Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

CHAPTER 07
CAPITAL ASSET PRICING AND ARBITRAGE
PRICING THEORY

1. The required rate of return on a stock is related to the required

rate of return on the stock market via beta. Assuming the beta of
Google remains constant, the increase in the risk of the market
will increase the required rate of return on the market, and thus
increase the required rate of return on Google.

2. An example of this scenario would be an investment in the SMB

and HML. As of yet, there are no vehicles (index funds or ETFs)
to directly invest in SMB and HML. While they may prove
superior to the single index model, they are not yet practical, even
for professional investors.

3. a. False. According to CAPM, when beta is zero, the “excess”

return should be zero.

b. False. CAPM implies that the investor will only require risk
premium for systematic risk. Investors are not rewarded for
bearing higher risk if the volatility results from the firm-specific
risk, and thus, can be diversified.

c. False. We can construct a portfolio with the beta of .75 by

investing .75 of the investment budget in the market portfolio and
the remainder in T-bills.

4. E(r) = rf + β [E(rM) – rf ] , rf = 4%, rM = 6%

$1 Discount Store: E(r) = 4% + 1.5  6% = 13%
Everything $5: E(r) = 4% + 1.0  6% = 10%

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

5. $1 Discount Store is overpriced; Everything $5 is underpriced.

6. a. 15%. Its expected return is exactly the same as the market

return when beta is 1.0.

7. Statement a is most accurate.

The flaw in statement b is that beta represents only the systematic

risk. If the firm-specific risk is low enough, the stock of Kaskin,
Inc. could still have less total risk than that of Quinn, Inc.

Statement c is incorrect. Lower beta means the stock carries less

systematic risk.

8. The APT may exist without the CAPM, but not the other way.
Thus, statement a is possible, but not b. The reason is that the
APT accepts the principle of risk and return, which is central to
CAPM, without making any assumptions regarding individual
investors and their portfolios. However, these assumptions are
necessary to CAPM.

9. E(rp) = rf + β [E(rM) – rf ] Given rf = 5% and E(rM)= 15%, we can

calculate 
20% = 5% + (15% – 5%)   = 1.5

10. If the beta of the security doubles, then so will its risk
premium. The current risk premium for the stock is: (13% – 7%)
= 6%, so the new risk premium would be 12%, and the new
discount rate for the security would be: 12% + 7% = 19%

If the stock pays a constant dividend in perpetuity, then we know

from the original data that the dividend (D) must satisfy the
equation for a perpetuity:

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

Price = Dividend/Discount rate

40 = D/0.13  D = 40  0.13 = $5.20
At the new discount rate of 19%, the stock would be worth:
$5.20/0.19 = $27.37
The increase in stock risk has lowered the value of the stock by
31.58%.

11. The cash flows for the project comprise a 10-year annuity of
$10 million per year plus an additional payment in the tenth year of
$10 million (so that the total payment in the tenth year is $20
million). The appropriate discount rate for the project is:
rf + β [E(rM) – rf ] = 9% + 1.7  (19% – 9%) = 26%
Using this discount rate:
10
10
NPV = –20 +  10 t +
1.26 t =1 1.2610

= –20 + [10  Annuity factor (26%, 10 years)] + [10  PV

factor (26%, 10 years)]
= 15.64
The internal rate of return on the project is 49.55%. The highest value
that beta can take before the hurdle rate exceeds the IRR is
determined by:
49.55% = 9% + (19% – 9%)  β = 40.55/10 = 4.055

12.
a. The beta is the sensitivity of the stock's return to the market
return, or, the change in the stock return per unit change in
the market return. We denote the aggressive stock A and the
defensive stock D, and then compute each stock's beta by
calculating the difference in its return across the two
scenarios divided by the difference in market return.
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

2 － 32
A = = 2.00
5 － 20
3.5 － 14
D = = 0.70
5 － 20

b. With the two scenarios equally likely, the expected rate of

return is an average of the two possible outcomes:
E(rA) = 0.5  (2% + 32%) = 17%

E(rD) = 0.5  (3.5% + 14%) = 8.75%

c. The SML is determined by the following: Expected return is

the T-bill rate = 8% when beta equals zero; beta for the
market is 1.0; and the expected rate of return for the market is:
0.5  (20% + 5%) = 12.5%
Thus, we graph the SML as following:
E(r)

SML

M
12.5%

D
D
8%

.7 1.0 2.0 

The equation for the security market line is: E(r) = 8% +

β(12.5% – 8%)

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

d. The aggressive stock has a fair expected rate of return of:

E(rA) = 8% + 2.0  (12.5% – 8%) = 17%
The security analyst’s estimate of the expected rate of
return is also 17%. Thus the alpha for the aggressive stock
is zero. Similarly, the required return for the defensive
stock is:
E(rD) = 8% + 0.7  (12.5% – 8%) = 11.15%
The security analyst’s estimate of the expected return for
D is only 8.75%, and hence:
αD = actual expected return – required return predicted by
CAPM
= 8.75% – 11.15% = –2.4%
The points for each stock are plotted on the graph above.

e. The hurdle rate is determined by the project beta (i.e.,

0.7), not by the firm’s beta. The correct discount rate is
therefore 11.15%, the fair rate of return on stock D.

13. Not possible. Portfolio A has a higher beta than Portfolio B,

but the expected return for Portfolio A is lower.

14. Possible. If the CAPM is valid, the expected rate of return

compensates only for systematic (market) risk as measured by
beta, rather than the standard deviation, which includes
nonsystematic risk. Thus, Portfolio A's lower expected rate of
return can be paired with a higher standard deviation, as long as
Portfolio A's beta is lower than that of Portfolio B.

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

15. Not possible. The reward-to-variability ratio for Portfolio A

is better than that of the market, which is not possible according to
the CAPM, since the CAPM predicts that the market portfolio is
the most efficient portfolio. Using the numbers supplied:
SA = 16 − 10 = 0.5
12

SM = 18 − 10 = 0.33
24

These figures imply that Portfolio A provides a better risk-reward

tradeoff than the market portfolio.

16. Not possible. Portfolio A clearly dominates the market

portfolio. It has a lower standard deviation with a higher expected
return.

17. Not possible. Given these data, the SML is: E(r) = 10% +
β(18% – 10%)
A portfolio with beta of 1.5 should have an expected return of:
E(r) = 10% + 1.5  (18% – 10%) = 22%
The expected return for Portfolio A is 16% so that Portfolio A
plots below the SML (i.e., has an alpha of –6%), and hence is
an overpriced portfolio. This is inconsistent with the CAPM.

18. Not possible. The SML is the same as in Problem 18. Here,
the required expected return for Portfolio A is: 10% + (0.9  8%)
= 17.2%
This is still higher than 16%. Portfolio A is overpriced, with
alpha equal to: –1.2%

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

19. Possible. Portfolio A's ratio of risk premium to standard

deviation is less attractive than the market's. This situation is
consistent with the CAPM. The market portfolio should provide
the highest reward-to-variability ratio.

20.
a.

Ford GM Toyota S&P

Beta 5 years 1.81 0.86 0.71 1.00
Beta first two years 2.01 1.05 0.47 3.78 SD
Beta last two years 1.97 0.69 0.49
SE of residual 12.01 8.34 5.14
SE beta 5 years 0.42 0.29 0.18
Intercept 5 years -0.93 -1.44 0.45
Intercept first two years -2.37 -1.82 1.80
Intercept last two years 0.81 -3.41 -1.91

b.

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

As a first pass, we note that large standard deviation of the

beta estimates. None of the subperiod estimates deviate from
the overall period estimate by more than two standard
deviations. That is, the t-statistic of the deviation from the
overall period is not significant for any of the subperiod beta
estimates. Looking beyond the aforementioned observation,
the differences can be attributed to different alpha values
during the subperiods. The case of Toyota is most revealing:
The alpha estimate for the first two years is positive and for
the last two years negative (both large). Following a good
performance in the "normal" years prior to the crisis, Toyota
surprised investors with a negative performance, beyond what
could be expected from the index. This suggests that a beta of
around 0.5 is more reliable. The shift of the intercepts from
positive to negative when the index moved to largely negative
returns, explains why the line is steeper when estimated for the
overall period. Draw a line in the positive quadrant for the
index with a slope of 0.5 and positive intercept. Then draw a
line with similar slope in the negative quadrant of the index
with a negative intercept. You can see that a line that
reconciles the observations for both quadrants will be steeper.
The same logic explains part of the behavior of subperiod
betas for Ford and GM.

21. Since the stock's beta is equal to 1.0, its expected rate of
return should be equal to that of the market, that is, 18%.
D + P1 − P0
E(r) =
P0

9 + P1 − 100
0.18 =  P1 = $109
100

22. If beta is zero, the cash flow should be discounted at the

risk-free rate, 8%:

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

PV = $1,000/0.08 = $12,500
If, however, beta is actually equal to 1, the investment should
yield 18%, and the price paid for the firm should be:
PV = $1,000/0.18 = $5,555.56
The difference ($6944.44) is the amount you will overpay if you
erroneously assume that beta is zero rather than 1.

23. Using the SML: 6% = 8% + β(18% – 8%)  β= –2/10 = –

0.2

24. We denote the first investment advisor 1, who has r1 = 19%

and 1 = 1.5, and the second investment advisor 2, as r2 = 16%
and 2 = 1.0. In order to determine which investor was a better
selector of individual stocks, we look at the abnormal return,
which is the ex-post alpha; that is, the abnormal return is the
difference between the actual return and that predicted by the
SML.

a. Without information about the parameters of this equation

(i.e., the risk-free rate and the market rate of return), we
cannot determine which investment adviser is the better
selector of individual stocks.

b. If rf = 6% and rM = 14%, then (using alpha for the abnormal

return):
α1 = 19% – [6% + 1.5  (14% – 6%)] = 19% – 18% = 1%
α2 = 16% – [6% + 1.0  (14% – 6%)] = 16% – 14% = 2%

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

Here, the second investment adviser has the larger abnormal

return and thus appears to be the better selector of
individual stocks. By making better predictions, the second
adviser appears to have tilted his portfolio toward under-
priced stocks.

c. If rf = 3% and rM = 15%, then:

α1 =19% – [3% + 1.5  (15% – 3%)] = 19% – 21% = –2%
α2 = 16% – [3%+ 1.0  (15% – 3%)] = 16% – 15% = 1%
Here, not only does the second investment adviser appear to
be a better stock selector, but the first adviser's selections
appear valueless (or worse).

25.
a. Since the market portfolio, by definition, has a beta of 1.0,
its expected rate of return is 12%.

b. β = 0 means the stock has no systematic risk. Hence, the

portfolio's expected rate of return is the risk-free rate, 4%.

c. Using the SML, the fair rate of return for a stock with β = –
0.5 is:
E(r) = 4% + (–0.5)  (12% – 4%) = 0.0%
The expected rate of return, using the expected price and
dividend for next year:
E(r) = ($41 + $3)/$40 – 1 = 0.10 = 10%
Because the expected return exceeds the fair return, the
stock must be under-priced.

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

26. The data can be summarized as follows:

Standard
Expected Return Beta Deviation
Portfolio A 11% 0.8 10%
Portfolio B 14% 1.5 31%
S & P 500 12% 1 20%
T-bills 6% 0 0%

a. Using the SML, the expected rate of return for any portfolio
P is:
E(rP) = rf + [E(rM) –rf ]
Substituting for portfolios A and B:
E(rA) = 6% + 0.8  (12% – 6%) = 10.8% < 11%
E(rB) = 6% + 1.5  (12% – 6%) = 15.0% > 14%
Hence, Portfolio A is desirable and Portfolio B is not.

b. The slope of the CAL supported by a portfolio P is given by:

E(rP) － rf
S=
P
Computing this slope for each of the three alternative
portfolios, we have:
S (S&P 500) = (12% − 6%)/20% = 6/20
S (A) = (11% − ) = 5/10 > S(S&P 500)
S (B) = (14% − ) = 8/31 < S(S&P 500)
Hence, portfolio A would be a good substitute for the S&P
500.

27. Since the beta for Portfolio F is zero, the expected return
for Portfolio F equals the risk-free rate.

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

For Portfolio A, the ratio of risk premium to beta is: (10 − 4)/1 =
6
The ratio for Portfolio E is higher: (9 − 4)/(2/3) = 7.5

This implies that an arbitrage opportunity exists. For instance, by

taking a long position in Portfolio E and a short position in
Portfolio F (that is, borrowing at the risk-free rate and investing
the proceeds in Portfolio E), we can create another portfolio
which has the same beta (1.0) but higher expected return than
Portfolio A. For the beta of the new portfolio to equal 1.0, the
proportion (w) of funds invested in E must be: 3/2 = 1.5.

Portfolio Contribution Contribution to

Weight In Asset to β Excess Return
Portfolio -1.0 x (10%- 4%) = -
-1 A -1 x βA = -1.0 6%
Portfolio 1.5 x (9% - 4%) =
1.5 E 1.5 x βE = 1.0 7.5%
Portfolio
-0.5 F -0.5 x 0 = 0 0
Investment
=0 βArbitrage = 0 α = 1.5%

As summarized above, taking a short position in portfolio A and

a long position in the new portfolio, we produce an arbitrage
portfolio with zero investment (all proceeds from the short sale of
Portfolio A are invested in the new portfolio), zero risk (because
 =  and the portfolios are well diversified), and a positive return
of 1.5%.

28. Substituting the portfolio returns and betas in the mean-beta

relationship, we obtain two equations in the unknowns, the risk-free
rate (rf) and the factor return (F):
14.0% = rf + 1  (F – rf )

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

14.8% = rf + 1.1  (F – rf )
From the first equation we find that F = 14%. Substituting this value
for F into the second equation, we get:
14.8% = rf + 1.1  (14% – rf )  rf = 6%

29.
a. Shorting equal amounts of the 10 negative-alpha stocks and
investing the proceeds equally in the 10 positive-alpha stocks
eliminates the market exposure and creates a zero-investment
portfolio. Using equation 7.5 and denoting the market factor as
RM, the expected dollar return is [noting that the expectation of
residual risk (e) in equation 7.8 is zero]:
$1,000,000  [0.03 + (1.0  RM)] – $1,000,000  [(–0.03)
+ (1.0  RM)]
= $1,000,000  0.06 = $60,000
The sensitivity of the payoff of this portfolio to the market
factor is zero because the exposures of the positive alpha and
negative alpha stocks cancel out. (Notice that the terms
involving RM sum to zero.) Thus, the systematic component of
total risk also is zero. The variance of the analyst's profit is not
zero, however, since this portfolio is not well diversified.

For n = 20 stocks (i.e., long 10 stocks and short 10 stocks) the

investor will have a $100,000 position (either long or short) in
each stock. Net market exposure is zero, but firm-specific risk
has not been fully diversified. The variance of dollar returns
from the positions in the 20 firms is:
20  [(100,000  0.30)2] = 18,000,000,000
The standard deviation of dollar returns is $134,164.

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

b. If n = 50 stocks (i.e., 25 long and 25 short), $40,000 is

placed in each position, and the variance of dollar returns is:
50  [(40,000  0.30)2] = 7,200,000,000
The standard deviation of dollar returns is $84,853.

Similarly, if n = 100 stocks (i.e., 50 long and 50 short),

$20,000 is placed in each position, and the variance of
dollar returns is:
100  [(20,000  0.30)2] = 3,600,000,000
The standard deviation of dollar returns is $60,000.
Notice that when the number of stocks increases by a factor of
5 (from 20 to 100), standard deviation falls by a factor of 5 =
2.236, from $134,164 to $60,000.

30. Any pattern of returns can be "explained" if we are free to

choose an indefinitely large number of explanatory factors. If a
theory of asset pricing is to have value, it must explain returns
using a reasonably limited number of explanatory variables (i.e.,
systematic factors).

31. The APT factors must correlate with major sources of

uncertainty, i.e., sources of uncertainty that are of concern to
many investors. Researchers should investigate factors that
correlate with uncertainty in consumption and investment
opportunities. GDP, the inflation rate, and interest rates are
among the factors that can be expected to determine risk
premiums. In particular, industrial production (IP) is a good
indicator of changes in the business cycle. Thus, IP is a candidate
for a factor that is highly correlated with uncertainties related to
investment and consumption opportunities in the economy.

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

32. The revised estimate of the expected rate of return of the

stock would be the old estimate plus the sum of the unexpected
changes in the factors times the sensitivity coefficients, as follows:
Revised estimate = 14% + [(1  1%) + (0.4  1%)] = 15.4%

33. Equation 7.11 applies here:

E(rP) = rf + P1 [E(r1) − rf] + P2 [E(r2) – rf]
We need to find the risk premium for these two factors:
1 = [E(r1) − rf] and

2 = [E(r2) − rf]
To find these values, we solve the following two equations with
two unknowns:
40% = 7% + 1.81 + 2.12
10% = 7% + 2.01 + (−.5)2
The solutions are: 1 = 4.47% and 2 = 11.86%
Thus, the expected return-beta relationship is:
E(rP) = 7% + 4.47P1 + 11.86P2

34. The first two factors (the return on a broad-based index and
the level of interest rates) are most promising with respect to the
likely impact on Jennifer’s firm’s cost of capital. These are both
macro factors (as opposed to firm-specific factors) that cannot be
diversified away; consequently, we would expect that there is a
risk premium associated with these factors. On the other hand, the
risk of changes in the price of hogs, while important to some
firms and industries, is likely to be diversifiable, and therefore is
not a promising factor in terms of its impact on the firm’s cost of
capital.

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

35. Since the risk free rate is not given, we assume a risk free
rate of 0%. The APT required (i.e., equilibrium) rate of return on
the stock based on rf and the factor betas is:
Required E(r) = 0 + (1  6) + (0.5  2) + (0.75  4) = 10%
According to the equation for the return on the stock, the actually
expected return on the stock is 6% (because the expected
surprises on all factors are zero by definition). Because the
actually expected return based on risk is less than the equilibrium
return, we conclude that the stock is overpriced.

CFA 1
Answer:
a, c, and d are true; b is incorrect because the SML doesn’t
require all investors to invest in the market portfolio but provides
a benchmark to evaluate investment performance for both
portfolios and individual assets.

CFA 2
Answer:
a. E(rX) = 5% + 0.8  (14% – 5%) = 12.2%
αX = 14% – 12.2% = 1.8%
E(rY) = 5% + 1.5  (14% – 5%) = 18.5%
αY = 17% – 18.5% = –1.5%
b.
i. For an investor who wants to add this stock to a well-
diversified equity portfolio, Kay should recommend
Stock X because of its positive alpha, while Stock Y has
a negative alpha. In graphical terms, Stock X’s expected
return/risk profile plots above the SML, while Stock Y’s
profile plots below the SML. Also, depending on the

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

individual risk preferences of Kay’s clients, Stock X’s

lower beta may have a beneficial impact on overall
portfolio risk.

ii. For an investor who wants to hold this stock as a single-

stock portfolio, Kay should recommend Stock Y,
because it has higher forecasted return and lower
standard deviation than Stock X. Stock Y’s Sharpe ratio
is:
(0.17 – 0.05)/0.25 = 0.48
Stock X’s Sharpe ratio is only:
(0.14 – 0.05)/0.36 = 0.25
The market index has an even more attractive Sharpe
ratio:
(0.14 – 0.05)/0.15 = 0.60
However, given the choice between Stock X and Y, Y is
superior. When a stock is held in isolation, standard
deviation is the relevant risk measure. For assets held in
isolation, beta as a measure of risk is irrelevant.
Although holding a single asset in isolation is not
typically a recommended investment strategy, some
investors may hold what is essentially a single-asset
portfolio (e.g., the stock of their employer company).
For such investors, the relevance of standard deviation
versus beta is an important issue.

CFA 3
Answer:

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

a. McKay should borrow funds and invest those funds

proportionally in Murray’s existing portfolio (i.e., buy more
risky assets on margin). In addition to increased expected
return, the alternative portfolio on the capital market line
(CML) will also have increased variability (risk), which is
caused by the higher proportion of risky assets in the total
portfolio.
b. McKay should substitute low beta stocks for high beta
stocks in order to reduce the overall beta of York’s portfolio.
By reducing the overall portfolio beta, McKay will reduce
the systematic risk of the portfolio and therefore the
portfolio’s volatility relative to the market. The security
market line (SML) suggests such action (moving down the
SML), even though reducing beta may result in a slight loss
of portfolio efficiency unless full diversification is
maintained. York’s primary objective, however, is not to
maintain efficiency but to reduce risk exposure; reducing
portfolio beta meets that objective. Because York does not
permit borrowing or lending, McKay cannot reduce risk by
selling equities and using the proceeds to buy risk free
assets (i.e., by lending part of the portfolio).

CFA 4
Answer:
a. “Both the CAPM and APT require a mean-variance
efficient market portfolio.” This statement is incorrect. The
CAPM requires the mean-variance efficient portfolio, but
APT does not.

b. “The CAPM assumes that one specific factor explains

security returns but APT does not.” This statement is
correct.

CFA 5

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

Answer:
a. A security’s expected return as a function of its systematic risk
()

CFA 6
Answer:
d. The expect return on the market, rM:

E(r) = rf + [E(rM) –rf ] = rf + 1.0  [E(rM) –rf ] = E(rM)

CFA 7
Answer:
d. Insufficient data given. We need to know the risk-free rate.

CFA 8
Answer:
d. Insufficient data given. We need to know the risk-free rate.

CFA 9
Answer:
Under the CAPM, the only risk that investors are compensated
for bearing is the risk that cannot be diversified away (i.e.,
systematic risk). Because systematic risk (measured by beta) is
equal to 1.0 for each of the two portfolios, an investor would
expect the same rate of return from each portfolio. Moreover,
since both portfolios are well diversified, it does not matter
whether the specific risk of the individual securities is high or
low. The firm-specific risk has been diversified away from both
portfolios.

CFA 10
Answer:
b. Offer an arbitrage opportunity:

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

rf = 8% and E(rM) = 16%

E(rX) = rf + X[E(rM) – rf] = 8% + 1.0  (16% − 8%) = 16%
E(rY) = rf + Y [E(rM) – rf] = 8% + 0.25  (16% − 8%) = 10%
Therefore, there is an arbitrage opportunity.

CFA 11
Answer:
c. Positive alpha investment opportunities will quickly disappear,
because once such opportunity is observed, the arbitrageurs will
take the large position in it, and therefore push the price back to
equillibirum.

CFA 12
Answer:
d. A risk-free arbitrage opportunity exists.

CFA 13
Answer:
c. Investors will take on as large a position as possible only if
the mispricing opportunity is an arbitrage. Otherwise,
considerations of risk and diversification will limit the position
they attempt to take in the mispriced security.

CFA 14
Answer:
d. APT does not require the restrictive assumptions concerning
the market portfolio. It takes merely the actions of few
arbitrageurs to enforce the fair market price.

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.