Chapter 11 Risk and Return in Capital Markets

11.1 A First Look at Risk and Return

1) On average, stocks have delivered higher returns than bonds in the long run.

Answer: TRUE
2) In the United States over the long term, small stocks have provided the highest return followed by the large stocks in the
S&P 500.

Answer: TRUE
3) Rational (co li tri) investors ________ fluctuations in the value of their investments.
A) are averse to (chong lai)
B) prefer
C) are indifferent to
D) none of the above

Answer: A
4) Stocks with high returns are expected to have
A) high variability.
B) low variability.
C) no relation to variability.
D) inverse relationship with variability

Answer: A
5) Historically, stocks have delivered a ________ return on average compared to Treasury bills but have experienced
________ fluctuations in values.
A) higher, higher
B) higher, lower
C) lower, higher
D) lower, lower

Answer: A
6) Investors demand a higher return for investments that have larger fluctuations in values because
A) they do not like risk.
B) they are risk seeking.
C) they invest for the long term.
D) none of the above

Answer: A
7) Which of the following investments offered the lowest overall return over the past eighty years?
A) small stocks
B) Treasury bills
C) S&P 500
D) corporate bonds

Answer: B
8) Which of the following investments offered the highest overall return over the past eighty years?
A) Treasury bills
B) S&P 500
C) small stocks
D) corporate bonds

Answer: C
9) Which of the following investments had the largest fluctuations overall return over the past eighty years?
A) small stocks
B) S&P 500
C) corporate bonds
D) Treasury bills
Answer: A

11.2 Historical Risks and Returns of Stocks

1) Suppose you invested $60 in the Ishares Dividend Stock Fund (DVY) a month ago. It paid a dividend of $0.70 today and
then you sold it for $65. What was your return on the investment?
A) 8.25%
B) 9.00%
C) 9.50%
D) 9.75%
Answer: C
Explanation: C) $(65 + 0.7) - 60 = 5.7; 5.7 / 60 = 9.5%

2) Suppose you invested $56 in the Ishares Dividend Stock Fund (DVY) a month ago. It paid a dividend of $0.37 today and
then you sold it for $61. What was your return on the investment?
A) 9.01%
B) 9.98%
C) 9.59%
D) 8.80%
Answer: C
Explanation: C) 61+ 0.37 - 56 = 5.37; 5.37 / 56 = 9.59%

3) Suppose you invested $75 in the Ishares Dividend Stock Fund (DVY) a month ago. It paid a dividend of $0.50 today and
then you sold it for $70. What was your return on the investment?
A) -8.00%
B) -6.00%
C) -7.00%
D) -6.99%
Answer: B Explanation: B) 70 + 0.50 = 70.5; 70.5 - 75 = -4.5; -4.5 / 75 = -6.00%

4) Greg purchased stock in Bear Stearns and Co. at a price of $89 per share one year ago. The company was acquired by JP
Morgan at a price of $10 per share. What is Greg's return on his investment?
A) -88.76%
B) -96.25%
C) -79.00%
D) -85.45%
Answer: A Explanation: A) 10 - 89 = - 79; -79 / 89 = -88.76%

5) You own shares in Yahoo that were purchased at a price of $21 per share. Microsoft has offered to purchase Yahoo and
buy your shares at a price of $31 per share. What will be your return if you tender your shares to Microsoft and the deal is
completed?
A) 47.62%
B) 33.45%
C) 49.65%
D) 43.34%
Answer: A Explanation: A) 31 - 21 = 10; 10 / 21 = 47.62%

6) Suppose you invested $98 in the Ishares High Yield Fund (HYG) a month ago. It paid a dividend of $0.47 today and
then you sold it for $99. What was your dividend yield and capital gains yield on the investment?
A) 0.45%, 1.09%
B) 0.47%, 1.02%
C) 0.47%, 1.08%
D) 1.02%, 1.12%
Answer: B Explanation: B) Div yld = 0.47 / 99 = 0.47%; cap gain = 99 - 98 = 1; 1 / 98 = 1.02%

7) Suppose you invested $100 in the Ishares High Yield Fund (HYG) a month ago. It paid a dividend of $1 today and then
you sold it for $100. What was your dividend yield and capital gains yield on the investment?
A) 2%, 1%
B) 0%, 1%
C) 3%, 1%
D) 1%, 0%
Answer: D Explanation: D) 1 / 100 = 1%; cap gains yield = 100 - 100 = 0

8) Suppose you invested $100 in the Ishares High Yield Fund (HYG) a month ago. It paid a dividend of $2 today and then
you sold it for $99. What was your dividend yield and capital gains yield on the investment?
A) 2%, -1%
B) 2%, 1%
C) -2%, 1%
D) 1%, 2%
Answer: A Explanation: A) 2/100 = 2%; -1 / 100 = -1%

9) Your investment over one year yielded a capital gains yield of 5% and no dividend yield. If the sale price was $119 per
share, what was the cost of the investment?
A) $126.25
B) $111.67
C) $113.33
D) $117.25
Answer: C Explanation: C) 119 / 1.05 = 113.33

10) Amazon.com stock prices gave a realized return of 5%, -5%, 10%, and -10% over four successive quarters. What is the
annual realized return for Amazon.com for the year?
A) -1.25%
B) 2.50%
C) 0.00%
D) 1.25%
Answer: A Explanation: A) 1.05 × 0.95 × 1.10 × 0.9 = 0.9875; 0.9875 - 1 = -1.25%

11) Amazon.com stock prices gave a realized return of 20%, 10%, -10%, and -10% over four successive quarters. What is
the annual realized return for Amazon.com for the year?
A) 6.92%
B) 11.31%
C) 7.91%
D) 10.00%
Answer: A Explanation: A) 1.2 × 1.1 × 0.9 × 0.9 = 1.0692; 1.0692 - 1 = 6.92%

12) Amazon.com stock prices gave a realized return of 20%, 10%, 10%,and 15% over four successive quarters. What is the
annual realized return for Amazon.com for the year?
A) 60.00%
B) 66.98%
C) 55.00%
D) 71.25%
Answer: B Explanation: B) 1.2 × 1.1 × 1.1 × 1.15 = 1.6698; 1.6698 - 1 = 66.98%
13) IGM Realty had a price of $30, $30, $35, $33, and $25 at the end of the last five quarters. If IGM pays a dividend of $2
at the end of each quarter, what is the annual realized return on IGM?
A) 8.61%
B) 7.6% Date Price Dividend Return Cum. Return
C) 7.10% 1 $30 $2
D) 8.09% 2 $30 $2 6.667%
Answer: B 3 $35 $2 23.333% 1.3154%
4 $33 $2 0% 1.3154%
5 $25 $2 -18.1819% 1.076%
Ann. Ret = 7.6%
14) You purchased Enron stock at a price of $30 per share. Its price was $20 after six months and the company declared
bankruptcy at the end of the next six months. The realized return over the last year is:
A) -99%
B) -75%
C) -150%
D) -100%
Answer: D Explanation: D) 0 - 30 / 30 = -100%

15) The S&P 500 index delivered a return of 20%, -10%, 25%, and 5% over four successive years. What is the arithmetic
average annual return per year?
A) 12%
B) 15%
C) 10%
D) 11%
Answer: C Explanation: C) (20 - 10 + 25 +5) / 4 = 10%

16) The S&P 500 index delivered a return of 15%, 20%, 20%, -25% over four successive years. What is the arithmetic
average annual return per year?
A) 8.5%
B) 9.5%
C) 6.5%
D) 7.5%
Answer: D Explanation: D) (15 + 20 + 20 - 25) / 4 = 7.5%

17) The S&P 500 index delivered a return of 20%, 10%, -25%, and -5% over four successive years. What is the arithmetic
average annual return per year?
A) -5%
B) 0%
C) 5%
D) 3%
Answer: B Explanation: B) (20 + 10 - 25 - 5) / 4 = 0%

18) You purchase a 30-year, zero-coupon bond for a price of $20. The bond will pay back $100 after 30 years and make no
interim payments. The annual compounded return (geometric average return) on this investment is:
A) 5.31%
B) 6.54%
C) 4.78%
D) 5.51%
Answer: D Explanation: D) Using a financial calculator: N = 30, PV = -20, FV = 100; CPT = I/Y; I/Y = 5.51%

19) Suppose that a stock gave a realized return of 20% over a two-year time period and a 10% return over the third year.
The geometric average annual return is:
A) 9.70%
B) 11.20%
C) 14.96%
D) 16.55%
Answer: D Explanation: D) 1.2 × 1.2 × 1.1 = 1.584; geometric average = (1.584)^(1/3)=1.1655; hence 16.55%

20) If returns on stock A are more volatile than the returns on stock B, the geometric average return of stock A is ________
the geometric average return of stock B when their arithmetic average return is the same.
A) the same as
B) higher than
C) lower than
D) cannot say for sure
Answer: C
21) Suppose the quarterly arithmetic average return for a stock is 5% per quarter and the stock gives a return of 10% each
over the next two quarters. The arithmetic average return over the six quarters is:
A) 9%
B) 6.67%
C) 7.5%
D) 10%
Answer: B Explanation: B) (5 + 5 + 5 + 5 + 10 + 10) / 6 = 6.67%

22) The geometric average annual return for a large capitalization stock portfolio is 12% for ten years and 5% per year for
the next five years. The geometric average annual return for the entire 15-year period is:
A) 9.95%
B) 9.62%
C) 9.11%
D) 10.23%
Answer: B Explanation: B) Compound return for first ten years = (1.12)^10 = 3.1058;
compound return for next 5 years = (1.05)^5 = 1.27628;
total return over 15 years = 3.1058 × 1.27628 = 3.9639;
geometric average annual return = (3.9639)^(1/15) = 1.0962; hence answer = 9.62%

23) Bear Stearns' stock price closed at $100, $105, $56, $30, $2 over five successive weeks. The weekly standard deviation
of the stock price calculated from this sample is:
A) $29.76
B) $50.25
C) $44.43
D) $35.23
Answer: C Explanation: C) Average return = (100 + 105 + 56 + 30 + 2) / 5 = 58.6;
standard deviation = ((100 - 58.6)^2 + (105 - 58.6)^2 + (56 - 58.6)^2 + (30 - 58.6)^2 + (2 - 58.6)^2)) / (5 - 1) = $44.43

24) Ford Motor Company had realized returns of 10%, 20%, 20%, and 10% over four quarters. What is the quarterly
standard deviation of returns for Ford calculated from this sample?
A) 5.77%
B) 5.11%
C) 5.99%
D) 5.00%
Answer: A Explanation: A) Average return = (10 + 20 + 20 +10) / 4 = 15;
standard deviation = ((10 - 15)^2 + (20 - 15)^2 + (20 - 15)^2 + (10 - 15)^2 ))/(4 - 1) = 5.77%

25) Ford Motor Company had realized returns of 5%, 15%, -10%, and -5% over four quarters. What is the quarterly
standard deviation of returns for Ford?
A) 9.91%
B) 10.71%
C) 10.31%
D) 11.09%
Answer: D Explanation: D) Average return = (5 + 15 - 10 - 5) / 4 = 1.25;
standard deviation = (( 5 - 1.25)^2 + (15 - 1.25)^2 + (-10 - 1.25)^2 + ( -5 - 1.25)^2 )) / (4 - 1) = 11.09%

26) Ford Motor Company had realized returns of 10%, 25%, -20%, and -15% over four quarters. What is the quarterly
standard deviation of returns for Ford?
A) 19.67%
B) 25.32%
C) 21.21%
D) 23.13%
Answer: C Explanation: C) Average return = ( 10 + 25 - 20 - 15) / 4 = 0;
standard deviation = ((10)^2 + (25)^2 + (20)^2 + ( 15)^2 )) / (4 - 1) = 21.21%
27) The standard deviation of returns of:
I. small capitalization stocks is higher than that of large capitalization stocks.
II. large capitalization stocks is lower than that of corporate bonds.
III. corporate bonds is higher than that of Treasury bills.
Which statement is true?
A) I and III
B) I, II, and III
C) I and II
D) I only
Answer: A
28) Treasury bill returns are 5%, 4%, 3%, and 6% over four years. The standard deviation of returns of Treasury bills is:
A) 1.51%
B) 1.11%
C) 1.00%
D) 1.29%
Answer: D Explanation: D) Average return = (5 + 4 + 3 + 6) / 4 = 4.5;
standard deviation = (( 5 - 4.5)^2 + (4 - 4.5)^2 + (3 - 4.5)^2 + ( 6 - 4.5)^2 )) / (4 - 1) = 1.29%

29) If asset A's return is exactly two times asset B's return, then following risk return tradeoff, the standard deviation of
asset A should be ________ times the standard deviation of asset B.
A) 3
B) 2
C) 1
D) 4
Answer: B
30) If the returns on a stock index can be characterized by a normal distribution with mean 12%, the probability that returns
will be lower than 12% over the next period equals:
A) 50%
B) 25%
C) 46%
D) 33%
Answer: A
31) The probability mass between two standard deviations around the mean for a normal distribution is:
A) 66%
B) 90%
C) 75%
D) 95%
Answer: D
32) The Ishares Bond Index fund (TLT) has a mean and annual standard deviation of returns of 7% and 10%, respectively.
What is the 66% confidence interval for the returns on TLT?
A) -5%,10%
B) 7%,10%
C) -3%, 17%
D) -10%,10%
Answer: C 66% confidence interval = mean - standard deviation, mean + standard deviation; 7 - 10 = -3%; 7 + 10 =17%

33) The average annual return over the period 1886-2006 for stocks that comprise the S&P 500 is 10%, and the standard
deviation of returns is 20%. Based on these numbers, what is a 95% confidence interval for 2007 returns?
A) -15%,25%
B) -20%,40%
C) -30%, 50%
D) -30%,40%
Answer: C Explanation: C) 10 - 2 × 20 = -30%; 10 + 2 × 20 = 50%

34) The average annual return over the period 1886-2006 for stocks that comprise the S&P 500 is 12%, and the standard
deviation of returns is 20%. Based on these numbers what is a 95% confidence interval for 2007 returns?
A) -28%, 52%
B) -10%,40%
C) -20%,35%
D) -15%, 35%
Answer: A Explanation: A) 12 - 2 × 20 = -28%; 12 + 2 × 20 = 52%

35) The average annual return over the period 1886-2006 for stocks that comprise the S&P 500 is 10.5%, and the standard
deviation of returns is 18.5%. Based on these numbers what is a 95% confidence interval for 2007 returns?
A) -18.5%, 18.5%
B) -10%, 10%
C) -26.5%, 47.5%
D) -37%, 37%
Answer: C Explanation: C) 10.5 - 2 × 18.5 = -26.5%; 10.5 + 2 × 18.5 = 47.5%

36) Which of the following statements is FALSE?

A) The geometric average return is a better description of the long-run historical performance of an investment.
B) The geometric average return will always be above the arithmetic average return, and the difference grows with the
volatility of the annual returns.
C) The compounded geometric average return is most often used for comparative purposes.
D) We should use the arithmetic average return when we are trying to estimate an investment's expected return over a
future horizon based on its past performance.
Answer: B) The geometric average return will always be below the arithmetic average return, and the difference grows
with the volatility of the annual returns.

37) If a stock pays dividends at the end of each quarter, with realized returns of R1, R2, R3, and R4 each quarter, then the
annual realized return is calculated as:
A) Rannual = (1 + R1)(1 + R2)(1 + R3)(1 + R4) - 1
B) Rannual = R1 + R2 + R3 + R4
C) Rannual = (1 + R1)(1 + R2)(1 + R3)(1 + R4)
R R R R
D) Rannual = 1 2 3 4
4
Answer: A

Use the table for the question(s) below.

Consider the following price and dividend data for Ford Motor Company:
Date Price ($) Dividend ($) 38) Assume that you purchased Ford Motor Company stock at the closing
December 31, 2004 $14.64 price on December 31, 2004 and sold it after the dividend had been paid at
January 26, 2005 $13.35 $0.10 the closing price on January 26, 2005. Your dividend yield for this period
April 28, 2005 $9.14 $0.10
July 29, 2005 $10.74 $0.10
is closest to:
October 28, 2005 $8.02 $0.10 A) -8.15%
December 30, 2005 $7.72 B) -8.80%
C) 0.70%
D) 0.75%
Answer: C Explanation: C) div / P0 = 0.10 / 14.64 = 0.0068

39) Assume that you purchased Ford Motor Company stock at the closing price on December 31, 2004 and sold it after the
dividend had been paid at the closing price on January 26, 2005. Your capital gains rate (yield) for this period is closest to:
A) 0.70%
B) 0.75%
C) -8.80%
D) -8.15%
Answer: C Explanation: C) (P1 - P0) / P0 = (13.35 - 14.64) / 14.64 = -0.088115

40) Assume that you purchased Ford Motor Company stock at the closing price on December 31, 2004 and sold it after the
dividend had been paid at the closing price on January 26, 2005. Your total return rate (yield) for this period is closest to:
A) 0.70%
B) -8.13%
C) -8.80%
D) 0.75%
Answer: B Explanation: B) (P1 + D1 - P0) / P0 = (13.35 + 0.10 - 14.64) / 14.64 = -0.08128

41) Assume that you purchased Ford Motor Company stock at the closing price on December 31, 2004 and sold it at the
closing price on December 30, 2005. Your realized annual return is for the year 2005 is closest to:
A) -44.5%
B) -45.1%
C) -47.3%
D) -48.5%
Answer: B
Explanation: B) Date Price ($) Dividend ($) Return (1 + return)
December 31, 2004 $14.64 1 1 The last column in the table contains the
January 26, 2005 $13.35 $0.10 -8.13% 0.918716 0.918716 cumulative product of (1 + returns)
April 28, 2005 $9.14 $0.10 -30.79% 0.692135 0.635875
July 29, 2005 $10.74 $0.10 18.60% 1.185996 0.754145
October 28, 2005 $8.02 $0.10 -24.39% 0.756052 0.570173
December 30, 2005 $7.72 -3.74% 0.962594 0.548845
The Product of
(1 + returns) - 1 = -0.45116
Use the table for the question(s) below.
Consider the following realized annual returns:
S&P 500 IBM 42) The average annual return on the S&P 500 from 1996 to 2005 is closest to:
Realized Realized A) 8.75%
Year-end Return Return
B) 4.00%
1996 23.6% 46.3%
1997 24.7% 26.7% C) 7.10%
1998 30.5% 86.9% D) 9.75%
1999 9.0% 23.1% Answer: A
2000 -2.0% 0.2% R  R  ...  R R  R  ...  R 0.878
Explanation: A) Rannual = 1 2 N = 1 2 10 = = 8.82%
2001 -17.3% -3.2% N 10 10
2002 -24.3% -27.0% 43) The average annual return on IBM from 1996 to 2005 is closest to:
2003 32.2% 27.9% A) 18.2%
2004 4.4% -5.1%
B) 16.40%
2005 7.4% -11.3%
C) 18.7%
D) 29.9%
Answer: B
R  R  ...  R R  R  ...  R 1.638
Explanation: B) Rannual = 1 2 N = 1 2 10 = = 16.45%
N 10 10
44) The average annual return over the period 1926-2009 for the S&P 500 is 11.7%, and the standard deviation of returns
is 20.5%. Based on these numbers, what is a 95% confidence interval for 2010 returns?
A) 1.5%,, 22.0%
B) -8.8%, 32.2%
C) -29.3%, 52.7%
D) -29.3%, 73.2%
Answer: C Explanation: C) 11.7% - (2 × 20.5%) = -29.3%; 11.7% +( 2 × 20.5%) = 52.7%

45) The average annual return over the period 1926-2009 for the S&P 500 is 11.7%, and the standard deviation of returns
is 20.5%. Based on these numbers, what is a 67% confidence interval for 2010 returns?
A) 1.5%,, 22.0%
B) -8.8%, 32.2%
C) -29.3%, 52.7%
D) -29.3%, 73.2%
Answer: B Explanation: B) 11.7% - (1 × 20.5%) = -8.8%; 11.7% +( 1 × 20.5%) = 32.2%
46) The average annual return over the period 1926-2009 for small stocks is 22.1%, and the standard deviation of returns is
22.1%. Based on these numbers, what is a 95% confidence interval for 2010 returns?
A) 11.1%,, 33.2%
B) 0%, 44.2%
C) -22.1%, 44.2%
D) -22.1%, 66.3%
Answer: D Explanation: D) 22.1% - (2 × 22.1%) = -22.1%; 22.1% +( 2 × 22.1%) =66.3%

47) McCoy paid a one-time special dividend of $3.20 on October 18, 2010. Suppose you bought McCoy stock for $47.00
on July 18, 2010, and sold it immediately after the dividend was paid for $63.32. What was your realized return from
holding McCoy?
A) 4.15%
B) 6.8%
C) 34.7%
D) 41.5%
Answer: D Explanation: D) ($3.20 + $63.32 - $47.00)/$47.00 = 41.5%

48) McCoy paid a one-time special dividend of $3.20 on October 18, 2010. Suppose you bought McCoy stock for $47.00
on July 18, 2010, and sold it immediately after the dividend was paid for $63.32. What was your capital gain yield from
holding McCoy?
A) 4.15%
B) 6.8%
C) 34.7%
D) 41.5%
Answer: C Explanation: C) ($63.32 - $47.00)/$47.00 = 34.7%

11.3 The Historical Tradeoff between Risk and Return

1) Rational investors may be willing to choose an investment that has additional risk but does not offer additional reward.

Answer: FALSE
2) Historical evidence on the returns of large portfolios of stock and bonds shows that investments with higher volatility
have rewarded investors with higher returns.

Answer: TRUE
3) There is a clear link between the volatility of returns for individual stocks and the returns for individual stocks.

Answer: FALSE
4) While ________ seems to be a reasonable measure of risk when evaluating a large portfolio, the ________ of an
individual security does not explain the size of its average return.
A) volatility, volatility
B) the mean return, standard deviation
C) mode, volatility
D) none of the above
Answer: A

5) There is an overall relationship between ________ and ________larger stocks have a lower volatility overall.
A) size, risk
B) mean, standard deviation
C) risk aversion, size
D) volatility, mean
Answer: A

6) The excess return is the difference between the average return on a security and the average return for
A) Treasury bonds.
B) a portfolio of securities with similar risk.
C) a broad-based market portfolio like the S&P 500 index.
D) Treasury bills.
Answer: D

7) Which of the following statements is FALSE?

A) Expected return should rise proportionately with volatility.
B) Investors would not choose to hold a portfolio that is more volatile unless they expected to earn a higher return.
C) Smaller stocks have lower volatility than larger stocks.
D) The largest stocks are typically more volatile than a portfolio of large stocks.

Answer: C Explanation: C) Smaller stocks have higher volatility than larger stocks.
8) Which of the following statements is FALSE?
A) Investments with higher volatility have rewarded investors with higher average returns.
B) Investments with higher volatility should have a higher risk premium and, therefore, higher returns.
C) Volatility seems to be a reasonable measure of risk when evaluating returns on large portfolios and the returns of
individual securities.
D) Riskier investments must offer investors higher average returns to compensate them for the extra risk they are taking on.
Answer: C
Use the table for the question(s) below.
Consider the following average annual returns:
Investment Average Return
Small Stocks 23.2%
S&P 500 13.2%
Corporate Bonds 7.5%
Treasury Bonds 6.2%
Treasury Bills 4.8%

9) What is the excess return for the portfolio of small stocks?

A) 10.0%
B) 15.7%
C) 18.4%
D) 17.0%
Answer: C
10) What is the excess return for the S&P 500?
A) 5.7%
B) 7.0%
C) 0%
D) 8.4%
Answer: D
11) What is the excess return for corporate bonds?
A) 2.7%
B) 1.3%
C) -5.7%
D) 0%
Answer: A
12) What is the excess return for Treasury bills?
A) 0%
B) -8.4%
C) -2.7%
D) -1.4%
Answer: A
13) Which of the following statements is FALSE?
A) On average, larger stocks have higher volatility than smaller stocks.
B) Portfolios of large stocks are typically less volatile than individual large stocks.
C) On average, smaller stocks have higher returns than larger stocks.
D) On average, Treasury Bills have lower returns than corporate bonds.
Answer: A
14) Which of the following statements is TRUE?
A) On average, smaller stocks have lower volatility than Treasury bills.
B) Portfolios of smaller stocks are typically less volatile than individual small stocks.
C) On average, smaller stocks have lower returns than larger stocks.
D) On average, Treasury bills have higher returns than world stocks.
Answer: B

11.4 Common Versus Independent Risk

1) The risk that inflation rates are likely to increase in the next year is an example of common risk.

Answer: TRUE
2) A portfolio of stocks where each stock has a large component of independent risk benefits when such stocks are held in
a portfolio, because the independent risks are averaged out. This is also referred to as diversification of risks.

Answer: TRUE
3) A portfolio of stocks can achieve diversification benefits if the stocks that comprise the portfolio are
A) not perfectly correlated.
B) perfectly correlated.
C) susceptible to common risks only.
D) both B and C
Answer: A

4) Two slot machines offer to double your money 3 times out of 5. Machine A takes $10 bets and Machine B takes $100
bets on each occasion. A risk-averse investor prefers to bet on:
A) machine A
B) machine B
C) does not matter
D) none of the above
Answer: A

5) Common risk is also called

A) diversifiable risk.
B) correlated risk.
C) uncorrelated risk.
D) independent risk.
Answer: B
Use the information for the question(s) below.
Big Cure and Little Cure are both pharmaceutical companies. Big Cure presently has a potential "blockbuster" drug before
the Food and Drug Administration (FDA) waiting for approval. If approved, Big Cure's blockbuster drug will produce $1
billion in net income for Big Cure. Little Cure has ten separate, less important drugs before the FDA waiting for approval.
If approved, each of Little Cure's drugs would produce $100 million in net income for Little Cure. The probability of the
FDA approving a drug is 50%.

6) What is the expected payoff for Big Cure's Blockbuster drug?

A) $100 million
B) $0
C) $1 billion
D) $500 million
Answer: D Explanation: D) expected payoff = prob of payoff × amount if successful = 0.5 × $1 billion = $500 million

7) What is the expected payoff for Little Cure's ten drugs?

A) $500 million
B) $100 million
C) $1 billion
D) $0
Answer: A = 0.5 × $100 = $50 million for each drug $50 million × 10 drugs = $500 million

11.5 Diversification in Stock Portfolios

1) Independent risks can be diversified by holding a large number of uncorrelated assets with independent risks.

Answer: TRUE
2) A stock whose return does not depend on overall economic conditions has a low systematic risk.

Answer: FALSE
3) Investors should earn a risk premium for bearing unsystematic risk.

Answer: FALSE
4) In general, it is possible to eliminate ________ risk by holding a large portfolio of assets.
A) unsystematic
B) systematic
C) unsystematic and systematic
D) none of the above
Answer: A

5) Apple computer's stock price jumped when it announced that its revenue had increased because of the successful launch
of iPad and the increased sales of Macbook computers. This is an example of
A) market risk.
B) unsystematic risk.
C) systematic risk.
D) both A and C
Answer: B

6) As we increase the number of stocks in a portfolio, the standard deviation of returns of the portfolio
A) increases.
B) remains unchanged.
C) decreases.
D) none of the above
Answer: C

7) Because investors can eliminate unsystematic risk "for free" by diversifying their portfolios, they ________ a risk
premium for bearing it.
A) do not require
B) require
C) are indifferent about
D) none of the above
Answer: A

8) The risk premium of a security is determined by its ________ risk and does not depend on its ________ risk.
A) systematic, undiversifiable
B) systematic, unsystematic
C) diversifiable, diversifiable
D) all of the above
Answer: B

9) When investing for a long horizon, investors care about the volatility of ________ returns and not the volatility of
________ returns.
A) average, cumulative
B) cumulative, average
C) mean, cumulative
D) mean, average
Answer: B
10) Many former employees at Enron, an energy trading and supply company, had a large part of their portfolio invested in
Enron stock. These employees were bearing a high degree of ________ risk.
A) unsystematic
B) systematic
C) market specific
D) non-diversifiable
Answer: A

11) Which of the following is NOT a diversifiable risk?

A) the risk that oil prices rise, increasing production costs
B) the risk that the CEO is killed in a plane crash
C) the risk of a key employee being hired away by a competitor
D) the risk of a product liability lawsuit
Answer: A

12) Which of the following is NOT a systematic risk?

A) the risk that oil prices rise, increasing production costs
B) the risk that the economy slows, reducing demand for your firm's products
C) the risk that your new product will not receive regulatory approval
D) the risk that the Federal Reserve raises interest rates
Answer: C

13) Which of the following types of risk does NOT belong?

A) idiosyncratic risk
B) market risk
C) unique risk
D) unsystematic risk
Answer: B

14) Which of the following types of risk does NOT belong?

A) Undiversifiable risk
B) Market risk
C) Systematic risk
D) Idiosyncratic risk
Answer: D

15) Which of the following statements is FALSE?

A) The risk premium of a security is determined by its systematic risk and does not depend on its diversifiable risk.
B) When we combine many stocks in a large portfolio, the firm-specific risks for each stock will average out and be
diversified.
C) Fluctuations of a stock's returns that are due to firm-specific news are common risks.
D) The volatility in a large portfolio will decline until only the systematic risk remains.

Answer: C Explanation: C) Fluctuations of a stock's returns that are due to firm-specific news are not common risks.

Use the information for the question(s) below.

Consider an economy with two types of firms, S and I. S firms always move together, but I firms move independently of
each other. For both types of firms there is a 70% probability that the firm will have a 20% return and a 30% probability
that the firm will have a -30% return.
16) What is the expected return for an individual firm?
A) 3%
B) 5%
C) 14%
D) -5%
Answer: B Explanation: B) expected return = 0.7(20%) + 0.3(-30%) = 5%
17) The standard deviation for the return on an individual firm is closest to:
A) 23.0%
B) 5.25%
C) 15.0%
D) 10.0%
Answer: A Explanation: A) expected return = 0.7(20%) + 0.3(-30%) = 5%
standard deviation = 0.7(0.20  0.05) 2  0.3(0.30  0.05) 2 = 0.2291

18) The standard deviation for the return on an portfolio of 20 type S firms is closest to:
A) 15.0%
B) 23.0%
C) 5.25%
D) 5.10%
Answer: B Explanation: B) expected return = 0.7(20%) + 0.3(-30%) = 5%
standard deviation = 0.7(0.20  0.05) 2  0.3(0.30  0.05) 2 = 0.2291
Since all these firms move the same, there is no adjustment to the standard deviation.

19) The standard deviation for the return on a portfolio of 20 type I firms is closest to:
A) 5.25%
B) 15.0%
C) 5.10%
D) 23.0%
Answer: C Explanation: C) expected return = 0.7(20%) + 0.3(-30%) = 5%
standard deviation = 0.7(0.20  0.05) 2  0.3(0.30  0.05) 2 = 0.2291
Since all these firms move independently, stdev = stdev(single firm) / number of obs = 0.2291 / 20 = 0.0512

20) If the Federal Reserve were to change from an expansionary to contractionary monetary policy, this would be an
example of:
A) unsystematic risk.
B) systematic risk.
C) independent risk.
D) diversification risk.
Answer: B

21) Independent risk is more closely related to:

A) unsystematic risk.
B) systematic risk.
C) common risk.
D) diversification risk.
Answer: A

22) The risk premium of a stock is is not affected by its:

A) undiversifiable risk.
B) typical risk.
C) systematick risk.
D) unsystematic risk.
Answer: D