Investment Chapter 7 Exam Questions With
Verified Answers
Alpha - answer✔A stock's expected return beyond that induced by the market index; its expected
excess return when the market's excess return is zero.
arbitrage - answer✔Creation of riskless profits made possible by relative mispricing among
securities.
arbitrage portfolio - answer✔A zero-net-investment, risk-free portfolio with a positive return.
arbitrage pricing theory (APT) - answer✔A theory of risk-return relationships derived from no-
arbitrage considerations in large capital markets.
capital asset pricing model (CAPM) - answer✔A model that relates the required rate of return on
a security to its systematic risk as measured by beta.
expected return-beta relationship
. - answer✔Implication of the CAPM that security risk premiums (expected excess returns) will
be proportional to beta
factor portfolio - answer✔A well-diversified portfolio constructed to have a beta of 1 on one
factor and a beta of zero on any other factor.
market portfolio (M) - answer✔The portfolio for which each security is held in proportion to its
total market value.
multifactor models - answer✔Models of security returns that respond to several systematic
factors.
mutual fund theorem - answer✔States that all investors desire the same portfolio of risky assets
and can be satisfied by a single mutual fund composed of that portfolio.
security characteristic line (SCL) - answer✔A plot of a security's expected excess return over the
risk-free rate as a function of the excess return on the market.
security market line (SML) - answer✔Graphical representation of the expected return-beta
relationship of the CAPM.
well-diversified portfolio - answer✔A portfolio sufficiently diversified that nonsystematic risk is
negligible.
The CAPM assumes investors are - answer✔- rational
- single-period planners who agree on a common input list from security analysis
- seek mean-variance optimal portfolios.
all investors will hold identical risky portfolios - answer✔(a) markets are large and investors are
price takers
(b) there are no taxes or transaction costs
(c) all risky assets are publicly traded
(d) any amount can be borrowed and lent at a fixed, risk-free rate
The CAPM implies that, in equilibrium - answer✔the market portfolio is the unique mean-
variance efficient tangency portfolio, which indicates that a passive strategy is efficient.
The market portfolio - answer✔- a value-weighted portfolio
- Each security is held in a proportion equal to its market value divided by the total market value
of all securities
The risk premium on the market portfolio - answer✔proportional to its variance, σ2M and to the
risk aversion of the average investor.
The CAPM implies that - answer✔the risk premium on any individual asset or portfolio is the
product of the risk premium of the market portfolio and the asset's beta
The security market line - answer✔- shows the return demanded by investors as a function of the
beta of their investment.
- This expected return is a benchmark for evaluating investment performance
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