R02 CAPM and multi-factor models: free practice questions

1. Question 1 of 5

   Why does the CAPM say non-systematic risk isn't rewarded?

   Option A: It's always smaller than systematic riskOption B: It only affects bonds, not sharesOption C: It's covered by the FSCSOption D: It can be eliminated by diversification

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   The answer is D: It can be eliminated by diversification

   Because non-systematic risk can be diversified away, the CAPM says investors aren't rewarded for bearing it. The relevant measure of risk is a security's sensitivity to the market: its beta.

   Why the other options are wrong

   A

   That isn't the reason.

   B

   It affects individual securities of all kinds.

   C

   Compensation schemes don't affect expected returns.

2. Question 2 of 5

   What are shares with a beta between 0 and 1 often called?

   Option A: Hedged securitiesOption B: Aggressive securitiesOption C: Risk-free securitiesOption D: Defensive securities

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   The answer is D: Defensive securities

   A beta between 0 and 1 means the security is expected to move less than the market but in the same direction. Such securities are called defensive; those above 1 are aggressive.

   Why the other options are wrong

   A

   That isn't the term used.

   B

   Aggressive securities have betas above 1.

   C

   Only the risk-free asset has no risk.

3. Question 3 of 5

   In the CAPM equation, what does (Rm − Rf) represent?

   Option A: The security's total returnOption B: The market risk premiumOption C: The security's standard deviationOption D: The security's beta

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   The answer is B: The market risk premium

   Rm − Rf is the market risk premium: the market's expected excess return over the risk-free rate. Multiplied by the security's beta, it gives the security's own risk premium.

   Why the other options are wrong

   A

   The total expected return is E(R), not the premium.

   C

   Standard deviation isn't in the CAPM equation.

   D

   Beta is the multiplier applied to it.

4. Question 4 of 5

   Which is a recognised limitation of the CAPM?

   Option A: It ignores the risk-free rateOption B: It rewards investors for taking on specific, diversifiable riskOption C: Betas are based on past data and don't seem stable over timeOption D: It can't produce an expected return for an individual share

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   The answer is C: Betas are based on past data and don't seem stable over time

   Betas are calculated from history and aren't stable, the true market portfolio can't be observed (and betas differ depending on the index used), and some studies haven't found the predicted link between beta and return.

   Why the other options are wrong

   A

   The risk-free rate is central to the model.

   B

   It says specific risk isn't rewarded.

   D

   Producing an expected return is what it does.

5. Question 5 of 5

   How does arbitrage pricing theory (APT) differ from the CAPM?

   Option A: It allows for more than one type of systematic riskOption B: It specifies exactly which factors to useOption C: It rewards investors for diversifiable riskOption D: It assumes all investors hold the same portfolio

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   The answer is A: It allows for more than one type of systematic risk

   Like the CAPM, APT bases returns on systematic risk, but it allows several risk factors, each with its own beta, and assumes each investor holds a unique portfolio. Its flexibility is also a weakness, as it doesn't identify the factors.

   Why the other options are wrong

   B

   A difficulty with APT is that it doesn't say which factors are relevant.

   C

   Like the CAPM, it doesn't reward diversifiable risk.

   D

   It assumes each investor holds a unique portfolio.

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