File: ch06

Multiple Choice

1. While certain investors look for income-producing investments, most investors are more concerned with total return investing. Total return is measured by: a) Dividends b) Coupon payments on bonds c) Yield plus capital appreciation or depreciation d) Capital appreciation or depreciation Ans: C EASY Response: Total return consists of investment income plus capital gains (or losses). Investment income, or yield, can come from dividends on stocks or coupon payments from bonds. Section: Return.

2. Why would an investor choose to invest in any risky asset? a) Because they expect a return adequate to compensate them for the extra risk. b) The government requires risky investments to provide higher returns. c) Investors want very safe investments. d) Risk and return move in opposite directions. Ans: A EASY Response: An investor would only purchase a risky asset if they expected to earn a return that justified the level of risk they were assuming. Section: Risk.

3. Which of the following is NOT a source of risk involved with investing in financial assets? a) Interest rate risk b) Inflation risk c) Investment risk d) Liquidity risk Ans: C

MEDIUM Response: All investments have certain components of their total risk, consisting of interest rate risk, inflation risk, liquidity risk, business risk, market risk, financial risk and sometimes currency and country (political) risk. Section: Risk.

4. One of the most basic tenets of general investment philosophy is: a) Past returns should always be extrapolated into the future. b) Investors should purchase a security if its expected return compensates for its risk. c) Realized returns are generally close to expected returns, in any short period. d) The investments with higher expected returns are usually safer. Ans: B EASY Response: Investing always involves a tradeoff between risk and return. Section: Risk.

5. For U.S. investors, which of the following is a source of risk involved with international investments, but not with domestic investments? a) Inflation risk b) Business risk c) Exchange rate risk d) Liquidity risk Ans: C MEDIUM Response: In addition to the traditional sources of risk with investing, purchasing international securities adds an additional layer of risk created by the difference in currency values between countries. Section: Risk.

6. Which of the following is included in "market risk"? a) Specific risk b) Business risk c) Interest rate risk d) Financial risk Ans: C DIFFICULT Response: Both financial risk and business risk come from the specific company under

consideration, whereas interest rate risk affects the entire market. Section: Risk.

7. Formula 6-4 shows us how to calculate Total Return TR = (CFt + PE -PB) / PB Which part of the formula represents the yield? a) CFt b) CFt / Pb c) PE -PB d) (PE -PB) / PB Ans: B DIFFICULT Response: The total return can be broken down algebraically into yield and capital gain. Section: Measuring Risk

8. The total return on a treasury bond is measured by: a) the present value of its coupon payments only b) .interest rate risk c) coupon payments plus capital gain or loss d) dividends plus capital gain or loss Ans: C MEDIUM Response: Total return always consists of yield plus capital gain or loss. Section: Returns.

9. How does one calculate the Cumulative Wealth Index? a) Add the total returns for each year and add to the starting amount. b) Multiply the return relatives for each year, and multiply by the starting amount. c) Adding the return relatives for each year, and add to the starting amount. d) Multiply the total returns for each year, and multiply by the starting amount. Ans: B EASY Response: The Cumulative Wealth Index is often used by mutual funds to simply express returns in dollar terms to retail investors . Section: Realized Returns and Risks from Investing

10. Investments in non-U.S. companies and funds expose investors to all of the following risks EXCEPT: a) Exchange rate risk b) Country (political) risk. c) Diversification risk d) Market risk. Ans: C MEDIUM Response: International investments are viewed as a necessary component of any properly diversified portfolio today, but such investments do have additional unique risks like currency and political risk. Section: Risk.

11. Which is of the following is an appropriate time to use the arithmetic mean, rather than the geometric mean? a) The arithmetic mean is a better measure of typical performance over a single period. b) The geometric mean is a better measure of typical performance over a single period. c) The geometric mean shows the compound average rate of growth over several periods. d) The arithmetic mean does better at adjusting for inflation. Ans: A MEDIUM Response: The arithmetic mean does not consider the effects of compounding over multiple periods, thus is a simple method for measuring the typical performance for any given single period of time. Section: Summary Statistics for Returns

12. Which of the following best explains why analysts may want to adjust nominal returns to real returns? a) Nominal returns are returns in name only. b) Only real returns are the actual returns the investor receives. c) The investor receives money returns, but with inflation, the value of money falls. d) Real and nominal returns are measuring the same thing. Ans: C MEDIUM Response: Inflation-adjusted returns are a more accurate way of measuring the real effect of investment performance, given the impact of inflation on the value of money. Section: Summary Statistics for Returns.

13. Which is the best way to accurately calculate the inflation adjusted total return? a) (1+ TR) / (1+inf) 1 b) TR inf c) TR + inf d) cannot be determined Ans: A MEDIUM Response: The real return is adjusted for inflation by subtracting the expected rate of inflation. Section: Summary Statistics for Returns.

14. Which of the following is NOT another way to express the concept of risk? a) Dispersions of outcomes b) Variability c) The chance the actual outcome will differ from the expected outcome d) The total return Ans: D EASY Response: Risk reflects the uncertainty of investment outcomes, i.e. the variability in returns. Section: Risk

15. Consider the following investments, each of which has a series of total returns over time. Which series is likely to have the lowest variability? a) A one-year treasury bill held to maturity. b) Common stock c) Mutual funds d) Corporate bonds Ans: A EASY Response: The treasury bill held to maturity will have an actual return exactly equal to the expected return. Section: Measuring Risk.

16. The standard deviation of total returns can be calculated for all but which of the following? a) The series of total returns for a specific stock over a specified period in the past. b) The series of total returns for a mutual fund over a specified period in the past. c) The series of total returns for a specific stock over a specified period in the future. d) The series of total returns for a portfolio of securities over a specified period in the past. Ans: C MEDIUM Response: We cannot directly calculate the standard deviation for future returns, but we can use the standard deviation of past returns to extrapolate future returns and help us better forecast the future. Section: Measuring Risk

17. All of the following are categories of a particular securitys risk premium EXCEPT: a) Time premium between long term and short term treasury bonds. b) Default premium between corporate bonds and treasury bonds. c) Equity risk premium between a stock and a treasury security. d) The risk-free rate of return. Ans: D MEDIUM Response: There are several types of risk premium, but the risk-free rate represents the rate on riskless Treasury bills. Section: Measuring Risk.

18. Figure 6-2, page 6-33, shows much higher increases in cumulative wealth, over long periods from common stocks, than other investments. Given this history, why would anyone choose other investments? a) Everyone wants to increase their cumulative wealth as much as possible. b) Treasury and corporate bonds are better protection against inflation. c) Common stocks have a higher chance of losing value, in the short term. d) Investing on common stocks provides funds for private businesses. Ans: C EASY Response: Common stocks have substantially higher risk or variability than Treasury or corporate bonds. Section: Measuring Risk.

19. Which of the following asset classes has demonstrated the greatest volatility over time?

a) Large-cap stocks b) Treasury bonds c) Small-cap stocks d) Treasury bills Ans: C EASY Response: Small-cap stocks have been much more volatile than other asset classes, but have also delivered greater returns throughout history. Section: Realized Returns and Risks from Investing.

20. What best explains the vast difference in cumulative wealth index for common stocks versus Treasury bonds, over long periods? a) Common stocks have much higher volatility, over a long period of time. b) While common stocks have higher returns, it is the compounding of returns over time that makes such a huge difference. c) Treasury bonds are much safer than common stocks. d) Common stocks have higher returns than Treasury bonds, over time. Ans: B EASY Response: Compounding even small differences in return can produce huge differences in wealth over time. Section: Realized Returns and Risk from Investing.

Type: True-False

1. The return on any investment can be subdivided into yield and capital gain. Ans: True Response: Section: Return.

2. We have to wait for at least a year to accurately measure the capital gain or loss on an investment. Ans: False Response: Section: Return

3. Risk is the chance that an actual outcome from an investment will differ from the expected outcome. Ans: True Response: Section: Risk.

4. Financial risk shows that companies financed with much debt are more predictable. Ans: False Response: Section: Risk.

5. The telecommunications industry is one of the safest industries because the FCC regulates the industry. Ans: False Response: This was true before the deregulation of the industry in the 1980's. Section: Risk.

6. Return relative is the total return (in decimal form) plus 1. Ans: True Response: Section: Measuring Returns.

7. The Cumulative Wealth Index is the ratio of the starting amount and the ending amount. Ans: True Response: Section: Measuring Returns.

8. Inflation in the economy can affect all investments. Ans: True Response: Section: Summary Statistics for Returns.

9. The standard deviation and the variance measure the same thing. Ans: True Response: The variance is the square of the standard deviation. Section: Measuring Risk.

10. The equity risk premium has remained remarkably constant over long periods of time. Ans: False Response: Some researchers expect the risk premium to decrease in the next few years, perhaps to zero. Section: Measuring Risk.