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FINANCE Chapter 9 Reading Assignment

Terms in this set (27)

The dollar return on a stock investment includes which of these?
- Capital gains and losses only
- Dividends only
- Capital gains only
- Dividend income and capital gains or losses
Dividend income and capital gains or losses
How can the percentage return on a stock be defined?
Dollar return/Money Invested
The S&P 500 had the highest decade average return for which period?
1950s
How is standard deviation defined in relation to investments?
Measure of past return volatility, or risk
What type of relationship exists between risk and expected return?
- negative
- zero
- positive
- indeterminate
positive
Based on actual performance for the period 1950-2017, which one of the following displayed the least amount of risk and why? Select the best answer.
- T-bills as their returns were less volatile.
- S&P 500 as its average return for the period exceeded T-bonds and T-bills.
- T-bills as their decade average returns were all positive.
- Long-term Treasury bonds because their returns were higher than the Treasury bills.
T-bills as their returns were less volatile

Reasoning:
- The S&P 500 had the highest average return but was also the riskiest as seen in the volatility of those returns
- The same is true for both the S&P 500 and for long-term treasury bills. T-bills were the least risky as their returns were the least volatile
- Treasury bond returns are more volatile than T-bill returns. Thus, T-bonds are riskier than T-bills
How is the term "dollar return" defined?
- Amount of profit or loss from an investment expressed in dollars
- Amount of profit or loss from an investment expressed as a percentage of the investment's cost
- Amount of profit or loss from an investment expressed as a percentage of the ending price
- Amount of profit or loss expressed as an annual rate
Amount of profit or loss from an investment expressed in dollars.

Reasoning:
- The second option defines a percentage return. The dollar return is the amount of profit or loss expressed in DOLLARS
- percentage returns are rates
The percentage total return on a stock investment is expressed as a percentage of what?
Initial investment

Reasoning:
- percentage returns are expressed as a percentage of the initial investment amount
- we calculate percentage return by dividing the dollar return by the investment's value at the beginning of the time period
Risk, as it is used in the coefficient of variation (CoV), is best defined as a measure of which one of these?
- Changes in price resulting from interest rate changes
- Volatility of returns
- Possibility of default
- Changes in price due to changes in expected rates of growth
Volatility of returns

Reasoning:
- The coefficient of variation (CoV) is a common relative measure of the risk-vs-reward relationship
Risk, as used in CoV, is a measure of the volatility of returns. Interest rate risk is only one factor which can affect returns
- Expected growth rates are only one factor which can affect returns
What type of risk exists in a fully-diversified portfolio?
Market risk only

Reasoning:
- Firm-specific risk is eliminated through diversification, leaving only market risk
What does standard deviation measure?
Total Risk

Reasoning:
Standard deviation measures total risk, which includes both firm-specific and market risk
How can firm-specific risk be defined?
- Risk that affects all securities
- Risk arising from one firm that affects all firms
- Risk that can be reduced by diversification
- Risk that cannot be reduced by diversification
Risk that can be reduced by diversification

Reasoning:
- Risk that can be reduced by diversification
- firm-specific risk only affects one firm or one industry. Market risk affects all securities
- firm-specific risk only affects one firm or industry and can be reduced by diversification
Modern portfolio theory (MPT) is designed to achieve which one of these?
- Highest return with no regard to risk]
- Lowest return with no risk
- Average return with lowest level of risk
- Highest return for a given level of risk
Highest return for a given level of risk

Reasoning:
- risk is always present as market risk cannot be diversified away. MPT describes how to achieve the highest return for a given level of risk.
- returns will be low at the lowest level of risk
What is the definition of the coefficient of variation?
Measure of total risk to reward

Reasoning:
- the coefficient of variation is the amount of risk per unit of return
- lower values are preferred by investors
Stock investors cannot avoid which type of risk?
Market Risk

Reasoning:
- investors can avoid firm-specific, or diversifiable risk, by creating diversified portfolios
Which of these sets represents an optimal portfolio? Select all that apply.
- 10 percent return; 15 percent standard deviation
- 10.5 percent return; 17 percent standard deviation
- 11.5 percent return; 17 percent standard deviation
- 11 percent return; 15 percent standard deviation
11.5 percent return; 17 percent standard deviation
11 percent return; 15 percent standard deviation

Reasoning:
- these two portfolios offer the highest return for the given level of risk
- the other ones have the same level of risk but a lower return
How is standard deviation defined in relation to investments?
Measure of past return volatility, or risk

Reasoning:
- Standard deviation is a measure of past return volatility, or risk.
- Standard deviation measures total risk, which includes both firm-specific and market risk
What is the primary focus of modern portfolio theory (MPT)?
- Eliminating all portfolio risk
- Achieving the maximum possible rate of return for a portfolio
- Minimizing portfolio risk
- Minimizing portfolio risk for a given level of return
Minimizing portfolio risk for a given level of return

Reasoning:
- Market risk CAN NOT be eliminated.
- MPT describes how to achieve the lowest level of risk for a given rate of return or the highest rate of return for a given level of risk
What are the characteristics of an efficient portfolio?
Maximum expected return for a given level of risk

Reasoning:
- an efficient portfolio is defined as a portfolio with the maximum expected return for a given level of risk.
- only if the risk level equal that of the overall market will the rate of return equal the market rate
- actual returns vary over time.
Which of these represents an optimal portfolio comprised of two stocks? Select all that apply.
- 14.9 percent return; 25.4 percent standard deviation
- 14.2 percent return; 24.8 percent standard deviation
- 14.3 percent return; 24.8 percent standard deviation
- 14.8 percent return; 25.4 percent standard deviation
14.9 percent return; 25.4 percent standard deviation
14.3 percent return; 24.8 percent standard deviation

Reasoning:
- these two have the highest return for their level of risk
- the others have the same level of risk but a lower return
Assume a portfolio with a return of 12 percent with a standard deviation of 18 percent is an efficient portfolio. Which one of these is most apt to also be an efficient portfolio?
- 12 percent return; 19 percent standard deviation
- 13 percent return; 17 percent standard deviation
- 11 percent return; 19 percent standard deviation
- 13 percent return; 19 percent standard deviation
13 percent return; 19 percent standard deviation
What is the shape of the efficient frontier and what does this imply?
Upward sloping; direct relationship between risk and return

Reasoning:
- The efficient frontier is upward-sloping indicating a direct relationship between risk and return
- An upward-sloping function indicates a direct relationship
How is correlation defined?
Measure of the co-movement between the returns on two variables
Which one of these is the correct formula for computing the return on a portfolio comprised of unequal amounts of stocks A, B, and C?
- Rp = (RA + RB + RC)/3
- Rp = (wA × RA) + (wB × RB) + (wC × RC)
Rp = (wA × RA) + (wB × RB) + (wC × RC)

Reasoning:
- the return on a portfolio equals the sum of the weight of each security times each security's return
- This formula only works if the portfolio is equally invested in each stock. For unequal weights, the portfolio return equals the sum of the weight of each security times each security's return.
On a graph with expected return on the vertical axis and standard deviation on the horizontal axis, where is an efficient portfolio located?
At the highest return achievable for any selected standard deviation

Reasoning:
- The top left corner would indicate an inverse relationship between risk and return. The relationship is actually direct.
- Depending on the scale of the graph, the center point may or may not be an efficient portfolio. An efficient portfolio is defined as the highest return achievable for any selected standard deviation.
- Efficient portfolios generally do not form a linear function but do represent the highest returns achievable for each level of risk.
Which of these defines correlation?
- Statistical value ranging from -1 to +1
- Average value ranging from -1 to +1
- Statistical value ranging from 0 to 1
- Average value ranging from 0 to 1
Statistical value ranging from -1 to +1

Reasoning:
- Correlation is a measurement of the co-movement between two variables that range between -1 and +1
-
What determines the weights to be used in computing a portfolio rate of return? Select an answer that applies to both equal and unequal portfolio allocations.
- 100 percent divided by the number of securities held in the portfolio
- Market capitalization of each security divided by the total market capitalization of all securities
- Market value of each security expressed as a percentage of the total portfolio value
- Market value of each security expressed as a percentage of the initial investment in that security
Market value of each security expressed as a percentage of the total portfolio value

Reasoning:
- Answer 1 only applies if the portfolio is equally invested in each security. For any portfolio, the weights can be computed by dividing the market value of each security by the total portfolio value.
- Answer 2; Market capitalization refers to the total market value of all shares of a stock that are outstanding. Portfolio weights are based only on the value of the shares invested in the portfolio.
- The weights are computed by dividing the market value of each security by the total portfolio value.
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