Deck 10: Investment Basics: Understanding Risk and Return

Question 1

An investment's required rate of return is

A)the return you expect to receive in the upcoming period.
B)its long-run average return.
C)the return required by government regulators.
D)the return it must earn to reward investors for undertaking its inherent risks.

Answer 1

the return it must earn to reward investors for undertaking its inherent risks.

Question 2

A company loses sales volume because a competitor introduces a better product.This is an example of

A)random risk.
B)market risk.
C)systematic risk.
D)beta risk.

Answer 2

random risk.

Question 3

The iron law of risk and return means that

A)to earn higher investment returns you must undertake higher investment risk.
B)to earn higher investment return you run the risk of filing a fraudulent tax return.
C)most investments require your strict adherence to securities laws.
D)as a beginning investor you run the risk of substantial investment losses.

Answer 3

to earn higher investment returns you must undertake higher investment risk.

Question 4

Statistical correlation studies of returns of the three key financial assets indicates that

A)there is strong positive correlation among their returns.
B)it makes sense to hold Treasury bonds and Treasury bills together,but not stocks.
C)holding a portfolio of all three assets increased return and decreased risk.
D)there is rather poor correlation among their returns.

Question 5

Which item below is not a guideline for effective diversification? Diversify

A)among tangibles and intangibles.
B)among assets and liabilities.
C)on a global basis.
D)within asset groups.

Question 6

One perspective on risk asserts that the longer an investment is held,the

A)less its risk because its periodic returns will be less variable.
B)less its risk because its overall return will be higher.
C)greater its risk because its overall return will be lower.
D)greater its risk because its periodic returns will be more variable.

Question 7

One perspective on risk asserts that the longer an investment is held,the

A)greater its risk because there is less chance of earning the long-run average return.
B)less its risk because there is a greater chance of earning the long-run average return.
C)greater the risk because the long-run average return will be lower.
D)less the risk because the long-run average return will be higher.

Question 8

A risk premium is the difference between

A)the return on an investment and its risk.
B)the return on an investment and the return on Treasury bills.
C)the rate of inflation and the return on Treasury bills.
D)the intrinsic value of an investment and its market price.

Question 9

An examination of historical returns on financial assets over the period 1970-2006 indicates the following risk premiums

A)3.32% for Treasury bills.
B)-6.81% for Treasury bills.
C)4.07% for common stocks.
D)-8.32% for common stocks.

Question 10

The returns on Asset A are strongly,negatively correlated with Asset B's returns;thus,holding the two assets together will

A)significantly reduce portfolio risk.
B)significantly increase portfolio risk.
C)have little or no effect on portfolio risk.
D)significantly reduce portfolio return.

Question 11

Examining evidence of returns on common stocks and Treasury bills indicates that common stocks had

A)the higher rate of return and the greater risk.
B)the lower rate of return and the greater risk.
C)the lower rate of return and the less risk.
D)the higher rate of return and the less risk.

Question 12

You are evaluating two investments,A and B.Data appear below: AB Expected return 10% 12% Highest possible return 20% 14% Lowest possible return 0% - 4% The riskier investment is

A)A,because it has a lower expected return.
B)A,because it has a wider range of returns.
C)B,because it has a possible loss.
D)B,because its possible highest return is less than A.

Question 13

Which explanation below is most appropriate in explaining why diversification can reduce investment risk?

A)The greater the number of assets held,the greater the portfolio return.
B)The greater the risk taken,the greater the portfolio return.
C)Asset returns are often poorly correlated.
D)Asset returns tend to be stable over time.

Question 14

Which combination of assets is likely to be most effective in reducing portfolio risk?

A)Two stocks in the same industry,such as GM and Ford
B)Two stocks in the same country,such as GM and IBM
C)Two precious metals,such as gold and silver
D)One precious metal and one stock,such as gold and GM

Question 15

Which risk item below is not related to changing economic conditions?

A)Financial risk
B)Business cycle risk
C)Inflation risk
D)Interest-rate risk

Question 16

The returns on Asset A are strongly,positively correlated with Asset B's returns;thus,holding the two assets together will

A)significantly reduce portfolio risk.
B)significantly increase portfolio risk.
C)have little or no effect on portfolio risk.
D)significantly increase portfolio return.

Question 17

Which item below is not related to risks associated with conditions of a security issuer?

A)Interest rate risk
B)Management risk
C)Business risk
D)Financial risk

Question 18

The market risk premium is the difference between the market return and

A)the return on corporate bonds.
B)the return on Treasury bonds.
C)the inflation rate.
D)the return on Treasury bills.

Question 19

The most appropriate view of investment risk is

A)the possibility of investing in fraudulent schemes.
B)a range of possible returns the greater the range,the greater the risk.
C)the possibility of not achieving your investment goal.
D)the possibility of total loss.

Question 20

Order the following investments in terms of their historic returns from highest to lowest.

A)stocks,bonds,Treasury bills
B)Treasury bills,stocks,bonds
C)bonds,stocks,Treasury bills
D)bonds,Treasury bills,stocks

Question 21

A stock's alpha value is calculated as

A)expected return minus required return.
B)required return minus expected return.
C)required return plus expected return.
D)expected return divided by the stock's beta.

Question 22

A stock's required return depends upon

A)only its beta value.
B)its beta value and the risk-free rate of return.
C)its beta value,the risk-free rate of return,and the market risk premium.
D)its beta value,the risk-free rate of return,the market risk premium,and its alpha value.

Question 23

Which of the following changes would not lead to an increase in a security's required return? An increase in

A)the market risk premium.
B)risk-free rate.
C)the security's beta.
D)the security's random risk.

Question 24

Dollar cost averaging

A)is a technique to buy stocks,using their betas as guides.
B)is an attempt to buy stocks over time at an average alpha value.
C)attempts to invest an average amount of funds in each portfolio asset.
D)invests an equal amount of funds in an asset at periodic intervals.

Question 25

Risk is often viewed as a range of investment returns.

Question 26

Assume that you are considering investing in Xerox common stock.You have found that its beta is +1.2 and you think a market risk premium should be 8%.If you could earn 12% on risk-free Treasury securities,Xerox has a required return of ________%.

A)24.0
B)14.4
C)21.6
D)22.4

Question 27

Which item below is not a valid reason for selling a security?

A)Its price has increased to such an extent that it is now overvalued.
B)Its alpha has increased.
C)The investor has an opportunity for a tax swap.
D)The investor's objectives change.

Question 28

A dividend reinvestment plan (DRIP)

A)is offered by most stockbrokerage firms,rather than individual companies.
B)is constructed to acquire a fixed number of shares when dividends are paid.
C)accomplishes the same objective as dollar cost averaging;i.e. ,investing a relatively fixed amount of funds at regular intervals.
D)offers investors the choice of receiving a dividend or having the company buy back some of their shares at a set price.

Question 29

Comparing a stock's required return (RR)to its expected return (ER),we can say

A)the stock is a good buy when they are equal.
B)that each represents a different concept and,so,they may have quite different values.
C)they are simply different perspectives on the same concept and,so,they should have the same value.
D)the stock is a good buy only when RR is greater than ER.

Question 30

A security's beta (also called beta weight)is a statistic that measures

A)the responsiveness of its return over time to returns of the overall market.
B)its degree of random risk.
C)the range of its returns over a period of time.
D)its risk in relation to a risk-free asset.

Question 31

Which method of investing probably involves the most risk?

A)Using the CAPM as a guide to select securities
B)Using a market-timing strategy to manage a portfolio
C)Using a buy-and-hold approach to manage a portfolio
D)Using DRIPS and dollar cost averaging to build a portfolio

Question 32

Which alternative is not true with respect to market timing?

A)It tries to increase return by trading in and out of the market over time.
B)It can increase portfolio risk.
C)Evidence shows that amateurs do it poorly,while professionals do it very well.
D)All of the above are true.

Question 33

A buy-and-hold strategy implies that you

A)do not try to increase return by frequent trading.
B)do not sell stocks for tax reasons.
C)believe in exploiting economic cycles.
D)are an unsophisticated investor who needs professional help.

Question 34

Investment risk can be broken down into random risk and market risk.By diversifying,an investor can eliminate

A)only random risk.
B)only market risk.
C)both random risk and market risk.
D)a portion,but not all,of each.

Question 35

An example of a zero-beta asset is

A)the stock of a rapidly-growing Internet company,such as Yahoo!.
B)the stock of a mature company,such as General Motors.
C)a Treasury bill.
D)a thoroughly diversified portfolio of common stocks.

Question 36

Given the data below,which is the correct ranking of securities (best to worst)in terms of their relative appeal?
Security A B C
Expected return 8% 20% 40%
Required return 14% 8% 30%

A)A,C,B
B)B,C,A
C)C,B,A
D)C,A,B

Question 37

In order to adequately diversify a portfolio,you need to buy a minimum of ________ securities.

A)5
B)20
C)75
D)115

Question 38

You have just read the annual report of a mutual fund.It boasted of a 26% return and advertised that it had beat the market return last year by three percentage points.In doing some research you discover the fund had a beta of +1.5 and the return on risk-free Treasury securities was 15.0%.Assuming a market risk premium of 8.0% should be used to evaluate performance means that

A)the fund's performance was impressive;three percentage points is significant,given the above data.
B)the fund's performance was good,but not impressive;it beat the market,but only by one percentage point not three.
C)the fund's performance was no better than what you would have expected.
D)the fund's performance was actually a percentage point less than what you would have expected.

Question 39

The higher a stock's beta,the

A)higher its expected return.
B)higher its market risk.
C)lower its random risk.
D)lower its required return.

Question 40

Assume that GM common stock has a beta of + 0.8.If you expect the market to go up 20% next year,you should also expect GM's price to go up

A)16.0%.
B)16.8%.
C)19.2%.
D)30.0%.

Question 41

Given the longer an asset is held,the greater the potential range of returns.

Question 42

Interest rate risk is closely related to inflation risk.

Question 43

Business risk refers to problems encountered by simply going into business.

Question 44

Firm specific risk can be entirely eliminated if the returns on two firms have perfect negative correlation.

Question 45

The historical record of returns and risks shows rather clearly that as investment return increases,so does investment risk.

Question 46

Over the period 2000 through 2006,the average annual return on stocks was about 20%.

Question 47

All other factors being the same,firms that are more dependent on stock issues for raising financial capital have greater financial risk.

Question 48

Over the period 1970 through 2006,the average annual return on Treasury bills was about 3%.

Question 49

Inflation risk means that an investment's return might be either higher or lower than the inflation rate.

Question 50

Holding foreign assets in a portfolio tends to reduce the portfolio risk.

Question 51

Evidence shows that returns on corporate stocks and Treasury bills were about equal.

Question 52

Over the period 1970 through 2006,the average annual return on stocks was about 11%.

Question 53

Interest-rate risk refers to the potential decline in a security's price as interest rates rise.

Question 54

Over the period 2000 through 2006,the average annual return on Treasury bills was about 3%.

Question 55

Holding gold and silver together is probably less risky than holding only one of them with GM stock.

Question 56

Financial risk is associated with business firms that borrow heavily to finance their operations.

Question 57

To reduce risk,you should look for assets with highly positively correlated related returns.

Question 58

Evidence shows that the return on U.S.Treasury bills was negative.

Question 59

To reduce risk,you should diversify among asset groups.

Question 60

Generally,the longer an asset is held,the more likely we are to receive its expected return.

Question 61

The market risk premium is the expected return for accepting overall market risk.

Question 62

A stock's alpha value = expected return minus required return.

Question 63

Dollar cost averaging is a method of selecting securities that focuses upon application of the CAPM.

Question 64

Generally,a portfolio of 20 securities is adequate to eliminate most market risk.

Question 65

Dollar cost averaging consist of investing equal dollar amounts at regular intervals.

Question 66

A market risk premium refers to difference in yields between the risk-free rate and the overall market.

Question 67

A stock's beta is positively related the market risk premium.

Question 68

In constructing a portfolio of investments,you can eliminate random risk but not market risk.

Question 69

A stock with a 1.5 beta would have 50% more risk than the overall market.

Question 70

A decrease in the market risk premium will lead to an increase in securities' required returns.

Question 71

A good investment is one with a negative alpha value.

Question 72

A dividend reinvestment plan can be a routine way to invest in a stock.

Question 73

Historical data suggest a market risk premium of about 20%.

Question 74

If the risk-free rate of return increases,required returns on all other securities should increase as well.

Question 75

Suppose the risk-free rate is 9%,the market risk premium is 8%,and a security's beta is 0.6;then,you should require a return on the security of 13.4%.

Question 76

If a security's beta is 1.5 and the market return is expected to increase 20%,the security's return should increase 21.5%.

Question 77

An increase in a security's random risk should lead to an increase in its beta value.

Question 78

A possible advantage of dollar cost averaging is that it eliminates investors' emotions.

Question 79

A security's beta is a measurement of its random risk.

Question 80

Generally,a portfolio of 20 securities is adequate to eliminate most random risk.