Online Quiz

Part I (Easy questions)

1. Consider the multifactor APT with two factors. A well-diversified portfolio A has an expected
return of 12%, a beta of 1 on factor 1, and a beta of 0.5 on factor 2. The risk premium on the
factor-1 portfolio is 5%. The risk-free rate of return is 2%. What is the risk-premium on factor 2
if no arbitrage opportunities exist?
A) 8%
B) 10%
C) 12%
D) 14%
E) 16%

Answer: B
12% = 1(5%) + 0.5x + 2%; x = 10%.

2. Consider a one-factor economy. A well-diversified portfolio A has a beta of 1.0 on the factor,
and portfolio B has a beta of 2.0 on the factor. The expected returns on portfolios A and B are
10% and 14%, respectively. Assume that the risk-free rate is 5%. Suppose you invested
$1,000,000 in the risk-free asset and $1,000,000 in portfolio B, and sold short $2,000,000 of
portfolio A. Your expected profit from this strategy would be ___
A) −$10,000.
B) $0.
C) $10,000.
D) $20,000.
E) $30,000.

Answer: A
After one period, risk-free asset = 1*1.05 = 1.05 MM$; B = 1*1.14 = 1.14 MM$; A = -2*1.1 = -
2.2 MM$, so profits = 1.05 + 1.14 - 2.2 = -0.01 MM$

3. Consider the multifactor APT. The risk premiums on the factor 1 and factor 2 portfolios are
5% and 6%, respectively. The risk-free rate of return is 2%. Stock A has an expected return of
10% and a beta on factor 1 of 0.8. Stock A has a beta on factor 2 of
A) 0.2.
B) 0.5.
C) 0.67.
D) 1.5.
E) 2.
Answer: C
10% = 2% + 5%(0.8) + 6%(x); x = 0.67.

4. The APT differs from the CAPM because the APT

A) places more emphasis on market risk.
B) minimizes the importance of diversification.
C) recognizes multiple unsystematic risk factors.
D) recognizes multiple systematic risk factors.

Answer: D

5. A well-diversified portfolio is defined as

A) one that is diversified over a large enough number of securities that the
nonsystematic variance is essentially zero.
B) one that contains securities from at least three different industry sectors.
C) a portfolio whose factor beta equals 1.0.
D) a portfolio that is equally weighted.
E) a portfolio whose factor beta equals 0.

Answer: A

6. In a factor model, the return on a stock in a particular period will be related to

A) factor risk.
B) nonfactor risk.
C) factor risk and nonfactor risk.
D) None of the options are true.

Answer: C

7. If you believe in the ________ form of the EMH, you believe that stock prices reflect all
relevant information, including historical stock prices and current public information about the
firm, but not information that is available only to insiders.
A) semi-strong
B) strong
C) weak
D) All of the options are correct.
E) None of the options are correct.

Answer: A
8. Proponents of the EMH typically advocate
A) an active trading strategy.
B) investing in an index fund.
C) a passive investment strategy.
D) an active trading strategy and investing in an index fund.
E) investing in an index fund and a passive investment strategy.

Answer: E

9. If you believe in the _______ form of the EMH, you believe that stock prices only reflect all
information that can be derived by examining market trading data, such as the history of past
stock prices, trading volume or short interest.
A) semi-strong
B) strong
C) weak
D) All of the options are correct.
E) None of the options are correct.

Answer: C

10. The weak form of the efficient-market hypothesis asserts that

A) stock prices do not rapidly adjust to new information contained in past prices or past
data.
B) future changes in stock prices cannot be predicted from past prices.
C) technicians can outperform the market.
D) stock prices do not rapidly adjust to new information contained in past prices or past
data, and future changes in stock prices cannot be predicted from past prices.
E) future changes in stock prices cannot be predicted from past prices, and technicians
cannot expect to outperform the market.

Answer: E

11. The weather forecast says that a devastating freeze is to hit Florida tonight during the peak of
the citrus harvest. If the price of Florida Orange's stock ____, then markets are inefficient.
A) drops immediately
B) increases immediately.
C) gradually declines for the next several weeks.
D) gradually increases for the next several weeks.

Answer: C
12. Which of the following are used by fundamental analysts to determine proper stock prices?
I. Trendlines
II. Earnings forecasts
III. Dividend prospects
IV. Expectations of future interest rates
A) I, II, and III
B) I, II, and IV
C) II, III, and IV
D) II, III
E) All of the items are used by fundamental analysts.

Answer: C

13. Stock A has a beta of 1.0. The market return yesterday was 1%. You observe that A had a
return yesterday of 0.8%. Assuming that markets are efficient, this suggests that
A) bad news about A was announced yesterday.
B) good news about A was announced yesterday.
C) no news about A was announced yesterday.
D) some bad news about the economy was announced yesterday.

Answer: A

14. What phrase measures the result of market inefficiency?

A) idiosyncratic risk
B) beta
C) volatility
D) alpha
E) systematic risk

Answer: D
 Part 2 (Difficult questions)

15. Assume that both X and Y are well-diversified portfolios and the risk-free rate is 1%.
Portfolio X has an expected return of 10% and a beta of 1. Portfolio Y has an expected return of
5% and a beta of .5. In this situation, you would conclude _________.
A. that portfolios X and Y are in equilibrium
B. Both A and B are overpriced
C. A is overpriced relative to B
D. A is underpriced relative to B
E. Both A and B are underpriced

Answer: D
Price of systematic risk: A = (10%-1%)/1 = 9%; B = (5%-1%)/0.5 = 8%. So, A is underpriced
relative to B.

16. Consider the single factor APT. Portfolio A has a beta of 1 and an expected return of 11%.
Portfolio B has a beta of .5 and an expected return of 6%. The risk-free rate of return is 2%. If
you want to take advantage of an arbitrage opportunity, you should take a short position in
portfolio __________ and a long position in portfolio _________.
A. A; A
B. A; B
C. B; A
D. B; B

Answer: C
Risk premium per unit of beta: A = (11%-2%)/1 = 9%; B = (6%-2%)/0.5 = 8%. So, buy A and
short B.

17. Which of the statements would likely indicate market inefficiency?

A. Two stocks have the same market betas but different return volatilities.
B. Two stocks have the same market betas but had different returns yesterday.
C. After a negative earnings announcement, the stock’s price increased.
D. High E/P stocks often have higher returns.
E. None of the options.

Answer: E
A and B: They could have different idiosyncratic risks.
C: The negative earnings announced may turn out better than the market expected.
D: E/P might proxy for some systematic risk, so it is not surprising to see high E/P stocks have
higher returns. If high E/P stocks have abnormally high returns (e.g., a positive alpha), then
markets are inefficient.

18. 100 students are asked to flip a coin 100 times. One student is crowned the winner (tossed 80
heads). This is most closely associated with
A) the student’s skills.
B) selection bias.
C) overconfidence.
D) the lucky event issue.

Answer: D

19. Consider an APT world with one systematic risk: market risk. The market portfolio has an
expected return of 8% and risk-free interest rate is 2%. A financial analyst estimates the
following characteristics for a well-diversified Portfolio A. Assume that the analyst is correct.
Portfolio E(R) Market BETA
A 9% 1.1

Which of the following constitutes an arbitrage (a zero-cost portfolio) strategy?

A. Short sell A, buy Market portfolio, borrow at the risk-free rate.
B. Short sell A, buy Market portfolio, invest in the risk-free asset.
C. Short sell Market portfolio, buy A, borrow at the risk-free rate.
D. Short sell Market portfolio, buy A, invest in the risk-free asset.
E. Short sell market portfolio, buy A.

Answer: D
Price of systematic risk per unit of beta: Market portfolio = 8% -2% = 6%; A = (9% - 2%)/1.1 =
6.4%. So, buy A and short market portfolio. For example, long $1 of A and $0.1 of rf, and short
$1.1 of market portfolio (so the arbitrage portfolio has zero beta and zero initial costs). After one
period, profits = 1.09 + 0.102 – 1.1*1.08 = $0.004.
20. Consider a single factor APT. Portfolio A has a beta of 1.0 and an expected return of 12%.
Portfolio B has a beta of 0.8 and an expected return of 10%. Both A and B are well diversified.
The risk-free rate of return is 1%. Which of the following could be an arbitrage portfolio?

A) Short $1 of A and $0.25 the riskless asset, long $1.25 of B

B) Short $1.25 of A and $1 the riskless asset, long $2.25 of B
C) long $1.25 of A, short $1 of B and $0.25 the riskless asset
D) long $2.25 of B, short $1 of A and $1.25 the riskless asset
E) Short $1 of A and $1.25 of B, long $2.25 of the riskless asset

Answer: A
Zero beta portfolio: w_A * beta_A + (1-w_A) * beta_B = 0, so w_A = beta_B/(beta_B –
Beta_A) = 0.8/(0.8-1) = -4. So w_B = 1 – w_A = 5.
Expected return of this zero beta portfolio = w_A * 12% + w_B * 10% = -4*12% + 5*10% =
2%, which is higher than rf.
So, long this zero beta portfolio and short rf = short A + long B + short rf.
For example, Short $1 of A + Long $1.25 of B + Short $ 0.25 of rf, which has zero initial costs.
After one period, gains = $0.0025.