APT

Question 1

Assumptions of CAPM and APT

Answer 1

To derive the CAPM several unreasonable assumptions were needed

1. Investors have mean-variance preferences
2. Investors have same expectations
3. Investors plan for one identical holding period
4. Investors borrow and lend at a fixed risk-free rate
5. Investors are price-takers
6. Investors pay no taxes nor transaction costs

The APT is based on only three (and more reasonable) assumptions

1. Secuity returns can be described by a factor model
2. Idiosyncratic risk can be diversified away
3. Markets are perfectly competitive: there are no arbitrage opportunities (…APT)

Question 2

What kind of portfolios do APT apply?

Answer 2

APT applies only to well- diversified portfolio.

Question 3

Both CAPM and APT stipulate

Answer 3

a relationship between expected return and risk

Question 4

In a multi-factor APT model, the coefficients on the macro factors are often called

Answer 4

factor betas, factor sensitivities, or factor loadings.

Question 5

Guidance as to determination of the risk premium on various facctors

Answer 5

The multifactor APT provides no guidance as to the determination of the risk premium on the
various factors. The CAPM assumes that the excess market return over the risk-free rate is
the market premium in the single factor CAPM.

Question 6

An arbitrage opportunity exists if an investor can construct a __________ investment
portfolio that will yield a sure profit.

Answer 6

Zero
If the investor can construct a portfolio without the use of the investor’s own funds and the
portfolio yields a positive profit, arbitrage opportunities exist.

Question 7

The APT was developed in 1976 by

Answer 7

Ross

Question 8

What is arbitrage?

Answer 8

Arbitrage is earning of positive profits with a zero (risk-free) investment.

Question 9

In developing the APT, Ross assumed that uncertainty in asset returns was a result of

Answer 9

both common macroeconomic factors and firm-specific factors

Question 10

An investor will take as large a position as possible when an equilibrium price
relationship is violated. This is an example of _________.

Answer 10

a risk-free arbitrage
When the equilibrium price is violated, the investor will buy the lower priced asset and
simultaneously place an order to sell the higher priced asset. Such transactions result in riskfree
arbitrage. The larger the positions, the greater the risk-free arbitrage profits.

Question 11

What is the difference between CAPM and APT

Answer 11

The CAPM assumes that market returns represent systematic risk. The APT recognizes that
other macroeconomic factors may be systematic risk factors.

Question 12

What is the advantage of APT over CAPM?

Answer 12

The APT provides no guidance concerning the determination of the risk premiums on the
factor portfolios. Risk must be considered in both the CAPM and APT.
A major advantage of
APT over the CAPM is that a specific benchmark market portfolio is not required.

Question 13

To take advantage of an arbitrage opportunity, an investor would

Answer 13

1. construct a zero investment portfolio that will yield a sure profit.
2. make simultaneous trades in two markets without any net investment.
3. buy the asset in the low-priced market and short sell in the high-priced market.

Question 14

The factor F in the APT model represent

Answer 14

the deviation from its expected value of a factor that affects all security returns.
（F measures the unanticipated portion of a factor that is common to all security returns.）

Question 15

Which of the following factors were used by Fama and French in their multi-factor
model?

Answer 15

1. Return on the market index.
2. Excess return of small stocks over large stocks.
3. Excess return of high book-to-market stocks over low book-to-market stocks.