MODULE 6 QUIZ

Element Corp had these annual returns over the past four years: +12%, +6%, -8%, and +20%. What is the standard deviation for Element Corp. over the past four years?

11.8% LO 6.2.2

Which of the following is the most appropriate and accurate indicator for determining a client's risk tolerance level? A) Questionnaire B) There is no single appropriate method for determining risk tolerance. C) Beta D) Standard deviation

A client's risk tolerance level is an intangible and subjective factor. No single method accurately determines that risk level. LO 6.2.5

Stock XYZ has an average return of 12%; its returns fall within a range of -2% to +26% approximately 68% of the time. Which one of these numbers is closest to the standard deviation of returns of Stock XYZ? A) 28% B) 14% C) 19% D) 8%

A standard deviation of 14% means an investor can expect a return on an investment to vary ±14 from the average return approximately 68% of the time. LO 6.2.2

You are considering buying a stock that has a mean return of 14% and a standard deviation of 20. You can expect the return to fall within what range 95% of the time?

A stock with a standard deviation of 20 will deviate from the mean by one standard deviation 68% of the time, two standard deviations 95% of the time, and three standard deviations 99% of the time. So for this stock, plus or minus 40 from the mean of 14% would be -26% and +54%. LO 6.2.2

You are about to recommend the purchase of an additional mutual fund to add to a client's portfolio, with the objective of reducing the portfolio's total risk. Upon analysis of several funds, you determine that the standard deviations of the current portfolio and each of the potential new funds are equal, but that the correlation coefficients of these funds with the current portfolio are as shown in the answer choices below. Which of the funds should you recommend? A) Fund D: correlation coefficient = -0.08 B) Fund A: correlation coefficient = +0.91 C) Fund B: correlation coefficient = +0.65 D) Fund C: correlation coefficient = 0.00

According to modern portfolio theory, total portfolio risk, as measured by standard deviation, is lowered by combining securities in a portfolio so that individual securities have negative (or low positive) correlations between each other's rates of return. LO 6.2.4

Taylor, a personal friend of yours, has been a practicing veterinarian for eight years. She is 35 years old and has a 3-year-old daughter. Taylor has a moderate risk tolerance, wants to save for retirement, and is considering increasing her investment in the following mutual fund. Taylor has asked you for your recommendation. Risk-free return 7.0% Return of market 12.5% Which of the following is CORRECT regarding the risk and return of the fund? A) The fund has less risk and greater return than the market. B) The fund has less risk and less return than the market. C) The fund has equal risk and greater return than the market. D) The fund has greater risk and less return than the market.

B. A beta of 1 represents the risk of the market. A beta of less than 1 represents risk less than the market's risk, and a beta of greater than 1 represents risk greater than that of the market. LO 6.2.1

Stock XYZ has an average return of 18% with a standard deviation of 21. Within what range could an investor expect a return to fall 68% of the time? A) 3% to 39% B) 0% to 21% C) -3% to 18% D) -3% to 39%

By definition, an investment's return will be within one standard deviation of the mean return 68% of the time. The mean return of 18% plus or minus one standard deviation is 18% - 21% (-3%) and 18% + 21% (39%). LO 6.2.2

Which of the following statements regarding investment theory is NOT correct? A) Combining two stocks with a negative covariance can significantly reduce the portfolio's standard deviation. B) In a well-diversified portfolio, diversifiable risk is zero. C) The beta coefficient may be used to help select a portfolio that is consistent with an investor's willingness to assume unsystematic risk. D) A correlation coefficient of 0.14 between the returns of Stock A and Stock B indicates that very little of Stock A's returns can be attributed to the returns of Stock B.

C. Beta is a measure of systematic risk, not unsystematic risk. The beta coefficient may be used to help select a portfolio that is consistent with an investor's willingness to assume systematic risk. LO 6.2.1

Gordon, age 40, wants to invest in a mutual fund that will provide capital appreciation. He wants a fund that will do as well as the overall market and has a low expense ratio, but he does not want to assume a high risk to achieve his objective. He is considering purchasing one of the following mutual funds: Fund A: a growth mutual fund that has a beta of 1.10 and invests in medium- to high-grade common stock Fund B: an index mutual fund that has a beta of 1.00 and invests in common stock that mirrors the S&P 500 Index Which of these funds would best meet Gordon's objective? A) Fund A, because it invests in lower-risk stocks than Fund B B) Fund A, because it can be expected to outperform the market and has an acceptable level of risk C) Fund B, because it has a beta of 1.00, has low expenses, and is less risky D) neither alternative is appropriate for his objective

C. Fund B can be expected to do as well as the overall market, will have a low expense ratio, and is less risk, as measured by beta, than Fund A. LO 6.2.1

Which of the following statements concerning a knowledge of the risk/return relationship is CORRECT? Future risk/return relationships are not guaranteed to match past risk/return relationships. Chances are that past relative relationships will not continue into the future. A reduction in risk also means a reduction in the possible return on the investment. The smaller the dispersion of returns, the greater the risk associated with a particular investment.

Chances are that past relative relationships will continue into the future. The smaller the dispersion of returns, the lower the risk associated with a particular investment. LO 6.1.1

Which of the following risks is specific to international investing? A) Business risk B) Reinvestment rate risk C) Event risk D) Exchange rate risk

Exchange rate risk pertains to foreign investments and is the risk for a U.S. investor that the exchange rates between a foreign currency and the U.S. dollar change adversely; that is, when the U.S. investor converts the foreign currency into U.S. dollars, she will get fewer dollars than previously. LO 6.1.2

Most fixed-income securities are subject to which of the following risks? Purchasing power risk Liquidity risk Default risk Reinvestment rate risk

Fixed-income securities are subject to a number of risks including purchasing power, liquidity, default, and reinvestment rate risk. LO 6.1.2

An investor is interested in holding a diversified portfolio to reduce unsystematic risk. This can best be accomplished by buying stock in A) companies with strong earnings and revenue growth. B) companies with low betas. C) foreign companies. D) companies with low correlation coefficients between them.

Holding stocks that have a low correlation coefficient between them will result in a diversified portfolio that reduces and virtually eliminates the degree of unsystematic (business) risk in the portfolio. Buying stocks in international companies and stocks with low betas can help to reduce systematic risk, but only if they have low correlations with other stocks. Buying stocks in companies with strong revenue and earnings growth often results in acquiring significant company-specific risk that is attributable to the underlying business. LO 6.2.4

Mutual fund I has a standard deviation of 4% and an expected return of 10%. Mutual fund J has a standard deviation of 8% and an expected return of 13%. If I and J have a correlation coefficient of -1.0, which of the following statements is CORRECT? A) A portfolio combining funds I and J may have an expected return less than 10%. B) J is less risky than I on a risk-adjusted basis. C) There is no combination of I and J such that the portfolio's standard deviation is zero. D) I and J are perfectly negatively correlated.

J's coefficient of variation is 8% ÷ 13% = 0.615. I's coefficient of variation = 4% ÷ 10% = 0.40. I is less risky, on a risk-adjusted basis, than J. Because I and J are perfectly negatively correlated (correlation coefficient of -1.0), there exists a combination of I and J such that the standard deviation is zero. The expected return of a portfolio is the weighted average, which cannot be less than the lowest expected return of the portfolio components. LO 6.2.4

Identify the types of bonds that are subject to the most default risk. A) U.S. Treasury bonds B) Junk bonds C) AA rated general obligation bonds D) U.S. savings bonds

Junk bonds, sometimes referred to as high-yield bonds, are subjected to the most default risk. Obligations of the U.S. government are free from default risk. AA rated bonds are not free from default risk, but they are less likely to default than junk bonds. LO 6.1.2

Which of these is NOT an unsystematic risk? A) Business risk B) Default risk C) Market risk D) Liquidity risk

Market risk. Unsystematic risk is the risk that affects only one company, country, or sector and its securities. Market risk is an example of a systematic risk.

The Mountain Fund has a standard deviation of 22, a mean return of 15%, and a correlation coefficient with the S&P 400 Mid-Cap Index of 0.85. Mountain Fund is subject to how much systematic risk?

R-squared gives us the amount of systematic risk, and we have been given R (correlation coefficient). So, we square 0.85 to come up with an R-squared of 0.7225, or 72%. LO 6.2.5

The Finite Mutual Fund has a correlation coefficient of 0.90 with the S&P 500 Index. How much of the price movement of the Finite Mutual Fund is explained by the S&P 500 Index? A) 75% B) 81% C) 100% D) 90%

R-squared gives us the amount of systematic risk, and we have been given R (correlation coefficient). So, we square 0.90 to come up with an R-squared of 0.81, or 81%. LO 6.2.5

The Dow Jones Utility Average has recently dropped 30% from its high, and you decide to recommend a utility sector fund to your clients. If they invest in the fund, your clients will be exposed to which of these risks? Interest rate risk Business risk Default risk Financial risk

Sector funds are subject to the unsystematic (diversifiable) risks of business risk and financial risk; utility sector funds are also subject to the nondiversifiable interest rate risk because of their high debt to total capital percentage. Stocks are not subject to default risk. LO 6.1.2

Assume your client's portfolio contains these: $20,000 of Stock A with a beta of 0.90 $50,000 of Stock B with a beta of 1.20 $30,000 of stock C with a beta of 1.10 What is the beta coefficient for this portfolio? A) 1.16 B) 1.11 C) 1.00 D) 1.05

The answer is 1.11. Calculated as follows: 0.20 × 0.90 = 0.18 0.50 × 1.20 = 0.60 0.30 × 1.10 = 0.33 0.18 + 0.60 + 0.33 = 1.11 Using the HP 10bII+: 0.9, INPUT, 20,000, Σ+ 1.2, INPUT, 50,000, Σ+ 1.1, INPUT, 30,000, Σ+ SHIFT, 6 key (x̅w,b) = 1.11 LO 6.2.1

What is the weighted average beta of a portfolio with 20% in Stock A with a beta of 0.9, 50% in Stock B with a beta of 1.2, and 30% in Stock C with a beta of 1.1?

The answer is 1.11. You can complete this calculator long-hand in this way: (0.9 x .2) + (1.2 x .5) + (1.1 x .3) = (0.18) + (0.6) + (.33) = 1.11 You can also do this faster using the following keystrokes on the HP 10bII+ (see Financial Calculator Workbook for steps using TI BAII+): 0.9, INPUT, 20, ∑+, 1.2, INPUT, 50, ∑+, 1.1, INPUT, 30, ∑+, DOWNSHIFT, 6 (alternate function is weighted average) = 1.11. LO 6.2.1

A stock that you are researching has an expected return of 22%, a beta of 1.2, a correlation coefficient of 0.65 with the Russell 2000, an R2 of 0.38 with the S&P 500, and a standard deviation of 28%. Which one of these is the stock's coefficient of variation?

The answer is 1.27. CV = standard deviation of asset ÷ expected return of asset, 28% ÷ 22% = 1.27. LO 6.2.3

Security A has a standard deviation of 12% and the market has a standard deviation of 16%. The correlation coefficient between Security A and the market is 0.75. What percent of the change in Security A's price can be explained by changes in the market?

The answer is 56%. Because the correlation coefficient is 0.75, the coefficient of determination (R2) is 0.5625, or 56%. Therefore, only 56% of investment returns can be explained by changes in the market (i.e., systematic risk represents 56%). LO 6.2.5

Bobby owns ABC stock that has mean return of 10.65%, a beta of 1.12, and a standard deviation of 9.05%. He decides to purchase MEJ stock that has a mean return of 11.5%, a beta of 0.98, and a standard deviation of 12.3%. Assume these stocks are weighted in the portfolio 70% for ABC and 30% for MEJ. Also, these stocks exhibit a covariance of 19.86. Calculate the standard deviation for this two-asset portfolio.

The answer is 7.88%.

What is the covariance between OPC and NIR stocks with a standard deviation of 9.13% and 11%, respectively, and a correlation coefficient of 0.85?

The answer is 85.37. The covariance between the two stocks is 85.37 (9.13 × 11 × 0.85). Covariance measures the extent to which two variables move together, either positively (together) or negatively (opposite). LO 6.2.4

ABC Mutual Fund has a correlation coefficient of 0.93 with the S&P 500 Index. How much of the price movement of the fund can be explained by the S&P 500 Index?

The answer is 86%. The correlation coefficient (R) has been given, so it needs to be squared (R2) in order to come up with the coefficient of determination. (0.932 = 0.8649, or 86%) LO 6.2.5

STU Corporation stock has an average rate of return of 24% and a standard deviation of 10%. The risk-free rate of return is 4%. Assuming the historical returns for STU stock are normally distributed, calculate the probability that this stock will have a return in excess of the risk-free rate of return.

The answer is 97.5%. The probability of a return above 24% is 50%. The probability of a return between 4% and 24% is 47.5% (95% ÷ 2). Therefore, the probability of a return above 4% is 97.5% (50% + 47.5%). LO 6.2.2

Steve and Haley, ages 48 and 45 respectively, invest in large-cap stocks, international stock mutual funds, and rental real estate. They consider themselves moderately aggressive investors. Their investment portfolio is subject to which of these investment risks? Investment manager risk Financial risk Exchange rate risk Default risk

The answer is I, II, and III. Their investment portfolio is subject to all of these risks except default risk. Investment manager risk is associated with the skills and philosophy of their mutual fund portfolio managers. Financial risk is the risk that a company's financial structure may negatively affect the value of an equity investment. By holding investments in international stock mutual funds, they are subject to exchange rate risk. LO 6.1.2

Candi purchases a 30-year zero-coupon corporate bond. The bond was issued by ABC Company, a Fortune 500 company. Her investment is subject to which of these risks? Default risk Reinvestment rate risk Purchasing power risk Interest rate risk

The answer is I, III, and IV. Zero-coupon bonds are not subject to reinvestment rate risk. However, they are subject to purchasing power, interest rate, and default risk. LO 6.1.2

Which of these are nondiversifiable risks? Business risk Interest rate risk Market risk Purchasing power risk

The answer is II, III, and IV. Business risk is a type of diversifiable, or unsystematic, risk. LO 6.1.2

Which of these statements regarding investment risk is CORRECT? A firm's decision to buy back some of its own stock in the open market by borrowing funds through a new bond issue is an example of reinvestment rate risk. Rising inflation represents purchasing power risk. A decline in a firm's share price as a result of a 20% decline in the S&P 500 Index represents market risk. A reduction in the value of an international stock mutual fund because of a depreciation of the Euro is an example of exchange rate risk.

The answer is II, III, and IV. Only statement I is incorrect. A firm's decision to buy back some of its own stock in the open market by borrowing funds through a new bond issue is an example of financial risk. LO 6.1.2

Choose the best measure of risk for an asset held in a well-diversified portfolio. A) Semivariance B) Correlation coefficient C) Beta D) Covariance

The answer is beta. Beta is the best measure of risk for an asset held in a well-diversified portfolio. LO 6.2.1

Which of these statements concerning portfolio diversification is CORRECT? A) Diversification reduces the portfolio's expected return because diversification reduces a portfolio's total risk. B) The benefits of diversification are not realized until at least 25 individual securities are included in the portfolio. C) By increasing the number of securities in a portfolio, the total risk would be expected to fall at a decreasing rate. D) Only systematic risk is reduced as diversification is increased.

The answer is by increasing the number of securities in a portfolio, the total risk would be expected to fall at a decreasing rate. As more and more securities are added to a portfolio, diversification benefits begin to diminish. The main attraction of diversification is the reduction of risk without an accompanying loss of return. LO 6.1.1

Which of these risks is diversifiable? A) Interest rate risk B) Market risk C) Purchasing power risk D) Default risk

The answer is default risk. Default risk is diversifiable (unsystematic) risk. The others are examples of systematic risk, or nondiversifiable risk. LO 6.1.2

ABC Corporation is a manufacturer of electronic devices used in the manufacturing of airplanes. Five years ago, the corporation floated a $100 million bond issue that would be used to finance improvements at its main manufacturing and distribution center. However, orders for its products have dropped dramatically due to much lower than anticipated demand. The company believes it may miss paying the coupon payment on the bond issue in the upcoming fiscal year. Which of these risks may the owners of ABC Corporation bonds be subject to by holding the bonds?

The answer is default risk. Default risk is the risk that a business will be unable to service its debt obligations. LO 6.1.2

Bobby has these securities in his portfolio: ABC common stock, XYZ common stock, PQR mutual fund (domestic small cap), DEZ mutual fund (foreign small cap), 30-year Treasury bond, and 5-year Treasury note. Point out the risk that should NOT concern Bobby. A) Reinvestment rate risk B) Systematic risk C) Default risk D) Financial risk

The answer is default risk. Treasuries are considered default risk-free. Financial risk is the uncertainty introduced from the method by which a firm finances its assets (i.e., debt versus equity financing). Reinvestment rate risk is the risk that as cash flows are received they will be reinvested at lower rates of return than the investment that generated the cash flows. Systematic risk is the risk that all securities are subject to and typically cannot be eliminated through diversification. LO 6.1.2

Andy owns a yen-denominated bond that matures in 15 years. Andy's bond is subject to which one of these combinations of systematic risk?

The answer is exchange rate risk and reinvestment rate risk. Because Andy owns a foreign investment, he would be subject to exchange rate risk. Also, coupon-paying bonds are subject to reinvestment rate risk. LO 6.1.2

Bill and Jane are considering adding additional assets to their investment portfolio. They consider themselves moderate-to-high-risk investors. Based on safety of principal, point out the investment that would offer the couple the least amount of protection from risk. A) High-grade common stock B) Futures C) Balanced mutual funds D) Real estate

The answer is futures. Based on the risk-return pyramid, futures will offer the couple the least amount of protection. However, due to their high risk, futures may offer the greatest amount of return. LO 6.1.1

Investors who want to bear the least amount of risk should acquire stocks with beta coefficients A) less than 0.5. B) greater than 1.0. C) less than 1.0. D) greater than 1.5.

The answer is less than 0.5. When seeking investments having the least amount of risk, the lowest beta should be selected. LO 6.2.1

Which one of these alternatives correctly outlines the importance of the portfolio perspective? A) Market participants should attempt to eliminate the unsystematic risk associated with each security by forming portfolios that will diversify away this risk. B) Market participants should analyze the risk-return trade-off of each individual security. C) Market participants should analyze the risk-return trade-off of the portfolio, not the risk-return trade-off of the individual investments in a portfolio. D) Market participants should focus on the systematic risk of the components of a portfolio not the unsystematic risk of the components of a portfolio.

The answer is market participants should analyze the risk-return trade-off of the portfolio, not the risk-return trade-off of the individual investments in a portfolio. The key underlying principle of the portfolio perspective is that market participants should analyze the risk-return trade-off of the portfolio as a whole, not the risk-return trade-off of the individual investments in the portfolio. LO 6.1.1

A general risk component representing the variability of a stock's total return as it directly relates to overall movements in the general economy is known as A) reinvestment rate risk. B) systematic risk. C) financial risk. D) business risk.

The answer is systematic risk. Systematic risk, also referred to as market risk, is the variability in a stock's total return that is directly associated with overall movements in the general economy and cannot be eliminated through diversification. LO 6.1.2

A distribution with a mean that is less than its median most likely A) is negatively skewed. B) has negative excess kurtosis. C) is positively skewed. D) symmetrical.

The answer is that the distribution is negatively skewed. A distribution with a mean that is less than its median is a negatively skewed distribution. A negatively skewed distribution is characterized by many small gains and a few extreme losses. Note that kurtosis is a measure of the peakedness of a return distribution. In a symmetrical distribution, the mean, median, and mode are all equal. LO 6.2.2

A beta coefficient of 1.3 indicates that a stock A) has more unsystematic risk than the market. B) is less volatile than the market. C) has less unsystematic risk than the market. D) is more volatile than the market.

The answer is that the stock is more volatile than the market. A beta that is higher than 1.0 indicates that the stock's volatility and risk are higher than that of the market. LO 6.2.1

Which one of these is a measure of a security's risk-adjusted return? A) Coefficient of determination B) Correlation coefficient C) Covariance D) Coefficient of variation

The answer is the coefficient of variation. The coefficient of variation is one of several ways to compute a security's risk-adjusted return. The coefficient of determination measures how much of the movement of a security is attributable to a second security. The correlation coefficient measures the strength of the relationship between two securities. Covariance is used in the computation of a portfolio's standard deviation. LO 6.2.3

Exchange rate risk refers to fluctuations in A) the price of one currency relative to other currencies. B) the values of bonds and other debt instruments. C) the prices of stocks on the New York Stock Exchange. D) the value of an investor's portfolio.

The answer is the price of one currency relative to other currencies. Relative currency prices and changes to them are the basis of exchange rate risk. LO 6.1.2

If two stocks have positive covariance, which of these statements is CORRECT? A) The rates of return tend to move in the same direction relative to their individual means. B) The two stocks must be in the same industry. C) The rates of return tend to move in the opposite direction relative to their individual means. D) If one stock doubles in price, the other will also double in price.

The answer is the rates of return tend to move in the same direction relative to their individual means. If one stock doubles in price, the other will also double in price is true if the correlation coefficient = 1. The two stocks need not be in the same industry. LO 6.2.4

If a security has an average return of 14.2% and a standard deviation of 8.4%, then A) the security's annual volatility can be expected to be within a range approximately 8.4% above and 8.4% below the current fair market value. B) the security's returns can be expected to be between 8.4% and 14.2% approximately 95% of the time. C) the security's returns can be expected to be between 5.8% and 22.6% approximately 68% of the time. D) the security's returns can be expected to always be positive.

The answer is the security's returns can be expected to be between 5.8% and 22.6% approximately 68% of the time. This security can be expected to have a return that does not range beyond one standard deviation on either side of its average return approximately 68% of the time. LO 6.2.2

You are comparing two stocks based on the statistics below. Which one is the better investment based on the risk/return relationship? Stock AStock BAverage Return3.00%9.00%Standard Deviation 3.9511.86

The answer is the two stocks have equal risk/reward profiles. The coefficient of variation is used to evaluate risk/return and is 3.95 ÷ 3.00 = 1.32 for stock A and 11.86 ÷ 9.00 = 1.32 for stock B, so both are equal in the amount of return relative to the risk. LO 6.2.3

Diversification reduces A) purchasing power risk. B) market risk. C) systematic risk. D) unsystematic risk.

The answer is unsystematic risk. Unsystematic risk can be diversified away by investing in approximately 10-15 large company stocks in different industries and 25-30 small company stocks in different industries. Systematic risk cannot be reduced by diversification. LO 6.1.1

The issuer-specific component of the variability in a stock's total return that is unrelated to overall market variability is known as A) fundamental risk. B) nondiversifiable risk. C) unsystematic risk. D) systematic risk.

The answer is unsystematic risk. Unsystematic risk is unique to a single security, business, industry, or country and may be reduced by diversification. LO 6.1.2

All of the following statements correctly explain investment risk except A) investors expect to earn a higher rate of return for assuming a higher level of risk. B) systematic risk may be reduced or eliminated by effective portfolio diversification. C) the beta coefficient measures an individual stock's relative volatility to the market. D) a stock's level of risk is a combination of market risk and diversifiable risk.

Unsystematic (diversifiable) risk may be effectively managed through portfolio diversification. LO 6.1.1

Which of the following is the risk that disappears in the portfolio construction process? A) Interest rate risk B) Purchasing power risk C) Unsystematic risk D) Systematic risk

Unsystematic risk (diversifiable risk) is the risk that is eliminated when the investor builds a well-diversified portfolio. LO 6.1.1

How to find least risk per unit of return?

Using the coefficient of variation (CV). JJJ Fund: 17 ÷ 10 = 1.70 LLL Fund: 25 ÷ 18 = 1.39 NNN Fund 10 ÷ 7 = 1.43 YYY Fund 19 ÷ 11 = 1.73 The stock with the lowest CV has the least amount of total risk per unit of expected return. LO 6.2.3