Corporate Finance - Assignment and Answer Key Part 7

Arrange the following investments from the lowest historical risk premium to the highest historical risk premium. 1. Treasury 2. Long bond 3. Canadian common 4. Small stock Which of the following are the most commonly used measures of volatility? (Select all that apply.) - Variance - Standard deviation While computing risk premium, risk-free return _____ - Benchmark The average squared deviation between the actual return and the average return is called the _____. - Variance The standard deviation for the Canadian common stock portfolio is about four times as large as the standard deviation for the ______ portfolio. - Treasury A distribution curve tends to have a smooth shape when _____. - the number of observations is very large With a normal distribution, the probability of a return being more than two standard deviations below the mean is approximately _____ percent. - 2.5 - The probability of the return falling between + and - two standard deviations is 95%. This means that 5% or returns are in the tails of the distribution, with half of those (2.5% of the population) in the positive. tail and half in the negative tail. In Canada, bonds produced a return of ______ in 2008. - 2.7 _____ were a bright spot for Canadian investors in 2008 and 2009. - Bonds Geometric averages are usually _____ arithmetic averages. - Less than Large volatility in returns gives rise to a(n) _____ difference in the arithmetic and geometric averages. - Large In which of the following cases would the arithmetic average and the geometric average be equal? - Returns identical Which of these statements are true of the arithmetic average return and the geometric average return? (Select all that apply.) - The arithmetic average return is usually greater than the geometric average return. - The difference between the two measures is high for highly volatile investments. If the geometric average return is 7% and the variance of returns is 0.04, find the approximate arithmetic average return. - 0.07 + 0.04/2 = 9% If stock GHI generated returns of 10% and 20% for 2 years, the geometric average rate of return is ______. (Round your answer to four decimals.) [(1 + 0.10)(1 + 0.20)]1/2 − 1 = 0.1489 = 14.89% The arithmetic average is probably too ______ for longer periods and the geometric average is probably too ______ for shorter periods. - High;low Assuming all the numbers are expressed in decimals, the geometric average rate of return is approximately equal to _____. - the arithmetic average minus half the variance If the arithmetic average return is 8% and the variance of returns is 0.06, find the approximate geometric average return. - 0.08 – 0.06/2 = 5% One year ago, Rick purchased shares of ZeeRow's common stock for $100 a share. Today, ZeeRow pays a dividend of $1 per share. If ZeeRow's common stock currently sells for $114 per share, what will be Rick's total return? - 15% Which of the following is commonly used to measure inflation? - The Consumer Price Index The _____ rate of return on risky investments is the difference between risky returns and risk-free returns. - excess Risk premium is defined as the _____. - excess return required from an investment in a risky asset over a risk-free investment TLCS As the number of observations ______, the shape of the normal distribution curve tends to become ______ . - increases; smoother The usefulness of the normal distribution stems from the fact that it is completely described by _____. - its mean and standard deviation With a normal distribution, the probability of returns being within +1 and –1 standard deviation of the mean returns is approximately _____. - 68 If stock ABC has a mean return of 10% with a standard deviation of 5%, then the probability of getting a return less than 0% is approximately _____. (Assume the returns are normally distributed.) - 2.5% A distribution curve tends to have a smooth shape when _____. - the number of observations is very large Which of the following are necessary to completely describe the normal distribution? (Select all that apply.) - average return - standard deviation With a normal distribution, the probability of an outcome being within two standard deviations of the mean is approximately ____%. - 95 _____ is a statistical measure of maximum loss used by banks and other financial institutions to manage risk exposures. - Value at risk The return earned in an average year over a multi-year period is called the - Arithmetic, average If stock ABC has a mean return of 10% with a standard deviation of 15%, then the probability that the return in a given year is in the range –5% to 25% is about _____. (Assume the returns are normally distributed.) - 68% The second lesson from studying capital market history is that the greater the _____, the greater the risk. - P, reward How much did the S&P/TSX lose from August 2008 through March 2009? - 50 _____ were a bright spot for Canadian investors in 2008 and 2009. - bonds The second lesson from studying capital market history is that the greater the potential reward, _____. - the greater the risk In Canada, bonds produced a return of ______ in 2008. - 2.7 Geometric Average return is defined as - the average compound return earned per year over a multi-year period Calculate the geometric average return using the following data for the yearly returns: 2014, 10%; 2015, 12.5%; 2016, 14.6%; 2017, 17%; and 2018, 18.9%. (Round your answer to four decimals.) - 14.56 Match the following terms relating to the geometric average return formula [(1 + R1) × (1 + R2) × ... × (1 + RT) ]1/T − 1 - R1Choice, Return in year oneReturn in year one - R2 - matches - Choice, Return in year twoReturn in year two - RT - matches - Choice, Return in year TReturn in year T - T - matches - Choice, Number of annual returnsNumber of annual returns Large volatility in returns gives rise to a(n) _____ difference in the arithmetic and geometric averages. - large The second lesson from studying capital market history is that the greater the potential reward, _____. - Gre, the risk True or false: The arithmetic average return is probably too high for longer periods, so long-run projected wealth levels calculated using arithmetic averages are regarded as optimistic. - true Assignment #11 True or false: The expected return on a security or other asset is equal to the sum of the possible returns multiplied by their probabilities. - True If investors are risk averse, it is reasonable to assume that the risk premium for the stock market will be _____. - positive If the expected return on a stock is 17%, and the risk-free rate is 5%, calculate the risk premium. - 12% Susan plans to invest in Stock A. If there is an increase in GDP, the return on the stock will be 22%; if there is a decrease in GDP, the stock will yield 10%. Assuming that the probabilities are the same, calculate Stock A's expected return. - 16 The principle of diversification has an important implication. When an investor diversifies his investments, only the _____ matters. - Sys. risk The return expected in the future on a risky asset is called the - expected return What is the expected risk premium? - It is the additional compensation for taking risk over and above the risk-free rate. Identify the correct mathematical expression for the risk premium on a security. - Risk premium = Expected return − Risk-free rate Which of the following is the correct formula for expected return? - E(R) = ∑jRj × Pj Which of the following is the correct formula for variance? - σ2 = ∑j [Rj ‒ E(R)]2 × Pj According to the principle of diversification, a highly diversified portfolio tends to have almost no _____. - unsystematic risk The computation of a return's variance involves four steps. Place these steps in a logical sequence from the first step to the last step. - CCSM Identify the true statements about a return's variance. (Select all that apply.) - It measures the riskiness of a security's returns. - It measures the spread of the sample returns on a security The principle of diversification has an important implication. When an investor diversifies his investments, only the _____ matters. - systematic risk The standard deviation of a return is _____. - the square root of the return's variance Portfolio A has an expected return of 10% and a standard deviation of 12%. Portfolio B has an expected return of 10% and a standard deviation of 13%. Which portfolio would a rational investor choose? - Portfolio A What is the expected risk premium? - It is the additional compensation for taking risk over and above the risk-free rate. To calculate the variance of a stock return, we first ______. - calculate the expected return Which of the following is true of the measurement of a return's variance? - It is measured by the squared deviations of a security's return from its expected return. Which of the following statements are true about a return's variance? (Select all that apply.) - Variance is measured by the squared deviations of a security's actual return from its expected return. - The standard deviation of a return is the square root of the return's variance. Portfolio A has an expected return of 17% and a standard deviation of 5%. Portfolio B has an expected return of 15% and a standard deviation of 5%. Which portfolio would a rational investor choose? - Portfolio A If you wish to create a portfolio of stocks, you would need to invest _____. - in the stocks of at least two corporations John's portfolio consists of Chi Corporation common stock worth $1,200 and Lambda Corporation common stock worth $400. Chi's portfolio weight is _____. - 75.00% Which of the following are examples of portfolios? (Select all that apply.) - An investment of $100,000 in the stocks of 50 publicly traded corporations - An investment of $100,000 in a combination of Canadian and Asian stocks - An investment of $100,000 in a combination of stocks and bonds A portfolio consists of the following: $50,000 in a Standard & Poor's 500 index fund, $30,000 in a bond fund, and $20,000 in a foreign stock fund. The expected return on the index fund is 7%, the expected return on the bond fund is –3%, and the expected return on the foreign stock fund is 18%. What is the expected return on the portfolio? - 6.2% What will happen to the expected returns on the existing securities in your portfolio if you add new securities to your portfolio? - The expected returns on the existing securities will not change. What is the standard deviation of a portfolio whose variance is 0.0025? - 5% If you wish to create a portfolio of stocks, you would need to invest _____. - in the stocks of at least two corporations A portfolio consists of two stocks, A and B. A has an expected return of 10%, and B has an expected return of 15%. What is the expected return on the portfolio? (Assume that there is an equal amount of investment in both the stocks.) - 12.5 Which of the following is the correct formula for the expected return on a portfolio? - E(Rp) = x1 × E(R1) + x2 × E(R2) + ...+ xn× E(Rn) If the correlation between two assets is zero, then we say that the assets are correlated. - False If the variance of a portfolio increases, then the portfolio's standard deviation will _____. - increase A portfolio consisting of individually risky assets that attain the lowest possible risk level for the expected rate of return when pooled together is called the - Minimum, variance, portfolio. Which of the following might affect the risky return of a stock? (Select all that apply.) - The Bank of Canada's decision on interest rates at their meeting next week - Government figures released on gross national product Which of the following is the formula for the variance of a portfolio consisting of two stocks U and L when the correlation between the stocks is given? (xL and xU are the portfolio weights for stocks U and L, respectively. CORRL,U is the correlation of the two stocks.) - σ2P = x2Lσ2L + x2Uσ2U + 2xL xUCORRL,UσLσU When a dollar in the future is discounted to the present, it is worth less because of the time value of money; however, when a news item is discounted, it has less of an impact on the market because the market _____. - already knew about most of the news item No risk-averse investor would hold any portfolio with expected return ______ . - below the minimum variance portfolio What is the uncertain or risky return on a security? - It is the portion of the return on a security that depends on unknown information. Identify the correct mathematical expression for the total return on a company's stock. - Total return = Expected return + Unexpected return When we discount an announcement or a news item, we mean it has ______ impact on the market. - less of an What is an unsystematic risk? - single A firm is subject to both systematic and unsystematic risks. Identify the examples of systematic risks. (Select all that apply.) - An increase in the federal funds rate - An increase in the corporate tax rate Which of the following are examples of unsystematic risks? (Select all that apply.) - Changes in management - Labour strikes Because systematic risks are market-wide effects, they are sometimes called _____. - market risks The total risk associated with an asset has two parts: ______ risk and ______ risk. - S, u When we discount an announcement or a news item, we mean it has ______ impact on the market. - less Unsystematic risks are also known as _____ risks. - asset-specific Which of the following are examples of systematic risks? (Select all that apply.) - Regulatory changes in tax rates - Future rates of inflation In the total return equation R = E(R) + m + ε, epsilon (ε) represents - Unsystematic risk Which of the following are examples of unsystematic risks faced by a firm? (Select all that apply.) - The death of the CEO - A hostile takeover attempt by a competitor What are the components of unexpected return (U) in the total return equation? (Select all that apply.) - The unsystematic portion - The systematic portion There is correlation between the unsystematic risks of two companies from different industries - zero What is an unsystematic risk? - It is a risk that affects a single asset or a small group of assets. Which of the following does epsilon (ε) represent in the total return equation R = E(R) + m + ε? - Unsystematic risk Which of the following are examples of unsystematic risks? (Select all that apply.) - Labour strikes - Changes in management How are the unsystematic risks of two different companies in two different industries related? - There is no relationship. The standard deviation of a portfolio ______ as the number of securities in the portfolio ______. - decreases; increases The benefit of diversification ______ as more and more securities are added to a portfolio. - declines Identify the effects of adding more securities to a portfolio on the portfolio's risks. (Select all that apply.) - Diversification reduces risk, but only up to a point. - The portfolio's diversifiable risk can be eliminated by diversification. Which of the following risks are reduced as more securities are added to the underlying portfolio? (Select all that apply.) - Asset-specific risk - Unique risk - Unsystematic risk Historical return data indicate that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio _____. - decreases Which type of risk does not change when securities are added to a portfolio? - Systematic risk Most of the benefit in risk reduction is realized when the number of securities reaches ______. - 10 _____ of ______ spreading an investment across a number of assets eliminates some, but not all, of the risk. - Principle, diversification Which of the following types of risk is NOT reduced by portfolio diversification? - Systematic or market risk The standard deviation of a portfolio ______ as the number of securities in the portfolio ______. - decreases; increases Systematic risk will _____. - not change when securities are added to a portfolio For a well-diversified portfolio, all of the risk is _____. - systematic risk Which type of risk does not change when securities are added to a portfolio? - Systematic risk A(n) ______ investor would prefer to avoid gambles with zero expected return. - risk-averse The reward for bearing risk depends only on the ______ risk of an investment. - systematic Identify the true statement about the systematic risk principle. - The market does not reward risks that are borne unnecessarily. Which type of risk is unaffected by the addition of securities to a portfolio? - Systematic risk Which of the following is true of a risk-averse investor? - A risk-averse investor avoids investments that have zero expected return. The expected return on a risky asset depends only on that asset's - systematic principle states that the reward for bearing risk depends only on the systematic risk of an investment. - Systematic, risk Identify the true statements about a beta coefficient. (Select all that apply.) - By definition, an average asset has a beta of 1.0 relative to itself. - It tells us how much systematic risk a particular asset has relative to an average asset representing the market portfolio. Which type of risk does not change when securities are added to a portfolio? - sys The calculation of a portfolio's beta is similar to the calculation of _____. - a portfolio's expected return A(n) ______ investor would prefer to avoid gambles with zero expected return. - risk-averse is the measure of the amount of systematic risk present in a particular risky asset relative to an average risky asset. - Beta, coefficient You own a stock portfolio invested in 40 percent in stock A and 60 percent in Stock B. The betas for these two stocks are 0.5 and 1.0, respectively. What is the portfolio beta? - 0.8 The returns of Asset B and risk-free asset are 10% and 5% respectively. If they are held in proportions of 0.60 (Asset A) and 0.40 (risk-free asset) in a portfolio, then the portfolio return is ______. - 8 The value of beta for a risk-free asset is ______. - 0 To invest more than 100% in an asset, an investor has to borrow additional funding at the ______ rate - risk-free The returns of Asset A and risk-free asset are 20% and 10% respectively. If they are held in proportions of 80% (Asset A) and 20% (risk-free asset) in a portfolio, then the portfolio return is ______. - 18 The beta of Asset A is 2. If Asset A and a risk-free asset are held in proportions of 0.60 (Asset A) and 0.40 (risk-free asset) in a portfolio, then the beta on this portfolio is ______. - 1.2 Why can a positive relationship between the expected return on a security and its beta be justified? - It is because the difference between the return on the market and the risk-free rate is likely to be positive. Since all assets in the market must have the ______ reward-to-risk ratio, they all must plot on the ______ line in market equilibrium. - same; same True or false: It is possible to invest more than 100% in an asset. - true The beta of a security measures _____. - the responsiveness of the security's return to the return on the market as a whole If the reward-to-risk ratio of Asset A is 6%, this means Asset A has a risk premium of 6% per unit of ______. - systematic risk _____provides a measure on the extent to which the returns on two assets in a portfolio move together. - correlation If an asset has twice as much systematic risk as another asset, its ______ is also twice as large. - risk premium What is the intercept of the security market line (SML)? - The risk-free rate The returns of Asset A and risk-free asset are 20% and 10% respectively. If they are held in proportions of 80% (Asset A) and 20% (risk-free asset) in a portfolio, then the portfolio return is ______. - 18% To calculate the beta of a security, a line is drawn relating the expected return on the security to different returns on the market. This line is called the - Characteristic line (E(RA) denotes the expected return on Asset A, Rf denotes the risk-free rate, and βA denotes the amount of systematic risk present in Asset A.) - [E(RA) – Rf] / βA The security market line (SML) shows that the relationship between a security's expected return and its beta is _____. - positive A portfolio made up of all the assets in the market is known as a(n) ______ portfolio. - market A positively sloped straight line displaying the relationship between systematic risk and expected return in financial markets is called the _____. - security market line The expected return on the market portfolio can be expressed as ______. - E(RM) According to the capital asset pricing model, what is the expected return on a security with a beta of zero? - The risk-free rate of return Which of the following statements are true of the security market line (SML)? (Select all that apply.) - It is a positively sloped straight line. - It describes the relationship between systematic risk and expected return in financial markets. - It is a line resulting from the plotting of expected returns and beta coefficients What can we say about the security market line (SML) if the expected return on the market is higher than the risk-free rate? - It will slope upward. The difference between the expected return on a market portfolio and the risk-free rate is the _____. - market-risk premium What is the expected return on a security with a beta of 1? - The expected return on the market What does the security market line depict? - It is a graphical depiction of the capital asset pricing model. Match the following components of the capital asset pricing model (CAPM). - The pure time value of money - matches - Choice, The risk-free rate, RfThe risk-free rate, Rf - The reward for bearing systematic risk - matches - Choice, Market risk premium, [E(RM) – Rf]Market risk premium, [E(RM) – Rf] - The amount of systematic risk - matches - Choice, Beta coefficient, βiBeta coefficient, βi What is the expected return on a security if the risk-free rate is 5%, the expected return on the market is 9%, and the security's beta is 1.5? - 11 If security ABC has a beta of 2.5 and security XYZ has a beta of 1.5, what will be the expected return on a portfolio that is invested equally in both securities? (Assume the risk-free rate is 4% and the market-risk premium is 9%.) - 22 Which of the following statements are true of the arbitrage pricing theory? (Select all that apply.) - It shows that the expected return on any risky asset is a linear combination of various factors. - It can handle multiple factors that the capital asset pricing model (CAPM) ignores As per the capital asset pricing model (CAPM), on which of the following does the expected return for a particular asset depend? (Select all that apply.) - The amount of systematic risk - The reward for bearing systematic risk - The pure time value of money If a security's expected return is equal to the risk-free rate of return and the market risk premium is greater than zero, what can you conclude about the value of the security's beta based on the capital asset pricing model (CAPM)? - It is equal to 0. What does the security market line depict? - It is a graphical depiction of the capital asset pricing model. An equilibrium asset pricing theory that is derived from a factor model by using diversification and arbitrage. - Arbitrage, pricing, theory What is the expected return on a security with a beta of 1.2, if the risk-free rate is 4.5% and the expected return on the market is 12.5%? - 14.1 True or false: Since the capital asset pricing model (CAPM) equation can be used only for individual securities, it cannot be used with portfolios. - false