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

Question 1

Stock market indexes are found in several countries outside the United States.

Answer 1

True

Question 2

Specific risks are generally associated with a single firm or industry.

Answer 2

True

Question 3

Market risk can be eliminated in a stock portfolio through diversification.

Answer 3

False

Question 4

Long-term corporate bonds are the only portfolio of securities found to be riskier than common stocks.

Question 5

Investors who bought shares of stock in March 2000 would most likely have seen the value of their investment decline over the next two-and-a-half years.

Question 6

Macro risks are faced by all common stock investors.

Question 7

Every additional stock added to a portfolio reduces the portfolio's level of risk by an equal amount.

Question 8

The historical record fails to show that investors have received a risk premium for holding risky assets.

Question 9

For investment horizons greater than 20 years, long-term corporate bonds traditionally have outperformed common stocks.

Question 10

The expected return on an investment includes compensation for both the time value of money and the risks assumed.

Question 11

The S&P 500 accounts for nearly 75% of the total market value of stocks traded in the United States.

Question 12

Historically speaking, the market risk premium in Italy has been higher than that of the United States.

Question 13

All financial managers and economists believe that long-run historical returns are the best available measure of future returns.

Question 14

The risk that remains in a stock portfolio after efforts to diversify is known as unique risk.

Question 15

If one portfolio's variance exceeds that of another portfolio, its standard deviation will also be greater than that of the other portfolio.

Question 16

The expected return on an investment provides compensation to investors both for waiting and for worrying.

Question 17

A share of stock currently sells for $60, pays an annual dividend of $4.00, and earned a rate of return of 20% over the past year. What did this stock sell for one year ago?

A) $42.00
B) $46.15
C) $48.46
D)$53.33

Question 18

Cyclical stocks tend to perform well when other stocks are performing well also.

Question 19

A market index is used to measure performance of a broad-based portfolio of stocks.

Question 20

Average returns on high-risk assets are higher than those on low-risk assets.

Question 21

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 22

Sue purchased a stock for $25 a share, held it for one year, received a $1.34 dividend, and sold the stock for $26.45. What nominal rate of return did she earn?

A) 11.16%
B) 14.23%
C) 12.09%
D)10.55%

Question 23

Stock A has 10 million shares outstanding and stock B has 5 million shares outstanding. Both stocks sell for $10 a share. What is their relative weighting if both stocks are represented in the S&P 500?

A) They have equal weighting, 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 24

Although Standard and Poor's Composite Index contains a limited number of U.S. publicly traded stocks, the Index represents:

A) all stocks in the industrial sector.
B) all stocks priced at $50 a share or more.
C) approximately 50% of U.S. stocks traded, in market value.
D)approximately 75% of U.S. stocks traded, in market value.

Question 25

The primary difference between U.S. Treasury bills and U.S. 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 26

Which one of these is considered to be the safest investment?

A) U.S. Treasury bonds
B) Common stock
C) U.S. Treasury bill
D)Preferred stock

Question 27

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

A) is the broadest-based of the market indexes.
B) is the only reliable market index.
C) accounts for approximately 70% of U.S. market value.
D)is the best-known of the U.S. market indexes.

Question 28

Assume market interest rates have risen substantially in the 5 years since an investor purchased Treasury bonds that were offering a 6% return over their 15-year life. If the investor sells now he or she is likely to realize a total return that is:

A) greater than 6%.
B) less than 6%.
C) equal to 2%.
D)equal to 6%.

Question 29

What is the percentage return on a stock that was purchased for $48.40, paid a $1.67 dividend, and was then sold after one year for $46.20?

A) -2.50%
B) -1.10%
C) 0.23%
D)-0.33%

Question 30

If a share of stock provided a 14.84% nominal rate of return over the previous year while the real rate of return was 6.65%, then the inflation rate was:

A) 8.89%.
B) 7.68%.
C) 8.03%.
D)9.12%.

Question 31

The Dow Jones Industrial Average is:

A) the most representative of the stock market indexes.
B) an index of 500 largest corporate stocks in America.
C) an index of 30 major industrial stocks.
D)an equally weighted index of all stocks traded on the New York Stock Exchange.

Question 32

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

A) -1.89%
B) 1.92%
C) -2.66%
D)2.47%

Question 33

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)the uncertainty of their maturity date.

Question 34

"Dow up 14. Story at 6:00." This means that:

A) the Dow was up 14% during today's trading.
B) 14 of the Dow's 30 stocks increased in price today.
C) a share of Dow stock went up by $14 today.
D)the Dow index increased by 14 points in today's trading.

Question 35

An investor receives a 15% total return by purchasing a stock for $40 and selling it after one year with a 5% capital gain. How much was received in dividend income during the year?

A) $2.00
B) $2.20
C) $4.00
D)$4.40

Question 36

Which one of the following statements seems most appropriate when the Dow Jones Industrial Average increases by 2%?

A) All stocks on the exchange increased by 2%.
B) All 30 DJIA stocks increased by 2%.
C) One market indicator was up by 2%.
D)The S&P 500 index increased by 2%.

Question 37

What nominal return was received by an investor when inflation averaged 3.46% and the real rate of return was 2.5%?

A) 0.96%
B) 5.96%
C) 6.05%
D)5.47%

Question 38

The actual real rate of return on an investment will be positive as long as the:

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

Question 39

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 40

What was the percentage return on a non-dividend-paying stock that was purchased for $40.00 and then sold after one year for $39.00?

A) -2.50%
B) -0.39%
C) -0.04%
D)-2.56%

Question 41

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 the average value of deviations from the mean.
D)sum of the deviations from the mean.

Question 42

Over a 20-year period an investment of $1,000 in common stocks returned an average of 11% in nominal terms and 4% in real terms. At the end of the 20 years, the portfolio value was:

A) $1,800 in real terms.
B) $3,679.19 in real terms.
C) $7,870.59 in nominal terms.
D)$8,062.31 in nominal terms.

Question 43

The wider the dispersion of returns on a stock, the:

A) lower the expected rate of return.
B) higher the standard deviation.
C) lower the real rate of return.
D)lower the variance.

Question 44

The idea that investors in a common stock may expect a lower total return if they purchase a stock with limited price volatility rather than one with high price volatility suggests that:

A) investors are irrational.
B) there is a relationship between risk and return.
C) real rates of return will be lower during periods of price stability.
D)stocks should be avoided when inflation is low.

Question 45

What is the standard deviation of returns of a 4-stock portfolio (each stock being equally weighted) that produced returns of 20%, 20%, 25%, and 30%?

A) 2.15%
B) 3.15%
C) 4.15%
D)5.15%

Question 46

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

A) 7.83%
B) 13.56%
C) 41.00%
D)225.00%

Question 47

A stock is expected to return 11% in a normal economy, 19% if the economy booms, and lose 8% if the economy moves into a recessionary period. The economists predict a 65% chance of a normal economy, a 25% chance of a boom, and a 10% chance of a recession. What is the expected return on the stock?

A) 11.98%
B) 12.06%
C) 11.10%
D)11.23%

Question 48

What is the variance of returns of a 3-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

Question 49

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 50

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 time periods.
D)average value of the investment.

Question 51

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

A) 5.48%.
B) 5.48% squared.
C) 900.00%.
D)900.00% squared.

Question 52

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

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

Question 53

What is the approximate standard deviation of returns if over the past 4 years an investment returned 8%, -12%, -12%, and 15%?

A) 9.26%
B) 10.26%
C) 11.26%
D)12.01%

Question 54

When the annual rate of return on U.S. 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 55

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

A) 1%.
B) 3%.
C) 8%.
D)11%.

Question 56

What is the variance of returns of a 3-stock portfolio (each stock being equally weighted) that produced returns of 20%, 25%, and 30%?

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

Question 57

From a historical perspective (1900-2013), 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%?

A) 14.3%
B) 12.3%
C) 15.1%
D)16.5%

Question 58

Which one of the following security classes has the highest standard deviation of returns?

A) Common stocks
B) Long-term Treasury bonds
C) Treasury bills
D)Corporate bonds

Question 59

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

A) possess the same level of risk.
B) earn the risk-free rate of return.
C) are included in the S&P 500 index.
D)earn the average market rate of return.

Question 60

What is the approximate variance of returns if over the past 3 years an investment returned 8%, -12%, and 15%?

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

Question 61

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 62

A stock investor owns a diversified portfolio of 15 stocks. What will be the most likely effect on the portfolio's standard deviation if one more stock is added?

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 63

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) The individual stock's standard deviation will be lower.
B) The 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 64

The major benefit of diversification is the:

A) increased expected return.
B) removal of all negative risk assets from the portfolio.
C) reduction in the portfolio's systematic risk.
D)reduction in the portfolio's total risk.

Question 65

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

A) 0%
B) 50%
C) 71%
D)100%

Question 66

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 67

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

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

Question 68

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)may be either positive or negative.

Question 69

The higher the standard deviation of a stock's annual returns, the:

A) lower the level of unique risk.
B) lower the expected rate of return.
C) higher the accuracy of predictions of the stock's return for any given year.
D)wider the dispersion of those returns over time.

Question 70

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 71

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 72

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 73

Which one of the following risk types can be most eliminated by adding stocks to a portfolio?

A) Systematic risk
B) Unique risk
C) Market risk
D)Inflation rate risk

Question 74

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) outperform when most stocks do poorly.
D)are negative in real terms.

Question 75

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

A) 8.67%
B) 13.00%
C) 13.43%
D)17.33%

Question 76

Which one 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 77

Which one 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 78

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

A) vary directly with the rest of the portfolio.
B) vary proportionally with the rest of the portfolio.
C) are less than perfectly correlated with the rest of the portfolio.
D)are perfectly correlated with the market portfolio.

Question 79

In general, which stocks should be combined into a portfolio if the goal is the greatest reduction possible in overall portfolio 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 80

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

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