Question 1

During the 1926 to 2008 period the Sharpe ratio was greatest for which of the following asset classes?

Accepted Answer

Large U.S. stocks had the greatest Sharpe ratio during the 1926 to 2008 period, indicating they provided the best risk-adjusted returns among the given asset classes.

Question 2

The reward/variability ratio is given by _________.

Accepted Answer

The reward/variability ratio, also known as the Sharpe ratio, is represented by the slope of the capital allocation line. It measures the trade-off between risk and return.

Question 3

The rate of return on _____ is known at the beginning of the holding period while the rate of return on ____ is not known until the end of the holding period.

Accepted Answer

The rate of return on Treasury bills is known at the beginning of the holding period because they are considered risk-free assets that offer a fixed interest rate. On the other hand, the rate of return on risky assets such as stocks, bonds, and mutual funds cannot be predicted with certainty and is only known at the end of the holding period.

Question 4

The excess return is the _________.

Accepted Answer

The excess return is defined as the rate of return in excess of the risk-free rate (such as the Treasury bill rate). Therefore, choice B is the only correct answer. Choice A is incorrect because no rate of return can be earned with certainty. Choice C is incorrect because the excess return does not relate to risk aversion. Choice D is incorrect because the excess return is typically not the same as the index return.

Question 5

Your investment has a 20% chance of earning a 30% rate of return,a 50% chance of earning a 10% rate of return and a 30% chance of losing 6%.What is your expected return on this investment?

Accepted Answer

The answer of Your investment has a 20% chance of...

Question 6

During the 1926 to 2008 period the geometric mean return on small firm stocks was ______.

Accepted Answer

The geometric mean return on small firm stocks during the 1926 to 2008 period was 11.43%. This is a historical statistic often cited in financial literature.

Question 7

If you require a real growth in the purchasing power of your investment of 8%,and you expect the rate of inflation over the next year to be 3%,what is the lowest nominal return that you would be satisfied with?

Accepted Answer

To calculate the required nominal return, we need to add the expected inflation rate to the real return required. So, required nominal return = required real return + expected inflation rate = 8% + 3% = 11%. Therefore, the lowest nominal return that the investor would be satisfied with is 11%. Choice D is the only option that meets this requirement.

Question 8

One method to forecast the risk premium is to use the _______.

Accepted Answer

Using the average historical excess returns for the asset under consideration is a common method to forecast the risk premium. This approach assumes that future risk premiums will be similar to past premiums, and uses historical data to estimate the expected returns on the asset. The other options are not as reliable in forecasting the risk premium. The coefficient of variation measures relative volatility, which may not be a good predictor of future returns. The risk free rate is not directly related to the risk premium, and variations in it may not accurately forecast risk. Similarly, the abnormal returns on the index portfolio may not be a good predictor of risk for a specific asset.

Question 9

If you are promised a nominal return of 12% on a one year investment,and you expect the rate of inflation to be 3%,what real rate do you expect to earn?

Accepted Answer

To calculate the real rate of return, we subtract the expected inflation rate from the nominal rate of return, and then divide by one plus the inflation rate. So, the real rate of return would be (12% - 3%) / (1 + 3%) = 8.74%. Choice B is the closest to this calculation.

Question 10

During the 1926 to 2008 period which one of the following asset classes provided the lowest real return?

Accepted Answer

Long-Term U.S. Treasury Bonds typically provide lower real returns compared to stocks due to their lower risk and fixed interest payments, which may not keep up with inflation over long periods.

Question 11

During the 1926 to 2008 period the geometric mean return on Treasury bills was _________.

Accepted Answer

The geometric mean return on Treasury bills from 1926 to 2008 was 5.31%.

Question 12

The market risk premium is defined as __________.

Accepted Answer

The market risk premium is defined as the difference between the return on an index fund and the return on Treasury bills. It represents the additional return investors require for taking on the risk of investing in the stock market compared to the risk-free rate offered by Treasury bills.

Question 13

You have an EAR of 9%.The equivalent APR with continuous compounding is _____.

Accepted Answer

The formula to convert EAR to APR with continuous compounding is APR = e^(EAR) - 1. Applying this formula, we get APR = e^(0.09) - 1 = 0.0862 or 8.62%. Therefore, the best choice is B.

Question 14

Both investors and gamblers take on risk.The difference between an investor and a gambler is that an investor _______.

Accepted Answer

An investor requires a risk premium to take on the risk, while a gambler is willing to take on risk without a risk premium. This is because investors typically make informed decisions based on an analysis of the market and the company's financials, while gamblers rely on chance or luck. While both take on risk, investors try to manage it through diversification and other strategies, while gamblers often ignore risk management. Therefore, the best choice is B.

Question 15

When calculating the variance of a portfolio's returns squaring the deviations from the mean results in ________.
I.preventing the sum of the deviations from always equaling zero
II.exaggerating the effects of large positive and negative deviations
III.a number in units of percentage of returns

Accepted Answer

Squaring the deviations from the mean helps prevent the sum of deviations from always equaling zero (I) but it also exaggerates the effects of large positive and negative deviations (II). It does not result in a number in units of percentage of returns (III).

Question 16

You have an APR of 7.5% with continuous compounding.The EAR is _____.

Accepted Answer

The formula for EAR with continuous compounding is e^r-1, where r is the APR. Substituting r=7.5%, we get e^0.075 - 1 = 7.79%. Therefore, the correct answer is choice C.

Question 17

Your investment has a 40% chance of earning a 15% rate of return,a 50% chance of earning a 10% rate of return and a 10% chance of losing 3%.What is the standard deviation of this investment?

Accepted Answer

E(r_p) = (.4)(15%) + (.5)(10%) + (.10)(−3%) = 10.7% σ(r_p) = .4(.15 − .107)² + .5(.10 − .107)² + .10(−.03 − .107)² σ(r_p) = 5.14%

Question 18

Historical returns have generally been __________ for stocks of small firms as/than for stocks of large firms.

Accepted Answer

Historical evidence suggests that small firms tend to have higher returns than large firms. This is often attributed to small firms being riskier and having greater potential for growth, which can result in higher returns for investors. However, it is important to note that this relationship may not hold true in all situations and there can be variations in returns for different types of small and large firms.

Question 19

During the 1985 to 2008 period the Sharpe ratio was greatest for which of the following asset classes?

Accepted Answer

Long-Term U.S. Treasury Bonds had the greatest Sharpe ratio during the 1985 to 2008 period. The Sharpe ratio measures the excess return earned over the risk-free rate per unit of volatility. The lower volatility of Treasury Bonds relative to stocks resulted in a higher Sharpe ratio during this period.

Question 20

Historically small firm stocks have earned higher returns than large firm stocks.When viewed in the context of an efficient market,this suggests that ___________.

Accepted Answer

The fact that historically small firm stocks have earned higher returns than large firm stocks suggests that small firms are riskier than large firms. This is because investors are willing to invest in small firms with the expectation of earning higher returns to compensate for the increased risk. In an efficient market, prices reflect all available information, so it is unlikely that small firms are consistently undervalued or large firms overvalued. Therefore, the explanation cannot be A, B, or D.

Quiz 5: Risk and Return: Past and Prologue