Chapter 7

What is the beta for stock A if the covariance between stock A and the market is 1.5 and the variance of the market is 2.5? a. .4 b. 3.75 c. .6 d. 1.67

.6 1.5/2.5 = .6

What is the return on a portfolio that consists of: $50,000 in an index fund, $30,000 in a bond fund, and $20,000 in a foreign stock fund? The expected returns are 7 percent, -3 percent, and 18 percent, respectively. a. 6.2% b. 7.26% c. 22% d. .06%

6.2% 50,000/ 100,000 = .5 30,000/100,000 = .3 20,000/100,000 = .2 (.07*.5)+(-.03*.3)+(.18*.2) (.035) + (-.009) + (.036)

Compound annual averages are usually ______ arithmetic averages. a. smaller than b. larger than c. the same as

Smaller than

Rank the following in order from the lowest variance to the highest variance over the time period from 1900-2014. Government Bonds Treasury Bills Common Stock

Treasury Bills Government Bonds Common Stock

True or false: It is possible for the specific risk of a portfolio to be reduced to zero. True False

True

Arrange the following investments from lowest historical risk premium to highest historical risk premium. Government Bonds Common Stocks US Treasury Bills

US Treasury Bills Government Bonds Common Stock

By definition, what is the beta of the average asset equal to? a. 1 b. 2 c. 0 d. Between 0 and 1

a. 1

Which of the following are true about the historical equity risk premiums of the countries studied by Dimson, Marsh, and Staunton? a. Switzerland had the lowest equity risk premium b. U.S. investors fared far better than investors around the world. c. The world average equity risk premium was 4.6 percent. d. Italy had the highest equity risk premium.

a. Switzerland had the lowest equity risk premium

What is the impact on the variance of a two-asset portfolio if the covariance between the two securities is negative? a. The variance can increase or decrease. b. The variance will decrease. c. There will be no effect on the variance. d. The variance will increase.

b. The variance will decrease.

Which of the following statements are true about variance? (select all that apply) a. Variance measures a security's expected return over many periods. b. Computation of variance requires the use of a computer. c. Standard deviation is the square root of variance. d. Variance is a measure of the squared deviations of a security's return from its expected return.

c. Standard deviation is the square root of variance. d. Variance is a measure of the squared deviations of a security's return from its expected return.

Compound annual averages are usually ______ arithmetic averages. a. less than b. greater than c. equal to

less than

Studying market history can reward us by demonstrating that: (Select all that apply) a. the greater the potential reward is, the lower the risk b. there is a reward for bearing risk c. the stock market is nothing but a casino d. the greater the potential reward is, the greater the risk

there is a reward for bearing risk the greater the potential reward is, the greater the risk

If stock GHI has returns of 10% and 15% over 2 years, the compound annual average rate of return can be calculated by: {[(1.10)(1.15)]^0.5} -1 (1.10/1.15)0.5+1 [(1.10+1.15)(0.5)]-1 {[1.10+1.15]^0.5}+1

{[(1.10)(1.15)]^0.5} -1

If stock GHI has returns of 10% and 20% over 2 years, the compound annual average rate of return can be calculated by: Multiple choice question. [(1.10+1.20)(0.5)]-1 {[1.10+1.20]^0.5}+1 (1.10/1.20)0.5+1 {[(1.10)(1.20)]^0.5} -1

{[(1.10)(1.20)]^0.5} -1

If a security's expected return is equal to the expected return on the market, its beta must be ____. a. 1 b. 2 c. 0 d. -1

a. 1

A firm is exposed to both market and specific risks. Which of the following are examples of market risks? (select all that apply) a. An increase in the Federal funds rate b. A fire in a manufacturing plant c. Management turnover d. An increase in the corporate tax rate

a. An increase in the Federal funds rate d. An increase in the corporate tax rate

As more securities are added to a portfolio, what will happen to the portfolio's total specific risk? (select all that apply) a. It may eventually be eliminated. b. It is likely to increase. c. It will not change. d. It is likely to decrease.

a. It may eventually be eliminated. d. It is likely to decrease.

Which type of risk does not change as we add more securities to a portfolio? a. Market risk b. Idiosyncratic risk c. Specific risk d. Company-specific risk

a. Market risk

Which of the following are examples of market risk? (select all that apply) a. Regulatory changes in tax rates b. Failed processes c. Future rates of inflation d. Labor strikes

a. Regulatory changes in tax rates c. Future rates of inflation

What is the main purpose of holding a diversified portfolio? a. To reduce total risk by spreading investment dollars across various assets b. To meet SEC regulatory requirements c. To increase total return by spreading investment dollars across various assets d. To reduce trading costs of the portfolio

a. To reduce total risk by spreading investment dollars across various assets

The average return on the stock market can be used to ___. a. compare stock returns with the returns on other securities b. find ways to beat the competition c. accurately forecast the market's returns in the future

a. compare stock returns with the returns on other securities

If the variance of a portfolio increases, then the portfolio standard deviation will _____. a. increase b. decrease c. not be affected

a. increase

Compound annual averages are usually ______ arithmetic averages. a. less than b. equal to c. greater than

a. less than

The ____________ is the difference between risky returns and risk-free returns. a. risk premium b. real return c. subliminal return d. nominal rate of return

a. risk premium

The standard deviation is the ______ of the variance. a. inverse b. square root c. square d. exponent

b. square root

The square of the standard deviation is equal to the ____. a. Sharpe ratio b. variance c. mean d. median return

b. variance

The standard deviation for common stock returns from 1900 to 2017 was: a. 25.8% b. 10.2% c. 19.7% d. 16.4%

c. 19.7%

Which of the following statements are true about correlation? (select all that apply) a. Correlation is not related to covariance. b. The correlation between two securities remains constant over time. c. Correlation is related to covariance. d. Correlation measures the interrelationship between the returns of two securities.

c. Correlation is related to covariance. d. Correlation measures the interrelationship between the returns of two securities.

What is specific risk? a. It is a risk that affects all the assets in a diversified portfolio. b. It is a risk that is always caused by external factors. c. It is a risk that affects a single asset or a small group of assets. d. It is a risk that is unavoidable.

c. It is a risk that affects a single asset or a small group of assets.

What is market risk? a. It is a risk that increases in a systematic, gradual fashion. b. It is a risk that is caused by failure of the internal control system of a corporation. c. It is a risk that threatens all businesses and cannot be diversified away. d. It is a risk that affects only one or a few assets.

c. It is a risk that threatens all businesses and cannot be diversified away.

What does beta measure? a. It measures the risk of a security in relation to a specific industry. b. It measures the risk of a security in relation to corporate bond holdings. c. It measures the risk of a security in relation to the overall market. d. It measures the risk of a security in relation to international stock markets.

c. It measures the risk of a security in relation to the overall market.

Which measure of return is best for making unbiased estimates of future returns? a. The average compound annual return b. The accounting average rate of return c. The arithmetic average return d. The average dollar return

c. The arithmetic average return

What is likely to happen to the total specific risk of a portfolio when we add new securities to a portfolio? a. The total specific risk of the portfolio will increase. b. There will be no effect on the total specific risk. c. The total specific risk of the portfolio will decrease.

c. The total specific risk of the portfolio will decrease.

The standard deviation for common stock returns from 1900 to 2014 was: a. 16.4% b. 25.8% c. 10.2% d. 19.9%

d. 19.9%

From 1900 to 2014, the U.S. had the world's ______ highest market risk premium. a. 15th b. 1st c. 18th d. 8th

d. 8th

What is market risk? a. It is a risk that affects only one or a few assets. b. It is a risk that is caused by failure of the internal control system of a corporation. c. It is a risk that increases in a systematic, gradual fashion. d. It is a risk that threatens all businesses and cannot be diversified away.

d. It is a risk that threatens all businesses and cannot be diversified away.

What is expected return? a. The expected variation in return over the next period. b. The variation in return during the last period. c. The return that an individual earned during the last period. d. The return that an individual expects to earn over the next period.

d. The return that an individual expects to earn over the next period.

What is the arithmetic average return for a stock that had annual returns of 8%, 2% and 11% for the past 3 years? a. 8% b. 6% c. 7% d. 5%

7%

If the annual stock market returns for Berry Company were 19 percent, 13 percent, and -8 percent, what was the arithmetic mean for those 3 years? a. 2% b. 1% c. 8% d. 6%

8% (19 + 13 - 8) / 3

True or false: A well-diversified portfolio will eliminate all risks. True False

False

True or false: Changes in dividend yields are excellent predictors of long-term required returns. True False

False

True or false: Investors will pay extra for firms that diversify. True False

False

True or false: Market risk will impact all securities in a portfolio equally. True False

False

The ______ mean is the best estimate of next year's return. a. compound annual b. the average of the arithmetic and compound annual mean c. arithmetic

arithmetic

What is the expected return of a portfolio consisting of stocks A and B if the expected return is 10 percent for A and 15 percent for B? Assume you are equally invested in both the stocks. a. 25% b. 12.5% c. 15% d. 10%

b. 12.5%

What is variance? a. A measure of the deviation of a security's actual return from its expected return b. A measure of the squared deviations of a security's return from its expected return c. A measure of the squared deviation of a security's actual return from the historical return of the industry d. A measure of the square of the expected return

b. A measure of the squared deviations of a security's return from its expected return

Why can an investor holding a well-diversified portfolio of securities ignore the specific risk of individual securities? a. Because specific risk is always insignificant regardless of the level of diversification b. Because specific risk should be eliminated or reduced through diversification c. Because there is a tax break for holding specific risk

b. Because specific risk should be eliminated or reduced through diversification

Which of the following are examples of specific risk? (select all that apply) a. The expected rate of inflation next year b. Changes in management c. Labor strikes d. Changes in the federal tax code

b. Changes in management c. Labor strikes

Which of the following are needed in order to compute the variance of a portfolio consisting of two stocks, A and B? a. The variance of the stock market index b. The covariance between stocks A and B c. The variances of stocks A and B d. The market value, in dollars, of the investments in stocks A and B

b. The covariance between stocks A and B c. The variances of stocks A and B d. The market value, in dollars, of the investments in stocks A and B

A firm faces many risks. Which of the following are examples of specific risks faced by a firm? (select all that apply) a. A change in the Federal Reserve's monetary policy b. The death of the CEO c. An increase in the dividend tax rate d. A hostile takeover attempt by a competitor

b. The death of the CEO d. A hostile takeover attempt by a competitor

Which of the following statements are true about expected return? (select all that apply) a. The expected return indicates the return that an investor earned in the past. b. The expected return can be calculated as the average of the returns in previous periods. c. The expected return reflects an estimate that can be based on sophisticated forecasts of future outcomes. d. The actual return can be higher or lower than the expected return.

b. The expected return can be calculated as the average of the returns in previous periods. c. The expected return reflects an estimate that can be based on sophisticated forecasts of future outcomes. d. The actual return can be higher or lower than the expected return.

The average return on the stock market can be used to ___. a. find ways to beat the market b. compare stock returns with the returns on other securities c. accurately forecast the market's returns in the future

b. compare stock returns with the returns on other securities

The standard deviation of a portfolio of two securities will be less than the weighted average of the standard deviation of the two securities when the correlation between the two securities ____. a. equals the covariance between the two securities b. is less than one c. is perfectly positive. d. is greater than one

b. is less than one

Diversification is possible as long as the correlation between securities is ____. a. equal to +1 b. less than +1 c. more than 1

b. less than +1

The variance of the return on a portfolio with many securities is _______ dependent on the covariances between the individual securities than on the variances of the individual securities. a. less b. more

b. more

In a two-asset portfolio, a ________ covariance of returns between the two securities will lead to the greatest reduction in the variance of the portfolio. a. relative b. negative c. systematic d. positive

b. negative

What is the impact on the variance of a two-asset portfolio if the covariance between the two securities is negative? a. There will be no effect on the variance. b. The variance will increase. c. The variance will decrease. d. The variance can increase or decrease.

c. The variance will decrease.

What is the main purpose of holding a diversified portfolio? a. To increase total return by spreading investment dollars across various assets b. To meet SEC regulatory requirements c. To reduce total risk by spreading investment dollars across various assets d. To reduce trading costs of the portfolio

c. To reduce total risk by spreading investment dollars across various assets

The dividend yield for a one-year period is equal to the annual dividend amount divided by the ____. a. ending stock price b. average of the beginning and ending stock prices c. beginning stock price

c. beginning stock price

The concept that present values can be added because the firm value is just the sum of its parts is called ____________. a. capital budgeting b. firm valuation c. value additivity d. diversification

c. value additivity

The __________ average should be used to make estimates of the opportunity cost of capital. a. equity b. compound c. dividend d. arithmetic

d. arithmetic

The risk premium is the difference between risky returns and ______ returns. a. federal funds b. inflation c. prime d. risk-free

d. risk-free