You are on page 1of 11

Financial Management: Principles and Applications, 11e (Titman)

Chapter 7 An Introduction to Risk and Return-History of Financial Market Returns


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 holding period return?
A) 35.00%
B) 12.50%
C) 17.50%
D) 25.00%
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
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
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
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%
Answer: B
Diff: 2
Topic: 7.1 Realized and Expected Rates of Return and Risk
Keywords: holding period return
1
Copyright 2011 Pearson Education, Inc.

Principles: Principle 2: There Is a Risk-Return Tradeoff


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%
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
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) 0%
B) 2%
C) 6%
D) 10%
Answer: B
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
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%
Answer: A
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

2
Copyright 2011 Pearson Education, Inc.

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

3
Copyright 2011 Pearson Education, Inc.

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

4
Copyright 2011 Pearson Education, Inc.

7.2 A Brief History of Financial Market Returns


1) The risk-return tradeoff tells us that expected returns should be higher on investments that
have higher risk.
Answer: TRUE
Diff: 1
Topic: 7.2 A Brief History of Financial Market Returns
Keywords: risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
2) Riskier investments have traditionally had lower returns than less risky investments have had.
Answer: FALSE
Diff: 1
Topic: 7.2 A Brief History of Financial Market Returns
Keywords: risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
3) Less risky investments have lower standard deviations than do more risky investments.
Answer: TRUE
Diff: 1
Topic: 7.2 A Brief History of Financial Market Returns
Keywords: risk, return
Principles: Principle 2: There Is a Risk-Return Tradeoff
4) Investments in emerging markets have higher volatility than do U.S. Stocks.
Answer: TRUE
Diff: 1
Topic: 7.2 A Brief History of Financial Market Returns
Keywords: standard deviation
Principles: Principle 2: There Is a Risk-Return Tradeoff
5) Expected return and realized return are the same thing.
Answer: FALSE
Diff: 1
Topic: 7.2 A Brief History of Financial Market Returns
Keywords: holding period return
Principles: Principle 2: There Is a Risk-Return Tradeoff
6) Historically, in the United States stocks have had higher returns and greater volatility than
have government bonds.
Answer: TRUE
Diff: 1
Topic: 7.2 A Brief History of Financial Market Returns
Keywords: risk, return
Principles: Principle 2: There Is a Risk-Return Tradeoff

5
Copyright 2011 Pearson Education, Inc.

7) Treasury Bills have less default risk than do Government Bonds.


Answer: TRUE
Diff: 1
Topic: 7.2 A Brief History of Financial Market Returns
Keywords: risk, return
Principles: Principle 2: There Is a Risk-Return Tradeoff
8) Investors are always rewarded for taking higher risk with higher realized returns.
Answer: FALSE
Diff: 1
Topic: 7.2 A Brief History of Financial Market Returns
Keywords: risk, return
Principles: Principle 2: There Is a Risk-Return Tradeoff
9) Investors make different investment choices partially because individuals do not all have the
same tolerance for risk.
Answer: TRUE
Diff: 1
Topic: 7.2 A Brief History of Financial Market Returns
Keywords: investor tolerance
Principles: Principle 2: There Is a Risk-Return Tradeoff
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) There is insufficient information to derive an answer.
B) 2.98%
C) 3.73%
D) 3.95%
Answer: C
Diff: 1
Topic: 7.3 Geometric vs. Arithmetic Average Rates of Return
Keywords: holding period return
Principles: Principle 1: Money Has a Time Value
2) Marcus Berger invested $9842.33 in Hawkeyehats, Inc. four years ago. He sold the stock
today for $11,396.22. What is his arithmetic average return?
A) There is insufficient information to derive an answer.
B) 2.98%
C) 3.73%
D) 3.95%
Answer: A
Diff: 1
Topic: 7.3 Geometric vs. Arithmetic Average Rates of Return
Keywords: arithmetic average return
Principles: Principle 1: Money Has a Time Value
6
Copyright 2011 Pearson Education, Inc.

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%
Answer: B
Diff: 2
Topic: 7.3 Geometric vs. Arithmetic Average Rates of Return
Keywords: arithmetic average return
Principles: Principle 1: Money Has a Time Value
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%
Answer: A
Diff: 2
Topic: 7.3 Geometric vs. Arithmetic Average Rates of Return
Keywords: compound interest
Principles: Principle 1: Money Has a Time Value
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
Answer: D
Diff: 2
Topic: 7.3 Geometric vs. Arithmetic Average Rates of Return
Keywords: compound interest
Principles: Principle 1: Money Has a Time Value

7
Copyright 2011 Pearson Education, Inc.

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%
Answer: A
Diff: 2
Topic: 7.3 Geometric vs. Arithmetic Average Rates of Return
Keywords: arithmetic average return
Principles: Principle 1: Money Has a Time Value
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%
Answer: B
Diff: 2
Topic: 7.3 Geometric vs. Arithmetic Average Rates of Return
Keywords: geometric average return
Principles: Principle 1: Money Has a Time Value
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
Answer: C
Diff: 2
Topic: 7.3 Geometric vs. Arithmetic Average Rates of Return
Keywords: holding period return
Principles: Principle 1: Money Has a Time Value
9) Arithmetic average rate of return takes compounding into effect.
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

8
Copyright 2011 Pearson Education, Inc.

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

9
Copyright 2011 Pearson Education, Inc.

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) Disney corporation, a growth company, opens a new theme park, which investors expect will
do tremendously well, and the stock price stays stable, while Urban Electric Company, which has
a set infrastructure, and generates 95% of its earnings from assets it owns, outperforms Disney.
Answer: A
Diff: 1
Topic: 7.4 What Determines Stock Prices?
Keywords: efficient markets
Principles: Principle 4: Market Prices Reflect Information
2) Stock prices go up when there is positive information about a company, and go down when
there is negative information about the company.
Answer: TRUE
Diff: 1
Topic: 7.4 What Determines Stock Prices?
Keywords: efficient markets
Principles: Principle 4: Market Prices Reflect Information
3) An investor with access to all publicly available information will be able to make higher than
expected profit if the market has semi-strong efficiency.
Answer: FALSE
Diff: 1
Topic: 7.4 What Determines Stock Prices?
Keywords: efficient markets
Principles: Principle 4: Market Prices Reflect Information
4) If a market has weak form efficiency, an investor can make higher than expected profits by
studying the past price patterns of a stock.
Answer: FALSE
Diff: 1
Topic: 7.4 What Determines Stock Prices?
Keywords: efficient markets
Principles: Principle 4: Market Prices Reflect Information

10
Copyright 2011 Pearson Education, Inc.

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

11
Copyright 2011 Pearson Education, Inc.