8 percent. You also
have the following information about three stocks.
Current Expected Expected

Stock Beta Price Price Dividend
X 1.25 $20 $23 $1.25
Y 1.50 $27 $29 $0.25
Z 0.90 $35 $38 $1.00
44. Refer to Exhibit 8.2. What are the expected (required) rates of return for the three stocks (in the order
X, Y, Z)?
a. 16.50%, 5.50%, 22.00%
b. 9.25%, 10.5%, 7.5%
c. 21.25%, 8.33%, 11.43%
d. 6.20%, 2.20%, 8.20%
e. 15.00%, 3.50%, 7.30%
ANS: B
Stock Required Estimated Evaluation
X .03 + 1.25(.08 − .03) = 9.25% undervalued
Y .03 + 1.50(.08 − .03) = 10.5% overvalued
Z .03 + 0.9(.08 − .03) = 7.5% undervalued
45. Refer to Exhibit 8.2. What are the estimated rates of return for the three stocks (in the order X, Y, Z)?
a. 21.25%, 8.33%, 11.43%
b. 6.20%, 2.20%, 8.20%
c. 16.50%, 5.50%, 22.00%
d. 9.25%, 10.5%, 7.5%
e. 15.00%, 3.50%, 7.30%
ANS: A
X .03 + 1.25(.08 − .03) = 9.25% undervalued
Y .03 + 1.50(.08 − .03) = 10.5% overvalued
Z .03 + 0.9(.08 − .03) = 7.5% undervalued
46. Refer to Exhibit 8.2. What is your investment strategy concerning the three stocks?
a. Buy X and Y, sell Z.
b. Sell X, Y and Z.
c. Sell X and Z, buy Y.
d. Buy X, Y and Z.
e. Buy X and Z, sell Y.
ANS: E
X .03 + 1.25(.08 − .03) = 9.25% undervalued
Y .03 + 1.50(.08 − .03) = 10.5% overvalued
Z .03 + 0.9(.08 − .03) = 7.5% undervalued
47. Recently you have received a tip that the stock of Bubbly Incorporated is going to rise from $57 to $61
per share over the next year. You know that the annual return on the S&P 500 has been 9.25% and the
90-day T-bill rate has been yielding 3.75% per year over the past 10 years. If beta for Bubbly is 0.85,
will you purchase the stock?
a. Yes, because it is overvalued.
b. No, because it is overvalued.
c. No, because it is undervalued.
d. Yes, because it is undervalued.
e. Yes, because the expected return equals the estimated return.
ANS: B
Expected Return = 3.75 + (0.85)(9.25 − 3.75) = 8.425%
Estimated Return = (61 − 57)  57 = 7.0175%
Estimated Return < Expected Return

 Stock is overvalued and should be sold.
48. Your broker has advised you that he believes that the stock of Brat Inc. is going to rise from $20 to
$22.15 per share over the next year. You know that the annual return on the S&P 500 has been 11.25%
and the 90-day T-bill rate has been yielding 4.75% per year over the past 10 years. If beta for Brat is
1.25, will you purchase the stock?
a. Yes, because it is overvalued
b. No, because it is overvalued
c. No, because it is undervalued
d. Yes, because it is undervalued
e. Yes, because the expected return equals the estimated return
ANS: B
Expected Return = 4.75 + (1.25)(11.25 − 4.75) = 12.875%
Estimated Return = (22.15 − 20)  20 = 10.75%

 Stock is overvalued and should be sold.

49. Recently you have received a tip that the stock of Buttercup Industries is going to rise from $76.00 to
$85.00 per share over the next year. You know that the annual return on the S&P 500 has been 13%
and the 90-day T-bill rate has been yielding 3% per year over the past 10 years. If beta for Buttercup is
b. Yes, because it is undervalued.
d. No, because it is overvalued.
ANS: D
Expected Return = 3 + (1.0)(13 − 3) = 13.0%

 Stock is overvalued and should not be purchased.
50. A friend has some reliable information that the stock of Puddles Company is going to rise from $43.00
to $50.00 per share over the next year. You know that the annual return on the S&P 500 has been 11%
and the 90-day T-bill rate has been yielding 5% per year over the past 10 years. If beta for Puddles is
ANS: B
Expected Return = 5 + (1.5)(11 − 5) = 14.0%
Estimated Return > Expected Return

 Stock is undervalued and should be purchased.
51. Recently your broker has advised you that he believes that the stock of Casey Incorporated is going to
rise from $55.00 to $70.00 per share over the next year. You know that the annual return on the S&P
500 has been 12.5% and the 90-day T-bill rate has been yielding 6% per year over the past 10 years. If
beta for Casey is 1.3, will you purchase the stock?
ANS: B
Expected Return = 6 + (1.3)(12.5 − 6) = 14.45%
Estimated Return > Expected Return

 Stock is undervalued and should be purchased.
52. A friend has information that the stock of Zip Incorporated is going to rise from $62.00 to $65.00 per
share over the next year. You know that the annual return on the S&P 500 has been 10% and the
90-day T-bill rate has been yielding 6% per year over the past 10 years. If beta for Zip is 0.9, will you
purchase the stock?
ANS: D
Expected Return = 6 + (0.9)(10 − 6) = 9.6%

 Stock is overvalued and should not be purchased.
53. Assume that as a portfolio manager the beta of your portfolio is 0.85 and that your performance is
exactly on target with the SML data under condition 1. If the true SML data is given by condition 2,
how much does your performance differ from the true SML?
(1) RFR = 0.0475 Rm(proxy) = 0.0975

(2) RK = 0.0325 Rm(true) = 0.0845
a. 1.33% higher
b. 2.35% lower
c. 8% lower
d. 1.33% lower
e. 2.35% higher
ANS: A
(proxy) k = 0.0475 + 0.85 (0.0975 − 0.0475) = 0.09
According to the true SML it should be:

(true) K = 0.0325 + 0.85 (0.0845 − 0.0325) = 0.0767
You have been overperforming by 1.33%.
(1) RFR = 0.0625 Rm(proxy) = 0.12

(2) RK = 0.078 Rm(true) = 0.10
a. 2.53% lower
b. 3.85% lower
c. 2.53% higher
d. 4.4% higher
e. 3.85% higher
ANS: C
(proxy) k = 0.0625 + 1.15 (0.12 − 0.0625) = 0.1286

(true) K = 0.078 + 1.15 (0.12 − 0.078) = 0.1033
(1) RFR = .08 Rm(proxy) = .11

(2) RK = .07 Rm(true) = .14
a. 4.2% lower
b. 3.6% lower
c. 3.8% lower
d. 4.2% higher
e. 3.6% higher
ANS: A
Since the market portfolio has a beta of 1, the market premium is .03 under the proxy and .07 under the
true. Thus, your return is
(proxy) k = .08 + 1.3 (.03) = .119 = 11.9%

(true) K = .07 + 1.3 (.07) = 16.1%
You have been underperforming by 4.2%.
(1) RFR = .09 Rm(proxy) = .12

(2) RK = .10 Rm(true) = .13
a. 2% lower
b. 1% lower
c. 5% lower
d. 1% higher
e. 2% higher
ANS: B
(proxy) k = .09 + 1.2 (.03) = .126 = 12.6%

(true) K = .10 + 1.2 (.03) = 13.6%
You have been underperforming by 1%.
(1) RFR = .07 Rm(proxy) = .15

(2) RK = .06 Rm(true) = .12
a. 3.2% lower
b. 6.4% lower
c. 4.9% lower
d. 3.2% higher
e. 6.4% higher
ANS: D
(proxy) k = .07 + 1.1 (.08) = .158 = 15.8%

(true) K = .06 + 1.1 (.06) = 12.6%
(1) RFR = .06 Rm(proxy) = .12

(2) RK = .05 Rm(true) = .11
a. 2.0% lower
b. 0.5% lower
c. 0.5% lower
d. 1.0% higher
e. 2.0% higher
ANS: D
(proxy) k = .06 + 1.4 (.06) = .144 = 14.4%

(true) K = .05 + 1.4 (.06) = 13.4%
You have been overperforming by 1%.
Exhibit 8.3
Return Proxy True

of Radtron Specific Index General Index
Period (Percent) (Percent) (Percent)
1 10 12 15
2 12 10 13
3 −10 −8 −8
4 −4 −10 0
59. Refer to Exhibit 8.3. The average true return is

a. 1%
b. 2%
c. 3%
d. 4%
e. 5%
ANS: E
R (True) = (15 + 13 − 8 + 0)/4 = 20/4 = 5%
60. Refer to Exhibit 8.3. The average proxy return is

a. 1%
b. 2%
c. 3%
d. 4%
e. 5%
ANS: B
R (Radtron) = (10 + 12 − 10 − 4)/4 = 8/4 = 2%
61. Refer to Exhibit 8.3. The average return for Radtron is

a. 1%
b. 2%
c. 3%
d. 4%
e. 5%
ANS: A
R (Proxy) = (12 + 10 − 8 − 10)/4 = 4/4 = 1%
62. Refer to Exhibit 8.3. The covariance between Radtron and the proxy index is
a. 57.30
b. 86.50
c. 88.00
d. 92.50
e. 107.90
ANS: C
(10 − 2) (12 − 1) = 88
(12 − 2) (10 − 1) = 90
(−10 − 2) (−8 − 1) = 108
(−4 − 2) (−10 − 1) = 66
352/4 = 88.00
63. Refer to Exhibit 8.3. The covariance between Radtron and the true index is
a. 57.30
b. 86.50
c. 88.00
d. 92.50
e. 107.90
ANS: B
(10 − 2) (15 − 5) = 80
(12 − 2) (13 − 5) = 80
(−10 − 2) (−8 − 5) = 156
(−4 − 2) (0 − 5) = 30
346/4 = 86.50
64. Refer to Exhibit 8.3. What is the beta for Radtron using the proxy index?
a. 0.87
b. 0.97
c. 1.02
d. 1.15
e. 1.28
ANS: A
(12 − 1)2 = 121 (15 − 5)2 = 100
(10 − 1)2 = 81 (13 − 5)2 = 64
(−8 − 1)2 = 81 (−8 − 5)2 = 169
(−10 − 1)2 = 121 (0 − 5)2 = 25
404/4 = 101 358/4 = 89.50
88  101 = 0.87
65. Refer to Exhibit 8.3. What is the beta for Radtron using the true index?
a. 0.87
b. 0.97
c. 1.02
d. 1.15
e. 1.28
ANS: B
(12 − 1)2 = 121 (15 − 5)2 = 100
(10 − 1)2 = 81 (13 − 5)2 = 64
(−8 − 1)2 = 81 (−8 − 5)2 = 169
(−10 − 1)2 = 121 (0 − 5)2 = 25
404/4 = 101 358/4 = 89.50
86.5  89.5 = 0.97
66. Consider an asset that has a beta of 1.5. The return on the risk-free asset is 6.5% and the expected
return on the stock index is 15%. The estimated return on the asset is 20%. Calculate the alpha for the
asset.
a. 19.25%
b. 0.75%
c. −0.75%
d. 9.75%
e. 9.0%
ANS: B
6.5 + 1.5(15 − 6.5) = 19.25%
alpha = 20 − 19.25 = 0.75%
67. The variance of returns for a risky asset is 25%. The variance of the error term, Var(e), is 8%. What
portion of the total risk of the asset, as measured by variance, is systematic?
a. 32%
b. 8%
c. 68%
d. 25%
e. 75%
ANS: C
8%/25% = 0.32. 1 − 0.32 = 68% systematic.
68. An investor wishes to construct a portfolio consisting of a 70% allocation to a stock index and a 30%
allocation to a risk free asset. The return on the risk-free asset is 4.5% and the expected return on the
stock index is 12%. The standard deviation of returns on the stock index is 6%. Calculate the expected
standard deviation of the portfolio.
a. 4.20%
b. 25.20%
c. 3.29%
d. 10.80%
e. 5.02%
ANS: A
0.7(6) = 4.2%

69. An investor wishes to construct a portfolio by borrowing 35% of his original wealth and investing all
the money in a stock index. The return on the risk-free asset is 4.0% and the expected return on the
stock index is 15%. Calculate the expected return on the portfolio.
a. 18.25%
b. 18.85%
c. 9.50%
d. 15.00%
e. 11.15%
ANS: B
−0.35(4) + 1.35(15) = 18.85%
70. An investor wishes to construct a portfolio consisting of a 70% allocation to a stock index and a 30%
allocation to a risk free asset. The return on the risk-free asset is 4.5% and the expected return on the
stock index is 12%. Calculate the expected return on the portfolio.
a. 8.25%
b. 16.50%
c. 17.50%
d. 9.75%
e. 14.38%
ANS: D
E(R) = 0.3(4.5) + 0.7(12) = 9.75%
71. A stock has a beta of 1.25. The risk free rate is 5% and the return on the market is 6%. The estimated
return for the stock is 14%. According to the CAPM you should
a. Sell because it is overvalued.
b. Sell because it is undervalued.
c. Buy because it overvalued.
d. Buy because it is undervalued.
e. Short because it is undervalued.
ANS: D
E(R) = 5 + 1.25(6 − 5) = 7.25%. The stock is undervalued.
72. Consider a risky asset that has a standard deviation of returns of 15. Calculate the correlation between
the risky asset and a risk free asset.
a. 1.0
b. 0.0
c. −1.0
d. 0.5
e. −0.5
ANS: B
The correlation between a risky asset and a risk-free asset is always zero.

73. The expected return for a stock, calculated using the CAPM, is 10.5%. The market return is 9.5% and
the beta of the stock is 1.50. Calculate the implied risk-free rate.
a. 7.50%
b. 13.91%
c. 17.50%
d. 21.88%
e. 14.38%
ANS: A
10.5 = X + 1.5(9.5 − X). X = 7.5%.
74. The expected return for a stock, calculated using the CAPM, is 25%. The risk free rate is 7.5% and the
beta of the stock is 0.80. Calculate the implied return on the market.
a. 7.50%
b. 13.91%
c. 17.50%
d. 21.88%
e. 14.38%
ANS: E
25 = 7.5 + 0.8(X). X = 14.38%
75. The expected return for Zbrite stock calculated using the CAPM is 15.5%. The risk free rate is 3.5%
and the beta of the stock is 1.2. Calculate the implied market risk premium.
a. 5.5%
b. 6.5%
c. 10.0%
d. 15.5%
e. 12.0%
ANS: C
15.5 = 3.5 + 1.2(X). X = 10%.
Exhibit 8.4
Stock Beta Current Price Expected Price Expected Dividend

X 0.8 $12.50 $13.10 $0.80
Y 1.1 $ 8.25 $ 9.76 $0.20
Z 2.1 $25.70 $30.04 $0.00
76. Refer to Exhibit 8.4. What are the expected returns for stocks X, Y, and Z for the next period based on
the above prices and dividends?
X Y Z
a. 4.8% 18.3% 16.9%
b. 10.7% 17.5% 14.4%
c. 11.2% 20.7% 16.9%
d. 12.3% 22.5% 22.3%
e. 13.1% 24.3% 18.2%
ANS: C
Expected return for X = (13.10 + 0.80 − 12.50)/12.50 = .112 or 11.2%
Expected return for Y = (9.76 + 0.20 − 8.25)/8.25 = .207 or 20.7%
Expected return for Z = (30.04 + 0.00 − 25.70)/25.70 = 16.9%
77. Refer to Exhibit 8.4. If the expected return on the market is 11.5% and the risk-free rate of return is
4.5%, then what are the required rates of return for stocks X, Y, and Z based on the CAPM?
X Y Z
a. 4.8% 18.3% 16.9%
b. 7.2% 20.7% 22.3%
c. 10.7% 17.5% 14.4%
d. 10.1% 12.2% 19.2%
e. 11.1% 12.2% 21.3%
ANS: C
Required return for X = .045 + 0.8(.115 − .045) = .101
Required return for Y = .045 + 1.1(.115 − .045) = .122
Required return for Z = .045 + 2.1(.115 − .045) = .192
78. Refer to Exhibit 8.4. Which of the following statements is correct?

a. Stocks X, Y, and Z are undervalued.
b. Stocks X, Y and Z are overvalued.
c. Stocks X and Y are overvalued and stock Z is undervalued.
d. Stocks X and Y are undervalued and stock Z is overvalued.
e. Stocks X, Y, and Z are all properly valued.
ANS: D
Stocks X and Y are undervalued because the expected returns are greater than the required returns
based on the CAPM. Stock Z is overvalued because the expected return is less than the required return
based on the CAPM.
Exhibit 8.5
Portfolio Expected Return Standard Deviation

A 9.8% 14.0%
B 6.7% 9.8%
C 11.2% 18.5%
79. Refer to Exhibit 8.5. Calculate the risk premium per unit of risk for the three portfolios above
assuming the risk-free rate is 4.0%.
A B C
a. 0.068 0.027 0.072
b. 0.414 0.276 0.389
c. 0.700 0.680 0.605
d. 0.300 0.280 0.205
e. 0.650 0.580 0.480
ANS: B
A: (.098 − .04)/.14 = 0.414
B: (.067 − .04)/.098 = 0.276
C: (.112 − .04)/.185 = 0.389
80. Refer to Exhibit 8.5. Which of the three portfolios are most likely to be the market portfolio?
a. Portfolio A
b. Portfolio B
c. Portfolio C
d. All of the portfolios are equally likely to be the market portfolio
e. There is insufficient information to differentiate between the three portfolios
ANS: A
Portfolio A is the most efficient portfolio in terms of return per unit of risk. Therefore, A is the most
likely candidate for being on the Efficient Frontier as the market portfolio.
81. Assume that the risk-free rate of return is 3% and the market portfolio on the Capital Market Line
(CML) has an expected return of 11% and a standard deviation of 14%. How should you invest
$100,000 if you are only willing to accept a total portfolio risk of 8%?
a. Invest $140,000 in the market portfolio and by borrowing $40,000 at the risk-free rate.
b. Invest $80,000 in the market portfolio and the remainder in the risk-free security.
c. Invest $63,636.36 in the market portfolio and the remainder in the risk-free security.
d. Invest $36,363.64 in the market portfolio and the remainder in the risk-free security.
e. Invest $100,000 on another portfolio on the CML that does not contain any of the market
portfolio or the risk-free security, but has a standard deviation of 8%.
ANS: D
Let X represent the amount of investment in the market portfolio. Then you can compute the desired
standard deviation of 7% as a weighted average of the two portfolios as follows (Note the standard
deviation for the risk-free security is 0):
0.08 = (X/(100,000 − X))(0.14) + 0

0.08 = 0.14X/(100,000 − X)
0.08(100,000 − X) = 0.14X
8,000 − 0.08X = 0.14X
8,000 = 0.22X
36,363.64 = X
Exhibit 8.6
Jonathan Crowley is a portfolio manager for a large pension fund. Last year his portfolio had an actual
return of 12.6% with a standard deviation of 13% and a beta of 1.3. The market risk premium for this
period of time was 6% and the risk-free rate of return was 5%.
82. Refer to Exhibit 8.6. Based on the Capital Asset Pricing Model (CAPM), what is the required rate of
return for this portfolio?
a. 6.3%
b. 7.8%
c. 10.6%
d. 12.8%
e. 15.4%
ANS: D
The required return for this portfolio on a risk adjusted is calculated using the CAPM as follows:
0.05 + 1.3(0.06) = 0.128.
83. Refer to Exhibit 8.6. How does Jonathan Crowley's portfolio compare to the market portfolio?
a. Crowley's portfolio is less risky than the market portfolio.
b. Crowley's portfolio significantly outperformed the market portfolio.
c. On a risk-adjusted basis Crowley's portfolio performed similar to the market portfolio.
d. On a risk-adjusted basis Crowley's portfolio significantly underperformed the market.
e. On a risk-adjusted basis Crowley's portfolio significantly outperformed the market.
ANS: C
The actual return of 12.6% is very close to the required return of 12.8% based on the CAPM.
84. Assume the risk-free rate is 4.5% and the expected return on the market is 11%. You anticipate Stock
XYZ to sell for $28 at the end of next year and pay a dividend of $2. The stock is currently selling for
$26.50 with a beta of 1.2. You currently hold stock XYZ in a well-diversified portfolio. Assuming you
have money to invest, you should:
a. Buy stock XYZ.
b. Sell stock XYZ.
c. Do nothing because it is properly valued.
d. Invest your money in the risk-free rate of return.
e. Both b and d above.
ANS: A
The expected return for stock XYZ is (28.00 − 26.50 + 2.00)/26.50 = 0.132.
The required return based on the CAPM is .045 + 1.2(.11 − .045) = 0.123.
The expected return for next period is greater than the required return based on the CAPM.
Exhibit 8.7
You expect the risk-free rate (RFR) to be 4 percent and the market return to be 10 percent. You also
have the following information about three stocks.
Current Expected Expected

Stock Beta Price Price Dividend
A 1.5 $10 $11.50 $1.00
B 1.1 $27 $30 $0.00
C 0.8 $35 $36 $1.50
85. Refer to Exhibit 8.7. What are the required rates of return for the three stocks (in the order A, B, C)?
a. 13.0%, 10.6%, 8.8%
b. 15.0%, 11.1%, 2.9%
c. 18.7%, 11.1%, 8.8%
d. 21.7%, 10.0%, 6.9%
e. 25.0%, 11.1%, 7.1%
ANS: A
A .04 + 1.5(.10 − .04) = 13.0% undervalued
B .04 + 1.1(.10 − .04) = 10.6% undervalued
C .04 + 0.8(.10 − .04) = 8.8% overvalued
86. Refer to Exhibit 8.7. What are the estimated rates of return for the three stocks (in the order A, B, C)?
a. 13.0%, 10.6%, 8.8%
b. 15.0%, 11.1%, 2.9%
c. 18.7%, 11.1%, 8.8%
d. 21.7%, 10.0%, 6.9%
e. 25.0%, 11.1%, 7.1%
ANS: E
A .04 + 1.5(.10 − .04) = 13.0% undervalued
B .04 + 1.1(.10 − .04) = 10.6% undervalued
C .04 + 0.8(.10 − .04) = 8.8% overvalued
87. Refer to Exhibit 8.7. What is your investment strategy concerning the three stocks?
a. Buy A and B, sell C.
b. Sell A, B and C.
c. Sell A and B, buy C.
d. Buy A, B and C.
e. Buy A and C, sell B.
ANS: A
A .04 + 1.5(.10 − .04) = 13.0% undervalued
Test Bank for Investment Analysis and Portfolio Management 10th Edition by Reilly
B .04 + 1.1(.10 − .04) = 10.6% undervalued
C .04 + 0.8(.10 − .04) = 8.8% overvalued
88. An investor constructs a portfolio with a 75% allocation to a stock index and a 25% allocation to a risk
free asset. The expected returns on the risk-free asset and the stock index are 3% and 10%,
respectively. The standard deviation of returns on the stock index is 14%. Calculate the expected
standard deviation of the portfolio.
a. 7.5%
b. 9.0%
c. 10.5%
d. 11.5%
e. 13.0%
ANS: C
0.75(14%) = 10.5%
89. An investor wishes to construct a portfolio by borrowing 30% of his initial wealth at the risk-free rate
of 3% and investing all the money in a stock index. The expected return on the stock index is 12%.
Calculate the expected return on the portfolio.
a. 14.7%
b. 15.6%
c. 17.1%
d. 18.9%
e. 19.7%
ANS: A
−0.3(3%) + 1.3(12%) = 14.7%
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PLATE XXXIV
Normal Knee-joint. (Child, seven years Tuberculosis of Knee, with Partial

old.) Dislocation. (Child, seven years old.)
With a better appreciation of the pathology of the condition

numerous methods were devised by which the germs should be
attacked in loco. Thus various antiseptics have been injected in
varying strengths, either into joint cavities or around them.
Lannelongue devised a “sclerotic method,” by which zinc chloride
solutions were injected into the peri-articular tissues, to so condense
and harden them as to imprison and destroy their contained germs.
The method, however, is an extremely painful one and has not found
general favor. For a long time iodoform was employed for the same
purpose, in emulsions of 10 per cent. and 20 per cent. strength, in
sterilized glycerin or olive oil. It affords a curious paradox that the
iodoform itself must be sterilized before being thus used. This
emulsion has been injected into the peri-articular tissues or into joint
cavities, which, when containing appreciable amounts of fluid, should
be first emptied and washed out; all of which can be done through
the same small trocar used for introduction of the iodoform. The
verdict of surgeons today is rather against the employment of
iodoform, since they have learned to not rely upon it because of
disappointment so often following its use.
Bier, in 1891, advised the so-called congestion treatment of
tuberculous joints, basing it upon the fact that tuberculosis does not
develop in lungs which are the seat of venous stasis from valvular
heart disease. He proposed to produce an artificial stasis, in the joint
structures and about them, by which living germs should be
destroyed and their disease products encapsulated, claiming that as
the result of the hyperemia thus produced the alexins are thus
brought into more complete contact with the bacilli. The method is
applicable to the limbs below the shoulder and hip. It consists in the
application of an Esmarch bandage above the affected joint, applied
with sufficient firmness to obstruct the returning blood, but not to
interfere with the arterial supply. If there be room the limb is also
bandaged below the joint with an ordinary cotton roller. This
congestion is kept up at daily intervals for increasing periods,
beginning with perhaps half an hour and continuing until it is in
operation at least half of the time. Meantime other methods of
treatment are not interdicted. In the earlier stages of tuberculous joint
disease this method has given very encouraging and pleasing
results. (See Fig. 208.)
Tuberculous hydrops may be treated by aspiration and elastic
compression. Should fluid distend the joint it should be opened and
thoroughly cleaned, then closed and perhaps drained.
The treatment of pyarthrosis and of peri-articular cold abscess has
long been a mooted subject. The orthopedic surgeons still adhere to
mildly or absolutely non-operative measures, whereas the general
surgeon prefers to adopt more radical methods. Each case should
be judged on its own merits, and these should include a careful
estimation of the general condition of the patient. Should evidences
of septic intoxication be present or the ordinary general signs of the
presence of pus, then these collections should be opened and
cleaned out. If hectic can be excluded, then other considerations will
indicate what is best. At all events there will be seen many cases
where a delay in operation will be advisable, in order to permit of
improvement of the general condition by measures above described.
To merely open up a tuberculous focus and leave at least two fresh
raw surfaces exposed to contamination is rather to invite the spread
of the disease than to correctly meet the indication. Every old focus
will be lined or surrounded with a more or less dense membrane
formerly called pyogenic, but now more correct knowledge shows it
to be pyophylactic. (See p. 113.) To leave this in situ is to leave
germ-laden walls, while to dissect it thoroughly is to make a larger,
fresh raw surface and to open up innumerable absorbent vessels.
Thus, whether it be removed in whole or in part, or allowed to
remain, some sufficiently strong caustic material should be promptly
employed, by which both destruction of living residual germs and
closure of the mouths of the absorbents shall be effected. This has
been set forth more fully when dealing with cold abscesses in
general, but is of so much importance that it may be reiterated here.
Whether the actual cautery, pure carbolic acid, strong zinc chloride
solution, or some other agent be used should depend upon
circumstances, but every portion of the surface which it is proposed
to leave more or less exposed to the possibility of infection should be
thus protected. In proportion to the intensity of the caustic action
there will be separation of more or less cauterized and sloughing
material, for whose escape provision should be made; but it will be
separated by the granulation process, aided by an active
phagocytosis, and when removed will leave a granulating surface
which is but slightly absorbent. These facts pertain to small incisions
for drainage as well as to extensive arthrectomies.
The operative treatment, then, of tuberculous arthritis varies from
tapping, with or without drainage, to complete arthrectomy or
amputation. When the joints of the foot or ankle are extensively
diseased, and the patient, as usually happens, is in poor condition, it
may appear that amputation will afford the most complete relief, and
that a stump with an artificial member will be of much more use to
the individual than a mutilated, tender, and disabled foot.
Fig. 208
Calcified mass in old “cold abscess” about hip-joint. (Buffalo Clinic. Skiagram by
Dr. Plummer.)
To incision with or without drainage is given the name arthrotomy.

When the joint is widely opened and portions removed with the sharp
spoon or otherwise, it is known as arthrectomy. When bone is
removed irregularly the measure is called atypical resection. When
entire bone ends are removed the operation becomes an exsection
or resection. The ordinary arthrectomy is not sufficient when foci are
present in the epiphyses. Here at least atypical resection is called
for. Arthrectomy may properly include a wide exposure of articular
surfaces and the removal of the thickened and diseased synovia,
with its fringes, or with the cartilages, by which cancellous structure
is more or less widely exposed. When arthrectomy is undertaken it
should be thoroughly made and by a large incision, since the more
completely the joint cavity can be inspected and attacked the better
are the interests of the patient subserved. All fresh or cold abscess
cavities which connect with the joint or lie in contact with it should
also be attacked at the same time, and those which do not
communicate with it should be separately drained. While drainage by
tube or other means will usually suffice, there are cases where the
disease is so extensive that it will pay to pack the cavity with balsam
gauze for a few days, placing secondary sutures by which the
incision can be closed after its removal. In the shoulder and hip, for
instance, such a method will give satisfactory results.
The advantage of avoidance of resection is the non-interference
with the epiphyses and their junctions, thus permitting the growth of
the bone to continue. Therefore complete and typical excisions
should be practised as seldom as possible, especially in growing
children. They may be practised to advantage even in advanced
age, and the writer has seen satisfactory results after complete
excision of tuberculous joints in senile cases. When operating upon
a tuberculous tarsal joint the surgeon is likely to find one or more of
the tarsal bones so much involved in the tuberculous disease that he
is compelled to scrape it out and thus leave a cavity almost the size
of the bone itself. Should he have to do this to a series of the bones
it would be better to make a formal resection of the tarsus or possibly
an amputation. The cavity should be left open with a sufficiently large
incision so that it may be easily packed. A cavity of this kind left
unpacked will fill up with clot, which will disintegrate and the result
will be much less satisfactory. In the former case there is an open
cavity which fills with granulations, but this can be kept accessible
under observation and with more effect and comfort. This is equally
true of those cavities where both arthrectomy and bone curettage
have been practised.
MOVABLE BODIES IN THE JOINTS.
Several different terms have been applied to loose and movable
bodies, even in the various joints, depending on their size,
arrangement, and appearance. Thus we have the rice-grain or
melon-seed bodies (corpora oryzoidea), which have already been
described and are now supposed to indicate a form of tuberculous
synovitis which has undergone a partial if not complete subsidence.
Again we have larger masses occurring singly or in very small
number, especially in the knee, to which the Germans have given the
significant name of joint mice. Also in the knee, owing to its peculiar
construction, another form of movable body is met with, i. e., a
displaced and more or less motile semilunar cartilage. This condition
was first described by Hey, and especially studied by Allingham, who
made it a prominent feature of what he described as “internal
derangement of the knee.” Lastly, in those joints in which synovial
fringes occur, the knee especially, it is held that portions may
become detached by having been infiltrated and cast off or broken
loose, and thus form a fourth variety of floating body. The joints most
often affected are the knee and the elbow. In many instances there is
a history of injury, especially when the mass is of considerable size.
The theory of an “osteochondritis dissecans” has also been invoked
to account for the resemblance between some of these bodies and
the articular cartilages. Some pathologists have held that they may
result from the organization of clots, which are subsequently rounded
off and shaped by attrition (Fig. 209). These bodies then may consist
of condensed fibrinous material, of cartilage, of true bone, or of
hyperplastic and fatty synovial tassels. To these may be added rare
instances of mucoid connective tissue.
Fig. 209
Floating bodies—“joint mice”—from knee-joint. (Lexer.)
Symptoms.—Rice-grain bodies may be suspected in cases of

chronic tuberculosis and often in arthritis deformans,
while in many instances they may be felt gliding beneath or between
the joint structures. A perfectly loose floating body will produce
symptoms which are quite distinctive. They consist of sudden and
intense pain, with such muscle spasm as to fix the joint and prevent
its use, thus “locking it.” Occurring at the knee the individual is
instantly disabled, but usually learns by some peculiar manipulation,
with or without assistance, to “unlock” the joint, and after a few
moments to resume its use. Such a complaint as this should always
suggest the condition. Patients who have had it for a long time learn
how to avoid it as well as how to relieve it, and will often discover
and be able to indicate to the surgeon the existence of a movable
body, and even to describe its usual resting place.
Partial or complete dislocation of a semilunar cartilage in the knee
is usually the result of traumatism, a distinct history of which can
generally be obtained. It may not have been discovered at the time,
owing to swelling or tenderness, but will produce its peculiar
symptoms later, i. e., after use of the joint is resumed. Here, again,
so long as it remain in proper position, it interferes but little; with a
misstep or sudden movement, however, the patient is seized with
sudden and painful disability. Here the movable cartilage may be felt
projecting near its proper location. In such cases as these it is
movable only to a certain extent and makes no free excursion about
the joint. When not detected it may be suspected from the
description which the patient gives of his seizures.
Diagnosis.—So far as diagnosis is concerned, when a movable
body can be felt all doubt is set at rest. When it cannot
be discovered its existence may be inferred with an accuracy
proportionate to the patient’s description of his difficulties.
Treatment.—The treatment of rice-grain bodies is essentially that
of the chronic hydrarthrosis and probably tuberculous
condition which have led to their formation. It will consist usually in
arthrotomy, with thorough irrigation; often in some form of
arthrectomy. With the larger floating bodies, the “joint mice,” the most
radical measures are the best. In most of these instances there will
be some degree at least of hydrarthrosis. The joint cavity being
distended and relaxed, the indication for arthrotomy is the more
urgent, since it will permit also of irrigation or of dry sponging, with
the same benefit with which analogous intraperitoneal conditions are
treated by the same measures. The joint may be opened by a
sufficiently ample incision, through which the foreign body or bodies
may be removed. The operator should not be satisfied with mere
removal of one, but should make a thorough search for others which
may have escaped previous detection.
Perhaps no operative measure in surgery better illustrates the
advantages of asepsis. This operation, which now can be done with
impunity, was in the pre-antiseptic era one which had a discouraging
fatality, death resulting from septic infection in about 40 per cent. of
cases.
FOREIGN BODIES IN THE KNEE-JOINT.

“Joint mice” are of sufficient frequency and significance to justify
brief separate consideration. According to Connell these may be
grouped as follows:
Those composed of foreign material, fatty tissue, fibrous
tissue, etc.;
Those composed of bone, cartilage, or of a mixture of the two.
Among the many explanations offered are the following:
Dry arthritis, with overgrowth of the margins of the cartilages;
Bony growths, separation from their attachments;
Infarct of the articular cartilage, with final separation;
Plate of bone formed outside of the joint and then invaginated;
Calcification or chondrification of enlarged synovial fringes;
Irritation and growth of embryonal cartilage or bone cells in
the synovial fringes;
Concretions whose nuclei are clots, torn fringes, or some
foreign body;
Some portion of the articular cartilages broken off by injury, or
damage and subsequent separation.
Injury figures largely in the opinion of most of the authorities, it
being well established that an injured portion of articular surface may
become subsequently detached by a fatty necrosis, spoken of by
König as osteochondritis dissecans, or by Paget as “quiet necrosis.”
Others imagine that these floating bodies are rarely of traumatic
origin.
Symptoms are usually marked and significant. There is sudden
sharp and shooting pain, sometimes so severe as to cause
faintness. Along with this there is “locking” i. e., fixation of the joint,
usually in the flexed position, probably due to the entanglement of
the floating body between the articular surfaces or between the bone
and the capsule.
It is the smaller rather than the larger bodies which give the most
acute symptoms. This “locking” may last for only a few moments or
for a number of hours and may or may not be followed by acute
effusion. When with the above symptoms the presence in the joint of
a movable mass can be made out diagnosis is complete. Some
patients discover the movable body in their own joints before they go
to the surgeon.
When the diagnosis is established the removal of the offending
material is imperative. In the pre-antiseptic era this was an extremely
hazardous operation. It is now one involving only theoretical risks.
Fig. 210 These bodies are sometimes
extremely movable and slip
about within the joint in a manner
to almost defy removal even after
the joint cavity is open. If such a
body can be felt and fixed by
digital pressure, or by the
method of “stockading”
suggested by Andrews some
years ago, i. e., fixation by
forcing sterilized pins into the
tissues around it so that it cannot
escape, it is then an easy matter
to cut down upon it and remove
it. Otherwise incision may require
to be sufficiently ample to permit
insertion of a finger and the
general exploration of the joint
before it is encountered. These
bodies sometimes exist in small
numbers, and it may be possible
to remove several through a
single opening. If the joint be
opened and explored it should
be done thoroughly in order that
nothing may escape. After
removal the capsule is closed
with buried sutures, the balance
of the wound closed as usual,
and the limb then dressed upon
a splint with absolute fixation for
several days, in order to ensure
physiological rest (Fig. 209).
Ankylosis of hip with contracture of
knee, following post-scarlatinal arthritis. ANKYLOSIS.
The term ankylosis implies angular deformity, but is used to
designate partial or complete fixation of joints, such fixation being
usually accompanied by more or less deformity or displacement. It is
a name for a condition and not for a disease, but is always produced
by the latter or by injury. The term itself implies nothing as to the
nature, extent, or appearance of the exciting cause. The actual
cause may have been disease of the joint, of the tissues around it, or
may have been the result of injury rather than of infectious or other
active disease.
For convenience we speak of fibrous, false, or pseudo-ankylosis,
and of that which is bony or actual. A more accurate use of terms
would lead us to refer to the former as contracture rather than true
ankylosis.
Contractures are the result of acute, usually septic intra-articular
and peri-articular processes, where muscle spasm is a pronounced
factor and where the intensity of the process has more or less
weakened the joint structures. The profession is hardly in the mood
to accept acute rheumatism as an infectious process. If true or not
the acute rheumatic affections are frequently followed by fibrous
ankylosis with contractures. Disfigurements of this kind are often
produced as the result of the surface lesions of severe burns or
ulcerations, followed by cicatricial contraction and the formation of
dense bands and scar tissue. This is a condition which can always
be foreseen and which should be guarded against with very great
care. (See Treatment of Burns.) Contractures also occur as the
result of certain diseases of the spinal cord, either as the result of
active contraction of one set of muscles, or of paralysis, by which the
opposing muscles are deprived of resistance and thus draw the limb
out of shape.
True ankylosis is sometimes fibrous, sometimes osseous, and
occasionally both combined. The older the case the more probable is
actual osseous union of joint surfaces. Bony ankylosis implies a
sharply destructive type of arthritis, which may have been originally
of pyogenic, gonorrheal, or tuberculous character, or else indicates a
series of very slow ossific and calcific changes, such as are
connected with the osteo-arthritis already described. Many of these
cases are to be referred to lesions of the cord, and many of them are
of polyarticular character. Fig. 195, illustrating one of the cases of so-
called “ossified men” under the writer’s observation, will portray a
series of lesions of this kind, most of the vertebral as well as the
other joints being involved in an absolute osseous union.
Fig. 211 Fig. 212
Bony ankylosis of hip. (Ransohoff.) Bony ankylosis of knee. (Ransohoff.)

Fig. 213
Bony ankylosis of hip with deformity. (Ransohoff.)
When a joint is stiff bony ankylosis may be inferred. So long as

there is any motion possible it is essentially of the fibrous type. The
condition is one easy of recognition, and is seen in all degrees of
completeness. In many instances joint fixation is accompanied by
adhesions of tendons and tendon sheaths, while as time passes all
the structures around a joint thus fixed become less movable and
more stiffened. Even the patella may become firmly attached to the
bony surface upon which it normally rests, and thus interfere with
motion of the knee almost as much as though the femur and the tibia
were alone involved. Occasionally one of the acute exanthems is
followed by contractures of a joint, with or without actual joint lesions,
by which when neglected distressing deformities are produced; such,
for instance, as partial flexion and fixation of the knees, or such
stiffening of the hips as to prevent the thighs from being separated.
While in such cases stiffening cannot always be prevented, deformity
at least can be if suitable measures instituted sufficiently early.
Figs. 211 and 212, from Ransohoff, illustrate osseous union in the
hip and the knee, while Fig. 213 illustrates the deformity which may
be produced by contractures and ankylosis at the hip.
The following tabular presentation of the types of ankylosis will
perhaps convey the greatest amount of information in small space:
Capsular
Peri- Tendinous
-
articular Extracapsular - Tendovaginal
Ankylosis, true and false - Muscular
Synovial
Articular - Cartilaginous
Osseous
Murphy has prepared the following table of the types of arthritis

which lead to some of these varieties, and which may be classed as
follows:
(a) Primary hematogenous fibrous arthritis
(b) Dry fibrous arthritis. Non-traumatic
With fracture into joint
(c) Traumatic fibrous arthritis -
Without fracture (contusion)
Cryptogenetic
Typhoid
Scarlatina
Hematogenous - Metastatic -
Pyemia
Arthritis - Gonorrhea
(d)
- Traumatic
Suppurative
Tuberculous
Osteitis - Osteomyelitic
Extension - (infective)
Peri-arthritis (phlegmon)
Panarthritis
(e) Ossifying arthritis (primary)
(f) Static adhesive
Treatment.—The best method of treatment should be determined

by the original character of the exciting cause, the
duration of the condition, the amount of deformity present, and the
degree of joint fixation. That which will be possible if done early will
be useless if not resorted to until the case is old and chronic. In
every acute or subacute condition which may threaten ankylosis
every possible precaution should be taken to prevent it. If ankylosis
be inevitable it should occur with the limb in the most suitable
position. At the elbow, for example, this will be the right-angle
position; at the knee, one with the leg almost completely extended.
In the lower extremity traction with weight and pulley will serve a
useful purpose in many instances, either to overcome a threatening
condition or to improve one actually existant. Mechanical measures
(i. e., use of various splints or forms of orthopedic apparatus) will
sometimes be of great use. These may be arranged for the purpose
of providing absolute rest, with fixation in a desirable position rather
than in one which is undesirable, or they may be made with such
devices as shall permit of frequent change of position.
The mildest operative measure which can be practised in these
cases is manipulation, either gentle and frequent, combined with
massage, or more violent and painful, such as requires anesthesia
for its performance. The question of when to resort to these
manipulations is one calling for the soundest judgment, as on one
side the surgeon faces the possibility of setting up a renewed and
more or less acute disturbance, and on the other of seeing a joint
gradually stiffen, perhaps in a bad position. There is also a third
difficulty, i. e., the necessity for continuing motion in order to prevent
the re-formation of adhesions, and this in spite of the fact that it may
be intensely painful to the patient. Fortunately, however, the use of
nitrous oxide anesthesia usually permits this to be done as often as
may be necessary with a minimum of discomfort.
Firm, fibrous ankylosis will be attacked with great hesitation by the
experienced surgeon. Even though he may succeed in restoring the
limb to a better position, he may feel quite positive that the patient
cannot undergo the pain of the subsequent frequent handling. With
bony ankyloses he may feel that nothing short of radical measures
will suffice. Here it is rarely a question of restoring motility but rather
of overcoming deformity. At the knee a wedge-shaped portion of the
joint may be removed, its angle corresponding to the angle of
deformity, and thus a crooked leg may be restored to the straight
position; in fact, with a raised heel under such a limb it may be made
almost as useful as ever. At the hip one may do a subcutaneous
osteotomy, dividing the femoral neck either with chisel or with a small
and protected saw, and then bringing the limb down into the normal
position of extension, allowing the bone to repair itself, and effecting
improvement only in position, or, by constantly moving it, securing a
false joint; or a more formal exsection may be made and by
removing the head of the femur and clearing out the acetabulum a
degree of motion may be established at this point. At the wrist,
elbow, and shoulder-joint resections will usually give good results if
the operation be performed before the muscles have almost
disappeared by atrophic processes.
Danger attaches to the performance of the so-called bloodless
operations, in that there is a possibility of laceration of nerve trunks
or of large vessels which may have become fixed in the condensed
tissues and be torn with them. There is more danger of this perhaps
at the knee than in other joints, and ruptures of the popliteal vessels
and nerves have been repeatedly reported. The first attempt in
breaking up such a joint should be to increase the degree of flexion.
If by efforts in this direction the tissues can be first released, then
there is less danger of their yielding when extension is made.
Another danger which threatens in all resistant cases, and especially
in elderly people, is fracture of bones. The writer has seen the upper
end of the tibia as well as the neck of the humerus yield under these
circumstances. In the latter event one should endeavor to prevent
bony union, and thus to gain a false joint in place of the original.
In regard to the nature of the operative attacks upon the above
types, the following is copied from Murphy:[33]
1. Tendon elongation (tendoplasty).
A. Extracapsular disease - 2. Tendovaginitis (exsection of sheath).
3. Cicatrices (removal).
1. Adhesive synovitis (exsection of capsule).

B. Intracapsular -
2. Replacement by aponeurosis or muscle.
1. Disconnect bones.
2. Remove neighboring bony processes or
prominences.
C. Osseous - 3. Liberate soft parts.
4. Prevent subsequent bony contact.
5. Interpose tissue to form hygroma or fibrous
surface.
D. Joints suitable for - 1. Mandibular.

operation. 2. Hip.
3. Shoulder.
4. Elbow.
5. Knee.
1. Flap formation (skin flap with fascia, or

muscular).
2. Exposure of ankylosed area.
3. Osseous separation.
E. Technique - 4. Transplantation and fixation of interposition
flap.
5. Replacement of bone.
6. Fixation of parts.
7. Drainage.
1. Passive motion
F. Subsequent treatment - 2. Active motion.
3. Forced traction.
[33] Journal American Medical Association, May 20, 1905, p. 1573.
To the various expedients which may be adopted for making

stiffened joints more useful may be given, in a general way, the term
arthroplasty. A variety of mechanical contrivances have been
resorted to in the past, operators hoping to be able to secure, for
instance, a movable knee instead of one which is stiff. Artificial joints,
made of celluloid, ivory, etc., have been used for experimental
purposes, but while occasionally they have given good results in
animals, they have rarely been satisfactory in man. For the
prevention of re-adhesion, plates of celluloid, thin metal, gutta-
percha, rubber, etc., have been used. These are either wrapped
around a bone end or are used for lining a bone cavity, and rapidly
accumulating experience is showing that this may be done with great
benefit.
Thoroughness of operative work is one of the important
contributing agents to the securement of wide range of motion,
especially in complete removal of synovial membrane, capsule, and
ligaments. Soft parts should be liberated thoroughly. Of the materials
which can be interposed between bone ends in order to prevent
reunion, muscular aponeurosis, with a certain amount of fatty tissue,
makes the best material for interposition. When aponeurosis cannot
be secured, then muscle should be tried, with some fat, as the
former flattens out and undergoes structural changes, with
conversion into fibrous tissue.
It should be represented to the patient as a legitimate scientific
experiment, and in such a way that no matter what may happen no
blame can be attached to the operator. In general it may always be
stated that the older the lesion the less satisfactory will be any
measure of treatment except possibly resection and arthroplasty.
ARTHRODESIS.
This term applies to the intentional production of ankylosis in a
joint previously healthy or nearly so, with the intention of stiffening a
useless limb and thus enhancing its usefulness. The measure
applies mainly to those cases of infantile paralysis, with loss of
control of the knee or ankle, or both, when by stiffening the limb it
can be made to serve the purpose of a crutch. It is the last resort in
this direction when there is no possibility for tendon grafting. Long
confinement of a limb in a fixed dressing will lead to considerable
stiffening of the joint, yet a joint so immobilized lacks that firmness of
support called for in cases above mentioned. Therefore when it is
desired to perform arthrodesis the joint is usually opened and more
or less of its articular surface removed, the intent being to produce
the effect in the shortest time and in the best way. It can be better
attained by a removal of articular surfaces with the saw and the
apposition of fresh bone surfaces to each other, their retention being
ensured either by sutures (tendon or wire) or accurate fixation in
plaster of Paris. Under these circumstances drainage should not be
necessary, and limbs can be completely enclosed in a fixed
dressing.
MAJOR OPERATIONS ON JOINTS.

Aside from arthrotomy and partial or complete arthrectomy, as
above mentioned, the latter, including removal of synovia or
cartilage, and perhaps curetting of bone foci, the formal resections or
excisions of joints remain to be considered. The latter is the
preferable term, as it is meant to include removal of the component
parts that enter into the construction of joints, while the term
resection implies rather the removal merely of portions of bone.
Joint excisions are practised especially for the following purposes:
(a) To atone for the result of old unreduced dislocations; (b) in certain
compound dislocations, with or without fracture; (c) in certain
comminuted fractures where there is no prospect of recovery with
useful joints; (d) in the destructive forms of acute arthritis where the
entire joint is disorganized and the bone ends carious; (e) in
tuberculous arthritis or panarthritis, with or without suppurative
complications; (f) in occasional instances of disabling osteo-arthritis;
(g) for relief of ankylosis, either for improvement of position (knee) or
restoration of motion; (h) occasionally after gunshot injuries.
Excisions required by the exigencies of traumatisms should be
promptly done. If the case be complicated with septic infection the
prognosis is much less favorable. For convenience of description
excisions may be classified as primary, intermediary, and secondary.
According to the joint involved, as at the knee, the purpose
underlying the operation is to effect an absolutely rigid bony
ankylosis.
The development and perfection of the general method of joint
excisions is a matter of but little more than a century. Previous to that
time amputation was almost the only resort when destruction had
occurred. The most prominent surgeons in the early development of
the measure were Park, of Liverpool, and Moreau, of France. During
the latter part of the past century Ollier, of Lyons, greatly improved
the technique by demonstrating the importance of the periosteum
and by introducing the so-called subperiosteal methods. This is of
great value in uninfected cases. It is a mistake, however, to
endeavor to save periosteum which has become involved in the
tuberculous process; in fact, in the presence of tuberculous disease
we cannot be too radical in the removal of all affected tissue.

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4. The market portfolio consists of all risky assets.

10. Beta is a measure of unsystematic risk.

16. There can be only one zero-beta portfolio.

25. The "true" market portfolio is unknown.

1. Which of the following is not an assumption of the Capital Market Theory?

2. The rate of return on a risk free asset should equal the

3. Which of the following statements about the risk-free asset is correct?

4. What does WRF = −0.50 mean?

5. The market portfolio consists of all

6. The separation theorem divides decisions on ____ from decisions on ____.

14. All portfolios on the capital market line are

23. In the presence of transactions costs, the SML will be

24. If the wrong benchmark (or market portfolio) is selected then

26. Beta is a measure of:

27. The Efficient Frontier refers to a set of portfolios that

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

COVRA,MI = 121.33  5 = 24.27

MI2 = 87.33  5 = 17.47  MI = 4.18

Beta for RA is (RA) = COVRA,MI  MI2 = 24.27  17.47 = 1.3893

RA2 = 387.33  5 = 77.47  RA = 8.8

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

The equation for the of the characteristic line for RA is:

PTS: 1 OBJ: Multiple Choice Problem

Return (RA) = −9.4122 + 1.3893(12) = 7.26%

PTS: 1 OBJ: Multiple Choice Problem

Current Expected Expected

Y .03 + 1.50(.08 − .03) = 10.5% overvalued

Z .03 + 0.9(.08 − .03) = 7.5% undervalued

PTS: 1 OBJ: Multiple Choice Problem

Y .03 + 1.50(.08 − .03) = 10.5% overvalued

Z .03 + 0.9(.08 − .03) = 7.5% undervalued

PTS: 1 OBJ: Multiple Choice Problem

Y .03 + 1.50(.08 − .03) = 10.5% overvalued

Z .03 + 0.9(.08 − .03) = 7.5% undervalued

PTS: 1 OBJ: Multiple Choice Problem

Estimated Return < Expected Return

PTS: 1 OBJ: Multiple Choice Problem

Estimated Return < Expected Return

6. The separation theorem divides decisions on from decisions on .