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Corporate Finance, 3e (Berk/DeMarzo) Chapter 13 Investor Behavior and Capital Market Efficiency. (ANswers Explained).

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Corporate Finance, 3e (Berk/DeMarzo) Chapter 13 Investor Behavior and Capital Market Efficiency 13.1 Competition and Capital Markets Use the following information to answer the question(s) ... below. Assume that the CAPM is a good description of stock price returns. The market expected return is 8% with 12% volatility and the risk-free rate is 3%. New news arrives that does not change any of these numbers, but it does change the expected returns of the following stocks: Stock Expected Return Volatility Beta Taggart Transcontinental 8% 28% 1.2 Rearden Metal 13% 40% 1.7 Wyatt Oil 7% 20% 0.8 Nielson Motors 10% 32% 1.3 1) The expected alpha for Taggart Transcontinental is closest to: A) -3.00% B) -1.00% C) 1.00% D) 3.00% ) αi = E[rs] - rf - βi(rm - rf), where rf - βi(rm - rf) is the CAPM return Stock Expected Return Volatility Beta CAPM Return Alpha Taggart Transcontinental 8% 28% 1.2 9.00% -1.00% Rearden Metal 13% 40% 1.7 11.50% 1.50% Wyatt Oil 7% 20% 0.8 7.00% 0.00% Nielson Motors 10% 32% 1.3 9.50% 0.50% Section: 13.1 Competition and Capital Markets Skill: Analytical 2) The expected alpha for Wyatt Oil is closest to: A) -3.00% B) -1.00% C) 0.00% D) 3.00% ) αi = E[rs] - rf - βi(rm - rf), where rf - βi(rm - rf) is the CAPM return Stock Expected Return Volatility Beta CAPM Return Alpha Taggart Transcontinental 8% 28% 1.2 9.00% -1.00% Rearden Metal 13% 40% 1.7 11.50% 1.50% Wyatt Oil 7% 20% 0.8 7.00% 0.00% Nielson Motors 10% 32% 1.3 9.50% 0.50% Section: 13.1 Competition and Capital Markets Skill: Analytical 3) Which of the following stocks represent buying opportunities? 1. Taggart Transcontinental 2. Rearden Metal 3. Wyatt Oil 4. Nielson Motors A) 1 only B) 1 and 2 only C) 2 and 3 only D) 2 and 4 only ) αi = E[rs] - rf - βi(rm - rf), where rf - βi(rm - rf) is the CAPM return Stock Expected Return Volatility Beta CAPM Return Alpha Taggart Transcontinental 8% 28% 1.2 9.00% -1.00% Rearden Metal 13% 40% 1.7 11.50% 1.50% Wyatt Oil 7% 20% 0.8 7.00% 0.00% Nielson Motors 10% 32% 1.3 9.50% 0.50% Both Rearden Metal and Nielson Motors represent buying opportunities due to their positive expected alphas. Section: 13.1 Competition and Capital Markets Skill: Analytical 4) Which of the following stocks represent selling opportunities? 1. Taggart Transcontinental 2. Rearden Metal 3. Wyatt Oil 4. Nielson Motors A) 1 only B) 1 and 2 only C) 2 and 3 only D) 2 and 4 only ) αi = E[rs] - rf - βi(rm - rf), where rf - βi(rm - rf) is the CAPM return Stock Expected Return Volatility Beta CAPM Return Alpha Taggart Transcontinental 8% 28% 1.2 9.00% -1.00% Rearden Metal 13% 40% 1.7 11.50% 1.50% Wyatt Oil 7% 20% 0.8 7.00% 0.00% Nielson Motors 10% 32% 1.3 9.50% 0.50% Only Taggart Transcontinental represents a selling opportunities due to its negative expected alpha. Section: 13.1 Competition and Capital Markets Skill: Analytical 5) A stock's alpha is defined as the stock's: A) expected return minus its required return. B) expected return minus its actual return. C) nominal return minus its required return. D) required return minus its actual return. Section: 13.1 Competition and Capital Markets Skill: Definition 13.2 Information and Rational Expectations 1) When all investors correctly interpret and use their own information, as well as information that can be inferred from market prices or the trades of others, they are said to have: A) sensation seeking expectations. B) positive expectations. C) rational expectations. D) confident expectations. Section: 13.2 Information and Rational Expectations Skill: Definition 2) The CAPM does not require investors have homogeneous expectations, but rather that they have: A) rational biases. B) no biases. C) heterogenous expectations. D) rational expectations. Section: 13.2 Information and Rational Expectations Skill: Conceptual 13.3 The Behavior of Individual Investors 1) Investors that suffer from a familiarity bias: A) prefer not to invest in companies they are familiar with. B) favor investments in companies they are familiar with. C) invest in the same stocks that their friends or family recommend. D) tend to overestimate the precision of their knowledge. Section: 13.3 The Behavior of Individual Investors Skill: Definition 2) The tendency of uninformed individuals to overestimate the precision of their knowledge is known as: A) overconfidence bias. B) herd behavior. C) familiarity bias. D) disposition bias. Section: 13.3 The Behavior of Individual Investors Skill: Definition 3) If investors have relative wealth concerns, they care most about: A) the return on their portfolio relative to their overall current wealth. B) the performance of their portfolio relative to that of their peers. C) their current portfolio performance relative to their past portfolio performance. D) the performance of their current wealth relative to their past wealth. Section: 13.3 The Behavior of Individual Investors Skill: Definition 4) An individual's desire for intense risk-taking experiences is known as: A) phenomenon seeking. B) herd seeking. C) sensation seeking. D) rational expectations seeking. Section: 13.3 The Behavior of Individual Investors Skill: Definition 5) Which of the following is NOT true regarding individual investor behavior? A) Individual investors fail to diversify their portfolios adequately. B) A vast majority of individual investors hold fewer than 10 stocks in their portfolio. C) Employees tend to overinvest in their company's own stock. D) Individual investors' portfolios consistently outperform the market averages. Section: 13.3 The Behavior of Individual Investors Skill: Conceptual 13.4 Systematic Trading Biases Use the following information to answer the question(s) below. Consider the price paths of the following stocks over a six-month period: Stock January February March April May June Taggart Transcontinental $15 $18 $21 $18 $20 $24 Rearden Metal $30 $22 $16 $24 $30 $36 Wyatt Oil $20 $21 $23 $24 $26 $26 Nielson Motors $20 $17 $14 $12 $14 $12 None of these stocks pay dividends. 1) Assume that you are an investor with the disposition effect and you bought each of these stocks in January. Suppose that it is currently the end of March, which stocks are you most inclined to sell? 1. Taggart Transcontinental 2. Rearden Metal 3. Wyatt Oil 4. Nielson Motors A) 1 only B) 1 and 3 only C) 2 only D) 2 and 4 only ) With the disposition effect investors are likely to sell winners and hold on to losers, so they would sell the two winners Taggart and Wyatt. Section: 13.4 Systematic Trading Biases Skill: Analytical 2) Assume that you are an investor with the disposition effect and you bought each of these stocks in January. Suppose that it is currently the end of March, which stocks are you most inclined to hold? 1. Taggart Transcontinental 2. Rearden Metal 3. Wyatt Oil 4. Nielson Motors A) 1 only B) 1 and 3 only C) 2 only D) 2 and 4 only ) With the disposition effect investors are likely to sell winners and hold on to losers, so they would hold the two losers Rearden and Nielson. Section: 13.4 Systematic Trading Biases Skill: Analytical 3) Assume that you are an investor with the disposition effect and you bought each of these stocks in January. Suppose that it is currently the end of June, which stocks are you most inclined to sell? 1. Taggart Transcontinental 2. Rearden Metal 3. Wyatt Oil 4. Nielson Motors A) 1 only B) 1 and 3 only C) 2 only D) 1, 2, and 3 only ) With the disposition effect investors are likely to sell winners and hold on to losers, so they would sell the three winners Taggart, Rearden, and Wyatt. Section: 13.4 Systematic Trading Biases Skill: Analytical 4) Assume that you are an investor with the disposition effect and you bought each of these stocks in January. Suppose that it is currently the end of June, which stocks are you most inclined to hold? 1. Taggart Transcontinental 2. Rearden Metal 3. Wyatt Oil 4. Nielson Motors A) 1 only B) 4 only C) 1 and 3 only D) 2 and 4 only ) With the disposition effect investors are likely to sell winners and hold on to losers, so they would hold the only loser: Nielson Motors. Section: 13.4 Systematic Trading Biases Skill: Analytical 5) If investors believe that others have superior information which they can take advantage of by copying their trades, this can lead to: A) an informational cascade effect. B) a disposition effect. C) a sensation seeking effect. D) an overconfidence bias. Section: 13.4 Systematic Trading Biases Skill: Definition 6) The tendency to hang on to losers and sell winners is known as the: A) cascade effect. B) disposition effect. C) overconfidence bias. D) systematic behavior bias. Section: 13.4 Systematic Trading Biases Skill: Definition 7) When investors imitate each other's actions, this is known as ________ behavior. A) pack B) flock C) herd D) shepherd Section: 13.4 Systematic Trading Biases Skill: Definition 13.5 The Efficiency of the Market Portfolio Use the following information to answer the question(s) below. Assume that the economy has three types of people. 20% are fad followers, 75% are passive investors, and 5% are informed traders. The portfolio consisting of all informed traders has a beta of 1.4 and an expected return of 16%. The market has an expected return of 10% and the risk-free rate is 4%. 1) The alpha for the informed investors is closest to: A) -2.4% B) -0.9% C) 0.0% D) 3.6% ) αi = E[rs] - rf - βi(rm - rf) = 16% - 4% - 1.4(10% - 4%) = 3.6% Section: 13.5 The Efficiency of the Market Portfolio Skill: Analytical 2) The alpha for the passive investors is closest to: A) -2.4% B) -0.9% C) 0.0% D) 3.6% ) αi = E[rs] - rf - βi(rm - rf) = 10% - 4% - 1.0(10% - 4%) = 0.0% Section: 13.5 The Efficiency of the Market Portfolio Skill: Analytical 3) The expected return for the fad follower's portfolio is closest to: A) 11.5% B) 12.4% C) 13.6% D) 16.0% ) Since the passive investors are holding the market, the fad followers must be the counter parties to the informed investors. The predicted (by CAPM) return on the portfolio they are trading is: ri = rf - βi(rm - rf) = 4% - 1.4(10% - 4%) = 12.4% This return will be split between the informed traders and the fad followers. Therefore: rp = wFF rFF + wIT rIT = 12.4% = rFF + 16% → rFF = 11.50% Diff: 3 Section: 13.5 The Efficiency of the Market Portfolio Skill: Analytical 4) The alpha for the fad follower's portfolio is closest to: A) -0.9% B) 0.0% C) 3.6% D) 6.0% ) Since the passive investors are holding the market, the fad followers must be the counter parties to the informed investors. The predicted (by CAPM) return on the portfolio they are trading is: ri = rf - βi(rm - rf) = 4% - 1.4(10% - 4%) = 12.4% This return will be split between the informed traders and the fad followers. Therefore: rp = wFF rFF + wIT rIT = 12.4% = rFF + 16% → rFF = 11.50% αi = E[rs] - rf - βi(rm - rf) = 11.5% - 4% - 1.4(10% - 4%) = -0.9% Section: 13.5 The Efficiency of the Market Portfolio Skill: Analytical Use the following information to answer the question(s) below. John Galt is a mutual fund manager at Atlas Asset Management. He can generate an alpha of 2% a year up to $500 million of invested capital. After that amount his skills are spread too thin, so he cannot add value and his alpha is zero for all investments over $500 million. Atlas Asset Management charges a fee of 0.80% on the total amount of money under management. Assume that there are always investors looking for positive alpha investments and no investor would invest in a fund with a negative alpha. Assume that the fund is in equilibrium, meaning that no investor either takes out money or wishes to invest new money into the fund. 5) The alpha that investors in Galt's fund expect to receive is closest to: A) -.80% B) 0.0% C) 0.80% D) 1.8% ) At equilibrium investors will invest to the point where the alpha is driven down to zero. Any alpha that is greater than zero will force more investment. Diff: 3 Section: 13.5 The Efficiency of the Market Portfolio Skill: Analytical 6) The amount of money that Galt's fund will have under management is closest to: A) $500 million B) $600 million C) $1,000 million D) $1,250 million ) At equilibrium, alpha must equal zero. Therefore: α = 0 = $500 × 2% - $X × 0.80% → $10 = 0.0080X → $X = $1,250 million Section: 13.5 The Efficiency of the Market Portfolio Skill: Analytical 7) The amount of fee income that Galt's fund will generate is closest to: A) $3.75 million B) $8.00 million C) $10.00 million D) $25.00 million ) At equilibrium, alpha must equal zero. Therefore: α = 0 = $500 × 2% - $X × 0.80% → $10 = 0.0080X → $X = $1,250 million under management Total fees = 1,250 million × 0.0080 = $10 million Section: 13.5 The Efficiency of the Market Portfolio Skill: Analytical 8) A stock's ________ measures the stock's return relative to that predicted based on its beta, at the time of some event. A) excessive abnormal return B) cumulative average return C) excessive predicted return D) cumulative abnormal return Section: 13.5 The Efficiency of the Market Portfolio Skill: Definition 13.6 Style-Based Anomalies and the Market Efficiency Debate Use the following information to answer the question(s) below. Stock Market Capitalization Expected Liquidating Dividend Beta Taggart Transcontinental $800 $920 1.10 Rearden Metal $600 $720 1.20 Wyatt Oil $1,000 $1,100 0.80 Nielson Motors $400 $500 1.40 All amounts are in millions. 1) The correlation between the expected return and the market capitalization of these stocks is A) negative. B) positive. C) zero. D) Unable to determine with the information given ) As the size increases the return goes down indicating a negative correlation. Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Analytical 2) If the risk-free rate is 3% and the market risk premium is 5%, then the CAPM's predicted expected return for Wyatt Oil is closest to: A) 7.0% B) 8.5% C) 9.0% D) 9.5% ) ri = rf - βi(rm - rf) = 3% + 0.8(5%) = 7% Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Analytical 3) If the risk-free rate is 3% and the market risk premium is 5%, then the CAPM's predicted expected return for Nielson Motors is closest to: A) 8.5% B) 9.0% C) 9.5% D) 10.0% ) ri = rf - βi(rm - rf) = 3% + 1.4(5%) = 10% Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Analytical 4) Which of the following statements is FALSE? A) If the market portfolio is efficient, then all securities and portfolios must plot on the SML, not just individual stocks. B) For most stocks the standard errors of the alpha estimates are large, so it is impossible to conclude that the alphas are statistically different from zero. C) It is not difficult to find individual stocks that, in the past have not plotted on the SML. D) Small stocks (those with lower market capitalization) have lower average returns. ) Small stocks (those with lower market capitalization) have higher average returns. Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 5) Which of the following statements is FALSE? A) The size effect is the observation that small stocks have positive alphas. B) When considering portfolios formed based on the book-to-market ratio, most of the portfolios plot below the security market line. C) The largest alphas occur in the smallest size deciles. D) When considering portfolios formed based on size, although the portfolios with the higher betas yield higher returns, most size portfolios plot above the security market line. ) When considering portfolios formed based on the market-to-book ratio, most of the portfolios plot above the security market line. Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 6) Which of the following statements is FALSE? A) Portfolios with high market capitalizations must have positive alphas if the market portfolio is not efficient. B) The book-to-market is the observation that firms with high book-to-market ratios have positive alphas. C) If the market portfolio is not efficient, then a portfolio of high book-to-market stocks will likely have positive alphas. D) Portfolios with low book-to-market ratios must have zero alphas if the market portfolio is efficient. ) Portfolios with low market capitalizations may have positive or negative alphas if the market portfolio is inefficient. Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 7) Which of the following statements is FALSE? A) A momentum strategy is one where you buy stocks that have had low past returns and (short) sell stocks that have had high past returns. B) Over the years since the discovery of the CAPM, it has become increasing clear to researchers and practitioners alike that forming portfolios based on market capitalization, book-to-market ratios, and past returns, one can construct trading strategies that have a positive alpha. C) Portfolios containing firms with the highest realized returns over the previous six months have positive alphas over the next six months. D) If the market portfolio is not efficient, then a portfolio of small stocks will likely have positive alphas. ) A momentum strategy is one where you buy stocks that have had high past returns and (short) sell stocks that have had low past returns. Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual Use the figure for the question(s) below. Consider the following graph of the security market line: 8) Portfolio "B": A) is less risky than the market portfolio. B) is overpriced. C) has a positive alpha. D) falls above the SML. Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 9) Portfolio "A": A) has a relatively lower expected return than predicted. B) has a positive alpha. C) falls below the SML. D) is overpriced. Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 10) Portfolio "C": A) is less risky than the market portfolio. B) has a relatively lower expected return than predicted. C) is underpriced. D) has a negative alpha. Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 11) Portfolio "D": A) falls below the SML. B) has a negative alpha. C) is overpriced. D) offers an expected return equal to the risk-free rate. Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 12) The market portfolio: A) is underpriced. B) has a positive alpha. C) is overpriced. D) falls on the SML. Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 13) Which of the following statements regarding portfolio "A" is/are correct? 1. Portfolio "A" has a positive alpha. 2. Portfolio "A" is overpriced. 3. Portfolio "A" is less risky than the market portfolio. 4. Portfolio "A" should not exist if the market portfolio is efficient. A) 1 and 2 B) 1, 3, and 4 C) 1 and 3 D) 1, 2, 3, and 4 Diff: 3 Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 14) Which of the following statements regarding portfolio "B" is/are correct? 1. Portfolio "B" has a positive alpha. 2. Portfolio "B" is overpriced. 3. Portfolio "B" is less risky than the market portfolio. 4. Portfolio "B" should not exist if the market portfolio is efficient. A) 2 and 4 B) 4 only C) 1, 3, and 4 D) 1 and 4 Diff: 3 Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 15) Which of the following statements regarding portfolio "C" is/are correct? 1. Portfolio "C" has a negative alpha. 2. Portfolio "C" is overpriced. 3. Portfolio "C" is less risky than the market portfolio. 4. Portfolio "C" should not exist if the market portfolio is efficient. A) 1 and 3 B) 2 and 4 C) 1, 3, and 4 D) 3 only Diff: 3 Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual Use the information for the question(s) below. Consider two firms, Chihuahua Corporation and Bernard Industries that are each expected to pay the same $1.5 million dollar dividend every year in perpetuity. Chihuahua Corporation is riskier and has an equity cost of capital of 15%. Bernard Industries is not as shaky as Chihuahua, so Bernard has an equity cost of capital of only 10%. Assume that the market portfolio is not efficient. Both stocks have the same beta and the CAPM would assign them both an expected return of 12% to both. 16) The market value for Chihuahua is closest to: A) $10.0 million B) $12.5 million C) $12.0 million D) $15 million ) MV = = = $10M Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Analytical 17) The market value for Bernard is closest to: A) $12.0 million B) $10 million C) $15.0 million D) $12.5 million ) MV = = = $15M Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Analytical 18) The alpha for Chihuahua is closest to: A) +2% B) -5% C) -3% D) +3% ) Alpha = expected return - predicted return (from CAPM) = .15 - .12 = .03 Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Analytical 19) The alpha for Bernard is closest to: A) +5% B) -2% C) -3% D) +2% ) Alpha = expected return - predicted return (from CAPM) = .10 - .12 = .-.02 Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Analytical 20) Various trading strategies appear to offer non-zero alphas when we examine real world data. If indeed these alphas are positive, it could be explained by any of the following EXCEPT: A) Investors are systematically ignoring positive-NPV investment opportunities. B) The market portfolio is inefficient, but the market portfolio proxy used to calculate the alphas is efficient. C) A stock's beta with the market portfolio does not adequately measure a stock's systematic risk. D) The positive alpha trading strategies contain risk that investors are unwilling to bear but the CAPM does not capture. Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 21) Which of the following is NOT an investment likely to be found in any proxy for the market portfolio? A) Human capital B) Stocks C) Bonds D) Precious metals Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 22) Which of the following statements is FALSE? A) If the CAPM correctly computes the risk premium, investors would stop investing only when they expected the alpha of an investment strategy to be negative. B) If the CAPM correctly computes the risk premium, an investment opportunity with a positive alpha is a positive NPV investment opportunity. C) If the CAPM correctly computes the risk premium, investors should flock to invest in positive alpha stocks. D) Anyone can implement a momentum trading strategy and therefore generate a positive investment opportunity. Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 23) Which of the following statements is FALSE? A) If indeed alphas are positive, it is possible that the positive alpha trading strategies contain risk that investors are unwilling to bear but the CAPM does not capture. B) If indeed alphas are positive, it is possible that the costs of implementing investment strategies are larger than the NPVs of undertaking them. C) If indeed alphas are positive, then investors have to be systematically ignoring negative-NPV investments opportunities. D) The only way a positive NPV investment opportunity can exist in a market is if some barrier to entry restricts competition. Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 24) Which of the following statements is FALSE? A) The existence of the momentum trading strategy has been widely known for at least ten years. B) The information required to implement a momentum strategy is not readily available to investors. C) If the market portfolio is not efficient, then a stock's beta with the market is not an adequate measure of its systematic risk. D) If the market portfolio is not efficient, then the so-called profits from a positive alpha trading strategy are really returns for bearing risk that investors are averse to and the CAPM doesn't capture. ) The information required to implement a momentum strategy is readily available to investors. Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 25) Which of the following statements is FALSE? A) A significant fraction of investors might care about aspects of their portfolios other than expected return and volatility, and so would be unwilling to hold inefficient investment portfolios. B) Although the true market portfolio of all invested wealth might be efficient, the proxy portfolio might not track the actual market very well. C) We might be using the wrong proxy portfolio when we calculate alphas. D) The true market portfolio consists of all traded investment wealth in the economy. Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 26) Which of the following statements is FALSE? A) Nonzero alphas may merely indicate that the wrong market proxy is beings used; they do not necessarily indicate forgone positive NPV investment opportunities. B) The true market portfolio contains much more than just stocks, it includes bonds, real estate, art, precious metals, and any other investment vehicles available. C) If the true market portfolio is efficient, but the proxy portfolio is not highly correlated with the true market portfolio, then the true market portfolio will not be efficient and stocks will have nonzero alphas. D) Much of the investment wealth cannot be included in the proxy for the market portfolio since it does not trade in competitive markets. Diff: 3 Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 27) Which of the following statements is FALSE? A) The most important example of non-tradeable wealth is human capital. B) If investors have a significant amount of non-tradeable wealth, this wealth will be an important part of their portfolios, but will not be part of the market portfolio of tradeable securities. C) If the entire portfolio of investments is efficient, then just the tradeable part of the portfolio should be efficient also. D) Researchers have found evidence that the presence of human capital can explain at least part of the reason for the inefficiency of the most commonly used market proxies. Diff: 3 Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 28) What does the existence of a positive alpha investment strategy imply? Answer: If, indeed, these alphas are positive, we are left to draw one of two conclusions: 1. Investors are systematically ignoring positive-NPV investment opportunities. That is, the CAPM correctly computes risk premiums, but investors are ignoring opportunities to earn extra returns without bearing any extra risk, either because they are unaware of them or because the costs to implement the strategies are larger than the NPV of undertaking them. 2. The positive-alpha trading strategies contain risk that investors are unwilling to bear but the CAPM does not capture. That is, a stock's beta with the market portfolio does not adequately measure a stock's systematic risk, and so the CAPM does not correctly compute the risk premium. Diff: 3 Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 29) Explain why the market portfolio proxy may not be efficient. Answer: The true market portfolio consists of all traded investment wealth in the economy. It therefore contains much more than just stocks—it includes bonds, real estate, art, precious metals, and any other investment vehicles available. Yet, we cannot include most of these investments in the market proxy because they do not trade in competitive markets. Instead, researchers use a proxy portfolio like the S&P 500 and assume that it will be highly correlated to the true market portfolio. If the true market portfolio is efficient but the proxy portfolio is not highly correlated with the true market, then the proxy will not be efficient and stocks will have nonzero alphas. In this case, the alphas merely indicate that the wrong proxy is being used; they do not indicate forgone positive-NPV investment opportunities. Another possibility is that the true market portfolio is inefficient—investors might care about characteristics other than the expected returns and volatility of their portfolios. Diff: 3 Section: 13.6 Style-Based Anomalies and the Market Efficiency Debate Skill: Conceptual 13.7 Multifactor Models of Risk 1) A group of portfolios from which we can form an efficient portfolio are called: A) factor portfolios. B) semi-efficient portfolios. C) partially efficient portfolios. D) characteristic portfolios. Section: 13.7 Multifactor Models of Risk Skill: Definition Use the equation for the question(s) below. Consider the following regression model: Rs - rf = as + (RF1 - rf) + (RF2 - rf) + e 2) The term as is a(n): A) error term that has an expectation of zero and is uncorrelated with either factor. B) measure of the expected percent change in the excess return of a security for a 1% change in the excess return of the first factor portfolio. C) measure of the expected percent change in the excess return of a security for a 1% change in the excess return of the second factor portfolio. D) constant term. Section: 13.7 Multifactor Models of Risk Skill: Conceptual 3) The term is a(n): A) measure of the expected percent change in the excess return of a security for a 1% change in the excess return of the second factor portfolio. B) error term that has an expectation of zero and is uncorrelated with either factor. C) constant term. D) measure of the expected percent change in the excess return of a security for a 1% change in the excess return of the first factor portfolio. Section: 13.7 Multifactor Models of Risk Skill: Conceptual 4) The term is a(n): A) measure of the expected percent change in the excess return of a security for a 1% change in the excess return of the second factor portfolio. B) constant term. C) error term that has an expectation of zero and is uncorrelated with either factor. D) measure of the expected percent change in the excess return of a security for a 1% change in the excess return of the first factor portfolio. Section: 13.7 Multifactor Models of Risk Skill: Conceptual 5) The term ε is a(n): A) measure of the expected percent change in the excess return of a security for a 1% change in the excess return of the first factor portfolio. B) error term that has an expectation of zero and is uncorrelated with either factor. C) measure of the expected percent change in the excess return of a security for a 1% change in the excess return of the second factor portfolio. D) constant term. Section: 13.7 Multifactor Models of Risk Skill: Conceptual 6) Which of the following statements is FALSE? A) The risk premium of any marketable security can be written as the sum of the risk premium of each factor multiplied by the sensitivity of the stock with that factor. B) The factor betas measure the sensitivity of the stock to a particular factor. C) If we use more than one portfolio as factors, then together these factors will capture systematic risk, but each factor captures different components of the systematic risk. D) When we use more than one portfolio to capture risk, the model is known as a single factor model. ) When we use more than one portfolio to capture risk, the model is known as a multi-factor model. Section: 13.7 Multifactor Models of Risk Skill: Conceptual 7) Which of the following statements is FALSE? A) It is not actually necessary to identify the efficient portfolio itself. All that is required is to identify a collection of portfolios from which the efficient portfolio can be constructed. B) Although we might not be able to identify the efficient portfolio itself, we know some characteristics of the efficient portfolio. C) An efficient portfolio can be constructed from other diversified portfolios. D) An efficient portfolio need not be well diversified. ) An efficient portfolio needs to be well diversified. Section: 13.7 Multifactor Models of Risk Skill: Conceptual 8) Which of the following statements is FALSE? A) A portfolio costs nothing to construct is called a self-financing portfolio. B) The most obvious portfolio to use in a multifactor model is the market portfolio itself. C) In general, a self-financing portfolio is any portfolio with portfolio weights that sum to one rather than zero. D) We can construct a self-financing portfolio by going long some stocks, and going short other stocks with equal market value. ) In general, a self-financing portfolio is any portfolio with portfolio weights that sum to zero rather than one. Section: 13.7 Multifactor Models of Risk Skill: Conceptual 9) Which of the following statements is FALSE? A) Rather than relying on the efficiency of a single portfolio (such as the market), multifactor models rely on the weaker condition that an efficient portfolio can be constructed from a collection of well-diversified portfolios or factors. B) A positive alpha in a single factor model means that the portfolios that implement the trading strategy capture risk that is not captured by the market portfolio. C) Multifactor models have a distinct advantage over single-factor models in that it is much easier to identify a collection of portfolios that captures systematic risk than just a single portfolio. D) Trading strategies based on market capitalization, book-to-market ratios, and momentum have been developed that appear to have zero alphas. ) Trading strategies based on market capitalization, book-to-market ratios, and momentum have been developed that appear to have positive alphas. Diff: 3 Section: 13.7 Multifactor Models of Risk Skill: Conceptual 10) Which of the following statements is FALSE? A) Because expected returns are not easy to estimate, each portfolio that is added to a multifactor model increases the difficulty of implementing the model. B) The self-financing portfolio made from high minus low book-to-market stocks is called the high-minus-low (HML) portfolio. C) The FFC factor specification was identified a little more than ten years ago. Although it is widely used in academic literature to measure risk, much debate persists about whether it really is a significant improvement over the CAPM. D) A trading strategy that each year short sells portfolio S (small stocks) and uses this position to buy portfolio B (big stocks) has produced positive risk adjusted returns historically. This self-financing portfolio is widely known as the small minus big (SMB) portfolio. ) A trading strategy that each year buys portfolio S (small stocks) and finances this position by short selling portfolio B (big stocks) has produced positive risk adjusted returns historically. This self-financing portfolio is widely known as the small minus big (SMB) portfolio. Diff: 3 Section: 13.7 Multifactor Models of Risk Skill: Conceptual 11) Which of the following statements is FALSE? A) As a practical matter, it is extremely difficult to identify portfolios that are efficient because we cannot measure the expected return and the standard deviation of a portfolio with great accuracy. B) The portfolios in a multifactor model can be thought of as either risk factors themselves or portfolios of stocks correlated with unobservable risk factors. C) Each factor beta is the expected percent change in the excess return of a security for a 1% change in the excess return of the factor portfolio. D) Even if the market portfolio is not efficient, it still must capture all components of systematic risk. Diff: 3 Section: 13.7 Multifactor Models of Risk Skill: Conceptual Use the equation for the question(s) below. Consider the following factor model: E[Rs] - rf = (E[RMkt] - rf) + E[RSMB] + E[RHML] + E[RPR1 YR] 12) The term measures the sensitivity of the securities returns to: A) size. B) book to market. C) momentum. D) the overall market. Section: 13.7 Multifactor Models of Risk Skill: Conceptual 13) The term measures the sensitivity of the securities returns to: A) momentum. B) the overall market. C) book to market. D) size. Section: 13.7 Multifactor Models of Risk Skill: Conceptual 14) The term measures the sensitivity of the securities returns to: A) book to market. B) momentum. C) size. D) the overall market. Section: 13.7 Multifactor Models of Risk Skill: Conceptual 15) The term measures the sensitivity of the securities returns to: A) the overall market. B) book to market. C) size. D) momentum. Section: 13.7 Multifactor Models of Risk Skill: Conceptual Use the table for the question(s) below. Consider the following information regarding the Fama French Carhart four factor model: Factor Portfolio Average Monthly Return (%) IBM Factor Betas GE Factor Betas Wal-Mart Factor Betas Rm - rf 0.64 0.712 0.937 0.782 SMB 0.17 -0.103 -0.214 0.224 HML 0.53 0.124 0.154 0.123 PR1 YR 0.76 0.276 -0.147 0.247 16) Using the FFC four factor model and the historical average monthly returns, the expected monthly return for IBM is closest to: A) 0.79% B) 0.53% C) 0.71% D) 1.01% ) Factor Portfolio Average Monthly Return (%) IBM Factor Betas GE Factor Betas Wal-Mart Factor Betas IBM Return Calc. GE Return Calc. Wal-Mart Return Calc. Rm - rf 0.64 0.712 0.937 0.782 0.456 0.600 0.500 SMB 0.17 -0.103 -0.214 0.224 -0.018 -0.036 0.038 HML 0.53 0.124 0.154 0.123 0.066 0.082 0.065 PR1 YR 0.76 0.276 -0.147 0.247 0.210 -0.112 0.188 E[Rs] = 0.714 0.533 0.791 The return calculation involves multiplying the average monthly return by the factor beta. Section: 13.7 Multifactor Models of Risk Skill: Analytical 17) Using the FFC four factor model and the historical average monthly returns, the expected monthly return for GE is closest to: A) 0.53% B) 0.73% C) 0.79% D) 0.71% ) Factor Portfolio Average Monthly Return (%) IBM Factor Betas GE Factor Betas Wal-Mart Factor Betas IBM Return Calc. GE Return Calc. Wal-Mart Return Calc. Rm - rf 0.64 0.712 0.937 0.782 0.456 0.600 0.500 SMB 0.17 -0.103 -0.214 0.224 -0.018 -0.036 0.038 HML 0.53 0.124 0.154 0.123 0.066 0.082 0.065 PR1 YR 0.76 0.276 -0.147 0.247 0.210 -0.112 0.188 E[Rs] = 0.714 0.533 0.791 Section: 13.7 Multifactor Models of Risk Skill: Analytical 18) Using the FFC four factor model and the historical average monthly returns, the expected monthly return for Wal-Mart is closest to: A) 0.71% B) 0.53% C) 1.38% D) 0.79% ) Factor Portfolio Average Monthly Return (%) IBM Factor Betas GE Factor Betas Wal-Mart Factor Betas IBM Return Calc. GE Return Calc. Wal-Mart Return Calc. Rm - rf 0.64 0.712 0.937 0.782 0.456 0.600 0.500 SMB 0.17 -0.103 -0.214 0.224 -0.018 -0.036 0.038 HML 0.53 0.124 0.154 0.123 0.066 0.082 0.065 PR1 YR 0.76 0.276 -0.147 0.247 0.210 -0.112 0.188 E[Rs] = 0.714 0.533 0.791 Section: 13.7 Multifactor Models of Risk Skill: Analytical 13.8 Methods Used in Practice 1) According to a survey of 392 CFOs conducted by John Graham and Campbell Harvey, the most common method used in corporate America to estimate the cost of capital is A) the CAPM. B) multifactor models. C) characteristic models. D) the dividend discount model. Section: 13.8 Methods Used in Practice Skill: Conceptual [Show More]

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