Exam 2 - Chapter 7 [BOOK]

Question 1

capital asset pricing model (CAPM)

Answer 1

A model that relates the required rate of return on a security to its systematic risk as measured by beta.

Question 2

market portfolio (M)

Answer 2

The portfolio for which each security is held in proportion to its total market value.

Question 3

mutual fund theorem

Answer 3

States that all investors desire the same portfolio of risky assets and can be satisfied by a single mutual fund composed of that portfolio.

Question 4

expected return–beta relationship

Answer 4

Implication of the CAPM that security risk premiums should be proportional to beta

Question 5

security market line (SML)

Answer 5

Graphical representation of the expected return-beta relationship of the CAPM.

Question 6

alpha

Answer 6

The abnormal rate of return on a security in excess of what would be predicted by an equilibrium model such as the CAPM.

Question 7

multifactor models

Answer 7

Models of security markets positing that returns respond to several systematic factors.

Question 8

arbitrage

Answer 8

Creation of riskless profits made possible by relative mispricing among securities.

Question 9

arbitrage pricing theory (APT)

Answer 9

A theory of risk-return relationships derived from no-arbitrage considerations in large capital markets.

Question 10

well-diversified portfolio

Answer 10

A portfolio sufficiently diversified that nonsystematic risk is negligible.

Question 11

factor portfolio

Answer 11

A well-diversified portfolio constructed to have a beta of 1 on one factor and a beta of 0 on any other factor.

Question 12

The CAPM assumes

Answer 12

investors are rational, single-period planners who agree on a common input list from security analysis and seek mean-variance optimal portfolios.

Question 13

The market portfolio is

Answer 13

value-weighted.

Question 14

The risk premium on the market portfolio

Answer 14

is proportional to its variance, image, and to the risk aversion of the average investor.

Question 15

The CAPM implies that the risk premium on any individual asset or portfolio

Answer 15

is the product of the risk premium of the market portfolio and the asset’s beta.

Question 16

The security market line shows the

Answer 16

return demanded by investors as a function of the beta of their investment.

Question 17

This expected return is a benchmark for

Answer 17

for evaluating investment performance.

Question 18

The intercept of the SCL, called ____, represents the average excess return on the security when the index excess return is ____. The CAPM implies that alphas should average ___.

Answer 18

alpha; zero; zero

Question 19

The CAPM and the security market line can be used to establish benchmarks for evaluation of investment performance or to determine appropriate discount rates for capital budgeting applications. They are also used in

Answer 19

regulatory proceedings concerning the “fair” rate of return for regulated industries.

Question 20

The CAPM is usually implemented as a _________, with all systematic risk summarized by the return on a broad market index.

Answer 20

single-factor model

Question 21

There are two general approaches to finding extra-market systematic risk factors.

Answer 21

One looks for factors that are empirically associated with high average returns and so may be proxies for relevant measures of systematic risk. The other focuses on factors that are plausibly important sources of risk to wide segments of investors and may thus command risk premiums.

Question 22

An arbitrage opportunity arises

Answer 22

when the disparity between two or more security prices enables investors to construct a zero net investment portfolio that will yield a sure profit.

Question 23

The presence of arbitrage opportunities and the resulting volume of trades will create pressure on

Answer 23

security prices that will persist until prices reach levels that preclude arbitrage.

Question 24

Only a few investors need to become aware of arbitrage opportunities

Answer 24

to trigger this process because of the large volume of trades in which they will engage

Question 25

When securities are priced so that there are no arbitrage opportunities, the

Answer 25

market satisfies the no-arbitrage condition.

Question 26

Price relationships that satisfy the no-arbitrage condition are important because

Answer 26

we expect them to hold in real-world markets.

Question 27

Portfolios are called well diversified if they include a

Answer 27

large number of securities in such proportions that the residual or diversifiable risk of the portfolio is negligible.

Question 28

In a single-factor security market, all well-diversified portfolios must satisfy ________ in order to satisfy the no-arbitrage condition.

Answer 28

the expected return–beta relationship of the SML

Question 29

If all well-diversified portfolios satisfy the expected return–beta relationship, then all but a ____ _____ of securities also must satisfy this relationship.

Answer 29

small number

Question 30

The APT implies the same expected return–beta relationship as the CAPM yet does not require ______ The price of this generality is that the APT does not guarantee this relationship for all securities at all times.

Answer 30

that all investors be mean-variance optimizers.

Question 31

A multifactor APT generalizes the

Answer 31

single-factor model to accommodate several sources of systematic risk.