Chapter 12 - An Alternative View of Risk and Return: The Arbitrage Pricing Theory
42. Calculate the stock's total return if the company announces that they had an industrial
accident and the operating facilities will close down for some time thus resulting in a loss by the company of 7% in return. A. -4.05% B. -2.05% C. 4.55% D. 0.40% E. 1.85%
R = 4.95% - 7% = -2.05%.
Difficulty level: Medium
Topic: ARBITRAGE PRICING THEORY Type: PROBLEMS
43. What would the stock's total return be if the actual growth in each of the factors was equal to growth expected? Assume no unexpected news on the patent. A. 4% B. 5% C. 6% D. 7% E. 8%
R = 6%, or the expected return on the stock.
Difficulty level: Medium
Topic: ARBITRAGE PRICING THEORY Type: PROBLEMS
Essay Questions
12-29
Chapter 12 - An Alternative View of Risk and Return: The Arbitrage Pricing Theory
44. An investor is considering the three stocks given below:
Calculate the expected return and beta of a portfolio equally weighted between stocks B and C. Demonstrate that holding stock A actually reduces risk by comparing the risk of a portfolio equally weighted between stock B and T-Bills with a portfolio equally weighted between stocks B and A.
Stock B and C: Rp = .5(13.3%) + .5(9.2%) = 11.25% Stock B and C: ?p = .5(2.1) + .5(0.75) = 1.425
Stock B and T-bills: ?B&TBILL = .5(2.1) + .5(0) = 1.05 Stock's B and A: ?B&A = .5(2.1) + .5(-0.1) = 1.00
Topic: PORTFOLIO RISK Type: ESSAYS
45. Explain the conceptual differences in the theoretical development of the CAPM and APT. CAPM depends on the efficient set and incorporate Rf to get the separation principle. The APT adds factors until there is no, or virtually no, correlation between unsystematic risks of securities. Both show unsystematic risk approaches zero and systematic risks remain.
Topic: CAPM AND APT Type: ESSAYS
12-30
Chapter 12 - An Alternative View of Risk and Return: The Arbitrage Pricing Theory
46. You have a 3 factor model to explain returns. Explain what a factor represents in the context of the APT? Each factor is multiplied by a beta. What do these represent and how do they relate to the actual return?
A factor is a variable that explains some of the return. It measures the unexpected change in some underlying \measures security response to a factor change and it explains how actual return varies from the expected return by the magnitude of ? times the value of the factor.
Topic: APT Type: ESSAYS
47. Discuss the Fama-French three factor model; both what it means and the factors of the model.
The Fama-French (1993) three factor model predicts expected excess returns on a portfolio. The model is based on factor loadings on three factors in addition to the actual factors. The first factor is the excess return on the market multiplied by the beta, as in the CAPM. The second and third factors are aimed at the size and value effects. The size factor is the difference between returns of a portfolio of small stocks and a portfolio of large stocks and is multiplied by its factor loading. The third variable is the value factor, which is the difference between returns on a portfolio of high book-to-market stocks and a portfolio of low book-to-market stocks
multiplied by its factor loading. The three factors together do a reasonable job at predicting excess portfolio return and are widely used in academic research and are becoming more widely used in practice.
Topic: FAMA-FRENCH THREE FACTOR MODEL Type: ESSAYS
12-31
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