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CHAPTER 12 AN ALTERNATIVE VIEW OF RISK AND RETURN: THE ARBITRAGE PRICING THEORY Answers to Concept Questions 1. Systematic risk is risk that cannot be diversified away through formation of a portfolio. Generally, systematic risk factors are those factors that affect a large number of firms in the market, however, those factors will not necessarily affect all firms equally. Unsystematic risk is the type of risk that can be diversified away through portfolio formation. Unsystematic risk factors are specific to the firm or industry. Surprises in these factors will affect the returns of the firm in which you are interested, but they will have no effect on the returns of firms in a different industry and perhaps little effect on other firms in the same industry. 2. Any return can be explained with a large enough number of systematic risk factors. However, for a factor model to be useful as a practical matter, the number of factors that explain the returns on an asset must be relatively limited. 3. The market risk premium and inflation rates are probably good choices. The price of wheat, while a risk factor for Ultra Products, is not a market risk factor and will not likely be priced as a risk factor common to all stocks. In this case, wheat would be a firm specific risk factor, not a market risk factor. A better model would employ macroeconomic risk factors such as interest rates, GDP, energy prices, and industrial production, among others. 4. a. Real GNP was higher than anticipated. Since returns are positively related to the level of GNP, returns should rise based on this factor. b. Inflation was exactly the amount anticipated. Since there was no surprise in this announcement, it will not affect Lewis-Striden returns. c. Interest rates are lower than anticipated. Since returns are negatively related to interest rates, the lower than expected rate is good news. Returns should rise due to interest rates. d. The President’s death is bad news. Although the president was expected to retire, his retirement would not be effective for six months. During that period he would still contribute to the firm. His untimely death means that those contributions will not be made. Since he was generally considered an asset to the firm, his death will cause returns to fall. However, since his departure was expected soon, the drop might not be very large. e. The poor research results are also bad news. Since Lewis-Striden must continue to test the drug, it will not go into production as early as expected. The delay will affect expected future earnings, and thus it will dampen returns now. f. The research breakthrough is positive news for Lewis Striden. Since it was unexpected, it will cause returns to rise.
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g. The competitor’s announcement is also unexpected, but it is not a welcome surprise. This announcement will lower the returns on Lewis-Striden.
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