FINA 3080 Practice Problems

CAPM and Multifactor Models

1. True or False (Briefly Explain)

(a) If the CAPM holds, the return of a well-diversified portfolio with no diversifiable risk and
a β = 1 is perfectly correlated (i.e., correlation = 1) with the market.
B=
m)
var(Um)
=

P
F (b) If the CAPM holds, a very risk-averse investor should hold predominantly low-beta
stocks. If the CAPM holds , the market portfolio is every investor's optimal risky portfolio , regardless of risk aversion

F (c) A security that lies below the Security Market Line (SML) is underpriced.
A security that lies below the SML has a lower reward-to-risk ratio
(d) Over the past year, the realized return on stock A was 12% and on stock B was 10%. The
F betas of A and B are 0.8 and 1.2, respectively. So the past year’s performance definitely
refutes the CAPM.

(e) The Arbitrage Pricing Theory (APT) requires all investors to hold the portfolio that has
F the highest Sharpe ratio.

(f) The Arbitrage Pricing Theory (APT) requires all investors to agree on securities’ expected
F returns, variances, and co-variances.

(g) If you want to test the Capital Asset Pricing Model (CAPM) using historical returns, you
need to run a regression of the securities’ returns on the market return, and examine the slope
and the intercept of the regression. excess returns on the market's excess returns
excess of risk-free rate)

2. CAPM, Riskfree Rate, and SML

Suppose the CAPM holds. Stock A has an expected return of 15% and a covariance of 20%
with the market portfolio, while Stock B has an expected return of 25% and a covariance of
40% with the market portfolio. There are other stocks in the market portfolio (and we do not

For
know how many).

(a) What is the riskfree rate? 5 % 0 . 06 -0 .

4rf = 0 .
05-0 .

22f
0 .

01 = 0 .
22f Erf = 0 .
05
(b) What is the reward-to-risk ratio of the market portfolio (i.e., market excess return divided
by market variance)?
#50 5
.

(c) Suppose Stock X has a beta of 2 and an expected return of 30%. What are the expected
return on the market portfolio and the variance? 30 %
57M505EVarIM) 0
-

(d) Draw the Security Market Line (SML) and label the axes. Show in the diagram where
you would find Stocks A, B, and X, as well as the market portfolio.
E(r) N
SML
*
1 "x
in
>B
3. One-Factor Model and Arbitrage

You believe that all securities are priced according to the following one-factor model:
20 12
.

For security i at time t, > 20 % 44 + =

2(Umf 44
-

-
rit = rf + βi(rmt - rf) + eit,
10% 4 % +
= 0 5[rmf 440) - -

F0. 6
where rf is the riskfree rate, rmt is the return on the market index at time t, and eit is the impact
of unanticipated firm-specific events on i at t.
V vv v
You are given the following information: rf = 4%, E(rA) = 20%, E(rB) = 10%, βA = 2, and βB
= 0.5. rmf 12% 16 % Umf
=
=

Vat = 20 % List 10 %
=

(a) Are the returns of A, B, and the riskfree asset in equilibrium? No

we should buy Blthe risk premium/betarations better) and sellA , and have zero net investment and zero risk
(b) If A and B are two well-diversified portfolios, describe an arbitrage strategy, show why it
is an arbitrage, and calculate the % profits. Buy lofB < + rf + 0 5 (Vm-rf) 10% = .
=

(c) Is your strategy in (b) still an arbitrage strategy if A and B are individual stocks? Briefly
explain.

(d) A and B are well-diversified portfolios, but the true model is a multi-factor model. Is
your strategy in (b) still an arbitrage strategy? Briefly explain.

4. Three-Factor APT

Suppose the Arbitrage Pricing Theory (APT) holds and the Fama-French model is the correct
model for APT. When you regress the monthly excess returns of ABC Corp on the Fama-

&
French factors, you obtain the following output:
Vf (1 2 + 0 6+ 0 8) =
-

.
. .

rABC – rf = 0.04 + 1.2(rM – rf) + 0.6 rSMB + 0.8 rHML + error

= +. 6

where rM is the return on the U.S. stock market portfolio, rf is the riskfree rate, rSMB is the
return on a portfolio of small stocks minus big stocks, and rHML is the return on a portfolio of
high book-to-market stocks minus low book-to-market stocks.

(a) What should the intercept term of the regression be if the APT holds (in equilibrium)?
The intercept term represents the alpha ; it shouldbe zere or at least very closeto zero
(b) Suppose you conclude that ABC Corp is underpriced, describe an arbitrage strategy. No
calculations necessary. Just briefly describe what you would do and how it is an arbitrage
strategy. we should buy ABC Corpina well-diversified portfolio and short another well-diversified portfolio
By 1 2 ,SMB 0 6 BHML 8
= .
= .

,
= 0 .

(c) When you run a similar regression with XYZ Corp, you get the following output:
Amount Beta
rXYZ – rf = 0.02 + 0.6(rM – rf) + 0.3 rSMB + 0.4 rHML + error
M -
I
-

1 .
2

2
USMB 0 6 .
0 . 6
UHML 0 .
8
Is it possible that XYZ has a higher standard deviation than ABC? Briefly explain.
Itis possible becauseXYE could have a higher firm-specific risk. The total risk is the
sum of systematic risk While the systematic risk is lower for XYE , the
.

firm-specific of XYZ could

be so
high that the total risk of XYZ is
higher than ABC