Portfolio Management 02 Portfolio Concepts 2

Test ID: 7441969

Portfolio Concepts 2

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Martz & Withers Enterprises has a beta of1.6. Wecan mostlikely assumethat: the future beta will be less than 1.6 but greater than 1.0.

calculating an adjusted beta willeasethe downward pressureontheforecasted beta. thestandard erroronthefuture beta forecastispositive.

Explanation

Thestandard erroris alwaysexpected to be zero, and the beta hasnothingto dowith thatestimate. Inthecaseof Martz & Withers, adjusted beta will almostcertainly belowerthanthecurrent beta. Most adjusted beta calculations are asfollows: adjusted beta = 1/3 + (2/3 × historical beta). Inthiscase, adjusted beta is1.4. Noteveryonewillusethetwo-thirds/one-third relationship, but any adjusted-beta equationwillresultin a value between1.0 and 1.6.

Which ofthefollowingstatements aboutusingthecapital assetpricingmodel (CAPM)to valuestocksisleast accurate? The model reflects how market forces restore investment prices to equilibrium

levels.

TheCAPM reflectsunsystematicriskusingstandard deviation.

IftheCAPM expected returnistoolow, thenthe asset'spriceistoo high.

Explanation

Thecapital assetpricingmodel assumes allinvestors hold themarketportfolio, and assuch unsystematicrisk, orrisknot related tothemarket, doesnotmatter. Thus, theCAPM doesnotreflectunsystematicrisk and doesnotrelyonstandard deviation asthemeasureofrisk butinstead uses beta asthemeasureofrisk. Theremainingstatements are accurate.

Identifythe most accuratestatementregardingmultifactormodelsfrom amongthefollowing. Macrofactor models include explanatoryvariables suchas the business cycle, interest rates,and inflation,and fundamental factor models include

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Question #5 of 119

Macrofactormodelsincludeexplanatory variablessuch asreal GDPgrowth and the price-to-earningsratio and fundamentalfactormodelsincludeexplanatory variables such asfirmsize and unexpected inflation.

Explanation

Macrofactormodelsincludemultipleriskfactorssuch asthe businesscycle, interestrates, and inflation. Fundamentalfactor modelsincludespecificcharacteristicsofthesecuritiesthemselvessuch asfirmsize and theprice-to-earningsratio.

Carla Vole has developed thefollowingmacroeconomicmodels:

Returnof StockA = 6.5% + (9.6 × productivity) + (5.4 × growth innumberof businesses) Returnof StockB = 18.7% + (2.5 × productivity) + (3.7 × growth innumberof businesses)

Assuming a portfoliocontains60% StockA and 40% StockB, theportfolio'ssensitivitytoproductivityisclosestto:

4.72. 5.34. 6.76.

Explanation

Tocalculatetheportfolio'sfactorsensitivity, weneed theweighted averageofthefactorsensitivityofeach stock: (9.6 × 60%) + (2.5 × 40%) = 6.76.

Assumeyou areconsideringforming a commonstockportfolioconsistingof25% StonebrookCorporation (Stone) and 75% RockwayCorporation (Rock). Asexpressed inthetwo-factorreturnsmodelspresented below, both ofthesestocks' returns are affected bytwocommonfactors:surprisesininterestrates and surprisesintheunemploymentrate.

R = 0.11 + 1.0F + 1.2F + ε R = 0.13 + 0.8F + 3.5F + ε

Assumethat atthe beginningoftheyear, interestrateswereexpected to be5.1% and unemploymentwasexpected to be 6.8%. Further, assumethat attheend oftheyear, interestrateswere actually5.3%, the actualunemploymentratewas7.2%, and therewerenocompany-specificsurprisesinreturns. Thisinformationissummarized inTable1 below:

T

able

1:

Expected

versus

Actual

Interest

Rates

and

U

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m

plo

ym

ent

Rates

Actual Expected Co

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-specific

returns

surprises

In

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Question #12 of 119

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Question #13 of 119

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Question #14 of 119

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Eliminatingshortsales.

Explanation

Constrainingportfolioweightsthrough theeliminationofshortsales and avoidingrebalancinguntilsignificantchangesoccurinthe efficientfrontiercan beeffectivestrategiesforlimitinginstability. However, eventhe best historical data isoftenoflimited usein

forecastingfuture values. Gatheringmore accurate historical data would help, compensateforinstability, butnot asmuch astheothertwo options.

Thecovarianceofthemarketreturnswith thestock'sreturnsis0.005 and thestandard deviationofthemarket'sreturnsis0.05. Whatis thestock's beta?

0.1.

1.0.

2.0.

Explanation

Beta = Cov(stock,market) ÷ (σ ) = 0.005 ÷ (0.05) = 2.0

Thesingle-factormarketmodelpredictsthatthesystematicportionofthe varianceof an asset'sreturnisequaltothe:

square of the asset's beta times the variance of the market portfolio.

covariance betweenthe asset'sreturns and themarketreturns. asset's beta.

Explanation

Oneofthepredictionsofthesingle-factormarketmodelisthat Var(R) = E V + V . Inotherwords, there aretwocomponentstothe

varianceofthereturnson asseti: a systematiccomponentrelated tothe asset's beta (E V ) and anunsystematiccomponentrelated to firm-specificsurprises (V ).

Which ofthefollowingstatementsregardingthecapitalmarketline (CML)isleast accurate? TheCML:

implies that all portfolios on the CMLare perfectly positively correlated.

dominateseverything belowthelineontheoriginalefficientfrontier.

slopeisequaltotheexpected returnofthemarketportfoliominustherisk-freerate.

stock MKT2 2

i i2 M2 ei2 i2 M2

Question #15 of 119

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Question #16 of 119

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TheslopeoftheCML = (theexpected returnofthemarket − therisk-freerate) / (thestandard deviationofreturnsonthemarketportfolio)

BecausetheCML is a straightline, itimpliesthat alltheportfoliosontheCML areperfectlypositivelycorrelated.

Accordingtothecapital assetpricingmodel (CAPM), iftheexpected returnon an assetistoohighgivenits beta, investorswill:

sell the stock until the price falls to the point where the expected return is again equal to that predictedby the securitymarket line.

buythestockuntilthepricefallstothepointwheretheexpected returnis againequaltothat predicted bythesecuritymarketline.

buythestockuntilthepricerisestothepointwheretheexpected returnis againequaltothat predicted bythesecuritymarketline.

Explanation

TheCAPM is anequilibriummodel:itspredictionsresultfrommarketforces actingtoreturnthemarkettoequilibrium. Iftheexpected

returnon an assetistemporarilytoo high givenits beta accordingtothe SML (which meansthemarketpriceistoolow), investorswill buy

thestockuntilthepricerisestothepointwheretheexpected returnis againequaltothatpredicted bythe SML.

Which ofthefollowingstatementsregardingthe arbitragepricingtheory (APT) and thecapital assetpricingmodel (CAPM)isleast accurate? APT:

and CAPMassume all investors hold the market portfolio.

doesnotidentifyitsriskfactors.

requiresfewer assumptionsthanCAPM.

Explanation

CAPM assumesthat allinvestors hold themarketportfolio, APT doesnotmakethis assumption.

Which ofthefollowing does NOT describethe arbitragepricingtheory (APT)?

It is an equilibrium-pricing model like the CAPM.

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There are assumed to be atleastfivefactorsthatexplain assetreturns.

Explanation

APTis a k-factormodel, inwhich thenumberoffactors, k, is assumed to be a lotsmallerthanthenumberof assets; nospecificnumber offactorsis assumed. Dependingonthe data used tofitthemodel, theremay be asfew astwoor asmany assevenfactors.

Thefactorriskpremiumonfactor j inthe arbitragepricingtheory (APT)can beinterpreted asthe:

expected risk premium investors require on a factor portfolio for factor j.

sensitivityofthemarketportfoliotofactor j.

expected returninvestorsrequireon a factorportfolioforfactor j.

Explanation

WecaninterprettheAPTfactorriskpremiumssimilartothewayweinterpretthemarketriskpremiumintheCAPM. Each factorpriceis theexpected riskpremium (extra expected returnminustherisk-freerate)investorsrequirefor a portfoliowith a sensitivityofone (β =1)

tothatfactor and a sensitivityof zeroto alltheotherfactors (a factorportfolio).

Which ofthefollowingstatementsregarding beta isleast accurate?

Beta is ameasure of systematic risk. Themarketportfolio has a beta of1.

Astockwith a beta of zerowilltend tomovewith themarket.

Explanation

Astockwith a beta of1willtend tomovewith themarket. Astockwith a beta of0willtend tomoveindependentlyofthemarket.

Jose Morales has beeninvestingforyears, mostlyusingindex funds. But because heisnotsatisfied with hisreturns, he decidestomeet

with Bill Smale, a financial adviserwith Big GainsAsset Management.

Moraleslaysout hisconcerns about activemanagement:

"Mutualfunds averagereturns belowtheir benchmarks." "Allthe buying and sellingmakesforless-efficientmarkets." "Expenses are higherwith activemanagement."

"Analystforecasts areoftenwrong."

Question #20 of 119

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In anefforttowin Morales' business, Smaleexplainsthe benefitsof activemanagement, startingwith thefactthatmarketefficiencyis a

primeconcernof activemanagers becauseefficientmarketsmake activemanagementpossible. Hethenexplainsthat active

management allowsfor betterprotection againstsystematicrisk, and thatBig Gainsusesmultifactormodelsto adjustinvestment strategiesto accountforeconomicchanges. Lastly, Smaletells Morales howBig GainsAsset Management haspledged nevertoreveal clients' personalinformationtothird parties.

Moralesseemswillingtolisten, so SmaleexplainsBig Gains' managementstrategy, which involves a modified versionoftheCapital AssetPricing Model (CAPM)usingtheDow JonesTotal MarketIndex. Heraves aboutthis valuationmodel, citingits abilitytoproject future alphas, determinetruemarket betasofindividualstocks, create an accuratepictureofthemarketportfolio, and provide an

alternativeforcalculated covariancesinthechartingofthe Markowitz Efficient Frontier.

After an hourof verbalsparringwith Smale, Moralesisnotyetconvinced ofthewisdomof activemanagement. HeturnstoTobinCapital,

calling Susan Worthan, a collegefriend whoworks as an analystintheequity department. TobinCapitalusesthe arbitragepricingtheory (APT)to valuestocks. WorthanexplainsthatAPToffersseveral benefitsrelativetotheCAPM, mostnotablyits dependenceonfewer

and lessrestrictive assumptions.

Afterlisteningto Worthan'sexplanationoftheAPT, Morales asked her howthetheory dealtwith mispriced stocks, drawing a tablewith

thefollowing data toillustrate his question:

S

to

c

k

Current

Price Est. Pricein1 Year Correlationwith S&P500

Standard Deviationof

Returns Beta

Xavier Flocking $45 $51 0.57 17% 1.68

Yaris Yarn $6 $6.75 0.40 7% 1.21

ZimmerAutos $167 $181 0.89 10.5% 0.34

Afterseeing Morales' stockexample, Worthantells himthat hestill doesnotunderstand APT and triestoexplain howthetheory deals

with mispriced stocks. Which ofthefollowingstatementsis most accurate? UnderAPT:

the calculation of unsystematic risk is so accurate that mispricings are rare. mispricingscannotoccur, and thereisno arbitrageopportunity.

anymispricingswill beimmediatelyrectified.

Explanation

Arbitragepricingtheory holdsthat any arbitrageopportunitieswill beexploited immediately, makingthemispricing disappear. (Study Session18, LOS 57.l)

Which ofthefollowingisleastlikely an assumptionofthemarketmodel?

The expectedvalue of the error term is zero.

Thefirm-specificsurprises areuncorrelated across assets. Unsystematicriskcan be diversified away.

Question #22 of 119

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Question #25 of 119

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The assumptionthatunsystematicriskcan be diversified awayis an assumptionofthe arbitragepricingtheory. (Study Session18, LOS 57.g)

Smalebestmakes hispoint aboutthesuperiorityof activemanagementwith hismentionof:

systematic risk. multifactormodels. marketefficiency.

Explanation

Systematicriskcannot be diversified away, and thereisno dependableevidencethat activemanagementcan helpcontrolit. Active

managers attempttocapitalizeoninefficienciesinthemarket, and a trulyefficientmarketwould eliminatetheneed for active

management. However, multifactormodels are a usefultoolfor activemanagers, and a high-qualitymodelmayindeed represent a

competitive advantageover a passivemanager. (Study Session18, LOS 57.j)

Which assumptionisrequired by both theCAPM and theAPT?

Asset prices are not discounted for unsystematic risk.

Allinvestors havethesamereturnexpectations. There arenotransactioncosts.

Explanation

The assumptionsthat allinvestors havethesameexpectations and thatthere arenotransactioncosts arespecifictoCAPM, notAPT. However, both models assumethatunsystematicriskcan be diversified away, and has a riskpremiumof zero. (Study Session18, LOS 57.n)

Which of Morales' arguments against activemanagementisleast accurate?

"Expenses are higher withactive management." "Allthe buying and sellingmakesforless-efficientmarkets." "Mutualfunds averagereturns belowtheir benchmarks."

Explanation

Whenlittlemoneyis activelymanaged, assetprices beginto deviatefromfair values. Activemanagementexploitsinefficiencies and drivesprices backtoward equilibrium. Both remaining arguments are valid. (Study Session18, LOS 57.m)

Assuming Morales' numbers arecorrect, portfolio allocationof65% ofonestock and 35% of a second would allow arbitrageprofitsto be

closestto:

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Question #26 of 119

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Question #27 of 119

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Question #28 of 119

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ᅞ A) 0.90%.

0%.

Explanation

Aportfoliocontaining65% Xavier Flocking and 35% ZimmerAutowould have a weighted average beta of (65% × 1.68) + (35% × 0.34) =

1.21, which isthesame asthe beta of Yaris Yarn. Theweighted averagereturnofthecombined portfoliois11.6%, versus a 12.5% return for Yaris Yarn. Buying Yaris Yarn and sellingthe Xavier/Zimmerportfoliowould earn anestimated 0.9% withoutinvesting anycapitalor takingon anysystematicrisk. (Study Session18, LOS 57.n)

Thesingle-factormarketmodel assumesthere are howmanysourcesofriskin assetreturns?

One.

Three.

Two.

Explanation

Themarketmodel assumesthatthere aretwosourcesofriskin assetreturns, unanticipated macroeconomicevents and firm-specific events.

ConnerCansshares have a beta of0.8. Assuming α is40%, Conner's adjusted beta isclosestto:

0.92.

0.88.

1.12.

Explanation

Adjusted beta = α + α × beta where α and α mustsumto1, so α = 60%.

Adjusted beta = 60% + 40% × 0.8 = 0.92.

Thefactormodelsforthereturnson Omni, Inc., (OM) and Garbo Manufacturing (GAR) are:

ROM = 20.0% − 1.0(FCONF) + 1.4(FTIME) + εOM RGAR = 15.0% − 0.5(FCONF) + 0.8 (FTIME) + εGAR

Whatisthefactorsensitivitytothetime-horizonfactor (TIME)of a portfolioinvested 20% in Omni and 80% in Garbo?

0.16.

1

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Question #29 of 119

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Question #30 of 119

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ᅚ C) 0.92.

-0.60.

Explanation

Thefactormodelfortheportfoliois:

RP = [(0.2)(20.0%) + (0.8)(15.0%)] + [(0.2)(-1.0) + (0.8)(-0.5)] (FCONF) + [(0.2)(1.4) + (0.8)(0.8)] (FTIME) + [(0.2) εOM + (0.8)εGAR]

= 16.0% −0.60(FCONF) + 0.92(FTIME) + (0.2)εOM + (0.8)εGAR

MaryCarruthers hascreated thefollowingmacroeconomicmodelforstockin Magma Metro Systems and ClampettPharmaceuticals:

R-Magma = 12% + (6.3 × GDPgrowth) + (0.056 × populationgrowth) + error. R-Clampett = 18% + (1.2 × GDPgrowth) - (0.231 × populationgrowth) + error.

Theexpected returnfor a portfoliocontaining65% Magma Metro Systems and 35% ClampettPharmaceuticalsisclosestto:

13%.

16%.

14%.

Explanation

Givennoinformation about GDP and populationgrowth, wecannotcalculatereturnsusingthe detailed model. Assuch, wefall backon thetraditional assumptionthatthefactors and randomerrorin a macroeconomicmodel areexpected toequal zero. Assuch, theexpected

returnfortheportfolioistheweighted averageoftheintercepts:65% × 12% = 7.8% and 35% × 18% = 6.3% thus7.8% + 6.3% = 14.1%.

Amulti-factormodelthatidentifiestheportfoliosthat bestexplainthe historicalcross-sectionalreturnsorcovariances among assetsis called a:

covariance factor model.

fundamentalfactormodel.

statisticalfactormodel.

Explanation

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that have beenshownto affect assetreturns, such as book-to-marketorprice-to-earningsratios.

In a multi-factormacroeconomicmodelthemean-zeroerrortermrepresents:

sampling error in estimating factor sensitivities.

theportionoftheindividual asset'sreturnthatisnotexplained bythesystematicfactors.

theno-arbitrageconditionimposed inmulti-factormodels.

Explanation

Themean-zeroerrortermrepresentstheunsystematic, firm-specific, diversifiablerisksthat arenotexplained bythesystematicfactors.

Whatisthe beta of Franklinstockifthecurrentrisk-freerateis6%, theexpected riskpremiumonthemarketportfoliois9%, and the expected rateofreturnon Franklinis17.7%?

1.3.

2.5.

3.9.

Explanation

UsingtheCapitalAssetPricing Model:

6

% + b

et

a (

9

%

)

= 1

7

.

7

%

b

et

a = 1.

3

Allen Marko, CFA, is analyzingthe diversification benefits availablefrominvestinginthreeequityfunds. Heis basing his analysison

monthlyreturnsforthethreefunds and an appropriatemarketindex overthepasttwentyyears. Hefeelsthatthereisnoreasonthatthe pastperformanceshould notcarryforward intothefuture. Treasury billscurrentlypay5%.

Ta

b

le

1:

Expected

Returns,

Variances,

and

Covariance

for

Funds

A,

B

,

&

C

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B

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urn

1

2

%

9

%

8%

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Question #35 of 119

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Marko has alsoobtained information about a fourth fund, Fund D. He doesnot have anyinformationregardingthecovarianceof Fund D with FundsA, B, and C. The averagereturn and varianceforfund D are10% and 0.018, respectively. The beta of Fund Dis0.714.

Based onthis data, whatistheexpected returnof a portfoliothatismadeupof60% of Fund A, 30% of Fund B, and 10% of Fund C?

10.2%.

10.7%.

11.4%.

Explanation

Expected returnfortheportfolio = (0.6)(0.12) + (0.3)(0.09) +(0.1)(0.08)= 0.107or10.7%. (Study Session18, LOS 57.a)

Which ofthefollowingisclosesttothestandard deviationof a portfoliothatismadeupof60% of Fund A, 30% of Fund B, and 10% of

Fund C?

14.840%.

13.062%.

2.205%.

Explanation

Standard deviationof a three assetportfolio:

&£963; = [(0.6)(0.0256) + (0.3)(0.0196) + (0.1)(0.0172) + 2(0.60)(0.30)(0.50)(0.16)(0.14) + 2(0.60)(0.10)(0.38)(0.16)(0.13)+ 2(0.3)

(0.1)(0.85)(0.14)(0.13)]

= [0.017062] = 0.13062or13.062%.

(Study Session18, LOS 57.a)

With respecttotherelativeefficienciesofthe Funds, which ofthefollowingis most accurate?

Fund B and D are both inefficient.

Fund Bisinefficientrelativeto Fund D. No determinationispossible.

portfolio 2 2 2 0.5

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Question #37 of 119

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ᅚ C) Explanation

To beinefficient, thereturnmust belowerwhilethe varianceis higher. Theonlycasewherethatrelationshipexistsiswith respectto

Fund B and D. (Study Session18, LOS 57.b)

If Marko had tochoosetoform a portfoliousingonlyT-bills and oneofthefourfunds, which should hechoose?

Fund A.

Fund D.

Fund B.

Explanation

Theeasiestwayto approach this questionistocalculatethe Sharperatioforeach fund and choosetheonewith the highestratio. The

highest Sharperatioreflectsthe highestexcessreturnfor a givenlevelofrisk.

The Sharperatios are asfollows:

Fund A = (12 − 5) / 16.00 = 0.44 Fund B = (9 − 5) / 14.00 = 0.29 Fund D = (10 − 5) / 13.42 = 0.37

Fund A hasthe highest Sharperatio and thereforewould bethe bestonetocombinewith T-bills.

An alternativewayto answerthe questioncan beseen bycombining Fund Awith T-billsin a portfoliotoget an average/expected return equaltoeach oftheotherportfolios and computingthe varianceforeach ofthoseportfolios. Thencomparethe varianceoftheportfolio composed ofA and theT-billstothecorresponding varianceoftheother asset.

Tofind the appropriateweightsfortheportfoliotoearnthereturnof Fund B, solvefor W inthefollowingequation:9% = W × 12% + (1 − W) × 5%. Thesolutionis W = 0.5714.

0.5714in Fund A and 0.429inT-bills has a varianceequalto (0.5714)(0.5714)(0.0256) = 0.00836.

Applyingthesameprocedureto Fund Dgives W = 0.80

0.80in Fund D and 0.20inT-bills has a varianceequalto (0.80)(0.80)(0.018) = 0.01152.

Thus, a CAL formed with Fund Acan dominatetheCAL ofeach oftheotherthreeportfolios. (Study Session18, LOS 57.d)

Which ofthefollowingstatementsregardingthegraph ofreturn vs. riskfor allpossibleportfoliocombinationsconsistingof FundsA, B, and Cisleast accurate?

If the objective of the portfolio manager is to maximize return the optimal portfolio

must lie on the curved line above the minimum-variance portfolio.

Combinationsof Fund A, B, and Cwill dominate allothercombinationsofportfoliosthat have

a lowerreturnforthesamelevelofrisk.

Iftheobjectiveoftheportfoliomanageristominimizerisktheoptimalportfoliomustlieonthe curved line belowtheminimum-varianceportfolio.

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Thecurved line belowtheminimum-varianceportfoliorepresents allportfoliocombinationsthat are dominated byotherportfolio combinations. Based ontheefficientfrontiercreated bythesetwofunds higherreturns atthesamelevelofriskcan be achieved above theminimum-varianceportfolio. (Study Session18, LOS 57.b)

The beta of Fund Ais1.2, theexpected returnofT-billsis5% and thestandard deviationforthemarketis13%. Whatisthecovariance

betweenthemarketportfolio and Fund A?

0.081.

0.156.

0.020.

Explanation

The beta forfund Aisequaltothecovarianceoffund A and themarket divided bythe varianceofthemarket. Therefore, 1.2 =

COV(A,Market) / (0.13)

SolvingforCOV(A,Market) = (1.2)(0.13) = 0.0203. (Study Session18, LOS 57.a)

Jennifer Watkins, CFA, is a portfoliomanager atQ-Metrics. She has derived a 2-factor arbitragepricingtheory (APT)modelofexpected

returnssheintendstousein herportfoliomanagementstrategies. Thetwo-factorAPTequation, inwhich thetwofactors areconfidence risk and industrialproduction, is:

E(R ) = R + 0.06β + 0.09β

Watkins determinesthesensitivitytoeach ofthetwofactorsforthree diversified portfolios aswell asfor her benchmark, the Wilshire

5000. Theresultsof her analysis areshowninthetable below.

Portfolio Sensitivity toConf.Risk Factor Sensitivity toIndust.Prod.Factor

J 1.50 1.00

K 0.80 1.20

L 1.00 2.00

Wilshire5000 1.00 1.50

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qua

l

to

4

.

0

%.

Watkinscompares her data and resultstothatof a colleaguewhousestheCapitalAssetPricing Model (CAPM)to analyzethesame portfolios. She determinesthat her analysisismore appropriateforthegivenportfolios.

Whatistheexpected returnonPortfolio K accordingtotheAPTequation?

22.0%.

2

2

P T-bill p,CONF p,PROD

p,CONF

p,PROD

Question #45 of 119

QuestionID:464551

ᅞ A)

ᅚ B)

ᅞ C)

Questions #46

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51 of 119

toexploitthe arbitrageopportunity. Wepurchase K usingtheproceedsfromsellingshort a portfolioconsistingof J and/or L. (LOS 57.l)

Aportfoliowith a factorsensitivityofoneto a particularfactorin a multi-factormodel and zeroto allotherfactorsiscalled a(n):

tracking portfolio.

factorportfolio.

arbitrageportfolio.

Explanation

Afactorportfoliois a portfoliowith a factorsensitivityofoneto a particularfactor and zeroto allotherfactors. An arbitrageportfoliois a

portfoliowith factorsensitivitiesof zeroto allfactors, positiveexpected netcash flow, and aninitialinvestmentof zero. Atracking

portfoliois a portfoliowith a specificsetoffactorsensitivities designed toreplicatethefactorexposuresof a benchmarkindex.

ColonialCapitalleans heavilyonthecapital assetpricingmodel (CAPM)initsinvestment-making decisions, butthecompany's analysts find it difficulttouse. In anefforttomakethecalculationseasier, Colonial hasmodified theCAPM tousethe S&P1500 SuperComposite Index as a benchmark.

Colonialrecently hired high-powered moneymanager Marjorie Kemp awayfrom a rivalcompanyin aneffortto boostitslaggingreturns. Kempunderstandsthe appealoftheCAPM butlikestousemultiple valuationmethodsforthepurposesofcomparison.

In herfirst act aschiefinvestmentofficerofColonial, Kempsent a memoto allportfoliomanagersinstructingthemtostartusing alternativemethodsfor valuing assets. Sheopened bytoutingthe benefitsofotherformsof asset valuation.

"TheCAPM requires a lotofunrealistic assumptions. ArbitragePricingTheory's (APT) assumptions arefarlessrestrictive." "Amajor benefitofmultifactormodelsrelativetotheCAPM istheir abilityto beeffectivelytested usingreal-life data."

"UnderAPT, riskiseasiertocalculatethanisthecasewith theCAPM, forwhich beta must beestimated based onunobservable returns."

"NeithermultifactormodelsnorAPTrequire anestimationofthemarketriskpremium."

Kempthencalled a meetingofColonial's analyststo discuss asset-valuationstrategies. The debategrew quitespirited.

AlongtimeColonial analystnamed Smatherssaid thecompany had experimented with multifactormodelsyearsearlier and could not comeupwith a modelthatsatisfied everyone. Hethenproposed creating a numberofmultifactormodelsfor differentsectors. The responseswere asfollows:

Floriosaid he didn'tlikeAPT becauseit did notindicatewhattheriskfactorswere.

Garcia said heliked APT becauseit acknowledged that arbitrageopportunitiesoccasionallyexist.

Ingesaid he disliked APT becauseit did not allow analyststoconsiderthemarketportfolio.

After about30minutes, Kemprealized nothingproductivewould occur, sosheseteveryonetowork analyzing a valuationmodel. She

wrotethefollowingequationon a blackboard:

Question #46 of 119

QuestionID:464529

ᅞ A)

ᅞ B)

ᅚ C)

Question #47 of 119

QuestionID:464530

ᅞ A)

ᅚ B)

ᅞ C)

Question #48 of 119

QuestionID:464531

ᅚ A)

ᅞ B)

ᅞ C)

Which factors, takenincombination, would createthebestmultifactormodelforutilitystocks?

Projected winter low temperature, projected change in energy prices, projected change in inflation, projectedmarket return.

Projected changeinenergyprices, interestratetermstructure, estimated GDPgrowth,

projected marketreturn.

Projected winterlowtemperature, interestratetermstructure, housingstarts, price/earnings factor.

Explanation

Withoutknowingthe accuracyofthefactorsensitivitiesor actuallylooking atthenumbersgenerated bytheequation, wecanonly assess the valueof a multifactormodel byconsideringwhethertheindividualfactors arerelevant. Winterlowtemperatures and energyprices are particularlyrelevanttoutilities, thefirstontherevenueside, and thesecond onthecostside. Becauseutilitiestend to be heavily

leveraged, interestrates affectthem. Inflationrates arerelevantformostcompanies, as areprice/earningsratios. Housingstarts are relevantforutilities, as houses arelargerthan apartments and moreexpensiveto heat and cool. However, utilities areconsidered diversifiers, and theirreturns arelesscorrelated tothoseofthe broadermarketthan arethereturnsofstocksinothersectors. Thesector is alsolesscorrelated toeconomicgrowth thanmost. Assuch, modelsthatconsider GDPgrowth ormarketreturns areprobablyofless

valuethantheonemodelthatconsidersneither. (LOS 57.j)

Which statementrepresents Kemp'sweakest argument?

"Neither multifactor models nor APT require an estimation of the market risk premium." "UnderAPT, riskiseasiertocalculatethanisthecasewith theCAPM, forwhich beta must

beestimated based onunobservablereturns."

"TheCAPM requires a lotofunrealistic assumptions. APT's assumptions arefarless restrictive."

Explanation

Itis debatablewhetherriskiseasiertocalculateunderAPT. True, the beta oftheunobservablemarketportfolioisnotneeded, butthe riskfactorsrequired fortheAPTequation arenotprovided. The analystmustselectthem. Assuch, thestatement abouttheeaseof calculatingriskisopenforinterpretation. Both remainingstatements arefactually accurate, with nointerpretationrequired. (LOS 57.l)

Kemp'sequationisclosestto:

amacroeconomic multifactor model. arbitragepricingtheory.

a microeconomicmultifactormodel.

Explanation

Question #49 of 119

QuestionID:464532

ᅚ A)

ᅞ B)

ᅞ C)

Question #50 of 119

QuestionID:464533

ᅞ A)

ᅚ B)

ᅞ C)

Question #51 of 119

QuestionID:464534

ᅚ A)

ᅞ B)

ᅞ C)

Question #52 of 119

QuestionID:464354

leavesfactormodels. Themarketreturnistechnicallyneither a macroeconomicormicroeconomic variable, butitcan beused with multifactormodels. Sincetheotherthree variablesrepresentmacrofactors, theequationisclosestto a macroeconomicmultifactor

model. (LOS 57.j)

Which analystmadethe mostsense?

Florio.

Inge. Garcia.

Explanation

Florio'sstatement aboutriskfactorsiscorrect, and reflects a weaknessinAPT. Garcia'sstatementisincorrect, becauseoneofthe

assumptionsinherentintheAPTisthat arbitrageopportunities donotexist. Ingeismistaken because, whileAPT doesnotrequirethe useofthemarketportfolio, an analystcancertainlyusethemarketportfolio as a factorif desired. (LOS 57.l)

Which ofthefollowingisleastlikely torepresent a major assumptionoftheArbitragePricingTheory?

Assets are priced so that there are no arbitrage opportunities.

Asset-specificriskisthemajorsourceofthe varianceofportfolioreturns.

Assetreturns are described by a factormodel.

Explanation

UndertheArbitragePricingTheory, we assumethatthere aremany assets, so asset-specificriskcan beeliminated. When a portfolio containsmanysecurities, thenonsystematicriskofindividual assetsmakes almostnocontributiontothe varianceofportfolioreturns. (LOS 57.l)

Which ofthefollowingstatementsregardingtheArbitragePricingTheoryisleastaccurate? ArbitragePricingTheory:

explains factor j's risk premium to be the expected return on a pure factor portfolio for factor j.

describestheexpected returnon an asset as a functionoftheriskfrom a setoffactors. makeslessrestrictive assumptionsthantheCAPM.

Explanation

APTexplainsfactor j'sriskpremiumto betheexpected returninexcessoftherisk-freerateon a purefactorportfolioforfactor j. Likethe CAPM, theAPT describes a financialmarketequilibrium, buttheAPTmakeslessrestrictive assumptionsthantheCAPM. APT

Question #55 of 119

QuestionID:464554

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ᅚ B)

ᅞ C)

Question #56 of 119

QuestionID:464347

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ᅞ B)

ᅞ C)

Question #57 of 119

QuestionID:464466

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ᅞ B)

ᅚ C)

variance). Itistheportfolio atthetipofthe bullet. Themarketportfolio, inwhich each assetis held inproportiontoitsmarket value,

cannot havethesmalleststandard deviationoftheportfoliosontheminimum variancefrontier.

Aportfoliowith a specificsetoffactorsensitivities designed toreplicatethefactorexposuresof a benchmarkindex iscalled a:

factor portfolio.

trackingportfolio.

arbitrageportfolio.

Explanation

Atrackingportfoliois a portfoliowith a specificsetoffactorsensitivities designed toreplicatethefactorexposuresof a benchmarkindex.

Afactorportfoliois a portfoliowith a factorsensitivityofoneto a particularfactor and zeroto allotherfactors. An arbitrageportfoliois a

portfoliowith factorsensitivitiesof zeroto allfactors, positiveexpected netcash flow, and aninitialinvestmentof zero.

Thecapital assetpricingmodel (CAPM) assumesthatinvestorscan borrow attherisk-freerate and shortsell, and also, thatthemarket portfolioisefficient. With respecttotherisk-freerate and sellingshort, themarketportfoliomay NOT beefficient:

if either borrowing at the risk-free rate or short-selling is not possible.

if both borrowing attherisk-freerate and short-selling arenotpossible.

undernocircumstances, themarketportfolioisefficient by definition.

Explanation

Thecapitalmarketline (CML)reliesonthe assumptionthatthemarketportfolioisefficient. Thatis, themarketportfolioliesonthe efficientfrontier and offersthe highestpossiblelevelofreturnforitslevelofrisk. Ifinvestors arenot allowed or abletoshortsellor borrow attherisk-freerate, however, themarketportfoliomaynot beefficient.

Which ofthefollowingisnot an assumptionofthe arbitragepricingtheory (APT)?

The market contains enough stocks so that unsystematic risk can be diversifiedaway. Returnson assetscan be described by a multi-factorprocess.

Securityreturns arenormally distributed.

Explanation

Question #58 of 119

QuestionID:464426

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ᅞ B)

ᅞ C)

Question #59 of 119

QuestionID:464566

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ᅞ B)

ᅞ C)

Question #60 of 119

QuestionID:464499

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ᅞ B)

ᅞ C)

Thecapitalmarketline:

helps determine asset allocation.

has a slopeequaltothemarketriskpremium.

usesnondiversifiablerisk.

Explanation

ThepurposeoftheCML isto determinethepercentages allocated tothemarketportfolio and therisk-free asset. Both remaining answers reflectcharacteristicsofthesecuritymarketline.

Which ofthefollowingmodelsis NOTconsistentwith theconceptthatinvestorscanearn an additionalriskpremiumfor holding dimensionsofriskunrelated tomarketmovements?

The capital asset pricing model (CAPM).

The arbitragepricingtheory.

Macroeconomicmulti-factormodels.

Explanation

TheCAPM suggeststhatsecurityreturnscan becaptured in a one-factor (market)model. Multifactormodels allowustocaptureother

dimensionsofrisk besidesoverallmarketrisk. Investorswith uniquecircumstancesthat differfromthe averageinvestormaywantto hold

portfoliostilted awayfromthemarketportfolioinorderto hedgeorspeculateonfactorslikerecessionrisk, interestrateriskorinflation risk. In doingsothey are abletoearn a substantialpremiumfor holding dimensionsofriskunrelated tomarketmovements.

Given a three-factor arbitragepricingtheoryAPTmodel, whatistheexpected returnonthe Freedom Fund?

Thefactorriskpremiumstofactors1, 2, and 3 are10%, 7% and 6%, respectively.

The Freedom Fund hassensitivitiestothefactors1, 2, and 3of1.0, 2.0 and 0.0, respectively. Therisk-freerateis6.0%.

30.0%.

24.0%.

33.0%.

Explanation

Question #61 of 119

QuestionID:464421

ᅚ A)

ᅞ B)

ᅞ C)

Question #62 of 119

QuestionID:464325

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ᅚ B)

ᅞ C)

Question #63 of 119

QuestionID:464561

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ᅞ B)

Whatistheexpected rateofreturnfor a stockthat has a beta of1.0iftheexpected returnonthemarketis15%?

15%.

Morethan15%.

Cannot be determined withouttherisk-freerate.

Explanation

Theexpected returnof a stockwith a beta of1.0must, on average, bethesame astheexpected returnofthemarketwhich also has a beta of1.0.

What aretheexpected return and expected standard deviationforthetwo-assetportfolio described as:

Expected

Return/Correlation

Variance

Weig

h

t

E(R

)

= 1

0

%

Var(1

)

=

9

%

w

=

30

%

E(R

)

= 1

5

%

Var(

2)

=

25

%

w

=

70

%

r

=

0

.

4

E(R ) σ

10.5% 15.58%

13.5% 39.47%

11.5% 3.95%

Explanation

E(R ) = wE(R) + wE(R) = (0.3)(10.0) + (0.7)(15.0) = 13.5%

σ = [(w )(σ ) + (w )(σ) + 2w wσ σ ρ ]

= [(0.3)(0.09) + (0.7)(0.25) + 2(0.3)(0.7)(0.3)(0.5)(0.4)] = 39.47%

SidneyPetersonisstarting a newfund thatis designed to havethesamefactorexposures astheDow JonesIndustrialAverage, but seekstooutperformtheindex by atleast2% annuallythorough superiorstockselection. To achievethis, thefund would mostlikely use

a:

tracking portfolio. bottom-upstrategy.

1 1

2 2

1,2

port port

port 1 1 2 2

port 12 12 22 22 1 2 1 2 1,21/2

ᅞ C)

Questions #64

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69 of 119

Question #64 of 119

QuestionID:464327

purefactorportfolio.

Explanation

Trackingportfolios aretypicallyused for active assetselection. Apurefactorportfoliowould beused toincreaseor decreaseexposureto onespecificfactor, such as GNP. A bottom-upstrategyisunsuitable becauseitsolelyfocuseson a firm'scharacteristics and failsto properlyinvestinthesameindustries astheindex.

Andy Green, CFA, and Sue Hutchinson, CFA, areconsidering adding alternativeinvestmentstotheportfoliotheymanagefor a private client. They havefound thatitisrecommended that a large, well-diversified portfolioliketheonethattheymanageshould include a 5to 10% allocationin alternativeinvestmentssuch ascommodities, distressed companies, emergingmarkets, etc.. Aftermuch discussion, Green and Hutchinson have decided thattheywillnotchooseindividual assetsthemselves. Instead ofchoosingindividual alternative investments, theywill add a hedgefund totheportfolio. They decideto divideuptheirresearch by havingeach ofthemtake a different focus. Intheirresearch of hedgefunds, Greenfocuseson hedgefundsthat havethe highestreturns. Hutchinsonfocusesonfinding hedgefundsthatcan allowtheclient'sportfoliotolowerriskwhile, with theuseofleverage, maintainthesamelevelofreturn.

Aftercompletingtheirresearch intofinding appropriate hedgefunds, Greenproposestwo hedgefunds:the New Horizon Emerging Market

Fund, which takeslong-termpositionsinemergingmarkets, and the Hi Rise Real Estate Fund, which holds a highlyleveraged realestate portfolio. Hutchinsonproposestwo hedgefunds:theQualityCommodity Fund, which takesconservativelong-termpositionsin

commodities, and theBeta Naught Fund, which manages anequitylong/shortportfoliothat hasthegoaloftargetingtheportfolio'smarket riskto zero. TheBeta Naught Fund engagesinshort-termpairtradingtocapture additionalreturnswhilekeepingthe beta ofthefund

equalto zero. Thetable belowliststhestatisticsfortheclient'sportfoliowithout any alternativeinvestments and forthefour hedgefunds

based uponrecent data. Theexpected return, standard deviation and beta oftheclientportfolio and the hedgefunds areexpected to have thesame valuesinthenearfuture. Greenusesthemarketmodeltoestimatecovariances betweenportfolioswith theirrespective betas

and the varianceofthemarketreturn. The varianceofthemarketreturnis324(%).

Curr

e

n

t

C

l

i

e

n

t

Po

r

t

f

ol

i

o

N

ew

H

o

riz

o

n

Hi Ri

se

R

e

a

l

E

st

a

te

Q

ua

l

i

ty

C

ommo

di

ty

Bet

a Nau

g

h

t

Av

e

ra

ge

1

0

%

20

%

1

0

%

6

%

4

%

S

t

d.

De

v.

1

6

%

50

%

1

6

%

1

6

%

25

%

Bet

a

0

.8

0

.

9

0

.

4

-

0

.

2

0

Green and Hutchinson have decided toselloff10% ofthecurrentclientportfolio and replaceitwith oneofthefour hedgefunds. They have agreed toselectthe hedgefund thatwillprovidethe highest Sharpe Ratiowhen10% oftheclient'sportfoliois allocated tothat

hedgefund.

As an alternativetoinvesting10% inone hedgefund, Green and Hutchinson have discussed investing5% intheBeta Naught Fund and 5% inoneoftheotherthree hedgefunds. Thisnew50/50 hedgefund portfoliowould thenserve asthe10% allocationin alternative investmentsfortheclient'sportfolio.

Green and Hutchinson divided uptheirresearch intoreturnenhancement and diversification benefits. Based uponthestated goalsoftheir research, which ofthetwo approachesismorelikelytolead to an appropriatechoice? Thefocusof: