Chapter 8 Index Models 163 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 Answer: C Difficulty: Easy Rationale: As more and more securities are added to the portfolio unsystematic risk decreases and most of the remaining risk is systematic as measured by the variance of the market portfolio. 2. The index model was first suggested by ____________. A Graham B Markowitz C Miller D Sharpe E none of the above Answer: D Difficulty: Easy Rationale: William Sharpe building on the work of Harry Markowitz developed the index model. 3. A single-index model uses __________ as a proxy for the systematic risk factor. A a market index such as the SampP 500 B the current account deficit C the growth rate in GNP D the unemployment rate E none of the above Answer: A Difficulty: Easy Rationale: The single-index model uses a market index such as the SampP 500 as a proxy for the market and thus for systematic risk. Chapter 8 Index Models 164 4. The Security Risk Evaluation book published by Merrill Lynch relies on the __________ most recent monthly observations to calculate regression parameters. A 12 B 36 C 60 D 120 E none of the above Answer: C Difficulty: Easy Rationale: Most published betas and other regression parameters including those published by Merrill Lynch are based on five years of monthly return data. 5. The Security Risk Evaluation book published by Merrill Lynch uses the __________ as a proxy for the market portfolio. A Dow Jones Industrial Average B Dow Jones Transportation Average C SampP 500 Index D Wilshire 5000 E none of the above Answer: C Difficulty: Easy Rationale: The Merrill Lynch data and much of the other published data sets are based on the SampP 500 index as a market proxy. 6. According to the index model covariances among security pairs are A due to the influence of a single common factor represented by the market index return B extremely difficult to calculate C related to industry-specific events D usually positive E A and D Answer: E Difficulty: Easy Rationale: Most securities move together most of the time and move with a market index or market proxy. Chapter 8 Index Models 165 7. The intercept calculated by Merrill Lynch in the regression equations is equal to A α in the CAPM B α rf1 β C α rf1 - β D 1 - α E none of the above Answer: C Difficulty: Moderate Rationale: The intercept that Merrill Lynch calls alpha is really using the parameters of the CAPM an estimate of a rf 1 - b. The apparent justification for this procedure is that on a monthly basis rf1 - b is small and is apt to be swamped by the volatility of actual stock returns. 8. Analysts may use regression analysis to estimate the index model for a stock. When doing so the slope of the regression line is an estimate of ______________. A the α of the asset B the β of the asset C the σ of the asset D the δ of the asset E none of the above Answer: B Difficulty: Moderate Rationale: The slope of the regression line b measures the volatility of the stock versus the volatility of the market. 9. In a factor model the return on a stock in a particular period will be related to _________. A firm-specific events B macroeconomic events C the error term D both A and B E neither A nor B Answer: D Difficulty: Moderate Rationale: The return on a stock is related to both firm-specific and macroeconomic events. Chapter 8 Index Models 166 10. Rosenberg and Guy found that __________ helped to predict a firms beta. A the firms financial characteristics B the firms industry group C firm size D both A and B E A B and C all helped to predict betas. Answer: E Difficulty: Moderate Rationale: Rosenberg and Guy found that after controlling for the firms financial characteristics the firms industry group was a significant predictor of the firms beta. 11. If the index model is valid _________ would be helpful in determining the...

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