Financial Management: Core Concepts, 4e (Brooks)
Chapter 8 Risk and Return
1) 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.
2) Janet bought a share of stock for $47.50 that paid a dividend of $.72 and sold one year later
for $51.38. What was her 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%
3) Felix bought a share of stock for $33.50 that paid a dividend of $.75 and sold six months later
for $31.50. What was his dollar profit or loss and holding period return?
A) -$3.00, -9.52%
B) -$3.85, -12.22%
C) -$.1.25, -3.73%
D) -$3.85, -9.52%
4) Gary 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%
5) Rose 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.
6) Lila purchased Hampton Industries Inc. stock for $18.35 and sold it 6 months later for $21.45
after receiving a $0.50 dividend. What was her holding period return (HPR), Annual Percentage
Rate (APR), and Effective Annual Rate (EAR)?
A) 20.34%, 40.68%, 9.70%
B) 14.17%, 28.34%, 30.35%
C) 19.62%, 39.24%, 43.09%
D) 20.34%, 40.68%, 44.82%
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.
8) 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 1% return on your investment, what is his EAR if the
earnings rate could be extrapolated for one year?
A) 1.00%
B) 12.00%
C) 12.68%
D) 126.82%
9) You purchased 1000 shares of stock for $25 per share. After holding the stock for 6 years and
not receiving any dividends, you sell the stock for $42 per share. What are the holding period
and annual return on this investment?
A) 9.20%, 1.63%
B) 68%, 9.03%
C) 62%, 7.66%
D) 18%, 2.87%
10) One definition of return is: .
11) 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.
12) Simple interest is akin to the effective annual rate (EAR) and compound interest is akin to
the annual percentage rate (APR).
13) 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.”
6
Copyright © 2019 Pearson Education, Inc.
8.2 Risk (Certainty and Uncertainty)
1) ________ is the absence of knowledge of the outcome of an event before it happens.
A) Return
B) Diversification
C) Uncertainty
D) Certainty
2) ________ 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
3) 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
4) Even if there is certainty of future payoffs, there can still be risk.
5) 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.
1) 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
2) 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
3) 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
4) 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
5) 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
6) 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
7) 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.
8) 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%
9) 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
10) 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 trade-off has not played out in any particular manner.
11) 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.
12) Over the 50-year period from 1950 to 1999, 3-month Treasury bills earned a positive average
annual rate of return in each year.
13) 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?
1) Which of the following statements is TRUE about variance?
A) Variance describes how spread out a set of numbers or a value 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.
2) Find the standard deviation for a security that has three one-year returns of 5%, 10%, and
15%.
A) 8.33%
B) 16.67%
C) 5.00%
D) 25.00%
3) Find the standard deviation for a security that has three one-year returns of -5%, 15%, and
20%.
A) 13.23%
B) 11.41%
C) 6.25%
D) 5.00%
4) 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
5) A more risky stock has a higher ________.
A) expected return
B) standard deviation
C) variance
D) B and C
6) Stock A, has returns of 10%, 20%, 30%, and 40%, over the last four years. What is the stock’s
standard deviation?
A) 166.67%
B) 12.91%
C) 4.08%
D) 2.15%
7) Stocks B, has returns of 5%, 15%, 30%, and 110%, over the most recent four year period.
What is the stock’s standard deviation of return over this time period?
A) 64.25%
B) 56.75%
C) 47.78%
D) 32.05%
8) The larger the variance, the smaller the dispersion.
9) 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.
10) 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.
11) Most stock analysts would agree that more variance is an indicator of less risk.
12) If stock A has a greater standard deviation than stock B then it must also have a greater
return.
13) Explain how the statistical concepts of mean and standard deviation apply to the financial
ideas of risk and return.
1) 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.
2) 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 40% chance that the stock will sell for $30.00 at the end of
one year. The alternative expectation is that there is a 60% chance that the stock will sell for
$10.00 at the end of one year. What is the expected percentage one-year return on this stock, and
what is the return standard deviation?
A) 6.67%, 37.33%
B) 12.00%, 93.50%
C) 20.00%, 65.30%
D) 14.00%, 119.67%
3) 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 standard deviation of returns on this stock?
A) -8.00%, 39.19%
B) -8.00%, 15.36%
C) 8.00%, 15.36%
D) -4.00%, -30.72%
4) 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?
Recession
Steady
Boom
Probability
.35
.55
.10
Bond price
$970
$1,000
$1,150
A) $1,000.00
B) $1,007.50
C) $1,004.50
D) $1,100.33
5) Given the expected returns and probabilities of various states of the world in this table, what is
the expected return for Dancine Company?
Dancine Company
State of the Economy
Probability of State
Return on State
Boom
.30
18%
Steady
.55
10%
Recession
.15
-5%
A) 9.45%
B) 12.40%
C) 10.15%
D) -0.75%
6) Albert estimates that there are three possible return outcomes for a stock he is considering for
purchase. He thinks that there is a 35% 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 15% 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 Albert’s
expected return on the stock he is considering for purchase?
A) 8.00%
B) 11.25%
C) 14.75%
D) 15.25%
7) An analyst is considering an investment in Treetops Inc. and has gathered the following
information. What is the expected return for a share of the firm’s stock?
State of the
Economy
Probability of the
State
Conditional Expected Return
Treetops Inc.
Recession
.20
-20%
Steady
.40
10%
Boom
.40
35%
A) 5.00%
B) 6.25%
C) 8.33%
D) 14.00%
8) Janette is considering an investment in Skytime Inc. and has gathered the following
information. What is the expected return for a share of the firm’s stock?
State of the
Economy
Probability of the
State
Conditional Expected Return
Skytime Inc.
Recession
.40
-10%
Steady
.20
10%
Boom
.40
45%
A) 45.00%
B) 65.00%
C) 16.00%
D) 15.00%
9) Andre is considering an investment in Bristol Inc. and has gathered the following information.
What is the expected standard deviation for a share of the firm’s stock?
State of the
Economy
Probability of the
State
Conditional Expected Return
Bristol Inc.
Recession
.40
-10%
Steady
.20
10%
Boom
.40
45%
A) 614.00%
B) 24.78%
C) 20.13%
D) 5.14%
10) Janette is considering an investment in Parson Inc. and has gathered the information in the
following table. What is the expected standard deviation for a share of the firm’s stock?
State of the
Economy
Probability of the
State
Conditional Expected Return
Parson Inc.
Recession
.25
-20%
Steady
.60
10%
Boom
.15
35
A) 17.46%
B) 22.48
C) 27.54%
D) 31.62%
11) 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.