Student name:__________

MULTIPLE CHOICE - Choose the one alternative that

best completes the statement or answers the question.
1) In the equation R = E(R) + U, the three symbols, from
left to right, stand for:

D) required
A) average return, expected return, and unexpected return, expected return,
return. and unbiased risk.
B) required return, expected return, and unbiased E) required return,
return. expected return, and
C) actual return, expected return, and unexpected unsystematic risk.
return.

2) The unexpected return on a security is made up of:

E) expected return
A) market risk and systematic risk. and idiosyncratic risk.
B) systematic risk and unsystematic risk.
C) idiosyncratic risk and unsystematic risk.
D) expected return and market risk.

3) The stock of a silver mining company most likely has

a:

E) beta equal to
A) zero inflation beta. the risk-free beta.
B) positive inflation beta.
C) beta that exactly matches the market beta.
D) negative inflation beta.

4) As used in the market model, the symbol "ε"

represents:

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 E) the expected
A) unsystematic risk. change in GNP.
B) beta.
C) systematic risk.
D) a stock's response to systematic risk.

5) The symbol “FI” is best defined as the:

rate.
A) indicated GNP value. E) surprise change
B) first and primary source of unexpected returns. in interest rates.
C) initial expected rate of return.
D) actual inflation rate minus the expected inflation

6) If an announcement by a firm causes the price of that

firm's stock to suddenly change, that price change will most
likely be driven by:

E) expectations of
A) the expected part of the announcement. a revised announcement in
B) market inefficiency. the near term.
C) the unexpected part of the announcement.
D) systematic risk.

7) Company A is a medical research company that

develops and tests new drugs. Company B is in the news
industry and publishes multiple newspapers. If Company A
discovers a new product and its stock rises in value by 5
percent as a result, this will most likely have ___ effect on
Company B's stock price because the discovery would be
classified as _______ risk.

C) a large; a
A) no; a systematic systematic
B) no; an unsystematic D) a large; an

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unsystematic
E) an indeterminate; market

8) If a security has a GNP beta of 1.5, then the security's

total rate of return will:

percentage change in GNP

A) increase by 1.5 percent for every 1 percent divided by a factor of 1.5.
decrease in GNP. E) increase by 1.5
B) increase by 1.5 percent every time the GNP percent whenever the GNP
increases by 1.5 percent. increases by 1.5 percent.
C) change by an amount equal to 1.5 times the
percentage amount of any unexpected change in GNP.
D) change by an amount equal to the unexpected

9) If the expected rate of GNP growth was 3 percent and

the actual rate was .2 percent higher than the expectation, the
total return on a stock would change by ____ based on a
multifactor model.

D) −3.2βGNP
A) 3.2βGNP E) 3βGNP
B) .2βGNP
C) −.2βGNP

10) A three-factor model would most likely include

factors such as:

E) GNP, interest
A) tax rates, inflation, and profit margin. rates, and PE ratios.
B) PE ratio, price-to-book ratio, and firm size.
C) firm size, inflation, and GNP.
D) inflation, GNP, and interest rates.

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11) A beta coefficient reflects the response of a security's return to:

E) idiosyncratic
A) the risk-free rate. risk.
B) an unsystematic risk.
C) a systematic risk.
D) the market rate of return.

12) Based on a multifactor model, systematic risk arises

from:

E) a positive
A) a common factor, F. covariance between
B) negative betas. securities.
C) the lack of market liquidity.
D) the variable, ε.

13) In a portfolio of risky assets, the portfolio's response

to any factor, Fi, can be determined by:

E) dividing the
A) multiplying the portfolio weighted average βi by percentage change in the
the factor Fi.. factor, Fi, by the total
B) computing the portfolio weighted average Fi. number of factors affecting
C) multiplying the CAPM beta times the factor. the portfolio.
D) summing the weighted random errors.

14) Based on a multifactor model, the concept of portfolio

diversification is to minimize which one of the following?

C) F
A) Weighted average β D) Weighted
B) Weighted average of (β × F) average of ε

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 E) Weighted average of E(R)

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15) A security held in a large, well-diversified portfolio
that has a beta of zero in a one-factor model will have an
actual return:

E) that is less than

A) of zero. the risk-free rate and can
B) closely equal to the market risk premium. be negative.
C) closely equal to the expected return.
D) that is positive and less than the risk-free rate.

16) Assume a security has no unsystematic risk. Given

this, the excess return on that security will be the highest if
the factor, F, ____ and the beta for that factor is ____.

E) decreases in
A) increases in value; high value; low
B) increases in value; low
C) remains constant; zero
D) decreases in value; high

17) Which type of risk is unaffected by portfolio

diversification?

E) All types of
A) Unsystematic risk risk are affected by
B) Idiosyncratic risk portfolio diversification.
C) Total risk
D) Systematic risk

18) If a large number of diverse securities are added to a

portfolio comprised of three stocks, then the:

A) weighted

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average expected return goes to zero. of return.
B) weighted average of the factor betas goes to zero. E) return of the
C) weighted average of the unsystematic risk goes to portfolio will equal the
zero. risk-free rate.
D) return of the portfolio must equal the market rate

19) Which one of the following statements is true?

unsystematic risk.
A) A well-diversified portfolio has negligible E) Both a well-
systematic risk. diversified portfolio and an
B) A well-diversified portfolio has negligible individual security have
unsystematic risk. negligible unsystematic
C) An individual security has negligible systematic risk.
risk.
D) An individual security has negligible

20) If an investor plans to add a stock to a well-diversified

portfolio, the investor should first consider the _____ risks of
that additional stock.

D) idiosyncratic
A) expected total E) firm-specific
B) historical total
C) systematic

21) Consider the security market line (SML) under the

one-factor model. Assume Point C lies on the SML but an
investor would prefer a point that also lies on the SML but is
lower and to the left of Point C. How can this investor obtain
that point for their portfolio?

B) Sell a portion
A) Replace the lower beta stocks in the portfolio with of the portfolio and use the
higher beta stocks proceeds to purchase

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undervalued stocks higher beta portfolio that
C) Sell the higher beta stocks in the portfolio and lies on the SML and risk-
replace them with undervalued stocks free assets
D) Replace the portfolio with undervalued stocks and
risk-free assets
E) Replace the portfolio with a combination of a

22) The slope of the security market line represents the:

E) market risk
A) risk-premium for an individual security. premium.
B) risk-free rate of return.
C) market rate of return.
D) total return per unit of beta.

23) The single-factor model generally uses ___ as the

single factor.

E) the risk-free
A) arbitrage fees return
B) GNP
C) the inflation rate
D) the market risk premium

24) Assuming the single-factor model applies, the factor

beta for the market portfolio is:

data.
A) zero. E) irrelevant to
B) one. the model.
C) the average of the risk-free beta and the beta for
the highest risk security in the portfolio.
D) impossible to calculate without collecting sample

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25) Assume the single-factor model is applied to a security that has a negative factor
beta. The security will:

of return.
A) always have a positive rate of return. E) have an actual
B) have an expected return greater than the risk-free rate of return that can be
rate. positive, negative, or zero.
C) have an actual return that equals the risk-free rate.
D) have an expected return equal to the market rate

26) Estimating the rate of return for any portfolio lying on

the security market line requires which of the following?

E) Portfolio beta,
A) Market rate of return and the portfolio beta the risk-free rate, and the
B) Market rate of return, market beta, and the risk- market risk premium
free rate
C) Risk-free rate, factor beta, and the industry beta
D) Factor beta and the market risk premium

27) The acronym APT stands for:

E) assured price
A) arbitrage pricing techniques. techniques.
B) absolute profit theory.
C) arbitrage pricing theory.
D) asset pricing theory.

28) A factor, as used in APT, is a variable that:

D) measures the
A) represents a nondiversifiable risk. response of a specific asset
B) affects the returns of risky assets in an to a systematic risk.
unsystematic fashion. E) represents a
C) correlates the returns of a risky asset with those of firm-specific risk.
a risk-free asset.

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29) A criticism of the CAPM is that it:

D) utilizes too
A) ignores the rate of return on the market portfolio. many factors.
E) contradicts the
B) ignores the risk-free rate. single-factor APT model.
C) requires a single measure of systematic risk.

30) The general purpose of identifying multiple factors in

the APT model is to:

unsystematic risk of one

A) identify the top three factors that have the largest security is unrelated to the
impact on the market rate of return. unsystematic risk of any
B) identify and eliminate all systematic risks from a other security.
portfolio. E) reduce the
C) identify the quantity of each factor that is needed slope of the security
to reduce a portfolio's risk, as measured by beta, to a level market line, thereby
equal to that of the overall market. reducing portfolio risk.
D) reduce the unsystematic risk to a level where the

31) If you were to consider the CAPM as a one-factor

model, then the factor would be the:

E) individual beta
A) rate of inflation. of each security or
B) market risk premium. portfolio.
C) GNP.
D) risk-free rate.

32) Which one of the following statements is true?

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 estimate of a security's
A) Both APT and CAPM argue that expected excess expected return than does
return must be proportional to the beta(s). APT.
B) APT and CAPM are the only quantitative E) CAPM assigns
approaches to measure expected returns in risky assets. a beta of 1 to the market
C) The factors to be used in the APT are easier to while APT assigns the
identify than the factor used in the CAPM. market a beta of zero.
D) CAPM provides the means for a more-detailed

33) Parametric or empirical models rely:

firm’s realm of control.

A) on security betas explaining systematic factor E) primarily on
relationships. financial market models
B) on finding regularities and relations in past market and theories.
data.
C) on security returns always being located on the
capital market line.
D) solely on factors within the security’s issuing

34) When using the empirical approach, rather than a risk-

based model, to compute an expected rate of return on a
security, the beta values are replaced with:

the risk-free rate.

A) the ratio of the market rate of return to the risk- E) the average
free rate. standard deviation of the
B) a singular value equal to the market-to-book value security's historical returns.
of the firm.
C) the firm's various attributes.
D) the ratio of the firm's historical average return to

35) A growth-stock portfolio is probably best

characterized as having a:

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 D) low PE ratio as
A) high PE ratio as compared to the overall market. compared to the overall
market.
B) lower risk premium than the overall market. E) a lower beta
C) low level of systematic risk and a high level of than the overall market.
unsystematic risk.

36) When selecting a benchmark, it is important to match

the security or portfolio that will be evaluated to securities:

E) of similar style
A) that have an opposing style. that are available for
B) that have identical factor betas for all factors in purchase.
the pricing model being utilized.
C) that closely mimic the overall market.
D) with the same PE ratios.

37) The Fama-French three-factor model seems to support

the notion that higher returns can best be earned over time on:

E) the overall
A) large, growth stocks. stock market.
B) large, value stocks.
C) small, value stocks.
D) small, growth stocks.

38) The systematic response coefficient for productivity,

βp, would produce an unexpected change in any security
return of (βP ×____) if the expected rate of productivity was
1.5 percent and the actual rate was 2.25 percent.

D) − 2.25 percent
A) .75 percent E) 1.5 percent
B) −.75 percent
C) 2.25 percent

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39) Alpha stock has an expected return of 8.2 percent and
betas of: βGNP = 1.23; βI = .97; and βEx = 1.08. This expectation
is based on a three-factor model with expected values of:
GNP growth of −1 percent; inflation of 2.4 percent; and
export growth of 3.5 percent. However, actual growth in these
factors turns out to be .55 percent, 1.8 percent, and 2.6
percent, respectively. Assuming there was no unexpected
news related specifically to the stock, what was the stock's
total rate of return?

D) 7.85 percent
A) 8.04 percent E) 8.85 percent
B) 8.55 percent
C) 8.47 percent

40) Overton Markets stock has an expected return of 7.8

percent and betas of: βGNP = 1.06; βI = 1.01; and βEx = .52.
This expectation is based on a three-factor model with
expected values of: GNP growth of 2.6 percent; inflation of
3.1 percent; and export growth of 1.4 percent. However,
actual growth in these factors turns out to be 3.1 percent, 2.6
percent, and .2 percent, respectively. Calculate the stock's
total return if the company unexpectedly announces that an
important patent filing has been granted sooner than expected
and will earn the company 5 percent more in return, (i.e. from
10 percent up to 15 percent).

D) 10.90 percent
A) 16.02 percent E) 11.02 percent
B) 12.20 percent
C) 11.55 percent

41) Outdoor Products stock has an expected return of 12.6 expected values of: GNP
percent and betas of: βGNP = 1.52; βI = 1.06; and βEx = 1.28. growth of 3.2 percent;
This expectation is based on a three-factor model with inflation of 2.9 percent;

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and export growth of 2.2 percent. However, actual growth in temporarily which will
these factors turns out to be 3.6 percent, 3.2 percent, and 2.5 reduce the return by 7
percent, respectively. Calculate the stock's total return if the percent (from 10 percent
company unexpectedly announces they had an industrial down to 3 percent).
accident and the operating facilities will close down

D) 7.42 percent
A) −4.05 percent E) −1.85 percent
B) 6.91 percent
C) 3.57 percent

42) Suppose you identified three important systematic risk

factors given by exports, inflation, and industrial production.
At the beginning of the year, a firm's stock return is estimated
at 9.6 percent and the growth in the three factors is estimated
at −1 percent, 2.5 percent, and 3.5 percent, respectively. The
factor betas are: βEX = 1.8, βI = .7, and βIP = 1. What would be
the stock's total return if the actual growth in each of the
factors was equal to the expected growth and no unexpected
company news occurred?

D) 14.6 percent
A) 4.6 percent E) 8.7 percent
B) 5.9 percent
C) 9.6 percent

43) The systematic response coefficient for productivity,

βp, would produce an unexpected change in any security
return of [βP ×___ ] if the expected rate of productivity was
1.8 percent and the actual rate was 2.2 percent.

B) −.4 percent
A) .4 percent C) 2.2 percent

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 D) −2.2 percent E) 1.8 percent

44) Assume the single-factor APT model applies and a

portfolio exists such that half of the funds are invested in
risky Security Q and the rest in a risk-free asset. Security Q
has a beta of 1.8. The portfolio has a factor beta of:

D) 1.
A) 0. E) 1.8.
B) .8.
C) .9.

45) Assume the single-factor model applies and a portfolio

exists such that 65 percent of the funds are invested in risky
Security Q and the rest in the risk-free asset. Security Q has a
beta of 1.5. The portfolio has a beta of:

D) .975.
A) 1.500. E) 1.000.
B) .925.
C) .650.

46) Assume a one-factor model where the factor is

associated with the overall market. Suppose JSC's common
stock has a factor beta of .8, the risk-free rate is 3.2 percent,
and the expected market rate of return is 11.2 percent. What is
the expected return for JSC stock?

D) 9.60 percent
A) 10.25 percent E) 12.16 percent
B) 6.40 percent
C) 7.20 percent

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47) Suppose ABC's common stock has a return of 12.87 model, what is the factor
percent, the risk-free rate is 2.65 percent, the market return is beta?
13.46 percent, and there is currently no unsystematic
influence affecting ABC's return. Given a one-factor APT

D) .962
A) .896 E) .979
B) .945
C) 1.003

48) Suppose a sizeable, fully diversified portfolio has an

F1 beta of .9, an F2 beta of 1.4, and an expected return of 11.6
percent. If F1 turns out to be 1.1 percent and F2 is −.8 percent,
what will be the actual rate of return based on a two-factor
arbitrage pricing model?

D) 12.32 percent
A) 12.05 percent E) 12.58 percent
B) 11.47 percent
C) 11.72 percent

49) Suppose Binder Corporation's common stock has an

actual return of 12.34 percent compared to its expected return
of 12.6 percent. The risk-free rate was expected to be 4.3
percent, which it was. The beta of Fi is .9 and the beta of FGNP
is 1.1. If inflation unexpectedly increased by 1.4 percent, what
was the unexpected change in GNP?

D) −1.38 percent
A) 2.02 percent E) −2.02 percent
B) 1.38 percent
C) −.82 percent

ESSAY. Write your answer in the space provided or on a separate sheet of paper.

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50) In a multifactor model, explain what a factor
represents and the role that beta plays in relation to factors.
How do factors and betas affect the actual return?

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51) Verbally describe a graph that illustrates the one-
factor model.

52) Explain the conceptual differences in the theoretical

development of the CAPM and the APT.

53) Explain the concept of a benchmark and why

benchmarks provide value when evaluating the performance
of a security or portfolio.

Answer Key

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Test name: Chapter 12 Test Bank
1) C
2) B
3) B
4) A
5) D
6) C
7) B
8) C
9) B
10) D
11) C
12) A
13) A
14) D
15) C
16) A
17) D
18) C
19) B

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20) C
21) E
22) E
23) D
24) B
25) E
26) E
27) C
28) A
29) C
30) D
31) B
32) A
33) B
34) C
35) A
36) E
37) C
38) A
ΔR = βPFP = βP(2.25% − 1.5)
ΔR = βP(.75%)

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39) B
E(R) = .082 + 1.23[.0055 − (−.01)] + .97(.018 E(R) = .0855, or
− .024) + 1.08(.026 − .035) + 0 8.55%

40) B
E(R) = .078 + 1.06(.031 − .026) + 1.01(.026 E(R) = .1220, or
− .031) + .52(.002 − .014) + .05 12.20%

41) B
E(R) = .126 + 1.52(.036 − .032) + 1.06(.032
− .029) + 1.28(.025 − .022) − .07
E(R) = .0691, or 6.91%

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42) C
E(R) = 9.6%, which is the expected return on the stock

43) A
Ri = βPFP Ri = βP(.4%)
Ri = βP(2.2% − 1.8)
44) C
βPortfolio = .5(1.8) + .5(0)
βPortfolio = .9

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45) D
βPortfolio =.65(1.5) + (1 − .65)(0) βPortfolio = .975

46) D
E(RJSC) = .032 + .8(.112 − .032) E(RJSC) = .0960, or
9.60%
47) B
.1287 = .0265 + β(.1346 − .0265)
β = .945

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48) B
R = .116 + .9(.011) + 1.4(−.008) R = .1147, or
11.47%
49) D
(.1234 − .126) = .9(.014) + 1.1(FGNP) FGNP = −.0138, or
−1.38%
50) A factor is a variable that helps identify estimated return
the difference between an actual return and an plus the sum of the
estimated return. Each factor measures the individual betas
surprise, or unexpected change, in a specific times their
systematic risk. A factor's beta measures a respective factors,
security's or portfolio's response to a change in assuming there is no
that factor. The actual return is equal to the unsystematic risk.

51) The one-factor model can be graphed intersect the origin

with the return percent on the factor, F, on the with positive beta
horizontal axis and the excess return percent lines being
on the stock as the vertical axis. The slope of upsloping.
the line that represents a security is the factor
beta for that security. All security lines will
52) CAPM is built on the efficient set and diversified portfolio
then incorporates the use of a riskless asset. but idiosyncratic, or
The APT adds factors until there is little, if unsystematic, risk
any, correlation between the unsystematic can be eliminated.
risks of individual securities. Both processes
illustrate that systematic risk remains in a
53) A benchmark is often times an index with specific

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characteristics such as an index based on the index allows you to
S&P 500, or on an international portfolio, or compare returns
on small-growth stocks, or even on a specific against a benchmark
group of fixed-income securities. Comparing a with similar risk
specific security or portfolio against its related characteristics.

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