Empirical Evidence on Security Returns

Question 1

True or false.

The key property of the expected return-beta relationship described by the SML is that the expected excess return on securities is determined only by systematic risk (as measured by beta) and should be independent of nonsystematic risk, as measured by the variance of the residuals, which also were estimated from the first-pass regression.

Answer 1

True

Question 2

Which of the following factors are likely candidates to increase the market risk factor in a multifactor SML?

a) Factors that hedge consumption against uncertainty in prices of important consumption categories of general inflation.
b) Factors that hedge future investment opportunities (interest rates, market volatility, market risk premium).
c) Factors that hedge assets missing from the market index (labor income or private business).
d) All of the above

Answer 2

d) All of the above

Question 3

When betas are measure against the true market portfolio, which includes aggregated labor income, the SML will be________ than that of the simple CAPM.

a) Steeper
b) Flatter
c) Constant
d) This cannot be determined

Answer 3

b) Flatter

Labor income is not perfectly correlated with the market-index portfolio, hence the possibility of negative returns to labor will represent a source of risk not fully captured by the index. Stocks with a positive beta on the value of labor contribute to this risk factor; therefore, they will command lower prices or equivalently, provide a larger-than-CAPM risk premium. By adding this factor, the SML becomes multidimensional.

Question 4

True or false.

On average, ‘glamour firms’, which are characterized by recent good performance, higher prices and lower B/M ratios tend to overperform ‘value firms’ because their high prices reflect excessive optimism relative to those lower B/M firms.

Answer 4

False.

on average, ‘glamour firms’, which are characterized by recent good performance, higher prices and lower B/M ratios tend to UNDERperform ‘value firms’ because their high prices reflect excessive optimism relative to those lower B/M firms.

Question 5

Following is NOT true about Roll’s critique to testing CAPM using first- and second pass regressions.

a) Roll suggests that the problem begins with the market index, which is not the theoretical portfolio against which the second pass regression should hold. Instead, one should use the return of a zero-beta stock portfolio as a proxy for risk free rate.
b) According to Roll, even if the relationship is valid with respect to the true (unknown) index, we may not find it. As a result, the second pass relationship may be meaningless.
c) Roll suggests that the CAPM is not testable in any circumstances if R^2 is too low
d) According to Roll, we would need also data on the individual investors’ wealth. Not knowing the true composition of the market portfolio makes the CAPM untestable.

Answer 5

c) Roll suggests that the CAPM is not testable in any circumstances if R^2 is too low. This is not part of Roll’s critique. Instead, Roll argues that due to lack of data on market portfolio composition, i.e., the wealth of the investor, CAPM is untestable. Instead, one should use a portfolio of zero-beta stocks as the theoretical portfolio against which the second pass regression should hold. This zero-beta portfolio return would be a substitute for the risk free rate.

Question 6

Following is NOT true about measurement error in CAPM test:

a) In reality, we cannot observe the true beta nor expected return, which we in turn need to estimate. By construct, an estimation entails some degree of measurement error.
b) If it was possible to observe the true beta, and the true expected return, it would be very easy to test for the CAPM due to no measurement error.
c) The effect of measurement errors can be reduced by looking at portfolios rather than individual securities, since the latter case, e.g., a high-beta security is more likely to be affected by a positive measurement error. Instead, in a portfolio of e.g., 50 stocks, it is more likely that a positive measurement error is offset by a negative measurement error in another stock. The basket is more stable than the individual components.
d) All options are correct

Answer 6

d) All options are correct

Question 7

True or false

Wealth and consumption should be positively correlated and, hence, market volatility and consumption volatility should also be positively correlated. Periods of high market volatility might coincide with periods of high consumption volatility.

Answer 7

True

Question 8

Concerning the conventional CAPM and CCAPM (consumption CAPM), which of the following statements are NOT true?

a) CCAPM differs from the conventional CAPM in the beta being measured relatively to consumption growth rather than market growth.
b) CCAPM argues that what matters to investors is not their wealth per se, but their lifetime flow of consumption.
c) The conventional CAPM focuses on the covariance of security returns with returns for the market portfolio (which in tracks aggregate wealth), while the consumption-based CAPM focuses on the covariance of security returns with returns for a portfolio that tracks consumption growth.
d) All of the options are correct

Answer 8

d) All of the options are correct

Question 9

Which is NOT a hypotheses for the second-pass regression for a two-factor SML?

a) The intercept is zero
b) The slope is equal to the average return on the index portfolio
c) The factor slope coefficient equals the average return on the factor
d) All of the above are correct

Answer 9

d) All of the above are correct

Question 10

Which is NOT a hypotheses for the second-pass regression for a one-factor SML?

a) The intercept is zero
b) The slope is equal to the average return on the index portfolio
c) The factor slope coefficient equals the average return on the factor
d) All of the above are correct

Answer 10

c) The factor slope coefficient equals the average return on the factor

Question 11

True or false

Even if the single-factor CCAPM (with a consumption-tracking portfolio used as the index) performs better than the CAPM, it is still possible that the consumption portfolio does not capture the size and growth characteristics captured by the SMB (i.c., small minus big capitalization) and HML (i.e., high minus low book-to-market ratio) factors of the Fama-French three-factor model. Therefore, it is expected that the Fama- French model with consumption provides a better explanation of returns than does the model with consumption alone.

Answer 11

True

Question 12

Which of the following is NOT true about the Equity Premium Puzzle?

a) originates from the observation that equity returns exceeded the risk-free rate to an extent that is inconsistent with the covariance of returns with consumption risk and reasonable levels of risk aversion.
b) the equity premium puzzle is the result of applying a full rationality model of investor choice to equity investment.
c) a plausible explanation for the puzzle is survivorship bias
d) a plausible explanation for the puzzle is unexpected capital gain
e) all of the above are correct

Answer 12

e) all of the above are correct

Question 13

According to the CAPM, what should be the intercept of SCL when regressions are stated in the excess return form?

Answer 13

When stated in excess return form, the SCL should pass through the origin, that is, have a zero intercept.

Question 14

When the SML has a _____ intercept and its slope is less than the mean excess return on the market portfolio, it is _____ than predicted by the CAPM.

a) Positive, constant
b) Negative, flatter
c) Positive, flatter
d) Positive, steeper

Answer 14

c) Positive, flatter

Question 15

True or false

Low-beta stocks are found to have yielded returns that, on average, were higher than they should have been on the basis of their beta. Conversely, high-beta stocks were found to have yielded, on average, lower returns than they should have on the basis of their betas.

Answer 15

True

Question 16

What would you conclude if you performed the Fama and MacBeth tests and found that the coefficients on β^2 and σ(e) were positive?

a) Positive β^2: that the relationship between risk and returns is linear
b) Positive β^2: that the relationship between risk and returns is nonlinear
c) Positive σ(e): firm-specific risk affects expected return
c) Positive σ(e): firm-specific risk does not affect expected return

Answer 16

b) Positive β^2: that the relationship between risk and returns is nonlinear. High-beta securities would provide expected returns more than proportional to risk.
c) Positive σ(e): firm-specific risk affects expected return, a direct contradictions on the CAPM and APT

Question 17

Following is NOT true about Roll’s critique to testing CAPM using first- and second pass regressions.

a) Roll suggests that the problem begins with the market index, which is not the theoretical portfolio against which the second pass regression should hold. Instead, one should use the return of a zero-beta stock portfolio as a proxy for risk free rate.
b) According to Roll, even if the relationship is valid with respect to the true (unknown) index, we may not find it. As a result, the second pass relationship may be meaningless.
c) Roll suggests that the CAPM is not testable in any circumstances if R^2 is too low
d) According to Roll, we would need also data on the individual investors’ wealth. Not knowing the true composition of the market portfolio makes the CAPM untestable.

Answer 17

WRONG: c) Roll suggests that the CAPM is not testable in any circumstances if R^2 is too low. This is not part of Roll’s critique. Instead, Roll argues that due to lack of data on market portfolio composition, i.e., the wealth of the investor, CAPM is untestable. Instead, one should use a portfolio of zero-beta stocks as the theoretical portfolio against which the second pass regression should hold. This zero-beta portfolio return would be a substitute for the risk free rate.

Question 18

Following is NOT true about measurement error in CAPM test:

a) In reality, we cannot observe the true beta nor expected return, which we in turn need to estimate. By construct, an estimation entails some degree of measurement error.
b) If it was possible to observe the true beta, and the true expected return, it would be very easy to test for the CAPM due to no measurement error.
c) The effect of measurement errors can be reduced by looking at portfolios rather than individual securities, since the latter case, e.g., a high-beta security is more likely to be affected by a positive measurement error. Instead, in a portfolio of e.g., 50 stocks, it is more likely that a positive measurement error is offset by a negative measurement error in another stock. The basket is more stable than the individual components.
d) All options are correct

Answer 18

d) All options are correct

Question 19

Following is NOT true about bubbles:

a) The price of stocks can be explained on the basis of fundamentals such as expectations of dividends discounted by an appropriate discount rate, reflecting the time value of money and risk. Bubbles, however, to some extent, represent deviations from fundamental market efficiencies.
b) Bubbles is an extra component of the price that simply depends on the expectations that the price is moving up in the coming period. I.e., in the presence of a bubble, prices appear to differ from intrinsic values. It is suggested that the price of a stock in the market is equal to the sum of the fundamental value and the bubble (if there is one)
c) Bubbles are difficult to predict and exploit. We only know the price of the stock, not the actual value. Thus, we cannot determine accurately the size of the bubble, and it is difficult to determine whether there is a bubble, and if yes, how big.
d) Bubbles are easier to spot right before they burst
e) Bubbles are easier to spot after they burst

Answer 19

WRONG: d) Bubbles are easier to spot right before they burst.
INSTEAD: e) Bubbles are easier to spot after they burst

Question 20

Following is NOT trues about Technical analysis:

a) uses prices and volume information to predict stock price patterns and to proxy buy or sell pressure in the market.
b) is always more optimistic in predicting future stock prices than fundamental analysis provided that market is efficient
c) If we were able to show that technical analysis was actually successful in predicting stock prices, we would provide the results of a weak form of market efficiency, since we would be able to predict prices simply on the basis on past prices and volume.
d) All of the above are true

Answer 20

WRONG: b) Both technical analysis (B) and fundamental analysis (C) are based on public information, and thus, neither should generate excess profits if markets are operating efficiently.

Question 21

True or false.

The consumption-based asset pricing model (CCAPM) is exactly like the regular CAPM, but differs in the beta being measured relatively to consumption growth rather than market. It implies that what matters to investors is not their wealth per se, but their lifetime flow of consumption. Given this framework, the generalization of the standard CAPM is that instead of measuring systematic risk based on the covariance of returns with the market return (a measure that focuses only on wealth), we are better off using the covariance of returns with aggregate/ economywide consumption.

Answer 21

True