Sample Questions 3
MULTIPLE CHOICE QUESTIONS
1- The Capital Asset Pricing Model:
a. has serious flaws because of its complexity.
b. measures relevant risk of a security and shows the relationship between risk and
expected return.
c. was developed by Markowitz in the 1930s.
d. discounts almost all of the Markowitz portfolio theory
2- Which of the following is not one of the assumptions of the CAPM?
a. All investors have the same one-period time horizon.
b. There are no personal income taxes.
c. There is no interest rate charged on borrowing.
d. There are no transaction costs.
3- Which of the following is an assumption of the CAPM?
a. Single investors can affect the market by their buying and selling decisions.
b. There is no inflation.
c. Investors prefer capital gains over dividends.
d. Different investors have different probability distributions.
4- Which of the following regarding investors and the CAPM is true?
a. Investors recognize that all the assumptions of the CAPM are unrealistic.
b. Investors recognize that all of the CAPM assumptions are not unrealistic.
c. Investors are not aware of the assumptions of the CAPM model.
d. Investors recognize the CAPM is useless for individual investors.
5- Market equilibrium exists:
a. only in fiction.
b. when prices are fixed for the one-time period of the investors.
c. when prices are at levels that provide no incentive for speculation.
d. only in money markets, not in capital markets
6- What does it mean when the CAPM is called “robust”?
a. The CAPM requires no assumptions.
b. Even if most of the assumptions of the CAPM are relaxed, most of the
conclusions will still hold.
c. The CAPM is based on realistic assumptions.
d. No other model can represent stock returns better than the CAPM.
7- Which of the following statements about the difference between the SML and the
CML is true? The:
a. intercept of the CML is the origin while the intercept of the SML is RF.
b. CML consists of efficient portfolios, while the SML is concerned with all
portfolios or securities.
c. CML could be downward sloping while that is impossible for the SML.
d. CML and the SML are essentially the same except in terms of the securities
represented.
8- Select the true statement regarding the results of CAPM tests.
a. The SML appears not to be linear.
b. The intercept term is a generally found to be higher than the risk-free rate.
c. The slope of the CAPM is steeper than posited by the theory.
d. Investors are rewarded for assuming systematic and unsystematic risk.
9- Which of the following statements best summarizes the conclusions reached
regarding the stability of betas?
a. Betas for individual securities and large portfolios are unstable.
b. Betas for individual securities are unstable.
c. Betas for individual securities and large portfolios are stable.
d. Betas for large portfolios are unstable.
10- What does the slope of the CML represent? The:
a. amount of return expected for bearing the risk of a portfolio.
b. market price of risk for efficient portfolios.
c. market price of risk for any given security.
d. expected return on the market portfolio.
11- The SML can be used to analyze the relationship between risk and required return
for:
a. all assets.
b. inefficient portfolios.
c. only efficient portfolios.
d. only individual securities.
12- Select the correct statement regarding the market portfolio. It:
a. is readily and precisely observable.
b. should include all risky assets.
c. is the lowest point of tangency between the risk-free rate and the efficient
frontier.
d. should be composed of stocks or bonds.
13- The systematic risk level of a security:
a. is not related to the variability of the overall market portfolio.
b. is the slope of the security market line.
c. can be measured by standard deviation.
d. can be calculated as the ratio of the stock’s covariance with the market portfolio
to the variance of the market’s return.
14- Select the statement which correctly describes the calculation of the required rate of
return of a portfolio.
a. It is unaffected by changes in the beta value.
b. It increases if the expected return on the market declines.
c. It decreases if the risk-free rate declines; everything else remaining constant.
d. It is independent of changes in the market return and the risk-free rate.
15- Choose the statement below that is not correct.
a. With the addition of risk-free borrowing and lending, the old Markowitz
efficient frontier is dominated by a new efficient frontier.
b. With the introduction of risk-free borrowing and lending, the new efficient
frontier will be a straight line.
c. With the introduction of risk-free borrowing and lending, the new efficient
frontier will be an arc that is higher than the old Markowitz arc representing the
efficient frontier.
d. In equilibrium, all risky assets must be in the market portfolio.
16- Select the incorrect statement. The:
a. SML uses beta as the measure of risk.
b. SML is a relationship between expected return and risk for efficient portfolios
only.
c. beta for a stock measures its contribution to the risk of the market portfolio.
d. larger the beta for a security, the larger its equilibrium expected return.
17- If markets are truly efficient and in equilibrium:
a. all assets would lie on the SML.
b. any assets that plot below the SML would be considered undervalued.
c. any assets that lie above the SML would be considered overvalued.
d. no assets would lie on the SML.
18- Which of the following statements regarding beta is true?
a. Beta is an absolute measure of risk.
b. Beta is a relative measure of risk.
c. Beta is a abstract measure of risk.
d. Beta is a geometric measure of risk.
19- The central issue of efficient markets concerns:
a. regulations.
b. information.
c. participants.
d. structure.
20- An efficient market is defined as one in which:
a. all participants have the same opportunity to make the make the same returns.
b. all participants have the same legal rights and transaction costs.
c. securities’ prices quickly and fully reflect all available information.
d. securities’ prices are completely in line with the intrinsic value.
21- All “known” information means:
a. past information only.
b. past and current information.
c. past, current, and inferred information.
d. past, current, inferred and relative information.
22- What is the result of the widespread usage of the Internet with regards to efficient
markets?
a. It makes information cheaper and more accessible thus making markets more
efficient.
b. It is subject to new regulations thus marking markets less efficient.
c. It increases the volatility of security prices thus making markets less efficient.
d. It decreases competition among brokers thus making markets more efficient.
23- If a market is inefficient, as new information is received about a security:
a. nothing will happen.
b. the stock price will fall at first and then later rise.
c. there will be a lag in the adjustment of the stock price.
d. there will be negative demand for the stock.
24- All of the following conditions must occur for a market to be considered efficient
except:
a. Information is costless and widely available to market participants at
approximately the same time.
b. Information is generated in a specific fashion such that announcements are
basically dependent on each other.
c. There are a large number of rational, profit-maximizing investors who actively
participate in the market.
d. Investors react quickly and fully to the new information, causing stock prices to
adjust accordingly.
25- The random walk hypothesis is most related to the:
a. weak-form EMH.
b. semi-strong-form EMH.
c. semi-weak-form EMH.
d. strong-form EMH.
26- The overreaction hypothesis tends to:
a. support the weak-form EMH.
b. not support the weak-form EMH.
c. support the semi-strong-form EMH.
d. not support the semi-strong-form EMH.
27- Weak-form market efficiency:
a. implies that the expected return on any security is zero.
b. incorporates semi-strong-form efficiency.
c. involves historical price and volume information.
d. is compatible with technical analysis.
28- Which of the following is not a test of semi-strong-form efficiency?
a. Insider transactions
b. Stock splits
c. Accounting changes
d. Dividend announcements
29- Assuming that the efficient market hypothesis is true, which of the following
regarding the implica-tions of the EMH is incorrect?
a. Technical analysis and the weak form of the EMH directly conflict.
b. Most investors can do a superior job of analysis and profit thereby.
c. Professional money managers would still have certain important tasks to
perform.
d. Investors who use the same data and make the same interpretations as other
investors will experience only average results.
30- The __________ is not a market anomaly.
a. size effect
b. January effect
c. Day-of-the-week effect
d. accounting changes effect
31- According to the weak form of the EMH:
a. successive price changes are biased.
b. successive price changes are dependent.
c. specified trading rules can prove to be extremely useful in generating excess
returns.
d. successive price changes are independent.
32- In an efficient market, it is not necessary for a portfolio manager to:
a. determine and quantify the risk preferences of a client.
b. minimize total transaction costs.
c. ascertain the tax implications of alternative investments.
d. attempt to maximize the portfolio’s rate of return by superior market timing.
33- The paradox of efficient markets is that:
a. even though markets are efficient overall, there are pockets of inefficiency.
b. investors attempting to uncover and use information about security prices help
make the market more efficient.
c. news about anomalies makes the market less efficient.
d. investors make the market less efficient
34- According to the semi-strong form of the EMH, investors who invest in a stock
after a highly positive announcement concerning the stock can expect to earn a(n):
a. normal return because the stock will be fairly priced when purchased.
b. extraordinary return because the new information will not affect the price until
later.
c. loss because things often are not what they seem.
d. zero return because the next price is expected to be the same as the last price.
SHORT ANSWER QUESTIONS
1- How are securities chosen and in what proportions are they represented in the market
portfolio M?
Answer: All assets are included in portfolio M in proportion to their market value. In
practice, the S&P/TSX Composite Index is often used as a proxy for the
market portfolio.
2- An analyst determined that for the past two quarters the risk-free rate has exceeded
the return on the market portfolio. Does this information disprove the CML?
Answer: No, it merely shows that actual returns often diverge from expected returns.
The CML is founded on expected values, so that proof or disproof does not
lie in historical values.
3- At a given point in time the SML dictates that a security with a beta of 1.10 should
require a return of 18 per cent. Analysts determine that a particular stock with an
observed beta of 1.10 has an expected return of 20 per cent. Outline the scenario
that will bring the security’s return into equilibrium.
Answer: Investors will recognize the security as a good buy (undervalued) and will start
buying it, increasing demand. The price will be bid up until the return drops
to 18 per cent as required by the SML.
4- Betas of individual securities are unstable over time. What are some characteristics
that could cause a company’s beta to change over time?
Answer: A few examples include earnings, cash flow, management, and financial
leverage.
5- What are the assumptions in the CAPM? Can these be relaxed without destroying
the conclusions of the model?
Answer: (1) homogeneous expectations, (2) one-period time horizon, (3) borrow-lend at
RF, (4) no transaction costs, (5) no personal income taxes, (6) no inflation,
(7) investor-price takers, and (8)
capital markets in equilibrium.
Assumptions can be relaxed and still reach most of the same general
conclusions.
6- What types of information are considered in each of the three forms of the EMH?
Answer: Weak form – past price and volume data
Semi-strong form – all public information
Strong form – all information, public and private
7- How is insider trading related to the strong-form EMH?
Answer: If the strong-form EMH were valid, insider information would have no value to
investors because the information would be reflected in current prices. There
would be no need for laws against insider trading if the strong-form EMH
were valid.
8- Do investors stand to earn abnormal profits on initial public offerings? How can this
be reconciled with the semi-strong form of the EMH?
Answer: Investors are often able to earn abnormal profits on IPOs. IPOs are generally
underpriced by the underwriters to assure sales. The price then adjusts
quickly to the “true” economic value. Thus, the investors who get the issue
at the offering price stand to make abnormal profits because the market did
not set the price. (The underwriters did.)
9- If securities are fairly priced, then the portfolio manager, it might be argued, has little
to do, since searching for undervalued stocks is a losing proposition. What other
activities do money managers perform?
Answer: Portfolio managers need to (a) diversify the portfolio; (b) set appropriate risk
levels; (c) determine tax consequences for investors; and (d) reduce
transaction costs consistent with trading requirements.
10- What is a market anomaly? Give examples of several market anomalies.
Answer: An anomaly is an exception to a rule. Market anomalies are exceptions to the
efficient market hypothesis. Several examples follow:
(i) Size effect studies shows that small capitalization stocks tend to earn higher
risk-adjusted returns than large companies.
(ii) January effect studies have found abnormal returns for small stocks in the
month of January, especially during the first five days.