Chapter.7 Test Bank Introduction To Risk And Return

Principles of Corporate Finance, 13e (Brealey)

Chapter 7 Introduction to Risk and Return

1) Which of the following portfolios has the least risk?

A) A portfolio of Treasury bills

B) A portfolio of long-term U.S. government bonds

C) A portfolio of U.S. common stocks of small firms

D) A portfolio of U.S. common stocks of large firms

2) For long-term U.S. government bonds, which risk concerns investors the most?

A) Interest rate risk

B) Default risk

C) Market risk

D) Liquidity risk

3) What has been the average annual real rate of interest on Treasury bills over the past 117 years (from 1900 to 2017)?

A) Less than 2%

B) Between 2% and 3%

C) Between 3% and 4%

D) Greater than 4%

4) What has been the average annual nominal rate of interest on Treasury bills over the past 117 years (1900-2017)?

A) Less than 1%

B) Between 1% and 2%

C) Between 2% and 3%

D) Greater than 3%

5) What has been the average annual nominal rate of return on a portfolio of U.S. common stocks over the past 117 years (from 1900 to 2017)?

A) Less than 2%

B) Between 2% and 5%

C) Between 5% and 11%

D) Greater than 11%

6) One dollar invested in a portfolio of long-term U.S. government bonds in 1900 would have grown in nominal value by the end of year 2017 to:

A) $719.

B) $66.

C) $74.

D) $293.

7) One dollar invested in a portfolio of U.S. common stocks in 1900 would have grown in nominal value by the end of year 2017 to

A) $47,661.

B) $245.

C) $74.

D) $6.

8) What has been the average annual rate of return in real terms for a portfolio of U.S. common stocks between 1900 and 2017?

A) Less than 2%

B) Between 2% and 5%

C) Between 5% and 8%

D) Greater than 8%

9) Which portfolio has had the lowest average annual nominal rate of return during the 1900-2017 periods?

A) Portfolio of small U.S. common stocks

B) Portfolio of U.S. government bonds

C) Portfolio of Treasury bills

D) Portfolio of large U.S. common stocks

10) Which portfolio had the highest average annual return in real terms between 1900 and 2017?

A) Portfolio of U.S. common stocks

B) Portfolio of U.S. government bonds

C) Portfolio of Treasury bills

D) None of the answers

11) A standard error measures

A) nominal annual rate of return on a portfolio.

B) risk of a portfolio.

C) reliability of an estimate.

D) real annual rate of return on a portfolio.

12) Which of the following is an estimate of the standard error of the mean?

A) The average annual rate of return divided by the square root of the number of observations

B) The variance divided by the number of observations

C) The standard deviation of returns divided by the square root of the number of observations

D) The variance of returns divided by the square root of the number of observations

13) Which portfolio has had the highest average risk premium during the period 1900-2017?

A) Common stocks

B) Government bonds

C) Treasury bills

D) None of the answers

14) If the standard deviation of annual returns is 19.8 percent and the number of years of observation is 107, what is the standard error?

A) 4.23 percent

B) 1.91 percent

C) 0.47 percent

D) 19.8 percent

15) If the average annual rate of return for common stocks is 11.7 percent, and 4.0 percent for U.S. Treasury bills, what is the average market risk premium?

A) 15.7 percent

B) 4.0 percent

C) 7.7 percent

D) Not enough information is provided.

16) Spill Drink Company's stocks had -8 percent, 11 percent, and 24 percent rates of return, respectively, during the last three years; calculate the (arithmetic) average rate of return for the stock.

A) 8 percent per year

B) 9 percent per year

C) 10 percent per year

D) 11 percent per year

17) For log normally distributed returns, annual compound returns equal

A) the arithmetic average return minus half the variance.

B) the arithmetic average return plus half the variance.

C) the arithmetic average return minus half the standard deviation.

D) the arithmetic average return plus half the standard deviation.

18) Which of the following provides a correct measure of the opportunity cost of capital regardless of the timing of cash flows?

A) Arithmetic average

B) Geometric average

C) Hyperbolic mean

D) Opportunistic mean

19) Assume the following data: Risk-free rate = 4.0 percent; average risk premium = 7.7 percent. Calculate the required rate of return for the risky asset.

A) 5.6 percent

B) 7.6 percent

C) 11.7 percent

D) 30.8 percent

20) Which of the following countries has had the lowest risk premium?

A) United States

B) Denmark

C) Italy

D) Germany

21) Which of the following countries has had the highest risk premium?

A) Germany

B) Denmark

C) United States

D) Switzerland

22) Mega Corporation has the following returns for the past three years: 7 percent, 13 percent, and 10 percent. Use the following formulas to calculate the variance of the returns and the standard deviation of the returns:

Variance (m) = expected value of (m - rm)2

Standard deviation of m = .

A) 64.00 and 8.00 percent

B) 124.00 and 11.10 percent

C) 6.00 and 2.45 percent

D) 30.00 and 10.00 percent

23) Macro Corporation has had the following returns for the past three years: -10 percent, 10 percent, and 30 percent. Use the following formulas to calculate the standard deviation of the returns:

Variance (m) = expected value of (m - rm)2

Standard deviation of m = .

A) 10.00 percent

B) 16.33 percent

C) 18.21 percent

D) 30.00 percent

24) Sun Corporation has had returns of -6 percent, 16 percent, 18 percent, and 28 percent for the past four years. Calculate the standard deviation of the returns using the correction for the loss of a degree of freedom shown below.

When variance is estimated from a sample of observed returns, we add the squared deviations and divide by N -1, where N is the number of observations. We divide by N -1 rather than N to correct for a loss of a degree of freedom. The formula is

Variance(m ) =

Where m is the market return in period t and rm is the mean of the values of rmt.

A) 11.6 percent

B) 14.3 percent

C) 13.4 percent

D) 14.0 percent

25) Which portfolio had the highest standard deviation during the period between 1900 and 2014?

A) Common stocks

B) Government bonds

C) Treasury bills

D) None of the answers is correct.

26) What has been the approximate standard deviation of returns of U.S. common stocks during the period between 1900 and 2017?

A) 19.7 percent

B) 33.4 percent

C) 8.9 percent

D) 2.8 percent

27) The standard deviation of U.S. returns, from 1995 to the financial crisis years later had increased (approximately) by:

A) 20%.

B) 30%.

C) 40%.

D) 60%.

28) A statistical measure of the degree to which securities' returns move together is called a

A) variance.

B) correlation coefficient.

C) standard deviation.

D) geometric average.

29) The type of the risk that can be eliminated by diversification is called

A) market risk.

B) unique risk.

C) interest rate risk.

D) default risk.

30) Unique risk is also called

A) systematic risk.

B) non-diversifiable risk.

C) firm-specific risk.

D) market risk.

31) Market risk is also called

A) systematic risk.

B) undiversifiable risk.

C) firm-specific risk.

D) systematic risk and undiversifiable risk.

32) Stock A has an expected return of 10 percent per year and stock B has an expected return of 20 percent. If 40 percent of a portfolio's funds are invested in stock A and the rest in stock B, what is the expected return on the portfolio of stock A and stock B?

A) 10 percent

B) 20 percent

C) 16 percent

D) 14 percent

33) As the number of stocks in a portfolio is increased,

A) unique risk decreases and approaches zero.

B) market risk decreases.

C) unique risk decreases and becomes equal to market risk.

D) total risk approaches zero.

34) Stock M and Stock N have had the following returns for the past three years: 12 percent, -10 percent, 32 percent; and 15 percent, 6 percent, 24 percent, respectively. Calculate the covariance between the two securities. (Ignore the correction for the loss of a degree of freedom set out in the text.)

A) -99

B) 126

C) +250

D) -250

35) Stock P and Stock Q have had annual returns of -10 percent, 12 percent, 28 percent; and 8 percent, 13 percent, 24 percent, respectively. Calculate the covariance of return between the securities. (Ignore the correction for the loss of a degree of freedom set out in the text.)

A) -149.00

B) +149.00

C) +99.33

D) -100.00

36) Stock X has a standard deviation of return of 10 percent. Stock Y has a standard deviation of return of 20 percent. The correlation coefficient between the two stocks is 0.5. If you invest 60 percent of your funds in stock X and 40 percent in stock Y, what is the standard deviation of your portfolio?

A) 10.3 percent

B) 21.0 percent

C) 12.2 percent

D) 14.8 percent

37) If the correlation coefficient between the returns on stock C and stock D is +1.0, the standard deviation of return for stock C is 15 percent, and that for stock D is 30 percent, calculate the covariance between stock C and stock D.

A) +45

B) -450

C) +450

D) -45

38) What range of values can correlation coefficients take?

A) Zero to + 1

B) -1 to + 1

C) -Infinity to + infinity

D) Zero to + infinity

39) If the covariance between stock A and stock B is 100, the standard deviation of stock A is 10 percent and that of stock B is 20 percent, calculate the correlation coefficient between the two securities.

A) -0.5

B) +1.0

C) +0.5

D) 0.0

40) For a two-stock portfolio, the maximum reduction in risk occurs when the correlation coefficient between the two stocks equals

A) +1.0.

B) -0.5.

C) -1.0.

D) 0.0.

41) For a portfolio of N-stocks, the formula for portfolio variance contains

A) N variance terms.

B) N(N - 1)/2 variance terms.

C) N2 variance terms.

D) N - 1 variance terms.

42) For a portfolio of N-stocks, the formula for portfolio variance contains

A) N covariance terms.

B) N(N - 1)/2 different covariance terms.

C) N2 covariance terms.

D) N - 1 covariance terms.

43) Beta is a measure of

A) unique risk.

B) total risk.

C) market risk.

D) liquidity risk.

44) The beta of the market portfolio is

A) +1.0.

B) +0.5.

C) 0.0.

D) -1.0.

45) For each additional 1 percent change in market return, the return on a stock having a beta of 2.2 changes, on average, by

A) 1.00 percent.

B) 0.55 percent.

C) 2.20 percent.

D) 1.10 percent.

46) Which of the following portfolios will have the highest beta?

A) Portfolio of U.S. Treasury bills

B) Portfolio of U.S. government bonds

C) Portfolio containing 50 percent U.S. Treasury bills and 50 percent U.S. government bonds

D) Portfolio of U.S. common stocks

47) If the standard deviation of returns on the market is 20 percent, and the beta of a well-diversified portfolio is 1.5, calculate the standard deviation of this portfolio.

A) 30 percent.

B) 20 percent.

C) 15 percent.

D) 10 percent.

48) The correlation coefficient between a stock and the market portfolio is +0.6. The standard deviation of return of the stock is 30 percent and that of the market portfolio is 20 percent. Calculate the beta of the stock.

A) 1.1

B) 1.0

C) 0.9

D) 0.6

49) The historical nominal returns for stock A were -8 percent, +10 percent, and +22 percent. The nominal returns for the market portfolio were +6 percent, +18 percent, and 24 percent during this same time. Calculate the beta for stock A.

A) 1.64

B) 0.61

C) 1.00

D) 0.50

50) The annual returns for three years for stock B were 0 percent, 10 percent, and 26 percent. Annual returns for three years for the market portfolio were +6 percent, 18 percent, and 24 percent. Calculate the beta for the stock.

A) 0.75

B) 1.36

C) 1.00

D) 0.74

51) The correlation coefficient between stock B and the market portfolio is 0.8. The standard deviation of stock B is 35 percent and that of the market is 20 percent. Calculate the beta of the stock.

A) 1.0

B) 1.4

C) 0.8

D) 0.7

52) The covariance between Amazon stock and the S&P 500 is 0.05. The standard deviation of the stock market is 20%. What is the beta of Amazon?

A) 0.00

B) 1.00

C) 1.25

D) 1.42

53) What is the beta of a security where the expected return is double that of the stock market, there is no correlation coefficient relative to the U.S. stock market, and the standard deviation of the stock market is 0.18?

A) 0.00

B) 1.00

C) 1.25

D) 2.00

54) Treasury bills typically provide higher average returns, both in nominal terms and in real terms, than long-term government bonds.

55) A risk premium is the difference between a security's return and the Treasury bill return.

56) For log normally distributed returns, the annual geometric average return is greater than the arithmetic average return.

57) According to the authors, a reasonable range for the risk premium in the United States is 5 percent to 8 percent.

58) The standard statistical measures of the variability of stock returns are beta and covariance.

59) Diversification reduces the risk of a portfolio because the prices of different securities do not move exactly together.

60) The portfolio risk that cannot be eliminated by diversification is called unique risk.

61) The portfolio risk that cannot be eliminated by diversification is called market risk.

62) The beta of a well-diversified portfolio is equal to the value weighted average beta of the securities included in the portfolio.

63) The average beta of all stocks in the market is zero.

64) A portfolio with a beta of one offers an expected return equal to the market risk premium.

65) Stocks with high standard deviations will necessarily also have high betas.

66) Low standard deviation stocks always have low betas.

67) A stock having a covariance with the market that is higher than the variance of the market will always have a beta above 1.0.

68) By purchasing U.S. government bonds, an investor can achieve both a risk-free nominal rate of return and a risk-free real rate of return.

69) A risk premium generated by comparing stocks to 10-year U.S. Treasury bonds will be smaller than a risk premium generated by comparing stocks to U.S. Treasury bills.

70) One can easily calculate the estimated risk premium on stocks via the statistical analysis of historical stock returns.

71) The standard deviation of a two-stock portfolio generally equals the value-weighted average of the standard deviations of the two stocks.

72) The covariance between the returns on two stocks equals the correlation coefficient multiplied by the standard deviations of the two stocks.

73) For the most part, stock returns tend to move together. Thus, pairs of stocks tend to have both positive covariances and correlations.

74) If returns on two stocks tended to move in opposite directions, then the covariances and correlations on the two stocks would be negative.

75) Diversification can reduce portfolio risk even in the case when correlations across stock returns equal zero.

76) The variability of a well-diversified portfolio mostly reflects the contributions to risk from the standard deviations of the stocks within that portfolio.

77) The risk of a well-diversified portfolio depends on the market risk of the securities included in the portfolio.

78) Define the term risk premium.

79) Regarding stock returns, briefly explain the term variance.

80) Briefly explain how diversification reduces risk.

81) In the formula for calculating the variance of an N-stock portfolio, how many covariance and variance terms are there?

82) Briefly explain how the beta of a stock is estimated.

83) Briefly explain what the beta of a stock means.

84) Discuss the importance of beta as a measure of risk.

85) Briefly explain the difference between beta as a measure of risk and variance as a measure of risk.

86) Briefly explain how individual securities affect portfolio risk.

87) What is the beta of a portfolio with a large number of randomly selected stocks?

88) How can individual investors diversify?

89) Briefly explain the concept of value additivity.

90) Explain why international stocks may have high standard deviations but low betas.