Chapter 8 Index Models

Multiple Choice Questions 1. As diversification increases, the total variance of a portfolio approaches ____________. A) 0 B) 1 C) the variance of the market portfolio D) infinity E) none of the above Ans er! C Diffic"lty! Easy #ationale! As more and more sec"rities are added to the portfolio, "nsystematic risk decreases and most of the remainin$ risk is systematic, as meas"red by the variance of the market portfolio. %. &he inde' model as first s"$$ested by ____________. A) (raham B) )arko it* C) )iller D) +harpe E) none of the above Ans er! D Diffic"lty! Easy #ationale! ,illiam +harpe, b"ildin$ on the ork of -arry )arko it*, developed the inde' model. .. A sin$le/inde' model "ses __________ as a pro'y for the systematic risk factor. A) a market inde', s"ch as the +01 200 B) the c"rrent acco"nt deficit C) the $ro th rate in (31 D) the "nemployment rate E) none of the above Ans er! A Diffic"lty! Easy #ationale! &he sin$le/inde' model "ses a market inde', s"ch as the +01 200, as a pro'y for the market, and th"s for systematic risk.

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4. &he +ec"rity #isk Eval"ation book p"blished by )errill 5ynch relies on the __________ most recent monthly observations to calc"late re$ression parameters. A) 1% B) .6 C) 60 D) 1%0 E) none of the above Ans er! C Diffic"lty! Easy #ationale! )ost p"blished betas and other re$ression parameters, incl"din$ those p"blished by )errill 5ynch, are based on five years of monthly ret"rn data. 2. &he +ec"rity #isk Eval"ation book p"blished by )errill 5ynch "ses the __________ as a pro'y for the market portfolio. A) Do 7ones 8nd"strial Avera$e B) Do 7ones &ransportation Avera$e C) +01 200 8nde' D) ,ilshire 2000 E) none of the above Ans er! C Diffic"lty! Easy #ationale! &he )errill 5ynch data 9and m"ch of the other p"blished data sets) are based on the +01 200 inde' as a market pro'y. 6. Accordin$ to the inde' model, covariances amon$ sec"rity pairs are A) d"e to the infl"ence of a sin$le common factor represented by the market inde' ret"rn B) e'tremely diffic"lt to calc"late C) related to ind"stry/specific events D) "s"ally positive E) A and D Ans er! E Diffic"lty! Easy #ationale! )ost sec"rities move to$ether most of the time, and move ith a market inde', or market pro'y.

Chapter 8 Index Models

:. &he intercept calc"lated by )errill 5ynch in the re$ression e;"ations is e;"al to A) in the CAPM B) + rf(1 + ) C) + rf(1 - ) D) 1 - E) none of the above Ans er! C Diffic"lty! )oderate #ationale! &he intercept that )errill 5ynch calls alpha is really, "sin$ the parameters of the CA1), an estimate of a < rf 91 / b). &he apparent ="stification for this proced"re is that, on a monthly basis, rf91 / b) is small and is apt to be s amped by the volatility of act"al stock ret"rns. >. Analysts may "se re$ression analysis to estimate the inde' model for a stock. ,hen doin$ so, the slope of the re$ression line is an estimate of ______________. A) the of the asset B) the of the asset C) the of the asset D) the of the asset E) none of the above Ans er! B Diffic"lty! )oderate #ationale! &he slope of the re$ression line, b, meas"res the volatility of the stock vers"s the volatility of the market. ?. 8n a factor model, the ret"rn on a stock in a partic"lar period ill be related to _________. A) firm/specific events B) macroeconomic events C) the error term D) both A and B E) neither A nor B Ans er! D Diffic"lty! )oderate #ationale! &he ret"rn on a stock is related to both firm/specific and macroeconomic events.

165

10. #osenber$ and ("y fo"nd that __________ helped to predict a firm@s beta. A) the firm@s financial characteristics B) the firm@s ind"stry $ro"p C) firm si*e D) both A and B E) A, B and C all helped to predict betas. Ans er! E Diffic"lty! )oderate #ationale! #osenber$ and ("y fo"nd that after controllin$ for the firm@s financial characteristics, the firm@s ind"stry $ro"p as a si$nificant predictor of the firm@s beta. 11. 8f the inde' model is valid, _________ o"ld be helpf"l in determinin$ the covariance bet een assets A and 5. A) k B) 5 C) ) D) all of the above E) none of the above Ans er! D Diffic"lty! )oderate #ationale! 8f the inde' model is valid A, B, and C are determinants of the covariance bet een A and 5. 1%. #osenber$ and ("y fo"nd that ___________ helped to predict firms@ betas. A) debtBasset ratios B) market capitali*ation C) variance of earnin$s D) all of the above E) none of the above Ans er! D Diffic"lty! )oderate #ationale! #osenber$ and ("y fo"nd that A, B, and C ere determinants of firms@ betas.

Chapter 8 Index Models

1.. 8f a firm@s beta as calc"lated as 0.6 in a re$ression e;"ation, )errill 5ynch o"ld state the ad="sted beta at a n"mber A) less than 0.6 b"t $reater than *ero. B) bet een 0.6 and 1.0. C) bet een 1.0 and 1.6. D) $reater than 1.6. E) *ero or less. Ans er! B Diffic"lty! )oderate #ationale! Betas, on avera$e, e;"al oneC th"s, betas over time re$ress to ard the mean, or 1. &herefore, if historic betas are less than 1, ad="sted betas are bet een 1 and the calc"lated beta. 14. &he beta of E''on stock has been estimated as 1.% by )errill 5ynch "sin$ re$ression analysis on a sample of historical ret"rns. &he )errill 5ynch ad="sted beta of E''on stock o"ld be ___________. A) 1.%0 B) 1..% C) 1.1. D) 1.0 E) none of the above Ans er! C Diffic"lty! )oderate #ationale! Ad="sted beta D %B. sample beta < 1B.91)C D %B.91.%) < 1B. D 1.1.. 12. Ass"me that stock market ret"rns do not resemble a sin$le/inde' str"ct"re. An investment f"nd analy*es 100 stocks in order to constr"ct a mean/variance efficient portfolio constrained by 100 investments. &hey ill need to calc"late _____________ e'pected ret"rns and ___________ variances of ret"rns. A) 100, 100 B) 100, 4?20 C) 4?20, 100 D) 4?20, 4?20 E) none of the above Ans er! A Diffic"lty! )oderate #ationale! &he e'pected ret"rns of each of the 100 sec"rities m"st be calc"lated. 8n addition, the 100 variances aro"nd these ret"rns m"st be calc"lated.

167

16. Ass"me that stock market ret"rns do not resemble a sin$le/inde' str"ct"re. An investment f"nd analy*es 100 stocks in order to constr"ct a mean/variance efficient portfolio constrained by 100 investments. &hey ill need to calc"late ____________ covariances. A) 42 B) 100 C) 4,?20 D) 10,000 E) none of the above Ans er! C Diffic"lty! )oderate #ationale! 9n% / n)B% D 910,000 / 100)B% D 4,?20 covariances m"st be calc"lated. 1:. Ass"me that stock market ret"rns do follo a sin$le/inde' str"ct"re. An investment f"nd analy*es %00 stocks in order to constr"ct a mean/variance efficient portfolio constrained by %00 investments. &hey ill need to calc"late ________ estimates of e'pected ret"rns and ________ estimates of sensitivity coefficients to the macroeconomic factor. A) %00C 1?,?00 B) %00C %00 C) 1?,?00C %00 D) 1?,?00C 1?.?00 E) none of the above Ans er! B Diffic"lty! )oderate #ationale! Eor a sin$le/inde' model, n9%00), e'pected ret"rns and n9%00) sensitivity coefficients to the macroeconomic factor m"st be estimated. 1>. Ass"me that stock market ret"rns do follo a sin$le/inde' str"ct"re. An investment f"nd analy*es 200 stocks in order to constr"ct a mean/variance efficient portfolio constrained by 200 investments. &hey ill need to calc"late ________ estimates of firm/specific variances and ________ estimates for the variance of the macroeconomic factor. A) 200C 1 B) 200C 200 C) 1%4,:20C 1 D) 1%4,:20C 200 E) %20,000C 200 Ans er! A Diffic"lty! )oderate #ationale! Eor the sin$le/inde' model, n9200) estimates of firm/specific variances m"st be calc"lated and 1 estimate for the variance of the common macroeconomic factor.

Chapter 8 Index Models

1?. Consider the sin$le/inde' model. &he alpha of a stock is 0F. &he ret"rn on the market inde' is 16F. &he risk/free rate of return is 5%. The stock earns a return that e cee!s the risk-free rate "# 11% an! there are no fir$s%ecific e&ents affectin' the stock %erfor$ance. The of the stock is (((((((. A) 0.6: B) 0.:2 C) 1.0 D) 1... E) 1.20 Ans er! C Diffic"lty! )oderate #ationale! 11F D 0F < b911F)C b D 1.0. %0. +"ppose yo" held a ell/diversified portfolio ith a very lar$e n"mber of sec"rities, and that the sin$le inde' model holds. 8f the G of yo"r portfolio as 0.%0 and G) )as *.1+, the of the portfolio o"ld be appro'imately ________. A) 0.64 B) 0.>0 C) 1.%2 D) 1.26 E) none of the above Ans er! C Diffic"lty! Diffic"lt #ationale! s%p B s%m D b%C 90.%)%B90.16)% D 1.26C b D 1.%2. %1. +"ppose the follo in$ e;"ation best describes the evol"tion of over time! t - *..5 + *./5t/1 0f a stock ha! a of *.+ 1ast #ear, #ou )ou1! forecast the to "e ((((((( in the co$in' #ear. A) 0.42 B) 0.60 C) 0.:0 D) 0.:2 E) none of the above Ans er! C Diffic"lty! Easy #ationale! 0.%2 < 0.:290.6) D 0.:0.

169

%%. )errill 5ynch estimates the inde' model for a stock "sin$ re$ression analysis involvin$ total ret"rns. &hey estimated the intercept in the re$ression e;"ation at 6F and the at 0.2. &he risk/free rate of ret"rn is 1%F. &he tr"e of the stock is ________. A) 0F B) .F C) 6F D) ?F E) none of the above Ans er! A Diffic"lty! Diffic"lt #ationale! 6F D a < 1%F 91 / 0.2)C a D 0F. %.. &he inde' model for stock A has been estimated ith the follo in$ res"lt! #A D 0.01 < 0.?#) < eA 0f ) D 0.%2 and #%A D 0.%2, the standard deviation of ret"rn of stock A is _________. A) 0.%0%2 B) 0.%200 C) 0.4200 D) 0.>100 E) none of the above Ans er! C Diffic"lty! Diffic"lt #ationale! #% D b%s%) B s%C0.%2 D H90.>1)90.%2)%IBs%C s D 0.4200. %4. &he inde' model for stock B has been estimated ith the follo in$ res"lt! #B D 0.01 < 1.1#) < eB 0f ) D 0.%0 and #%B D 0.20, the standard deviation of the ret"rn on stock B is _________. A) 0.1111 B) 0.%111 C) 0..111 D) 0.4111 E) none of the above Ans er! C Diffic"lty! Diffic"lt #ationale! #% D b%s%) B s%C 0.2 D H91.1)%90.%)%IBs%C s D 0..111.

Chapter 8 Index Models

%2. +"ppose yo" forecast that the market inde' ill earn a ret"rn of 15% in the co$in' #ear. Treasur# "i11s are #ie1!in' +%. The una!2uste! of Mo"i1 stock is 1.3*. A reasona"1e forecast of the return on Mo"i1 stock for the co$in' #ear is ((((((((( if #ou use Merri11 4#nch a!2uste! "etas. A) 12.0F B) 12.2F C) 16.0F D) 16.>F E) none of the above Ans er! D Diffic"lty! Diffic"lt #ationale! Ad="sted beta D %B.91..) < 1B. D 1.%0C E9r)) D 6F < 1.%09?F) D 16.>F. %6. &he inde' model has been estimated for stocks A and B ith the follo in$ res"lts! #A D 0.01 < 0.2#) < eA #B D 0.0% < 1..#) < eB ) - *..5 (eA) - *..* (eB) D 0.10 &he covariance bet een the ret"rns on stocks A and B is ___________. A) 0.0.>4 B) 0.0406 C) 0.1?%0 D) 0.0020 E) 0.4000 Ans er! B Diffic"lty! Diffic"lt #ationale! Cov9#A,#B) D bAbBs%) D 0.291..)90.%2)% D 0.0406.

171

%:. &he inde' model has been estimated for stocks A and B ith the follo in$ res"lts! #A D 0.01 < 0.>#) < eA #B D 0.0% < 1.%#) < eB ) - *..* (eA) - *..* (eB) D 0.10 &he standard deviation for stock A is __________. A) 0.0626 B) 0.06:6 C) 0.%261 D) 0.%600 E) none of the above Ans er! C Diffic"lty! Diffic"lt #ationale! A - 5(*.6)%90.%)% < 90.%)%I1B% D 0.%261. %>. &he inde' model has been estimated for stock A ith the follo in$ res"lts! #A D 0.01 < 0.>#) < eA ) - *..* (eA) D 0.10 &he standard deviation of the ret"rn for stock A is __________. A) 0.0.26 B) 0.1>>6 C) 0.1600 D) 0.6400 E) none of the above Ans er! B Diffic"lty! Diffic"lt #ationale! 7 - 5(.6)%90.%)% < 90.1)%I1B% D 0.1>>6. %?. +ec"rity ret"rns A) are based on both macro events and firm/specific events. B) are based on firm/specific events only. C) are "s"ally positively correlated ith each other. D) A and B. E) A and C. Ans er! E Diffic"lty! Easy #ationale! +tock ret"rns are "s"ally hi$hly positively correlated ith each other. +tock ret"rns are affected by both macro economic events and firm/specific events.

Chapter 8 Index Models

.0. &he sin$le/inde' model A) $reatly red"ces the n"mber of re;"ired calc"lations, relative to those re;"ired by the )arko it* model. B) enhances the "nderstandin$ of systematic vers"s nonsystematic risk. C) $reatly increases the n"mber of re;"ired calc"lations, relative to those re;"ired by the )arko it* model. D) A and B. E) B and C. Ans er! D Diffic"lty! Easy #ationale! &he sin$le inde' model both $reatly red"ces the n"mber of calc"lations and enhances the "nderstandin$ of the relationship bet een systematic and "nsystematic risk on sec"rity ret"rns. .1. &he +ec"rity Characteristic 5ine 9+C5) A) plots the e'cess ret"rn on a sec"rity as a f"nction of the e'cess ret"rn on the market. B) allo s one to estimate the beta of the sec"rity. C) allo s one to estimate the alpha of the sec"rity. D) all of the above. E) none of the above. Ans er! D Diffic"lty! Easy #ationale! &he sec"rity characteristic line, hich plots the e'cess ret"rn of the sec"rity as a f"nction of the e'cess ret"rn of the market allo s one to estimate both the alpha and the beta of the sec"rity. .%. &he expected impact of "nanticipated macroeconomic events on a sec"rity@s ret"rn d"rin$ the period is A) incl"ded in the sec"rity@s e'pected ret"rn. B) *ero. C) e;"al to the risk free rate. D) proportional to the firm@s beta. E) infinite. Ans er! B Diffic"lty! )oderate #ationale! &he e'pected val"e of "nanticipated macroeconomic events is *ero, beca"se by definition it m"st avera$e to *ero or it o"ld be incorporated into the e'pected ret"rn.

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... Covariances bet een sec"rity ret"rns tend to be A) positive beca"se of +EC re$"lations. B) positive beca"se of E'chan$e re$"lations. C) positive beca"se of economic forces that affect many firms. D) ne$ative beca"se of +EC re$"lations E) ne$ative beca"se of economic forces that affect many firms. Ans er! C Diffic"lty! )oderate #ationale! Economic forces s"ch as b"siness cycles, interest rates, and technolo$ical chan$es tend to have similar impacts on many firms. .4. 8n the sin$le/inde' model represented by the e;"ation ri D E9ri) + iE < ei, the term ei represents A) the impact of "nanticipated macroeconomic events on sec"rity i@s ret"rn. B) the impact of "nanticipated firm/specific events on sec"rity i@s ret"rn. C) the impact of anticipated macroeconomic events on sec"rity i@s ret"rn. D) the impact of anticipated firm/specific events on sec"rity i@s ret"rn. E) the impact of chan$es in the market on sec"rity i@s ret"rn. Ans er! B Diffic"lty! )oderate #ationale! &he te'tbook disc"sses a model in hich macroeconomic events are "sed as a sin$le inde' for sec"rity ret"rns. &he ei term represents the impact of "nanticipated firm/specific events. &he ei term has an e'pected val"e of *ero. Jnly "nanticipated events o"ld affect the ret"rn. .2. +"ppose yo" are doin$ a portfolio analysis that incl"des all of the stocks on the 3K+E. Lsin$ a sin$le/inde' model rather than the )arko it* model _______ the n"mber of inp"ts needed from _______ to ________. A) increases, abo"t 1,400, more than 1.4 million B) increases, abo"t 10,000, more than 1%2,000 C) red"ces, more than 1%2,000, abo"t 10,000 D) red"ces, more than 4 million, abo"t ?,000 E) increases, abo"t 120, more than 1,200 Ans er! D Diffic"lty! )oderate #ationale! &his e'ample is disc"ssed in the te'tbook. &he main point for the st"dents to remember is that the sin$le/inde' model drastically red"ces the n"mber of inp"ts re;"ired.

Chapter 8 Index Models

.6. Jne McostN of the sin$le/inde' model is that it A) is virt"ally impossible to apply. B) prohibits speciali*ation of efforts ithin the sec"rity analysis ind"stry. C) re;"ires forecasts of the money s"pply. D) is le$ally prohibited by the +EC. E) allo s for only t o kinds of risk // macro risk and micro risk. Ans er! E Diffic"lty! )oderate #ationale! &he sin$le/inde' model disc"ssed in chapter 10 broke risk into macro and micro portions. 8n this model other factors s"ch as ind"stry effects. .:. &he +ec"rity Characteristic 5ine 9+C5) associated ith the sin$le/inde' model is a plot of A) the sec"rity@s ret"rns on the vertical a'is and the market inde'@s ret"rns on the hori*ontal a'is. B) the market inde'@s ret"rns on the vertical a'is and the sec"rity@s ret"rns on the hori*ontal a'is. C) the sec"rity@s e'cess ret"rns on the vertical a'is and the market inde'@s e'cess ret"rns on the hori*ontal a'is. D) the market inde'@s e'cess ret"rns on the vertical a'is and the sec"rity@s e'cess ret"rns on the hori*ontal a'is. E) the sec"rity@s ret"rns on the vertical a'is and Beta on the hori*ontal a'is. Ans er! C Diffic"lty! )oderate #ationale! &he st"dent needs to remember that it is the e'cess ret"rns that are plotted and that the sec"rity@s ret"rns are plotted as a dependent variable. .>. &he idea that there is a limit to the red"ction of portfolio risk d"e to diversification is A) contradicted by both the CA1) and the sin$le/inde' model. B) contradicted by the CA1). C) contradicted by the sin$le/inde' model. D) s"pported in theory, b"t not s"pported empirically. E) s"pported both in theory and by empirical evidence. Ans er! E Diffic"lty! )oderate #ationale! &he benefits of diversification are limited to the level of systematic risk. Ei$"re >.1 sho s this concept $raphically.

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.?. 8n their st"dy abo"t predictin$ beta coefficients, hich of the follo in$ did #osenber$ and ("y find to be factors that infl"ence betaO 8) 88) 888) 8P) A) B) C) D) E) ind"stry $ro"p variance of cash flo dividend yield $ro th in earnin$s per share

8 and 88 8 and 888 8, 88, and 888 8, 88, and 8P 8, 88, 888, and 8P

Ans er! E Diffic"lty! )oderate #ationale! All of the factors mentioned, as ell as variance of earnin$s, firm si*e, and debt/to/asset ratio, ere fo"nd to help predict betas. 40. 8f a firm@s beta as calc"lated as 1.6 in a re$ression e;"ation, )errill 5ynch o"ld state the ad="sted beta at a n"mber A) less than 0.6 b"t $reater than *ero. B) bet een 0.6 and 1.0. C) bet een 1.0 and 1.6. D) $reater than 1.6. E) *ero or less. Ans er! C Diffic"lty! )oderate #ationale! Betas, on avera$e, e;"al oneC th"s, betas over time re$ress to ard the mean, or 1. &herefore, if historic betas are more than 1, ad="sted betas are bet een 1 and the calc"lated beta. 41. &he beta of a stock has been estimated as 1.> by )errill 5ynch "sin$ re$ression analysis on a sample of historical ret"rns. &he )errill 5ynch ad="sted beta of the stock o"ld be ___________. A) 1.%0 B) 1.2. C) 1.1. D) 1.0 E) none of the above Ans er! B Diffic"lty! )oderate #ationale! Ad="sted beta D %B. sample beta < 1B.91)C D %B.91.>) < 1B. D 1.2..

Chapter 8 Index Models

4%. Ass"me that stock market ret"rns do not resemble a sin$le/inde' str"ct"re. An investment f"nd analy*es 40 stocks in order to constr"ct a mean/variance efficient portfolio constrained by 40 investments. &hey ill need to calc"late _____________ e'pected ret"rns and ___________ variances of ret"rns. A) 100, 100 B) 40, 40 C) 4?20, 100 D) 4?20, 4?20 E) none of the above Ans er! B Diffic"lty! )oderate #ationale! &he e'pected ret"rns of each of the 40 sec"rities m"st be calc"lated. 8n addition, the 40 variances aro"nd these ret"rns m"st be calc"lated. 4.. Ass"me that stock market ret"rns do not resemble a sin$le/inde' str"ct"re. An investment f"nd analy*es 40 stocks in order to constr"ct a mean/variance efficient portfolio constrained by 40 investments. &hey ill need to calc"late ____________ covariances. A) 42 B) :>0 C) 4,?20 D) 10,000 E) none of the above Ans er! B Diffic"lty! )oderate #ationale! 9n% / n)B% D 91,600 / 40)B% D :>0 covariances m"st be calc"lated. 44. Ass"me that stock market ret"rns do follo a sin$le/inde' str"ct"re. An investment f"nd analy*es 60 stocks in order to constr"ct a mean/variance efficient portfolio constrained by 60 investments. &hey ill need to calc"late ________ estimates of e'pected ret"rns and ________ estimates of sensitivity coefficients to the macroeconomic factor. A) %00C 1?,?00 B) %00C %00 C) 60C 60 D) 1?,?00C 1?.?00 E) none of the above Ans er! C Diffic"lty! )oderate #ationale! Eor a sin$le/inde' model, n960), e'pected ret"rns and n960) sensitivity coefficients to the macroeconomic factor m"st be estimated.

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42. Consider the sin$le/inde' model. &he alpha of a stock is 0F. &he return on the $arket in!e is 1*%. The risk-free rate of return is 3%. The stock earns a return that e cee!s the risk-free rate "# 11% an! there are no fir$-s%ecific e&ents affectin' the stock %erfor$ance. The of the stock is (((((((. A) 0.64 B) 0.:2 C) 1.1: D) 1... E) 1.20 Ans er! A Diffic"lty! )oderate #ationale! :F D 0F < b911F)C b D 0.6.6. 46. +"ppose yo" held a ell/diversified portfolio ith a very lar$e n"mber of sec"rities, and that the sin$le inde' model holds. 8f the of yo"r portfolio as 0.%2 and ) )as *..1, the of the %ortfo1io )ou1! "e a%%ro i$ate1# ((((((((. A) 0.64 B) 1.1? C) 1.%2 D) 1.26 E) none of the above Ans er! B Diffic"lty! Diffic"lt #ationale! s%p B s%m D b%C 90.%2)%B90.%1)% D 1.41:C b D 1.1?. 8/. 9u%%ose #ou he1! a )e11-!i&ersifie! %ortfo1io )ith a &er# 1ar'e nu$"er of securities, an! that the sin'1e in!e $o!e1 ho1!s. 0f the of #our %ortfo1io )as *.16 an! ) )as *..., the of the %ortfo1io )ou1! "e a%%ro i$ate1# ((((((((. A) 0.64 B) 1.1? C) 0.>% D) 1.26 E) none of the above Ans er! C Diffic"lty! Diffic"lt #ationale! s%p B s%m D b%C 90.1>)%B90.%%)% D 0.66?C b D 0.>%.

Chapter 8 Index Models

4>. +"ppose the follo in$ e;"ation best describes the evol"tion of over time! Qt D *.8 + *.+t/1 0f a stock ha! a of *.: 1ast #ear, #ou )ou1! forecast the to "e ((((((( in the co$in' #ear. A) 0.42 B) 0.60 C) 0.:0 D) 0.?4 E) none of the above Ans er! D Diffic"lty! Easy #ationale! 0.4 < 0.690.?) D 0.?4. 4?. +"ppose the follo in$ e;"ation best describes the evol"tion of over time! t - *.3 + *..t/1 0f a stock ha! a of *.6 1ast #ear, #ou )ou1! forecast the to "e ((((((( in the co$in' #ear. A) 0.46 B) 0.60 C) 0.:0 D) 0.?4 E) none of the above Ans er! A Diffic"lty! Easy #ationale! 0.. < 0.%90.>) D 0.46. 20. &he inde' model for stock A has been estimated ith the follo in$ res"lt! #A D 0.01 < 0.?4#) < eA 0f ) D 0..0 and #%A D 0.%>, the standard deviation of ret"rn of stock A is _________. A) 0.%0%2 B) 0.%200 C) 0.4200 D) 0.2.%? E) none of the above Ans er! D Diffic"lty! Diffic"lt

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#ationale! #% D b%s%) B s%C 0.%> D H90.?4) %90..0) %I B .%>C s D 0.2.%?.

Chapter 8 Index Models

21. .0. A reasonable forecast of the ret"rn on )obil stock for the comin$ year is _________ if yo" "se )errill 5ynch ad="sted betas. A) 12.0F B) 12.2F C) 16.0F D) 14.6F E) none of the above Ans er! D Diffic"lty! Diffic"lt #ationale! Ad="sted beta D %B.91.2) < 1B. D 1...C E9r)) D 4F < 1...9>F) D 14.6F. 2%. &he inde' model has been estimated for stocks A and B ith the follo in$ res"lts! #A D 0.01 < 0.>#) < eA #B D 0.0% < 1.1#) < eB ) - *.3* (eA) - *..* (eB) D 0.10 &he covariance bet een the ret"rns on stocks A and B is ___________. A) 0.0.>4 B) 0.0406 C) 0.1?%0 D) 0.0020 E) 0.0:?% Ans er! E Diffic"lty! Diffic"lt #ationale! Cov9#A,#B) D bAbBs%) D 0.>91.1)90..0)% D 0.0:?%. 2.. 8f a firm@s beta as calc"lated as 1..2 in a re$ression e;"ation, )errill 5ynch o"ld state the ad="sted beta at a n"mber A) less than 1..2 B) bet een 0.0 and 1.0. C) bet een 1.0 and 1..2. D) $reater than 1..2. E) *ero or less. Ans er! C Diffic"lty! )oderate #ationale! Betas, on avera$e, e;"al oneC th"s, betas over time re$ress to ard the mean, or 1. &herefore, if historic betas are less than 1, ad="sted betas are bet een 1 and the calc"lated beta.

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24. &he beta of a stock has been estimated as 1.4 by )errill 5ynch "sin$ re$ression analysis on a sample of historical ret"rns. &he )errill 5ynch ad="sted beta of the stock o"ld be ___________. A) 1.%: B) 1..% C) 1.1. D) 1.0 E) none of the above Ans er! A Diffic"lty! )oderate #ationale! Ad="sted beta D %B. sample beta < 1B.91)C D %B.91.4) < 1B. D 1.%:. 22. &he beta of a stock has been estimated as 0.>2 by )errill 5ynch "sin$ re$ression analysis on a sample of historical ret"rns. &he )errill 5ynch ad="sted beta of the stock o"ld be ___________. A) 1.01 B) 0.?2 C) 1.1. D) 0.?0 E) none of the above Ans er! D Diffic"lty! )oderate #ationale! Ad="sted beta D %B. sample beta < 1B.91)C D %B.90.>2) < 1B. D 0.?0. 26. Ass"me that stock market ret"rns do not resemble a sin$le/inde' str"ct"re. An investment f"nd analy*es 1%2 stocks in order to constr"ct a mean/variance efficient portfolio constrained by 1%2 investments. &hey ill need to calc"late _____________ e'pected ret"rns and ___________ variances of ret"rns. A) 1%2, 1%2 B) 1%2, 12,6%2 C) 12,6%2, 1%2 D) 12,6%2, 12,6%2 E) none of the above Ans er! A Diffic"lty! )oderate #ationale! &he e'pected ret"rns of each of the 1%2 sec"rities m"st be calc"lated. 8n addition, the 1%2 variances aro"nd these ret"rns m"st be calc"lated.

Chapter 8 Index Models

2:. Ass"me that stock market ret"rns do not resemble a sin$le/inde' str"ct"re. An investment f"nd analy*es 1%2 stocks in order to constr"ct a mean/variance efficient portfolio constrained by 1%2 investments. &hey ill need to calc"late ____________ covariances. A) ?0 B) 1%2 C) :,:20 D) 12,6%2 E) none of the above Ans er! C Diffic"lty! )oderate #ationale! 9n% / n)B% D 912,6%2 / 1%2)B% D :,:20 covariances m"st be calc"lated. 2>. Ass"me that stock market ret"rns do not resemble a sin$le/inde' str"ct"re. An investment f"nd analy*es 1.% stocks in order to constr"ct a mean/variance efficient portfolio constrained by 1.% investments. &hey ill need to calc"late ____________ covariances. A) 100 B) 1.% C) 4,?20 D) >,646 E) none of the above Ans er! D Diffic"lty! )oderate #ationale! 9n% / n)B% D 91:,4%4 / 1.%)B% D >,646 covariances m"st be calc"lated. 2?. Ass"me that stock market ret"rns do follo a sin$le/inde' str"ct"re. An investment f"nd analy*es %1: stocks in order to constr"ct a mean/variance efficient portfolio constrained by %1: investments. &hey ill need to calc"late ________ estimates of e'pected ret"rns and ________ estimates of sensitivity coefficients to the macroeconomic factor. A) %1:C 4:,0>? B) %1:C %1: C) 4:,0>?C %1: D) 4:,0>?C 4:,0>? E) none of the above Ans er! B Diffic"lty! )oderate #ationale! Eor a sin$le/inde' model, n9%1:), e'pected ret"rns and n9%1:) sensitivity coefficients to the macroeconomic factor m"st be estimated.

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60. Ass"me that stock market ret"rns do follo a sin$le/inde' str"ct"re. An investment f"nd analy*es 200 stocks in order to constr"ct a mean/variance efficient portfolio constrained by :20 investments. &hey ill need to calc"late ________ estimates of firm/specific variances and ________ estimates for the variance of the macroeconomic factor. A) :20C 1 B) :20C :20 C) 1%4,:20C 1 D) 1%4,:20C :20 E) 26%,200C :20 Ans er! A Diffic"lty! )oderate #ationale! Eor the sin$le/inde' model, n9:20) estimates of firm/specific variances m"st be calc"lated and 1 estimate for the variance of the common macroeconomic factor. 61. Consider the sin$le/inde' model. &he alpha of a stock is 0F. &he ret"rn on the market inde' is 10F. &he risk/free rate of ret"rn is 2F. &he stock earns a ret"rn that e'ceeds the risk-free rate "# 5% an! there are no fir$-s%ecific e&ents affectin' the stock %erfor$ance. The of the stock is (((((((. A) 0.6: B) 0.:2 C) 1.0 D) 1... E) 1.20 Ans er! C Diffic"lty! )oderate #ationale! 2F D 0F < b92F)C b D 1.0. 6%. +"ppose yo" held a ell/diversified portfolio ith a very lar$e n"mber of sec"rities, and that the sin$le inde' model holds. 8f the G of yo"r portfolio as 0.%4 and ) )as *.16, the of the %ortfo1io )ou1! "e a%%ro i$ate1# ((((((((. A) 0.64 B) 1... C) 1.%2 D) 1.26 E) none of the above Ans er! B Diffic"lty! Diffic"lt #ationale! s%p B s%m D b%C 90.%4)%B90.1>)% D 1.:>C b D 1....

Chapter 8 Index Models

6.. +"ppose yo" held a ell/diversified portfolio ith a very lar$e n"mber of sec"rities, and that the sin$le in!e $o!e1 ho1!s. 0f the of #our %ortfo1io )as *.18 an! ) )as *.1:, the of the %ortfo1io )ou1! "e a%%ro i$ate1# ((((((((. A) 0.:4 B) 0.>0 C) 1.%2 D) 1.26 E) none of the above Ans er! A Diffic"lty! Diffic"lt #ationale! s%p B s%m D b%C 90.14)%B90.1?)% D 0.24C b D 0.:4. 64. +"ppose the follo in$ e;"ation best describes the evol"tion of over time! t - *.3* + *./*t/1 0f a stock ha! a of *.6. 1ast #ear, #ou )ou1! forecast the to "e ((((((( in the co$in' #ear. A) 0.?1 B) 0.:: C) 0.6. D) 0.>: E) none of the above Ans er! D Diffic"lty! Easy #ationale! 0..0 < 0.:090.>%) D 0.>:4. 62. &he inde' model has been estimated for stocks A and B ith the follo in$ res"lts! #A D 0.0. < 0.:#) < eA #B D 0.01 < 0.?#) < eB ) - *.35 (eA) - *..* (eB) D 0.10 &he covariance bet een the ret"rns on stocks A and B is ___________. A) 0.0.>4 B) 0.0406 C) 0.1?%0 D) 0.0::% E) 0.4000 Ans er! D Diffic"lty! Diffic"lt

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#ationale! Cov9#A,#B) D bAbBs%) D 0.:90.?)90..2)% D 0.0::%.

Chapter 8 Index Models

Essay Questions 66. Disc"ss the advanta$es of the single-index model over the Markowitz model in terms of numbers o !ariable estimates re"uired and in terms of understanding risk relationships. Diffic"lty! )oderate Ans er! Eor a 20 sec"rity portfolio, the Markowitz model re;"ires the follo in$ parameter estimates! n D 20 estimates of e'pected ret"rnsC n D 20 estimates of variancesC #n$ - n%&$ D 1,%%2 estimates of covariancesC ',($) estimates. Eor a 20 sec"rity portfolio, the single-index model re;"ires the follo in$ parameter estimates! n D 20 estimates of e'pected e'cess ret"rns, E9#)C n - 5* esti$ates of sensiti&it# coefficients, iC n - 5* esti$ates of the fir$-s%ecific &ariances, %9ei)C ' esti$ate for the &ariance of the co$$on $acroecono$ic factor, %)C or #(n * '% estimates. 8n addition, the sin$le/inde' model provides f"rther insi$ht by reco$ni*in$ that different firms have different sensitivities to macroeconomic events. &he model also s"mmari*es the distinction bet een macroeconomic and firm/specific risk factors. &his ;"estion is desi$ned to ascertain that the st"dent "nderstands the si$nificant simplifications and improvements offered by the sin$le/inde' model over the )arko it* model.

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6:. Disc"ss the security characteristic line #+C,%. Diffic"lty! )oderate Ans er! &he security characteristic line #+C,% is the res"lt of estimatin$ the re$ression e;"ation of the sin$le/inde' model. &he +C5 is a plot of the typical e'cess ret"rns on a sec"rity over the risk/free rate as a f"nction of the e'cess ret"rn on the market. &he slope of the +C5 is the beta of the sec"rity, and they/intercept, alpha, is the e'cess ret"rn on the sec"rity hen the e'cess market ret"rn is *ero. &his ;"estion is desi$ned to ascertain that the st"dent "nderstands ho the +C5 is obtained, as this relationship is the one that is most fre;"ently "sed by p"blished information services for the estimation of the re$ression parameters, alpha and beta. 6>. Disc"ss the -ad.usted betas- p"blished by )errill 5ynch in +ec"rity #isk Eval"ation. Diffic"lty! Easy Ans er! Jver time, sec"rity betas move to ard 1, as the avera$e beta of all sec"rities is 1 and variables re$ress to ard the mean. &h"s, if a historic beta has been $reater than 1, the chances are that in the f"t"re, this beta ill be less than the historic beta. &he opposite relationship ill be observed if the historic beta has been less than one. )errill 5ynch "ses the follo in$ relationship to calc"late -ad.usted betas-. Ad="sted beta D %B. 9sample beta) < 1B. 91). &his ;"estion is important, as many p"blished so"rces ;"ote an Rad="sted betaR ith no e'planation as to ho s"ch a n"mber as obtained. &he re$ression to ard the mean is a valid statistical concept and it is important that the st"dent "nderstands that this concept represents the theory behind the possibly "ndoc"mented Rad="sted betasR.