Deck 11: Introduction to Risk, Return, and the Opportunity Cost of Capital

Question 1

What real rate of return is earned by a one-year investor in a bond that was purchased for $1,000, has an 8 percent coupon, and was sold for $960 when the inflation rate was 6 percent?

A)-1.89 percent
B)1.92 percent
C)5.66 percent
D)11.47 percent Nominal return =

Answer 1

-1.89 percent

Question 2

If a share of stock provided a 14.0 percent nominal rate of return over the previous year while the real rate of return was 6.0 percent, then the inflation rate was:

A)1.89 percent
B)7.55 percent
C)8.00 percent
D)9.12 percent

Answer 2

7.55 percent

Question 3

Although several stock indexes are available to inform U.S.investors of market changes, the Dow Jones Industrial Average:

A)Is the broadest-based of the market indices
B)Is the only reliable market index
C)Accounts for approximately 70 percent of U.S.market value
D)Is the best-known of the U.S.market indexes

Answer 3

Is the best-known of the U.S.market indexes

Question 4

In addition to the number of stocks represented, a difference between the TSX 300 and the Dow is that the TSX 300:

A)Dates back to the 19^th century while the Dow is a recent innovation
B)Is value-weighted while the Dow is an equal-weighted index
C)Includes foreign stocks while the Dow is domestic
D)Index includes dividends in its return while the Dow does not

Question 5

How is it possible for real rates of return to increase during times when the rate of inflation increases?

A)Inflation increased more than the real return
B)Nominal returns actually decreased
C)Nominal returns increased more than inflation
D)Nominal returns increased less than inflation

Question 6

A maturity premium is offered on long-term Treasury bonds due to:

A)The risk of changing interest rates
B)The risk of default
C)Their unique risk
D)Their systematic risk

Question 7

Real rates of return will be positive as long as:

A)The nominal return is positive
B)The inflation rate is positive
C)The nominal return exceeds the inflation rate
D)The inflation rate exceeds the real return

Question 8

What is the percentage return on a stock that was purchased for $40.00 and paid a $3.00 dividend after one year, then sold for $39.00?

A)(2.50 percent)
B)2.50 percent
C)5.00 percent
D)7.50 percent

Question 9

What nominal return was received by an investor when inflation averaged 8.0 percent and the real rate of return was a negative 2.5 percent?

A)5.30 percent
B)5.36 percent
C)6.50 percent
D)10.77 percent

Question 10

Although the TSX 300 contains a small proportion of Canadian publicly traded stocks, it represents:

A)All stocks that prefer to be equal-weighted
B)All stocks that prefer to be value-weighted
C)Approximately 50 percent of Canadian stocks traded, in value
D)Approximately 70 percent of Canadian stocks traded, in value

Question 11

The primary difference between Canadian Treasury bills and Canadian Treasury bonds is that the bills:

A)Do not have default risk
B)Have more price volatility
C)Have a shorter maturity at time of issue
D)Offer a higher return

Question 12

The TSX 300 index is:

A)The most representative of stock market indexes
B)An index of Canada's major corporations
C)An index of 300 major stocks
D)An equally weighted index of all stocks traded on the New York Stock Exchange

Question 13

Stock A has 10 million shares issued and Stock B has 5 million shares issued.What is their relative weighting if both stocks are represented in the S&P 500?

A)Equal-weightings, like all S&P 500 stocks
B)B has twice the weighting, to account for having fewer shares
C)A has twice the weighting, to account for having more shares
D)They are weighted according to their expected performance

Question 14

An investor receives a 15 percent total return by purchasing a stock for $40 and selling it after one year with a 10 percent capital gain.How much was received in dividend income during the year?

A)$2.00
B)$2.20
C)$4.00
D)$6.00

Question 15

Real rates of return are typically less than nominal rates of return due to:

A)Inflation
B)Capital gains
C)Dividend payments
D)Depreciation

Question 16

If a stock is purchased for $25 per share and held one year, during which time a $3.50 dividend is paid and the price climbs to $28.25, the nominal rate of return is:

A)13.00 percent
B)14.00 percent
C)23.01 percent
D)27.00 percent

Question 17

Which of the following statements is true for a stock that sells now for $60, pays an annual dividend of $3.00, and experienced a 30 percent return on investment over the past year? Its price one year ago was:

A)$42.00
B)$46.15
C)$48.46
D)$56.10

Question 18

"TSX up 14.Story at 6:00 p.m." This means that:

A)The TSX was up 14 percent during today's trading
B)14 of the TSX's 300 stocks increased in price today
C)A share of TSX stock went up by $14 today
D)The TSX index increased by 14 points in today's trading

Question 19

Market interest rates have risen substantially in the five years since an investor purchased Treasury bonds that were offering a 7 percent return.If the investor sells now she is likely to receive:

A)Greater than a 7 percent total return
B)Less than a 7 percent total return
C)A 7 percent total rate of return
D)A 7 percent nominal return but less than a 7 percent real return

Question 20

Which of the following statements seems most appropriate when the TSX 300 increases by 2 percent?

A)All stocks on the exchange increased by 2 percent
B)Only 2 percent of the TSX index's stocks increased
C)A broad-based market indicator was up by 2 percent
D)The S&P 500 index increased by 2 percent

Question 21

The variance of a stock's returns can be calculated as the:

A)Average value of deviations from the mean
B)Average value of squared deviations from the mean
C)Square root of average value of deviations from the mean
D)Sum of the deviations from the mean

Question 22

What is the standard deviation of a portfolio's returns if the mean return is 15 percent, the variance of returns is 184, and there are three stocks in the portfolio?

A)7.83 percent
B)13.56 percent
C)41.00 percent
D)225.00 percent standard deviation =

Question 23

If the standard deviation of a portfolio's returns is known to be 30 percent, then its variance is:

A)5.48 percent
B)5.48 percent squared
C)900.00 percent
D)900.00 percent squared

Question 24

The variance of an investment's returns is a measure of the:

A)Volatility of the rates of return
B)Probability of a negative return
C)Historic return over long periods
D)Average value of the investment

Question 25

An estimation of the opportunity cost of capital for projects that have an "average" level of risk is the rate of return on:

A)Treasury bills
B)The market portfolio
C)The market portfolio minus the rate of return on Treasury bills
D)Treasury bonds plus a maturity premium

Question 26

Which of the following statements is correct for an investor starting with $1,000 in common stocks over a 20-year investment horizon in which stocks averaged 11 percent in nominal terms and 4 percent in real terms? The portfolio value is now approximately:

A)$1,800 in real terms
B)$3,679 in real terms
C)$3,870 in nominal terms
D)$8,062 in nominal terms FV = $1,000(1.11)²⁰
= 1,000 (8.06231)
= 8,062.31
FV = $1,000(1.04)²⁰
= 1,000(2.19112)

Question 27

When the annual rate of return on Canadian Treasury bills is historically high, investors expect the risk premium on the stock market to be:

A)Considerably lower than normal
B)Considerably higher than normal
C)Approximately normal
D)Approximately equal to zero

Question 28

The idea that investors in common stock may expect a lower total return when prices are relatively stable suggests that:

A)Investors are irrational
B)Risk premiums decline with inflation
C)Real rates of return will be lower during periods of price stability
D)Stocks should be avoided when inflation is low

Question 29

The appropriate opportunity cost of capital is the return that investors give up on alternative investments with:

A)The same risk
B)The risk-free return
C)The expected return on the TSX 300
D)The normal, common stock risk premium

Question 30

What is the approximate standard deviation of returns for a one-year project that is equally likely to return 100 percent as it is to provide a 100 percent loss?

A)0 percent
B)50 percent
C)71 percent
D)100 percent Mean = (.5 x 100%) + (.5 x-100)
= 50-50
= 0%
Variance =

Question 31

From a historical perspective (1926-2000), what would you expect to be the approximate return on a diversified portfolio of common stocks in a year that Treasury bills offered 7.5 percent?

A)8.5 percent
B)12.5 percent
C)14.5 percent
D)19.5 percent

Question 32

In a year in which common stocks offered an average return of 18 percent, Treasury bonds offered 10 percent and Treasury bills offered 7 percent, the risk premium for common stocks was:

A)1 percent
B)3 percent
C)8 percent
D)11 percent

Question 33

What is the variance of return of a three-stock portfolio (with unequal weights 25%, 50% and 25%) that produced returns of 20%, 25% and 30%, respectively?

A)10.00
B)12.50
C)15.00
D)20.00 Mean =

Question 34

What is the approximate variance of returns if over the past three years an investment returned 8.0 percent, -12.0 percent, and 15.0 percent?

A)31
B)131
C)182
D)961 Mean =

Question 35

Which of the following security portfolios should offer the highest maturity premium?

A)Common stocks, because they never mature
B)Long-term Treasury bonds, because of potential fluctuations in interest rates
C)Treasury bills, because of fluctuations in inflation rates
D)The Dow, because it is the oldest and most stable index

Question 36

Which of the following guarantees is offered to common stock investors?

A)Guaranteed to receive dividends
B)Guaranteed to receive capital gains
C)Guaranteed only to receive a refund of principal
D)No guarantees of any form

Question 37

The risk premium that is offered on common stock is equal to the:

A)Expected return on the stock
B)Real rate of return on the stock
C)Excess of expected return over a risk-free return
D)Expected return on the S&P 500 index

Question 38

Common stocks have offered an annual risk premium in nominal terms, but they have:

A)Also offered the risk premium in real terms
B)Not offered a risk premium in real terms
C)Not offered more than corporate bonds in real terms
D)offered only slightly more than Treasury bonds in real terms

Question 39

What is the variance of a three-stock portfolio that produced returns of 20 percent, 25 percent and 30 percent?

A)16.67
B)33.33
C)50.00
D)100.00

Question 40

What is the approximate standard deviation of returns if over the past four years an investment returned 8.0%, -12.0%, -12% and 15.0%?

A)9.26%
B)10.26%
C)11.26%
D)12.26% Mean =

Question 41

Industries that generally perform well when other industries are performing well are referred to as:

A)Diversified industries
B)Cyclical industries
C)risk-free industries
D)Systematic risk industries

Question 42

Which statement is correct concerning macro risk exposure?

A)All firms face equal macro risk exposure
B)Only portfolios of stocks face macro risk exposure
C)Macro risk exposure affects the cost of capital
D)Macro risk exposure is less important to diversified investors than micro risk exposure

Question 43

The benefits of portfolio diversification are highest when the individual securities have returns that:

A)Vary directly with the rest of the portfolio
B)Vary indirectly with the rest of the portfolio
C)Are uncorrelated with the rest of the portfolio
D)Are countercyclical

Question 44

Which of the following risks would be classified as a unique risk for an auto manufacturer?

A)Interest rates
B)Steel prices
C)Business cycles
D)Foreign exchange rates

Question 45

What is the expected return on a portfolio that will decline in value by 13 percent in a recession, will increase by 16 percent in normal times, and will increase by 23 percent during boom times if each scenario has equal likelihood?

A)8.67 percent
B)13.00 percent
C)13.43 percent
D)17.33 percent Expected return =

Question 46

Although unique risk is present in differing amounts, individual stocks are:

A)Exposed to the same amount of market risk
B)Exposed to differing amounts of market risk also
C)Not exposed to market risk; only the general economy is subject to market risk
D)Able to diversify away their market risk

Question 47

A stock that is considered to be a positive risk asset is added to a portfolio.As a result, the portfolio will:

A)Have lower average returns
B)Have a lower variance of returns
C)Have a higher volatility of returns
D)Have a lower correlation of returns with stock market indexes

Question 48

The standard deviations of individual stocks are generally higher than the standard deviation of the market portfolio because individual stocks:

A)Offer higher returns
B)Have more systematic risk
C)Have no diversification of risk
D)Do not have unique risk

Question 49

In general, which stocks should be combined in a portfolio if the goal is to reduce overall risk?

A)Stocks with returns that are positively correlated
B)Stocks with returns that are negatively correlated
C)Stocks with returns that are not correlated
D)Stocks that have the highest expected returns

Question 50

Which of the following risk types can be diversified by adding stocks to a portfolio?

A)Systematic risk
B)Unique risk
C)Default risk
D)Market risk

Question 51

Risk factors that are expected to affect only a specific firm are referred to as:

A)Market risk
B)Diversifiable risk
C)Systematic risk
D)Risk premiums

Question 52

When high growth is expected in the economy, an investor should receive higher returns from:

A)Cyclical investments
B)Countercyclical investments
C)Stocks with negative correlations
D)Stocks with low standard deviations

Question 53

Which of the following risks is most important to a well-diversified investor in common stocks?

A)Market risk
B)Unique risk
C)Total risk
D)Diversifiable risk

Question 54

Most of the beneficial effects of diversification will have been received by the time a portfolio of common stocks contains _____ stocks.

A)2
B)5
C)20
D)50

Question 55

A firm is said to be countercyclical if its returns:

A)Continue to decrease, year after year
B)Continue to increase, year after year
C)Are better when most firms do poorly
D)Are negative in real terms

Question 56

What is the typical relationship between the standard deviation of an individual common stock and the standard deviation of a diversified portfolio of common stocks?

A)Individual stock's standard deviation will be lower
B)Individual stock's standard deviation will be higher
C)The standard deviations should be equal
D)There is no way to predict this relationship

Question 57

A stock investor owns a diversified portfolio of 15 stocks.What will be the likely effect on portfolio standard deviation from adding one more stock?

A)A slight increase will occur
B)A large increase will occur
C)A slight decrease will occur
D)A large decrease will occur

Question 58

Which of the following concerns is likely to be most important to portfolio investors seeking diversification?

A)Total volatility of individual securities
B)Standard deviation of individual securities
C)Correlation of returns between securities
D)Achieving the risk-free rate of return

Question 59

The major benefit of diversification is to:

A)Increase the expected return
B)Remove negative risk assets from the portfolio
C)Reduce the portfolio's systematic risk
D)Reduce the expected risk

Question 60

The incremental risk to a portfolio from adding another stock:

A)Is always greater than the average portfolio risk
B)Is always less than the average portfolio risk
C)Is always positive
D)Is often positive but can be negative

Question 61

Perhaps the best way to reduce macro risk in a stock portfolio is to invest in stocks that:

A)Have only unique risks
B)Have diversified away the macro risk
C)Have low exposure to business cycles
D)Pay guaranteed dividends

Question 62

Which of the following statements is incorrect concerning stock indexes?

A)They have been developed for foreign stocks
B)They have been developed for smaller companies
C)Indexes include all common stocks
D)Some indexes are equal-weighted

Question 63

The fact that historical returns on Treasury bills are less volatile than common stock returns indicates that:

A)The variance of Treasury bill returns is zero
B)The standard deviation of Treasury bill returns is negative
C)The real return on Treasury bills has been zero
D)Common stocks should offer a higher return than Treasury bills

Question 64

Investment risk can best be described as the:

A)Dispersion of possible returns
B)Elimination of macro risk through diversification
C)Possibility of changes in the cost of capital
D)Level of systematic risk for an undiversified investor

Question 65

When viewing the long-term trend of volatility in U.S.stocks, it is readily apparent that:

A)Volatility has continually increased
B)Volatility has continually decreased
C)Volatility has offered little discernable trend
D)Volatility has remained constant for years

Question 66

Averaging the deviations from the mean for a portfolio of securities will:

A)Compute the standard deviation
B)Compute the variance
C)Equal zero
D)Equal the number of securities in the portfolio

Question 67

Which of the following companies might you expect to be exposed to less macro risk?

A)A large producer of flour
B)A regional airline
C)A major commercial bank
D)An electric utility

Question 68

Which of the following would you expect to represent the broadest-based index of Canadian stocks?

A)TSX 300
B)CDNX
C)Standard and Poor's Composite
D)Financial Times Index

Question 69

What percentage return is achieved by an investor who purchases a stock for $30, receives a $1.50 dividend, and sells the share one year later for $28.50?

A)-5 percent
B)0 percent
C)5 percent
D)10 percent

Question 70

If a stock's returns are volatile, then the stock:

A)Cannot be considered a negative risk asset
B)Can still be considered a negative risk asset
C)Has macro risk, but no unique risk
D)Does not offer diversification potential

Question 71

Which of the following firms is likely to exhibit the least macro risk exposure?

A)Furniture manufacturer
B)Oil driller
C)Dog food processor
D)Auto manufacturer

Question 72

If a project's expected return is 15 percent, which represents a 35 percent return in a booming economy and a 5 percent return in a stagnant economy, what is the probability of a booming economy?

A)18.33 percent
B)25.00 percent
C)33.33 percent
D)50.00 percent 15% = 35 %(X) + 5%(1 - X)
10% = 30%X

Question 73

If when a coin is tossed the observance of a head rewards you with a dollar and the observance of a tail costs you fifty cents, how much would you expect to gain after twenty tosses?

A)$5.00
B)$7.50
C)$10.00
D)$15.00 Expected return = 20 x [($1.00 x .5) - (.50 x .5)]
= 20 x ($.25)

Question 74

One common reason for reporting standard deviations rather than variances is that standard deviations:

A)Are lower
B)Are stated in understandable units
C)Account properly for negative returns
D)Take probability estimates into consideration

Question 75

Common stock is held for two years, during which time it receives an annual dividend of $10.The stock was sold for $100 and generated an average annual return of 16 percent.What price was paid for the stock?

A)$61.60
B)$64.80
C)$88.00
D)$90.90 .32 =

Question 76

A stock is held one year, during which time its dividend yield was greater than its capital gains yield.For this stock, the percentage return:

A)Is positive
B)Is negative
C)Equals the dividend yield
D)Cannot be determined

Question 77

If a stock is purchased for $12.50 per share and held one year, during which time a $1.50 dividend is paid and the price drops to $10.75, the percentage return is:

A)-2%
B)-1%
C)1%
D)2%

Question 78

The addition of a negative risk asset to a portfolio of assets will:

A)Increase the portfolio's expected return
B)Decrease the portfolio's expected return
C)Increase the portfolio's expected volatility
D)Decrease the portfolio's expected volatility

Question 79

How is the calculation of a variance affected by an observation with a negative rate of return when other returns are positive?

A)It reduces the variance
B)It increases the variance
C)Variance is not affected by negatives or positives
D)The effect cannot be determined from this information

Question 80

Treasury bonds have provided a higher historical return than Treasury bills, which can be attributed to:

A)Greater default risk
B)A higher level of unique risk
C)Greater price risk due to longer maturities
D)The fact that they are less frequently traded than bills