File: Ch.

06, Chapter 6: The Risks and Returns from Investing

Multiple Choice Questions

1. Total return is equal to:

a. capital gain + price change.

b. yield + income.
c. capital gain - loss.
d. yield + price change.

Ans: d
Difficulty: Easy
Ref: Return

2. All of the following represent the yield component of total return EXCEPT:

a. Dividend payment on common stock

b. Coupon interest payment on bonds
c. Capital gain upon sale of stock
d. Dividend payment on preferred stock

Ans: c
Difficulty: Easy
Ref: Return

3. Investors should be willing to invest in riskier investments only:

a. if the term is short

b. if there are no safe alternatives except for holding cash
c. if the expected return is adequate for the risk level
d. if they are true speculators

Ans: c
Difficulty: Easy
Ref: Risk

4. If interest rates are expected to rise, you would expect:

a. bond prices to fall more than stock prices

b. bond prices to rise more than stock prices
c. stock prices to fall more than bond prices
d. stock prices to rise and bond prices to fall

Ans: a
Difficulty: Moderate

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Ref: Risk

5. An impending recession is an example of:

a. interest rate risk

b. inflation risk
c. market risk
d. financial risk

Ans: c
Difficulty: Moderate
Ref: Risk

6. Financial risk is most associated with:

a. the use of equity financing by corporations

b. the use of debt financing by corporations
c. equity investments held by corporations
d. debt investments held by corporations

Ans: b
Difficulty: Moderate
Ref: Risk

7. Political stability is the major factor concerning:

a. exchange-rate risk
b. systematic risk
c. nonsystematic risk
d. country risk

Ans: d
Difficulty: Moderate
Ref: Risk

8. Liquidity risk:

a. is the risk that investment bankers normally face

b. is lower for small OTC stocks than for large NYSE stocks
c. is a risk associated with secondary market transactions
d. increases whenever interest rates increase

Ans: c
Difficulty: Moderate
Ref: Risk

9. The recent housing bubble and resulting credit crisis of 2008 is a perfect example
of:
a. nonsystematic risk

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The Risks and Returns from Investing
b. systematic risk
c. inflation risk
d. political risk

Ans: b
Difficulty: Easy
Ref: Risk

10. If a U.S. investor buys foreign stock, his dollar-denominated return will
increase if the dollar:

a. appreciates in value.
b. depreciates in value.
c. remains unchanged.
d. moves to a net gain position.

Ans: b
Difficulty: Difficult
Ref: Risk

11. New financial disclosure regulations affecting the brokerage industry are
a type of:

a. market risk
b. financial risk
c. business risk
d. liquidity risk

Ans: c
Difficulty: Moderate
Ref: Risk

12. If interest rates rose, you would expect ------------ to also rise.

a. business risk
b. financial risk
c. liquidity risk
d. inflation risk

Ans: d
Difficulty: Moderate
Ref: Risk

13. The best return measure to use if you are trying to measure the total effect of
returns over time given some stated beginning amount is the:

a. total return
b. return relative
c. cumulative wealth index

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The Risks and Returns from Investing
d. total yield

Ans: a
Difficulty: Moderate
Ref: Measuring Returns

14. Total return as defined in the text is:

a. the difference between the sale price and the purchase price of an investment.
b. measured by dividing the sum of all cash flows received by the amount invested.
c. the reciprocal of a return relative.
d. measured by dividing all cash flows received by its selling price.

Ans: b
Difficulty: Moderate
Ref: Measuring Returns

15. Which of the following is true regarding the cumulative wealth index? It:

a. is measured by adding up the total returns over the holding period and dividing by
the investment
b. uses a beginning index value (often set to $1 but it can be set to any amount)
c. is the present value of the future cash flows expected from the investment
d. uses the arithmetic mean as the rate of growth of one’s wealth

Ans: b
Difficulty: Difficult
Ref: Measuring Returns

16. The ----------- is 1 plus the total return.

a. arithmetic mean
b. return relative
c. cumulative wealth index
d. geometric mean

Ans: b
Difficulty: Difficult
Ref: Measuring Returns

17. The return relative solves the problem of:

a. inflation
b negative returns
c. interest rates
d. tax differences

Ans: b
Difficulty: Moderate

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The Risks and Returns from Investing
Ref: Measuring Returns

18. If the Dow Jones Industrials had a price appreciation of 6 percent one year and yet
total return for the year was 9 percent, the difference would be due to:

a. the tax treatment of capital gains.

b. the cumulative wealth effect.
c. dividends.
d. profits.

Ans: c
Difficulty: Moderate
Ref: Measuring Returns

19. In order to determine the compound growth rate of an investment over

some period, an investor would calculate the:

a. arithmetic mean
b. geometric mean
c. calculus mean
d. arithmetic median

Ans: b
Difficulty: Moderate
Ref: Summary Statistics for Returns

20. A major difference between real and nominal returns is that:

a. real returns adjust for inflation and nominal returns do not

b. real returns use actual cashflows and nominal returns use expected cashflows
c. real returns adjust for commissions and nominal returns do not
d. real returns show the highest possible return and nominal returns show the lowest
possible return

Ans: a
Difficulty: Moderate
Ref: Summary Statistics for Returns

21. When most people refer to mean rate of return, they are referring to the:

a. holding period rate of return

b. arithmetic average rate of return
c. geometric average rate of return
d. cumulative average rate of return

Ans: b
Difficulty: Easy
Ref: Summary Statistics for Returns

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The Risks and Returns from Investing
22. Which of the following statements regarding the arithmetic mean and the
geometric mean is true?

a. The arithmetic mean is always a better measure of average performance

b. The geometric mean is always a better measure of average performance
c. The arithmetic mean is a better measure of performance over single periods
d. The geometric mean is the best estimate of the expected return for the next period

Ans: c
Difficulty: Difficult
Ref: Summary Statistics for Returns

23. The equity risk premium is:

a. the difference between the expected return on stocks and bonds

b. the difference between the expected return on high-grade stocks and low-grade
stocks
c. the difference between the expected return on stocks and the risk-free rate
d. the difference between the expected return on a stock market index and the
inflation rate

Ans: c
Difficulty: Moderate
Ref: Measuring Risk

24. Which of the following statements concerning the equity risk premium is
true?

a. Some scholars think it is too low

b. There is no direct way to measure it
c. It predicts high future returns on stocks
d. It is expected to increase in the future

Ans: b
Difficulty: Difficult
Ref: Measuring Risk

25. The standard deviation measures:

a. systematic risk of a security.

b. unsystematic risk of a security.
c. total risk of a security.
d. the equity risk premium.

Ans: c
Difficulty: Moderate
Ref: Measuring Risk

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The Risks and Returns from Investing
26. Present value is based on the concept of:

a. compounding
b. systematic risk
c. duration
d. discounting

Ans: d
Difficulty: Easy
Ref: Compounding and Discounting

27. Over the period 1926-2007, which of the following financial assets showed the
greatest amount of price volatility, as measured by standard deviation?

a. Small-cap stocks
b. Large-cap stocks
c. Treasury bonds
d. Treasury bills

Ans: a
Difficulty: Moderate
Ref: Realized Returns and Risks from Investing

28. A number of prominent observers expect the equity risk premium in the future to
be:

a. Considerably lower than that of the past

b. Considerably higher than that of the past
c. Very similar to the historical average
d. No change is expected from recent years

Ans: a,
Difficulty: Difficult
Ref: Realized Returns and Risks from Investing

29. If you invest in German bonds and the Euro becomes stronger during your
holding period, then:

a. you will be able to buy back fewer dollars when you redeem your bond or it
matures
b. your dollar-denominated return will increase
c. your-dollar denominated return will decrease
d. your return will be the interest you receive

Ans: b
Difficulty: Difficult

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Response: See p. 6-15
Ref: Taking A Global Perspective

30. As the dollar falls,

a. foreign investors owning U.S. stocks suffer.

b. U.S. investors owning U.S. stocks suffer.
c. U.S. investors owning foreign stocks suffer.
d. foreign investors owning foreign stocks suffer.

Ans: a
Difficulty: Moderate
Ref: Taking A Global Perspective

True-False Questions

1. Another name for a capital gain is yield.

Ans: F
Difficulty: Easy
Ref: Return

2. Return and risk are inversely related.

Ans: F
Difficulty: Easy
Ref: Risk

3. The less the variability of return, the greater the risk.

Ans: F
Difficulty: Easy
Ref: Risk

4. Bond prices and interest rates are inversely related.

Ans: T
Difficulty: Moderate
Ref: Risk

5. It is generally easier to predict interest rate risk than market risk.

Ans: T
Difficulty: Difficult
Ref: Risk

6. New regulations concerning auto emissions would be a type of market risk for
the auto industry.

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The Risks and Returns from Investing
Ans: F
Difficulty: Moderate
Ref: Risk

7. International mutual funds offer investors global diversification without exchange

rate risk.

Ans: F
Difficulty: Difficult
Ref: Risk

8. A Chinese stock denominated in Chinese yuan will have an increase in its

dollar-denominated return if the Chinese yuan strengthens against the dollar.

Ans: T
Difficulty: Difficult
Ref: Taking A Global Perspective

9. Holding interest rates constant, a narrowing of the equity risk premium implies a
decline in the rate of return on stocks because the amount earned beyond the risk-free rate
is reduced.

Ans: T
Difficulty: Moderate
Ref: Summary Statistics for Returns

10. The most common measure of inflation is the Producer Price Index.

Ans: F
Difficulty: Easy
Ref: Summary Statistics for Returns

11. The standard deviation of returns, calculated as the square root of the variance of
returns, is a measure of total risk of an asset or portfolio.

Ans: T
Difficulty: Moderate
Ref: Measuring Risk

12. Both present value and future value are based upon the concept of the time value
of money.

Ans: T
Difficulty: Easy
Ref: Compounding and Discounting

Short-Answer Questions

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The Risks and Returns from Investing
 1. Assume you are a U. S. citizen who purchases $20,000 worth of bonds of the
Deep Shaft Mining Company in Kenya. What sources of risk can you identify
with this investment?

Answer: Business risk, country risk, political risk, exchange-rate risk.

Difficulty: Moderate
Ref: Compounding and Discounting

2. What common variable is used in the calculation of both the cumulative wealth
index and the geometric mean return? How is the common variable calculated?
How is it used in each?

Answer: The total return (TR) is used in both calculations.

TR = [CFt + (PE - PB)]/PB.
CWIn = WI0 (1 + TR1)(1 + TR2) . . . (1 + TRn)
G = [(1 + TR1)(1 + TR2) . . . (1 + TRn)] 1/n - 1
Difficulty: difficult

3. When should an investor use the arithmetic mean return? The geometric mean
return?

Answer: The arithmetic mean is better for single period returns, whereas, the
geometric mean is better for multiple periods.
Difficulty: Moderate

4. What is the best measure of risk for returns of a sole proprietorship?

Answer: The best measure of risk for a sole proprietorship (a single asset) is
standard deviation of returns to capture total risk, since there is no
diversification.
Difficulty: Moderate

5. What was the effect on foreign investors owning U.S. stocks when the dollar fell
in 2002?

Answer: Foreign investors owning U.S. stocks suffered from the unfavorable
currency movement as well as decline in the U.S. stock markets.
Difficulty: Moderate

Fill-in-the-blank Questions

1. CFt + (PE - PB) CFt + PC

TR = -------------- = ---------
PB PB

where

Chapter Six 79
The Risks and Returns from Investing
 CFt = ______________________________________________
PE = ______________________________________________
PB = ______________________________________________
PC = ______________________________________________

Answer: cash flows during measurement period t, price at the end of period t (or
sale price), purchase of asset or price at the beginning of the period,
change in price during the period
Difficulty: Moderate

Critical Thinking/Essay Questions

1. The returns and risk measures on this chapter are calculated from historical data.
Are such measures good predictors of the future? What are some circumstances
that could change to change future return and risk? How can an investor use these
return and risk measures to help construct a portfolio?

Answer: Historical risk and returns are a starting point for the analyst to assess
future prospects. The return and risk parameters for individual companies
can change due to changes in management, product decisions,
competition, regulation, changes in financial structure, etc. An analyst can
use historical data and temper it with judgment about the future for
constructing a portfolio.
Difficulty: Moderate

2. What is the major drawback of the total return measure? Why is it the most
common return calculation used by investors?

Answer: The total return measure does not account for the time value of money.
The cash flows received are not discounted using present value
techniques. This is a serious flaw in the measure. However, since many
investors do not consider inflation in their calculations and the total return
measure is a quick way to measure return, it is widely used by investors.
Difficulty: Moderate

Problems

1. A stock is purchased for $50 on January 1 and sold on December 31 for $72. A
$5.00 per share dividend is paid during the year.

(a) Calculate the TR.

(b) Calculate the RR.

Solution: (a) TR = (Dividend + Change in Price)/ Beginning Price

= ($5 + $22)/$50 = 0.54 or 54 percent

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The Risks and Returns from Investing
 (b) RR = TR + 1.0 = 0.54 + 1.0 = 1.54

OR

RR = ($5 + 72)/$50 = 77/50 = 1.54

Difficulty: Moderate

2. The S&P 500 showed the following TRs for a 6 year period: 11.1 percent, -5.2
percent, 20.3 percent, 26.7 percent, -12.4 percent, and 2.2 percent.

(a) Calculate the arithmetic mean return for the 6 year period.
(b) Calculate the geometric mean return for the 6 year period.

Solution: (a) Arithmetic mean = X/n = [11.1 + (-5.2) + 20.3 + 26.7 + (-

12.4) + 2.2]/6
= 42.7/6 = .0712 or 7.12 percent

(b) To calculate the geometric mean, convert to RRs and obtain the product of the six
RRs.

G = [1.111 x .948 x 1.203 x 1.267 x .876 x 1.022]1/6 - 1

= [1.4372] - 1 = 1.0623 - 1 = .0623 or 6.23 percent
1/6

Difficulty: difficult

3. Calculate the future value of $100,000 at the end of 64 years given an interest rate
of 10.38 percent.

Solution: Future Value = Present Value (1 + r)n

= $100,000 (1.1038) 64
= $100,000 (555.8849840)
= $55,588,498.40
Difficulty: Easy
or on a financial calculator:
100000 PV, 64N, 10.38 Int,
Solve for FV = $55,588,498,40

4. John Crossborder buys 1 share of Telmex at 140 pesos when the value of the peso
is stated in dollars at $0.35. One year later, Telmex is selling for 155 pesos and
paid a dividend of 5 pesos during the year. If after 1 year the value of the pesos is
$0.29, what will John's rate of return be in U. S. dollars?

Solution: Return Relative in pesos = [(155 - 140 + 5)/140] + 1.0 = 1.1429

Domestic TR = 1.1429[0.29/0.35] - 1 = -0.0531 or -5.31

percent
Difficulty: difficult

5. If you deposit $1,000 today at 12 percent, how much will you have in 10 years?

Solution: Using a financial calculator: 1000 PV, 12 interest rate, 10 N,

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The Risks and Returns from Investing
 solve for FV = $3,105.85
Difficulty: Easy

6. What is the present value of $20,000 to be received in 40 years if the interest rate
is 9 percent?

Solution: Using a financial calculator: 20000 FV, 9 interest rate, 40 N,

solve for PV = $636.75
Difficulty: Easy

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The Risks and Returns from Investing