Deck 9: Risk and Return

Question 1

Long-run average returns on equity investments:

A) are much higher than those on debt.
B) are the same as the average returns on debt.
C) are the same as the average returns on debt plus any dividends.
D) are lower than those on debt.

Answer 1

A

Question 2

Risk in finance:

A) is variability in return.
B) can be decomposed into business-specific and market components.
C) will be accepted by some investors if higher expected returns are offered in compensation.
D) All of the above

Answer 2

D

Question 3

Modern portfolio theory suggests that:

A) it is always wise to create a stock portfolio that captures a high average rate of return.
B) the higher the expected return, the higher the portfolio's risk.
C) it is always wise to create a stock portfolio consisting of similar stocks.
D) a riskless portfolio is always the wisest alternative.

Answer 3

B

Question 4

Recent thinking in theoretical finance grapples with the issue of risk and return for combinations of stocks. This theory is called:

A) portfolio theory.
B) expectations theory.
C) efficient market theory.
D) All of the above

Question 5

Which of the following is true of a portfolio?

A) It is usually held by high net worth investors.
B) It is considered diversified only if it contains both stocks and bonds.
C) Its risk and return are different from but based on those of the individual securities in it.
D) It is available to institutional investors and pension funds.

Question 6

A stock that is risky on a stand-alone basis:

A) is just as risky in a portfolio.
B) is one that just about never produces a return that's higher than expected.
C) is likely to produce a return that is substantially different from its mean or expected return.
D) will have no effect on a portfolio's risk if it is added carefully.

Question 7

Stocks that have high financial rewards are generally accompanied by:

A) high dividend payments.
B) low dividend payments because of internally generated growth.
C) high risk.
D) All of the above

Question 8

Below are two examples of tossing two coins simultaneously, with the following probability distribution of returns: EXAMPLE #1 (Two coins tossed simultaneously)
Head + head yields 40% gain
Head + tail yields 10% gain
Tail + head yields 10% gain
Tail + tail yields 20% loss
EXAMPLE #2 (Two coins tossed simultaneously)
Head + head yields 70% gain
Head + tail yields 10% gain
Tail + head yields 10% gain
Tail + tail yields 50% loss
From the two examples, which of the following statements is true?

A) example 1 has a higher expected return, but also has higher risk
B) example 2 has a higher expected return, but also has higher risk
C) example 2 has a lower expected return, but also has higher risk
D) the examples have the same expected returns and example 2 has higher risk

Question 9

The underlying principles of portfolio theory include:

A) diversifying business-specific risk away.
B) basing decisions on stocks' risk/return characteristics in a portfolio context rather than on a stand-alone basis.
C) getting the highest available return for the amount of risk the investor is comfortable with.
D) All of the above

Question 10

Risk is:

A) the probability that return will be less than expected.
B) the standard deviation of the probability distribution of returns.
C) variability in return.
D) All of the above

Question 11

With respect to the probability distribution of returns:

A) a risky stock has a higher probability of producing a return that is substantially closer to the mean of the distribution and a less risky stock has a higher probability of producing a return that is substantially away from the mean of the distribution.
B) high risk implies variability in return such that returns in successive years are likely to be insignificantly different from one another.
C) a less risky stock is likely to produce a return that is close to the mean of the distribution while a more risky stock has a higher probability of producing a return that is substantially away from the mean of the distribution.
D) low risk implies variability in return such that returns in successive years are likely to be considerably different from one another.

Question 12

Standard deviation is an important concept in portfolio theory because:

A) it is a measure of risk for a stock when it is held on a stand-alone basis.
B) it is a measure of risk for a stock when it is held in a diversified portfolio.
C) it is a measure of the variability of a stock's return.
D) Both a. and c. are correct
E) All of the above are correct

Question 13

The return that investors feel is most likely to occur based on currently available information is known as the:

A) required return.
B) expected return.
C) either the required or expected return.
D) neither the required or expected return.

Question 14

The required rate of return on a stock:

A) is the risk-free rate plus a premium for the risk associated with the stock.
B) is the return expected based upon currently available information.
C) is the minimum return that generates trading.
D) is entirely determined by the return on an average stock.

Question 15

The return on an investment in stock:

A) is subject to risk but is generally non-negative like a savings account.
B) has a standard deviation that has historically been small relative to its average value.
C) consists of dividend and capital gains yields.
D) is always very risky.

Question 16

Risk can be viewed as:

A) the degree of variability of return.
B) the standard deviation of the probability distribution of return.
C) the chance that return will be less than expected.
D) a value neutral concept.
E) All of the above

Question 17

Over most of the twentieth century, which of the following was greater?

A) Equity returns
B) Debt returns
C) Inflation rate
D) They were all equal

Question 18

An investor's goal can be described best as:

A) maximizing returns while minimizing risk.
B) maximizing returns.
C) capturing the high average returns of equity investing while limiting the associated risk as much as possible.
D) avoiding risk regardless of the risk premium offered.

Question 19

The return on equity investments:

A) is the risk free rate plus the return on debt investments.
B) consists of the risk free rate and the market premium.
C) consists of dividend and capital gains yields.
D) can never be negative.

Question 20

The risks associated with owning a single stock are called:

A) systematic risk because all stocks in the system are affected.
B) market risk because the stocks are purchased in the stock market.
C) stand-alone risk because the stock stands alone outside of any portfolio.
D) business risk because the stocks represent businesses.

Question 21

The goal of a portfolio owner is to:

A) maximize both risk and return, as the higher the risk, the higher is the return.
B) investment only in risk-free assets that help avoid taxes.
C) capture the high average returns of equities while minimizing the associated risk.
D) avoid diversification and focus on stocks from one particular market.

Question 22

Portfolios:

A) are held only by rich investors.
B) are considered diversified if they contain many stocks from one industry.
C) have their own risk and returns.
D) can be diversified away.

Question 23

The risk remaining after extensive diversification is primarily:

A) unsystematic risk.
B) systematic risk.
C) coefficient of variation risk.
D) standard deviation risk.

Question 24

Which of the following is an underlying principle of the portfolio theory?

A) Both systematic and unsystematic risk can be eliminated through diversification.
B) Portfolio owners are concerned with the performance of the entire portfolio rather than that of the individual stocks in it.
C) The lower the returns on a stock are, the higher is its risk.
D) A stock's risk is independent of its return.

Question 25

The ____ the standard deviation, the ____ the investment.

A) smaller, larger the expected return on
B) larger, riskier
C) smaller, riskier
D) larger, smaller the expected return on

Question 26

Which of the following statements is most correct?

A) Business-specific risk cannot be eliminated by diversification.
B) Investors are not compensated for bearing business specific risk.
C) Risk that cannot be diversified away is the risk peculiar to the stock under consideration.
D) You cannot ignore the business-specific risk even if you hold a very large portfolio.
E) All of the above statements are correct.

Question 27

The minimum return that will make an investment acceptable to an investor is called:

A) the required rate of return.
B) the risk premium.
C) the risk-free interest rate.
D) beta.

Question 28

The risks that diversification cannot eliminate are:

A) interest rate risk.
B) risk due to a recession.
C) inflation risk.
D) systematic risk.
E) All of the above

Question 29

Which of the following is a correct definition of risk?

A) Risk is the probability that returns will be less than expected.
B) Risk is the variability of the probability distribution of returns.
C) Both of the above are correct.
D) Neither of the above is correct.

Question 30

Stocks with equal stand-alone risk can have:

A) the same risk impacts on a portfolio.
B) opposite risk impacts on a portfolio.
C) no risk impacts on a portfolio.
D) All of the above

Question 31

Investors don't diversify entirely with negative beta stocks because:

A) they are generally poor investments otherwise.
B) they're not as desirable or exciting as high beta stocks on which one can make a lot of money.
C) there aren't very many of them around.
D) All of the above

Question 32

Which of the following statements about the beta coefficient of a stock is true?

A) A beta of > 1 implies that the stock's volatility is less than that of the market.
B) A beta of < 0 implies that the stock tends to move against the market.
C) A beta of 1 implies a volatility independent of the market's volatility.
D) A beta of < 1 implies that the stock's movement is independent of the market.

Question 33

Which of the following is not an example of a source of systematic or market risk?

A) Interest rate changes
B) Foreign competition with an industry's products
C) Changes in the overall economic outlook
D) Changes in the inflation rate

Question 34

In general, investments yielding higher returns will have:

A) lower tax rates.
B) higher dividend payments.
C) higher risk.
D) lower standard deviations.

Question 35

Which of the following statements is false?

A) Beta is meaningful only if an investor holds a well-diversified portfolio.
B) You can completely eliminate risk if you hold a well-diversified portfolio.
C) A portfolio composed of only one stock will not be well diversified.
D) A wise investor diversifies to capture the high average return of stocks while avoiding as much risk as possible.
E) All of the above statements are correct.

Question 36

Risk aversion implies that an investor:

A) will accept no risk.
B) places the same value on all risky investments.
C) demands a premium for accepting risk.
D) assigns a negative value to all risky investments.

Question 37

Portfolio theory can be dangerous to a small investor because:

A) he or she doesn't have much money to lose.
B) beta, the theoretical measure of risk, ignores business-specific risk, which is significant to an investor who doesn't have a large enough portfolio to diversify it away.
C) it makes investing seem more scientific than it really is.
D) the stock market is very unforgiving.

Question 38

Which of the following securities would not be selected?

A) Security A: Expected return: 14%, Standard deviation: 14%
B) Security B: Expected return: 10%, Standard deviation: 12%
C) Security C: Expected return: 11%, Standard deviation: 10%
D) Security D: Expected return: 9%, Standard deviation: 0%

Question 39

According to portfolio theory, the most relevant risk for any widely traded individual security is its:

A) unsystematic risk.
B) standard deviation.
C) covariance risk.
D) systematic risk.

Question 40

A portfolio is a collection of:

A) all risk-free assets in the market.
B) financial and non-financial assets in the market.
C) investment assets held by an investor.
D) financial assets and liabilities of a company.

Question 41

The coefficient of variation is a:

A) relative measure of variation.
B) ratio of standard deviation to variance.
C) continuous random variable.
D) measure of return.

Question 42

Market risk is:

A) caused by things that affect all stocks.
B) the chance that an investor will lose money in the stock market.
C) diversified away.
D) the variance of the probability distribution.

Question 43

The ____ is an absolute measure of risk, and the ____ is a relative measure of risk.

A) systematic risk, unsystematic risk
B) standard deviation, coefficient of variation
C) correlation, covariance
D) security market line, characteristic line

Question 44

The standard deviation is:

A) the square of the variance.
B) the square root of the variance.
C) one-half of the variance.
D) twice the variance.

Question 45

When comparing two equal-sized investments, the ____ is an appropriate measure of total risk.

A) standard deviation
B) coefficient of variation
C) correlation
D) disjointed variance

Question 46

Which of the following statements is false?

A) The most commonly used index with which to measure risk is the standard deviation.
B) The standard deviation measures the average deviation of the various outcomes from the expected rate of return.
C) The variance is the square root of the standard deviation.
D) The greater the volatility, the larger the standard deviation.
E) All of the above statements are correct.

Question 47

The narrower the probability distribution of expected future returns, the smaller the ____ of a given investment.

A) risk
B) variance
C) standard deviation
D) Both a & b
E) All of the above

Question 48

The principle of risk aversion can best be described as:

A) the observation that investors are unwilling to acquire very risky securities regardless of their risk premiums.
B) the hypothesis that people always prefer investments with less risk to those with more risk if the expected returns are equal.
C) the observation that risky securities usually offer unattractive expected returns when the possibility of loss is considered.
D) All of the above

Question 49

A distribution's variance and standard deviation:

A) indicates the mean or expected return.
B) measures the area under the curve.
C) shows the likelihood that an actual return will be some distance away from the expected value.
D) All of the above

Question 50

Which of the following is true regarding the variance of a probability distribution?

A) A large variance implies a wide distribution with steeply sloping sides and a high peak.
B) A small variance implies a wide distribution with gently sloping sides and a high peak.
C) A large variance implies a wide distribution with gently sloping sides and a low peak.
D) A small variance implies a narrow distribution with steeply sloping sides and a low peak.

Question 51

The two distinctly different parts of the movement of stock returns are:

A) market risk and systematic risk.
B) business-specific and unsystematic risk.
C) unsystematic risk and systematic risk.
D) All of the above

Question 52

Diversifiable risk is:

A) measured by beta.
B) company-specific.
C) the unsystematic risk.
D) Both b & c

Question 53

Investors that prefer lower risk when expected returns are equal are said to be:

A) risk tolerant.
B) risk seeking.
C) risk averse.
D) None of the above

Question 54

Happenings that causes unsystematic risk include:

A) inflation.
B) interest rates changes.
C) local strikes.
D) recession.

Question 55

The most likely outcome a random variable may take is referred to as the:

A) average value.
B) mean.
C) expected value.
D) All of the above

Question 56

Which of the following does not describe risk aversion?

A) Investors prefer lower risk when returns are equal.
B) Investors expect higher returns when risk increases.
C) Investors try to avoid risk at all costs.
D) All of the above describe risk aversion.
E) None of the above describes risk aversion.

Question 57

The ____ is a statistical measure of the mean or average value of the possible outcomes.

A) probability distribution
B) standard deviation
C) expected value
D) coefficient of variation

Question 58

Risk aversion means:

A) investors prefer less risk when expected returns are equal.
B) investors always choose low risk stocks.
C) gamblers don't behave rationally.
D) investors avoid risk at all costs.

Question 59

Which of the following is NOT an example of systematic risk?

A) Inflation
B) Recession
C) Management risk
D) Interest rate risk

Question 60

Market risk:

A) is the degree to which a stock's return moves with the market's return.
B) is caused by things that affect specific companies or industries.
C) can be diversified away.
D) is the chance of losing money in the stock market.

Question 61

The Security Market Line (SML) relates risk to return, for a given set of market conditions. If risk aversion increases, which of the following would most likely occur?

A) The market risk premium would increase.
B) The risk-free rate would increase.
C) The slope of the SML would increase.
D) Both a & c
E) All of the above

Question 62

A beta value of 0.5 for a security indicates:

A) the security has average systematic risk.
B) the security has above-average systematic risk.
C) the security has no unsystematic risk.
D) the security has below-average systematic risk.

Question 63

A statistic known as a stock's beta coefficient measures:

A) total risk.
B) systematic or market risk.
C) unsystematic or business-specific risk.
D) None of the above

Question 64

The slope of the SML is determined by the:

A) beta of the market.
B) market risk premium.
C) risk-free rate.
D) the required return.

Question 65

The market risk associated with an individual stock is most closely identified with the:

A) variance of the returns of the stock.
B) variance of the returns on the market.
C) beta of the stock.
D) beta of the market.

Question 66

The beta of a stock:

A) measures its risk on a stand-alone basis.
B) measures its risk in a well-diversified portfolio.
C) is based on the historical relationship between the performance of that stock and the performance of the market.
D) Both a. and b. are correct.
E) Both b. and c. are correct.

Question 67

____ risk CAN be diversified away by investing in a diversified portfolio.

A) Systematic
B) Business-specific
C) Unsystematic
D) Both b & c

Question 68

A stock with a beta of 1.0 will:

A) always generate a return equal to the market average.
B) always generate a return that is close to the market average.
C) always generate a return that is at least as large as the market average..
D) All of the above are correct.
E) None of the above is correct.

Question 69

It is important to understand that business-specific (unsystematic) risk is not included in the capital asset pricing model, because beta measures only market (systematic) risk. The underlying assumption is that:

A) we don't need to worry about business-specific risk in portfolios because it's diversified away.
B) we can't measure business-specific risk so it's useless to worry about it.
C) business-specific risk is usually small compared with market risk.
D) All of the above

Question 70

Which of the following statements about the beta coefficient is not true?

A) A beta of > 1 implies that the stock's volatility is greater than that of the market.
B) A beta of < 0 implies that the stock tends to move against the market.
C) A beta of 1 implies a volatility equal to that of the market.
D) All of the above are true.

Question 71

The actual or expected return on a portfolio is equal to:

A) the average of the returns on the stocks in the portfolio weighted by the dollar amounts invested in each stock
B) the simple average of the returns on the stocks in the portfolio plus the risk-free rate of return.
C) the sum of the products of the anticipated returns.
D) the simple average of returns on the stocks in the portfolio less the risk-free rate of return.

Question 72

The security market line:

A) relates an individual security's return to the returns of other securities in the same industry.
B) provides a picture of the risk-return tradeoff required by diversified investors.
C) has as its slope the beta of the security.
D) None of the above

Question 73

The security market line proposes that the required rates of return are determined by the following formulation:

A) k_m = k_rf + (k_x - k_rf)b_x.
B) k_x = k_rf + (k_m - k_rf)b_x.
C) k_rf = k_x + (k_m - k_x)b_x.
D) k_x = k_rf + (k_m - k_rf)b_m.

Question 74

Consider a portfolio with a known average return and standard deviation. Which of the following stocks, if added to the portfolio, will reduce its risk through diversification?

A) A stock whose return is perfectly negatively correlated with the portfolio's return
B) A stock whose return is perfectly positively correlated with the portfolio's return
C) A stock whose return has zero correlation with the portfolio's return
D) Any stock added to a portfolio will reduce its risk regardless of its correlation with the portfolio

Question 75

An intuitively pleasing and prudent investment strategy is to hold:

A) high beta stocks in a rising market and low beta stocks in a declining market.
B) high beta stocks in both rising and declining markets.
C) low beta stocks in both rising and declining markets.
D) high beta stocks in a declining market and low beta stocks in a rising market.

Question 76

The slope of the characteristic line for a specific security is an estimate of ____ for that security.

A) beta
B) systematic risk
C) total risk
D) a and b

Question 77

Inflation, war, political upheaval, and other broad economic events cause:

A) business specific risk.
B) diversifiable risk.
C) non-diversifiable unsystematic risk.
D) market risk.

Question 78

Assume that you own a portfolio with a known average return and standard deviation. Which of the following stocks, if added to your portfolio, will not reduce its risk through diversification?

A) A stock whose return is negatively correlated with that of your portfolio and has a lower standard deviation.
B) A stock whose return is positively correlated with that of your portfolio and has a lower standard deviation.
C) A stock whose return is positively correlated with that of your portfolio and has a higher standard deviation than your stock.
D) All of the above will reduce the risk of your investment through diversification.
E) None of the above will reduce the risk of your investment through diversification.

Question 79

All other things being equal, what is the major impact that an increase in the expected inflation rate would be expected to have on the security market line?

A) Reduce its slope
B) Shift it down
C) Shift it up
D) Reduce required returns for investors in any individual asset

Question 80

The Security Market Line (SML) relates risk to return, for a given set of market conditions. If the risk-free rate increases, which of the following would most likely occur?

A) The market risk premium would increase.
B) Beta would increase.
C) The slope of the SML would increase.
D) The SML line would shift up.