CHAPTER 1—THE INVESTMENT SETTING
TRUE/FALSE
1. The rate of exchange between certain future dollars and certain current dollars is known as the pure
rate of interest.
2. An investment is the current commitment of dollars over time to derive future payments to compensate
the investor for the time funds are committed, the expected rate of inflation and the uncertainty of
future payments.
3. The holding period return (HPR) is equal to the holding period yield (HPY) stated as a percentage.
4. The geometric mean of a series of returns is always larger than the arithmetic mean and the difference
increases with the volatility of the series.
5. The expected return is the average of all possible returns.
6. Two measures of the risk premium are the standard deviation and the variance.
7. The variance of expected returns is equal to the square root of the expected returns.
8. The coefficient of variation is the expected return divided by the standard deviation of the expected
return.
9. Nominal rates are averages of all possible real rates.
10. The risk premium is a function of the volatility of operating earnings, sales volatility and inflation.
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11. An individual who selects the investment that offers greater certainty when everything else is the same
is known as a risk averse investor.
12. Investors are willing to forgo current consumption in order to increase future consumption for a
nominal rate of interest.
MULTIPLE CHOICE
1. The basic trade-off in the investment process is
a.
between the anticipated rate of return for a given investment instrument and its degree of
risk.
b.
between understanding the nature of a particular investment and having the opportunity to
purchase it.
c.
between high returns available on single instruments and the diversification of instruments
into a portfolio.
d.
between the desired level of investment and possessing the resources necessary to carry it
out.
2. The rate of exchange between future consumption and current consumption is
a.
The nominal risk-free rate.
b.
The coefficient of investment exchange.
c.
The pure rate of interest.
d.
The consumption/investment paradigm.
e.
The expected rate of return.
3. The _____________ the variance of returns, everything else remaining constant, the ______ the
dispersion of expectations and the ________________ the risk.
a.
Larger, greater, lower
b.
Larger, smaller, higher
c.
Larger, greater, higher
d.
Smaller, greater, lower
e.
Smaller, greater, greater
4. The coefficient of variation is a measure of
a.
Central tendency.
b.
Absolute variability.
c.
Absolute dispersion.
d.
Relative variability.
e.
Relative return.
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5. The nominal risk free rate of interest is a function of
a.
The real risk free rate and the investment’s variance.
b.
The prime rate and the rate of inflation.
c.
The T-bill rate plus the inflation rate.
d.
The tax free rate plus the rate of inflation.
e.
The real risk free rate and the rate of inflation.
6. In the phrase “nominal risk free rate,” nominal means
a.
Computed.
b.
Historical.
c.
Market.
d.
Average.
e.
Risk adverse.
7. If a significant change is noted in the yield of a T-bill, the change is most likely attributable to
a.
A downturn in the economy.
b.
A static economy.
c.
A change in the expected rate of inflation.
d.
A change in the real rate of interest.
e.
A change in risk aversion.
8. The real risk-free rate is affected by two factors:
a.
The relative ease or tightness in capital markets and the expected rate of inflation.
b.
The expected rate of inflation and the set of investment opportunities available in the
economy.
c.
The relative ease or tightness in capital markets and the set of investment opportunities
available in the economy.
d.
Time preference for income consumption and the relative ease or tightness in capital
markets.
e.
Time preference for income consumption and the set of investment opportunities available
in the economy.
9. Which of the following is not a component of the risk premium?
a.
Business risk
b.
Financial risk
c.
Liquidity risk
d.
Exchange rate risk
e.
Unsystematic market risk
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10. The ability to sell an asset quickly at a fair price is associated with
a.
Business risk.
b.
Liquidity risk.
c.
Exchange rate risk.
d.
Financial risk.
e.
Market risk.
11. The variability of operating earnings is associated with
a.
Business risk.
b.
Liquidity risk.
c.
Exchange rate risk.
d.
Financial risk.
e.
Market risk.
12. The uncertainty of investment returns associated with how a firm finances its investments is known as
a.
Business risk.
b.
Liquidity risk.
c.
Exchange rate risk.
d.
Financial risk.
e.
Market risk.
13. What will happen to the security market line (SML) if the following events occur, other things
constant: (1) inflation expectations increase, and (2) investors become more risk averse?
a.
Shift up and keep the same slope
b.
Shift up and have less slope
c.
Shift up and have a steeper slope
d.
Shift down and keep the same slope
e.
Shift down and have less slope
14. A decrease in the market risk premium, all other things constant, will cause the security market line to
a.
Shift up
b.
Shift down
c.
Have a steeper slope
d.
Have a flatter slope
e.
Remain unchanged
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15. A decrease in the expected real growth in the economy, all other things constant, will cause the
security market line to
a.
Shift up
b.
Shift down
c.
Have a steeper slope
d.
Have a flatter slope
e.
Remain unchanged
16. Unsystematic risk refers to risk that is
a.
Undiversifiable
b.
Diversifiable
c.
Due to fundamental risk factors
d.
Due to market risk
e.
None of the above
17. The security market line (SML) graphs the expected relationship between
a.
Business risk and financial risk
b.
Systematic risk and unsystematic risk
c.
Risk and return
d.
Systematic risk and unsystematic return
e.
None of the above
18. Two factors that influence the nominal risk-free rate are:
a.
The relative ease or tightness in capital markets and the expected rate of inflation.
b.
The expected rate of inflation and the set of investment opportunities available in the
economy.
c.
The relative ease or tightness in capital markets and the set of investment opportunities
available in the economy.
d.
Time preference for income consumption and the relative ease or tightness in capital
markets.
e.
Time preference for income consumption and the set of investment opportunities available
in the economy.
19. Measures of risk for an investment include
a.
Variance of returns and business risk
b.
Coefficient of variation of returns and financial risk
c.
Business risk and financial risk
d.
Variance of returns and coefficient of variation of returns
e.
All of the above
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20. Sources of risk for an investment include
a.
Variance of returns and business risk
b.
Coefficient of variation of returns and financial risk
c.
Business risk and financial risk
d.
Variance of returns and coefficient of variation of returns
e.
All of the above
21. Modern portfolio theory assumes that most investors are
a.
Risk averse
b.
Risk neutral
c.
Risk seekers
d.
Risk tolerant
e.
None of the above
22. Which of the following is not a component of the required rate of return?
a.
Expected rate of inflation
b.
Time value of money
c.
Risk
d.
Holding period return
e.
All of the above are components of the required rate of return
23. All of the following are major sources of uncertainty EXCEPT:
a.
Business risk
b.
Financial risk
c.
Default risk
d.
Country risk
e.
Liquidity risk
24. The total risk for a security can be measured by its
a.
Beta with the market portfolio
b.
Systematic risk
c.
Standard deviation of returns
d.
Unsystematic risk
e.
Alpha with the market portfolio
7
Exhibit 1-1
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
Assume you bought 100 shares of NewTech common stock on January 15, 2009 at $50.00 per share
and sold it on January 15, 2010 for $40.00 per share.
25. Refer to Exhibit 1-1. What was your holding period return?
a.
-10%
b.
-0.8
c.
25%
d.
0.8
e.
-20%
26. Refer to Exhibit 1-1. What was your holding period yield?
a.
-10%
b.
-0.8
c.
25%
d.
0.8
e.
-20%
27. Refer to Exhibit 1-2. What was your annual holding period return?
a.
0.8667
b.
-0.1333
c.
0.0333
d.
0.9534
e.
-0.0466
28. Refer to Exhibit 1-2. What was your annual holding period yield?
a.
-0.0466
b.
-0.1333
c.
0.0333
d.
0.3534
e.
0.8667
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
The common stock of XMen had the following historic prices.
Time
Price of XMen
3/01/2004
50.00
3/01/2005
47.00
3/01/2006
76.00
3/01/2007
80.00
3/01/2008
85.00
3/01/2009
90.00
29. Refer to Exhibit 1-3. What was your holding period return for the time period 3/1/2004 to 3/1/2009?
a.
0.1247
b.
1.8
c.
0.1462
d.
0.40
e.
0.25
30. Refer to Exhibit 1-3. What was your annual holding period yield (Annual HPY)?
a.
0.1462
b.
0.1247
c.
1.8
d.
0.40
e.
0.25
31. Refer to Exhibit 1-3. What was your arithmetic mean annual yield for the investment in XMen?
a.
0.1462
b.
0.1247
c.
1.8
d.
0.40
e.
0.25
32. Refer to Exhibit 1-3. What was your geometric mean annual yield for the investment in XMen?
a.
0.25
b.
0.40
c.
1.8
d.
0.1247
e.
0.1462
= Standard Deviation of Returns/Expected Rate of Return
= 6.25/6 = 1.04
10
Exhibit 1-4
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
You have concluded that next year the following relationships are possible:
Economic Status
Probability
Rate of Return
Weak Economy
.15
-5%
Static Economy
.60
5%
Strong Economy
.25
15%
33. Refer to Exhibit 1-4. What is your expected rate of return [E(Ri)] for next year?
a.
4.25%
b.
6.00%
c.
6.25%
d.
7.75%
e.
8.00%
34. Refer to Exhibit 1-4. Compute the standard deviation of the rate of return for the one year period.
a.
0.65%
b.
1.45%
c.
4.0%
d.
6.25%
e.
6.4%
35. Refer to Exhibit 1-4. Compute the coefficient of variation for your portfolio.
a.
0.043
b.
0.12
c.
1.40
d.
0.69
e.
1.04
11
Exhibit 1-5
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
Assume that during the past year the consumer price index increased by 1.5% percent and the
securities listed below returned the following nominal rates of return.
Canadian T-bills
2.75%
Canadian corporate bonds
4.75%
36. Refer to Exhibit 1-5. What are the real rates of return for each of these securities?
a.
4.29% and 6.32%
b.
1.23% and 4.29%
c.
3.20% and 6.32%
d.
1.23% and 3.20%
e.
3.75% and 5.75%
37. Refer to Exhibit 1-5. If next year the real rates all rise by 10% while inflation climbs from 1.5% to
2.5%, what will be the nominal rate of return on each security?
a.
1.24% and 1.52%
b.
1.35% and 3.52%
c.
3.89% and 6.11%
d.
3.52% and 3.89%
e.
1.17% and 6.11%
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38. Refer to Exhibit 1-5. If over the past 20 years the annual returns on the S&P 500 market index
averaged 12% with a standard deviation of 18%, what was the coefficient of variation?
a.
0.6
b.
0.6%
c.
1.5
d.
1.5%
e.
0.66%
= 18% / 12% = 1.5
39. Given investments A and B with the following risk return characteristics, which one would you prefer
and why?
Standard Deviation
Investment
Expected Return
of Expected Returns
A
12.2%
7%
B
8.8%
5%
a.
Investment A because it has the highest expected return.
b.
Investment A because it has the lowest relative risk.
c.
Investment B because it has the lowest absolute risk.
d.
Investment B because it has the lowest coefficient of variation.
e.
Investment A because it has the highest coefficient of variation.
13
Exhibit 1-6
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
You are provided with the following information
Nominal return on risk-free asset = 4.5%
Expected return for asset i = 12.75%
Expected return on the market portfolio = 9.25%
40. Refer to Exhibit 1-6. Calculate the risk premium for asset i
a.
4.5%
b.
8.25%
c.
4.75%
d.
3.5%
e.
None of the above
41. Refer to Exhibit 1-6. Calculate the risk premium for the market portfolio
a.
4.5%
b.
8.25%
c.
4.75%
d.
3.5%
e.
None of the above
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
Consider the following information
Nominal annual return on Canadian T-bills for year 2009 = 3.5%
Nominal annual return on Canadian corporate bonds for year 2009= 4.75%
Nominal annual return on Canadian large-cap stocks for year 2009 = 8.75%
Consumer price index January 1, 2009 = 165
Consumer price index December 31, 2009 = 169
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42. Refer to Exhibit 1-7. Compute the rate of inflation for the year 2009
a.
2.42%
b.
4.0%
c.
1.69%
d.
1.24%
e.
None of the above
43. Refer to Exhibit 1-7. Calculate the real rate of return for Canadian T-bills
a.
2.26%
b.
1.81%
c.
-0.5%
d.
1.05%
e.
None of the above
44. Refer to Exhibit 1-7. Calculate the real rate of return for Canadian corporate bonds.
a.
3.06%
b.
2.27%
c.
2.51%
d.
3.5%
e.
None of the above
45. Refer to Exhibit 1-7. Calculate the real rate of return for Canadian large-cap stocks.
a.
7.06%
b.
6.18%
c.
4.75%
d.
3.75%
e.
None of the above
Stock
Shares
Price(t)
MV(t)
Price(t+1)
MV(t+1)
HPR
HPY
Weight
HPY
1
15
10
150
12
180
1.2
0.2
0.29
0.058
2
25
15
375
16
400
1.07
0.07
0.71
0.048
525
580
0.106
15
Exhibit 1-8
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
Assume that you hold a two stock portfolio. You are provided with the following information on your
holdings.
Stock
Shares
Price(t)
Price(t+1)
1
15
10
12
2
25
15
16
46. Refer to Exhibit 1-8. Calculate the HPY for Stock 1.
a.
10%
b.
20%
c.
15%
d.
12%
e.
7%
Stock
Shares
Price(t)
MV(t)
Price(t+1)
MV(t+1)
HPR
HPY
Weight
HPY
1
15
10
150
12
180
1.2
0.2
0.29
0.058
2
25
15
375
16
400
1.07
0.07
0.71
0.048
525
580
0.106
47. Refer to Exhibit 1-8. Calculate the HPY for Stock 2
a.
5%
b.
6%
c.
7%
d.
8%
e.
10%
16
48. Refer to Exhibit 1-8. Calculate the market weights for Stocks 1 and 2 based on period t values
a.
39% for stock 1 and 61% for stock 2
b.
50% for stock 1 and 50% for stock 2
c.
71% for stock 1 and 29% for stock 2
d.
29% for stock 1 and 71% for stock 2
e.
None of the above
49. Refer to Exhibit 1-8. Calculate the HPY for the portfolio
a.
10.6%
b.
6.95%
c.
13.5%
d.
10%
e.
15.7%
17
Exhibit 1-9
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
You purchased 100 shares of GE common stock on January 1, for $29 per share. A year later you
received $1.25 in dividends per share and you sold it for $28 per share.
50. Refer to Exhibit 1-9. Calculate your holding period return (HPR) for this investment in GE stock.
a.
0.9655
b.
1.0086
c.
1.0357
d.
1.0804
e.
1.0973
51. Refer to Exhibit 1-9. Calculate your holding period yield (HPY) for this investment in GE stock.
a.
0.0345
b.
0.0090
c.
0.0086
d.
0.0643
e.
0.0804
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
The annual rates of return of Stock Z for the last four years are 0.10, 0.15, -0.05, and 0.20,
respectively.
52. Refer to Exhibit 1-10. Compute the arithmetic mean annual rate of return for Stock Z.
a.
0.03
b.
0.04
c.
0.06
d.
0.10
e.
0.40
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53. Refer to Exhibit 1-10. Compute the standard deviation of the annual rate of return for Stock Z.
a.
0.0070
b.
0.0088
c.
0.0837
d.
0.0935
e.
0.1145
54. Refer to Exhibit 1-10. Compute the coefficient of variation for Stock Z.
a.
0.837
b.
0.935
c.
1.070
d.
1.145
e.
1.281
55. Refer to Exhibit 1-10. Compute the geometric mean rate of return for Stock Z.
a.
0.051
b.
0.074
c.
0.096
d.
0.150
e.
1.090