Finance Exam 2 Vocabulary
Bill saves $3,000 per year in his IRA starting at age 25 and continuing to age 65, when he retires. The amount Bill has in his IRA at age 65 can be characterized as the future value of an annuity.
True
Company unique risk can be virtually eliminated with a portfolio consisting of approximately 20 securities.
True
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.
True
The slope of the characteristic line of a security is that security's beta.
True
Total risk equals systematic risk plus unsystematic risk.
True
Unique security risk can be eliminated from an investor's portfolio through diversification.
True
A typical measure for the riskminus−free rate of return is the
U.S. Treasury bill rate
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?
U.S. Treasury bills
A firm announces a decrease in its earnings forecast.
Unsystematic risk
A manufacturer loses a product liability suit.
Unsystematic risk
Beginning with an investment in one company's securities, as we add securities of other companies to our portfolio, which type of risk declines?
Unsystematic risk
The CEO of a firm retires.
Unsystematic risk
Which of the following types of risk is diversifiable?
Unsystematic, or company−unique risk
The beta of a T-bill is one
False
The portfolio beta is simply the sum of the betas of the individual stocks in the portfolio.
False
The risk−return trade−off that investors face on a day−to−day basis is based on realized rates of return because expected returns involve too much uncertainty.
False
The category of securities with the highest historical risk premium is
Small company stocks.
Required rate of return
minimum rate of return necessary to attract an investor to purchase or hold a security
Risk
potential variability in future cash flows
Risk premium
the additional return expected for assuming risk
Future value
the amount to which your investment will grow, or a future dollar amount
Expected rate of return
the arithmetic mean or average of all possible outcomes where those outcomes are weighed by the probability that each will occur
Annual percentage rate (APR)
the interest rate that indicates the amount of interest paid or earned in one year without compounding
Nominal or stated interest rate
the interest rate that the lender or credit card company states you are paying
Annuity future value factor
value of ((1 + r)^n - 1)/r used as a multiplier to calculate the future value of an annuity
Annuity present value factor
value of ((1 + r)^n - 1)/r used as a multiplier to calculate the present value of an annuity
Systematic risk (market risk or nondiversifiable risk
(1) The risk related to an investment return that cannot be eliminated through diversification. Systematic risk results from factors that affect all stocks. Also called market risk or nondiversifiable risk. (2) The risk of a project from the viewpoint of a well-diversified shareholder. This measure takes into account that some of the projects risk will be diversified away by shareholders as they combine this stock with other stocks in their portfolios.
Most stocks have betas between
.60 and 1.60
How many different securities must be owned to essentially diversify away unsystematic risk? (Select best choice)
1 5 20 100 Answer: 20
Of the following, which differs in meaning from the other three?
Asset - unique risk
What is diversifying among different kinds of assets known as?
Asset allocation
The appropriate measure for risk according to the capital asset pricing model is
Beta
Portfolio risk is typically measured by ________ while the risk of a single investment is measured by ________.
Beta; standard deviation
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
Between 4% and 20%
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?
Common stock of small firms
Of the following different types of securities, which is typically considered most risky?
Common stocks of small companies
What method is used to measure a firm's market risk?
Estimating the beta coefficient of the characteristic line using the regression method
A rational investor will always prefer an investment with a lower standard deviation of returns, because such investments are less risky.
False
Adding stocks to a bond portfolio will increase the riskiness of the portfolio because stocks have higher standard deviations of returns than bonds.
False
An investment earning simple interest is preferred over an investment earning compound interest because the simplicity adds value.
False
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%.
False
Another name for an assets expected rate of return is holding-period return
False
As the required rate of return of an investment decreases, the market price of the investment decreases.
False
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%.
False
Historically, investments with the highest returns have the lowest standard deviations because investors do not like risk.
False
Negative historical returns are not possible during periods of high volatility (high standard deviations of returns) due to the risk−return trade−off.
False
Portfolio performance is determined mainly by stock selection and market timing, with less emphasis on asset allocation.
False
Proper diversification generally results in the elimination of risk.
False
You are considering buying some stock in Continental Grain. Which of the following are examples of nonminus−diversifiable risks? I. Risk resulting from a general decline in the stock market. II. Risk resulting from a possible increase in income taxes. III. Risk resulting from an explosion in a grain elevator owned by Continental. IV. Risk resulting from a pending lawsuit against Continental.
I and II
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.
II, III
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
Investment A if A and B are of equal risk
The minimum rate of return necessary to attract an investor to purchase or hold a security is referred to as the
Investor's required rate of return
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?
Lake Tours is more likely to have negative returns than Rogue Rec.
Changes in the general economy, like changes in interest rates or tax laws, represent what type of risk?
Market risk
The capital asset pricing model
Provides a risk−return trade−off in which risk is measured in terms of beta.
How can investors reduce the risk associated with an investment portfolio without having to accept a lower expected return?
Purchase a variety of securities; i.e., diversify.
If the beta for stock A equals zero, then
Stock A's required return is equal to the risk-free rate of return
Production costs of a firm increase due to rising oil prices.
Systematic risk
The Federal Reserve announces that it will lower the interest rate to boost the economy.
Systematic risk
The inflation rate increases unexpectedly.
Systematic risk
A stock's beta is a measure of its
Systematic risk.
Effective annual rate (EAR)
The annual compound rate that produces the same return as the nominal, or quoted, rate when money is compounded on a nonannual basis, the EAR provides the true rate of return.
The beta of ABC Co. stock is the slope of
The characteristic line for a plot of ABC Co. returns against the returns of the market portfolio for the same period
Stock A has a beta of 1.2 and a standard deviation of returns of 18%. Stock B has a beta of 1.8 and a standard deviation of returns of 18%. If the market risk premium increases, then
The required return on stock B will increase more than the required return on stock A
Stock A has a beta of 1.2 and a standard deviation of returns of 14%. Stock B has a beta of 1.8 and a standard deviation of returns of 18%. If the riskminus−free rate of return increases and the market risk premium remains constant, then
The required returns on stocks A and B will both increase by the same amount.
A security with a beta of one has a required rate of return equal to the overall market rate of return.
True
A stock with a beta of 1.4 has 40% more variability in returns than the average stock.
True
An all−stock portfolio is more risky than a portfolio consisting of all bonds.
True
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.
True
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.
True
It is never appropriate to compare nominal rates unless they include the same number of compounding periods per year.
True
Small company stocks have historically had higher average annual returns than large company stocks, and also a higher risk premium.
True
Stocks that plot above the security market line are underpriced because their expected returns exceed their risk
True
The T−bill return is used in the CAPM model as the risk−free rate.
True
The benefits of diversification occur as long as the investments in a portfolio are not perfectly positively correlated.
True
The beta of a T - bill is zero
True
The expected rate of return from an investment is equal to the expected cash flows divided by the initial investment.
True
The future value of an annuity due is greater than the future value of an otherwise identical ordinary annuity.
True
Amortized loan
a loan that is paid on in equal periodic payments
Capital asset pricing model (CAPM)
a model stating that the expected rate of return on an investment (in this case a stock) is a function of (1) the risk-free rate, (2) the investments systematic risk, and (3) the expected risk premium for the market portfolio of all risky securities
Annuity
a series of equal dollar payments made for a specified number of years
Standard deviation
a statistical measure of the spread of a probability distribution calculated by squaring the difference between each outcome and its expected value, weighting each value by its probability, summing over all possible outcomes, and taking the square root of this sum
Ordinary annuity
an annuity in which the cash flows occur at the end of each period
Annuities due
an annuity in which the payments occur at the beginning of each period
Perpetuity
an annuity with an infinite life
Simple interest
if you only earned interest on you initial investment, it would be referred to as simple interest
Compound annuity
depositing an equal sum of money at the end of each year for a certain number of years and allowing it to grow
Asset allocation
identifying and selecting the asset classes appropriate for a specific investment portfolio and determining the proportions of those assets within the portfolio
Characteristic line
the line of "best fit" through a series of returns for a firms stock relative to the markets returns. The slope of the line frequently called beta, represents the average movement of the firms stock returns in response to a movement in the markets returns
Holding-period return (historical or realized rate of return)
the rate of return earned on an investment, which equals the dollar gain divided by the amount invested
Risk-free rate of return
the rate of return on risk-free investments. The interest rates on short-term U.S. government securities are commonly used to measure this rate
Portfolio beta
the relationship between a portfolios returns and the market returns. It is a measure of the portfolios nondiversifiable risk
Beta is a statistical measure of
the relationship between an investments returns and the market return
Beta
the relationship between an investments returns and the markets returns. This is a measure of the investments nondiversifiable risk
Security market line
the return line that reflects the attitudes of investors regarding the minimum acceptable return for a given level of systematic risk associated with a security line
Unsystematic risk (company-unique risk or diversifiable risk)
the risk related to an investment return that can be eliminated through diversification. Unsystematic risk is the result of factors that are unique to the particular firm. Also called company-unique risk
Compound interest
the situation in which interest paid on an investment during the first period is added to the principal. During the second period, interest is earned on the original principal plus the interest earned during the first period.
Present value
the value in todays dollars of a future payment discounted back to present at the required rate of return
Future value factor
the value of (1 + r)^n used as a multiple to calculate an amounts future value
Present value factor
the value of 1/(1+r)^n used as a multiplier to calculate an amount's present value
