Arbitrage Pricing Theory

In developing the APT, the uncertainty in asset returns as a result of

• a common macroeconomic factor

• firm-specific factors

• pricing error

• both common macroeconomic factors and firm-specific factors

1. Arbitrage opportunity means you can earn a positive return with:

• zero initial investment and some risk.

• zero initial investment and zero risk.

• positive initial investment and low risk.

• low risk.

What role does the risk-free rate play in Arbitrage Pricing Theory?

• It determines the market risk premium

• It is used to discount future cash flows

• It serves as a benchmark for measuring excess returns

•  It is not considered in APT calculations

Security A has a beta of 1.0 and an expected return of 12% and security B has a beta of 0.75 and expected return of 10%.The risk-free rate is 6%.

Given the above parameters, which of the following is correct if a new portfolio is created?

• An arbitrage opportunity exists because the new portfolio which consists 75% of security A and the 25% of risk-free asset, has the same beta but a different expected return with security B.

• An arbitrage opportunity does not exist because the expected return of security A and risk-free asset are different with security B.

• An arbitrage opportunity exists because the new portfolio with 25% of security A and 75% ofthe risk-free asset has the same beta but different expected return with security B.

• An arbitrage opportunity does not exist because it can make a comparison between expected return of the new portfolio and security B.

Security A has a beta of 1.0 and an expected return of 12% and security B has a beta of 0.75 and expected return of 10%.The risk-free rate is 6%. 

According to the above question, calculate Jensen’s alpha of your arbitrage.

• -0.5%

• 0%

• 0.5%

• 1.5%

6. The benchmark portfolios in the APT are factor portfolios, which are well-diversified portfolios constructed to have a beta of _____ on one of the factors and a beta of _____ on any other factor.

• 1, 1

• 2, 1

• 1, 0

• 0, 0

The general arbitrage pricing theory (APT) differs from the single-factor capital asset pricing model (CAPM) because the APT:

• Places more emphasis on market risk.

• Minimizes the importance of diversification.

• Recognizes multiple unsystematic risk factors.

• Recognizes multiple systematic risk factors.

6. In contrast to the capital asset pricing model, arbitrage pricing theory:

• Requires that markets be in equilibrium.

• Uses risk premiums based on micro variables.

• Specifies the number and identifies specific factors that determine expected returns.

• Does not require restrictive assumptions concerning the market portfolio.

6. A zero-investment portfolio with a positive alpha could arise if:

7. 
   

• The expected return of the portfolio equals zero.

• The capital market line is tangent to the opportunity set.

• The Law of One Price remains unviolated.

• A risk-free arbitrage opportunity exists.

The feature of the general version of the arbitrage pricing theory (APT) that offers the greatest potential advantage over the simple CAPM is the:

•  Identification of anticipated changes in production, inflation, and term structure of interest rates as key factors explaining the risk–return relationship.

• Superior measurement of the risk-free rate of return over historical time periods.

• Variability of coefficients of sensitivity to the APT factors for a given asset over time.

• Use of several factors instead of a single market index to explain the risk–return relationship.