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Chapter 12

Some Lessons from Capital Market History


Chapter 12 Some Lessons from Capital Market History Answer Key

Multiple Choice Questions

1. Last year, T-bills returned 2 percent while your investment in large-company stocks earned
an average of 5 percent. Which one of the following terms refers to the difference between
these two rates of return?
A. risk premium
B. geometric return
C. arithmetic
D. standard deviation
E. variance
Refer to section 12.3

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-1
Section: 12.3
Topic: Risk premium

2. Which one of the following best defines the variance of an investment's annual returns over
a number of years?
A. The average squared difference between the arithmetic and the geometric average annual
returns.
B. The squared summation of the differences between the actual returns and the average
geometric return.
C. The average difference between the annual returns and the average return for the period.
D. The difference between the arithmetic average and the geometric average return for the
period.
E. The average squared difference between the actual returns and the arithmetic average
return.
Refer to section 12.4

AACSB: N/A
Bloom's: Comprehension
Difficulty: Intermediate
Learning Objective: 12-1
Section: 12.4
Topic: Variance

3. Standard deviation is a measure of which one of the following?


A. average rate of return
B. volatility
C. probability
D. risk premium
E. real returns
Refer to section 12.4

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-1
Section: 12.4
Topic: Standard deviation

4. Which one of the following is defined by its mean and its standard deviation?
A. arithmetic nominal return
B. geometric real return
C. normal distribution
D. variance
E. risk premium
Refer to section 12.4

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-1
Section: 12.4
Topic: Normal distribution

5. The average compound return earned per year over a multi-year period is called the _____
average return.
A. arithmetic
B. standard
C. variant
D. geometric
E. real
Refer to section 12.5

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-1
Section: 12.5
Topic: Geometric average return

6. The return earned in an average year over a multi-year period is called the _____ average
return.
A. arithmetic
B. standard
C. variant
D. geometric
E. real
Refer to section 12.5

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-1
Section: 12.5
Topic: Arithmetic average return

7. Assume that the market prices of the securities that trade in a particular market fairly reflect
the available information related to those securities. Which one of the following terms best
defines that market?
A. riskless market
B. evenly distributed market
C. zero volatility market
D. Blume's market
E. efficient capital market
Refer to section 12.6

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-4
Section: 12.6
Topic: Efficient capital market

8. Which one of the following statements best defines the efficient market hypothesis?
A. Efficient markets limit competition.
B. Security prices in efficient markets remain steady as new information becomes available.
C. Mispriced securities are common in efficient markets.
D. All securities in an efficient market are zero net present value investments.
E. Profits are removed as a market incentive when markets become efficient.
Refer to section 12.6

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-4
Section: 12.6
Topic: Efficient markets

9. Stacy purchased a stock last year and sold it today for $3 a share more than her purchase
price. She received a total of $0.75 in dividends. Which one of the following statements is
correct in relation to this investment?
A. The dividend yield is expressed as a percentage of the selling price.
B. The capital gain would have been less had Stacy not received the dividends.
C. The total dollar return per share is $3.
D. The capital gains yield is positive.
E. The dividend yield is greater than the capital gains yield.
Refer to section 12.1

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-1
Section: 12.1
Topic: Returns

10. Which one of the following correctly describes the dividend yield?
A. next year's annual dividend divided by today's stock price
B. this year's annual dividend divided by today's stock price
C. this year's annual dividend divided by next year's expected stock price
D. next year's annual dividend divided by this year's annual dividend
E. the increase in next year's dividend over this year's dividend divided by this year's dividend
Refer to section 12.1

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-1
Section: 12.1
Topic: Dividend yield

11. Bayside Marina just announced it is decreasing its annual dividend from $1.64 per share
to $1.50 per share effective immediately. If the dividend yield remains at its preannouncement level, then you know the stock price:
A. was unaffected by the announcement.
B. increased proportionately with the dividend decrease.
C. decreased proportionately with the dividend decrease.
D. decreased by $0.14 per share.
E. increased by $0.14 per share.
Refer to section 12.1

AACSB: N/A
Bloom's: Comprehension
Difficulty: Intermediate
Learning Objective: 12-1
Section: 12.1
Topic: Dividend yield

12. Which one of the following statements related to capital gains is correct?
A. The capital gains yield includes only realized capital gains.
B. An increase in an unrealized capital gain will increase the capital gains yield.
C. The capital gains yield must be either positive or equal to zero.
D. The capital gains yield is expressed as a percentage of the sales price.
E. The capital gains yield represents the total return earned by an investor.
Refer to section 12.1

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-1
Section: 12.1
Topic: Capital gains yield

13. Which of the following statements is correct in relation to a stock investment?


I. The capital gains yield can be positive, negative, or zero.
II. The dividend yield can be positive, negative, or zero.
III. The total return can be positive, negative, or zero.
IV. Neither the dividend yield nor the total return can be negative.
A. I only
B. I and II only
C. I and III only
D. I and IV only
E. IV only
Refer to section 12.1

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-1
Section: 12.1
Topic: Stock returns

14. The real rate of return on a stock is approximately equal to the nominal rate of return:
A. multiplied by (1 + inflation rate).
B. plus the inflation rate.
C. minus the inflation rate.
D. divided by (1 + inflation rate).
E. divided by (1- inflation rate).
Refer to section 12.3

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-1
Section: 12.3
Topic: Real return

15. As long as the inflation rate is positive, the real rate of return on a security will be ____
the nominal rate of return.
A. greater than
B. equal to
C. less than
D. greater than or equal to
E. unrelated to
Refer to section 12.3

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-1
Section: 12.3
Topic: Real return

16. Small-company stocks, as the term is used in the textbook, are best defined as the:
A. 500 newest corporations in the U.S.
B. firms whose stock trades OTC.
C. smallest twenty percent of the firms listed on the NYSE.
D. smallest twenty-five percent of the firms listed on NASDAQ.
E. firms whose stock is listed on NASDAQ.
Refer to section 12.2

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-2
Section: 12.2
Topic: Small-company stocks

17. Which one of the following statements is a correct reflection of the U.S. markets for the
period 1926-2007?
A. U.S. Treasury bill returns never exceeded a 9 percent return in any one year during the
period.
B. U.S. Treasury bills provided a positive rate of return each and every year during the period.
C. Inflation equaled or exceeded the return on U.S. Treasury bills every year during the
period.
D. Long-term government bonds outperformed U.S. Treasury bills every year during the
period.
E. National deflation occurred at least once every decade during the period.
Refer to section 12.2

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-2
Section: 12.2
Topic: Historical record

18. Which one of the following categories of securities had the highest average return for the
period 1926-2007?
A. U.S. Treasury bills
B. large company stocks
C. small company stocks
D. long-term corporate bonds
E. long-term government bonds
Refer to section 12.3

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-2
Section: 12.3
Topic: Historical returns

19. Which one of the following categories of securities had the lowest average risk premium
for the period 1926-2007?
A. long-term government bonds
B. small company stocks
C. large company stocks
D. long-term corporate bonds
E. U.S. Treasury bills
Refer to section 12.3

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-3
Section: 12.3
Topic: Risk premium

20. Which one of the following categories of securities has had the most volatile returns over
the period 1926-2007?
A. long-term corporate bonds
B. large-company stocks
C. intermediate-term government bonds
D. U.S. Treasury bills
E. small-company stocks
Refer to section 12.4

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-3
Section: 12.4
Topic: Historical riskss

21. Which one of the following statements correctly applies to the period 1926-2007?
A. Large-company stocks earned a higher average risk premium than did small-company
stocks.
B. Intermediate-term government bonds had a higher average return than long-term corporate
bonds.
C. Large-company stocks had an average annual return of 14.7 percent.
D. Inflation averaged 2.6 percent for the period.
E. U.S. Treasury bills had a positive average real rate of return.
Refer to section 12.3

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-2
Section: 12.3
Topic: Historical returns

22. Which one of the following time periods is associated with high rates of inflation?
A. 1929-1933
B. 1957-1961
C. 1978-1981
D. 1992-1996
E. 2001-2005
Refer to section 12.2

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-2
Section: 12.2
Topic: Inflation

23. Which one of the following statements concerning U.S. Treasury bills is correct for the
period 1926- 2007?
A. The annual rate of return always exceeded the annual inflation rate.
B. The average risk premium was 0.7 percent.
C. The annual rate of return was always positive.
D. The average excess return was 1.1 percent.
E. The average real rate of return was zero.
Refer to sections 12.2 and 12.3

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-2
Section: 12.2 and 12.3
Topic: Historical returns

24. Which one of the following is a correct ranking of securities based on their volatility over
the period of 1926-2007? Rank from highest to lowest.
A. large company stocks, U.S. Treasury bills, long-term government bonds
B. small company stocks, long-term corporate bonds, large company stocks
C. small company stocks, long-term corporate bonds, intermediate-term government bonds
D. large company stocks, small company stocks, long-term government bonds
E. intermediate-term government bonds, long-term corporate bonds, U.S. Treasury bills
Refer to section 12.4

AACSB: N/A
Bloom's: Knowledge
Difficulty: Intermediate
Learning Objective: 12-3
Section: 12.4
Topic: Historical riskss

25. What was the highest annual rate of inflation during the period 1926-2007?
A. between 0 and 3 percent
B. between 3 and 5 percent
C. between 5 and 10 percent
D. between 10 and 15 percent
E. between 15 and 20 percent
Refer to section 12.2

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-2
Section: 12.2
Topic: Inflation

26. The excess return is computed as the:


A. return on a security minus the inflation rate.
B. return on a risky security minus the risk-free rate.
C. risk premium on a risky security minus the risk-free rate.
D. the risk-free rate plus the inflation rate.
E. risk-free rate minus the inflation rate.
Refer to section 12.3

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-1
Section: 12.3
Topic: Excess return

27. Which one of the following earned the highest risk premium over the period 1926-2007?
A. long-term corporate bonds
B. U.S. Treasury bills
C. small-company stocks
D. large-company stocks
E. long-term government bonds
Refer to section 12.3

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-3
Section: 12.3
Topic: Risk premium

28. What was the average rate of inflation over the period of 1926-2007?
A. less than 2.0 percent
B. between 2.0 and 2.5 percent
C. between 2.5 and 3.0 percent
D. between 3.0 and 3.5 percent
E. greater than 3.5 percent
Refer to section 12.3

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-2
Section: 12.3
Topic: Inflation

29. Assume that you invest in a portfolio of large-company stocks. Further assume that the
portfolio will earn a rate of return similar to the average return on large-company stocks for
the period 1926-2007. What rate of return should you expect to earn?
A. less than 10 percent
B. between 10 and 12.5 percent
C. between 12.5 and 15 percent
D. between 15 and 17.5 percent
E. more than 17.5 percent
Refer to section 12.3

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-2
Section: 12.3
Topic: Historical returns

30. The average annual return on small-company stocks was about _____ percent greater than
the average annual return on large-company stocks over the period 1926-2007.
A. 3
B. 5
C. 7
D. 9
E. 11
Refer to section 12.3

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-2
Section: 12.3
Topic: Historical returns

31. Which one of the following was the least volatile over the period of 1926-2007?
A. large-company stocks
B. inflation
C. long-term corporate bonds
D. U.S. Treasury bills
E. intermediate-term government bonds
Refer to section 12.4

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-3
Section: 12.4
Topic: Historical risks

32. Which one of the following statements is correct?


A. The greater the volatility of returns, the greater the risk premium.
B. The lower the volatility of returns, the greater the risk premium.
C. The lower the average return, the greater the risk premium.
D. The risk premium is unrelated to the average rate of return.
E. The risk premium is not affected by the volatility of returns.
Refer to sections 12.3 and 12.4

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-3
Section: 12.3 and 12.4
Topic: Risk premium

33. Which of the following correspond to a wide frequency distribution?


I. relatively low risk
II. relatively low rate of return
III. relatively high standard deviation
IV. relatively large risk premium
A. II only
B. III only
C. I and II only
D. II and III only
E. III and IV only
Refer to section 12.4

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-3
Section: 12.4
Topic: Frequency distribution

34. To convince investors to accept greater volatility, you must:


A. decrease the risk premium.
B. increase the risk premium.
C. decrease the real return.
D. decrease the risk-free rate.
E. increase the risk-free rate.
Refer to section 12.4

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-3
Section: 12.4
Topic: Risk premium

35. If the variability of the returns on large-company stocks were to increase over the longterm, you would expect which of the following to occur as a result?
I. decrease in the average rate of return
II. increase in the risk premium
III. increase in the 68 percent probability range of the frequency distribution of returns
IV. decrease in the standard deviation
A. I only
B. IV only
C. II and III only
D. I and III only
E. II and IV only
Refer to section 12.4

AACSB: N/A
Bloom's: Analysis
Difficulty: Intermediate
Learning Objective: 12-3
Section: 12.4
Topic: Variability of returns

36. Which one of the following statements is correct based on the historical record for the
period 1926-2007?
A. The standard deviation of returns for small-company stocks was double that of largecompany stocks.
B. U.S. Treasury bills had a zero standard deviation of returns because they are considered to
be risk-free.
C. Long-term government bonds had a lower return but a higher standard deviation on
average than did long-term corporate bonds.
D. Inflation was less volatile than the returns on U.S. Treasury bills.
E. Long-term government bonds underperformed intermediate-term government bonds.
Refer to section 12.4

AACSB: N/A
Bloom's: Comprehension
Difficulty: Intermediate
Learning Objective: 12-3
Section: 12.4
Topic: Historical returns and risks

37. What is the probability that small-company stocks will produce an annual return that is
more than one standard deviation below the average?
A. 1.0 percent
B. 2.5 percent
C. 5.0 percent
D. 16 percent
E. 32 percent
Refer to section 12.4

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-3
Section: 12.4
Topic: Probability distribution

38. According to Jeremy Siegel, the real return on stocks over the long-term has averaged
about:
A. 6.8 percent
B. 8.7 percent
C. 10.4 percent
D. 12.3 percent
E. 14.8 percent
Refer to section 12.5

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-2
Section: 12.5
Topic: Historical returns

39. The historical record for the period 1926-2007 supports which one of the following
statements?
A. A higher-risk security will provide a higher rate of return next year than will a lower-risk
security.
B. If you need a stated amount of money next year, your best investment option today for
those funds would be long-term government bonds.
C. Increased long-run potential returns are obtained by lowering risks.
D. It is possible for small-company stocks to more than double in value in any one given year.
E. Inflation was positive each year throughout the period of 1926-2007.
Refer to sections 12.2 and 12.4

AACSB: N/A
Bloom's: Knowledge
Difficulty: Intermediate
Learning Objective: 12-2
Section: 12.2 and 12.4
Topic: Historical returns

40. Which of the following statements are true based on the historical record for 1926-2007?
I. Risk and potential reward are inversely related.
II. Risk-free securities produce a positive real rate of return each year.
III. Returns are more predictable over the short-term than they are over the long-term.
IV. Bonds are generally a safer investment than are stocks.
A. I only
B. IV only
C. II and III only
D. II and IV only
E. II, III, and IV only
Refer to sections 12.3 and 12.4

AACSB: N/A
Bloom's: Comprehension
Difficulty: Intermediate
Learning Objective: 12-2
Section: 12.3 and 12.4
Topic: Historical returns and risks

41. Estimates of the rate of return on a security based on a historical arithmetic average will
probably tend to _____ the expected return for the long-term while estimates using the
historical geometric average will probably tend to _____ the expected return for the shortterm.
A. overestimate; overestimate
B. overestimate; underestimate
C. underestimate; overestimate
D. underestimate; underestimate
E. accurately; accurately
Refer to section 12.5

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-1
Section: 12.5
Topic: Blume's formula

42. The primary purpose of Blume's formula is to:


A. compute an accurate historical rate of return.
B. determine a stock's true current value.
C. consider compounding when estimating a rate of return.
D. determine the actual real rate of return.
E. project future rates of return.
Refer to section 12.5

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-1
Section: 12.5
Topic: Blume's formula

43. Which two of the following are the most likely reasons why a stock price might not react
at all on the day that new information related to the stock issuer is released?
I. insiders knew the information prior to the announcement
II. investors need time to digest the information prior to reacting
III. the information has no bearing on the value of the firm
IV. the information was anticipated
A. I and II only
B. I and III only
C. II and III only
D. II and IV only
E. III and IV only
Refer to section 12.6

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-4
Section: 12.6
Topic: Market efficiency

44. Which one of the following is most indicative of a totally efficient stock market?
A. extraordinary returns earned on a routine basis
B. positive net present values on stock investments over the long-term
C. zero net present values for all stock investments
D. arbitrage opportunities which develop on a routine basis
E. realizing negative returns on a routine basis
Refer to section 12.6

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-4
Section: 12.6
Topic: Market efficiency

45. Which one of the following statements is correct concerning market efficiency?
A. Real asset markets are more efficient than financial markets.
B. If a market is efficient, arbitrage opportunities should be common.
C. In an efficient market, some market participants will have an advantage over others.
D. A firm will generally receive a fair price when it issues new shares of stock.
E. New information will gradually be reflected in a stock's price to avoid any sudden change
in the price of the stock.
Refer to section 12.6

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-4
Section: 12.6
Topic: Market efficiency

46. Efficient financial markets fluctuate continuously because:


A. the markets are continually reacting to old information as that information is absorbed.
B. the markets are continually reacting to new information.
C. arbitrage trading is limited.
D. current trading systems require human intervention.
E. investments produce varying levels of net present values.
Refer to section 12.6

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-4
Section: 12.6
Topic: Market efficiency

47. Inside information has the least value when financial markets are:
A. weak form efficient.
B. semiweak form efficient.
C. semistrong form efficient.
D. strong form efficient.
E. inefficient.
Refer to section 12.6

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-4
Section: 12.6
Topic: Market efficiency

48. According to theory, studying historical stock price movements to identify mispriced
stocks:
A. is effective as long as the market is only semistrong form efficient.
B. is effective provided the market is only weak form efficient.
C. is ineffective even when the market is only weak form efficient.
D. becomes ineffective as soon as the market gains semistrong form efficiency.
E. is ineffective only in strong form efficient markets.
Refer to section 12.6

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-4
Section: 12.6
Topic: Market efficiency

49. Which of the following statements related to market efficiency tend to be supported by
current evidence?
I. Markets tend to respond quickly to new information.
II. It is difficult for investors to earn abnormal returns.
III. Short-run prices are difficult to predict accurately based on public information.
IV. Markets are most likely weak form efficient.
A. I and III only
B. II and IV only
C. I and IV only
D. I, III, and IV only
E. I, II, and III only
Refer to section 12.6

AACSB: N/A
Bloom's: Comprehension
Difficulty: Intermediate
Learning Objective: 12-4
Section: 12.6
Topic: Market efficiency

50. If you excel in analyzing the future outlook of firms, you would prefer the financial
markets be ____ form efficient so that you can have an advantage in the marketplace.
A. weak
B. semiweak
C. semistrong
D. strong
E. perfect
Refer to section 12.6

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-4
Section: 12.6
Topic: Market efficiency

51. You are aware that your neighbor trades stocks based on confidential information he
overhears at his workplace. This information is not available to the general public. This
neighbor continually brags to you about the profits he earns on these trades. Given this, you
would tend to argue that the financial markets are at best _____ form efficient.
A. weak
B. semiweak
C. semistrong
D. strong
E. perfect
Refer to section 12.6

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-4
Section: 12.6
Topic: Market efficiency

52. The U.S. Securities and Exchange Commission periodically charges individuals with
insider trading and claims those individuals have made unfair profits. Given this, you would
be most apt to argue that the markets are less than _____ form efficient.
A. weak
B. semiweak
C. semistrong
D. strong
E. perfect
Refer to section 12.6

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-4
Section: 12.6
Topic: Market efficiency

53. Individuals who continually monitor the financial markets seeking mispriced securities:
A. earn excess profits over the long-term.
B. make the markets increasingly more efficient.
C. are never able to find a security that is temporarily mispriced.
D. are overwhelmingly successful in earning abnormal profits.
E. are always quite successful using only historical price information as their basis of
evaluation.
Refer to section 12.6

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 12-4
Section: 12.6
Topic: Market efficiency

54. One year ago, you purchased a stock at a price of $32.16. The stock pays quarterly
dividends of $0.20 per share. Today, the stock is selling for $28.20 per share. What is your
capital gain on this investment?
A. -$4.16
B. -$3.96
C. -$3.76
D. -$3.16
E. -$2.96
Capital gain = $28.20 - $32.16 = -$3.96

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 12-1
Section: 12.1
Topic: Capital gain

55. Six months ago, you purchased 100 shares of stock in Global Trading at a price of $38.70
a share. The stock pays a quarterly dividend of $0.15 a share. Today, you sold all of your
shares for $40.10 per share. What is the total amount of your dividend income on this
investment?
A. $15
B. $30
C. $45
D. $50
E. $60
Dividend income = ($0.15 2) 100 = $30

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 12-1
Section: 12.1
Topic: Dividend income

56. A year ago, you purchased 400 shares of Stellar Wood Products, Inc. stock at a price of
$8.62 per share. The stock pays an annual dividend of $0.10 per share. Today, you sold all of
your shares for $4.80 per share. What is your total dollar return on this investment?
A. -$382
B. -$372
C. -$1,528
D. -$1,488
E. -$1,360
Total dollar return = ($4.80 - $8.62 + $0.10) 400 = -$1,488

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 12-1
Section: 12.1
Topic: Total dollar return

57. You own 400 shares of Western Feed Mills stock valued at $51.20 per share. What is the
dividend yield if your annual dividend income is $352?
A. 1.68 percent
B. 1.72 percent
C. 1.83 percent
D. 1.13 percent
E. 1.21 percent
Dividend yield = ($352/400)/$51.20 = 1.72 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 12-1
Section: 12.1
Topic: Dividend yield

58. West Wind Tours stock is currently selling for $48 a share. The stock has a dividend yield
of 2.6 percent. How much dividend income will you receive per year if you purchase 200
shares of this stock?
A. $24.96
B. $36.20
C. $124.80
D. $362.00
E. $249.60
Dividend income = $48 0.026 200 = $249.60

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 12-1
Section: 12.1
Topic: Dividend yield

59. One year ago, you purchased a stock at a price of $47.50 a share. Today, you sold the
stock and realized a total loss of 22.11 percent. Your capital gain was -$12.70 a share. What
was your dividend yield?
A. 4.63 percent
B. 4.88 percent
C. 5.02 percent
D. 12.67 percent
E. 14.38 percent
Dividend yield = -0.2211 - (-12.70/$47.50) = 4.63 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 12-1
Section: 12.1
Topic: Dividend yield

60. You just sold 600 shares of Wesley, Inc. stock at a price of $31.09 a share. Last year, you
paid $30.92 a share to buy this stock. Over the course of the year, you received dividends
totaling $1.20 per share. What is your total capital gain on this investment?
A. -$618
B. -$102
C. $102
D. $618
E. $720
Capital gain = ($31.09 - $30.92) 600 = $102

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 12-1
Section: 12.1
Topic: Capital gain

61. Last year, you purchased 500 shares of Analog Devices, Inc. stock for $11.16 a share. You
have received a total of $120 in dividends and $7,190 from selling the shares. What is your
capital gains yield on this stock?
A. 26.70 percent
B. 26.73 percent
C. 28.85 percent
D. 29.13 percent
E. 31.02 percent
Capital gains yield = [($7,190/500) - $11.16]/$11.16 = 28.85 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 12-1
Section: 12.1
Topic: Capital gains yield

62. Today, you sold 200 shares of Indian River Produce stock. Your total return on these
shares is 5.65 percent. You purchased the shares one year ago at a price of $31.10 a share. You
have received a total of $100 in dividends over the course of the year. What is your capital
gains yield on this investment?
A. 3.68 percent
B. 4.04 percent
C. 5.67 percent
D. 7.26 percent
E. 7.41 percent
Capital gains yield = .0565 - [($100/$200)/$31.10] = 4.04 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 12-1
Section: 12.1
Topic: Capital gains yield

63. Four months ago, you purchased 1,500 shares of Lakeside Bank stock for $11.20 a share.
You have received dividend payments equal to $0.25 a share. Today, you sold all of your
shares for $8.60 a share. What is your total dollar return on this investment?
A. -$3,900
B. -$3,525
C. -$3,150
D. -$2,950
E. -$2,875
Total dollar return = ($8.60 - $11.20 + $0.25) 1,500 = -$3,525

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 12-1
Section: 12.1
Topic: Dollar returns

64. One year ago, you purchased 500 shares of Best Wings, Inc. stock at a price of $9.60 a
share. The company pays an annual dividend of $0.10 per share. Today, you sold all of your
shares for $15.60 a share. What is your total percentage return on this investment?
A. 38.46 percent
B. 39.10 percent
C. 39.72 percent
D. 62.50 percent
E. 63.54 percent
Total percentage return = ($15.60 - $9.60 + $0.10)/$9.60 = 63.54 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 12-1
Section: 12.1
Topic: Percentage return

65. Last year, you purchased a stock at a price of $47.10 a share. Over the course of the year,
you received $2.40 per share in dividends while inflation averaged 3.4 percent. Today, you
sold your shares for $49.50 a share. What is your approximate real rate of return on this
investment?
A. 6.30 percent
B. 6.79 percent
C. 7.18 percent
D. 9.69 percent
E. 10.19 percent
Nominal return = ($49.50 - $47.10 + $2.40)/$47.10 = 10.19 percent
Approximate real return = 0.1019 - 0.034 = 6.79 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 12-1
Section: 12.3
Topic: Approximate real return

66. One year ago, you purchased 200 shares of a stock at a price of $54.18 a share. Today, you
sold those shares for $40.25 a share. During the past year, you received total dividends of
$164 while inflation averaged 4.2 percent. What is your approximate real rate of return on this
investment?
A. -24.20 percent
B. -28.40 percent
C. -20.00 percent
D. 20.00 percent
E. 24.20 percent
Nominal return = [$40.25 - $54.18 + ($164/200)]/$54.18 = -0.2420
Approximate real return = -0.2420 - 0.042 = -28.40 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 12-1
Section: 12.3
Topic: Approximate real return

67. What is the amount of the excess return on a U.S. Treasury bill if the risk-free rate is 2.8
percent and the market rate of return is 8.35 percent?
A. 0.00 percent
B. 2.80 percent
C. 5.55 percent
D. 8.35 percent
E. 11.15 percent
There is no excess return, or risk premium, for a risk-free security such as the T-bill.

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 12-1
Section: 12.3
Topic: Risk-free security

68. A stock had returns of 11 percent, -18 percent, -21 percent, 5 percent, and 34 percent over
the past five years. What is the standard deviation of these returns?
A. 18.74 percent
B. 20.21 percent
C. 20.68 percent
D. 22.60 percent
E. 23.49 percent
Average return = (0.11 - 0.18 - 0.21 + 0.05 + 0.34)/5 = .022;
= [1/(5 - 1)] [(0.11 - 0.022)2 + (-0.18 - 0.022)2 + (-0.21 -0.022)2 + (0.05 - 0.022)2 + (0.34 0.022)2] = 22.60 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Intermediate
Learning Objective: 12-1
Section: 12.4
Topic: Standard deviation

69. The common stock of Air United, Inc., had annual returns of 15.6 percent, 2.4 percent,
-11.8 percent, and 32.9 percent over the last four years, respectively. What is the standard
deviation of these returns?
A. 13.29 percent
B. 14.14 percent
C. 16.50 percent
D. 17.78 percent
E. 19.05 percent
Average return = (0.156 + 0.024 - 0.118 + 0.329)/4 = -.09775
=[1/(4 - 1)] [(0.156 - 0.09775)2 + (0.024 - 0.09775)2 + (-0.118 - 0.09775)2 + (0.329 0.09775)2] = 19.05 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Intermediate
Learning Objective: 12-1
Section: 12.4
Topic: Standard deviation

70. A stock had annual returns of 3.6 percent, -8.7 percent, 5.6 percent, and 11.1 percent over
the past four years. Which one of the following best describes the probability that this stock
will produce a return of 20 percent or more in a single year?
A. less than 0.1 percent
B. less than 0.5 percent but greater than 0.1 percent
C. less than 1.0 percent but greater the 0.5 percent
D. less than 2.5 percent but greater than 1.0 percent
E. less than 5 percent but greater than 2.5 percent
Average return = (0.036 - 0.087 + 0.056 + 0.111)/4 = 0.0290
= [1/(4 - 1)] [(0.036 - 0.029)2 + (-0.087 - 0.029)2 + (0.056 - 0.029)2 + (0.111 - 0.029)2] =
0.0836
Upper end of 95 percent range = 0.0290 + (2 0.0836) = 19.62 percent
Upper end of 99 percent range = 0.0290 + (3 0.0836) = 27.98 percent
A return of 20 percent or more in a single year has between a 1 percent and a 2.5 percent
probability of occurring in any one year.

AACSB: Analytic
Bloom's: Analysis
Difficulty: Intermediate
Learning Objective: 12-3
Section: 12.4
Topic: Probability of occurrence

71. A stock has an expected rate of return of 13 percent and a standard deviation of 21
percent. Which one of the following best describes the probability that this stock will lose at
least half of its value in any one given year?
A. 0.1 percent
B. 0.5 percent
C. 1.0 percent
D. 2.5 percent
E. 5.0 percent
Lower bound of 99 percent range = 0.13 - (3 0.21) = -50 percent
Probability of losing 50 percent or more in any one year is 0.5 percent.

AACSB: Analytic
Bloom's: Analysis
Difficulty: Basic
Learning Objective: 12-3
Section: 12.4
Topic: Probability of occurrence

72. A stock has returns of 18 percent, 11 percent, -21 percent, and 6 percent for the past four
years. Based on this information, what is the 95 percent probability range of returns for any
one given year?
A. -13.56 to 20.56 percent
B. -24.60 to 31.80 percent
C. -30.62 to 37.62 percent
D. -47.68 to 54.68 percent
E. -71.73 to 71.73 percent
Average return = (0.18 + 0.11 - 0.21 + 0.06)/4 = 0.035
= (0.18 - 0.035)2 + (0.11 - 0.035)2 + (-0.21 - 0.035)2 + (0.06 - 0.035)2] = .170587
95% probability range = 0.035 (2 0.170587) percent = -30.62 to 37.62 percent

AACSB: Analytic
Bloom's: Analysis
Difficulty: Intermediate
Learning Objective: 12-3
Section: 12.4
Topic: Probability of occurrence

73. Your friend is the owner of a stock which had returns of 25 percent, -36 percent, 1 percent,
and 16 percent for the past three years. Your friend thinks the stock may be able to achieve a
return of 50 percent or more in a single year. Based on these returns, what is the probability
that your friend is correct?
A. less than 0.5 percent
B. greater than 0.5 percent but less than 1.0 percent
C. greater than 1.0 percent but less than 2.5 percent
D. greater than 2.5 percent but less than 16 percent
E. greater than 16.0 percent
Average return = (0.25 - 0.36 + 0.01 + 0.16)/4 = 0.015
= [1/(4 - 1)] [(0.25 - 0.015)2 + (-0.36 - 0.015)2 + (0.01 - 0.015)2 + (0.16 - 0.015)2] =
0.2689
Upper end of 68 percent range = 0.015 + (1 0.2689) = 28.39 percent
Upper end of 95 percent range = 0.015 + (2 0.2689) = 55.28 percent
The probability of earning at least 50 percent in any one year is greater than 2.5 percent but
less than 16 percent.

AACSB: Analytic
Bloom's: Analysis
Difficulty: Intermediate
Learning Objective: 12-3
Section: 12.4
Topic: Probability of occurrence

74. A stock had returns of 15 percent, 8 percent, 12 percent, -21 percent, and -4 percent for the
past five years. Based on these returns, what is the approximate probability that this stock will
return at least 15 percent in any one given year?
A. less than 0.5 percent
B. greater than 0.5 percent but less than 1.0 percent
C. greater than 1.0 percent but less than 2.5 percent
D. greater than 2.5 percent but less than 16 percent
E. greater than 16.0 percent
Average return = (0.15 + 0.08 + 0.12 - 0.21 - 0.04)/5 = 0.02
= [1/(5 - 1)] [(0.15 - 0.02)2 + (0.08 - 0.02)2 + (0.12 - 0.02)2 + (-0.21 - 0.02)2 + (-0.04 0.02)2] = 0.1475
Upper end of 68 percent range = 0.02 + 0.1475 = 16.75 percent
Probability of earning at least 15 percent in any one year is greater than 16 percent.

AACSB: Analytic
Bloom's: Analysis
Difficulty: Intermediate
Learning Objective: 12-3
Section: 12.4
Topic: Probability of occurrence

75. A stock had returns of 14 percent, 13 percent, -10 percent, and 7 percent for the past four
years. Which one of the following best describes the probability that this stock will lose no
more than 10 percent in any one year?
A. greater than 0.5 but less than 1.0 percent
B. greater than 1.0 percent but less than 2.5 percent
C. greater than 2.5 percent but less than 16 percent
D. greater than 84 percent but less than 97.5 percent
E. greater than 95 percent
Average return = (0.14 + 0.13 - 0.10 + 0.07)/4 = 0.06
= [1/(4 - 1)][(0.14 - 0.06)2 + (0.13 - 0.06)2 + (-0.10 - 0.06)2 + (0.07 - 0.06)2] = 0.11106
Lower bound of 68 percent range = 0.06 - (1 0.11106) = -5.11 percent
Lower bound of 95 percent range = 0.06 - (2 0.11106) = -16.21 percent
Probability of losing more than 10 percent in any given year is between 2.5 and 16 percent.
Thus, the probability of NOT losing more than 10 percent is between 84 and 97.5 percent.

AACSB: Analytic
Bloom's: Analysis
Difficulty: Intermediate
Learning Objective: 12-3
Section: 12.4
Topic: Probability of occurrence

76. Over the past five years, a stock produced returns of 11 percent, 14 percent, 2 percent, -9
percent, and 5 percent. What is the probability that an investor in this stock will not lose more
than 10 percent in any one given year?
A. greater than 0.5 but less than 1.0 percent
B. greater than 1.0 percent but less than 2.5 percent
C. greater than 2.5 percent but less than 16 percent
D. greater than 84 percent but less than 97.5 percent
E. greater than 95 percent
Average return = (0.11 + 0.14 + 0.02 - 0.09 + 0.05)/5 = 0.046
= [1/(5 - 1)][(0.11 - 0.046)2 + (0.14 - 0.046)2 + (0.02 - 0.046)2 + (-0.09 - 0.046)2 + (0.05 0.046)2] = 0.08961
Lower bound of 68% probability range = 0.046 - (1 0.08961) = -4.36 percent
Lower bound of 95% probability range = 0.046 - (2 0.08961) = -13.32 percent
The probability of losing 10 percent or more is greater than 2.5 percent but less than 16
percent. Thus, the probability of NOT losing more than 10 percent is greater than 84 percent
but less than 97.5 percent.

AACSB: Analytic
Bloom's: Analysis
Difficulty: Intermediate
Learning Objective: 12-3
Section: 12.4
Topic: Probability of occurrence

77. A stock has annual returns of 6 percent, 14 percent, -3 percent, and 2 percent for the past
four years. The arithmetic average of these returns is _____ percent while the geometric
average return for the period is _____ percent.
A. 4.57; 4.75
B. 4.75; 4.57
C. 6.33; 6.19
D. 6.19; 6.33
E. 6.33; 6.33
Arithmetic average = (0.06 + 0.14 - 0.03 + 0.02)/4 = 4.75 percent
Geometric return = (1.06 1.14 0.97 1.02).25 - 1 = 4.57 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 12-1
Section: 12.5
Topic: Arithmetic and geometric returns

78. A stock has annual returns of 13 percent, 21 percent, -12 percent, 7 percent, and -6 percent
for the past five years. The arithmetic average of these returns is _____ percent while the
geometric average return for the period is _____ percent.
A. 3.89; 3.62
B. 3.89; 4.60
C. 3.62; 3.89
D. 4.60; 3.62
E. 4.60; 3.89
Arithmetic average = (0.13 + 0.21- 0.12 + 0.07 - 0.06)/5 = 4.60 percent
Geometric return = (1.13 1.21 0.88 1.07 0.94).20 - 1 = 3.89 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 12-1
Section: 12.5
Topic: Arithmetic and geometric returns

79. A stock had returns of 16 percent, 4 percent, 8 percent, 14 percent, -9 percent, and -5
percent over the past six years. What is the geometric average return for this time period?
A. 4.26 percent
B. 4.67 percent
C. 5.13 percent
D. 5.39 percent
E. 5.60 percent
Geometric average = (1.16 1.04 1.08 1.14 0.91 0.95)1/6 - 1 = 4.26 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 12-1
Section: 12.5
Topic: Geometric return

80. A stock had the following prices and dividends. What is the geometric average return on
this stock?

A. -15.87 percent
B. -15.21 percent
C. -13.33 percent
D. -12.91 percent
E. -11.48 percent
Return for year 2 = ($16.62 - $16.40 + $0.50)/$16.40 = 4.3902 percent
Return for year 3 = ($15.48 - $16.62 + $0.50)/$16.62 = -3.8508 percent
Return for year 4 = ($9.15 - $15.48 + $0.25)/$15.48 = -39.2765 percent
Geometric return = (1.043902 0.961492 0.607235)1/3 - 1 = -15.21 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 12-1
Section: 12.5
Topic: Geometric return

81. Over the past fifteen years, the common stock of The Flower Shoppe, Inc. has produced
an arithmetic average return of 12.2 percent and a geometric average return of 11.5 percent.
What is the projected return on this stock for the next five years according to Blume's
formula?
A. 11.70 percent
B. 11.89 percent
C. 12.00 percent
D. 12.03 percent
E. 12.12 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Intermediate
Learning Objective: 12-1
Section: 12.5
Topic: Blume's formula

82. Based on past 26 years, Westerfield Industrial Supply's common stock has yielded an
arithmetic average rate of return of 9.63 percent. The geometric average return for the same
period was 8.57 percent. What is the estimated return on this stock for the next 4 years
according to Blume's formula?
A. 8.70 percent
B. 8.92 percent
C. 9.13 percent
D. 9.38 percent
E. 9.50 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Intermediate
Learning Objective: 12-1
Section: 12.5
Topic: Blume's formula

83. A stock has a geometric average return of 14.6 percent and an arithmetic average return of
15.5 percent based on the last 33 years. What is the estimated average rate of return for the
next 6 years based on Blume's formula?
A. 14.79 percent
B. 14.96 percent
C. 15.28 percent
D. 15.36 percent
E. 15.42 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Intermediate
Learning Objective: 12-1
Section: 12.5
Topic: Blume's formula

Essay Questions

84. Define and explain the three forms of market efficiency.


The current stock price reflects the following information for each form of efficiency:

Feedback: Refer to section 12.6

AACSB: Reflective thinking


Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 12-4
Section: 12.6
Topic: Market efficiency

85. What are the two primary lessons learned from capital market history? Use historical
information to justify that these lessons are correct.
First, there is a reward for bearing risk, and second, the greater the risk, the greater the
potential reward. As evidence, students should provide a brief discussion of the historical rates
of return and the related standard deviations of the various asset classes discussed in the text.
Feedback: Refer to sections 12.3 and 12.4

AACSB: Reflective thinking


Bloom's: Comprehension
Difficulty: Intermediate
Learning Objective: 12-2 and 12-3
Section: 12.3 and 12.4
Topic: Capital market history

86. How can an investor lose money on a stock while making money on a bond investment if
there is a reward for bearing risk? Aren't stocks riskier than bonds?
There is a reward for bearing risk over the long-term. However, the nature of risk implies the
returns on a high risk security will be more volatile than the returns on a low risk security.
Thus, stocks can produce lower returns in the short run. It is the acceptance of this risk that
justifies the potential long-term reward.
Feedback: Refer to section 12.3

AACSB: Reflective thinking


Bloom's: Analysis
Difficulty: Intermediate
Learning Objective: 12-2
Section: 12.3
Topic: Risk and return

87. Shawn earned an average return of 14.6 percent on his investments over the past 20 years
while the S&P 500, a measure of the overall market, only returned an average of 13.9 percent.
Explain how this can occur if the stock market is efficient.
An investor can purchase securities that have a higher level of risk than the overall market.
In an efficient market, these securities will earn a higher return over the long-term as
compensation for the assumption of the increased risk. This is the first lesson of the capital
markets: There is a reward for bearing risk.
Feedback: Refer to section 12.3

AACSB: Reflective thinking


Bloom's: Analysis
Difficulty: Intermediate
Learning Objective: 12-2 and 12-3
Section: 12.3
Topic: Risk and return

88. You want to invest in an index fund which directly correlates to the overall U.S. stock
market. How can you determine if the market risk premium you are expecting to earn is
reasonable for the long-term?
You could compare your expectation to the historical market risk premium for the United
States, as well as other industrialized countries, realizing of course, that the future will not be
exactly like the past. Nevertheless, this should indicate whether or not your expectation is at
least reasonable.
Feedback: Refer to section 12.4

AACSB: Reflective thinking


Bloom's: Analysis
Difficulty: Intermediate
Learning Objective: 12-3
Section: 12.4
Topic: Historical risk premium

Multiple Choice Questions

89. Suppose a stock had an initial price of $80 per share, paid a dividend of $1.35 per share
during the year, and had an ending share price of $87. What was the capital gains yield?
A. 1.55 percent
B. 1.69 percent
C. 8.05 percent
D. 8.75 percent
E. 10.44 percent
Capital gains yield = ($87 - $80)/$80 = 8.75 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
EOC #: 12-2
Learning Objective: 12-1
Section: 12.1
Topic: Capital gains yield

90. Suppose you bought a 15 percent coupon bond one year ago for $950. The face value of
the bond is $1,000. The bond sells for $985 today. If the inflation rate last year was 9 percent,
what was your total real rate of return on this investment?
A. -4.88 percent
B. -5.32 percent
C. 9.61 percent
D. 9.78 percent
E. 10.47 percent
Nominal return = ($985 - $950 + $150)/$950 = 0.1947
Real return = [(1 + 0.1947)/(1 + 0.09)] - 1 = 9.61 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
EOC #: 12-4
Learning Objective: 12-1
Section: 12.3
Topic: Nominal and real returns

91. Calculate the standard deviation of the following rates of return:

A. 10.79 percent
B. 12.60 percent
C. 13.48 percent
D. 14.42 percent
E. 15.08 percent
Average return = (0.07 + 0.25 + 0.14 - 0.15 + 0.16)/5 = 0.094
Standard deviation = [1/(5 - 1)] [(0.07 - 0.094)2 + (0.25 - 0.094)2 +(0.14 - 0.094)2 +(-0.15 0.094)2 + (0.16 - 0.094)2] = 15.08 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
EOC #: 12-7
Learning Objective: 12-1
Section: 12.4
Topic: Standard deviation

92. You've observed the following returns on Crash-n-Burn Computer's stock over the past
five years: 2 percent, -12 percent, 27 percent, 22 percent, and 18 percent. What is the variance
of these returns?
A. 0.02070
B. 0.02588
C. 0.01725
D. 0.01684
E. 0.02633
Average = (0.02 - 0.12 + 0.27 + 0.22 + 0.18)/5 = 0.114
Variance = [1/(5 - 1)] [(0.02 - 0.114)2 + (-0.12 - 0.114)2 + (0.27 - 0.114)2 + (0.22 - 0.114)2 +
(0.18 - 0.114)2] = 0.02588

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
EOC #: 12-9
Learning Objective: 12-1
Section: 12.4
Topic: Variance

93. You've observed the following returns on Crash-n-Burn Computer's stock over the past
five years: 3 percent, -10 percent, 24 percent, 22 percent, and 12 percent. Suppose the average
inflation rate over this time period was 3.6 percent and the average T-bill rate was 4.8 percent.
Based on this information, what was the average nominal risk premium?
A. 5.15 percent
B. 5.40 percent
C. 6.01 percent
D. 6.37 percent
E. 6.60 percent
Average return = (0.03 - 0.10 + 0.24 + 0.22 + 0.12)/5 = 0.102
Average nominal risk premium = 0.102 - 0.048 = 5.40 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
EOC #: 12-10
Learning Objective: 12-1
Section: 12.3
Topic: Nominal risk premium

94. You bought one of Great White Shark Repellant Co.'s 10 percent coupon bonds one year
ago for $760. These bonds pay annual payments, have a face value of $1,000, and mature 14
years from now. Suppose you decide to sell your bonds today when the required return on the
bonds is 14 percent. The inflation rate over the past year was 3.7 percent. What was your total
real return on this investment?
A. 8.97 percent
B. 9.11 percent
C. 9.18 percent
D. 9.44 percent
E. 9.58 percent

Nominal return = ($759.92 - $760 + $100)/$760 = 0.13147


Real return = [(1 + 0.13147)/(1 + 0.037)] - 1 = 9.11 percent

AACSB: Analytic
Bloom's: Analysis
Difficulty: Intermediate
EOC #: 12-13
Learning Objective: 12-1
Section: 12.3
Topic: Real return

95. You find a certain stock that had returns of 4 percent, -5 percent, -15 percent, and 16
percent for four of the last five years. The average return of the stock for the 5-year period
was 13 percent. What is the standard deviation of the stock's returns for the five-year period?
A. 21.39 percent
B. 24.98 percent
C. 27.16 percent
D. 31.23 percent
E. 34.02 percent
Return for missing year: 0.04 - 0.05 - 0.15 + 0.16 + x = 0.13 5; x = 65 percent
Std dev = [1/(5 - 1)] [(0.04 - 0.13)2 + (-0.05 - 0.13)2 + (-0.15 - 0.13)2 + (0.16 - 0.13)2 + (0.65
- 0.13)2 = 31.23 percent

AACSB: Analytic
Bloom's: Analysis
Difficulty: Intermediate
EOC #: 12-14
Learning Objective: 12-3
Section: 12.4
Topic: Standard deviation

96. A stock had returns of 12 percent, 16 percent, 13 percent, 19 percent, 15 percent, and -6
percent over the last six years. What is the geometric average return on the stock for this
period?
A. 10.90 percent
B. 11.18 percent
C. 13.56 percent
D. 14.76 percent
E. 15.01 percent
Geometric average = (1.12 1.16 1.13 1.19 1.15 0.94)1/6 - 1 = 11.18 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Intermediate
EOC #: 12-15
Learning Objective: 12-1
Section: 12.5
Topic: Geometric average return

97. Assume that the returns from an asset are normally distributed. The average annual return
for the asset is 18.1 percent and the standard deviation of the returns is 32.5 percent. What is
the approximate probability that your money will triple in value in a single year?
A. less than 0.5 percent
B. less than 1 percent but greater than 0.5 percent
C. less then 2.5 percent but greater than 1 percent
D. less than 5 percent but greater than 2.5 percent
E. less than 10 percent but greater than 5 percent
The upper tail of the 99 percent range = 0.181 + (3 0.325) = 1.156 = 115.6 percent, which is
less than the 200 percent required to triple your money. Thus, the probability of occurrence is
less than 0.5 percent.

AACSB: Analytic
Bloom's: Analysis
Difficulty: Basic
EOC #:12-17
Learning Objective: 12-3
Section: 12.4
Topic: Probability ranges

98. Over a 34-year period an asset had an arithmetic return of 13 percent and a geometric
return of 10.5 percent. Using Blume's formula, what is your best estimate of the future annual
returns over the next 10 years?
A. 11.18 percent
B. 11.27 percent
C. 11.84 percent
D. 12.32 percent
E. 12.46 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Intermediate
EOC #: 12-20
Learning Objective: 12-1
Section: 12.5
Topic: Blume's formula

Chapter 13 Return, Risk, and the Security Market Line Answer


Key

Multiple Choice Questions


1.

You own a stock that you think will produce a return of 11 percent in
a good economy and 3 percent in a poor economy. Given the
probabilities of each state of the economy occurring, you anticipate
that your stock will earn 6.5 percent next year. Which one of the
following terms applies to this 6.5 percent?

A.
B.
C.
D.
E.

arithmetic return
historical return
expected return
geometric return
required return

Refer to section 13.1


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.1
Topic: Expected return

2.

Suzie owns five different bonds valued at $36,000 and twelve


different stocks valued at $82,500 total. Which one of the following
terms most applies to Suzie's investments?

A.
B.
C.
D.
E.

index
portfolio
collection
grouping
risk-free

Refer to section 13.2


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-02 The impact of diversification.
Section: 13.2
Topic: Portfolio

3.

Steve has invested in twelve different stocks that have a combined


value today of $121,300. Fifteen percent of that total is invested in
Wise Man Foods. The 15 percent is a measure of which one of the
following?

A.
B.
C.
D.
E.

portfolio return
portfolio weight
degree of risk
price-earnings ratio
index value

Refer to section 13.2


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-02 The impact of diversification.
Section: 13.2
Topic: Portfolio weight

4.

Which one of the following is a risk that applies to most securities?

A.
B.
C.
D.
E.

unsystematic
diversifiable
systematic
asset-specific
total

Refer to section 13.4


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-03 The systematic risk principle.
Section: 13.4
Topic: Systematic risk

5.

A news flash just appeared that caused about a dozen stocks to


suddenly drop in value by about 20 percent. What type of risk does
this news flash represent?

A.
B.
C.
D.
E.

portfolio
nondiversifiable
market
unsystematic
total

Refer to section 13.4


AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-03 The systematic risk principle.
Section: 13.4
Topic: Unsystematic risk

6.

The principle of diversification tells us that:

A. concentrating an investment in two or three large stocks will


eliminate all of the unsystematic risk.
B. concentrating an investment in three companies all within the
same industry will greatly reduce the systematic risk.
C. spreading an investment across five diverse companies will not
lower the total risk.
D. spreading an investment across many diverse assets will eliminate
all of the systematic risk.
E. spreading an investment across many diverse assets will eliminate
some of the total risk.
Refer to section 13.5
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-02 The impact of diversification.
Section: 13.5
Topic: Diversification

7.

The _____ tells us that the expected return on a risky asset depends
only on that asset's nondiversifiable risk.

A.
B.
C.
D.
E.

efficient markets hypothesis


systematic risk principle
open markets theorem
law of one price
principle of diversification

Refer to section 13.6


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-03 The systematic risk principle.
Section: 13.6
Topic: Systematic risk

8.

Which one of the following measures the amount of systematic risk


present in a particular risky asset relative to the systematic risk
present in an average risky asset?

A.
B.
C.
D.
E.

beta
reward-to-risk ratio
risk ratio
standard deviation
price-earnings ratio

Refer to section 13.6


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-03 The systematic risk principle.
Section: 13.6
Topic: Beta

9.

Which one of the following is a positively sloped linear function that is


created when expected returns are graphed against security betas?

A.
B.
C.
D.
E.

reward-to-risk matrix
portfolio weight graph
normal distribution
security market line
market real returns

Refer to section 13.7


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: Security market line

10.

Which one of the following is represented by the slope of the security


market line?

A.
B.
C.
D.
E.

reward-to-risk ratio
market standard deviation
beta coefficient
risk-free interest rate
market risk premium

Refer to section 13.7


AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: Security market line

11.

Which one of the following is the formula that explains the


relationship between the expected return on a security and the level
of that security's systematic risk?

A.
B.
C.
D.
E.

capital asset pricing model


time value of money equation
unsystematic risk equation
market performance equation
expected risk formula

Refer to section 13.7


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: Capital asset pricing model

12.

Treynor Industries is investing in a new project. The minimum rate of


return the firm requires on this project is referred to as the:

A.
B.
C.
D.
E.

average arithmetic return.


expected return.
market rate of return.
internal rate of return.
cost of capital.

Refer to section 13.8


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.8
Topic: Cost of capital

13.

The expected return on a stock given various states of the economy


is equal to the:

A. highest expected return given any economic state.


B. arithmetic average of the returns for each economic state.
C. summation of the individual expected rates of return.
D. weighted average of the returns for each economic state.
E. return for the economic state with the highest probability of
occurrence.
Refer to section 13.1
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.1
Topic: Expected return

14.

The expected return on a stock computed using economic


probabilities is:

A. guaranteed to equal the actual average return on the stock for the
next five years.
B. guaranteed to be the minimal rate of return on the stock over the
next two years.
C. guaranteed to equal the actual return for the immediate twelve
month period.
D. a mathematical expectation based on a weighted average and not
an actual anticipated outcome.
E. the actual return you should anticipate as long as the economic
forecast remains constant.
Refer to section 13.1
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.1
Topic: Expected return

15.

The expected risk premium on a stock is equal to the expected return


on the stock minus the:

A.
B.
C.
D.
E.

expected market rate of return.


risk-free rate.
inflation rate.
standard deviation.
variance.

Refer to section 13.1


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.1
Topic: Risk premium

16.

Standard deviation measures which type of risk?

A.
B.
C.
D.
E.

total
nondiversifiable
unsystematic
systematic
economic

Refer to section 13.1


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-03 The systematic risk principle.
Section: 13.1
Topic: Standard deviation

17.

The expected rate of return on a stock portfolio is a weighted


average where the weights are based on the:

A.
B.
C.
D.
E.

number of shares owned of each stock.


market price per share of each stock.
market value of the investment in each stock.
original amount invested in each stock.
cost per share of each stock held.

Refer to section 13.2


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.2
Topic: Expected return

18.

The expected return on a portfolio considers which of the following


factors?
I. percentage of the portfolio invested in each individual security
II. projected states of the economy
III. the performance of each security given various economic states
IV. probability of occurrence for each state of the economy

A.
B.
C.
D.
E.

I and III only


II and IV only
I, III, and IV only
II, III, and IV only
I, II, III, and IV

Refer to section 13.2


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.2
Topic: Expected return

19.

The expected return on a portfolio:


I. can never exceed the expected return of the best performing
security in the portfolio.
II. must be equal to or greater than the expected return of the worst
performing security in the portfolio.
III. is independent of the unsystematic risks of the individual
securities held in the portfolio.
IV. is independent of the allocation of the portfolio amongst individual
securities.

A.
B.
C.
D.
E.

I and III only


II and IV only
I and II only
I, II, and III only
I, II, III, and IV

Refer to sections 13.2 and 13.6


AACSB: Analytic
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.2 and 13.6
Topic: Expected return

20.

If a stock portfolio is well diversified, then the portfolio variance:

A. will equal the variance of the most volatile stock in the portfolio.
B. may be less than the variance of the least risky stock in the
portfolio.
C. must be equal to or greater than the variance of the least risky
stock in the portfolio.
D. will be a weighted average of the variances of the individual
securities in the portfolio.
E. will be an arithmetic average of the variances of the individual
securities in the portfolio.
Refer to section 13.5
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-02 The impact of diversification.
Section: 13.5
Topic: Diversification

21.

The standard deviation of a portfolio:

A. is a weighted average of the standard deviations of the individual


securities held in the portfolio.
B. can never be less than the standard deviation of the most risky
security in the portfolio.
C. must be equal to or greater than the lowest standard deviation of
any single security held in the portfolio.
D. is an arithmetic average of the standard deviations of the
individual securities which comprise the portfolio.
E. can be less than the standard deviation of the least risky security
in the portfolio.
Refer to section 13.2
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.2
Topic: Standard deviation

22.

The standard deviation of a portfolio:

A. is a measure of that portfolio's systematic risk.


B. is a weighed average of the standard deviations of the individual
securities held in that portfolio.
C. measures the amount of diversifiable risk inherent in the portfolio.
D. serves as the basis for computing the appropriate risk premium for
that portfolio.
E. can be less than the weighted average of the standard deviations
of the individual securities held in that portfolio.
Refer to section 13.5
AACSB: Analytic
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 13-02 The impact of diversification.
Section: 13.5
Topic: Standard deviation

23.

Which one of the following statements is correct concerning a


portfolio of 20 securities with multiple states of the economy when
both the securities and the economic states have unequal weights?

A. Given the unequal weights of both the securities and the economic
states, the standard deviation of the portfolio must equal that of
the overall market.
B. The weights of the individual securities have no effect on the
expected return of a portfolio when multiple states of the economy
are involved.
C. Changing the probabilities of occurrence for the various economic
states will not affect the expected standard deviation of the
portfolio.
D. The standard deviation of the portfolio will be greater than the
highest standard deviation of any single security in the portfolio
given that the individual securities are well diversified.
E. Given both the unequal weights of the securities and the economic
states, an investor might be able to create a portfolio that has an
expected standard deviation of zero.
Refer to section 13.2
AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 13-02 The impact of diversification.
Section: 13.2
Topic: Standard deviation

24.

Which one of the following events would be included in the expected


return on Sussex stock?

A. The chief financial officer of Sussex unexpectedly resigned.


B. The labor union representing Sussex' employees unexpectedly
called a strike.
C. This morning, Sussex confirmed that its CEO is retiring at the end
of the year as was anticipated.
D. The price of Sussex stock suddenly declined in value because
researchers accidentally discovered that one of the firm's products
can be toxic to household pets.
E. The board of directors made an unprecedented decision to give
sizeable bonuses to the firm's internal auditors for their efforts in
uncovering wasteful spending.
Refer to section 13.3
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.3
Topic: Expected return

25.

Which one of the following statements is correct?

A. The unexpected return is always negative.


B. The expected return minus the unexpected return is equal to the
total return.
C. Over time, the average return is equal to the unexpected return.
D. The expected return includes the surprise portion of news
announcements.
E. Over time, the average unexpected return will be zero.
Refer to section 13.3
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.3
Topic: Unexpected returns

26.

Which one of the following statements related to unexpected returns


is correct?

A. All announcements by a firm affect that firm's unexpected returns.


B. Unexpected returns over time have a negative effect on the total
return of a firm.
C. Unexpected returns are relatively predictable in the short-term.
D. Unexpected returns generally cause the actual return to vary
significantly from the expected return over the long-term.
E. Unexpected returns can be either positive or negative in the short
term but tend to be zero over the long-term.
Refer to section 13.3
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.3
Topic: Unexpected returns

27.

Which one of the following is an example of systematic risk?

A. investors panic causing security prices around the globe to fall


precipitously
B. a flood washes away a firm's warehouse
C. a city imposes an additional one percent sales tax on all products
D. a toymaker has to recall its top-selling toy
E. corn prices increase due to increased demand for alternative fuels
Refer to section 13.4
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-03 The systematic risk principle.
Section: 13.4
Topic: Systematic risk

28.

Unsystematic risk:

A. can be effectively eliminated by portfolio diversification.


B. is compensated for by the risk premium.
C.
is measured by beta.
D.
is measured by standard deviation.
E.
is related to the overall economy.
Refer to section 13.4
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-03 The systematic risk principle.
Section: 13.4
Topic: Unsystematic risk

29.

Which one of the following is an example of unsystematic risk?

A. income taxes are increased across the board


B.
a national sales tax is adopted
C. inflation decreases at the national level
D. an increased feeling of prosperity is felt around the globe
E. consumer spending on entertainment decreased nationally
Refer to section 13.4
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-03 The systematic risk principle.
Section: 13.4
Topic: Unsystematic risk

30.

Which one of the following is least apt to reduce the unsystematic


risk of a portfolio?

A.
B.
C.
D.
E.

reducing the number of stocks held in the portfolio


adding bonds to a stock portfolio
adding international securities into a portfolio of U.S. stocks
adding U.S. Treasury bills to a risky portfolio
adding technology stocks to a portfolio of industrial stocks

Refer to section 13.5


AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-03 The systematic risk principle.
Section: 13.5
Topic: Unsystematic risk

31.

Which one of the following statements is correct concerning


unsystematic risk?

A. An investor is rewarded for assuming unsystematic risk.


B. Eliminating unsystematic risk is the responsibility of the individual
investor.
C. Unsystematic risk is rewarded when it exceeds the market level of
unsystematic risk.
D. Beta measures the level of unsystematic risk inherent in an
individual security.
E. Standard deviation is a measure of unsystematic risk.
Refer to sections 13.5 and 13.6
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-03 The systematic risk principle.
Section: 13.5 and 13.6
Topic: Unsystematic risk

32.

Which one of the following statements related to risk is correct?

A. The beta of a portfolio must increase when a stock with a high


standard deviation is added to the portfolio.
B. Every portfolio that contains 25 or more securities is free of
unsystematic risk.
C. The systematic risk of a portfolio can be effectively lowered by
adding T-bills to the portfolio.
D. Adding five additional stocks to a diversified portfolio will lower the
portfolio's beta.
E. Stocks that move in tandem with the overall market have zero
betas.
Refer to section 13.5
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-03 The systematic risk principle.
Section: 13.5
Topic: Risk

33.

Which one of the following risks is irrelevant to a well-diversified


investor?

A.
B.
C.
D.
E.

systematic risk
unsystematic risk
market risk
nondiversifiable risk
systematic portion of a surprise

Refer to section 13.5


AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-03 The systematic risk principle.
Section: 13.5
Topic: Unsystematic risk

34.

Which of the following are examples of diversifiable risk?


I. earthquake damages an entire town
II. federal government imposes a $100 fee on all business entities
III. employment taxes increase nationally
IV. toymakers are required to improve their safety standards

A.
B.
C.
D.
E.

I and III only


II and IV only
II and III only
I and IV only
I, III, and IV only

Refer to section 13.5


AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-02 The impact of diversification.
Learning Objective: 13-03 The systematic risk principle.
Section: 13.5
Topic: Unsystematic risk

35.

Which of the following statements are correct concerning diversifiable


risks?
I. Diversifiable risks can be essentially eliminated by investing in
thirty unrelated securities.
II. There is no reward for accepting diversifiable risks.
III. Diversifiable risks are generally associated with an individual firm
or industry.
IV. Beta measures diversifiable risk.

A.
B.
C.
D.
E.

I and III only


II and IV only
I and IV only
I, II and III only
I, II, III, and IV

Refer to sections 13.5 and 13.6


AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-03 The systematic risk principle.
Section: 13.5 and 13.6
Topic: Unsystematic risk

36.

Which one of the following is the best example of a diversifiable risk?

A.
B.
C.
D.
E.

interest rates increase


energy costs increase
core inflation increases
a firm's sales decrease
taxes decrease

Refer to section 13.5


AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-02 The impact of diversification.
Learning Objective: 13-03 The systematic risk principle.
Section: 13.5
Topic: Unsystematic risk

37.

Which of the following statements concerning risk are correct?


I. Nondiversifiable risk is measured by beta.
II. The risk premium increases as diversifiable risk increases.
III. Systematic risk is another name for nondiversifiable risk.
IV. Diversifiable risks are market risks you cannot avoid.

A.
B.
C.
D.
E.

I and III only


II and IV only
I and II only
III and IV only
I, II, and III only

Refer to section 13.5


AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-03 The systematic risk principle.
Section: 13.5
Topic: Systematic and unsystematic risk

38.

The primary purpose of portfolio diversification is to:

A.
B.
C.
D.
E.

increase returns and risks.


eliminate all risks.
eliminate asset-specific risk.
eliminate systematic risk.
lower both returns and risks.

Refer to section 13.5


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-02 The impact of diversification.
Learning Objective: 13-03 The systematic risk principle.
Section: 13.5
Topic: Diversification

39.

Which one of the following indicates a portfolio is being effectively


diversified?

A.
B.
C.
D.
E.

an increase in the portfolio beta


a decrease in the portfolio beta
an increase in the portfolio rate of return
an increase in the portfolio standard deviation
a decrease in the portfolio standard deviation

Refer to section 13.5


AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-03 The systematic risk principle.
Section: 13.5
Topic: Diversification

40.

How many diverse securities are required to eliminate the majority of


the diversifiable risk from a portfolio?

A.
B.
C.
D.
E.

5
10
25
50
75

Refer to section 13.5


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-02 The impact of diversification.
Learning Objective: 13-03 The systematic risk principle.
Section: 13.5
Topic: Diversification

41.

Systematic risk is measured by:

A.
B.
C.
D.
E.

the mean.
beta.
the geometric average.
the standard deviation.
the arithmetic average.

Refer to section 13.6


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-03 The systematic risk principle.
Section: 13.6
Topic: Systematic risk

42.

Which one of the following is most directly affected by the level of


systematic risk in a security?

A.
B.
C.
D.
E.

variance of the returns


standard deviation of the returns
expected rate of return
risk-free rate
market risk premium

Refer to section 13.7


AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: CAPM

43.

Which one of the following statements is correct concerning a


portfolio beta?

A. Portfolio betas range between -1.0 and +1.0.


B. A portfolio beta is a weighted average of the betas of the
individual securities contained in the portfolio.
C. A portfolio beta cannot be computed from the betas of the
individual securities comprising the portfolio because some risk is
eliminated via diversification.
D. A portfolio of U.S. Treasury bills will have a beta of +1.0.
E. The beta of a market portfolio is equal to zero.
Refer to section 13.6
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.6
Topic: Beta

44.

The systematic risk of the market is measured by:

A.
B.
C.
D.
E.

a beta of 1.0.
a beta of 0.0.
a standard deviation of 1.0.
a standard deviation of 0.0.
a variance of 1.0.

Refer to section 13.6


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.6
Topic: Beta

45.

At a minimum, which of the following would you need to know to


estimate the amount of additional reward you will receive for
purchasing a risky asset instead of a risk-free asset?
I. asset's standard deviation
II. asset's beta
III. risk-free rate of return
IV. market risk premium

A.
B.
C.
D.
E.

I and III only


II and IV only
III and IV only
I, III, and IV only
I, II, III, and IV

Refer to section 13.7


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: CAPM

46.

Total risk is measured by _____ and systematic risk is measured by


_____.

A.
B.
C.
D.
E.

beta; alpha
beta; standard deviation
alpha; beta
standard deviation; beta
standard deviation; variance

Refer to section 13.6


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.6
Topic: Risk measures

47.

The intercept point of the security market line is the rate of return
which corresponds to:

A.
B.
C.
D.
E.

the risk-free rate.


the market rate.
a return of zero.
a return of 1.0 percent.
the market risk premium.

Refer to section 13.7


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: Security market line

48.

A stock with an actual return that lies above the security market line
has:

A. more systematic risk than the overall market.


B. more risk than that warranted by CAPM.
C. a higher return than expected for the level of risk assumed.
D. less systematic risk than the overall market.
E. a return equivalent to the level of risk assumed.
Refer to section 13.7
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: Security market line

49.

The market rate of return is 11 percent and the risk-free rate of


return is 3 percent. Lexant stock has 3 percent less systematic risk
than the market and has an actual return of 12 percent. This stock:

A.
is underpriced.
B.
is correctly priced.
C. will plot below the security market line.
D.
will plot on the security market line.
E. will plot to the right of the overall market on a security market line
graph.
Refer to section 13.7
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: Security market line

50.

Which one of the following will be constant for all securities if the
market is efficient and securities are priced fairly?

A.
B.
C.
D.
E.

variance
standard deviation
reward-to-risk ratio
beta
risk premium

Refer to section 13.7


AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: Reward-to-risk ratio

51.

The reward-to-risk ratio for stock A is less than the reward-to-risk


ratio of stock B. Stock A has a beta of 0.82 and stock B has a beta of
1.29. This information implies that:

A. stock A is riskier than stock B and both stocks are fairly priced.
B. stock A is less risky than stock B and both stocks are fairly priced.
C. either stock A is underpriced or stock B is overpriced or both.
D. either stock A is overpriced or stock B is underpriced or both.
E. both stock A and stock B are correctly priced since stock A is
riskier than stock B.
Refer to section 13.7
AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: Reward-to-risk ratio

52.

The market risk premium is computed by:

A. adding the risk-free rate of return to the inflation rate.


B. adding the risk-free rate of return to the market rate of return.
C. subtracting the risk-free rate of return from the inflation rate.
D. subtracting the risk-free rate of return from the market rate of
return.
E. multiplying the risk-free rate of return by a beta of 1.0.
Refer to section 13.7
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: Market risk premium

53.

The excess return earned by an asset that has a beta of 1.34 over
that earned by a risk-free asset is referred to as the:

A.
B.
C.
D.
E.

market risk premium.


risk premium.
systematic return.
total return.
real rate of return.

Refer to section 13.7


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: Risk premium

54.

The _____ of a security divided by the beta of that security is equal to


the slope of the security market line if the security is priced fairly.

A.
B.
C.
D.
E.

real return
actual return
nominal return
risk premium
expected return

Refer to section 13.7


AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: Reward-to-risk ratio

55.

The capital asset pricing model (CAPM) assumes which of the


following?
I. a risk-free asset has no systematic risk.
II. beta is a reliable estimate of total risk.
III. the reward-to-risk ratio is constant.
IV. the market rate of return can be approximated.

A.
B.
C.
D.
E.

I and III only


II and IV only
I, III, and IV only
II, III, and IV only
I, II, III, and IV

Refer to section 13.7


AACSB: Analytic
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: CAPM

56.

According to CAPM, the amount of reward an investor receives for


bearing the risk of an individual security depends upon the:

A. amount of total risk assumed and the market risk premium.


B. market risk premium and the amount of systematic risk inherent in
the security.
C. risk free rate, the market rate of return, and the standard deviation
of the security.
D. beta of the security and the market rate of return.
E. standard deviation of the security and the risk-free rate of return.
Refer to section 13.7
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: Risk premium

57.

Which one of the following should earn the most risk premium based
on CAPM?

A. diversified portfolio with returns similar to the overall market


B.
stock with a beta of 1.38
C.
stock with a beta of 0.74
D.
U.S. Treasury bill
E.
portfolio with a beta of 1.01
Refer to section 13.7
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: Risk premium

58.

You want your portfolio beta to be 0.90. Currently, your portfolio


consists of $4,000 invested in stock A with a beta of 1.47 and $3,000
in stock B with a beta of 0.54. You have another $9,000 to invest and
want to divide it between an asset with a beta of 1.74 and a risk-free
asset. How much should you invest in the risk-free asset?

A.
B.
C.
D.
E.

$3,965.52
$4,425.29
$4,902.29
$5,034.48
$5,683.92

BetaPortfolio = 0.90 = ($4,000/$16,000)(1.47) + ($3,000/$16,000)(0.54)


+ (x/$16,000)(1.74) + (($9,000 - x)/$16,000)(0); Investment in riskfree asset = $9,000 - $3,965.52 = $5,034.48
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.2 and 13.6
Topic: Portfolio beta

59.

You have a $12,000 portfolio which is invested in stocks A and B, and


a risk-free asset. $5,000 is invested in stock A. Stock A has a beta of
1.76 and stock B has a beta of 0.89. How much needs to be invested
in stock B if you want a portfolio beta of 1.10?

A.
B.
C.
D.
E.

$3,750.00
$4,333.33
$4,706.20
$4,943.82
$5,419.27

BetaPortfolio = 1.10 = ($5,000/$12,000)(1.76) + (x/$12,000)(0.89) +


(($12,000 - $5,000 - x)/$12,000)(0); x = $4,943.82
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.2 and 13.6
Topic: Portfolio beta

60.

You recently purchased a stock that is expected to earn 30 percent in


a booming economy, 9 percent in a normal economy, and lose 33
percent in a recessionary economy. There is a 5 percent probability of
a boom and a 75 percent chance of a normal economy. What is your
expected rate of return on this stock?

A.
B.
C.
D.
E.

-3.40 percent
-2.25 percent
1.65 percent
2.60 percent
3.50 percent

E(r) = (0.05 0.30) + (0.75 0.09) + (0.20 -0.33) = 1.65 percent


AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.1
Topic: Expected return

61.

The common stock of Manchester & Moore is expected to earn 13


percent in a recession, 6 percent in a normal economy, and lose 4
percent in a booming economy. The probability of a boom is 5
percent while the probability of a recession is 45 percent. What is the
expected rate of return on this stock?

A.
B.
C.
D.
E.

8.52
8.74
8.65
9.05
9.28

percent
percent
percent
percent
percent

E(r) = (0.45 0.13) + (0.50 0.06) + (0.05 - 0.04) = 8.65 percent


AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.1
Topic: Expected return

62.

You are comparing stock A to stock B. Given the following


information, what is the difference in the expected returns of these
two securities?

A.
B.
C.
D.
E.

-0.85 percent
2.70 percent
3.05 percent
13.45 percent
13.55 percent

E(r)A = (0.45 0.12) + (0.55 -0.22) = -6.70 percent


E(r)B = (0.45 0.17) + (0.55 -0.31) = -9.40 percent
Difference = -6.70 percent - (-9.40 percent) = 2.70 percent
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.1
Topic: Expected return

63.

Jerilu Markets has a beta of 1.09. The risk-free rate of return is 2.75
percent and the market rate of return is 9.80 percent. What is the risk
premium on this stock?

A.
B.
C.
D.
E.

6.47
7.03
7.68
8.99
9.80

percent
percent
percent
percent
percent

Risk premium = 1.09 (0.098 - 0.0275) = 7.68 percent


AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.1
Topic: Risk premium

64.

If the economy is normal, Charleston Freight stock is expected to


return 16.5 percent. If the economy falls into a recession, the stock's
return is projected at a negative 11.6 percent. The probability of a
normal economy is 80 percent while the probability of a recession is
20 percent. What is the variance of the returns on this stock?

A.
B.
C.
D.
E.

0.010346
0.012634
0.013420
0.013927
0.014315

E(r) = (0.80 0.165) + (0.20 -0.116) = 0.1088


Var = 0.80 (0.165 - 0.1088)2 + 0.20 (-0.116 - 0.1088)2 = 0.012634
AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.1
Topic: Variance

65.

The rate of return on the common stock of Lancaster Woolens is


expected to be 21 percent in a boom economy, 11 percent in a
normal economy, and only 3 percent in a recessionary economy. The
probabilities of these economic states are 10 percent for a boom, 70
percent for a normal economy, and 20 percent for a recession. What
is the variance of the returns on this common stock?

A.
B.
C.
D.
E.

0.002150
0.002606
0.002244
0.002359
0.002421

E(r) = (0.10 0.21) + (0.70 0.11) + (0.20 0.03) = 0.104


Var = 0.10 (0.21 - 0.104)2 + 0.70 (0.11 - 0.104)2 + 0.20 (0.03 0.104)2 = 0.002244
AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.1
Topic: Variance

66.

The returns on the common stock of New Image Products are quite
cyclical. In a boom economy, the stock is expected to return 32
percent in comparison to 14 percent in a normal economy and a
negative 28 percent in a recessionary period. The probability of a
recession is 25 percent while the probability of a boom is 20 percent.
What is the standard deviation of the returns on this stock?

A.
B.
C.
D.
E.

21.41
21.56
25.83
32.08
39.77

percent
percent
percent
percent
percent

E(r) = (0.20 0.32) + (0.55 0.14) + (0.25 -0.28) = 0.071


Var = 0.20 (0.32 - 0.071)2 + 0.55 (0.14 - 0.071)2 + 0.25 (-0.28 0.071)2 = 0.045819
Std dev = 0.045819 = 21.41 percent
AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.1
Topic: Standard deviation

67.

What is the standard deviation of the returns on a stock given the


following information?

A.
B.
C.
D.
E.

1.57
2.03
2.89
3.42
4.01

percent
percent
percent
percent
percent

E(r) = (0.30 0.15) + (0.65 0.12) + (0.05 0.06) = 0.126


Var = 0.30 (0.15 - 0.126)2 + 0.65 (0.12 - 0.126)2 + 0.05 (0.06 0.126)2 = 0.000414
Std dev = 0.000414 = 2.03 percent
AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.1
Topic: Standard deviation

68.

You have a portfolio consisting solely of stock A and stock B. The


portfolio has an expected return of 9.8 percent. Stock A has an
expected return of 11.4 percent while stock B is expected to return
6.4 percent. What is the portfolio weight of stock A?

A.
B.
C.
D.
E.

59
68
74
81
87

percent
percent
percent
percent
percent

0.098 = [0.114 x] + [0.064 (1 - x)]; x = 68 percent


AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.2
Topic: Portfolio weight

69.

You own the following portfolio of stocks. What is the portfolio weight
of stock C?

A.
B.
C.
D.
E.

39.85
42.86
44.41
48.09
52.65

percent
percent
percent
percent
percent

Portfolio weightC = (600 $18)/[(500 $14) + (200 $23) + (600


$18) + (100 $47)] = $10,800/$27,100 = 39.85 percent
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.2
Topic: Portfolio weight

70.

You own a portfolio with the following expected returns given the
various states of the economy. What is the overall portfolio expected
return?

A.
B.
C.
D.
E.

6.49 percent
8.64 percent
8.87 percent
9.86 percent
10.23 percent

E(r) = (0.27 0.17) + (0.70 0.08) + (0.03 -0.11) = 9.86 percent


AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.2
Topic: Expected return

71.

What is the expected return on a portfolio which is invested 25


percent in stock A, 55 percent in stock B, and the remainder in stock
C?

A.
B.
C.
D.
E.

-1.06 percent
2.38 percent
2.99 percent
5.93 percent
6.10 percent

E(r)Boom = (0.25 0.19) + (0.55 0.09) + (0.20 0.06) = 0.109


E(r)Normal = (0.25 0.11) + (0.55 0.08) + (0.20 0.13) = .0975
E(r)Bust = (0.25 -0.23) + (0.55 0.05) + (0.20 0.25) = 0.02
E(r)Portfolio = (0.05 0.109) + (0.45 0.0975) + (0.50 0.02) = 5.93
percent
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.2
Topic: Expected return

72.

What is the expected return on this portfolio?

A.
B.
C.
D.
E.

11.48
12.37
13.03
13.42
13.97

percent
percent
percent
percent
percent

Portfolio value = (300 $28) + (500 $10) + (600 $19) = $8,400


+ $5,000 + $11,400 = $24,800; E(r) = ($8,400/$24,800) (0.12) +
($5,000/$24,800) (0.07) + ($11,400/$24,800) (0.15) = 12.37 percent
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.2
Topic: Expected return

73.

What is the expected return on a portfolio that is equally weighted


between stocks K and L given the following information?

A.
B.
C.
D.
E.

11.13
11.86
12.25
13.32
14.40

percent
percent
percent
percent
percent

E(r) = 0.25[(0.16 + 0.13)/2] + 0.75[(0.12 + 0.08)/2] = 11.13 percent


AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.2
Topic: Expected return

74.

What is the expected return on a portfolio comprised of $6,200 of


stock M and $4,500 of stock N if the economy enjoys a boom period?

A.
B.
C.
D.
E.

10.93
11.16
12.55
12.78
13.69

percent
percent
percent
percent
percent

E(r)Boom = [$6,200/($6,200 + $4,500)][0.20] + [$4,500/($6,200 +


$4,500)] [0.05] = 13.69 percent
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.2
Topic: Expected return

75.

What is the variance of the returns on a portfolio that is invested 60


percent in stock S and 40 percent in stock T?

A.
B.
C.
D.
E.

.000017
.000023
.000118
.000136
.000161

E(r)Boom = (0.60 0.17) + (0.40 0.07) = 0.13


E(r)Normal = (0.60 0.13) + (0.40 0.10) = 0.118
E(r)Portfolio = (0.20 0.13) + (0.80 0.118) = 0.1204
VarPortfolio = 0.20 (0.13 - 0.1204)2] + 0.80 (0.118 - 0.1204)2 = .000023
AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 13-02 The impact of diversification.
Section: 13.2
Topic: Variance

76.

What is the variance of the returns on a portfolio comprised of $5,400


of stock G and $6,600 of stock H?

A.
B.
C.
D.
E.

.000709
.000848
.001475
.001554
.001568

E(r)Boom = [$5,400/($5,400 + $6,600)][0.21] + [($6,600/($5,400 +


$6,600)][0 .13] = 0.166
E(r)Normal = [$5,400/($5,400 + $6,600)][0.13] + [$6,600/($5,400 +
$6,600)][0.05] = 0.086
E(r)Portfolio = (0.36 0.166) + (0.64 0.086) = 0.1148
VarPortfolio = [0.36 (0.166 - 0.1148)2] + [0.64 (0.086 - 0.1148)2] =
0.001475
AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.2
Topic: Variance

77.

What is the standard deviation of the returns on a portfolio that is


invested 52 percent in stock Q and 48 percent in stock R?

A.
B.
C.
D.
E.

1.66
2.47
2.63
3.28
3.41

percent
percent
percent
percent
percent

E(r)Boom = (0.52 0.14) + (.0.48 0.16) = 0.1496


E(r)Normal = (0.52 0.08) + (0.48 0.11) = 0.0944
E(r)Portfolio = (0.10 .0.1496) + (0.90 0.0944) = 0.09992
VarPortfolio = [0.10 (0.1496 - 0.09992)2] + [0.90 (0.0944 0.09992)2] = 0.000274
Std dev = 0.000274 = 1.66 percent
AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.2
Topic: Standard deviation

78.

What is the standard deviation of the returns on a $30,000 portfolio


which consists of stocks S and T? Stock S is valued at $21,000.

A.
B.
C.
D.
E.

2.07
2.61
3.36
3.49
3.63

percent
percent
percent
percent
percent

E(r)Boom = [$21,000/$30,000] [0.11] + [($30,000 - $21,000)/$30,000]


[0.05] = 0.092
E(r)Normal = [$21,000/$30,000] [0.08] + [($30,000 - $21,000)/$30,000]
[0.06] = 0.074
E(r)Bust = [$21,000/$30,000] [-0.05] + [($30,000 - $21,000)/$30,000]
[0.08] = -0.011
E(r)Portfolio = (0.05 0.092) + (0.85 0.074) + (0.10 -0.011) =
0.0664
VarPortfolio = [0.05 (0.074 - 0.0664)2] + [0.85 (0.068 - 0.0664)2] +
[0.10 (0.028 - 0.0664)2] = .000680940
Std dev = 0.000680940 = 2.61 percent
AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.2
Topic: Standard deviation

79.

What is the standard deviation of the returns on a portfolio that is


invested in stocks A, B, and C? Twenty five percent of the portfolio is
invested in stock A and 40 percent is invested in stock C.

A.
B.
C.
D.
E.

6.31
6.49
7.40
7.83
8.72

percent
percent
percent
percent
percent

E(r)Boom = (0.25 0.17) + (0.35 0.06) + (0.40 0.22) = 0.1515


E(r)Normal = (0.25 0.08) + (0.35 0.10) + (0.40 0.15) = 0.115
E(r)Bust = (0.25 -0.03) + (0.35 0.19) + (0.40 -0.25) = -0.041
E(r)Portfolio = (0.05 0.1515) + (0.55 0.115) + (0.40 -0.041) =
0.054425
VarPortfolio = [0.05 (0.1515 - 0.054425)2] + [0.55 (0.115 0.054425)2] + [0.40 (-0.041 - 0.054425)2] = 0.006132
Std dev = .006132 = 7.83 percent
AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.2
Topic: Standard deviation

80.

What is the beta of the following portfolio?

A.
B.
C.
D.
E.

.95
1.01
1.05
1.09
1.23

ValuePortfolio = $6,700 + $3,000 + $8,500 = $18,200


BetaPortfolio = ($6,700/$18,200 1.41) + ($4,900/$18,200 1.23) +
($8,500/$18,200 0.79) = 1.09
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.6
Topic: Beta

81.

Your portfolio is comprised of 40 percent of stock X, 15 percent of


stock Y, and 45 percent of stock Z. Stock X has a beta of 1.16, stock Y
has a beta of 1.47, and stock Z has a beta of 0.42. What is the beta
of your portfolio?

A.
B.
C.
D.
E.

0.87
1.09
1.13
1.18
1.21

BetaPortfolio = (0.40 1.16) + (0.15 1.47) + (0.45 0.42) = 0.87


AACSB: Analytic

Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.6
Topic: Beta

82.

Your portfolio has a beta of 1.12. The portfolio consists of 40 percent


U.S. Treasury bills, 30 percent stock A, and 30 percent stock B. Stock
A has a risk-level equivalent to that of the overall market. What is the
beta of stock B?

A.
B.
C.
D.
E.

1.47
1.52
1.69
1.84
2.73

BetaPortfolio = 1.12 = (0.4 0) + (0.3 1) + (0.3 B); B = 2.73


The beta of a risk-free asset is zero. The beta of the market is 1.0.
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.6
Topic: Beta

83.

You would like to combine a risky stock with a beta of 1.68 with U.S.
Treasury bills in such a way that the risk level of the portfolio is
equivalent to the risk level of the overall market. What percentage of
the portfolio should be invested in the risky stock?

A.
B.
C.
D.
E.

32
40
54
60
68

percent
percent
percent
percent
percent

BetaPortfolio = 1.0 = [(x) 1.68] + [(1 - x) 0]; x = 60 percent


AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy

Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.6
Topic: Beta

84.

The market has an expected rate of return of 11.2 percent. The longterm government bond is expected to yield 5.8 percent and the U.S.
Treasury bill is expected to yield 3.9 percent. The inflation rate is 3.6
percent. What is the market risk premium?

A.
B.
C.
D.
E.

6.0
7.3
7.6
8.5
9.3

percent
percent
percent
percent
percent

Market risk premium = 11.2 percent - 3.9 percent = 7.3 percent


AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: Risk premium

85.

The risk-free rate of return is 3.9 percent and the market risk
premium is 6.2 percent. What is the expected rate of return on a
stock with a beta of 1.21?

A.
B.
C.
D.
E.

10.92
11.40
12.22
12.47
12.79

percent
percent
percent
percent
percent

E(r) = 0.039 + (1.21 0.062) = 11.40 percent


AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: CAPM

86.

The common stock of Jensen Shipping has an expected return of 14.7


percent. The return on the market is 10.8 percent and the risk-free
rate of return is 3.8 percent. What is the beta of this stock?

A.
B.
C.
D.
E.

.92
1.23
1.33
1.41
1.56

E(r) = 0.147 = 0.038 + (0.108 - 0.038); = 1.56


AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: CAPM

87.

The common stock of United Industries has a beta of 1.34 and an


expected return of 14.29 percent. The risk-free rate of return is 3.7
percent. What is the expected market risk premium?

A.
B.
C.
D.
E.

7.02 percent
7.90 percent
10.63 percent
11.22 percent
11.60 percent

E(r) = 0.1429 = 0.037 + 1.34 Mrp; Mrp = 7.90 percent


AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: CAPM

88.

The expected return on JK stock is 15.78 percent while the expected


return on the market is 11.34 percent. The stock's beta is 1.51. What
is the risk-free rate of return?

A.
B.
C.
D.
E.

2.22
2.31
2.42
2.50
2.63

percent
percent
percent
percent
percent

E(r) = 0.1578 = rf + 1.51 (0.1134 - rf); rf = 2.63 percent


AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: CAPM

89.

Thayer Farms stock has a beta of 1.12. The risk-free rate of return is
4.34 percent and the market risk premium is 7.92 percent. What is
the expected rate of return on this stock?

A.
B.
C.
D.
E.

8.35 percent
9.01 percent
10.23 percent
13.21 percent
13.73 percent

E(r) = 0.0434 + (1.12 0.0792) = 13.21 percent


AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: CAPM

90.

The common stock of Alpha Manufacturers has a beta of 1.14 and an


actual expected return of 15.26 percent. The risk-free rate of return is
4.3 percent and the market rate of return is 12.01 percent. Which one
of the following statements is true given this information?

A. The actual expected stock return will graph above the Security
Market Line.
B.
The stock is underpriced.
C. To be correctly priced according to CAPM, the stock should have an
expected return of 21.95 percent.
D. The stock has less systematic risk than the overall market.
E. The actual expected stock return indicates the stock is currently
underpriced.
E(r) = 0.043 + 1.14 (0.1201 - 0.043) = 13.09 percent
The stock is underpriced because its actual expected return is greater
than the CAPM return.
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: CAPM

91.

Which one of the following stocks is correctly priced if the risk-free


rate of return is 3.7 percent and the market risk premium is 8.8
percent?

A.
B.
C.
D.
E.

A
B
C
D
E

E(r)A = 0.037 + (0.64 0.088) = 0.0933


E(r)B = 0.037 + (0.97 0.088) = 0.1224
E(r)C = 0.037 + (1.22 0.088) = 0.1444 Stock C is correctly priced.
E(r)D = 0.037 + (1.37 0.088) = 0.1576
E(r)E = 0.037 + (1.68 0.088) = 0.1848
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: CAPM

92.

Which one of the following stocks is correctly priced if the risk-free


rate of return is 3.2 percent and the market rate of return is 11.76
percent?

A.
B.
C.
D.
E.

A
B
C
D
E

E(r)A = 0.0354 + [0.87 (0.1176 - 0.0354)] = 0.1069


E(r)B = 0.0354 + [1.09 (0.1176 - 0.0354)] = 0.1250 Stock B is
correctly priced.
E(r)C = 0.0354 + [1.18 (0.1176 - 0.0354)] = 0.1324
E(r)D = 0.0354 + [1.34 (0.1176 - 0.0354)] = 0.1456
E(r)E = 0.0354 + [1.62 (0.1176 - 0.0354)] = 0.1686
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: CAPM

93.

You own a portfolio that has $2,000 invested in Stock A and $3,500
invested in Stock B. The expected returns on these stocks are 14
percent and 9 percent, respectively. What is the expected return on
the portfolio?

A.
B.
C.
D.
E.

10.06
10.50
10.82
11.13
11.41

percent
percent
percent
percent
percent

E(Rp) = [$2,000/($2,000 + $3,500)] [0.14] + [$3,500/($2,000 +


$3,500)] [0.09] = 10.82 percent
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
EOC: 13-2
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.1
Topic: Expected return

94.

You have $10,000 to invest in a stock portfolio. Your choices are Stock
X with an expected return of 13 percent and Stock Y with an
expected return of 8 percent. Your goal is to create a portfolio with an
expected return of 12.4 percent. All money must be invested. How
much will you invest in stock X?

A.
B.
C.
D.
E.

$800
$1,200
$4,600
$8,800
$9,200

E(Rp) = 0.124 = .13x + .08(1 - x); x = 88 percent


Investment in Stock X = 0.88($10,000) = $8,800
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
EOC: 13-4
Learning Objective: 13-01 How to calculate expected returns.

Section: 13.2
Topic: Expected return

95.

What is the expected return and standard deviation for the following
stock?

A.
B.
C.
D.
E.

15.49 percent; 14.28 percent


15.49 percent; 14.67 percent
18.80 percent; 14.95 percent
18.80 percent; 15.74 percent
18.80 percent'; 16.01 percent

E(R) = 0.10(-0.19) + 0.60(0.17) + 0.30(0.35) = 18.80 percent


2 = 0.10(-0.19 - 0.188)2 + 0.60(0.17 - 0.188)2 + 0.30(0.35 - 0.188)2
= 0.022356
= 0.022356 = 14.95 percent
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
EOC: 13-7
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.2
Topic: Standard deviation

96.

What is the expected return of an equally weighted portfolio


comprised of the following three stocks?

A.
B.
C.
D.
E.

16.33
18.60
19.67
20.48
21.33

percent
percent
percent
percent
percent

E(Rp)Boom = (0.19 + 0.13 + 0.31)/3 = 0.21


E(Rp)Bust = (0.15 + 0.11 + 0.17)/3 = 0.1433
E(Rp) = 0.64(0.21) + 0.36(0.1433) = 18.60 percent
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
EOC: 13-9
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.2
Topic: Expected return

97.

Your portfolio is invested 30 percent each in Stocks A and C, and 40


percent in Stock B. What is the standard deviation of your portfolio
given the following information?

A.
B.
C.
D.
E.

12.38
12.64
12.72
12.89
13.97

percent
percent
percent
percent
percent

E(Rp)Boom = 0.3(0.25) + 0.4(0.25) + 0.3(0.45) = 0.31


E(Rp)Good = 0.3(0.10) + 0.4(0.13) + 0.3(0.11) = 0.115
E(Rp)Poor = 0.3(0.03) + 0.4(0.05) + 0.3(0.05) = 0.044
E(Rp)Bust = 0.3(-0.04) + 0.4(-0.09) + 0.3(-0.09) = -0.075
E(Rp) = 0.25(0.31) + 0.25(0.115) + 0.25(0.044) + 0.25(-0.075) =
0.0985
p2 = 0.25(0.31 - 0.0985)2 + 0.25(0.115 - 0.0985)2 + 0.25(0.044 0.0985)2 + 0.25(-0.075 - 0.0985)2 = 0.019519250
p = 0.019519250 = 13.97 percent
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
EOC: 13-10
Learning Objective: 13-01 How to calculate expected returns.
Section: 13.2
Topic: Standard deviation

98.

You own a portfolio equally invested in a risk-free asset and two


stocks. One of the stocks has a beta of 1.9 and the total portfolio is
equally as risky as the market. What is the beta of the second stock?

A.
B.
C.
D.
E.

0.75
0.80
0.94
1.00
1.10

p = 1.0 = (1/3)(0) + (1/3)(x) + (1/3)(1.9); x = 1.1


AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
EOC: 13-12
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.6
Topic: Beta

99.

A stock has an expected return of 11 percent, the risk-free rate is 5.2


percent, and the market risk premium is 5 percent. What is the
stock's beta?

A.
B.
C.
D.
E.

1.08
1.16
1.29
1.32
1.35

E(Ri) = 0.11 = 0.052 + i(0.04); i = 1.16


AACSB: Analytic
Blooms: Analyze
Difficulty: 1 Easy
EOC: 13-14
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: CAPM

100. A stock has a beta of 1.2 and an expected return of 17 percent. A


risk-free asset currently earns 5.1 percent. The beta of a portfolio
comprised of these two assets is 0.85. What percentage of the
portfolio is invested in the stock?

A.
B.
C.
D.
E.

71
77
84
89
92

percent
percent
percent
percent
percent

p = 0.85 = 1.2x + (1 - x)(0); Bp = 71 percent


AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
EOC: 13-17
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: CAPM

101. Consider the following information on three stocks:

A portfolio is invested 35 percent each in Stock A and Stock B and 30


percent in Stock C. What is the expected risk premium on the
portfolio if the expected T-bill rate is 3.3 percent?

A.
B.
C.
D.
E.

11.47
12.38
16.67
24.29
25.82

percent
percent
percent
percent
percent

E(Rp)Boom = 0.35(0.42) + 0.35(0.35) + 0.30(0.65) = 0.4645


E(Rp)Normal = 0.35(0.31) + 0.35(0.18) + 0.30(0.04) = 0.1835
E(Rp)Bust = 0.35(0.17) + 0.35(-0.17) + 0.30(-0.64) = -0.192
E(Rp) = 0.45(0.51) + 0.50(0.229) + 0.05(-0.122) = 0.2912
RPi = 0.2912 - 0.033 = 29.99 percent
AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
EOC: 13-23
Learning Objective: 13-02 The impact of diversification.
Section: 13.1
Topic: Portfolio risk premium

102. Suppose you observe the following situation:

Assume these securities are correctly priced. Based on the CAPM,


what is the return on the market?

A.
B.
C.
D.
E.

13.99
14.42
14.67
14.78
15.01

percent
percent
percent
percent
percent

Rf: (0.12 - Rf)/0.8 = (0.16 - Rf)/1.1; Rf = 1.33 percent


RM: 0.12 = 0.0133 + 0.8(RM - 0.0133); RM = 14.67 percent
AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
EOC: 13-27
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: CAPM

103. Consider the following information on Stocks I and II:

The market risk premium is 8 percent, and the risk-free rate is 3.6
percent. The beta of stock I is _____ and the beta of stock II is _____.

A.
B.
C.
D.
E.

2.08;
2.08;
3.21;
4.47;
4.03;

2.47
2.76
3.84
3.89
3.71

E(RI) = 0.06(0.15) + 0.69(0.35) + 0.25(0.43) = 0.358


BI: 0.358 = 0.036 + BI (0.08); BI = 4.03
E(RII) = 0.06(-0.35) + 0.69(0.35) + 0.25(0.45) = 0.333
BII: 0.333 = 0.036 + BII (0.08); BII = 3.71
AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
EOC: 13-26
Learning Objective: 13-04 The security market line and the risk-return trade-off.
Section: 13.7
Topic: CAPM

104. Suppose you observe the following situation:

Assume the capital asset pricing model holds and stock A's beta is
greater than stock B's beta by 0.21. What is the expected market risk
premium?

A.
B.
C.
D.
E.

8.8 percent
9.5 percent
12.6 percent
17.9 percent
20.0 percent

E(RA) = 0.22(-0.12) + 0.48(0.10) + 0.30(0.23) = .0906


E(RB) = 0.22(-0.27) + 0.48(0.05) + 0.30(0.28) = .0486
SlopeSML = (.0906 - 0.0486)/0.21 = 20 percent
AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
EOC: 13-28
Learning Objective: 13-03 The systematic risk principle.
Section: 13.7
Topic: Security market line