Deck 8: Risk and Return

Question 1

Jarvis bought a share of stock for $15.75 that paid a dividend of $.45 and sold three months later for $18.65. What was his dollar profit or loss and holding period return?

A) $2.90, 18.41%
B) $3.35, 21.27%
C) -$2.90, -18.41%
D) $.45, 2.86%

Answer 1

B

Question 2

Your investment advisor informs you that you do not need to pay a fee for his services. Instead, he invests your money for one month and keeps all of the proceeds before investing it for you. If your advisor makes and keeps a 2% return on your investment, what is his EAR if the earnings rate could be extrapolated for one year?

A) 2.00%
B) 24.00%
C) 26.82%
D) 126.82%

Answer 2

C

Question 3

Travis bought a share of stock for $31.50 that paid a dividend of $.85 and sold six months later for $27.65. What was his dollar profit or loss and holding period return?

A) -$3.00, -9.52%
B) -$3.85, -12.22%
C) -$.85, -2.70%
D) -$3.85, -9.52%

Answer 3

A

Question 4

The textbook provides a history of returns from 1950 through 1999 for four classifications of securities in the United States. Rank the average returns from the highest to lowest over this time period.

A) Large-company stocks, small-company stocks, 3-month U.S. Treasury bills, long-term government bonds
B) Long-term government bonds, 3-month U.S. Treasury bills, small-company stocks, large-company stocks
C) Small-company stocks, large-company stocks, long-term government bonds, 3-month U.S. Treasury bills
D) Large-company stocks, long-term government bonds, small-company stocks, 3-month U.S. Treasury bills

Question 5

Finance functions in a two-parameter world of risk and return. Define risk and return in a financial sense and discuss how these two concepts are "joined at the hip."

Question 6

Simple interest is akin to the effective annual rate (EAR) and compound interest is akin to the annual percentage rate (APR).

Question 7

Robert invested in stock and received a positive return over a 9-month period. Which of the following types of returns will be greater?

A) Holding period return (HPR)
B) Effective annual return
C) Annual percentage rate
D) There is not enough information to make a definitive choice.

Question 8

Alice purchased Hampton Industries Inc. stock for $14.65 and sold it 6 months later for $17.38 after receiving a $0.25 dividend. What was Alice's holding period return (HPR), Annual Percentage Rate (APR), and Effective Annual Rate (EAR)?

A) 20.34%, 40.68%, 9.70%
B) 18.63%, 37.27%, 40.74%
C) 17.15%, 34.29%, 37.23%
D) 20.34%, 40.68%, 44.82%

Question 9

Which of the statements below is TRUE?

A) Investors want to maximize return and maximize risk.
B) Investors want to maximize return and minimize risk.
C) Investors want to minimize return and maximize risk.
D) Investors want to minimize return and minimize risk.

Question 10

One definition of return is:

Question 11

________ may be defined as a measure of uncertainty in a set of potential outcomes for an event in which there is a chance for some loss.

A) Diversification
B) Risk
C) Uncertainty
D) Collaboration

Question 12

The practice of not putting all of your eggs in one basket is an illustration of ________.

A) variance
B) diversification
C) portion control
D) expected return

Question 13

Even if there is certainty of future payoffs, there can still be risk.

Question 14

Joe bought a share of stock for $47.50 that paid a dividend of $.72 and sold one year later for $51.38. What was Joe's dollar profit or loss and holding period return?

A) $0.72, 7.55%
B) $3.88, 8.95%
C) $4.60, 9.68%
D) $3.88, 9.68%

Question 15

The textbook provides a history of returns from 1950 through 1999 for four classifications of securities in the United States. Rank the average standard deviation ( measure of risk) from the highest to lowest over this time period.

A) Large-company stocks, small-company stocks, 3-month U.S. Treasury bills, long-term government bonds
B) Long-term government bonds, 3-month U.S. Treasury bills, small-company stocks, large-company stocks
C) Small-company stocks, large-company stocks, long-term government bonds, 3-month U.S. Treasury bills
D) Large-company stocks, long-term government bonds, small-company stocks, 3-month U.S. Treasury bills

Question 16

Which of the following investments is considered to be default risk-free?

A) Currency options
B) AAA rated corporate bonds
C) Common stock
D) Treasury bills

Question 17

________ is the absence of knowledge of the outcome of an event before it happens.

A) Return
B) Diversification
C) Uncertainty
D) Certainty

Question 18

The holding period return (HPR) is the return measured from the initial purchase to the final sale of the investment without regard to the length of time the investment is held.

Question 19

Amy bought a share of stock for $64.50 that paid a dividend of $.50 and sold nine months later for $64.00. What was her dollar profit or loss and holding period return?

A) $0.50, 0.78%
B) -$0.50, -0.78%
C) $0.00, 0.00%
D) There is no correct solution to this question.

Question 20

Define risk. Give an example of a risk-free investment and explain why you claim it has no risk. Give an example of a risky investment and explain why you claim the investment to be risky.

Question 21

Which of the following classifications of securities had NO negative one-year returns over the period 1950-1999?

A) Long-term government bonds
B) Large-company stocks
C) 3-month U.S. Treasury bills
D) Each of the classification of securities listed experienced at least one negative one-year return over the listed time period.

Question 22

Which of the following classifications of securities had the smallest one-year return over the period 1950-1999?

A) Long-term government bonds
B) 3-month U.S. Treasury bills
C) Small-company stocks
D) Large-company stocks

Question 23

Historically, the ________ risk an investor is willing to accept the ________ the potential return for the investment

A) more, lesser
B) less, greater
C) more, greater
D) Historically, the risk/return tradeoff has not played out in any particular manner.

Question 24

Which of the following classifications of securities had the smallest range of annual returns over the period 1950-1999?

A) Large-company stocks
B) Long-term government bonds
C) Small-company stocks
D) 3-month U.S. Treasury bills

Question 25

Which of the following classifications of securities had the largest range of annual returns over the period 1950-1999?

A) Large-company stocks
B) Long-term government bonds
C) Small-company stocks
D) 3-month U.S. Treasury bills

Question 26

The chart below gives information for four classes of U.S. securities over the 50-year time period from 1950 - 1999. Order the securities from highest average annual return to lowest for this time period. Now rank the securities from highest to lowest based on risk. Is the information consistent with what financial theory tells us? Why or why not?

Question 27

Over the 50-year period from 1950 to 1999, 3-month Treasury bills earned a positive average annual rate of return in each year.

Question 28

Over the 50-year period from 1950 to 1999, 3-month Treasury bills earned a higher average annual rate of return than long-term government bonds.

Question 29

If you were required to estimate the average return for one category of securities for the coming year, history tells us that you should have the greatest degree of confidence estimating which of the following?

A) Long-term government bonds
B) 3-month U.S. Treasury bills
C) Small-company stocks
D) Large-company stocks

Question 30

Stocks A, B, C, and D have standard deviations, respectively, of 20%, 5%, 10%, and 15%. Which one is the riskiest?

A) Stock A
B) Stock B
C) Stock C
D) Stock D

Question 31

Which of the following classifications of securities had the largest one-year return over the period 1950-1999?

A) Small-company stocks
B) Long-term government bonds
C) 3-month U.S. Treasury bills
D) Large-company stocks

Question 32

Stocks A, B, C, and D have returns of 10%, 20%, 30%, and 40%, respectively. What is their variance?

A) 66.67%
B) 166.67%
C) 4.08%
D) 2.15%

Question 33

The larger the variance, the smaller the dispersion.

Question 34

Stocks A, B, C, and D have returns of 5%, 15%, 30%, and 110%, respectively. What is their standard deviation?

A) 64.25%
B) 56.75%
C) 47.78%
D) 32.05%

Question 35

Which of the following ranges of annual returns best describes the variability for small-company stocks in the United States for the period 1950-1999?

A) 0% to 15%
B) -10% to 40%
C) -30% to 55%
D) -40% to 100%

Question 36

Which of the following statements is true about variance?

A) Variance describes how spread out a set of numbers or values is around its mean or average.
B) Variance is essentially the variability from the average.
C) The larger the variance, the greater the dispersion.
D) All of the above statements are true.

Question 37

Find the variance for a security that has three one-year returns of -5%, 15%, and 20%.

A) 175.00%
B) 75.00%
C) 58.33%
D) 25.00%

Question 38

A more risky stock has a higher ________.

A) expected return
B) standard deviation
C) variance
D) B and C

Question 39

Find the variance for a security that has three one-year returns of 5%, 10%, and 15%.

A) 10.00%
B) 16.67%
C) 25.00%
D) 30.00%

Question 40

Over the 50-year period from 1950 to 1999, the portfolio of large U.S. stocks has had a greater variance than the portfolio of small U.S. stocks.

Question 41

You are considering buying a share of stock in a firm that has the following two possible payoffs with the corresponding probability of occurring. The stock has a purchase price of $15.00. You forecast that there is a 30% chance that the stock will sell for $30.00 at the end of one year. The alternative expectation is that there is a 70% chance that the stock will sell for $10.00 at the end of one year. What is the expected percentage return on this stock, and what is the return variance?

A) 6.67%, 9.17%
B) 1.00%, 93.50%
C) 6.67%, 37.33%
D) 84.00%, $9.67

Question 42

Explain how the statistical concepts of mean and standard deviation apply to the financial ideas of risk and return.

Question 43

Which of the following statements about probabilities is INCORRECT?

A) The sum of all probabilities of a particular event must sum to 100%.
B) Each possible outcome must have a non-negative probability.
C) Probability is a statistical tool for estimating future outcomes.
D) Probability is associated with an ex-post view.

Question 44

George is considering an investment in Vandelay Inc. and has gathered the information in the following table. What is the expected standard deviation for a share of the firm's stock?

A) 17.46%
B) 22.48
C) 27.54%
D) 31.62%

Question 45

Use the information in the table to calculate the expected return and standard deviation of an equally-weighted portfolio.

Question 46

You are considering buying a share of stock in a firm that has the following two possible payoffs with the corresponding probability of occurring. The stock has a purchase price of $50.00. You forecast that there is a 40% chance that the stock will sell for $70.00 at the end of one year. The alternative expectation is that there is a 60% chance that the stock will sell for $30.00 at the end of one year. What is the expected percentage return on this stock, and what is the return variance?

A) -8.00%, 15.36%
B) 4.00%, 30.72%
C) 8.00%, 15.36%
D) -4.00%, -30.72%

Question 47

Andre is considering an investment in Pollard's Inc. and has gathered the following information. What is the expected return for a share of the firm's stock?

A) 45.00%
B) 65.00%
C) 16.50%
D) 15.00%

Question 48

When looking at the history of returns, we are taking an "ex-ante" review and when we are looking at the future of returns we are taking an "ex-post" view.

Question 49

Use the following table: What is the difference between the standard deviation of a small-company stock and a 3-month T-bill?

A) 7.0%
B) 5.5%
C) 4.0%
D) 3.5%

Question 50

Andre is considering an investment in Pollard's Inc. and has gathered the following information. What is the expected standard deviation for a share of the firm's stock?

A) 17.48%
B) 122.63%
C) 20.13%
D) 5.14%

Question 51

Most stock analysts would agree that more variance is an indicator of less risk.

Question 52

Given the expected returns and probabilities of various states of the world in this table, what is the expected return for Carbide Company? Carbide Company

A) 10.15%
B) 5.40%
C) 5.50%
D) -0.75%

Question 53

Stock A B C D Expected Return 5% 5% 7% 6%
Standard Deviation 10% 12% 12% 11%
Which of the following statements is true?

A) A is a better investment than B.
B) B is a better investment than C.
C) C is a better investment than D.
D) D is a better investment than C.

Question 54

Use the following table: What is the difference between the variances for large- and small-company stocks?

A) 40.25%
B) 36.75%
C) 27.30%
D) 14.90%

Question 55

Evidence from the 50-year period from 1950 to 1999 indicates that returns and risk (as measured by the standard deviation of returns) are positively related.

Question 56

Which of the statements below is NOT correct?

A) If two investments have the same expected return, the investment with the lower risk is preferred.
B) If two investments have the same expected return, the investment with the greater risk is preferred.
C) If two investments have the same expected risk, the investment with the higher expected return is preferred.
D) If one investment has a higher expected return and a greater level of risk than another, it is not clear which investment is the preferred choice.

Question 57

Ronnie estimates that there are three possible return outcomes for a stock he is considering for purchase. He thinks that there is a 45% chance the economy will boom and his stock will return 25%, a 50% chance the economy will continue at its current pace and the stock will return 8%, and finally, that there is a 5% chance that the economy will falter and the expected return on his stock will be -10%. Given these probabilities and conditional expected returns, what is Ronnie's expected return on the stock he is considering for purchase?

A) 8.00%
B) 9.00%
C) 10.25%
D) 15.25%

Question 58

Your investment banking firm has estimated what your new issue of bonds is likely to sell for under several different economic conditions. What is the expected (average) selling price of each bond?

A) $1,000.00
B) $1,007.50
C) $1,040.00
D) $1,100.33

Question 59

If stock A has a greater standard deviation than stock B then it must also have a greater return.

Question 60

George is considering an investment in Vandelay Inc. and has gathered the following information. What is the expected return for a share of the firm's stock?

A) 5.00%
B) 6.25%
C) 8.33%
D) 10.00%

Question 61

________ is risk that cannot be diversified away.

A) Unsystematic risk
B) Systematic risk
C) Firm-specific risk
D) Diversifiable risk

Question 62

The correlation coefficient, a measurement of the comovement between two variables, has what range?

A) From 0.0 to +10.0
B) From 0.0 to +1.0
C) From -1.0 to +10.0
D) From =1.0 to -1.0

Question 63

The primary benefit of diversification is:

A) an increase in expected return.
B) an equal reduction in risk and return.
C) a reduction in risk.
D) diversification has no real benefit; it is a shell game promoted by investment advisors who are the only real winners.

Question 64

For purposes of maximum portfolio diversification, which for the following would provide the greatest diversification?

A) Security A with a correlation coefficient of -0.0
B) Security B with a correlation coefficient of 0.0
C) Security C with a correlation coefficient of -0.50
D) Security D with a correlation coefficient of 0.50

Question 65

Which of the following statements is FALSE?

A) The maximum benefits to diversification between securities occurs when they are perfectly positively correlated.
B) The maximum benefits to diversification between securities occurs when they are perfectly negatively correlated.
C) There is some benefit to diversification when the correlation between securities is 0.0.
D) There is some benefit to diversification when the correlation between securities is greater than 0.0 but less than 1.0.

Question 66

Denard has two investment opportunities. He can invest in The Sunglasses Company or The Umbrella Company. What is the expected return and standard deviation of each company?

A) The expected return for each company is 12.50% and the standard deviation for each company is 0.00%.
B) The expected return for each company is 12.50% and the standard deviation for each company is 12.50%.
C) The expected return for each company is 12.50% and the standard deviation for each company is 156.25%.
D) The expected return for each company is 12.50% and the standard deviation for each company is 25.00%.

Question 67

Unsystematic risk

A) is also known as nondiversifiable risk.
B) can be diversified away.
C) is system-wide risk.
D) is equal to 2 times the systematic risk.

Question 68

If two investments have the same expected return, a rational investor will choose the the investment with the greater risk in an effort to get a much larger return.

Question 69

Denard has two investment opportunities. He can invest in The Sunglasses Company or The Umbrella Company. If he diversifies his investment by putting 50% of his money into each company, what is the expected return and standard deviation of his portfolio?

A) The expected return for the portfolio is 12.50% and the standard deviation 0.00%.
B) The expected return for the portfolio is 25.00% and the standard deviation 0.00%.
C) The expected return for the portfolio is 12.50% and the standard deviation 12.50%.
D) The expected return for the portfolio is 25.00% and the standard deviation 25.00%.

Question 70

Which of the following securities could NOT have any benefits for diversification with your investment portfolio?

A) Treasury bills with a correlation coefficient of 0.0 with your portfolio
B) Alpha Company stock that has a correlation coefficient of -0.25 with your portfolio
C) Beta Company stock that has a correlation coefficient of 0.50 with your portfolio
D) All of these choices would reduce risk for your portfolio and therefore show at least some benefit to diversification.

Question 71

What are the two investment rules identified in the text? Evaluate the validity of the following statement and justify your reasoning. "Investors do not like risk and will always choose the investment with the least risk."

Question 72

You wish to diversify your single-security portfolio in a way that will maximize your reduction in risk. Which of the following securities should you add to your portfolio?

A) Treasury bills that have a correlation coefficient of 0.0 with your current security
B) Alpha Company stock that has a correlation coefficient of -0.25 with your current security
C) Beta Company stock that has a correlation coefficient of 0.50 with your current security
D) Delta Company bonds that have a correlation coefficient of 0.36 with your current security

Question 73

Diversification is

A) not putting all of your eggs in one basket.
B) spreading wealth over a variety of investment opportunities.
C) a common investment strategy.
D) All of the above

Question 74

The type of risk that can be diversified away is called ________.

A) unsystematic risk
B) systematic risk
C) nondiversifiable risk
D) system-wide risk

Question 75

Assuming that stocks represent most industries, the number of stocks necessary to eliminate nearly all unsystematic risk varies from ________.

A) 5 to 10
B) 10 to 20
C) 20 to 30
D) 30 to 50

Question 76

When considering expected returns, what is true about the states of the world?

A) They must have probabilities that sum to 100%.
B) They represent all possible outcomes.
C) They are sometimes simplified into outcomes such as boom, bust, and normal.
D) Statements A through C are all true.

Question 77

For most stocks, the correlation coefficient with other stocks is ________.

A) positive
B) negative
C) zero
D) The distribution of correlation coefficients between stocks is uniform from -1.0 to +1.0.

Question 78

An investor's total investment set may be referred to as ________.

A) the stock market
B) diversification
C) a financial portfolio
D) None of the above

Question 79

If two investments have the same level of risk, a rational investor will choose the investment with the higher expected rate of return.

Question 80

Correlation, a standardized measure of how stocks perform relative to one another in different states of the economy, has a range from ________.

A) 0.0 to +10.0
B) 0.0 to +1.0
C) -1.0 to +1.0
D) There is no range; correlation is a calculated number that can take on any value.