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CHAPTER 10Some Lessons from Capital Market History

I. DEFINITIONS

RISK PREMIUMa 1. The excess return required from a risky asset over that required from a risk-free asset is

called the:a. risk premium.b. geometric premium.c. excess return.d. average return.e. variance.

VARIANCEb 2. The average squared difference between the actual return and the average return is

called the:a. volatility return.b. variance.c. standard deviation.d. risk premium.e. excess return.

STANDARD DEVIATIONc 3. The standard deviation for a set of stock returns can be calculated as the:

a. positive square root of the average return.b. average squared difference between the actual return and the average return.c. positive square root of the variance.d. average return divided by N minus one, where N is the number of returns.e. variance squared.

NORMAL DISTRIBUTIONd 4. A symmetric, bell-shaped frequency distribution that is completely defined by its mean

and standard deviation is the _____ distribution.a. gammab. Poissonc. bi-modald. normale. uniform

GEOMETRIC AVERAGE RETURNd 5. The average compound return earned per year over a multi-year period is called the

_____ average return.a. arithmeticb. standardc. variantd. geometrice. real

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ARITHMETIC AVERAGE RETURNa 6. The return earned in an average year over a multi-year period is called the _____

average return.a. arithmeticb. standardc. variantd. geometrice. real

EFFICIENT CAPITAL MARKETe 7. An efficient capital market is one in which:

a. brokerage commissions are zero.b. taxes are irrelevant.c. securities always offer a positive rate of return to investors.d. security prices are guaranteed by the U.S. Securities and Exchange Commission to be

fair.e. security prices reflect available information.

EFFICIENT MARKETS HYPOTHESISa 8. The notion that actual capital markets, such as the NYSE, are fairly priced is called the:

a. Efficient Markets Hypothesis (EMH).b. Law of One Price.c. Open Markets Theorem.d. Laissez-Faire Axiom.e. Monopoly Pricing Theorem.

STRONG FORM EFFICIENCYb 9. The hypothesis that market prices reflect all available information of every kind is

called _____ form efficiency.a. openb. strongc. semi-strongd. weake. stable

SEMI STRONG FORM EFFICIENCYc 10. The hypothesis that market prices reflect all publicly-available information is called

_____ form efficiency.a. openb. strongc. semi-strongd. weake. stable

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WEAK FORM EFFICIENCYd 11. The hypothesis that market prices reflect all historical information is called _____ form

efficiency.a. openb. strongc. semi-strongd. weake. stable

II. CONCEPTS

TOTAL RETURNd 12. The total percentage return on an equity investment is computed using the formula

______, where P1 is the purchase cost, P2 represents the sale proceeds, and d is the dividend income.

a. (P2 P1) (P2 + d)b. (P1 P2) (P2 + d)c. (P1 P2 d) P1d. (P2 P1 + d) P1e. (P2 P1 + d) P2

DIVIDEND YIELDa 13. The dividend yield is equal to _____, where P1 is the purchase cost, P2 represents the

sale proceeds, and d is the dividend income.a. d P1b. d P1c. d P2d. d P2e. d (P1 + P2)

DIVIDEND YIELDc 14. The Zolo Co. just declared that they are increasing their annual dividend from $1.00 per

share to $1.25 per share. If the stock price remains constant, then:a. the capital gains yield will decrease.b. the capital gains yield will increase.c. the dividend yield will increase.d. the dividend yield will also remain constant.e. neither the capital gains yield nor the dividend yield will change.

CAPITAL GAINb 15. The dollar amount of the capital gain on an investment is computed as _____, where P1

is the purchase cost, P2 represents the sale proceeds, and d is the dividend income.a. P1 P2b. P2 P1c. P2 P1d. P1 P2 + de. P2 P1 d

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TOTAL RETURNe 16. The capital gains yield plus the dividend yield on a security is called the:

a. variance of returns.b. geometric return.c. average period return.d. summation of returns.e. total return.

REAL RETURNc 17. The real rate of return on a stock is approximately equal to the nominal rate of return:

a. multiplied by (1 + inflation rate).b. plus the inflation rate.c. minus the inflation rate.d. divided by (1 + inflation rate).e. divided by (1- inflation rate).

REAL RETURNc 18. As long as the inflation rate is positive, the real rate of return on a security investment

will be ____ the nominal rate of return.a. greater thanb. equal toc. less thand. greater than or equal toe. unrelated to

HISTORICAL RECORDd 19. A portfolio of large company stocks would contain which one of the following types of

securities?a. stock of the firms which represent the smallest 20 percent of the companies listed on the

NYSEb. U.S. Treasury billsc. long-term corporate bondsd. stocks of firms included in the S&P 500 indexe. long-term government bonds

HISTORICAL RECORDd 20. Based on the period of 1926 through 2003, _____ have tended to outperform other

securities over the long-term.a. U.S. Treasury billsb. large company stocksc. long-term corporate bondsd. small company stockse. long-term government bonds

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HISTORICAL RECORDa 21. Which one of the following types of securities has tended to produce the lowest real

rate of return for the period 1926 through 2003?a. U.S. Treasury billsb. long-term government bondsc. small company stocksd. large company stockse. long-term corporate bonds

HISTORICAL RECORDd 22. On average, for the period 1926 through 2003:

a. the real rate of return on U.S. Treasury bills has been negative.b. small company stocks have underperformed large company stocks.c. long-term government bonds have produced higher returns than long-term corporate

bonds.d. the risk premium on long-term corporate bonds has exceeded the risk premium on long-

term government bonds.e. the risk premium on large company stocks has exceeded the risk premium on small

company stocks.

HISTORICAL RECORDe 23. Over the period of 1926 through 2003, the annual rate of return on _____ has been

more volatile than the annual rate of return on_____:a. large company stocks; small company stocks.b. long-term government bonds; long-term corporate bonds.c. U.S. Treasury bills; long-term government bonds.d. long-term corporate bonds; small company stocks.e. large company stocks; long-term corporate bonds.

HISTORICAL RECORDd 24. During the period of 1926 through 2003 the annual rate of inflation:

a. was always positive.b. was only negative during the 3 years of the Great Depression.c. never exceeded 10 percent.d. fluctuated significantly from one year to the next.e. tended to be negative during the years of World War II.

HISTORICAL RECORDe 25. Based on the period of 1926 through 2003 the annual rate of inflation ranged from

_____ percent to _____ percent.a. -5; 6b. -5; 9c. -7; 6d. -7; 15e. -10; 18

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HISTORICAL RECORDb 26. $1 invested in U.S. Treasury bills in 1926 would have increased in value to ____ by

2003.a. $10b. $17c. $30d. $43e. $60

HISTORICAL RECORDd 27. Which one of the following is a correct ranking of securities based on their volatility

over the period of 1926 to 2003? Rank from highest to lowest.a. large company stocks, U.S. Treasury bills, long-term government bondsb. small company stocks, long-term corporate bonds, large company stocksc. small company stocks, long-term government bonds, long-term corporate bondsd. large company stocks, long-term corporate bonds, long-term government bondse. long-term government bonds, long-term corporate bonds, U.S. Treasury bills

HISTORICAL RECORDd 28. $1 invested in small company stocks in 1926 would have increased in value to _____ by

2003.a. $60b. $2,284c. $4,092d. $10,953e. $13,185

HISTORICAL RECORDd 29. The highest rate of annual inflation between 1926 and 2003 was_____ percent.

a. 7b. 10c. 13d. 18e. 22

HISTORICAL RECORDe 30. The annual return on long-term government bonds has ranged between _____ percent

and _____ percent during the period 1926 to 2003.a. -2; 8b. -4; 6c. -5; 10d. -6; 29e. -7; 44

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HISTORICAL RECORDe 31. Over the period of 1926 to 2003, small company stocks had an average return of _____

percent.a. 8.8b. 10.2c. 12.4d. 14.6e. 17.5

HISTORICAL AVERAGE RETURNSc 32. Over the period of 1926 to 2003, the average rate of inflation was _____ percent.

a. 2.0b. 2.7c. 3.1d. 3.8e. 4.3

HISTORICAL AVERAGE RETURNSc 33. The average annual return on long-term corporate bonds for the period of 1926 to 2003

was _____ percent.a. 3.8b. 5.8c. 6.2d. 7.9e. 8.4

AVERAGE RETURNSb 34. The average annual return on small company stocks was about _____ percent greater

than the average annual return on large-company stocks over the period of 1926 to 2003.

a. 3b. 5c. 7d. 9e. 11

RISK PREMIUMa 35. The average risk premium on U.S. Treasury bills over the period of 1926 to 2003 was

_____ percent.a. 0.0b. 1.6c. 2.2d. 3.1e. 3.8

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RISK PREMIUMa 36. Which one of the following is a correct statement concerning risk premium?

a. The greater the volatility of returns, the greater the risk premium.b. The lower the volatility of returns, the greater the risk premium.c. The lower the average rate of return, the greater the risk premium.d. The risk premium is not correlated to the average rate of return.e. The risk premium is not affected by the volatility of returns.

RISK PREMIUMc 37. The risk premium is computed by ______ the average return for the investment.

a. subtracting the inflation rate fromb. adding the inflation rate toc. subtracting the average return on the U.S. Treasury bill fromd. adding the average return on the U.S. Treasury bill toe. subtracting the average return on long-term government bonds from

RISK PREMIUMc 38. The excess return you earn by moving from a relatively risk-free investment to a risky

investment is called the:a. geometric average return.b. inflation premium.c. risk premium.d. time premium.e. arithmetic average return.

RISK PREMIUMb 39. To convince investors to accept greater volatility in the annual rate of return on an

investment, you must:a. decrease the risk premium.b. increase the risk premium.c. decrease the expected rate of return.d. decrease the risk-free rate of return.e. increase the risk-free rate of return.

FREQUENCY DISTRIBUTIONa 40. Which one of the following takes the shape of a bell curve?

a. frequency distributionb. variancec. risk premium graphd. standard deviatione. deviation of returns

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VARIANCEe 41. Which of the following statements are correct concerning the variance of the annual

returns on an investment?I. The larger the variance, the more the actual returns tend to differ from the average

return.II. The larger the variance, the larger the standard deviation.III. The larger the variance, the greater the risk of the investment.IV. The larger the variance, the higher the expected return.a. I and III onlyb. II, III, and IV onlyc. I, III, and IV onlyd. I, II, and III onlye. I, II, III, and IV

VARIANCEa 42. The variance of returns is computed by dividing the sum of the:

a. squared deviations by the number of returns minus one.b. average returns by the number of returns minus one.c. average returns by the number of returns plus one.d. squared deviations by the average rate of return.e. squared deviations by the number of returns plus one.

STANDARD DEVIATIONb 43. Which of the following statements concerning the standard deviation are correct?

I. The greater the standard deviation, the lower the risk.II. The standard deviation is a measure of volatility.III. The higher the standard deviation, the less certain the rate of return in any one given

year.IV. The higher the standard deviation, the higher the expected return.a. I and III onlyb. II, III, and IV onlyc. I, III, and IV onlyd. I, II, and III onlye. I, II, III, and IV

STANDARD DEVIATIONa 44. The standard deviation on small company stocks:

I. is greater than the standard deviation on large company stocks.II. is less than the standard deviation on large company stocks.III. had an average value of about 33 percent for the period 1926 to 2003.IV. had an average value of about 20 percent for the period 1926 to 2003.a. I and III onlyb. I and II onlyc. II and III onlyd. II and IV onlye. I and IV only

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ARITHMETIC VS. GEOMETRIC AVERAGESb 45. Estimates using the arithmetic average will probably tend to _____ values over the

long-term while estimates using the geometric average will probably tend to _____ values over the short-term.

a. overestimate; overestimateb. overestimate; underestimatec. underestimate; overestimated. underestimate; underestimatee. accurately; accurately

MARKET EFFICIENCYd 46. In an efficient market, the price of a security will:

a. always rise immediately upon the release of new information with no further price adjustments related to that information.

b. react to new information over a two-day period after which time no further price adjustments related to that information will occur.

c. rise sharply when new information is first released and then decline to a new stable level by the following day.

d. react immediately to new information with no further price adjustments related to that information.

e. be slow to react for the first few hours after new information is released allowing time for that information to be reviewed and analyzed.

MARKET EFFICIENCYc 47. If the financial markets are efficient, then investors should expect their investments in

those markets to:a. earn extraordinary returns on a routine basis.b. generally have positive net present values.c. generally have zero net present values.d. produce arbitrage opportunities on a routine basis.e. produce negative returns on a routine basis.

MARKET EFFICIENCYd 48. Which one of the following statements is correct concerning market efficiency?

a. Real asset markets are more efficient than financial markets.b. If a market is efficient, arbitrage opportunities should be common.c. In an efficient market, some market participants will have an advantage over others.d. A firm will generally receive a fair price when it sells shares of stock.e. New information will gradually be reflected in a stocks price to avoid any sudden

change in the price of the stock.

MARKET EFFICIENCYc 49. Financial markets fluctuate daily because they:

a. are inefficient.b. slowly react to new information.c. are continually reacting to new information.d. offer tremendous arbitrage opportunities.e. only reflect historical information.

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MARKET EFFICIENCYd 50. Insider trading does not offer any advantages if the financial markets are:

a. weak form efficient.b. semiweak-form efficient.c. semistrong-form efficient.d. strong-form efficient.e. inefficient.

MARKET EFFICIENCYe 51. According to theory, studying historical prices in order to identify mispriced stocks will

not work in markets that are _____ efficient.I. weak-formII. semistrong-formIII. strong-forma. I onlyb. II onlyc. I and II onlyd. II and III onlye. I, II, and III

MARKET EFFICIENCYe 52. Which of the following tend to reinforce the argument that the financial markets are

efficient?I. Information spreads rapidly in todays world.II. There is tremendous competition in the financial markets.III. Market prices continually fluctuate.IV. Market prices react suddenly to unexpected news announcements.a. I and III onlyb. II and IV onlyc. I, II, and III onlyd. II, III, and IV onlye. I, II, III, and IV

MARKET EFFICIENCYa 53. If you excel in analyzing the future outlook of firms, you would prefer that the financial

markets be ____ form efficient so that you can have an advantage in the marketplace.a. weakb. semiweakc. semistrongd. stronge. perfect

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MARKET EFFICIENCYc 54. Your best friend works in the finance office of the Delta Corporation. You are aware

that this friend trades Delta stock based on information he overhears in the office. You know that this information is not known to the general public. Your friend continually brags to you about the profits he earns trading Delta stock. Based on this information, you would tend to argue that the financial markets are at best _____ form efficient.

a. weakb. semiweakc. semistrongd. stronge. perfect

MARKET EFFICIENCYc 55. The U.S. Securities and Exchange Commission periodically charges individuals for

insider trading and claims those individuals have made unfair profits. Based on this fact, you would tend to argue that the financial markets are at best _____ form efficient.

a. weakb. semiweakc. semistrongd. stronge. perfect

MARKET EFFICIENCYb 56. Individuals that continually monitor the financial markets seeking mispriced securities:

a. tend to make substantial profits on a daily basis.b. tend to make the markets more efficient.c. are never able to find a security that is temporarily mispriced.d. are always quite successful using only well-known public information as their basis of

evaluation.e. are always quite successful using only historical price information as their basis of

evaluation.

III. PROBLEMS

DOLLAR RETURNSb 57. One year ago, you purchased a stock at a price of $32.50. The stock pays quarterly

dividends of $.40 per share. Today, the stock is worth $34.60 per share. What is the total amount of your dividend income to date from this investment?

a. $.40b. $1.60c. $2.10d. $2.50e. $3.70

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DOLLAR RETURNSd 58. Six months ago, you purchased 100 shares of stock in ABC Co. at a price of $43.89 a

share. ABC stock pays a quarterly dividend of $.10 a share. Today, you sold all of your shares for $45.13 per share. What is the total amount of your capital gains on this investment?

a. $1.24b. $1.64c. $40.00d. $124.00e. $164.00

DOLLAR RETURNSd 59. A year ago, you purchased 300 shares of IXC Technologies, Inc. stock at a price of

$9.03 per share. The stock pays an annual dividend of $.10 per share. Today, you sold all of your shares for $28.14 per share. What is your total dollar return on this investment?

a. $5,703b. $5,733c. $5,753d. $5,763e. $5,853

DIVIDEND YIELDb 60. You purchased 200 shares of stock at a price of $36.72 per share. Over the last year,

you have received total dividend income of $322. What is the dividend yield?a. 3.2 percentb. 4.4 percentc. 6.8 percentd. 9.2 percente. 11.4 percent

DIVIDEND YIELDd 61. Winslow, Inc. stock is currently selling for $40 a share. The stock has a dividend yield

of 3.8 percent. How much dividend income will you receive per year if you purchase 500 shares of this stock?

a. $152b. $190c. $329d. $760e. $1,053

DIVIDEND YIELDc 62. One year ago, you purchased a stock at a price of $32 a share. Today, you sold the stock

and realized a total return of 25 percent. Your capital gain was $6 a share. What was your dividend yield on this stock?

a. 1.25 percentb. 3.75 percentc. 6.25 percentd. 18.75 percente. 21.25 percent

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CAPITAL GAINa 63. You just sold 200 shares of Langley, Inc. stock at a price of $38.75 a share. Last year

you paid $41.50 a share to buy this stock. Over the course of the year, you received dividends totaling $1.64 per share. What is your capital gain on this investment?

a. -$550b. -$222c. -$3d. $550e. $878

CAPITAL GAINb 64. You purchased 300 shares of Deltona, Inc. stock for $44.90 a share. You have received

a total of $630 in dividends and $14,040 in proceeds from selling the shares. What is your capital gains yield on this stock?


CAPITAL GAINd 65. Today, you sold 200 shares of SLG, Inc. stock.. Your total return on these shares is 12.5

percent. You purchased the shares one year ago at a price of $28.50 a share. You have received a total of $280 in dividends over the course of the year. What is your capital gains yield on this investment?


TOTAL RETURNd 66. Six months ago, you purchased 1,200 shares of ABC stock for $21.20 a share. You have

received dividend payments equal to $.60 a share. Today, you sold all of your shares for $22.20 a share. What is your total dollar return on this investment?

a. $720b. $1,200c. $1,440d. $1,920e. $3,840

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TOTAL RETURNc 67. Eight months ago, you purchased 400 shares of Winston, Inc. stock at a price of $54.90

a share. The company pays quarterly dividends of $.50 a share. Today, you sold all of your shares for $49.30 a share. What is your total percentage return on this investment?

a. -10.2 percentb. -9.3 percentc. -8.4 percentd. 12.0 percente. 13.4 percent

REAL RETURNb 68. Last year, you purchased a stock at a price of $51.50 a share. Over the course of the

year, you received $1.80 in dividends and inflation averaged 2.8 percent. Today, you sold your shares for $53.60 a share. What is your approximate real rate of return on this investment?


REAL RETURNe 69. Seven months ago, you purchased a stock at a price of $36.04 a share. Today, you sold

those shares for $43.15 a share. During the past seven months, you have received dividends totaling $0.24 a share while inflation has averaged 3.6 percent. What is your approximate real rate of return on this investment?


STANDARD DEVIATIONd 70. A stock had returns of 8 percent, -2 percent, 4 percent, and 16 percent over the past four

years. What is the standard deviation of this stock for the past four years?a. 6.3 percentb. 6.6 percentc. 7.1 percentd. 7.5 percente. 7.9 percent

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RETURN DISTRIBUTIONSa 71. A stock has an expected rate of return of 8.3 percent and a standard deviation of 6.4

percent. Which one of the following best describes the probability that this stock will lose 11 percent or more in any one given year?

a. less than 0.5 percentb. less than 1.0 percentc. less than 1.5 percentd. less than 2.5 percente. less than 5 percent

RETURN DISTRIBUTIONSd 72. A stock has returns of 3 percent, 18 percent, -24 percent, and 16 percent for the past

four years. Based on this information, what is the 95 percent probability range for any one given year?

a. -8.4 to 11.7 percentb. -16.1 to 22.6 percentc. -24.5 to 34.3 percentd. -35.4 to 41.9 percente. -54.8 to 61.3 percent

RETURN DISTRIBUTIONSc 73. A stock had returns of 8 percent, 14 percent, and 2 percent for the past three years.

Based on these returns, what is the probability that this stock will earn at least 20 percent in any one given year?


RETURN DISTRIBUTIONSc 74. A stock had returns of 11 percent, 1 percent, 9 percent, 15 percent, and -6 percent for

the past five years. Based on these returns, what is the approximate probability that this stock will earn at least 23 percent in any one given year?


RETURN DISTRIBUTIONSc 75. A stock had returns of 8 percent, 39 percent, 11 percent, and -24 percent for the past

four years. Which one of the following best describes the probability that this stock will NOT lose more than 43 percent in any one given year?


RETURN DISTRIBUTIONS

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b 76. Over the past five years, a stock produced returns of 14 percent, 22 percent, -16 percent, 2 percent, and 10 percent. What is the probability that an investor in this stock will NOT lose more than 8 percent nor earn more than 21 percent in any one given year?

a. 34 percentb. 68 percentc. 95 percentd. 99 percente. 100 percent

ARITHMETIC AVERAGEb 77. What are the arithmetic and geometric average returns for a stock with annual returns

of 4 percent, 9 percent, -6 percent, and 18 percent?a. 5.89 percent; 6.25 percentb. 6.25 percent; 5.89 percentc. 6.25 percent; 8.33 percentd. 8.3 percent; 5.89 percente. 8.3 percent; 6.25 percent

ARITHMETIC VS. GEOMETRIC AVERAGESc 78. What are the arithmetic and geometric average returns for a stock with annual returns

of 21 percent, 8 percent, -32 percent, 41 percent, and 5 percent?a. 5.6 percent; 8.6 percentb. 5.6 percent; 6.3 percentc. 8.6 percent; 5.6 percentd. 8.6 percent; 8.6 percente. 8.6 percent; 6.3 percent

GEOMETRIC AVERAGEb 79. A stock had returns of 6 percent, 13 percent, -11 percent, and 17 percent over the past

four years. What is the geometric average return for this time period?a. 4.5 percentb. 5.7 percentc. 6.2 percentd. 7.3 percente. 8.2 percent

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GEOMETRIC AVERAGEb 80. A stock had the following prices and dividends. What is the geometric average return

on this stock?Year Price Dividend 1 $23.19 2 $24.90 $.23 3 $23.18 $.24 4 $24.86 $.25


IV. ESSAYS

EFFICIENT MARKETS81. Define the three forms of market efficiency.

The student should present a straightforward discussion of weak (all past prices are in the current price), semi-strong (all public information is in the current price), and strong form (all information is in the current price) market efficiency.

HISTORICAL RETURNS82. What securities have offered the highest average annual returns over the last several

decades? Can we conclude that return and risk are related in real life?

The purpose of this question is to check student understanding of the capital market history discussion of the chapter, as well as to reiterate the concept of the risk-return trade-off. The securities categories discussed in the chapter are listed below in descending order of historical returns (and risk):

1. small company stocks2. large company stocks3. long-term corporate bonds4. long-term government bonds5. U.S. Treasury bills

By learning this hierarchy, and given that they are familiar with the attributes of each security, students should be left with little doubt that the maxim The greater the risk, the greater the return is an apt description of financial markets.

LESSONS83. What are the lessons learned from capital market history? What evidence is there to suggest

these lessons are correct?

First, there is a reward for bearing risk, and second, the greater the risk, the greater the reward. As evidence, the students should provide a brief discussion of the historical rates of return and standard deviation of returns of the various asset classes discussed in the text.

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EFFICIENT MARKETS84. Explain why it is that in an efficient market, investments have an expected NPV of zero.

In an efficient market, prices are fair so that the cost of an investment is neither too high nor too low. Thus, on average, investments in that market will yield a zero NPV. Investors get exactly what they pay for when they buy a security in an efficient market and firms get exactly what their stocks and bonds are worth when they sell them.

EFFICIENT MARKETS85. Do you think the lessons from capital market history will hold for each year in the future?

That is, as an example, if you buy small stocks will your investment always outperform U.S. Treasury bonds?

The student should realize that we are working with averages, so they should not expect riskier assets to always outperform less risky assets. The student should explain somewhere in their answer that this gets to the heart of what risk is. That is, the reason you expect to earn a higher return over the long haul is that your variability in price from year to year can be significant.

RISK AND RETURN86. Suppose you have $30,000 invested in the stock market and your banker comes to you and

tries to get you to move that money into the banks certificates of deposit (CDs). He explains that the CDs are 100% government insured and that you are taking unnecessary risks by being in the stock market. How would you respond?

The usual response is that bank CDs typically will offer a very low rate of return because of their low level of risk. Even if students do not know the relationship between yields on CDs and historical returns on stocks, they should recognize that because of the risk differences the CDs must have a lower expected return. So, if the investor in the question is willing to trade off some safety in order to have the chance to earn larger returns, the stock market is the correct investment.

MARKET EFFICIENCY87. Suppose your cousin invests in the stock market and doubles her money in a single year

while the market, on average, earned a return of only about 15 percent. Is your cousins performance a violation of market efficiency?

No, market efficiency does not preclude investors from beating the market. It is entirely possible to earn higher returns than the market at times. However, if your cousin is able to do so consistently, then there would certainly be some doubt cast upon market efficiency.

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INSIDER TRADING88. How do you think the stock market would be affected if the laws were changed so that

trading on insider information was no longer illegal? What would be the impact on the goal of the financial manager if such a change were to occur?

This open-ended question allows students to ponder market efficiency from a different angle. By allowing insiders to trade on their information, it would be possible for insiders to take advantage of uninformed investors. This may keep some investors out of the market because they would perceive the prices observed as no longer being fair. This change would provide a serious blow to the efficiency of the market and would also further complicate the issue of whos interest managers are working to satisfy.

MARKET EFFICIENCY89. Why should a financial decision maker such as a corporate treasurer or CFO be concerned

with market efficiency?

Good answers to this question might indicate that market efficiency is a necessary condition for the maximize shareholder wealth rule. Unless we are confident that the market price is an economically meaningful number, seeking to maximize it is silly. Similarly, students should recognize that there is a very strong link between managerial decisions and the value of the firm, as reflected in security prices. Finally, as a preview of the cost of capital discussion in later chapters, instructors might point out that market efficiency ensures that the required returns on new securities will be directly related to the risk-return profile of the firm and, therefore, to managerial actions.

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1. A conflict of interest between the stockholders and management of a firm is called: a. stockholders liability. b. corporate breakdown. c. the agency problem. d. corporate activism. e. legal liability.

2. Agency costs refer to: a. the total dividends paid to stockholders over the lifetime of a firm. b. the costs that result from default and bankruptcy of a firm. c. corporate income subject to double taxation. d. the costs of any conflicts of interest between stockholders and management. e. the total interest paid to creditors over the lifetime of the firm.

3. Financial managers should strive to maximize the current value per share of the existing stock because: a. doing so guarantees the company will grow in size at the maximum possible rate. b. doing so increases the salaries of all the employees. c. the current stockholders are the owners of the corporation. d. doing so means the firm is growing in size faster than its competitors. e. the managers often receive shares of stock as part of their compensation.

4. The decisions made by financial managers should all be ones which increase the: a. size of the firm. b. growth rate of the firm. c. marketability of the managers. d. market value of the existing owners equity. e. financial distress of the firm.

5. Which one of the following actions by a financial manager creates an agency problem? a. refusing to borrow money when doing so will create losses for the firm b. refusing to lower selling prices if doing so will reduce the net profits c. agreeing to expand the company at the expense of stockholders value d. agreeing to pay bonuses based on the market value of the company stock e. increasing current costs in order to increase the market value of the stockholders equity

6. Which of the following help convince managers to work in the best interest of the stockholders? I. compensation based on the value of the stock II. stock option plans III. threat of a proxy fight IV. threat of conversion to a partnership

2

a. I and II only b. II and III only c. I, II and III only d. I and III only e. I, II, III, and IV

7. A proxy fight occurs when? a. the board solicits renewal of current members b. a group solicits proxies to replace the board of directors c. a competitor offers to buy the firm d. the firm files for bankruptcy e. the firm is declared insolvent

1.C 2.D 3.C 4.D 5.C 6.C 7.B

(((() ) ) ) CH2CH2CH2CH2

1. Working capital management includes decisions concerning which of the following? I. accounts payable II. long-term debt III. accounts receivable IV. Inventory a. I and II only b. I and III only c. II and IV only d. I, II, and III only e. I, III, and IV only

2. Working capital management: a. ensures that sufficient equipment is available to produce the amount of product desired on a daily basis. b. ensures that long-term debt is acquired at the lowest possible cost. c. ensures that dividends are paid to all stockholders on an annual basis. d. balances the amount of company debt to the amount of available equity. e. is concerned with the upper portion of the balance sheet.

3. Net working capital is defined as: a. total liabilities minus shareholders equity. b. current liabilities minus shareholders equity. c. fixed assets minus long-term liabilities. d. total assets minus total liabilities. e. current assets minus current liabilities.

4. Which of the following are included in current assets? I. equipment II. Inventory III. accounts payable IV. Cash

3

a. II and IV only b. I and III only c. I, II, and IV only d. III and IV only e. II, III, and IV only

5. A _____ standardizes items on the income statement and balance sheet as a percentage of total sales and total assets, respectively. a. tax reconciliation statement b. statement of standardization c. statement of cash flows d. common-base year statement e. common-size statement

6. Financial ratios that measure a firms ability to pay its bills over the short run without undue stress are known as _____ ratios. a. asset management b. long-term solvency c. short-term solvency d. profitability e. market value

7. The current ratio is measured as: a. current assets minus current liabilities. b. current assets divided by current liabilities. c. current liabilities minus inventory, divided by current assets. d. cash on hand divided by current liabilities. e. current liabilities divided by current assets.

8. The quick ratio is measured as: a. current assets divided by current liabilities. b. cash on hand plus current liabilities, divided by current assets. c. current liabilities divided by current assets, plus inventory. d. current assets minus inventory, divided by current liabilities. e. current assets minus inventory minus current liabilities.

9. The cash ratio is measured as: a. current assets divided by current liabilities. b. current assets minus cash on hand, divided by current liabilities. c. current liabilities plus current assets, divided by cash on hand. d. cash on hand plus inventory, divided by current liabilities. e. cash on hand divided by current liabilities.

10. The financial ratio measured as total assets minus total equity, divided by total assets, is the: a. total debt ratio. b. equity multiplier. c. debt-equity ratio. d. current ratio. e. times interest earned ratio.

11. The debt-equity ratio is measured as total: a. equity minus total debt. b. equity divided by total debt.

4

c. debt divided by total equity. d. debt plus total equity. e. debt minus total assets, divided by total equity.

12. Ratios that measure how efficiently a firm uses its assets to generate sales are known as _____ ratios. a. asset management b. long-term solvency c. short-term solvency d. profitability e. market value

13. The inventory turnover ratio is measured as: a. total sales minus inventory. b. inventory times total sales. c. cost of goods sold divided by inventory. d. inventory times cost of goods sold. e. inventory plus cost of goods sold.

14. The financial ratio days sales in inventory is measured as: a. inventory turnover plus 365 days. b. inventory times 365 days. c. inventory plus cost of goods sold, divided by 365 days. d. 365 days divided by the inventory. e. 365 days divided by the inventory turnover.

15. The receivables turnover ratio is measured as: a. sales plus accounts receivable. b. sales divided by accounts receivable. c. sales minus accounts receivable, divided by sales. d. accounts receivable times sales. e. accounts receivable divided by sales.

16. The financial ratio days sales in receivables is measured as: a. receivables turnover plus 365 days. b. accounts receivable times 365 days. c. accounts receivable plus sales, divided by 365 days. d. 365 days divided by the receivables turnover. e. 365 days divided by the accounts receivable.

17. The total asset turnover ratio is measured as: a. sales minus total assets. b. sales divided by total assets. c. sales times total assets. d. total assets divided by sales. e. total assets plus sales.

1. e 2. e 3. e 4. a 5. e 6. c 7. b 8. d 9. e 10. a

11. c 12. a 13. c 14. e 15. b 16. d 17. b

5

Ch3Ch3Ch3Ch3 (((()+)+)+)++Ch.2+Ch.2+Ch.2+Ch.2

1. Ratios that measure a firms financial leverage are known as _____ ratios. a. asset management b. long-term solvency c. short-term solvency d. profitability e. market value

2. The equity multiplier ratio is measured as total: a. equity divided by total assets. b. equity plus total debt. c. assets minus total equity, divided by total assets. d. assets plus total equity, divided by total debt. e. assets divided by total equity.

3. The financial ratio measured as earnings before interest and taxes, divided by interest expense is the: a. cash coverage ratio. b. debt-equity ratio. c. times interest earned ratio. d. gross margin. e. total debt ratio.

4. The financial ratio measured as earnings before interest and taxes, plus depreciation, divided by interest expense, is the: a. cash coverage ratio. b. debt-equity ratio. c. times interest earned ratio. d. gross margin. e. total debt ratio.

5. Ratios that measure how efficiently a firms management uses its assets and equity to generate bottom line net income are known as _____ ratios. a. asset management b. long-term solvency c. short-term solvency d. profitability e. market value

6. The financial ratio measured as net income divided by sales is known as the firms: a. profit margin. b. return on assets. c. return on equity. d. asset turnover. e. earnings before interest and taxes.

7. The financial ratio measured as net income divided by total assets is known as the firms: a. profit margin. b. return on assets. c. return on equity. d. asset turnover. e. earnings before interest and taxes.

8. The financial ratio measured as net income divided by total equity is known as the firms: a. profit margin. b. return on assets. c. return on equity. d. asset turnover. e. earnings before interest and taxes.

6

9. The financial ratio measured as the price per share of stock divided by earnings per share is known as the: a. return on assets. b. return on equity. c. debt-equity ratio. d. price-earnings ratio. e. Du Pont identity.

10. The market-to-book ratio is measured as: a. total equity divided by total assets. b. net income times market price per share of stock. c. net income divided by market price per share of stock. d. market price per share of stock divided by earnings per share. e. market value of equity per share divided by book value of equity per share.

11. The _____ breaks down return on equity into three component parts. a. Du Pont identity b. return on assets c. statement of cash flows d. asset turnover ratio e. equity multiplier

12. On a common-size balance sheet, all _____ accounts are shown as a percentage of _____. a. income; total assets b. liability; net income c. asset; sales d. liability; total assets e. equity; sales

13. Which one of the following statements is correct concerning ratio analysis? a. A single ratio is often computed differently by different individuals. b. Ratios do not address the problem of size differences among firms. c. Only a very limited number of ratios can be used for analytical purposes. d. Each ratio has a specific formula that is used consistently by all analysts. e. Ratios can not be used for comparison purposes over periods of time.

14. Which of the following are liquidity ratios? I. cash coverage ratio II. current ratio III. quick ratio IV. inventory turnover a. II and III only b. I and II only c. II, III, and IV only d. I, III, and IV only e. I, II, III, and IV

15. An increase in which one of the following accounts increases a firms current ratio without affecting its quick ratio? a. accounts payable b. cash c. inventory d. accounts receivable e. fixed assets

16. A supplier, who requires payment within ten days, is most concerned with which one of the following ratios when granting credit? a. current b. cash c. debt-equity d. quick e. total debt

7

17. A firm has a total debt ratio of .47. This means that that firm has 47 cents in debt for every: a. $1 in equity. b. $1 in total sales. c. $1 in current assets. d. $.53 in equity. e. $.53 in total assets.

18. A banker considering loaning a firm money for ten years would most likely prefer the firm have a debt ratio of _____ and a times interest earned ratio of_____ . a. .75; .75 b. 50; 1.00 c. 45; 1.75 d. 40; 2.50 e. 35; 3.00

19. The higher the inventory turnover measure, the: a. faster a firm sells its inventory. b. faster a firm collects payment on its sales. c. longer it takes a firm to sell its inventory. d. greater the amount of inventory held by a firm. e. lesser the amount of inventory held by a firm.

20. Which one of the following statements is correct if a firm has a receivables turnover measure of 10? a. It takes a firm 10 days to collect payment from its customers. b. It takes a firm 36.5 days to sell its inventory and collect the payment from the sale. c. It takes a firm 36.5 days to pay its creditors. d. The firm has an average collection period of 36.5 days. e. The firm has ten times more in accounts receivable than it does in cash.

1.b 2.e 3.c 4.a 5.d 6.a 7.b 8.c 9.d 10.e

11.a 12.d 13.a 14.a 15.c 16.b 17.d 18.e 19.a 20.d

(((() ) ) ) Ch.4Ch.4Ch.4Ch.4 (((()+)+)+)++Ch.3+Ch.3+Ch.3+Ch.3 DOLDOLDOLDOLDFLDFLDFLDFLDTLDTLDTLDTL

Use the following data to answer Questions 1 and 2. If Jaycos sales increase by 10%, Jaycos EBIT increases by 15%. If Jaycos EBIT increases by 10%, Jaycos EPS increases by 12%.

1. Jaycos degree of operating leverage (DOL) and degree of financial leverage (DFL) are closest to: DOL DFL a. 1.8 1.2 b. 1.5 1.2 c. 1.8 1.4 d. 1.5 1.4

2. Jaycos degree of total leverage (DTL) is closest to: a. 1.2. b. 1.7. c. 1.8. d. 2.7.

8

Use the following data to answer Questions 3 and 4. Jayco, Inc. sells 10,000 units at a price of $5 per unit. Jaycos fixed costs are $8,000, interest expense is $2,000, variable costs are $3 per unit, and EBIT is $12,000. 3. Jaycos degree of operating leverage (DOL) and degree of financial leverage (DFL) are closest to:

DOL DFL a. 1.40 1.56 b. 1.40 1.20 c. 1.67 1.20 d. 1.67 1.56

4. Jaycos degree of total leverage (DTL) is closest to: a. 1.25. b. 1.50. c. 1.75. d. 2.00.

5. Vischer Concrete has $1.2 million in assets that are currently financed with 100% equity. Vischers EBIT is $300,000 and its tax rate is 30%. If Vischer changes its capital structure (recapitalizes) to include 40% debt, what is Vischers ROE before and after the change? Assume that the interest rate on debt is 5%. ROE at 100% equity ROE at 60% equity a. 17.5% 37.5% b. 17.5% 26.8% c. 25.0% 26.8% d. 25.0% 37.5%

6. Which of the following statements regarding the risks and potential rewards for owners and creditors of a business is TRUE? a. The potential reward for creditors is virtually unlimited assuming the business is profitable. b. In the event of bankruptcy, creditors have a claim to the assets of the firm that must be met before equity owners receive anything. c. Owners have less risk than creditors. d. In exchange for the risk they bear, creditors have the authority to make decisions regarding how the business is run.

1. b

DOL = (increase in EBIT / increase in sales) = 0.15 / 0.10 = 1.5;

DFL = (increase in EPS / increase in EBIT) = 0.12 / 0.10 = 1.2

2. c

DTL = DOL DFL = 1.2 1.5 = 1.8

3. c

DOL = [Q(P - V)] / [Q(P - V) - F] = [10,000 (5 - 3)] / [10,000 (5 - 3) - 8,000] = 1.67

DFL = EBIT / (EBIT - I) = 12,000 / (12,000 - 2,000) = 1.2

4. d

DTL = (Q(P-V)) / [Q(P-V)-F-I] = (10,000 (5-3)) / [10,000 (5-3) - 8,000 - 2,000]

= 2.0

9

or since we calculated the components in the previous answer,

DTL = DOL DFL = 1.67 1.2 = 2.0

5. b

With 100%

equity: With 60% equity:

EBIT $300,000 $300,000

Interest expense $0 $24,000 ($480,000 @ 5%)

Income before taxes $300,000 $276,000

Taxes at 30% $90,000 $82,800

Net income $210,000 $193,200

Shareholders' equity $1,200,000 $720,000

ROE = NI / Equity 17.5% 26.8%

6. b

In the event of bankruptcy, owners do not have a claim to corporate assets until

creditors have been paid in full. Creditors have a less risky position since they are

first in line to receive assets in the event of bankruptcy, but their potential reward

is limited to the promised interest and principal payments on the debt.

(((() ) ) ) CH4~5+Ch.5CH4~5+Ch.5CH4~5+Ch.5CH4~5+Ch.5

1. A firm's sustainable growth rate in sales does not directly depend on its: a. debt to equity ratio. b. profit margin. c. dividend policy. d. asset efficiency. e. all of the above.

2. The sustainable growth rate will be equivalent to the internal growth rate when: a. a firm has no debt. b. the growth rate is positive. c. the plowback ratio is positive but less than 1. d. a firm has a debt-equity ratio exactly equal to 1. e. net income is greater than zero.

3. The sustainable growth rate: a. assumes there is no external financing of any kind. b. is normally higher than the internal growth rate. c. assumes the debt-equity ratio is variable. d. is based on receiving additional external debt and equity financing. e. assumes that 100% of all income is retained by the firm.

4. If a firm bases its growth projection on the rate of sustainable growth, and shows positive net income, then the: a. fixed assets will have to increase at the same rate, regardless of the current capacity level. b. number of common shares outstanding will increase at the same rate of growth. c. debt-equity ratio will have to increase. d. debt-equity ratio will remain constant while retained earnings increase. e. fixed assets, debt-equity ratio, and number of common shares outstanding will all increase.

10

5. Marcies Mercantile wants to maintain its current dividend policy, which is a payout ratio of 40%. The firm does not want to increase its equity financing but is willing to maintain its current debt-equity ratio. Given these requirements, the maximum rate at which Marcies can grow is equal to:

a. 40% of the internal rate of growth. b. 60% of the internal rate of growth. c. the internal rate of growth. d. the sustainable rate of growth. e. 60% of the sustainable rate of growth.

6. You are the beneficiary of a life insurance policy. The insurance company informs you that you have two options for receiving the insurance proceeds. You can receive a lump sum of $50,000 today or receive payments of $641 a month for ten years. You can earn 6.5% on your money. Which option should you take and why? a. You should accept the payments because they are worth $56,451.91 today. b. You should accept the payments because they are worth $56,523.74 today. c. You should accept the payments because they are worth $56,737.08 today. d. You should accept the $50,000 because the payments are only worth $47,757.69 today. e. You should accept the $50,000 because the payments are only worth $47,808.17 today.

7. Your employer contributes $25 a week to your retirement plan. Assume that you work for your employer for another twenty years and that the applicable discount rate is 5%. Given these assumptions, what is this employee benefit worth to you today? a. $13,144.43 b. $15,920.55 c. $16,430.54 d. $16,446.34 e. $16,519.02

8. You have a sub-contracting job with a local manufacturing firm. Your agreement calls for annual payments of $50,000 for the next five years. At a discount rate of 12%, what is this job worth to you today? a. $180,238.81 b. $201,867.47 c. $210,618.19 d. $223,162.58 e. $224,267.10

9. The Ajax Co. just decided to save $1,500 a month for the next five years as a safety net for recessionary periods. The money will be set aside in a separate savings account which pays 3.25% interest compounded monthly. It deposits the first $1,500 today. If the company had wanted to deposit an equivalent lump sum today, how much would it have had to deposit? a. $82,964.59 b. $83,189.29 c. $83,428.87 d. $83,687.23 e. $84,998.01

10. You need some money today and the only friend you have that has any is your miserly friend. He agrees to loan you the money you need, if you make payments of $20 a month for the next six months. In keeping with his reputation, he requires that the first payment be paid today. He also charges you 1.5% interest per month. How much money are you borrowing? a. $113.94 b. $115.65 c. $119.34 d. $119.63 e. $119.96

11. You buy an annuity which will pay you $12,000 a year for ten years. The payments are paid on the first day of each year. What is the value of this annuity today at a 7% discount rate?

11

a. $84,282.98 b. $87,138.04 c. $90,182.79 d. $96,191.91 e. $116,916.21

12. You are scheduled to receive annual payments of $10,000 for each of the next 25 years. Your discount rate is 8.5%. What is the difference in the present value if you receive these payments at the beginning of each year rather than at the end of each year? a. $8,699 b. $9,217 c. $9,706 d. $10,000 e. $10,850

13. You are comparing two annuities with equal present values. The applicable discount rate is 7.5%. One annuity pays $5,000 on the first day of each year for twenty years. How much does the second annuity pay each year for twenty years if it pays at the end of each year? a. $4,651 b. $5,075 c. $5,000 d. $5,375 e. $5,405

14. Martha receives $100 on the first of each month. Stewart receives $100 on the last day of each month. Both Martha and Stewart will receive payments for five years. At an 8% discount rate, what is the difference in the present value of these two sets of payments? a. $32.88 b. $40.00 c. $99.01 d. $108.00 e. $112.50

15. What is the future value of $1,000 a year for five years at a 6% rate of interest? a. $4,212.36 b. $5,075.69 c. $5,637.09 d. $6,001.38 e. $6,801.91

16. You borrow $149,000 to buy a house. The mortgage rate is 7.5% and the loan period is 30 years. Payments are made monthly. If you pay for the house according to the loan agreement, how much total interest will you pay? a. $138,086 b. $218,161 c. $226,059 d. $287,086 e. $375,059

17. You retire at age 60 and expect to live another 27 years. On the day you retire, you have $464,900 in your retirement savings account. You are conservative and expect to earn 4.5% on your money during your retirement. How much can you withdraw from your retirement savings each month if you plan to die on the day you spend your last penny? a. $2,001.96 b. $2,092.05 c. $2,398.17 d. $2,472.00 e. $2,481.27

18. Your local travel agent is advertising an extravagant global vacation. The package deal requires that you pay $5,000 today, $15,000 one year from today, and a final payment of $25,000 on the day you leave two years from today. What is the cost of this vacation in todays dollars if the discount rate is 6%? a. $39,057.41 b. $41,400.85 c. $43,082.39 d. $44,414.14 e. $46,518.00

19. One year ago, the Jenkins Family Fun Center deposited $3,600 in an investment account for the purpose of buying new equipment four years from today. Today, it is adding another $5,000 to this

12

account. It plans on making a final deposit of $7,500 to the account next year. How much will be available when it is ready to buy the equipment, assuming it earns a 7% rate of return? a. $18,159.65 b. $19,430.84 c. $19,683.25 d. $20,194.54 e. $20,790.99

20. What is the future value of the following cash flows at the end of year 3 if the interest rate is 6%? The cash flows occur at the end of each year. Year 1 Year 2 Year 3 $5,180 $9,600 $2,250 a. $15,916.78 b. $18,109.08 c. $18,246.25 d. $19,341.02 e. $19,608.07

1.e 2.a 3.b 4.d 5.d 6.a 7.c 8.a 9.b 10.b

11.c 12.a 13.d 14.a 15.c 16.c 17.e 18.b 19.e 20.c

(((() ) ) ) CH.6+Ch.7CH.6+Ch.7CH.6+Ch.7CH.6+Ch.7

1. The term structure of interest rates is a. the relationship among interest rates of different bonds with the same maturity. b. the structure of how interest rates move over time. c. the relationship among the terms to maturity of different bonds. d. the relationship among interest rates on bonds with different maturities

2. The risk structure of interest rates is a. the structure of how interest rates move over time. b. the relationship among interest rates of different bonds with the same maturity. c. the relationship among the terms to maturity of different bonds. d. the relationship among interest rates on bonds with different maturities.

3. Which of the following long-term bonds should have the lowest interest rate? a. Corporate Baa bonds b. U.S. Treasury bonds c. Corporate Aaa bonds d. Municipal bonds

4. Which of the following long-term bonds should have the highest interest rate? a. Corporate Baa bonds b. U.S. Treasury bonds c. Corporate Aaa bonds d. Municipal bonds

5. The risk premium on corporate bonds becomes smaller if a. the riskiness of corporate bonds increases. b. the liquidity of corporate bonds increases. c. the liquidity of corporate bonds decreases. d. the riskiness of corporate bonds decreases. e. either (b) or (d) occur.

13

6. Bonds with relatively low risk of default are called a. zero coupon bonds. b. junk bonds. c. investment grade bonds. d. none of the above.

7. Bonds with relatively high risk of default are called a. Brady bonds. b. junk bonds. c. zero coupon bonds. d. investment grade bonds.

8. A corporation suffering big losses might be more likely to suspend interest payments on its bonds, thereby a. raising the default risk and causing the demand for its bonds to rise. b. raising the default risk and causing the demand for its bonds to fall. c. lowering the default risk and causing the demand for its bonds to rise. d. lowering the default risk and causing the demand for its bonds to fall.

9. (I) If a corporation suffers big losses, the demand for its bonds will rise because of the higher interest rates the firm must pay. (II) The spread between the interest rates on bonds with default risk and default-free bonds is called the risk premium. a. (I) is true, (II) false. b. (I) is false, (II) true. c. Both are true. d. Both are false.

10. The relationship among interest rates on bonds with identical default risk, but different maturities, is called the a. time-risk structure of interest rates. b. liquidity structure of interest rates. c. bond demand curve. d. yield curve.

11. Yield curves can be classified as a. upward-sloping. b. downward-sloping. c. flat. d. all of the above. e. only (a) and (b) of the above.

12. Typically, yield curves are a. gently upward-sloping. b. gently downward-sloping. c. flat. d. bowl shaped. e. mound shaped.

13. When yield curves are steeply upward-sloping, a. long-term interest rates are above short-term interest rates. b. short-term interest rates are above long-term interest rates. c. short-term interest rates are about the same as long-term interest rates. d. medium-term interest rates are above both short-term and long-term interest rates. e. medium-term interest rates are below both short-term and long-term interest rates.

14. Economists attempts to explain the term structure of interest rates a. illustrate how economists modify theories to improve them when they are inconsistent with the empirical evidence.

14

b. illustrate how economists continue to accept theories that fail to explain observed behavior of interest rate movements. c. prove that the real world is a special case that tends to get short shrift in theoretical models. d. have proved entirely unsatisfactory to date.

15. According to the pure expectations theory of the term structure, a. the interest rate on long-term bonds will exceed the average of expected future short-term interest rates.

b. interest rates on bonds of different maturities move together over time. c. buyers of bonds prefer short-term to long-term bonds. d. all of the above. e. only (a) and (b) of the above.

16. According to the pure expectations theory of the term structure, a. when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise in the future. b. when the yield curve is downward-sloping, short-term interest rates are expected to decline in the future. c. buyers of bonds prefer short-term to long-term bonds. d. all of the above. e. only (a) and (b) of the above.

17. According to the pure expectations theory of the term structure, a. when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise in the future. b. when the yield curve is downward-sloping, short-term interest rates are expected to remain relatively stable in the future. c. investors have strong preferences for short-term relative to long-term bonds, explaining why yield curves typically slope upward. d. all of the above. e. only (a) and (b) of the above.

18. According to the pure expectations theory of the term structure, a. yield curves should be as equally likely to slope downward as slope upward. b. when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise in the future. c. when the yield curve is downward-sloping, short-term interest rates are expected to remain relatively stable in the future. d. all of the above. e. only (a) and (b) of the above.

19. If the expected path of one-year interest rates over the next four years is 5 percent, 4 percent, 2 percent, and 1 percent, then the pure expectations theory predicts that todays interest rate on the four-year bond is a. 1 percent. b. 2 percent. c. 4 percent. d. none of the above.

15

20. If the expected path of one-year interest rates over the next five years is 1 percent, 2 percent, 3 percent, 4 percent, and 5 percent, the pure expectations theory predicts that the bond with the highest interest rate today is the one with a maturity of a. one year. b. two years. c. three years. d. four years. e. five years.

1.d 2.b 3.d 4.a 5.e 6.c 7.b 8.b 9.b 10.d

11.d 12.a 13.a 14.a 15.b 16.e 17.a 18.e 19.d 20.e

(((() ) ) ) CH8~CH9CH8~CH9CH8~CH9CH8~CH9----4444

1. The excess return required from a risky asset over that required from a risk-free asset is called the: a. risk premium. b. geometric premium. c. excess return. d. average return. e. variance.

2. The average squared difference between the actual return and the average return is called the: a. volatility return. b. variance. c. standard deviation. d. risk premium. e. excess return.

3. The standard deviation for a set of stock returns can be calculated as the: a. positive square root of the average return. b. average squared difference between the actual return and the average return. c. positive square root of the variance. d. average return divided by N minus one, where N is the number of returns. e. variance squared.

4. A symmetric, bell-shaped frequency distribution that is completely defined by its mean and standard deviation is the _____ distribution. a. gamma b. Poisson c. bi-modal d. normal e. uniform

5. The average compound return earned per year over a multi-year period is called the _____ average return.

a. arithmetic b. standard c. variant d. geometric e. real

6. The return earned in an average year over a multi-year period is called the _____ average return. a. arithmetic b. standard c. variant d. geometric e. real

7. The excess return you earn by moving from a relatively risk-free investment to a risky investment is called the:

16

a. geometric average return. b. inflation premium. c. risk premium. d. time premium. e. arithmetic average return.

8. The capital gains yield plus the dividend yield on a security is called the: a. variance of returns. b. geometric return. c. average period return. d. current yield. e. total return.

9. A portfolio of large company stocks would contain which one of the following types of securities? a. stocks of the firms which represent the smallest 20% of the companies listed on the NYSE b. U.S. Treasury bills c. long-term corporate bonds d. stocks of firms included in the S&P 500 index e. long-term government bonds

10. Which one of the following is a correct statement concerning risk premium? a. The greater the volatility of returns, the greater the risk premium. b. The lower the volatility of returns, the greater the risk premium. c. The lower the average rate of return, the greater the risk premium. d. The risk premium is not correlated to the average rate of return. e. The risk premium is not affected by the volatility of returns.

11. The risk premium is computed by ______ the average return for the investment. a. subtracting the inflation rate from b. adding the inflation rate to c. subtracting the average return on the U.S. Treasury bill from d. adding the average return on the U.S. Treasury bill to e. subtracting the average return on long-term government bonds from

12. Which of the following statements are correct concerning the variance of the annual returns on an investment? I. The larger the variance, the more the actual returns tend to differ from the average return. II. The larger the variance, the larger the standard deviation. III. The larger the variance, the greater the risk of the investment. IV. The larger the variance, the higher the expected return. a. I and III only b. II, III, and IV only c. I, III, and IV only d. I, II, and III only e. I, II, III, and IV

13. Which of the following statements concerning the standard deviation are correct? I. The greater the standard deviation, the lower the risk. II. The standard deviation is a measure of volatility. III. The higher the standard deviation, the less certain the rate of return in any one given year. IV. The higher the standard deviation, the higher the expected return. a. I and III only b. II, III, and IV only

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c. I, III, and IV only d. I, II, and III only e. I, II, III, and IV

14. A capital gain occurs when: a. the selling price is less than the purchase price. b. the purchase price is less than the selling price. c. there is no dividend paid. d. there is no income component of return. e. never, as they can not exist.

15. Six months ago, you purchased 1,200 shares of ABC stock for $21.20 a share. You have received dividend payments equal to $.60 a share. Today, you sold all of your shares for $22.20 a share. What is your total dollar return on this investment? a. $720 b. $1,200 c. $1,440 d. $1,920 e. $3,840

16. A stock had returns of 8%, -2%, 4%, and 16% over the past four years. What is the standard deviation of this stock for the past four years? a. 6.3% b. 6.6% c. 7.1% d. 7.5% e. 7.9%

17. Over the past five years, a stock produced returns of 14%, 22%, -16%, 2%, and 10%. What is the probability that an investor in this stock will NOT lose more than 8% nor earn more than 21% in any one given year? a. 34% b. 68% c. 95% d. 99% e. 100%

18. What are the arithmetic and geometric average returns for a stock with annual returns of 21%, 8%, -32%, 41%, and 5%? a. 5.6%; 8.6% b. 5.6%; 6.3% c. 8.6%; 5.6% d. 8.6%; 8.6% e. 8.6%; 6.3%

19. A stock had the following prices and dividends. What is the geometric average return on this stock?

a. 3.2% b. 3.4% c. 3.6% d. 3.8% e. 4.0%

20. Excelsior shares are currently selling for $25 each. You bought 200 shares one year ago at $24 and received dividend payments of $1.50 per share. What was your percentage capital gain this year? a. 4.17% b. 6.25% c. 10.42% d. 104.17% e. 110.42%

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21. The prices for IMB over the last 3 years are given below. Assuming no dividends were paid, what was the 3-year holding period return? Given the following information: Year 1 return = 10%, Year 2 return = 15%, Year 3 return = 12%. a. 12.3% b. 13.9% c. 15.8% d. 41.7% e. 46.5%

22. The return pattern on your favorite stock has been 5%, 8%, -12%, 15%, 21% over the last five years. What has been your average return and holding period return over the last 5 years? a. 4.5%; 6.5% b. 7.4%; 38.9% c. 7.4%; 7.76% d. 7.4%; 76.73% e. None of the above

23. A portfolio is: a. a group of assets, such as stocks and bonds, held as a collective unit by an investor. b. the expected return on a risky asset. c. the expected return on a collection of risky assets. d. the variance of returns for a risky asset. e. the standard deviation of returns for a collection of risky assets.

24. The percentage of a portfolio's total value invested in a particular asset is called that asset's: a. portfolio return. b. portfolio weight. c. portfolio risk. d. rate of return. e. investment value.

25. Risk that affects a large number of assets, each to a greater or lesser degree, is called _____ risk. a. idiosyncratic b. diversifiable c. systematic d. asset-specific e. total

26. Risk that affects at most a small number of assets is called _____ risk. a. portfolio b. undiversifiable c. market d. unsystematic e. total

27. The principle of diversification tells us that: a. concentrating an investment in two or three large stocks will eliminate all of your risk. b. concentrating an investment in three companies all within the same industry will greatly reduce your overall risk. c. spreading an investment across five diverse companies will not lower your overall risk at all. d. spreading an investment across many diverse assets will eliminate all of the risk. e. spreading an investment across many diverse assets will eliminate some of the risk.

28. The _____ tells us that the expected return on a risky asset depends only on that asset's nondiversifiable risk. a. Efficient Markets Hypothesis (EMH) b. systematic risk principle c. Open Markets Theorem d. Law of One Price e. principle of diversification

29. The amount of systematic risk present in a particular risky asset, relative to the systematic risk present in an average risky asset, is called the particular asset's: a. beta coefficient. b. reward-to-risk ratio.

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c. total risk. d. diversifiable risk. e. Treynor index.

30. The beta of a security is calculated by: a. dividing the covariance of the security with the market by the variance of the market. b. dividing the correlation of the security with the market by the variance of the market. c. dividing the variance of the market by the covariance of the security with the market. d. dividing the variance of the market by the correlation of the security with the market. e. None of the above.

31. When computing the expected return on a portfolio of stocks the portfolio weights are based on the: a. number of shares owned in each stock. b. price per share of each stock. c. market value of the total shares held in each stock. d. original amount invested in each stock. e. cost per share of each stock held.

32. The standard deviation of a portfolio will tend to increase when: a. a risky asset in the portfolio is replaced with U.S. Treasury bills. b. one of two stocks related to the airline industry is replaced with a third stock that is unrelated to the airline industry. c. the portfolio concentration in a single cyclical industry increases. d. the weights of the various diverse securities become more evenly distributed. e. short-term bonds are replaced with Treasury Bills.

33. Which one of the following is an example of systematic risk? a. the price of lumber declines sharply b. airline pilots go on strike c. the Federal Reserve increases interest rates d. a hurricane hits a tourist destination e. people become diet conscious and avoid fast food restaurants

34. The systematic risk of the market is measured by: a. a beta of 1.0. b. a beta of 0.0. c. a standard deviation of 1.0. d. a standard deviation of 0.0. e. a variance of 1.0.

35. Unsystematic risk: a. can be effectively eliminated through portfolio diversification. b. is compensated for by the risk premium. c. is measured by beta. d. cannot be avoided if you wish to participate in the financial markets. e. is related to the overall economy.

36. Which one of the following is an example of unsystematic risk? a. the inflation rate increases unexpectedly

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b. the federal government lowers income taxes c. an oil tanker runs aground and spills its cargo d. interest rates decline by one-half of one percent e. the GDP rises by 2% more than anticipated

37. The primary purpose of portfolio diversification is to: a. increase returns and risks. b. eliminate all risks. c. eliminate asset-specific risk. d. eliminate systematic risk. e. lower both returns and risks.

38. 38. Which one of the following would indicate a portfolio is being effectively diversified? a. an increase in the portfolio beta b. a decrease in the portfolio beta c. an increase in the portfolio rate of return d. an increase in the portfolio standard deviation e. a decrease in the portfolio standard deviation

39. The majority of the benefits from portfolio diversification can generally be achieved with just _____ diverse securities. a. 3 b. 6 c. 30 d. 50 e. 75

40. Which one of the following measures is relevant to the systematic risk principle? a. variance b. alpha c. standard deviation d. theta e. beta

1~5 ABCDD 6~10ACEDA 11~15 CEBBD 16~20 DBCBA

21~25 DBABC 26~30 DEBAA 31~35 CCCAA 36~40 CCECE

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1. The expected return on a portfolio: A. can be greater than the expected return on the best performing security in the portfolio. B. can be less than the expected return on the worst performing security in the portfolio. C. is independent of the performance of the overall economy. D. is limited by the returns on the individual securities within the portfolio. E. is an arithmetic average of the returns of the individual securities when the weights of those securities are unequal.

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2. If a stock portfolio is well diversified, then the portfolio variance: A. will equal the variance of the most volatile stock in the portfolio. B. may be less than the variance of the least risky stock in the portfolio. C. must be equal to or greater than the variance of the least risky stock in the portfolio. D. will be a weighted average of the variances of the individual securities in the portfolio. E. will be an arithmetic average of the variances of the individual securities in the portfolio.

3. A security that is fairly priced will have a return _____ the Security Market Line. A. below B. on or below C. on D. on or above E. above

4. The intercept point of the security market line is the rate of return which corresponds to: A. the risk-free rate of return. B. the market rate of return. C. a value of zero. D. a value of 1.0. E. the beta of the market.

5. A stock with an actual return that lies above the security market line: A. has more systematic risk than the overall market. B. has more risk than warranted based on the realized rate of return. C. has yielded a higher return than expected for the level of risk assumed. D. has less systematic risk than the overall market. E. has yielded a return equivalent to the level of risk assumed.

6. The market risk premium is computed by: A. adding the risk-free rate of return to the inflation rate. B. adding the risk-free rate of return to the market rate of return. C. subtracting the risk-free rate of return from the inflation rate. D. subtracting the risk-free rate of return from the market rate of return. E. multiplying the risk-free rate of return by a beta of 1.0.

7. The excess return earned by an asset that has a beta of 1.0 over that earned by a risk-free asset is referred to as the: A. market rate of return. B. market risk premium. C. systematic return. D. total return. E. real rate of return.

8. The efficient set of portfolios: A. contains the portfolio combinations with the highest return for a given level of risk. B. contains the portfolio combinations with the lowest risk for a given level of return. C. is the lowest overall risk portfolio. D. Both A and B. E. Both A and C.

9. A well-diversified portfolio has negligible: A. expected return. B. systematic risk. C. unsystematic risk. D. variance.

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E. Both C and D

10. The Capital Market Line is the pricing relationship between: A. efficient portfolios and beta. B. the risk-free asset and standard deviation of the portfolio return. C. the optimal portfolio and the standard deviation of portfolio return. D. beta and the standard deviation of portfolio return. E. None of the above.

11. Beta measures: A. the ability to diversify risk. B. how an asset covaries with the market. C. the actual return on an asset. D. the standard deviation of the assets' returns. E. All of the above.

12. The dominant portfolio with the lowest possible risk is: A. the efficient frontier. B. the minimum variance portfolio. C. the upper tail of the efficient set. D. the tangency portfolio. E. None of the above.

13. An efficient set of portfolios is: A. the complete opportunity set. B. the portion of the opportunity set below the minimum variance portfolio. C. only the minimum variance portfolio. D. the dominant portion of the opportunity set. E. only the maximum return portfolio.

14. The combination of the efficient set of portfolios with a riskless lending and borrowing rate results in: A. the capital market line which shows that all investors will only invest in the riskless asset. B. the capital market line which shows that all investors will invest in a combination of the riskless asset and the tangency portfolio. C. the security market line which shows that all investors will invest in the riskless asset only. D. the security market line which shows that all investors will invest in a combination of the riskless asset and the tangency portfolio. E. None of the above.

15. According to the Capital Asset Pricing Model: A. the expected return on a security is negatively and non-linearly related to the security's beta. B. the expected return on a security is negatively and linearly related to the security's beta. C. the expected return on a security is positively and linearly related to the security's variance. D. the expected return on a security is positively and non-linearly related to the security's beta. E. the expected return on a security is positively and linearly related to the security's beta

16. The diversification effect of a portfolio of two stocks: A. increases as the correlation between the stocks declines.

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B. increases as the correlation between the stocks rises. C. decreases as the correlation between the stocks rises. D. Both A and C. E. None of the above.

17. The separation principle states that an investor will: A. choose any efficient portfolio and invest some amount in the riskless asset to generate the expected return.

B. choose an efficient portfolio based on individual risk tolerance or utility. C. never choose to invest in the riskless asset because the expected return on the riskless asset is lower over time. D. invest only in the riskless asset and tangency portfolio choosing the weights based on individual risk tolerance. E. All of the above.

18. When a security is added to a portfolio the appropriate return and risk contributions are: A. the expected return of the asset and its standard deviation. B. the expected return and the variance. C. the expected return and the beta. D. the historical return and the beta. E. these both can not be measured.

19. The correlation between stocks A and B is the: A. covariance between A and B divided by the standard deviation of A times the standard deviation of B. B. standard deviation A divided by the standard deviation of B. C. standard deviation of B divided by the covariance between A and B. D. variance of A plus the variance of B dividend by the covariance. E. None of the above.

20. You have a portfolio of two risky stocks which turns out to have no diversification benefit. The reason you have no diversification is the returns: A. are too small. B. move perfectly opposite of one another. C. are too large to offset. D. move perfectly with one another. E. are completely unrelated to one another.

21. If the correlation between two stocks is +1, then a portfolio combining these two stocks will have a variance that is: A. less than the weighted average of the two individual variances. B. greater than the weighted average of the two individual variances. C. equal to the weighted average of the two individual variances. D. less than or equal to average variance of the two weighted variances, depending on other information. E. None of the above.

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22. The total number of variance and covariance terms in a portfolio is N2. How many of these would be (including non-unique) covariances? A. N B. N2 C. N2- N D. N2- N/2 E. None of the above.

23. You want your portfolio beta to be 1.20. Currently, your portfolio consists of $100 invested in stock A with a beta of 1.4 and $300 in stock B with a beta of .6. You have another $400 to invest and want to divide it between an asset with a beta of 1.6 and a risk-free asset. How much should you invest in the risk-free asset? A. $0 B. $140 C. $200 D. $320 E. $400

24. You are comparing stock A to stock B. Given the following information, which one of these two stocks should you prefer and why?

A. Stock A; because it has an expected return of 7% and appears to be more risky. B. Stock A; because it has a higher expected return and appears to be less risky than stock B. C. Stock A; because it has a slightly lower expected return but appears to be significantly less risky than stock B. D. Stock B; because it has a higher expected return and appears to be just slightly more risky than stock A. E. Stock B; because it has a higher expected return and appears to be less risky than stock A.

25. Zelo, Inc. stock has a beta of 1.23. The risk-free rate of return is 4.5% and the market rate of return is 10%. What is the amount of the risk premium on Zelo stock? A. 4.47% B. 5.50% C. 5.54% D. 6.77% E. 12.30%

26. What is the expected return on this portfolio?

A. 9.50% B. 9.67% C. 9.78% D. 10.59% E. 10.87%

27. Your portfolio has a beta of 1.18. The portfolio consists of 15% U.S. Treasury bills, 30% in stock A, and 55% in stock B. Stock A has a risk-level equivalent to that of the overall market. What is the beta of stock B? A. .55 B. 1.10 C. 1.24 D. 1.40 E. 1.60

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28. The risk-free rate of return is 4% and the market risk premium is 8%. What is the expected rate of return on a stock with a beta of 1.28? A. 9.12% B. 10.24% C. 13.12% D. 14.24% E. 15.36%

29. The stock of Big Joe's has a beta of 1.14 and an expected return of 11.6%. The risk-free rate of return is 4%. What is the expected return on the market? A. 7.60% B. 8.04% C. 9.33% D. 10.67% E. 12.16%

30. The stock of Martin Industries has a beta of 1.43. The risk-free rate of return is 3.6% and the market risk premium is 9%. What is the expected rate of return on Martin Industries stock? A. 11.3% B. 14.1% C. 16.5% D. 17.4% E. 18.0%

31. Which one of the following stocks is correctly priced if the risk-free rate of return is 2.5% and the market risk premium is 8%?

A. A B. B C. C D. D E. E

32. The variance of Stock A is .004, the variance of the market is .007 and the covariance between the two is .0026. What is the correlation coefficient? A. .9285 B. .8542 C. .5010 D. .4913 E. .3510

33. A portfolio has 50% of its funds invested in Security One and 50% of its funds invested in Security Two. Security One has a standard deviation of 6%. Security Two has a standard deviation of 12%. The securities have a coefficient of correlation of 0.5. Which of the following values is closest to portfolio variance? A. .0027 B. .0063 C. .0095 D. .0104 E. One must have covariance to calculate expected value.

34. A portfolio has 25% of its funds invested in Security C and 75% of its funds invested in Security D. Security C has an expected return of 8% and a standard deviation of 6%. Security D has an expected return of 10% and a standard deviation of 10%. The securities have a coefficient of correlation of 0.6. Which of the following values is closest to portfolio return and variance? A. .090; .0081 B. .095; .001675 C. .095; .0072 D. .100; .00849 E. Cannot calculate without the number of covariance terms.

35. In the equation R = + U, the three symbols stand for: A. average return, expected return, and unexpected return.

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B. required return, expected return, and unbiased return. C. actual total return, expected return, and unexpected return. D. required return, expected return, and unbiased risk. E. risk, expected return, and unsystematic risk.

36. Systematic risk is defined as: A. a risk that specifically affects an asset or small group of assets. B. any risk that affects a large number of assets. C. any risk that has a huge impact on the return of a security. D. the random component of return. E. None of the above.

37. A company owning gold mines will probably have a _____ inflation beta because an ___ increase in inflation is usually associated with an increase in gold prices. A. negative; anticipated B. positive; anticipated C. negative; unanticipated D. positive; unanticipated E. None of the above.

38. If company A, a medical research company, makes a new product discovery and their stock rises 5%, this will have: A. no effect on Company B's, a newspaper, stock price because it is a systematic risk element. B. no effect on Company B's, a newspaper, stock price because it is an unsystematic risk element. C. a large effect on Company B's, a newspaper, stock price because it is a systematic risk element. D. a large effect on Company B's, a newspaper, stock price because it is an unsystematic risk element. E. None of the above.

39. A criticism of the CAPM is that it: A. ignores the return on the market portfolio. B. ignores the risk-free return. C. requires a single measure of systematic risk. D. utilizes too many factors. E. None of the above.

40. An advantage of the APT over CAPM is: A. APT can handle multiple factors. B. if the factors can be properly identified, the APT may have more explanation/predictive power for returns.

C. the APT forces unsystematic risk to be negative to offset systematic risk; thus making the total portfolio risk free, allowing for an arbitrage opportunity for the astute investor. D. Both A and B. E. All of the above.

1~5 DBCAC 6~10 DBDCC 11~15 BBDBE 16~20 DDCAD

21~25 CCABD 26~30 DEDDC 31~35 BDBCC 36~40 BDBCD

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1. A financial contract that gives its owner the right, but not the obligation, to buy or sell a specified asset at an agreed-upon price on or before a given future date is called a(n) _____ contract. A. option B. futures C. forward D. swap E. straddle

2. The act where an owner of an option buys or sells the underlying asset, as is his right, is called ______ the option. A. striking B. exercising C. opening D. splitting E. strangling

3. The fixed price in an option contract at which the owner can buy or sell the underlying asset is called the option's: A. opening price. B. intrinsic value. C. strike price. D. market price. E. time value.

4. The last day on which an owner of an option can elect to exercise is the _____ date. A. ex-payment B. ex-option C. opening D. expiration E. intrinsic

5. An option that may be exercised at any time up to its expiration date is called a(n) _____ option. A. futures B. Asian C. Bermudan D. European E. American

6. An option that may be exercised only on the expiration date is called a(n) _____ option. A. European B. American C. Bermudan D. futures E. Asian

7. A trading opportunity that offers a riskless profit is called a(n): A. put option. B. call option. C. market equilibrium. D. arbitrage. E. cross-hedge.

8. The value of an option if it were to immediately expire, that is, its lower pricing bound, is called an option's _____ value. A. strike B. market C. volatility D. time E. intrinsic

9. An option that grants the right, but not the obligation, to sell shares of the underlying asset on a particular date at a specified price is called: A. either an American or a European option. B. an American call. C. an American put. D. European

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