Chapter 13

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1. Award: 10.00 points Problems? Adjust credit for all students. Lotsa Lenses paid a dividend of $1.13 last year and plans a dividend growth rate of 3.10% indefinitely. Lotsa’s stock price is now $13.69. What return can Lotsa Lenses’ investors expect on their stock? Note: Do not round intermediate calculations. Round your answer to 2 decimal places. Expected return 11.61 % Explanation: The expected return can be calculated as E ( r ) = D 1 ÷ P 0 ) + g = (($1.13 × 1.031) ÷ $13.69) + 0.031 = 11.61% Worksheet Difficulty: 1 Basic Source: Investments (Bodie, 13e, ISBN 1266836322) > Chapter 13: Empirical Evidence on Security Returns > Chapter 13 Additional Algorithmic Problems References

2. Award: 10.00 points Problems? Adjust credit for all students. Elk City Utility recently paid a dividend of $3.81 per share. Dividends are expected to grow at a rate of 4.20%. Elk City stock currently sells for $38.45 per share. If you were on the utility regulatory commission, what rate of return would you allow Elk City to earn? Note: Round your answer to 2 decimal places. Rate of return 14.53 % Explanation: Given the information provided, the discounted cash flow model can be used to determine a fair rate of return of 14.53% for Elk City Utility: E ( r ) = ( D 1 ÷ P 0 ) + g = D 0 × (1 + g ) ÷ P 0 + g E ( r ) = ($3.81 × 1.042) ÷ $38.45 + 0.042 = ($3.97 ÷ $38.45) + 0.042 = 14.53% Worksheet Difficulty: 1 Basic Source: Investments (Bodie, 13e, ISBN 1266836322) > Chapter 13: Empirical Evidence on Security Returns > Chapter 13 Additional Algorithmic Problems References

3. Award: 10.00 points Problems? Adjust credit for all students. The common stock of Royal Ranch House is selling for $19.70. The firm pays dividends that are expected to grow at a rate of 4.10% indefinitely. Your investment horizon is 8 years. What do you estimate the price of Royal Ranch House stock will be at that time? Note: Round your answer to 2 decimal places. $ Stock price 27.17 Explanation: Since the growth rate is stable, the price of the stock will grow at the same rate as its dividends. The price in 8 years will be P 8 = P 0 × (1 + g ) 8 = $19.70 × 1.041 8 = $27.17 Worksheet Difficulty: 1 Basic Source: Investments (Bodie, 13e, ISBN 1266836322) > Chapter 13: Empirical Evidence on Security Returns > Chapter 13 Additional Algorithmic Problems References

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4. Award: 10.00 points Problems? Adjust credit for all students. Hornberger, Incorporated recently paid a dividend of $2.00 per share. The next dividend is expected to be $2.03 per share. Hornberger has a return on equity of 11.60%. What percentage of its earnings does Hornberger plow back into the firm? Note: Round your answer to 2 decimal places. Plowback ratio 12.93 % Explanation: We can use the relationship g = ROE × b to find the plowback ratio ( b ). The growth rate implied by the recent dividend and the expected dividend is estimated using the equation D 1 = D 0 × (1 + g ): $2.03 = $2.00 × (1 + g ) 1 + g = $2.03 ÷ $2.00 = 1.015 g = 1.50% Then 1.50% = 11.60% × b b = 1.50% ÷ 11.60% = 12.93% Worksheet Difficulty: 1 Basic Source: Investments (Bodie, 13e, ISBN 1266836322) > Chapter 13: Empirical Evidence on Security Returns > Chapter 13 Additional Algorithmic Problems References

5. Award: 10.00 points Problems? Adjust credit for all students. Dishwasher’s Delights plows back 68.50% of its earnings to take on projects that earn the firm a rate of return of 13.50%. Dishwasher’s stockholders require a return of 12.00% on their common stock. Earnings per share are expected to be $5.00 next year. Required: a. What is the expected growth rate for Dishwasher’s common stock? Note: Do not round intermediate calculations.Round your answer to 2 decimal places. Growth rate 9.25 % b. What is the expected dividend next year? Note: Do not round intermediate calculations. Round your answer to 2 decimal places. $ Dividend 1.58 c. What is the intrinsic value of Dishwasher’s stock? Note: Do not round intermediate calculations. Round your answer to 2 decimal places. $ Intrinsic value 57.22 d. If Dishwasher’s management chose to pay out all earnings as dividends, what would be the intrinsic value of its stock? Note: Do not round intermediate calculations. Round your answer to 2 decimal places. $ Intrinsic value 41.67 e. What is the present value of growth opportunities for Dishwasher's Delights? Note: Do not round intermediate calculations. Round your answer to 2 decimal places. $ PVGO 15.55 Explanation: a. The expected growth rate equals the return on equity times the plowback ratio: g = ROE × b = 13.50% × 0.685 = 9.25%. b. Dishwasher's Delights plows back 68.50% of its earnings and pays out the other 31.50% as dividends. D 1 = EPS 1 × 0.315 = $5.000 × 0.315 = $1.58. c. The intrinsic value of Dishwasher’s stock equals D 1 ÷ ( k − g ) = $1.58 ÷ (0.120 − 0.0925) = $57.22. d. If Dishwasher’s management chose to pay out all earnings as dividends, the growth rate would equal zero ( g = ROE × b = 13.50% × 0 = 0%), the dividend next year would be $5.00, and the intrinsic value would equal D 1 ÷ ( k − g ) = $5.00 ÷ (0.120 − 0) = $41.67 e. The present value of growth opportunities for Dishwasher's Delights equals the intrinsic value of their stock based on the policy of reinvesting 68.50% of their earnings in the business minus the intrinsic value of their stock based on a reinvestment rate of 0%. PVGO = $57.22 − 41.67 = $15.55 The stock is worth more if they plow back some of the funds since they can reinvest funds to earn a rate of return of 13.50%, which is higher than the investors’ required return of 12.00%. Worksheet Difficulty: 2 Intermediate Source: Investments (Bodie, 13e, ISBN 1266836322) > Chapter 13: Empirical Evidence on Security Returns > Chapter 13 Additional Algorithmic Problems References

6. Award: 10.00 points Problems? Adjust credit for all students. Indigo Ink Supply paid a dividend of $6.5 last year on its common stock. It is expected that this dividend will grow at a rate of 6.5% for the next five years. After that, the company will settle into a slower growth pattern and plans to pay dividends that will grow at a rate of 3% per year. Investors require a return of 9.5% on the stock. Required: a. What will be the dividend paid out for the next six years? Note: Round your answers to 4 decimal places. $ $ $ $ $ $ D1 = 6.9225 D2 = 7.3725 D3 = 7.8517 D4 = 8.3620 D5 = 8.9056 D6 = 9.1727 b. What is the intrinsic value of Indigo’s stock? Note: Round your answer to 2 decimal places. $ Intrinsic value 119.57 Explanation: a. The dividends over the next 5 years will be: D1 = $6.50 × 1.06501 = $6.9225 D2 = $6.50 × 1.06502 = $7.3725 D3 = $6.50 × 1.06503 = $7.8517 D4 = $6.50 × 1.06504 = $8.3620 D5 = $6.50 × 1.06505 = $8.9056 The dividend in the sixth year will be D 6 = $8.9056 × 1.03 = $9.1727. b. Based on the dividend for the sixth year, the intrinsic value at time 5 will be P 5 = D 6 ÷ ( k − g ) with the appropriate growth rate being 3.00%. P 5 = $9.1727 ÷ (0.095 − 0.030) = $141.1189 The relevant cash flows and their present values are shown in the table below. The intrinsic value of the stock today equals $119.57. Time (t) CFt Present Value at 11% 1 $6.9225 $6.32 2 $7.3725 $6.15 3 $7.8517 $5.98 4 $8.3620 $5.82 5 $8.9056 + 141.1189 = $150.0245 $95.30 Intrinsic Value = $119.57 Worksheet Difficulty: 3 Challenge Source: Investments (Bodie, 13e, ISBN 1266836322) > Chapter 13: Empirical Evidence on Security Returns > Chapter 13 Additional Algorithmic Problems References

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7. Award: 10.00 points Problems? Adjust credit for all students. Jumbo Shrimp Oxymorons, Incorporated recently paid a dividend of $2.06 per share. The firm expects explosive growth of 20% over the next two years. After that the firm’s managers expect that growth will drop to 14% for the following three years, then settle at 8% indefinitely. If investors require a rate of return of 14.80% on Jumbo’s stock: Required: a. What will be the dividend paid out for the next six years? Note: Round your answers to 4 decimal places. $ $ $ $ $ $ D1 = 2.4720 D2 = 2.9664 D3 = 3.3817 D4 = 3.8551 D5 = 4.3949 D6 = 4.7464 b. What is its intrinsic value today? Note: Round your answer to 2 decimal places. Intrinsic value 46.07 Explanation: Since the growth rate changes three times, a multi-stage dividend discount model is used to find the value of the stock. The dividend calculations for the first five years are shown below. Time Growth Rate Dividend 1 20% D1 = $2.06 × 1.20 = $2.4720 2 20% D2 = $2.4720 × 1.20 = $2.9664 3 14% D3 = $2.9664 × 1.14 = $3.3817 4 14% D4 = $3.3817 × 1.14 = $3.8551 5 14% D5 = $3.8551 × 1.14 = $4.3949 The dividend at time 6 will be based on a growth rate of 8%, so D 6 = $4.3949 × 1.08 = $4.7464 We will use D 6 to find the value at time 5 of all future dividends to be received. The value at time 5 of all future dividends to be received is based on the dividend at time 6, the required rate of return, and the growth rate beyond time 5: P 5 = D 6 ÷ ( k − g ) = $4.7464 ÷ (0.1480 − 0.08) = $69.8006 The cash flows to be discounted back to time 0 and their present value at the required rate of return are shown in the table below. The intrinsic value of the stock today is the sum of the present values, or $46.0696. Time (t) CFt Present Value at 15.40% 1 $2.4720 $2.4720 ÷ (1.1480) 1 = $2.1533 2 $2.9664 $2.9664 ÷ (1.1480) 2 = $2.2508 3 $3.3817 $3.3817 ÷ (1.1480) 3 = $2.2352 4 $3.8551 $3.8551 ÷ (1.1480) 4 = $2.2196 5 $4.3949 + 69.8006 = $74.1954 $74.1954 ÷ (1.1480) 5 = $37.2107 Total PV 0 = $46.0696 Worksheet Difficulty: 3 Challenge Source: Investments (Bodie, 13e, ISBN 1266836322) > Chapter 13: Empirical Evidence on Security Returns > Chapter 13 Additional Algorithmic Problems References

1. Award: 10.00 points 2. Award: 10.00 points 3. Award: 10.00 points 4. Award: 10.00 points The expected return/beta relationship is used: by regulatory commissions in determining the costs of capital for regulated firms. in court rulings to determine discount rates to evaluate claims of lost future incomes. to advise clients as to the composition of their portfolios. All of the options are correct. None of the options are correct. The risk/return relationship is appropriate for all of the uses cited above. References Multiple Choice Diﬃculty: 1 Basic The expected return/beta relationship is not used: by regulatory commissions in determining the costs of capital for regulated firms. in court rulings to determine discount rates to evaluate claims of lost future incomes. to advise clients as to the composition of their portfolios. by regulatory commissions in determining the costs of capital for regulated firms and to advise clients as to the composition of their portfolios. None of the options are correct. The risk/return relationship is appropriate for all of the uses cited above. References Multiple Choice Diﬃculty: 1 Basic _________ argued in his famous critique that tests of the expected return/beta relationship are invalid and that it is doubtful that the CAPM can ever be tested. Kim Markowitz Modigliani Roll None of the options are correct. These arguments were made by Richard Roll in his famous critique of the CAPM, resulting the Institutional Investor article, "Is Beta Dead?" References Multiple Choice Diﬃculty: 1 Basic Fama and MacBeth (1973) found that the relationship between average excess returns and betas was: linear, only. nonexistent, only. as expected, based on earlier studies, only. linear and as expected, based on earlier studies. Fama and MacBeth did not examine the relationship between excess returns and beta. The Fama and MacBeth study validated earlier studies of the excess returns/beta relationship. References Multiple Choice Diﬃculty: 2 Intermediate                        

5. Award: 10.00 points 6. Award: 10.00 points 7. Award: 10.00 points 8. Award: 10.00 points In the empirical study of a multifactor model by Chen, Roll, and Ross, a factor (the factors) that appeared to have significant explanatory power in explaining security returns was (were): the change in the expected rate of inﬂation, only. the risk premium on corporate bonds, only. the unexpected change in the rate of inﬂation, only. industrial production, only. the risk premium on corporate bonds , the unexpected change in the rate of inﬂation, and industrial production. Of the variables tested, Chen, Roll, and Ross found that the risk premium on corporate bonds, the unexpected change in the rate of inﬂation, and industrial production were significant predictors of security returns. References Multiple Choice Diﬃculty: 3 Challenge In the empirical study of a multifactor model by Chen, Roll, and Ross, a factor that did not appear to have significant explanatory power in explaining security returns was: the change in the expected rate of inﬂation. the risk premium on corporate bonds. the unexpected change in the rate of inﬂation. industrial production. None of the options are correct. Of the variables tested, Chen, Roll, and Ross found that the risk premium on corporate bonds, the unexpected change in the rate of inﬂation, and industrial production were significant predictors of security returns. References Multiple Choice Diﬃculty: 3 Challenge In the results of the earliest estimations of the security market line by Lintner (1965) and by Miller and Scholes (1972), it was found that the average difference between a stock's return and the risk-free rate was ________ to its nonsystematic risk. positively related negatively related unrelated related in a nonlinear fashion None of the options are correct. These results were surprising, as it was expected that systematic, not nonsystematic, risk would be positively related to stock returns. References Multiple Choice Diﬃculty: 2 Intermediate In the results of the earliest estimations of the security market line by Miller and Scholes (1972), it was found that the average difference between a stock's return and the risk-free rate was _________ to its beta. positively related negatively related unrelated inversely related not proportional These results are consistent with the CAPM. References Multiple Choice Diﬃculty: 2 Intermediate                        

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9. Award: 10.00 points 10. Award: 10.00 points 11. Award: 10.00 points 12. Award: 10.00 points In the results of the earliest estimations of the security market line by Miller and Scholes (1972), it was found that the average difference between a stock's return and the risk-free rate was _________ to its nonsystematic risk and _________ to its beta. positively related; negatively related negatively related; positively related positively related; positively related negatively related; negatively related not related; not related The risk premium was positively related to both factors. References Multiple Choice Diﬃculty: 2 Intermediate In the 1972 empirical study by Black, Jensen, and Scholes, they found that the estimated slope of the security market line was _________ what the CAPM would predict. higher than equal to less than twice as much as More information is required to answer this question. These studies found that the SML was "too ﬂat" compared to CAPM predictions by a statistically significant margin. References Multiple Choice Diﬃculty: 2 Intermediate In the 1972 empirical study by Black, Jensen, and Scholes, they found that the estimated slope of the security market line was _________ what the CAPM would predict. ﬂatter than equal to steeper than one-half as much as None of the options are correct. These studies found that the SML was "too ﬂat" compared to CAPM predictions by a statistically significant margin. References Multiple Choice Diﬃculty: 2 Intermediate If a professionally-managed portfolio consistently outperforms the market proxy on a risk-adjusted basis and the market is eﬃcient, it should be concluded that: the CAPM is invalid, only. the proxy is inadequate, only. either the CAPM is invalid, or the proxy is inadequate, only. the CAPM is valid and the proxy is adequate, only. None of the options are correct. If a professionally-managed portfolio consistently outperforms the market proxy on a risk-adjusted basis and the market is eﬃcient, it should be concluded that either the CAPM is invalid or the proxy is inadequate; however, unfortunately, one cannot conclude which one (or both) is the problem. References Multiple Choice Diﬃculty: 2 Intermediate                        

13. Award: 10.00 points 14. Award: 10.00 points 15. Award: 10.00 points 16. Award: 10.00 points Given the results of the early studies by Lintner (1965) and Miller and Scholes (1972), one would conclude that: high beta stocks tend to outperform the predictions of the CAPM. low beta stocks tend to outperform the predictions of the CAPM. there is no relationship between beta and the predictions of the CAPM. high beta stocks and low beta stocks tend to outperform the predictions of the CAPM. None of the options are correct. Low-beta stocks have provided returns that, on average, were higher than they should have been on the basis of their beta. References Multiple Choice Diﬃculty: 2 Intermediate If a market proxy portfolio consistently beats all professionally-managed portfolios on a risk-adjusted basis, it may be concluded that: the CAPM is valid, only. the market proxy is mean/variance eﬃcient, only. the CAPM is invalid, only. the CAPM is valid and the market proxy is mean/variance eﬃcient. the market proxy is mean/variance eﬃcient and the CAPM is invalid. If such results were obtained consistently, one could be assured that the model is valid and that the market proxy is mean/variance eﬃcient. References Multiple Choice Diﬃculty: 2 Intermediate In developing their test of a multifactor model, Chen, Roll, and Ross hypothesized that _________ might be a proxy for systematic factors. the monthly growth rate in industrial production, only, unexpected inﬂation, only, expected inﬂation, only, the monthly growth rate in industrial production and unexpected inﬂation the monthly growth rate in industrial production, unexpected inﬂation, and expected inﬂation In their model, Chen, Roll, and Ross hypothesized that the monthly growth rate in industrial production, unexpected inﬂation, and expected inﬂation might be proxies for systematic risk. However, of the above factors, only the monthly growth rate in industrial production and unexpected inﬂation appeared to have significant explanatory power. References Multiple Choice Diﬃculty: 2 Intermediate Kandel and Stambaugh (1995) expanded Roll's critique of the CAPM by arguing that tests rejecting a positive relationship between average return and beta are demonstrating: the ineﬃciency of the market proxy used in the tests. that the relationship between average return and beta is not linear. that the relationship between average return and beta is negative. the need for a better way of explaining security returns. None of the options are correct. These results are typical of the results of similar studies. References Multiple Choice Diﬃculty: 2 Intermediate                        

17. Award: 10.00 points 18. Award: 10.00 points 19. Award: 10.00 points In the 1972 empirical study by Black, Jensen, and Scholes, they found that the risk-adjusted returns of high beta portfolios were _________ the risk-adjusted returns of low beta portfolios. greater than equal to less than unrelated to More information is necessary to answer this question. These results are inconsistent with what would be predicted with the CAPM. References Multiple Choice Diﬃculty: 2 Intermediate The research by Fama and French suggesting that CAPM is invalid has generated which of the following responses? Better econometrics should be used in the test procedure. Estimates of asset betas need to be improved. Theoretical sources and implications of research that contradicts CAPM needs to be reconsidered. The single-index model needs to account for nontraded assets and the cyclical behavior of asset betas. All of the options are correct. All four responses have been given in the literature responding to the Fama-French critique. References Multiple Choice Diﬃculty: 2 Intermediate Consider the regression equation: r it − r ft = a i + b i ( r mt − r ft ) + e it where: r it = return on stock i in month t r ft = the monthly risk-free rate of return in month t r mt = the return on the market portfolio proxy in month t This regression equation is used to estimate: the security characteristic line. benchmark error. the capital market line. All of the options are correct. None of the options are correct. The security characteristic line is a graphical depiction of the excess returns on the security as a function of the excess returns on the market. References Multiple Choice Diﬃculty: 2 Intermediate                  

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20. Award: 10.00 points 21. Award: 10.00 points 22. Award: 10.00 points Consider the regression equation: r i − r f = g 0 + g 1 b 1 + g 2 s 2 >( e i ) + e it where: r i − r f = the average difference between the monthly return on stock i and the monthly risk-free rate b i = the beta of stock i σ 2 ( e i ) = a measure of the nonsystematic variance of the stock i If you estimated this regression equation and the CAPM was valid, you would expect the estimated coeﬃcient, g 0 , has to be: 0. 1. equal to the risk-free rate of return. equal to the average difference between the monthly return on the market portfolio and the monthly risk-free rate. None of the options are correct. In this model, the coeﬃcient, g 0 , represents the excess return of the security, which would be zero if the CAPM held. References Multiple Choice Diﬃculty: 2 Intermediate Consider the regression equation: r i − r f = g 0 + g 1 b i + g 2 s 2 ( e i ) + e it where: r i − r t = the average difference between the monthly return on stock i and the monthly risk-free rate b i = the beta of stock i s 2 ( e i ) = a measure of the nonsystematic variance of the stock i If you estimated this regression equation and the CAPM was valid, you would expect the estimated coeﬃcient, g 1 , to be: 0. 1. equal to the risk-free rate of return. equal to the average difference between the monthly return on the market portfolio and the monthly risk-free rate. equal to the average monthly return on the market portfolio. The variable measured by the coeﬃcient, g 1 , in this model is the market risk premium. References Multiple Choice Diﬃculty: 2 Intermediate Consider the regression equation: r i − r f = g 0 + g 1 b i + g 2 s 2 ( e i ) + e it where: r i − r t = the average difference between the monthly return on stock i and the monthly risk-free rate b i = the beta of stock i σ 2 ( e i ) = a measure of the nonsystematic variance of the stock i If you estimated this regression equation and the CAPM was valid, you would expect the estimated coeﬃcient, g 2 , to be: 0. 1. equal to the risk-free rate of return. equal to the average difference between the monthly return on the market portfolio and the monthly risk-free rate. None of the options are correct. If the CAPM is valid, the excess return on the stock is predicted by the systematic risk of the stock and the excess return on the market, not by the nonsystematic risk of the stock. References Multiple Choice Diﬃculty: 2 Intermediate                  

23. Award: 10.00 points 24. Award: 10.00 points 25. Award: 10.00 points 26. Award: 10.00 points Consider the regression equation: r i − r f = g 0 + g 1 b i + e it where: r i − r f = the average difference between the monthly return on stock i and the monthly risk-free rate b i = the beta of stock i This regression equation is used to estimate: the benchmark error. the security market line. the capital market line. the benchmark error and the security market line. the benchmark error, the security market line, and the capital market line. The security market line is a graphical depiction of the excess returns on the security and a function of the beta of the security. References Multiple Choice Diﬃculty: 2 Intermediate Benchmark error: refers to the use of an incorrect market proxy in tests of the CAPM, only. can result in inconclusive tests of the CAPM, only. can result in incorrect evaluation measures for portfolio managers, only. refers to the use of an incorrect market proxy in tests of the CAPM and can result in inconclusive tests of the CAPM. All of the options are correct. If an incorrect market proxy is used, all of these options can result. References Multiple Choice Diﬃculty: 1 Basic The CAPM is not testable unless: the exact composition of the true market portfolio is known and used in the tests. all individual assets are included in the market proxy. the market proxy and the true market portfolio are highly negatively correlated. the exact composition of the true market portfolio is known and used in the tests, and all individual assets are included in the market proxy. all individual assets are included in the market proxy and the market proxy, and the true market portfolio are highly negatively correlated. The exact composition of the true market portfolio is known and used in the tests and all individual assets are included in the market proxy must be true for the CAPM to be tested; however, the exact composition of the true market portfolio cannot be known, thus the CAPM probably can never be tested. References Multiple Choice Diﬃculty: 1 Basic In their multifactor model, Chen, Roll, and Ross found: that two market indexes, the equally-weighted NYSE and the value-weighted NYSE, were not significant predictors of security returns. that the value-weighted NYSE index had the incorrect sign, implying a negative market risk premium. expected changes in inﬂation-predicted security returns. Both "that two market indexes, the equally-weighted NYSE and the value-weighted NYSE, were not significant predictors of security returns." & "that the value-weighted NYSE index had the incorrect sign, implying a negative market risk premium." All of the options are correct. Two market indexes, the equally-weighted NYSE and the value-weighted NYSE, a negative market risk premium, and unexpected changes in inﬂation were significant predictors of security returns. References Multiple Choice Diﬃculty: 2 Intermediate                        

27. Award: 10.00 points 28. Award: 10.00 points 29. Award: 10.00 points 30. Award: 10.00 points Early tests of the CAPM involved: establishing sample data, only. estimating the security characteristic line, only. estimating the security market line, only. All of the options are correct. None of the options are correct. These three basic steps, establishing sample data, estimating security characteristic lines, and estimating the security market line, were all necessary to test the implications of the CAPM. References Multiple Choice Diﬃculty: 1 Basic According to Roll, the only testable hypothesis associated with the CAPM is: the number of ex-post mean-variance eﬃcient portfolios. the exact composition of the market portfolio. whether the market portfolio is mean-variance eﬃcient. the SML relationship. None of the options are correct. According to Roll, the only testable hypothesis about the CAPM is that the market portfolio is mean-variance eﬃcient. References Multiple Choice Diﬃculty: 1 Basic One way that Black, Jensen and Scholes overcame the problem of measurement error was to: group securities into portfolios. use a two-stage regression methodology. reduce the precision of beta estimates. set alpha equal to one. None of the options are correct. Black, Jensen and Scholes, in their landmark study, found that grouping securities into well-diversified portfolios significantly reduced measurement error. References Multiple Choice Diﬃculty: 2 Intermediate Strongest evidence in support of the CAPM has come from demonstrating that: the market beta is equal to 1.0. nonsystematic risk has significant explanatory power in estimating security returns. the average return-beta relationship is highly significant. the intercept in tests of the excess returns-beta relationship is exactly zero. professional investors do not generally outperform market indexes, demonstrating that the market is eﬃcient. Although tests of CAPM have not found the other options to be true, the CAPM is qualitatively supported by findings that the market portfolio is eﬃcient. References Multiple Choice Diﬃculty: 2 Intermediate                        

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31. Award: 10.00 points 32. Award: 10.00 points 33. Award: 10.00 points 34. Award: 10.00 points Which of the following would be required for tests of the multifactor CAPM and APT? Specification of risk factors Identification of portfolios that hedge these fundamental risk factors Tests of the explanatory power and risk premiums of the hedge portfolios All of the options are correct. None of the options are correct. Tests of multifactor models require a three-stage process described by all of the options. References Multiple Choice Diﬃculty: 1 Basic Tests of multifactor models indicate: the single-factor model has better explanatory power in estimating security returns. macroeconomic variables have no explanatory power in estimating security returns. it may be possible to hedge some economic factors that affect future-consumption risk with appropriate portfolios. multifactor models do not work. None of the options are correct. Tests of multifactor models suggest that industrial production, the risk premium on bonds, and unanticipated inﬂation have significant explanatory power for security returns, and it may be possible to hedge these risks if appropriate hedge portfolios can be constructed. References Multiple Choice Diﬃculty: 1 Basic Fama and French (1992) found that: firm size had better explanatory power than beta in describing portfolio returns. beta had better explanatory power than firm size in describing portfolio returns. beta had better explanatory power than book-to-market ratios in describing portfolio returns. macroeconomic factors had better explanatory power than beta in describing portfolio returns. None of the options are correct. Fama and French found that firm size and book-to-market ratios had significant explanatory power for portfolio returns, while beta did not. References Multiple Choice Diﬃculty: 2 Intermediate Which of the following statements is true about models that attempt to measure the empirical performance of the CAPM? The conventional CAPM works better than the conditional CAPM with human capital. The conventional CAPM works about the same as the conditional CAPM with human capital. The conditional CAPM with human capital yields a better fit for empirical returns than the conventional CAPM. Adding firm size to the model specification dramatically improves the fit. Adding firm size to the model specification worsens the fit. The results are presented in the below table. Coeﬃcient c 0 c vw c credit c labor c size R 2 A. The Static CAPM without Human Capital Estimate 1.24 − 0.10 1.35 t-statistic 5.16 − 0.28 Estimate 2.08 − 0.32 − 0.11 57.56 t-statistic 5.77 − 0.94 − 2.30 B. The Conditional CAPM with Human Capital Estimate 1.24 − 0.40 0.34 0.22 55.21 t-statistic 4.10 − 0.88 1.73 2.31 Estimate 1.70 − 0.40 0.20 0.10 − 0.07 64.73 t-statistic 4.14 − 1.06 2.72 2.09 − 1.30 References Multiple Choice Diﬃculty: 2 Intermediate                        

35. Award: 10.00 points 36. Award: 10.00 points 37. Award: 10.00 points Which of the following statements is false about models that attempt to measure the empirical performance of the CAPM? I. The conventional CAPM works better than the conditional CAPM with human capital. II. The conventional CAPM works about the same as the conditional CAPM with human capital. III. The conditional CAPM with human capital yields a better fit for empirical returns than the conventional CAPM. I only II only III only I and II II and III The results are presented in the below table. Coeﬃcient c 0 c vw c credit c labor c size R 2 A. The Static CAPM without Human Capital Estimate 1.24 − 0.10 1.35 t-statistic 5.16 − 0.28 Estimate 2.08 − 0.32 − 0.11 57.56 t-statistic 5.77 − 0.94 − 2.30 B. The Conditional CAPM with Human Capital Estimate 1.24 − 0.40 0.34 0.22 55.21 t-statistic 4.10 − 0.88 1.73 2.31 Estimate 1.70 − 0.40 0.20 0.10 − 0.07 64.73 t-statistic 4.14 − 1.06 2.72 2.09 − 1.30 References Multiple Choice Diﬃculty: 2 Intermediate A study by Mehra and Prescott (1985) found that historical average excess returns: have been too small to be consistent with rational security pricing. have been too large to be consistent with rational security pricing. have been too small to be consistent with fractional security pricing. prove CAPM is incorrect. prove the market is eﬃcient. They found that the average reward investors have earned has been "too generous." References Multiple Choice Diﬃculty: 2 Intermediate Fama and French (2002) studied the equity premium puzzle by breaking their sample into subperiods and found that: the equity premium was largest throughout the entire 1872-1999 period. the equity premium was largest during the 1872-1949 subperiod. the equity premium was largest during the 1950-1999 subperiod. the differences in equity premiums for the three time periods were statistically insignificant. the constant-growth dividend-discount model never works. They concluded that the equity premium puzzle has occurred mostly in modern times. This may be due to the difference between the dividend-discount model's (DDM) result of expected return in comparison to actual returns earned. The DDM yields a smaller risk premium during the 1950-1999 period, while actual returns have been higher. This may be due to unanticipated capital gains. References Multiple Choice Diﬃculty: 2 Intermediate                  

38. Award: 10.00 points 39. Award: 10.00 points 40. Award: 10.00 points 41. Award: 10.00 points Which of the following is/are result(s) of the Fama and French (2002) study of the equity premium puzzle? I. Average realized returns during 1950-1999 exceeded the internal rate of return (IRR) for corporate investments. II. The statistical precision of average historical returns is far higher than the precision of estimates from the dividend-discount model (DDM). III. The reward-to-variability ratio (Sharpe) derived from the DDM is far more stable than that derived from realized returns. IV. There is no difference between DDM estimates and actual returns with regard to IRR, statistical precision, or the Sharpe measure. I, II, and III I and III I and II II and III IV The study also predicts that future excess returns will be significantly lower than those experienced in recent decades. This has important implications for current investors. References Multiple Choice Diﬃculty: 3 Challenge Equity premium puzzle studies may be subject to survivorship bias because the time period covered was not long enough. an inappropriate index was used. the indexes used did not exist for the whole period of the study. both U.S. and foreign data were used. only U.S. data was used. Equity premium puzzle studies may be subject to survivorship bias because only U.S. data were used. References Multiple Choice Diﬃculty: 2 Intermediate Tests of the CAPM that use regression techniques are subject to inaccuracies because the statistical results used are almost always incorrect. the slope coeﬃcient of the regression equation is biased downward. the slope coeﬃcient of the regression equation is biased upward. the intercept of the regression equation is biased downward. the intercept of the regression equation is equal to the risk-free rate. This would be a problem even if it were possible to use the returns on the true market portfolio in these regressions. It is due to the fact that the independent variable (the beta that is found in the first-pass regression and used as the independent variable in the second-pass regression) is measured with error. References Multiple Choice Diﬃculty: 3 Challenge Which of the following must be done to test the multifactor CAPM or the APT? I. Specify the risk factors II. Identify portfolios that hedge the risk factors III. Test the explanatory power of hedge portfolios IV. Test the risk premiums of hedge portfolios I and II II and IV II and III I, II, and IV I, II, III, and IV All of these tasks must be completed. An example is the Chen, Roll, and Ross (1986) study, although they skipped II because they used the factors themselves and assumed that factor portfolios existed that could proxy for the factors. References Multiple Choice Diﬃculty: 2 Intermediate                        

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42. Award: 10.00 points 43. Award: 10.00 points 44. Award: 10.00 points 45. Award: 10.00 points The Fama and French three-factor model uses _________, _________, and _________ as factors. industrial production; term spread; default spread industrial production; inﬂation; default spread firm size; book-to-market ratio; market index firm size; book-to-market ratio; default spread None of the options are correct. The Fama and French three-factor model uses firm size, book-to-market ratio, and market index as factors. References Multiple Choice Diﬃculty: 1 Basic The Fama and French three-factor model does not use _________ as one of the explanatory factors. industrial production market firm size book-to-market ratio None of the option are correct. The Fama and French three-factor model does not use industrial production or inﬂation as explanatory factors. References Multiple Choice Diﬃculty: 1 Basic Jagannathan and Wang (2006) find that the CCAPM explains returns _________ the Fama-French three-factor model, and that the Fama-French three-factor model explains returns _________ the traditional CAPM. worse than; worse than worse than; better than better than; better than better than; worse than equally as well as; equally as well as Jagannathan and Wang (2006) find that the CCAPM explains returns better than the Fama-French three-factor model and that the Fama-French three-factor model explains returns better than the traditional CAPM. References Multiple Choice Diﬃculty: 2 Intermediate A major finding by Heaton and Lucas (2000) is that: the market rate of return does not help explain the rate of return of individual securities, and CAPM must be rejected. the market rate of return does explain the rate of return of individual securities. the change in proprietary wealth helps explain the rate of return of individual securities. All of the options are correct None of the options are correct. A major finding by Heaton and Lucas (2000) is that the market rate of return does not help explain the rate of return of individual securities, and CAPM must be rejected and the change in proprietary wealth helps explain the rate of return of individual securities. References Multiple Choice Diﬃculty: 2 Intermediate                        

46. Award: 10.00 points 47. Award: 10.00 points 48. Award: 10.00 points 49. Award: 10.00 points Liew and Vassalou (2000) show that returns on style portfolios (SMB and HML): seem like statistical ﬂukes. seem to predict GDP growth. may be proxies for business cycle risk. Both "seem to predict GDP growth." & "may be proxies for business cycle risk." are correct. None of the options are correct. Liew and Vassalou (2000) show that returns on style portfolios (SMB and HML) seem to predict GDP growth and may be proxies for business cycle risk. References Multiple Choice Diﬃculty: 2 Intermediate Petkova and Zhang (2005) examine the relationship between beta and the market risk premium and find: a countercyclical beta is negative in good economies and positive in bad economies. the beta of the HML portfolio is negative in good economies and positive in bad economies. a cyclical beta is positive in good economies and negative in bad economies. the beta of the HML portfolio is positive in good economies and negative in bad economies. a countercyclical beta and the beta of the HML portfolio are negative in good economies and positive in bad economies. Petkova and Zhang (2005) examine the relationship between beta and the market risk premium and find a countercyclical beta and the beta of the HML portfolio are negative in good economies and positive in bad economies. References Multiple Choice Diﬃculty: 2 Intermediate Studies by Chan, Karceski, and Lakonishok (2003) and La Porta, Lakonishok, Shleifer, and Vishny (1997) report that: the value premium is a manifestation of market irrationality. the value premium is a rational risk premia. the value premium is a statistical artifact found only in the U.S. All of the options are correct. None of the options are correct. Studies by Chan, Karceski, and Lakonishok (2003) and La Porta, Lakonishok, Shleifer, and Vishny (1997) report that the value premium is a manifestation of market irrationality. References Multiple Choice Diﬃculty: 2 Intermediate The Fama-French model: I. is a useful tool for benchmarking performance against a well defined set of factors. II. premia are determined by market irrationality. III. premia are determined by rational risk factors. IV. is not a useful tool for benchmarking performance against a well-defined set of factors. I only IV only I and II I and IV II and IV The Fama French model is a useful tool for benchmarking performance against a well defined set of factors, and the reason for the premia is unsettled. References Multiple Choice Diﬃculty: 2 Intermediate                        

50. Award: 10.00 points 51. Award: 10.00 points 52. Award: 10.00 points 53. Award: 10.00 points An extension of the Fama-French three-factor model was introduced by: Black. Scholes. Carhart. Jensen. Miller. An extension of the Fama-French three-factor model was introduced by Carhart. References Multiple Choice Diﬃculty: 2 Intermediate An extension of the Fama-French three-factor model includes a fourth factor to measure: default spread. term spread. momentum. industrial production. inﬂation. An extension of the Fama-French three-factor model includes a fourth factor to measure momentum. References Multiple Choice Diﬃculty: 2 Intermediate Liquidity embodies several characteristics, such as: trading costs. ease of sale. market depth. necessary price concessions to affect a quick transaction. All of the options are correct. Liquidity embodies several characteristics such as trading costs, ease of sale, market depth, and necessary price concessions to affect a quick transaction. References Multiple Choice Diﬃculty: 2 Intermediate Which of the following is NOT an addition to the Fama and French (1992) model. turnover volatility trin statistic working capital accruals All are correct. Trin statistic has nothing to do with CAPM or Fama and French. References Multiple Choice Diﬃculty: 3 Challenge                        

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54. Award: 10.00 points 55. Award: 10.00 points 56. Award: 10.00 points 57. Award: 10.00 points Which of the following factors will have a negative slope? book-to-market ratio momentum beta turnover None of the above are correct. Only turnover has a negative slope according to Lewellen’s research. References Multiple Choice Diﬃculty: 3 Challenge Which of the following factors will have a positive slope? size sales accruals in net working capital volatility dividend yield Only turnover has a negative slope according to Lewellen’s research. References Multiple Choice Diﬃculty: 3 Challenge The liquidity of illiquid stocks with high liquidity betas that generate higher average returns is referred to as a(n) _________. premium. alpha. market ineﬃciency. priced factor. None of the options are correct. If stocks with high liquidity betas have higher average returns, we conclude that liquidity is a “priced factor,” meaning that exposure to it offers higher expected return as compensation for the risk. References Multiple Choice Diﬃculty: 2 Intermediate The seller of an asset with limited buyers may suffer from reduced prices. This could be a result of market _________. premiums. illiquidity. factors. priced factor. None of the options are correct. Illiquidity leads to price ineﬃciency and asset mispricing due to the low volume of transactions. References Multiple Choice Diﬃculty: 2 Intermediate                        

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Chapter 13

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