7.

1 Realized and Expected Rates of Return and Risk

1) You purchased the stock of Sargent Motors at a price of $75.75 one year ago today. If you
sell the stock today for $89.00, what is your rate of return?
A) 35.00%
B) 12.50%
C) 17.50%
D) 25.00%

2) You have invested in a project that has the following payoff schedule:

Probability of
Payoff Occurrence
$40 .15
$50 .20
$60 .30
$70 .30
$80 .05

What is the expected value of the investment's payoff? (Round to the nearest $1.)
A) $60
B) $65
C) $58
D) $70

3) If there is a 20% chance we will get a 16% return, a 30% chance of getting a 14% return, a
40% chance of getting a 12% return, and a 10% chance of getting an 8% return, what is the
expected rate of return?
A) 12%
B) 13%
C) 14%
D) 15%

4) You are considering investing in a project with the following possible outcomes:

Probability of Investment
States Occurrence Returns
State 1: Economic boom 15% 16%
State 2: Economic growth 45% 12%
State 3: Economic decline 25% 5%
State 4: Depression 15% -5%

Calculate the expected rate of return for this investment.

A) 9.8%
B) 7.0%
C) 8.3%
D) 6.3%
5) Spartan Sofas, Inc. is selling for $50.00 per share today. In one year, Spartan will be selling
for $48.00 per share, and the dividend for the year will be $3.00. What is the cash return on
Spartan stock?
A) $51.00
B) $1.00
C) $2.00
D) $3.00

6) What is the standard deviation of an investment that has the following expected scenario?
18% probability of a recession, 2.0% return; 65% probability of a moderate economy, 9.5%
return; 17% probability of a strong economy, 14.2% return.
A) 3.68%
B) 1.23%
C) 8.47%
D) 6.66%

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%

8) Which of the following best measures an asset's risk?

A) Expected return
B) The standard deviation
C) The probability distribution
D) The cash return

9) The cash return on an investment is calculated as purchase price-selling price.

Answer: FALSE

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

11) Even though an investor expects a positive rate of return, it is possible that the actual return
will be negative.
Answer: TRUE

12) The expected rate of return is the weighted average of the possible returns for an
investment.
Answer: TRUE
13) The expected rate of return is the sum of each possible return times it likelihood of
occurrence.
Answer: TRUE

14) The higher the standard deviation, the less risk the investment has.
Answer: FALSE

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 = = (.20)(40%) + (.60)(15%) + (.20)(-20%)
= 8% + 9% - 4% = 13%
σi = ( ).
σi = ((40% - 13%)2(.2) + (15% - 13%)2 (.6) + (-20% - 13%)2 (.2)). = 19.13%

7.2 A Brief History of Financial Market Returns

1) Which of the following sequences is arranged in the correct order, from highest long-term
returns to lowest?
A) Small stocks, government bonds, large stocks
B) Large stocks, treasury bills, small stocks
C) Small stocks, large stocks, treasury bills
D) Government bonds, large stocks, treasury bills

2) Investments that have earned the highest rates of return over time also have
A) the lowest risk.
B) the highest standard deviation of returns.
C) the largest market capitalization.
D) the least sensitivity to inflation.

3) The difference between returns on stocks and government bonds is known as

A) the equity risk premium.
B) the risk and return tradeoff.
C) the maturity premium.
D) the risk/reward paradox.

4) An emerging market is
A) a market for small, but rapidly growing companies.
B) market for companies coming out from bankruptcy proceedings.
C) market for promising, but untested technologies.
D) a market located in an economy with low to middle per capita income.
5) The risk-return tradeoff tells us that expected returns should be higher on investments that
have higher risk.
Answer: TRUE

6) Riskier investments have traditionally had lower returns than less risky investments have had.
Answer: FALSE

7) Less risky investments have lower standard deviations than do more risky investments.
Answer: TRUE

8) Investments in emerging markets have higher volatility than do U.S. Stocks.

Answer: TRUE

9) Risky investments have the potential for higher returns, but also larger losses.
Answer: TRUE

10) Historically, in the United States stocks have had higher returns and greater volatility than
have government bonds.
Answer: TRUE

11) Treasury Bills have less default risk than do Government Bonds.
Answer: TRUE

12) Investors are always rewarded for taking higher risk with higher realized returns.
Answer: FALSE

13) During the financial crisis of 2007-2009, returns on real estate investment trusts (REITS)
and stocks moved in opposite directions.
Answer: FALSE

7.3 Geometric vs. Arithmetic Average Rates of Return

1) Marcus Berger invested $9842.33 in Hawkeyehats, Inc. four years ago. He sold the stock
today for $11,396.22. What is his geometric average return?
A) 2.98%
B) 3.73%
C) 3.95%
D) There is insufficient information to derive an answer.

2) Michael Lynch invested $10,000 in the Rearguard Fund four years ago. All earnings were
reinvested in the fund. If his compound annual rate of return was 7%, what is his investment
worth today?
A) $1,310.80
B) $10,700
C) $12,800
D) $762.89
Use the following to answer the following question(s).

Roddy Richards invested $12014.88 in Wolverine Meat Distributors (W.M.D.) five years ago.
The investment had yearly arithmetic returns of -9.7%, -8.1%, 15%, 7.2%, and 15.4%.

3) What is the arithmetic average return of Roddy Richard's investment?

A) 2.42%
B) 3.96%
C) 5.18%
D) 15.1%

4) What is the geometric average return of Roddy's Richard's investment?

A) 3.38%
B) 4.63%
C) 6.96%
D) 8.78%

5) How much money did Roddy Richards receive when he sold his shares of W.M.D.?
A) $12,014.88
B) $12,398.42
C) $13,663.47
D) $14,184.73

Use the following information to answer the following question(s).

Susan Bright will get returns of 18%, -20.3%, -14%, 17.6%, and 8.3% in the next five years on
her investment in CoffeeTown, Inc. stock, which she purchases for $73,419.66 today.

6) What is the arithmetic average return on her stock if she sells it five years from today?
A) 1.92%
B) 3.98%
C) 6.47%
D) 7.11%

7) What is the geometric average return on her stock if she sells it five years from today?
A) -2.33%
B) .59%
C) 3.67%
D) 4.88%

8) How much will Susan's stock be worth if she sells it five years from today?
A) $71,423.85
B) $73,419.66
C) $75,628.75
D) $80,333.40

9) Arithmetic average rate of return takes compounding into effect.

Answer: FALSE
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

11) If an investor holds earns 10% on her investment in the first year and loses 10% the next
year, she will have neither a gain nor a loss.
Answer: FALSE

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

7.4 What Determines Stock Prices?

1) Each of the following would tend to weaken the Efficient Market Hypothesis EXCEPT
A) There is publicly available information that Boeing Aircraft has procured a contract to build 25
planes for the U.S. Government and the price of Boeing quickly goes up.
B) ACG, Inc. performed well for the past six months, but they just lost a major distribution
contract, but the price of ACG stock continues to go up.
C) Louisville Slugger, Inc., gets a contract to supply bats for Little League play, a contract it
never had before, and stock price remains stable.
D) Muguet Company consistently underperforms the market in October, but outperforms the
market in May.

2) Jayden spends a lot of time studying charts of stocks past performance, but his investment
return are only average. This outcome supports
A) the weak-form efficient market hypothesis.
B) the semi-strong form efficient market hypothesis.
C) the strong form efficient market hypothesis.
D) all of the above.

3) Which of the following is consistent with the efficient market hypothesis?

A) so-called value stocks outperform growth stocks.
B) stocks that have performed well over the past year continue to perform well for several more
months.
C) a company announces higher than expected sales and earnings. The stock price
immediately increases by 10%.
D) a company announces higher than expected sales and earnings. The stock price remains
unchanged.

4) Madison was hired to design and decorate the offices of a large pharmaceutical
company. She accidentally read a report indicating that a new drug had just been approved by
the Food and Drug administration. She immediately bought the company's stock which doubled
in price over the following week. This outcome is inconsistent with
A) the weak-form efficient market hypothesis.
B) the semi-strong form efficient market hypothesis.
C) the strong form efficient market hypothesis. Her action was probably illegal.
D) all of the above.