Test Bank Answers International Asset Pricing Chapter 20

Chapter 20 International Asset Pricing

Notes to instructors:

Answers to non-numeric multiple choice questions are arranged alphabetically, so that answers are randomly assigned to the five outcomes.

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1. The capital market line is specific to an individual person and lies between the risk-free asset and the portfolio of assets held by that individual.

The capital market line lies between the risk-free asset and the market portfolio.

2. Under the traditional capital asset pricing model, each investor will choose to invest 100 percent of their funds in a risk-free asset, if it is available.

Each investor mixes the market portfolio with the risk-free asset.

3. The relevant risk of an asset to a well-diversified investor is the asset’s standard deviation of return.

Systematic risk is more important.

4. Systematic risk depends on how asset returns comove (or covary) with the market portfolio.

5. The security market line describes the relation between total risk and required return.

The SML describes the relation between systematic risk and required return.

6. Financial transactions in informationally efficient markets have NPVs of zero.

7. According to the security market line, the required return on an individual asset is equal to the risk-free rate plus a risk premium.

8. The risk premium in the security market line depends on the risk-free rate of interest and an asset’s systematic risk or beta.

The risk premium is the product of the market risk premium and the firm’s beta.

9. Systematic risks arise through asset-specific events such as a new product innovation.

Systematic risks arise through market-wide events.

10. Beta is a correlation coefficient times a ratio of standard deviations.

11. Market model beta measures an asset’s sensitivity to changes in the market.

12. Unsystematic risks arise through market-wide events such as real economic growth or changing investor sentiment regarding asset values.

Unsystematic risks are asset-specific (e.g., new products, changes in top management).

13. A national securities market can be informationally efficient in a domestic context and yet segmented in an international context.

14. Country-specific political risk is diversifiable and hence does not affect required return.

15. Empirical tests often find no relation between mean returns and market model betas.

16. Empirically, there is a strong cross-sectional relation between mean returns and market model betas.

There is almost no relation.

17. In most countries, large firms tend to have higher mean returns than small firms.

Small firms tend to have higher mean returns than large firms.

18. Market indices have no use because mean returns are unrelated to market model betas.

Market indices provide useful performance benchmarks.

19. Hedging does not add value to the firm in a perfect capital market.

20. The international asset pricing model measures market model betas against the globally diversified market portfolio.

21. Cross-country correlations typically are lower than cross-industry correlations, so that diversification across countries usually brings greater diversification benefits than diversification across industries

22. Managers have little incentive to hedge against currency risks.

As undiversified stakeholders, managers have an incentive to hedge against total risk.

23. Financial managers are unlikely to worry about currency risk exposure because it is largely a diversifiable risk.

It is diversifiable to the stockholders but not to the company, so managers often hedge.

24. An exporter typically benefits from an appreciation of the domestic currency whereas an importer is likely to suffer as the domestic currency appreciates.

False. The opposite is

25. Fama and French’s [“The Cross-Section of Expected Stock Returns,” Journal of Finance, (1992)] model of stock returns includes factors for size and value.

26. Firms with high book-to-market equity ratios are called value stocks.

27. In most countries around the world, growth stocks tend to have higher mean returns than value stocks.

False. The opposite is

28. Portfolios of stocks formed on recent stock market winners tend to have higher mean returns than portfolios of recent losers over the subsequent year.

29. Market model betas measured with unconditional (as opposed to conditional or time-varying) methods typically do not predict return in a statistically significant manner.

Betas estimated in a conditional manner (e.g., as in De Santis & Gérard’s “How Big is the Premium for Currency Risk,” Journal of Financial Economics, 1998) are more likely to have predictive power.

30. Market model betas measured with conditional (time-varying) methods do not predict return in a statistically significant manner.

For example, De Santis & Gérard (“How Big is the Premium for Currency Risk,” Journal of Financial Economics, 1998) found that conditional betas do predict returns in international markets.

Multiple Choice Select the BEST ANSWER

1. In an informationally efficient financial market, ___.

a. arbitrageurs make their profit with no net investment and no risk

b. asset prices reflect information

c. portfolios have the highest possible mean return at a given level of standard deviation (or the lowest standard deviation at a given level of mean return)

d. rational investors have equal access to prices and information

e. there are no market imperfections

2. The traditional capital asset pricing model (CAPM) requires several assumptions in addition to an assumption of perfect markets. Which of the following is not one of these assumptions?

a. Asset returns are certain.

b. Everyone can borrow and lend at the risk-free rate of interest.

c. Investors have homogeneous expectations.

d. Investors want more nominal return and less risk in their functional currency.

e. Nominal returns are normally distributed.

3. Which of the following statements about market model beta is ?

a. Market model beta is estimated by regressing an asset’s returns on market returns.

b. Market model beta captures that part of the variation in an individual asset that is linearly related to the market return.

c. Market model beta measures an asset’s total risk.

d. Market model beta based on a covariance or correlation coefficient.

e. The beta of the risk-free asset is zero.

4. In addition to the assumptions of the traditional capital asset pricing model, which of conditions (a) to (c) is necessary for the international asset pricing model to hold?

a. Investors have identical consumption baskets.

b. Investors only care about returns in their functional currency.

c. Purchasing power parity holds.

d. More than one of the above is necessary.

e. none of the above is necessary.

5. Which of the following statements regarding the hedge portfolio in the international asset pricing model is ?

a. If inflation is a constant in each currency, then the hedge portfolio reduces to the investor’s home-currency risk-free asset.

b. The hedge portfolio consists of domestic and foreign bonds.

c. The hedge portfolio serves as a store of value.

d. The hedge portfolio serves to hedge domestic inflation risk.

e. The hedge portfolio serves to hedge the currency risk of foreign assets.

6. Which of statements (a) through (d) is ?

a. Home asset bias is an indication of a segmented national market.

b. In completely segmented national markets, the systematic risk of an asset depends on its sensitivity to local market factors.

c. Purchasing power parity holds in segmented financial markets.

d. More than one of the above is

e. none of the above are

7. Which of the following statements concerning the one-factor market model is ?

a. A high correlation between two variables means that points lie relatively closely around a regression line between the two variables.

b. The one-factor market model captures the exposure of an individual security to fluctuations in the market factor.

c. The slope of a market model regression is equal to one.

d. The one-factor market model estimates betas for use in the security market line.

e. The market portfolio is often proxied by a domestic stock portfolio.

8. Which of the following statements concerning factor models is ?

a. Factor models assume a linear relation between required return and systematic risk.

b. Factor models can identify whether a particular factor is priced in the market.

c. The major attraction of a factor model is that the model tells you which factors should be priced.

d. The intercept term represents an asset’s expected return if all factors are equal to their expectation.

e. The systematic risk factor in the one-factor market model is the difference between actual market returns and the mean market return.

9. Which of (a) through (d) is inconsistent with the text’s summary of empirical studies of country and industry factors in international stock returns?

a. Cross-country correlations typically are lower than cross-industry correlations.

b. Diversifying across countries usually brings greater diversification benefits than diversifying across industries.

c. Although capital markets are becoming increasing integrated, correlations between national stock markets are not necessarily increasing.

d. There are periods where high volatility in selected industries (e.g., the IT bubble of the late 1990s) reduces industry correlations, and thereby increases the importance of industry diversification.

e. Each of the above is consistent with recent empirical studies.

10. Fama and French’s [“The Cross-Section of Expected Stock Returns,” Journal of Finance (1992)] model of stock returns includes factors for ____.

a. relative financial distress, and the domestic and global market indices

b. relative financial distress, the market index, and analysts’ earnings forecasts

c. relative financial distress, the market index, and currency risk

d. relative financial distress, the market index, and firm size

e. relative financial distress, the market index, and industrial production

11. Fama and French’s [“The Cross-Section of Expected Stock Returns,” Journal of Finance (1992)] model the relative financial distress factor as ____.

a. the book value of equity

b. the market value of equity

c. the difference in mean return between the smallest 10 percent of firms and the largest 10 percent of firms

d. the difference in mean return between value and growth stock portfolios

e. none of the above

12. Empirical studies typically find which of the following?

a. Large stocks tend to have higher mean returns than small stocks in international markets.

b. Growth stocks tend to have higher mean returns than value stocks in international markets.

c. Stocks with high market model betas tend to have higher mean returns than stocks with low betas in international markets.

d. more than one of the above

e. none of the above

13. Strategies that selectively buy or sell individual securities based on their recent return performance are called ____ strategies.

a. fundamental

b. market timing

c. momentum

d. trendline

e. none of the above

14. ______ are difficult to reconcile with informationally efficient markets.

a. Market factors

b. Momentum effects

c. The size effect

d. The value premium

e. None of the above is difficult to reconcile with an efficient market.

15. Which of statements (a) through (c) regarding the currency risk exposure of large multinational corporations is ?

a. Multinational corporations are likely to be exposed to currency risk.

b. Investors will prefer that managers hedge currency risk if the firm’s expected future cash flows can be increased through hedging.

c. Managers have little need to hedge exposures to currency risks that are diversifiable from the shareholders’ perspective.

d. Two of the above are

e. Each of the statements is

16. Which of statements (a) through (d) concerning De Santis and Gérard’s “How Big is the Premium for Currency Risk” [Journal of Financial Economics (1998)] conditional asset pricing model is ?

a. Their model constrained risks and required returns to be constant over time.

b. Currency risk is a small fraction of total risk in the United States stock market.

c. Market risk is priced in international stock markets.

d. Currency risk is priced in international stock markets.

e. All of the above are

17. The asset pricing model that is most commonly used today includes which of the following risk factors?

a. idiosyncratic risk

b. interest rate levels, changes, and changes-in-changes

c. liquidity risk

d. market, size, and value

e. supervisory board size, age, and turnover

Problems (These can be converted into Multiple Choice questions.)

1. If the risk-free rate is 5 percent, beta is 0.8, and the market risk premium is 6 percent, what is the required return on equity according to the CAPM?

2. As a security analyst for the Amsterdam branch of EASDAQ (a pan European stock exchange focused on high growth companies with international aspirations), you have identified the following model for Global Graphics: E[r] =  + _Z F_Z + _D F_D. Global’s expected euro return if all factors are equal to their expectation is  = 8%. Factors and factor sensitivities in euros are

Factor Beta

F_Z: firm size factor _Z = + 0.20

F_D: relative financial distress _D = + 0.30

a. What is Global’s expected return in a year when each factor is 10 percent higher than its expectation?

b. If Global’s stock price rises by 10 percent during this period, by how much does Global over- or underperform its expectation given each factor was 10 percent higher than its expectation?

3. As a security analyst for Citicorp based in London, you have identified the following model for Deutsche Bank: E[r] =  + _Term F_Term + _Risk F_Risk + _Spot F_Spot. Deutsche Bank’s expected euro return if all factors equal to their expectation is  = 10%. Factors and factor sensitivities in euros are

Factor Beta

F_Term: long minus short government bonds _Term = + 0.08

F_Risk: corporate minus government bonds _Risk = –0.10

F_Spot: change in the euro value of the dollar _Spot = –0.02

a. What is Deutsche Bank’s expected return in a year when each factor is 4 percent higher than its expectation?

b. If Deutsche Bank’s stock price rises by 16 percent during this period, by how much does it over- or underperform its expectation given each factor was 4 percent higher than its expectation?

4. You estimate a linear factor model for Freddie’s Fotos that includes three systematic risk factors: a size factor (SMB), a value factor (HML), and a currency factor (C). The risk-free rate is r_F = 3 percent. The market risk premium is 5 percent. Freddie’s expected return if all factors are equal to their expectation is  = 6 percent. Freddie’s exposure to the firm size factor F_SMB is _SMB = + 0.20, to the value factor F_HML is _HML = + 0.30, and to the currency factor F_C is _C = 0.

a. Calculate Freddie’s expected return in a year when each factor is 10 percent higher than its expectation.

b. Is Freddie exposed to currency risk?

Problem Solutions

1. r_S = r_F + _S (r_M  r_F) = 5% + [11%  5%] (0.8) = 9.8%.

2. a. E(r) =  + _ZF_Z + _DF_D = 8% + (0.20)(10%) + (0.30)(10%) = 13%.

b. With an expectation of 13 percent and an actual return of 10 percent, Global underperformed its expectation by 3 percent during the period.

3. a. E(r) =  + _Term F_Term + _Risk F_Risk + _Spot F_spot

= 10% + (0.08)(4%) + (–0.10)(4%) + (–0.02)(4%) = 9.84%

b. With an expectation of 9.84 percent and an actual return of 16 percent, DB outperformed its expectation by 6.16 percent during the period.

4. a. E(r) =  + _SMBF_SMB + _HMLF_HML + _cF_c = 6% + (0.20)(10%) + (0.30)(10%) + (0)(10%) = 11%.

b. Freddie’s currency beta of _C = 0 indicates that Freddie’s equity is not exposed to currency risk. It could be that Freddie is a classic domestic firm that is not exposed to exchange rates. Or, it could be that Freddie has transaction exposures or even an operating exposure to currency risk but that Freddie has managed its exposures—through financial or operating hedges—so that equity has no net exposure to currency risk.