Deck 6: The Meaning and Measurement of Risk and Return

Question 1

Due to strict stock market controls,the most a stock's value can drop in one trading day is 5%.

Answer 1

False

Question 2

You are considering a sales job that pays you on a commission basis or a salaried position that pays you $50,000 per year.Historical data suggests the following probability distribution for your commission income.Which job has the higher expected income?

A)The salary of $50,000 is greater than the expected commission of $49,630.
B)The salary of $50,000 is greater than the expected commission of $48,400.
C)The salary of $50,000 is less than the expected commission of $50,050.
D)The salary of $50,000 is less than the expected commission of $52,720.

Answer 2

The salary of $50,000 is greater than the expected commission of $49,630.

Question 3

A rational investor will always prefer an investment with a lower standard deviation of returns,because such investments are less risky.

Answer 3

False

Question 4

Variation in the rate of return of an investment is a measure of the riskiness of that investment.

Question 5

The risk-return tradeoff that investors face on a day-to-day basis is based on realized rates of return because expected returns involve too much uncertainty.

Question 6

Actual returns are always less than expected returns because actual returns are determined at the end of the period and must be discounted back to present value.

Question 7

The expected rate of return from an investment is equal to the expected cash flows divided by the initial investment.

Question 8

Stock A has the following returns for various states of the economy: State of Stock A's expected return is

A)9.9%.
B)12.7%.
C)13.8%.
D)16.5%.

Question 9

Cash flows is the most relevant variable to measure the returns on debt instruments,while GAAP net income is the most relevant variable to measure the returns on common stock.

Question 10

Another name for an asset's expected rate of return is holding-period return.

Question 11

Stock W has an expected return of 12% with a standard deviation of 8%.If returns are normally distributed,then approximately two-thirds of the time the return on stock W will be

A)between 12% and 20%.
B)between 8% and 12%.
C)between -4% and 28%.
D)between 4% and 20%.

Question 12

Stock W has the following returns for various states of the economy: Stock W's standard deviation of returns is

A)12%.
B)29%.
C)37%.
D)43%.

Question 13

Accounting profits is the most relevant variable the financial manager uses to measure returns.

Question 14

Which of the following investments is clearly preferred to the others for an investor who is not holding a well-diversified portfolio?

A)Investment A
B)Investment B
C)Investment C
D)Cannot be determined without information regarding the risk-free rate of return.

Question 15

Stock W has the following returns for various states of the economy: Stock W's standard deviation of returns is

A)10%.
B)14%.
C)17%.
D)20%

Question 16

For a well-diversified investor,an investment with an expected return of 10% with a standard deviation of 3% dominates an investment with an expected return of 10% with a standard deviation of 5%.

Question 17

The realized rate of return,or holding period return,is equal to the holding period dollar gain divided by the price at the beginning of the period.

Question 18

Stock A has the following returns for various states of the economy: State of Stock A's expected return is

A)5.4%.
B)7.2%.
C)8.2%.
D)9.6%

Question 19

Assume that you have $330,000 invested in a stock that is returning 11.50%,$170,000 invested in a stock that is returning 22.75%,and $470,000 invested in a stock that is returning 10.25%.What is the expected return of your portfolio?

A)15.6%
B)12.9%
C)18.3%
D)14.8%

Question 20

Use the following data: Market risk premium = 10% Risk free rate = 2% Beta of XYZ stock = 1.6 Beta of PDQ stock = 2.4 Investment in XYZ stock = $15,000 Investment in PDQ stock = $60,000 You have no assets other than your investments in XYZ and PDQ stock. What is the expected return of your portfolio? Show all work.

Question 21

Investment A has an expected return of 15% per year,while investment B has an expected return of 12% per year.A rational investor will choose

A)investment A because of the higher expected return.
B)investment B because a lower return means lower risk.
C)investment A if A and B are of equal risk.
D)investment A only if the standard deviation of returns for A is higher than the standard deviation of returns for B.

Question 22

The relevant variable a financial manager uses to measure returns is

A)net income determined using generally accepted accounting principles.
B)earnings per share minus dividends per share.
C)cash flows.
D)dividends.

Question 23

Historically,investments with the highest returns have the lowest standard deviations because investors do not like risk.

Question 24

The minimum rate of return necessary to attract an investor to purchase or hold a security is referred to as the

A)stock's beta.
B)investor's risk premium.
C)investor's required rate of return.
D)risk-free rate.

Question 25

You are considering investing in a project with the following possible outcomes: Calculate the expected rate of return and standard deviation of returns for this investment,respectively.

A)8.72%,12.99%
B)7.35%,12.99%
C)3.50%,1.69%
D)2.18%,1.69%

Question 26

An investor with a required return of 8% for stock A will purchase stock A if the expected return for stock A is less than or equal to 8%.

Question 27

Small company stocks have historically had higher average annual returns than large company stocks,and also a higher risk premium.

Question 28

You are given the following probability distribution for XYZ common stock's returns during the next year,which are assumed to be normally distributed.Show all work below,and complete the following: a.Calculate the standard deviation of the returns,and round to the nearest one-half percent. b.Draw a graphical representation of XYZ's normal distribution below (ye old bell-shaped curve).LABEL THE AXES OF THE GRAPH OR THE FOLLOWING RESULTS WILL BE MEANINGLESS.Using your result in part A for the standard deviation (rounded to the nearest one-half percent)explain and indicate on the graph,the probability that XYZ will return more than 13.5%,assuming a normal distribution.

Question 29

Rogue Recreation,Inc.has normally distributed returns with an expected return of 15% and a standard deviation of 5%,while Lake Tours,Inc.has normally distributed returns with an expected return of 15% and a standard deviation of 15%.Which of the following is true?

A)Lake Tours' investors are not being adequately compensated for relevant risk.
B)Rogue Rec is likely to experience returns larger than those of Lake Tours.
C)Lake Tours is more likely to have negative returns than Rogue Rec.
D)Rational investors will prefer Lake Tours,Inc.over Rogue Recreation,Inc.

Question 30

Discuss whether the standard deviation of a portfolio is,or is not,a weighted average of the standard deviations of the assets in the portfolio.Fully explain your answer.

Question 31

Bay Land,Inc.has the following distribution of returns: Assuming that these returns are normally distributed,what is the probability that Bay Land,Inc.will return less than 7.25%? Show all work,and clearly explain and state your answer.

Question 32

As the required rate of return of an investment decreases,the market price of the investment decreases.

Question 33

Negative historical returns are not possible during periods of high volatility (high standard deviations of returns)due to the risk-return tradeoff.

Question 34

In an efficient market,a stock with a standard deviation of returns of 12% could have a higher expected return than a stock with a standard deviation of 10% because the beta for the higher standard deviation stock could be lower than the beta for the lower standard deviation stock.

Question 35

Assume that you have $100,000 invested in a stock that is returning 14%,$150,000 invested in a stock that is returning 18%,and $200,000 invested in a stock that is returning 15%.What is the expected return of your portfolio?

A)13.25%
B)14.97%
C)15.67%
D)15.78%

Question 36

In general,the required rate of return is a function of (1)the time value of money,(2)the risk of an asset,and (3)the investor's attitude toward risk.

Question 37

Which of the following investments is clearly preferred to the others for a risk-averse investor?

A)Investment A
B)Investment B
C)Investment C
D)cannot be determined without additional information

Question 38

Changes in the general economy,like changes in interest rates or tax laws represent what type of risk?

A)company-unique risk
B)market risk
C)unsystematic risk
D)diversifiable risk

Question 39

Investment A and Investment B both have the same expected return,but Investment A is more risky than Investment B.In the technical jargon of modern portfolio theory,Investment A is said to "dominate" Investment B.

Question 40

Investment A has an expected return of 14% with a standard deviation of 4%,while investment B has an expected return of 20% with a standard deviation of 9%.Therefore

A)a risk averse investor will definitely select investment A because the standard deviation is lower.
B)a rational investor will pick investment B because the return adjusted for risk (20% - 9%)is higher than the return adjusted for risk for investment A ($14% - 4%).
C)it is irrational for a risk-averse investor to select investment B because its standard deviation is more than twice as big as investment A's,but the return is not twice as big.
D)rational investors could pick either A or B,depending on their level of risk aversion.

Question 41

You are considering a security with the following possible rates of return: a.Calculate the expected rate of return.
b.Calculate the standard deviation of the returns.

Question 42

Diversifying among different kinds of assets is called asset allocation.

Question 43

Assume that an investment is forecasted to produce the following returns: a 20% probability of a 12% return; a 50% probability of a 16% return; and a 30% probability of a 19% return.What is the standard deviation of return for this investment?

A)5.89%
B)16.1%
C)2.43%
D)15.7%

Question 44

A stock with a beta of 1 has systematic or market risk equal to the "typical" stock in the marketplace.

Question 45

If you were to use the standard deviation as a measure of investment risk,which of the following has historically been the highest risk investment?

A)common stock of large firms
B)U.S.Treasury bills
C)common stock of small firms
D)long-term government bonds

Question 46

An all-stock portfolio is more risky than a portfolio consisting of all bonds.

Question 47

Company unique risk can be virtually eliminated with a portfolio consisting of approximately 20 securities.

Question 48

Proper diversification generally results in the elimination of risk.

Question 49

You are considering the three securities listed below. a.Calculate the expected return for each security.
b.Calculate the standard deviation of returns for each security.
c.Compare Stock A with Stocks B and C.Is Stock A preferred over the others?

Question 50

Assume that an investment is forecasted to produce the following returns: a 10% probability of a $1,400 return; a 50% probability of a $6,600 return; and a 40% probability of a $1,500 return.What is the expected amount of return this investment will produce?

A)$4,040
B)$7,640
C)$12140
D)$1,540

Question 51

A well-diversified portfolio typically has systematic risk equal to about 40% of the portfolio's total risk.

Question 52

Adding stocks to a bond portfolio will increase the riskiness of the portfolio because stocks have higher standard deviations of returns than bonds.

Question 53

A stock with a beta of 1.4 has 40% more variability in returns than the average stock.

Question 54

Asset allocation is not recommended by financial planners because mixing different types of assets,such as stocks with bonds,makes it more difficult to track performance and adjust portfolios to changing market conditions.

Question 55

Of the following different types of securities,which is typically considered most risky?

A)long-term corporate bonds
B)long-term government bonds
C)common stocks of large companies
D)common stocks of small companies

Question 56

Assume that an investment is forecasted to produce the following returns: a 30% probability of a 12% return; a 50% probability of a 16% return; and a 20% probability of a 19% return.What is the expected percentage return this investment will produce?

A)33.3%
B)16.1%
C)9.5%
D)15.4%

Question 57

The category of securities with the highest historical risk premium is

A)large company stocks.
B)small company stocks.
C)government bonds.
D)small company corporate bonds.

Question 58

Total risk equals systematic risk plus unsystematic risk.

Question 59

The benefits of diversification occur as long as the investments in a portfolio are not perfectly positively correlated.

Question 60

If you were to use the standard deviation as a measure of investment risk,which of the following has historically been the least risky investment?

A)common stock of large firms
B)U.S.Treasury bills
C)common stock of small firms
D)long-term government bonds

Question 61

The relevant risk to an investor is that portion of the variability of returns that cannot be diversified away.

Question 62

The Beta of a T-bill is one.

Question 63

The Beta of a T-bill is zero.

Question 64

Unique security risk can be eliminated from an investor's portfolio through diversification.

Question 65

A security with a beta of one has a required rate of return equal to the overall market rate of return.

Question 66

Wendy purchased 800 shares of Genetics Stock at $3 per share on 1/1/12.Wendy sold the shares on 12/31/12 for $3.45.Genetics stock has a beta of 1.9,the risk-free rate of return is 4%,and the market risk premium is 9%.Wendy's holding period return is

A)15.0%.
B)16.5%.
C)17.6%.
D)21.1%.

Question 67

The market rewards the patient investor,for between 1926 and 2008,there has never been a time when an investor lost money if she held an all-stock portfolio for ten years.

Question 68

The portfolio beta is simply the sum of the betas of the individual stocks in the portfolio.

Question 69

Portfolio performance is determined mainly by stock selection and market timing,with less emphasis on asset allocation.

Question 70

An investor currently holds the following portfolio: The investor is worried that the beta of his portfolio is too high,so he wants to sell some stock C and add stock D,which has a beta of 1.0,to his portfolio.If the investor wants his portfolio to have a beta of 1.72,how much stock C must he replace with stock D?

A)$18,000
B)$24,000
C)$31,000
D)$36,000

Question 71

Which of the following statements is MOST correct concerning diversification and risk?

A)Diversification is mainly achieved by the selection of individual securities for each type of asset held in a portfolio.
B)Diversification is mainly achieved by the asset allocation decision,not the selection of individual securities within each asset category.
C)Large company stocks and small company stocks together in a portfolio lead to dramatic reductions in risk because their returns are negatively correlated.
D)Asset allocation is important for pension funds but not for individual investors.

Question 72

You are thinking of adding one of two investments to an already well- diversified portfolio. If you are a risk-averse investor,which one is the better choice?

A)Security A
B)Security B
C)Either security would be acceptable because they have the same beta.
D)Security B,but only if Security B's required return is greater than 12%

Question 73

Because risk is measured by variability of returns,how long we hold our investments does not matter very much when it comes to reducing risk.

Question 74

The characteristic line for any well-diversified portfolio is horizontal.

Question 75

You are going to invest all of your funds in one of three projects with the following distribution of possible returns: If you are a risk averse investor,which one should you choose?

A)Project 1
B)Project 2
C)Project 3
D)either Project 1 or Project 2 because they have the same expected return

Question 76

You are considering investing in Ford Motor Company.Which of the following are examples of diversifiable risk?
I.Risk resulting from possibility of a stock market crash.
II.Risk resulting from uncertainty regarding a possible strike against Ford.
III.Risk resulting from an expensive recall of a Ford product.
IV.Risk resulting from interest rates decreasing.

A)I only
B)I and IV
C)I,II,III,IV
D)II,III

Question 77

Beta represents the average movement of a company's stock returns in response to a movement in the market's returns.

Question 78

Which of the following statements is MOST correct concerning diversification and risk?

A)Risk-averse investors often choose companies from different industries for their portfolios because the correlation of returns is less than if all the companies came from the same industry.
B)Risk-averse investors often select portfolios that include only companies from the same industry group because the familiarity reduces the risk.
C)Only wealthy investors can diversify their portfolios because a portfolio must contain at least 50 stocks to gain the benefits of diversification.
D)Proper diversification generally results in the elimination of risk.

Question 79

Beta is a measurement of the relationship between a security's returns and the general market's returns.

Question 80

The slope of the characteristic line of a security is that security's Beta.