Inv01_03_28Question 1 of 33Chapter 03 - Risk and Return

Portfolio C has a standard deviation of 20% and a correlation with the market of 0.9. If the standard deviation of the market is 18%, what is the beta for C? A)0.93. B)1.00. C)1.11. D)1.32.

)1.00. Rationale Beta equals the standard deviation of the portfolio times the correlation, divided by the standard deviation of the market: (0.2 x 0.9) / 0.18 = 1.00.

Which of the following correlations represents the strongest relationship between two variables? A)-1.00 B)-0.50 C)+0.38 D)+0.78

-1.00 RationaleThe strongest relationship exists at +1 and -1. The weakest relationship is at zero.

Portfolio B has a standard deviation of 12% and a correlation with the market of 0.85. If the standard deviation of the market is 15%, what is the beta for B? A)0.54. B)0.68. C)0.80. D)1.2.

0.68. RationaleBeta equals the standard deviation of the portfolio times the correlation divided by the standard deviation of the market: 0.12 x 0.85 / 0.15 = 0.68.

The geometric return is equivalent to:1. The time weighted return.2. The dollar weighted return.3. The IRR. A)1 only. B)1 and 3. C)2 and 3. D)1, 2 and 3.

1, 2 and 3. RationaleThe geometric return and the internal trade of return are equivalent. Mathematics professionals tend to use the word geometric while finance professional use IRR. TWR and DWR are specific cases of the IRR, which makes them all equivalent. Keep in mind that TWR and DWR are often different because they measure different sets of cash flows.

Steve invested in the Hyper Growth mutual fund 5 years ago. His returns were 26%, -10%, 15%, 3% and 31%, respectively. What was his arithmetic average return over the five years? A)10%. B)11%. C)12%. D)13%.

13%. Rationale[26% -10% + 15% + 3% + 31%] / 5 = 13%.

Reese bought Acme, Inc. for $40 per share two years ago. Today, Acme is trading at $72 per share. What is the annualized return for Reese? A)80.00%. B)40.00%. C)34.16%. D)28.75%.

34.16%. RationaleAnnualized return = (1.8)1/2 -1 = 34.16%

A portfolio has three stocks as follows: Portfolio Percentage Beta Stock 1 50% 2.0 Stock 2 20% 0.7 Stock 3 30% 0.6 What is the weighted beta of the portfolio? A)1.32. B)1.60. C)1.40. D)1.00.

A)1.32. Rationale(0.50 x 2) + (0.20 x 0.7) + (0.30 x 0.6) = 1.32

Consider a firm with assets of $200 and equity of $200. This firm issues $50 in debt with a 10% annual interest rate to repurchase $25 in equity and to invest $25 into the business. The first year after issuing the debt, the firm has $18 in operating income. Compute the firm's return on equity. A)7.4%. B)9.6%. C)10.3%. D)11.8%.

A)7.4%. RationaleROE = ($18 OI - $5 interest) ÷ $175 = 0.07429Interest expense = $50 × 0.10 = $5Equity is $200 - $25 after the repurchase = $175

Waste Management increased the salvage value and extended the useful life of their garbage trucks. This action resulted in decreasing and deferring expenses. What type of risk does this describe? A)Interest rate risk. B)Market risk. C)Business risk. D)Accounting risk.

Accounting risk. Rationale Accounting risk is the risk that financial statements do not accurately reflect the financial condition of a business due to fraud or error.

Parker, who lives in Covington, Louisiana purchased three bonds from a company based in Brazil that were yielding 9.75% and paid a 12% coupon, semi-annually. The company went bankrupt and Parker never received his money. What type of risk was he subject to when he purchased the bond? A)Interest rate risk. B)Default risk. C)Exchange rate risk. D)All of the above.

All of the above. RationaleThe Brazilian bond is subject to exchange rate risk, default risk, and interest rate risk.

Portfolio A has a weighted beta coefficient of 1.5 and Portfolio B has a weighted beta coefficient of 0.9. With these assumptions, which of the following statements is correct? A)Because Portfolio A has a beta greater than 1.2, it is a better choice for most investors. B)Assuming the market were to drop by 5%, Portfolio B should drop less than Portfolio A. C)Neither portfolio is as volatile as the market. D)All of the above are correct.

Assuming the market were to drop by 5%, Portfolio B should drop less than Portfolio A. RationaleChoice a is incorrect as the statement speaks to risk, but not return. Choice b is correct. A is more volatile than the market and should therefore drop more than B. Choice c is incorrect as A is more volatile than the market.

Based on a normal distribution, 95% of all outcomes for investment returns should fall within: A)One standard deviation from the mean. B)Two standard deviations from the mean. C)Three standard deviations from the mean. D)Four standard deviations from the mean.

B)Two standard deviations from the mean. Rationale95% of all outcomes for a normal distribution should fall within two standard deviations of the mean.

Paul has $1 million saved for retirement. He expects to retire in 15 years. His retirement fund is expected to earn a nominal rate of 9%, and the inflation rate is estimated at 3%. How much money (in millions) should Paul have when he retires, in real dollars? A)$3.6. B)$2.5. C)$2.3. D)$1.8.

C)$2.3. Rationale Real return = (1.09/1.03)-1 = 5.8252%FV = $1m x (1.058252)15 = $2.34mAlternatively, on a financial calculator enter:PV = ($1,000,000)N = 15I = 5.8252PMT = 0Solve for FV = $2,337,957

Which of the following correlations represents the weakest relationship between two variables? A)-1.00. B)-0.40. C)+0.18. D)+0.88.

C)+0.18. RationaleThe strongest relationship exists at +1 and -1. The weakest relationship is at zero. Thus, the weakest relationship is 0.18 in this list.

Stan invested in the Great Growth mutual fund 5 years ago. His returns were 60%, -20%, 10%, 0% and 25%, respectively. What was the geometric average return over the five years? A)10%. B)11%. C)12%. D)13%.

C)12%. Rationale[(1+ 60%) x (1+ -20%) x (1 + 10%) x (1 + 0%) x (1 + 25%)] ^ 1/ 5 - 1= 11.97%.

Which of the following statements is not correct? A)Correlation ranges from -1 to +1. B)Coefficient of determination ranges from 0 to +1. C)Covariance is the ratio of the product of two standard deviations divided by their correlation coefficients. D)All of the above are correct.

C)Covariance is the ratio of the product of two standard deviations divided by their correlation coefficients. RationaleCorrelation ranges from -1 to +1. Coefficient of determination ranges from 0 to +1. In the covariance formula, the product of the standard deviations is multiplied by the correlation between A and B, not divided by it.

Which of the following describe the definition of risk? A)The return expected by investors over a long-term holding period. B)A prior periodic return. C)The uncertainty of future returns. D)The market premium, defined as the difference between the market and the return on a riskless asset, such as a T-bill.

C)The uncertainty of future returns. RationaleRisk can be defined as the variability in returns for a financial security. This means that future security prices and therefore future returns are uncertain.

Bubba, who lives in Scotland, invested £1 million in IBM, a US company, trading at a market value of $85 per share. The conversion rate for pounds to dollars was £1 to $1.65 at the time of the investment. Assume that after two years, the stock doubles in price and he sells the stock when the conversion rate for pounds to dollars is £1 to $2.00. How much is his gain in pounds? A)£1.2 million. B)£0.83 million. C)£0.65 million. D)£0.50 million.

C)£0.65 million. RationaleThe initial investment of £1 million at an exchange rate of $1.65 will buy $1.65 million. If the market price of the share doubles, so will the value of the dollar investment, hence Bubba will have $3.3 million ($1.65 x 2) at the end of the two-year period. The exchange rate on the date of sale has moved to $2.00 per £1, so the sales proceeds will be £1.65 million ($3.3 million divided by 2). Bubba has therefore turned his initial £1 million into £1.65 million and gained £0.65 million. The percentage gain can also be calculated using the nominal yield (100%) and the currency movement. The foreign currency (USD) weakened against GBP, it takes $2 to buy £1 at the date of sale but only $1.65 initially. This means at the date of sale $1 buys £0.50 (1/$2) and initially $1 bought £0.606 (1/$1.65). USD has therefore weakened by 17.50% [(0.5/0.606) - 1]. Bubba's gain is therefore [(1 + 100%) x (1 - 17.50%)] - 1 = (2 x 0.825) - 1 = 65%.

What is a statistical measure of the degree to which two assets move together called? A)Coefficient of variation. B)Variance. C)Covariance. D)Heteroskedasticity.

Covariance. RationaleCovariance is defined as the degree to which two assets move together.

Assume that an American's investment in the stock of a French company yielded a nominal rate of return of 18% in the past 12 months. Assume also that the Euro was worth 0.20 USD t the start of the period and 0.25 USD at the end of the period. In this case, the true rate of return for the investor was: A)-5.6%. B)11.3%. C)22.5%. D)47.5%.

D)47.5%. RationaleThe euro increased in value during the holding period. If the investor started with $100 and the euro was 0.20 per USD, then the investor could exchange his $100 for 500 Euros. The investment then grew by a nominal rate of 18% (500 EU x 1.18 = 590 EU). To bring the Euros back to dollars when the euro is now worth 0.25 per USD (590 x 0.25 = 147.50 USD). Therefore, the investor's return was more than the nominal 18%. Specifically, it was: [1.18 x (0.25/0.20)] - 1 = 47.5%

Standard deviation is? A)A statistical measure of the variation of numbers or data around the mean of those numbers or data. B)Used as a measure of risk for investors. C)Assumes the distribution is a normal distribution. D)All of the above

D)All of the above RationaleAll of the choices are correct.

Bugs has only one stock in his investment portfolio. The beta of the stock is 0.7. Bugs assumes that his investment portfolio is only 70% as risky as the market. Which is the correct response? A)He is right. B)He is wrong because the portfolio is only 30% as risky as the market. C)As long as the market index he is comparing to is appropriate, he is right. D)He is wrong because beta only measures systematic risk and having only one stock in a portfolio inherently has unsystematic risk.

D)He is wrong because beta only measures systematic risk and having only one stock in a portfolio inherently has unsystematic risk. Rationale One stock has a high level of unsystematic (diversifiable) risk.

Which of the following statements is correct? A)Coefficient of variation equals average return divided by standard deviation. B)Correlation and R2 range from -1 to +1. C)Covariance is the ratio of the product of two standard deviations divided by their correlation coefficients. D)None of the above are correct.

D)None of the above are correct. RationaleCorrelation ranges from -1 to +1. Coefficient of determination ranges from 0 to +1. Covariance equals the standard deviation of A times that of B multiplied by the correlation between A and B.

Uncle Robbie, who lives in Kenner, Louisiana, bought a Treasury bond on the secondary market that has 10 years until maturity and a 2% coupon payment, paid semi-annually. Which of the following risks is he subject to? A)Financial risk. B)Exchange rate risk. C)Default risk. D)Reinvestment rate risk.

D)Reinvestment rate risk. Rationale Uncle Robbie's bond is subject to reinvestment rate risk. The bond is not subject to default risk as it is a Treasury security.

Which of the following is a systematic risk? A)Country risk. B)Exchange rate risk. C)Executive risk. D)Business risk.

Exchange rate risk. RationaleCountry risk, executive risk, and business risk are all unsystematic risks that can be eliminated or minimized through diversification. Exchange rate risk is a systematic risk.

Which of the following statements concerning risk and return is not correct? A)Inflation risk, or purchasing power risk, is the variability in securities returns caused by a decline in the purchasing power of the invested dollars. B)Total return = yield + price change C)Exchange rate risk is the risk that currency fluctuations will cause an adverse effect on the return from an investment. D)Market risk includes a wide range of factors, including business cycles, changes in interest rates, global conflicts, as well as changes in consumer preferences.

Inflation risk, or purchasing power risk, is the variability in securities returns caused by a decline in the purchasing power of the invested dollars. RationaleChoice a is incorrect as inflation risk is not associated with the variability in securities returns. Rather, it is the decline in purchasing power of the amounts invested.

Which of the following statements concerning risk and return is not correct? A)Market risk includes a wide range of factors, including business cycles, changes in interest rates, global conflicts, as well as changes in consumer preferences. B)Total return = yield + price change. C)Exchange rate risk is the risk that currency fluctuations will cause an adverse effect on the return from an investment. D)Liquidity risk is a more significant risk for securities such as Treasury bills.

Liquidity risk is a more significant risk for securities such as Treasury bills. RationaleChoice d is incorrect as Treasury bills are extremely liquid. Liquidity refers to the ability to sell an asset quickly at a competitive price without loss of principal or price concessions.

Which of the following statements about investment risk is (are) correct? A)Financial risk is associated with the use of debt as a portion of the capital structure in lieu of equity and magnifies losses but not gains. B)Liquidity risk is the risk that an investment may not be able to be bought or sold quickly without a significant price concession. C)Both a and b. D)Neither a nor b.

Liquidity risk is the risk that an investment may not be able to be bought or sold quickly without a significant price concession. RationaleChoice a is incorrect as financial risk magnifies gains and losses.

Security Y has the following returns over five years: 3%, 6%, 0%, 6%, and 3%. What is the mean return and the standard deviation (sample) for Security Y? A)Mean of 3.6% and standard deviation of 6.4%. B)Mean of 3.6% and standard deviation of 2.5%. C)Mean of 3.0% and standard deviation of 6.4%. D)Mean of 3.0% and standard deviation of 2.5%.

Mean of 3.6% and standard deviation of 2.5%. RationaleThe correct answer is b.The mean equals 3.6% and the standard deviation equals 6.4%.Mean return = (3 + 6 + 0 + 6 + 3)/5 = 3.60%To calculate standard deviation using the formula:The differences from the mean are: 0.6, 2.4, 3.6, 2.4, and 0.6.The differences squared are: 0.36, 5.76, 12.96, 5.76, 0.36.Sum of differences equals: 25.2.Divided by 4: 6.3Square root = 2.51

The "doctor" describes himself as a "swinging for the fences" type of investor. He invests in 1 share of ABC stock that has a beta of 0.75 and concludes that he is only taking 3/4 of the risk of the market. Is he accurate? A)Yes, beta is 0.75 therefore 3/4 risk of market. B)No, beta only measures systematic risk. C)No, he has non-diversifiable risk that is greater than the market. D)Yes, while he has diversifiable risk, his risk is only 3/4 of the market.

No, beta only measures systematic risk. RationaleBeta only measures systematic risk (it assumes the stock is added to an already diversified portfolio). Since the doctor has only one stock he has a lot of unsystematic risk as well. Therefore, he is incorrect.

Which of the following is (are) correct regarding average returns? A)The geometric mean is equivalent to IRR. B)The arithmetic mean is the average return for a series of returns and will always be less than or equal to the geometric mean. C)Both a and b. D)Neither a nor b.

The geometric mean is equivalent to IRR. RationaleChoice b is incorrect as the arithmetic mean will always be greater than or equal to the geometric mean.

Based on a normal distribution, 99% of all outcomes for investment returns should fall within: A)One standard deviation. B)Two standard deviations. C)Three standard deviations. D)Four standard deviations.

Three standard deviations. Rationale99% of all outcomes for a normal distribution should fall within three standard deviations of the mean.

A commercial bank owns a portfolio of fixed income securities with a market value of $810 million. The bank is concerned about a spike in inflation during the coming month, citing a potential energy shortage. A surge in oil and natural gas price would place significant downward pressure on the value of the portfolio. The risk management measure most likely to help the bank is: A)Beta. B)Standard deviation. C)Value at risk. D)Correlation coefficient.

Value at risk. Rationale While beta and standard deviation are excellent risk management measures, they are designed to identify long term risks and variability. They reveal very little about short term risk. Value at risk, however, was developed as a result of the 1987 crash to help banks manage the potential losses during market downturns, especially over shorter terms.