Question 1

The coefficient of variation,calculated as the standard deviation of expected returns divided by the expected return,is a standardized measure of the risk per unit of expected return.

Accepted Answer

The given statement is true. The coefficient of variation is used to compare the risk of investments with different expected returns on a standardized basis. It is calculated as the ratio of the standard deviation of expected returns to the mean expected return.

Question 2

A bond that had a 20-year original maturity with 1 year left to maturity has more interest rate price risk than a 10-year original maturity bond with 1 year left to maturity.(Assume that the bonds have equal default risk and equal coupon rates,and they cannot be called.)

Accepted Answer

Both bonds have the same duration left until maturity (1 year), which means their interest rate price risk is primarily determined by the time until maturity rather than their original maturity length. Since both have 1 year left, their interest rate price risk should be similar, assuming all other factors are equal.

Question 3

An individual stock's diversifiable risk,which is measured by its beta,can be lowered by adding more stocks to the portfolio in which the stock is held.

Accepted Answer

Beta measures a stock's volatility relative to the overall market, not its diversifiable risk. Diversifiable risk is reduced through portfolio diversification, but beta reflects market risk, which cannot be diversified away.

Question 4

Time lines cannot be constructed in situations where some of the cash flows occur annually but others occur quarterly.

Accepted Answer

Time lines can be constructed for any set of cash flows, regardless of their frequency. The timeline will simply show the cash flows at their respective time intervals (e.g. annual or quarterly).

Question 5

One key conclusion of the Capital Asset Pricing Model is that the value of an asset should be measured by considering both the risk and the expected return of the asset,assuming that the asset is held in a well-diversified portfolio.The risk of the asset held in isolation is not relevant under the CAPM.

Accepted Answer

According to the CAPM, the relevant risk of an asset is its contribution to the risk of a well-diversified portfolio, not its standalone risk. Therefore, the value of an asset should be measured by considering its expected return and its contribution to the risk of the portfolio.

Question 6

According to the Capital Asset Pricing Model,investors are primarily concerned with portfolio risk,not the risks of individual stocks held in isolation.Thus,the relevant risk of a stock is the stock's contribution to the riskiness of a well-diversified portfolio.

Accepted Answer

According to the CAPM, investors are primarily concerned with the systematic risk, or market risk, of a stock rather than its idiosyncratic risk. This systematic risk is the stock's contribution to the riskiness of a well-diversified portfolio.

Question 7

Managers should under no conditions take actions that increase their firm's risk relative to the market,regardless of how much those actions would increase the firm's expected rate of return.

Accepted Answer

This statement is too absolute and not always true. Managers may need to take on some level of risk to achieve higher returns and remain competitive in the market. However, they should carefully assess and manage the level of risk they take on to ensure it is within acceptable limits for the company's risk tolerance and financial goals.

Question 8

If the discount (or interest)rate is positive,the present value of an expected series of payments will always exceed the future value of the same series.

Accepted Answer

The present value of an expected series of payments will be less than the future value of the same series if the discount (or interest) rate is positive, because the value of money decreases over time when discounted at a positive rate.

Question 9

According to the nonconstant growth model discussed in the textbook,the discount rate used to find the present value of the expected cash flows during the initial growth period is the same as the discount rate used to find the PVs of cash flows during the subsequent constant growth period.

Accepted Answer

The nonconstant growth model assumes a single discount rate is used throughout the entire valuation process, both for the initial period of nonconstant growth and the subsequent period of constant growth, to discount all expected cash flows to their present values.

Question 10

Some of the cash flows shown on a time line can be in the form of annuity payments while others can be uneven amounts.

Accepted Answer

This statement is true, as some cash flows can be in the form of regular annuity payments with equal amounts over time, while others can be uneven, one-time amounts.

Question 11

Because short-term interest rates are much more volatile than long-term rates,you would,in the real world,generally be subject to much more interest rate price risk if you purchased a 30-day bond than if you bought a 30-year bond.

Accepted Answer

Long-term bonds are generally more sensitive to interest rate changes than short-term bonds, meaning that their prices are more volatile in response to interest rate fluctuations.

Question 12

Diversification will normally reduce the riskiness of a portfolio of stocks.

Accepted Answer

By investing in a variety of stocks across different industries and sectors, diversification can help spread and reduce the overall risk of a portfolio. This is because events that negatively affect one industry or sector may not affect others in the same way, thereby cushioning the portfolio's overall performance.

Question 13

When adding a randomly chosen new stock to an existing portfolio,the higher (or more positive)the degree of correlation between the new stock and stocks already in the portfolio,the less the additional stock will reduce the portfolio's risk.

Accepted Answer

This statement is true because a higher degree of correlation indicates that the new stock moves in the same direction as the stocks already in the portfolio, meaning that the portfolio is already exposed to similar risks. Therefore, the addition of the new stock will not significantly increase or decrease the portfolio's risk. On the other hand, a lower degree of correlation indicates that the new stock moves differently from the stocks already in the portfolio, potentially providing diversification benefits and reducing the portfolio's overall risk.

Question 14

If a bank compounds savings accounts quarterly,the effective annual rate will exceed the nominal rate.

Accepted Answer

Compounding quarterly means that the interest is added to the account balance four times per year, which results in more frequent compounding than if it were compounded annually. This leads to a higher effective annual rate, which takes into account how often compounding occurs. Therefore, the effective annual rate will exceed the nominal rate for quarterly compounding.

Question 15

For bonds,price sensitivity to a given change in interest rates is generally greater the longer before the bond matures.

Accepted Answer

This is known as the duration principle, which states that the longer the time to maturity of a bond, the greater the percentage change in price for a given change in interest rates. This is because longer-term bonds have more future cash flows that are affected by changes in interest rates, making them more sensitive to those changes.

Question 16

The tighter the probability distribution of its expected future returns,the greater the risk of a given investment as measured by its standard deviation.

Accepted Answer

The tighter the probability distribution of expected future returns, the lower the risk of an investment as it means there is less variability in potential returns. Therefore, the statement is false.

Question 17

A "growing annuity" is a cash flow stream that grows at a constant rate for a specified number of periods.

Accepted Answer

A growing annuity is a cash flow stream that grows at a constant rate for a specified number of periods.

Question 18

Disregarding risk,if money has time value,it is impossible for the future value of a given sum to exceed its present value.

Accepted Answer

If money has time value, it means that the value of money changes over time due to factors such as inflation, interest rates, etc. Therefore, it is possible for the future value of a given sum to exceed its present value, especially if an investment with a higher rate of return is made. However, it is important to consider risk when making investment decisions.

Question 19

The market value of any real or financial asset,including stocks,bonds,or art work purchased in hope of selling it at a profit,may be estimated by determining future cash flows and then discounting them back to the present.

Accepted Answer

The statement is true. The value of an asset can be estimated by assessing its future cash flows and then discounting them back to their present value. This allows investors to determine the fair market value of an asset based on its potential to generate income or appreciation over time. This concept is widely used in finance and investment analysis to evaluate the worth of a wide range of assets, from stocks and bonds to real estate and collectibles.

Question 20

A zero coupon bond is a bond that pays no interest and is offered (and subsequently sells initially)at par.These bonds provide compensation to investors in the form of capital appreciation.

Accepted Answer

A zero coupon bond does not pay interest (coupon) and is typically sold at a deep discount to its face value, not at par. The investor's compensation comes from the bond being redeemed at its full face value at maturity, realizing a gain from the initial purchase price.

Quiz 29: Basic Financial Tools: a Review