Chap 008
Chap 008
Chap 008
Multiple Choice Questions 1. As diversification increases, the total variance of a portfolio approaches ____________. A) 0 B) 1 C) the variance of the market portfolio D) infinity E) none of the above Answer: C Difficulty: Easy Rationale: As more and more securities are added to the portfolio, unsystematic risk decreases and most of the remaining risk is systematic, as measured by the variance of the market portfolio. 2. The index model was first suggested by ____________. A) Graham B) Markowitz C) Miller D) Sharpe E) none of the above Answer: D Difficulty: Easy Rationale: William Sharpe, building on the work of Harry Markowitz, developed the index model. 3. A single-index model uses __________ as a proxy for the systematic risk factor. A) a market index, such as the S&P 500 B) the current account deficit C) the growth rate in GNP D) the unemployment rate E) none of the above Answer: A Difficulty: Easy Rationale: The single-index model uses a market index, such as the S&P 500, as a proxy for the market, and thus for systematic risk.
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4. The Security Risk Evaluation book published by Merrill Lynch relies on the __________ most recent monthly observations to calculate regression parameters. A) 12 B) 36 C) 60 D) 120 E) none of the above Answer: C Difficulty: Easy Rationale: Most published betas and other regression parameters, including those published by Merrill Lynch, are based on five years of monthly return data. 5. The Security Risk Evaluation book published by Merrill Lynch uses the __________ as a proxy for the market portfolio. A) Dow Jones Industrial Average B) Dow Jones Transportation Average C) S&P 500 Index D) Wilshire 5000 E) none of the above Answer: C Difficulty: Easy Rationale: The Merrill Lynch data (and much of the other published data sets) are based on the S&P 500 index as a market proxy. 6. According to the index model, covariances among security pairs are A) due to the influence of a single common factor represented by the market index return B) extremely difficult to calculate C) related to industry-specific events D) usually positive E) A and D Answer: E Difficulty: Easy Rationale: Most securities move together most of the time, and move with a market index, or market proxy.
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10. Rosenberg and Guy found that __________ helped to predict a firm's beta. A) the firm's financial characteristics B) the firm's industry group C) firm size D) both A and B E) A, B and C all helped to predict betas. Answer: E Difficulty: Moderate Rationale: Rosenberg and Guy found that after controlling for the firm's financial characteristics, the firm's industry group was a significant predictor of the firm's beta. 11. If the index model is valid, _________ would be helpful in determining the covariance between assets K and L. A) k B) L C) M D) all of the above E) none of the above Answer: D Difficulty: Moderate Rationale: If the index model is valid A, B, and C are determinants of the covariance between K and L. 12. Rosenberg and Guy found that ___________ helped to predict firms' betas. A) debt/asset ratios B) market capitalization C) variance of earnings D) all of the above E) none of the above Answer: D Difficulty: Moderate Rationale: Rosenberg and Guy found that A, B, and C were determinants of firms' betas.
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16. Assume that stock market returns do not resemble a single-index structure. An investment fund analyzes 100 stocks in order to construct a mean-variance efficient portfolio constrained by 100 investments. They will need to calculate ____________ covariances. A) 45 B) 100 C) 4,950 D) 10,000 E) none of the above Answer: C Difficulty: Moderate Rationale: (n2 - n)/2 = (10,000 - 100)/2 = 4,950 covariances must be calculated. 17. Assume that stock market returns do follow a single-index structure. An investment fund analyzes 200 stocks in order to construct a mean-variance efficient portfolio constrained by 200 investments. They will need to calculate ________ estimates of expected returns and ________ estimates of sensitivity coefficients to the macroeconomic factor. A) 200; 19,900 B) 200; 200 C) 19,900; 200 D) 19,900; 19.900 E) none of the above Answer: B Difficulty: Moderate Rationale: For a single-index model, n(200), expected returns and n(200) sensitivity coefficients to the macroeconomic factor must be estimated. 18. Assume that stock market returns do follow a single-index structure. An investment fund analyzes 500 stocks in order to construct a mean-variance efficient portfolio constrained by 500 investments. They will need to calculate ________ estimates of firm-specific variances and ________ estimates for the variance of the macroeconomic factor. A) 500; 1 B) 500; 500 C) 124,750; 1 D) 124,750; 500 E) 250,000; 500 Answer: A Difficulty: Moderate Rationale: For the single-index model, n(500) estimates of firm-specific variances must be calculated and 1 estimate for the variance of the common macroeconomic factor.
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22. Merrill Lynch estimates the index model for a stock using regression analysis involving total returns. They estimated the intercept in the regression equation at 6% and the at 0.5. The risk-free rate of return is 12%. The true of the stock is ________. A) 0% B) 3% C) 6% D) 9% E) none of the above Answer: A Difficulty: Difficult Rationale: 6% = a + 12% (1 - 0.5); a = 0%. 23. The index model for stock A has been estimated with the following result: RA = 0.01 + 0.9RM + eA If M = 0.25 and R2A = 0.25, the standard deviation of return of stock A is _________. A) 0.2025 B) 0.2500 C) 0.4500 D) 0.8100 E) none of the above Answer: C Difficulty: Difficult Rationale: R2 = b2s2M / s2;0.25 = [(0.81)(0.25)2]/s2; s = 0.4500. 24. The index model for stock B has been estimated with the following result: RB = 0.01 + 1.1RM + eB If M = 0.20 and R2B = 0.50, the standard deviation of the return on stock B is _________. A) 0.1111 B) 0.2111 C) 0.3111 D) 0.4111 E) none of the above Answer: C Difficulty: Difficult Rationale: R2 = b2s2M / s2; 0.5 = [(1.1)2(0.2)2]/s2; s = 0.3111.
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27. The index model has been estimated for stocks A and B with the following results: RA = 0.01 + 0.8RM + eA RB = 0.02 + 1.2RM + eB M = 0.20 (eA) = 0.20 (eB) = 0.10 The standard deviation for stock A is __________. A) 0.0656 B) 0.0676 C) 0.2561 D) 0.2600 E) none of the above Answer: C Difficulty: Difficult Rationale: A = [(0.8)2(0.2)2 + (0.2)2]1/2 = 0.2561. 28. The index model has been estimated for stock A with the following results: RA = 0.01 + 0.8RM + eA M = 0.20 (eA) = 0.10 The standard deviation of the return for stock A is __________. A) 0.0356 B) 0.1886 C) 0.1600 D) 0.6400 E) none of the above Answer: B Difficulty: Difficult Rationale: B = [(.8)2(0.2)2 + (0.1)2]1/2 = 0.1886. 29. Security returns A) are based on both macro events and firm-specific events. B) are based on firm-specific events only. C) are usually positively correlated with each other. D) A and B. E) A and C. Answer: E Difficulty: Easy Rationale: Stock returns are usually highly positively correlated with each other. Stock returns are affected by both macro economic events and firm-specific events.
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33. Covariances between security returns tend to be A) positive because of SEC regulations. B) positive because of Exchange regulations. C) positive because of economic forces that affect many firms. D) negative because of SEC regulations E) negative because of economic forces that affect many firms. Answer: C Difficulty: Moderate Rationale: Economic forces such as business cycles, interest rates, and technological changes tend to have similar impacts on many firms. 34. In the single-index model represented by the equation ri = E(ri) + iF + ei, the term ei represents A) the impact of unanticipated macroeconomic events on security i's return. B) the impact of unanticipated firm-specific events on security i's return. C) the impact of anticipated macroeconomic events on security i's return. D) the impact of anticipated firm-specific events on security i's return. E) the impact of changes in the market on security i's return. Answer: B Difficulty: Moderate Rationale: The textbook discusses a model in which macroeconomic events are used as a single index for security returns. The ei term represents the impact of unanticipated firm-specific events. The ei term has an expected value of zero. Only unanticipated events would affect the return. 35. Suppose you are doing a portfolio analysis that includes all of the stocks on the NYSE. Using a single-index model rather than the Markowitz model _______ the number of inputs needed from _______ to ________. A) increases, about 1,400, more than 1.4 million B) increases, about 10,000, more than 125,000 C) reduces, more than 125,000, about 10,000 D) reduces, more than 4 million, about 9,000 E) increases, about 150, more than 1,500 Answer: D Difficulty: Moderate Rationale: This example is discussed in the textbook. The main point for the students to remember is that the single-index model drastically reduces the number of inputs required.
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39. In their study about predicting beta coefficients, which of the following did Rosenberg and Guy find to be factors that influence beta? I) II) III) IV) A) B) C) D) E) industry group variance of cash flow dividend yield growth in earnings per share
I and II I and III I, II, and III I, II, and IV I, II, III, and IV
Answer: E Difficulty: Moderate Rationale: All of the factors mentioned, as well as variance of earnings, firm size, and debt-to-asset ratio, were found to help predict betas. 40. If a firm's beta was calculated as 1.6 in a regression equation, Merrill Lynch would state the adjusted beta at a number A) less than 0.6 but greater than zero. B) between 0.6 and 1.0. C) between 1.0 and 1.6. D) greater than 1.6. E) zero or less. Answer: C Difficulty: Moderate Rationale: Betas, on average, equal one; thus, betas over time regress toward the mean, or 1. Therefore, if historic betas are more than 1, adjusted betas are between 1 and the calculated beta. 41. The beta of a stock has been estimated as 1.8 by Merrill Lynch using regression analysis on a sample of historical returns. The Merrill Lynch adjusted beta of the stock would be ___________. A) 1.20 B) 1.53 C) 1.13 D) 1.0 E) none of the above Answer: B Difficulty: Moderate Rationale: Adjusted beta = 2/3 sample beta + 1/3(1); = 2/3(1.8) + 1/3 = 1.53.
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45. Consider the single-index model. The alpha of a stock is 0%. The return on the market index is 10%. The risk-free rate of return is 3%. The stock earns a return that exceeds the risk-free rate by 11% and there are no firm-specific events affecting the stock performance. The of the stock is _______. A) 0.64 B) 0.75 C) 1.17 D) 1.33 E) 1.50 Answer: A Difficulty: Moderate Rationale: 7% = 0% + b(11%); b = 0.636. 46. Suppose you held a well-diversified portfolio with a very large number of securities, and that the single index model holds. If the of your portfolio was 0.25 and M was 0.21, the of the portfolio would be approximately ________. A) 0.64 B) 1.19 C) 1.25 D) 1.56 E) none of the above Answer: B Difficulty: Difficult Rationale: s2p / s2m = b2; (0.25)2/(0.21)2 = 1.417; b = 1.19. 47. Suppose you held a well-diversified portfolio with a very large number of securities, and that the single index model holds. If the of your portfolio was 0.18 and M was 0.22, the of the portfolio would be approximately ________. A) 0.64 B) 1.19 C) 0.82 D) 1.56 E) none of the above Answer: C Difficulty: Difficult Rationale: s2p / s2m = b2; (0.18)2/(0.22)2 = 0.669; b = 0.82.
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54. The beta of a stock has been estimated as 1.4 by Merrill Lynch using regression analysis on a sample of historical returns. The Merrill Lynch adjusted beta of the stock would be ___________. A) 1.27 B) 1.32 C) 1.13 D) 1.0 E) none of the above Answer: A Difficulty: Moderate Rationale: Adjusted beta = 2/3 sample beta + 1/3(1); = 2/3(1.4) + 1/3 = 1.27. 55. The beta of a stock has been estimated as 0.85 by Merrill Lynch using regression analysis on a sample of historical returns. The Merrill Lynch adjusted beta of the stock would be ___________. A) 1.01 B) 0.95 C) 1.13 D) 0.90 E) none of the above Answer: D Difficulty: Moderate Rationale: Adjusted beta = 2/3 sample beta + 1/3(1); = 2/3(0.85) + 1/3 = 0.90. 56. Assume that stock market returns do not resemble a single-index structure. An investment fund analyzes 125 stocks in order to construct a mean-variance efficient portfolio constrained by 125 investments. They will need to calculate _____________ expected returns and ___________ variances of returns. A) 125, 125 B) 125, 15,625 C) 15,625, 125 D) 15,625, 15,625 E) none of the above Answer: A Difficulty: Moderate Rationale: The expected returns of each of the 125 securities must be calculated. In addition, the 125 variances around these returns must be calculated.
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60. Assume that stock market returns do follow a single-index structure. An investment fund analyzes 500 stocks in order to construct a mean-variance efficient portfolio constrained by 750 investments. They will need to calculate ________ estimates of firm-specific variances and ________ estimates for the variance of the macroeconomic factor. A) 750; 1 B) 750; 750 C) 124,750; 1 D) 124,750; 750 E) 562,500; 750 Answer: A Difficulty: Moderate Rationale: For the single-index model, n(750) estimates of firm-specific variances must be calculated and 1 estimate for the variance of the common macroeconomic factor. 61. Consider the single-index model. The alpha of a stock is 0%. The return on the market index is 10%. The risk-free rate of return is 5%. The stock earns a return that exceeds the risk-free rate by 5% and there are no firm-specific events affecting the stock performance. The of the stock is _______. A) 0.67 B) 0.75 C) 1.0 D) 1.33 E) 1.50 Answer: C Difficulty: Moderate Rationale: 5% = 0% + b(5%); b = 1.0. 62. Suppose you held a well-diversified portfolio with a very large number of securities, and that the single index model holds. If the of your portfolio was 0.24 and M was 0.18, the of the portfolio would be approximately ________. A) 0.64 B) 1.33 C) 1.25 D) 1.56 E) none of the above Answer: B Difficulty: Difficult Rationale: s2p / s2m = b2; (0.24)2/(0.18)2 = 1.78; b = 1.33.
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67. Discuss the security characteristic line (SCL). Difficulty: Moderate Answer: The security characteristic line (SCL) is the result of estimating the regression equation of the single-index model. The SCL is a plot of the typical excess returns on a security over the risk-free rate as a function of the excess return on the market. The slope of the SCL is the beta of the security, and they-intercept, alpha, is the excess return on the security when the excess market return is zero. This question is designed to ascertain that the student understands how the SCL is obtained, as this relationship is the one that is most frequently used by published information services for the estimation of the regression parameters, alpha and beta. 68. Discuss the "adjusted betas" published by Merrill Lynch in Security Risk Evaluation. Difficulty: Easy Answer: Over time, security betas move toward 1, as the average beta of all securities is 1 and variables regress toward the mean. Thus, if a historic beta has been greater than 1, the chances are that in the future, this beta will be less than the historic beta. The opposite relationship will be observed if the historic beta has been less than one. Merrill Lynch uses the following relationship to calculate "adjusted betas". Adjusted beta = 2/3 (sample beta) + 1/3 (1). This question is important, as many published sources quote an "adjusted beta" with no explanation as to how such a number was obtained. The regression toward the mean is a valid statistical concept and it is important that the student understands that this concept represents the theory behind the possibly undocumented "adjusted betas".