978-0132757089 Chapter 08 Part 1

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Financial Management: Principles and Applications, 11e (Titman)

Chapter 8 Risk and Return-Capital Market Theory

1) Which of the following investments is clearly preferred to the others?

Return Risk

A 14% 12%

B 22% 20%

C 18% 16%

A) Investment A

B) Investment B

C) Investment C

D) Cannot be determined

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: risk, return

Principles: Principle 2: There Is a Risk-Return Tradeoff

2) You are considering investing in U.S. Steel. Which of the following is an example of

nondiversifiable risk?

A) Risk resulting from foreign expropriation of U.S. Steel property

B) Risk resulting from oil exploration by Marathon Oil (a U.S. Steel subsidy)

C) Risk resulting from a strike against U.S. Steel

D) None of the above

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: diversifying risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

3) You are considering buying some stock in Continental Grain. Which of the following is an

example of nondiversifiable risk?

A) Risk resulting from a general decline in the stock market

B) Risk resulting from a news release that several of Continental’s grain silos were tainted

C) Risk resulting from an explosion in a grain elevator owned by Continental

D) Risk resulting from an impending lawsuit against Continental

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: diversifying risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

40% chance of getting a 12% return, and a 10% chance of getting an 8% return, what is the

expected rate of return?

A) 12%

B) 13%

C) 14%

D) 15%

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

40% chance of getting a 12% return, and a 10% chance of getting an 8% return, what would be

the standard deviation?

A) 2.24

B) 2.56

C) 2.83

D) 2.98

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: standard deviation

Principles: Principle 2: There Is a Risk-Return Tradeoff

6) You are considering investing in a project with the following possible outcomes:

Probability of Investment

States Occurrence Returns

State 1: Economic boom 15% 16%

State 2: Economic growth 45% 12%

State 3: Economic decline 25% 5%

State 4: Depression 15% -5%

Calculate the expected rate of return and standard deviation of returns for this investment.

A) 9.8%, 7.0%

B) 7.0%, 43.6%

C) 8.3%, 6.6%

D) 8.3%, 16.1%

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

7) The prices for the Guns and Hoses Corporation for the first quarter of 1992 are given below.

Find the holding period return for February.

Month End Price

January $135.28

February $119.40

March $141.57

A) 18.56%

B) 13.30%

C) -11.73%

D) 8.83%

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: holding period return

Principles: Principle 3: Cash Flows Are the Source of Value

8) Wilson, Inc. is expecting the following returns on their stock and related probabilities.

Calculate Wilson’s expected return.

State Probability Return

Boom 30% 30%

Normal 70% 10%

A) 16%

B) 14%

C) 12%

D) 10%

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

Use the following information, which describes the possible outcomes from investing in a

particular asset, to answer the following question(s).

State of the EconomyProbability of the States Percentage Returns

Economic recession 25% 5%

Moderate economic growth 55% 10%

Strong economic growth 20% 13%

9) The expected return from investing in the asset is:

A) 9.00%.

B) 9.35%.

C) 10.00%.

D) 10.55%.

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

10) The standard deviation of returns is:

A) 8.00%.

B) 7.63%.

C) 4.68%.

D) 2.76%.

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: standard deviation

Principles: Principle 2: There Is a Risk-Return Tradeoff

11) What is the expected rate of return for an investment that has the following expected

scenario? If there is an 18% probability of a recession, 2.0% return; if there is a 65% probability

of a moderate economy, 9.5% return; if there is a 17% probability of a strong economy, 14.2%

return.

A) 11.25%

B) 7.33%

C) 8.95%

D) 9.59%

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

12) What is the expected return on an investment that has the following expected scenario? If

there is a 10% probability of a booming economy, $250 return; if there is a 70% probability of a

moderate economy, $154 return; if there is a 20% probability of a declining economy, $50 return.

A) $154.00

B) $142.80

C) $65.00

D) $15.12

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

Use the following information, which describes the expected return and standard deviation for

three different assets, to answer the following question(s).

Asset X Asset Y Asset Z

Expected return9.5% 8.8% 9.5%

Standard deviation 4.9% 5.5% 5.5%

13) If an investor must choose between investing in either Asset X or Asset Y, then:

A) she will always choose Asset X over Asset Y.

B) she will always choose Asset Y over Asset X.

C) she will be indifferent between investing in Asset X and Asset Y.

D) none of the above.

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: risk, return

Principles: Principle 2: There Is a Risk-Return Tradeoff

14) If an investor must choose between investing in either Asset X or Asset Z, then:

A) he will always choose Asset X over Asset Z.

B) he will always choose Asset Z over Asset X.

C) he will be indifferent between investing in Asset X and Asset Z.

D) none of the above.

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: risk, return

Principles: Principle 2: There Is a Risk-Return Tradeoff

15) Which of the following is NOT an example of factors that affect systematic risk?

A) Changes in general interest rates

B) A firm wins a lawsuit dealing with patent infringement

C) Our country declares war in the Persian Gulf

D) Environmental awareness increases throughout the country

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: systematic risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

16) Which of the following best measures the risk of holding an asset in isolation (i.e., stand-

alone risk)?

A) The mean co-variance

B) The standard deviation

C) The coefficient of optimization

D) The standard asset pricing model

E) The omegatron

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

17) What is a practical measure that is used to quantify the risk of a single investment?

A) The systematic variation

B) The Fisher effect

C) The IRP

D) The standard deviation

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

18) What is the standard deviation of an investment that has the following expected scenario? If

there is an 18% probability of a recession, 2.0% return; if there is a 65% probability of a

moderate economy, 9.5% return; if there is a 17% probability of a strong economy, 14.2% return.

A) 3.68%

B) 1.23%

C) 8.47%

D) 6.66%

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: standard deviation

Principles: Principle 2: There Is a Risk-Return Tradeoff

19) You are considering investing in a firm that has the following possible outcomes:

Economic boom: probability of 25%; return of 25%

Economic growth: probability of 60%; return of 15%

Economic decline: probability of 15%; return of -5%

What is the expected rate of return on the investment?

A) 15.0%

B) 11.7%

C) 14.5%

D) 25.0%

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

20) Which of the following is an adequate method of achieving portfolio diversification?

A) Invest in various bonds and stocks.

B) Invest in stocks of different industries.

C) Invest internationally.

D) All of the above.

E) None of the above.

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: systematic risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

21) You have been employed by Telemetry Medical Instruments (TMI) for seven years and

participate in their 401 (k) plan by having 5% of your paycheck invested in the plan. You have

been so impressed with the performance of the company’s stock that you currently have all of

your 401 (k) money invested in TMI’s common stock. What does prudent investment

management suggest that you do about risk?

A) Close out your 401 (k) and put the money in the bank.

B) Increase your payroll deduction from 5% to 10% but keep all funds invested in TMI.

C) Close out your 401 (k) and invest in T-bills.

D) Take some of your investment out of TMI’s common stock and invest it in the stocks and

bonds of other firms.

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: diversifying risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

22) You bought Chemtron stock for $45 a year ago. It is selling for $54 today. What is your

holding period return?

A) 9%

B) 11%

C) 6%

D) 20%

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: holding period return

Principles: Principle 3: Cash Flows Are the Source of Value

23) You purchased the stock of Sargent Motors at a price of $75.75 one year ago today. If you

sell the stock today for $89.00, what is your holding period return?

A) 35.00%

B) 12.50%

C) 17.50%

D) 25.00%

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: holding period return

Principles: Principle 3: Cash Flows Are the Source of Value

24) Which of the following statements is correct?

A) Portfolio diversification reduces the variability of the returns on the individual stocks held in

a portfolio.

B) Portfolio A has but one security, while Portfolio B has 100 securities. Because of

diversification, we would expect Portfolio B to have lower risk.

C) If an investor buys enough stocks, he or she can, through diversification, eliminate all market

risk.

D) Diversification can be achieved by purchasing stocks that are perfectly positively correlated.

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: diversifying risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

25) Your broker mailed you your year-end statement. You have $25,000 invested in Dow

Chemical, $18,000 tied up in GM, $36,000 in Microsoft stock, and $11,000 in Nike. The

15.3% for Nike. What is the return of your entire portfolio?

A) 15.60%

B) 18.55%

C) 16.25%

D) 9.00%

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

26) According to the experts, a model portfolio should consist of a mix of securities that over the

long run should look something like this: cash or money market accounts, 5%; bonds, 25%;

domestic stocks, 35%; international stocks, 35%. What is the determination of the proportions of

various securities within a portfolio referred to as?

A) Risk assessment

B) Capital asset modeling

C) Beta selection

D) Portfolio regression

E) Asset allocation

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: portfolio composition

Principles: Principle 2: There Is a Risk-Return Tradeoff

27) By investing in different securities, an investor can lower his exposure to risk.

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

28) The greater the dispersion of possible returns, the riskier is the investment.

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: standard deviation

Principles: Principle 2: There Is a Risk-Return Tradeoff

29) For the most part, there has been a positive relation between risk and return historically.

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: risk, return

Principles: Principle 2: There Is a Risk-Return Tradeoff

30) The benefit from diversification is far greater when the diversification occurs across asset

types.

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

31) Investing in foreign stocks is one way to improve diversification of a portfolio.

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: diversifying risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

32) You are considering a security with the following possible rates of return:

0.20 16.8

a. Calculate the expected rate of return.

b. Calculate the standard deviation of the returns.

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff