Chapter 7 Chap Seven
Chapter 7 Chap Seven
Chapter 7 Chap Seven
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7) You are considering investing in a firm that has the following possible outcomes:
Economic boom: probability of 25%; return of 25%
Economic growth: probability of 60%; return of 15%
Economic decline: probability of 15%; return of -5%
What is the expected rate of return on the investment?
A) 15.0%
B) 11.7%
C) 14.5%
D) 25.0%
Answer: C
Diff: 2
Topic: 7.1 Realized and Expected Rates of Return and Risk
Keywords: holding period return
Principles: Principle 2: There Is a Risk-Return Tradeoff
8) Which of the following best measures the risk of holding an asset in isolation (i.e., stand-alone
risk)?
A) The mean co-variance
B) The standard deviation
C) The coefficient of optimization
D) The standard asset pricing model
E) The correlation
Answer: B
Diff: 2
Topic: 7.1 Realized and Expected Rates of Return and Risk
Keywords: standard deviation
Principles: Principle 2: There Is a Risk-Return Tradeoff
9) The holding period return is always positive.
Answer: FALSE
Diff: 1
Topic: 7.1 Realized and Expected Rates of Return and Risk
Keywords: holding period return
Principles: Principle 2: There Is a Risk-Return Tradeoff
10) Because returns are more certain for the least risky investments, the required return on these
investments should be higher than the required returns on more risky investments.
Answer: FALSE
Diff: 1
Topic: 7.1 Realized and Expected Rates of Return and Risk
Keywords: holding period return
Principles: Principle 2: There Is a Risk-Return Tradeoff
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11) Even though an investor expects a positive rate of return, it is possible that the actual return
will be negative.
Answer: TRUE
Diff: 1
Topic: 7.1 Realized and Expected Rates of Return and Risk
Keywords: holding period return
Principles: Principle 2: There Is a Risk-Return Tradeoff
12) The expected rate of return is the weighted average of the possible returns for an investment.
Answer: TRUE
Diff: 1
Topic: 7.1 Realized and Expected Rates of Return and Risk
Keywords: holding period return
Principles: Principle 2: There Is a Risk-Return Tradeoff
13) The expected rate of return is the sum of each possible return times it likelihood of
occurrence.
Answer: TRUE
Diff: 1
Topic: 7.1 Realized and Expected Rates of Return and Risk
Keywords: holding period return
Principles: Principle 2: There Is a Risk-Return Tradeoff
14) The higher the standard deviation, the less risk the investment has.
Answer: FALSE
Diff: 1
Topic: 7.1 Realized and Expected Rates of Return and Risk
Keywords: standard deviation
Principles: Principle 2: There Is a Risk-Return Tradeoff
15) Using the following information for McDonovan, Inc.'s stock, calculate their expected return
and standard deviation.
State
Probability
Return
Boom
20%
40%
Normal
60%
15%
Recession
20%
(20%)
Answer: Ki = (Ki)(Pi) = (.20)(40%) + (.60)(15%) + (.20)(-20%)
= 8% + 9% - 4% = 13%
2
i = ((Ki K) Pi).5
i = ((40%-13%)2(.2) + (15%-13%)2 (.6) + (-20%-13%)2 (.2)).5 = 19.13%
Diff: 2
Topic: 7.1 Realized and Expected Rates of Return and Risk
Keywords: standard deviation
Principles: Principle 2: There Is a Risk-Return Tradeoff
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10) An investor who wishes to hold a stock for five years will be most interested in geometric
average rather than in the arithmetic average return.
Answer: TRUE
Diff: 1
Topic: 7.3 Geometric vs. Arithmetic Average Rates of Return
Keywords: compound interest
Principles: Principle 1: Money Has a Time Value
11) If an investor holds a stock for six years, the value at the end of six years will be the initial
cost times (1 + geometric average return)to the sixth power.
Answer: TRUE
Diff: 1
Topic: 7.3 Geometric vs. Arithmetic Average Rates of Return
Keywords: compound interest
Principles: Principle 1: Money Has a Time Value
12) If an investor holds a stock for three years, the value at the end of three years will always be
the initial cost of the stock times (1 + arithmetic average return) to the third power.
Answer: FALSE
Diff: 1
Topic: 7.3 Geometric vs. Arithmetic Average Rates of Return
Keywords: compound interest
Principles: Principle 1: Money Has a Time Value
13) Why do the arithmetic average return and the geometric return differ?
Answer: The arithmetic average return does not take what the value of the investment was at the
start of each period. Hence, even though a company may have the same arithmetic return for two
consecutive years, the dollar amount of those returns will be different in later years than in the
first year. For instance, if the investor started with $1,000, and earned 20% the first year, lost
20% the second year, and earned 15% the third year, the average arithmetic return would be 5%,
and the 20% gain the first year would be $200, but the 20% loss the second year would be $240.
The investment would be worth $1104 after three years, giving an average geometric return of
3.35%, different from the average arithmetic return.
Diff: 2
Topic: 7.3 Geometric vs. Arithmetic Average Rates of Return
Keywords: compound interest
Principles: Principle 1: Money Has a Time Value
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5) If an individual with inside information can make higher than expected profits, the market is
no more than semi-strong form efficient.
Answer: TRUE
Diff: 1
Topic: 7.4 What Determines Stock Prices?
Keywords: efficient markets
Principles: Principle 4: Market Prices Reflect Information
6) Under the efficient market hypothesis, would securities be properly priced.
Answer: If markets were perfectly efficient, then investors would price a stock based on the
company's expected future cash flows, so at any time the security would be properly priced. If
good news becomes available, that would tend to increase the expected cash flows to a company,
the stock price will go up, meaning that the new price is then the proper price for the stock.
Diff: 2
Topic: 7.4 What Determines Stock Prices?
Keywords: efficient markets
Principles: Principle 4: Market Prices Reflect Information
7) Are markets moving toward being more efficient or toward being less efficient?
Answer: Empirical evidence shows that since about the year 2000 pricing anomalies have
diminished considerably. Hedge funds have been trying to exploit pricing inefficiencies, and by
doing so, eliminate the inefficiencies. Hence, the market appears to be becoming more efficient
over time.
Diff: 2
Topic: 7.4 What Determines Stock Prices?
Keywords: efficient markets
Principles: Principle 4: Market Prices Reflect Information
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