Chapter 6—The Trade-Off Between Risk and Return
MULTIPLE CHOICE
1. Which of the following is an example of systematic risk?
a.
IBM posts lower than expected earnings.
b.
Intel announces record earnings.
c.
The national trade deficit is higher than expected.
d.
None of the above.
2. Which of the following is an example of unsystematic risk?
a.
IBM posts lower than expected earnings.
b.
The Fed raises interest rates unexpectedly.
c.
The rate of inflation is higher than expected.
d.
None of the above.
3. What do you call the portion of your total return on a stock investment that is caused by an increase in
the value of the stock.
a.
Dividend yield.
b.
Risk-free return.
c.
Capital gain.
d.
None of the above.
4. What is one of the most important lessons from capital market history?
a.
Risk does not matter.
b.
There is a positive relationship between risk and return.
c.
You are always better off investing in stock.
d.
T-bills are the highest yielding investment.
5. What is the purpose of diversification?
a.
Maximize possible returns.
b.
Increase the risk of your portfolio.
c.
Lower the overall risk of your portfolio.
d.
None of the above.
Bavarian Sausage
You bought a share of Bavarian Sausage stock for $46.50 at the beginning of the year. During the year
the stock paid a $2.75 dividend and at the end of the year it trades at $52.75.
NARREND
6. Refer to Bavarian Sausage. What is the total return of your stock investment?
a.
5.91%
b.
13.44%
c.
26.69%
d.
19.35%
7. Refer to Bavarian Sausage. What is the capital gain/loss on your stock investment?
a.
5.91%
b.
13.44%
c.
19.35%
d.
28.24%
8. Refer to Bavarian Sausage. What is the total dollar return on your investment?
a.
$9.00
b.
$2.75
c.
$6.25
d.
$52.75
NARRBEGIN: Bavarian Sausage 2
Bavarian Sausage 2
You bought a share of Bavarian Sausage stock for $46.50 at the beginning of the year. During the year
the stock paid a $2.75 dividend and at the end of the year it trades at $44.75.
NARREND
9. Refer to Bavarian Sausage 2. What is the total return on your investment?
a.
2.15%
b.
-3.76%
c.
8.06%
d.
5.91%
10. Refer to Bavarian Sausage 2. What is the capital gain’s yield of your investment?
a.
2.15%
b.
-3.76%
c.
8.06%
d.
5.91%
11. If the return on your common stock investment is on average 18% and the return on Treasury bills was
5% over the same period of time, what is the risk premium that you earned.
a.
23%
b.
13%
c.
18%
d.
5%
NARRBEGIN: Stock Returns
Year
Return
Stock A
Stock B
Stock C
1
15%
12%
5%
2
25%
14%
-6%
3
8%
9%
10%
4
16%
25%
1%
5
5%
3%
15%
NARREND
12. What is the variance of returns for stock A?
a.
.00607
b.
.00653
c.
.00655
d.
.00506
13. What is the standard deviation of returns for stock A?
a.
8.09%
b.
8.08%
c.
7.79%
d.
6.53%
14. What is the variance of returns for stock B?
a.
.00653
b.
.00607
c.
.00528
d.
.00721
15. What is the standard deviation of returns for stock C?
a.
7.79%
b.
8.52%
c.
8.09%
d.
6.38%
16. What is the average return for stock A?
a.
12.6%
b.
13.8%
c.
5.00%
d.
8.26%
17. What is the average return of stock B?
a.
13.8%
b.
12.6%
c.
5.00%
d.
8.52%
18. What is the average return of stock C?
a.
13.8%
b.
12.6%
c.
5.00%
d.
8.52%
19. What is the average return of a portfolio that has 30% invested in stock A, 30% invested in stock B
and 40% invested in stock C?
a.
9.92%
b.
12.6%
c.
7.59%
d.
13.8%
20. What is the average return of a portfolio that has 10% invested in stock A, 40% invested in stock B
and 50% invested in stock C?
a.
9.92%
b.
15.32%
c.
13.80%
d.
8.92%
21. What is the average return of a portfolio that has 45% invested in stock A, 35% invested in stock B
and the rest invested in stock C?
a.
9.92%
b.
11.62%
c.
10.62%
d.
12.48%
22. Bavarian Sausage stock has an average historical return of 16.3% and a standard deviation of 5.3%. In
which range do you expect the returns of Bavarian Sausage 95% of the time.
a.
5.7%:26.9%
b.
5.3%:16.3%
c.
11.00%:21.6%
d.
6.2%:18.5%
23. Bavarian Sausage stock has an average historical return of 16.3% and a standard deviation of 5.3%. In
which range do you expect the returns of Bavarian Sausage 68% of the time.
a.
5.7%:26.9%
b.
5.3%:16.3%
c.
11.0%:21.6%
d.
6.2%:18.5%
24. Bavarian Sausage stock has an average historical return of 16.3% and a standard deviation of 5.3%.
What is the probability that the return on Bavarian Sausage will be less than 11%?
a.
84%
b.
50%
c.
16%
d.
32%
25. Bavarian Sausage stock has an average historical return of 16.3% and a standard deviation of 5.3%.
What is the probability that the return on Bavarian Sausage will be higher than 26.9 %?
a.
5%
b.
2.5%
c.
16%
d.
95%
26. Which of the following is not part of the procedure for valuing a risky asset?
a.
determining the asset’s expected cash flows
b.
choosing a discount rate that reflects the asset’s risk
c.
calculating the present value
d.
determining whether the project is mutually exclusive or not
27. The total return of an asset captures
a.
income paid by an asset over time.
b.
the capital gain or loss on the asset over time.
c.
the book value of the asset over time.
d.
a and b are both correct.
28. If you were to purchase an asset for $100 today and receive a dividend of $5 at the end of the year in
addition to selling the asset for $110, then what would the capital gain on the asset be?
a.
15%
b.
10%
c.
5%
d.
none of the above
29. You purchased a 10-year, 6% coupon bond (the bond makes semi-annual payments) last year based
upon a discount rate of 6%. One year later the discount rate has fallen to 5.5%. What is your total
return on the bond?
a.
6.000%
b.
3.512%
c.
9.512%
d.
none of the above
30. You purchased WPC common shares for $50 one year ago. You have received total dividends equal to
$8 during the year. If your total return during the period is 12%, then what was the price of WPC when
you sold the stock today?
a.
$52.00
b.
$48.00
c.
$98.00
d.
none of the above
31. You purchased stock of Blue McBrushes Corp one year ago for $85 and generated a total return of
20% during that time. If you just sold the stock for $89.50, then what were the total dividends that you
received during the year?
a.
$12.50
b.
$12.73
c.
$13.18
d.
none of the above
32. The additional return offered by a more risky investment relative to a safer one is called
a.
the risk-free rate.
b.
the risky return.
c.
the risk premium.
d.
the insurance premium.
33. You are analyzing the performance of different asset classes for a foreign economy. You find that over
the last 60 years the average annual return for equities was 12% while that of corporate bonds was
10% and the rate of inflation was about 3%. If inflation were projected to be around 1% for the
foreseeable future, then what would you project the return of equities to be during that same
foreseeable period?
a.
12%
b.
11%
c.
10%
d.
9%
34. The statistical term, variance is defined as
a.
the expected value of deviations from the mean.
b.
the expected value of squared deviations from the mean.
c.
the sum of squared deviations from the mean.
d.
the sum of squared deviations from the mean divided by the number of observations
available.
35. You are introduced to an investment that has an expected return of 20% equal to the standard deviation
of the distribution of returns. What is the probability that the investment will lose some of your initial
investment in the first year?
a.
50%
b.
34%
c.
16%
d.
unable to determine from the information given
36. You are introduced to an investment that has an expected return of 20% equal to the standard deviation
of the distribution of returns. What is the probability that the investment will have a return less than
20% in the first year? Assume a normal distribution.
a.
0%
b.
50%
c.
68%
d.
not enough information to determine
37. Your family has invested in a security over the last 100 years. The expected return during that period
has been .15 and the variance of the returns has been .048. Your investment advisor told you that the
security had a 95th percentile performance (with respect to its historical performance) this period.
What was the actual return during the period?
a.
15.0%
b.
19.8%
c.
37.0%
d.
58.8%
38. Over the last 3 years you have earned 5%, 7%, and 9% on your portfolio. What is the standard
deviation of the returns of that portfolio?
a.
.07
b.
.02
c.
.0004
d.
none of the above
39. You have it on good account that the probability of good returns on energy investments is equal to that
of poor returns. If we define good returns as 100% while that of poor returns is 50%, then what is the
probability of getting an exact return of 75% in the next year?
a.
50%
b.
25%
c.
0%
d.
there is not enough information to solve the problem.
40. If you were to plot the return of asset classes on a graph with the standard deviation of returns on the
horizontal axis and expected returns on the vertical axis, then which security class is most likely to be
in the farthest upper right hand corner of the graph?
a.
Treasury Bills
b.
Treasury Bonds
c.
Corporate Bonds
d.
Stocks
41. Which of the following asset classes would give you the greatest probability of achieving a return that
is closest to its expected return?
a.
Treasury Bills
b.
Treasury Bonds
c.
Corporate Bonds
d.
Stocks
42. You are presented with 4 distinct investment opportunities involving a Treasury Bill, a Treasury Bond,
a Corporate Bond, and a Stock. You are told that each of these investments are expected to produce
(after the cash is paid out then no other cash flows are anticipated) $100 one year from now. Which
asset should be the least expensive today, in terms of dollars that you will have to pay for the asset?
a.
Treasury Bills
b.
Treasury Bonds
c.
Corporate Bonds
d.
Stocks
43. If the standard deviation of a diversified portfolio is 20% and if the stocks in that portfolio are
positively correlated, then what would we expect the average standard deviation of stocks in that
portfolio to be?
a.
less than 20%
b.
20%
c.
greater than 20%
d.
you would need to know the percentage of each stock invested in that portfolio to
determine the answer
44. If we are able to eliminate all of the unsystematic risk in a portfolio then, what is the result?
a.
a risk-free portfolio
b.
a portfolio that contains only systematic risk
c.
a portfolio that has an expected return of zero
d.
such a portfolio cannot be constructed since there will always be unsystematic risk in any
portfolio
45. Stock X has 3 units of systematic risk and 2 units of unsystematic risk while Stock Y has 3 units of
systematic risk and 4 units of unsystematic risk. If Stock X is priced to generate an 8% return for
investors then what do we know about the return that Stock Y should be priced to return?
a.
Stock Y should be priced to return greater than 8%
b.
Stock Y should be priced to return 8%
c.
Stock Y should be priced to return less than 8%
d.
there is not enough information to solve this problem
46. Based upon the following levels of risk, which stock should have the highest price if each stock is
expected to produce the same level of cash over the future life of each asset?
Unsystematic risk units
Stock A
3
Stock B
5
Stock C
300
a.
Stock A
b.
Stock B
c.
Stock C
d.
there is not enough information to decide
47. You have the choice of introducing either Stock X or Stock Y into your fully diversified portfolio.
Both stocks have 5 units of systematic risk while Stock X has 6 units of unsystematic risk and Stock Y
has 8 units of unsystematic risk. Which stock offers the greatest opportunity from diversification?
a.
Stock X
b.
Stock Y
c.
both stock offer the same opportunity
d.
there is not enough information to determine the answer
NARRBEGIN: Hillary
Hillary Investments
Between 1999 and 2003, Hillary Investments has produced returns as follows:
1999
8%
2000
3%
2001
-1%
2002
-5%
2003
-3%
NARREND
48. Calculate the expected return for Hillary Investments.
a.
.003
b.
.004
c.
.005
d.
.006
49. What is the variance of the return of Hillary Investments?
a.
.01072
b.
.00268
c.
.00214
d.
none of the above
Exhibit 6-1
Suppose that an investor bought a bond last year for $980. The bond pays a 7% annual coupon and has
a face value of $1,000. Today, the same bond is selling for $960.
NARREND
50. Refer to Exhibit 6-1. If the investor sells the bond this morning, what is the total dollar return of the
investment?
a.
-$40
b.
$30
c.
$50
d.
$70
51. Refer to Exhibit 6-1. If the investor sells the bond this morning, what is the total percentage return of
the investment?
a.
5.10%
b.
5.21%
c.
7.00%
d.
9.18%
Terry Corporation
One year ago, Jason purchased 50 shares of Terry Corporation stock at $20 per share. Today, one year
later, the stock pays a $2 per share dividend and the price is now $22 per share.
NARREND
52. Refer to Terry Corporation. What is the total dollar return on the investment for the one year?
a.
$4
b.
$50
c.
$75