1.Which of the following does NOT describe the arbitrage pricing theory (APT)?

A)   It is an equilibrium-pricing model like the CAPM.

B)   There are assumed to be at least five factors that explain asset returns.

C)   It requires a weaker set of assumptions than the CAPM to derive.

D)   Expected asset returns are linear functions of the asset's risk relative to a set of factors.

The correct answer was B)     

APT is a k-factor model, in which the number of factors, k, is assumed to be a lot smaller than the number of assets; no specific number of factors is assumed. Depending on the data used to fit the model, there may be as few as two or as many as seven factors.

2.Which of the following best completes the following statement? The capital asset pricing model (CAPM) is:

A)   the most realistic model in explaining the risk-return relationship.

B)   a subset of the arbitrage pricing theory (APT) model.

C)   a useful model in calculating expected returns.

D)   a relatively easy model to implement and test.

The correct answer was B)

The APT is less restrictive than the CAPM; it does not require the assumptions that investors have quadratic utility functions, security returns are normally distributed, or the existence of a mean variance efficient market portfolio. The CAPM is a subset of the APT where it is assumed that only the relationship to the market portfolio is useful in explaining returns. The APT is more flexible because it can have k factors. However, these factors are not defined in theory.

3.Which of the following is an assumption of the arbitrage pricing theory (APT)?

A)   Investors have quadratic utility functions.

B)   Security returns are normally distributed.

C)   The process generating asset returns can be represented by a 5-factor model.

D)   Assets are priced such that no arbitrage opportunities exist.

The correct answer was D)

APT implies that investors will undertake infinitely large positions (long and short) to exploit any perceived mispricing, causing asset prices to adjust immediately to their equilibrium values.

4.Which of the following is an assumption of the arbitrage pricing theory (APT)?

A)   No arbitrage opportunities exist.

B)   Investors have quadratic utility functions.

C)   The market portfolio is value weighted and contains all securities.

D)   Returns are normally distributed.

The correct answer was A)

APT assumes that:

§ Asset returns are described by a multiple factor process

§ There are enough stocks that unsystematic risk can be diversified away

§ No arbitrage opportunities exist

5.Which of the following is not an assumption of the arbitrage pricing theory (APT)?

A)   Returns on assets can be described by a multi-factor process.

B)   The market contains enough stocks so that unsystematic risk can be diversified away.

C)   No arbitrage opportunities exist.

D)   Security returns are normally distributed.

The correct answer was D)

APT does not require that security returns be normally distributed.