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# CHAPTER 1

## A Brief History of Risk and Return

I. DEFINITIONS
TOTAL RETURN
1. The total dollar return on an equity investment is defined as the:
a. increase in value of a share of stock over a period of time.
b. income received divided by the initial value of the security.
c. capital gain or loss plus any dividend income.
d. realized capital gain or loss.
DIVIDEND YIELD
2. The annual dividend at time t + 1 divided by the stock price at time t is called the:
a. annualized rate of return.
b. capital gain.
c. total annual rate of return.
d. total dollar return.
e. dividend yield.
CAPITAL GAINS YIELD
3. The capital gains yield is equal to:
a. (Pt Pt + 1 + Dt + 1) / Pt + 1.
b. (Pt + 1 Pt + Dt) / Pt.
c. Dt + 1 / Pt.
d. (Pt + 1 Pt) / Pt.
e. (Pt + 1 Pt) / Pt + 1.
4. The risk premium is defined as the rate of return on:
a. a risky asset minus the risk-free rate.
b. the overall market.
c. a U.S. Treasury bill.
d. a risky asset minus the rate of inflation.
e. a riskless investment.
STANDARD DEVIATION
5. The standard deviation is a measure of:
a. total return.
b. dividend income.
c. capital gains and losses.
d. a frequency distribution.
e. volatility.

VARIANCE
6. The variance measures the:
a. total difference between the actual returns and the average return.
b. average squared difference between the actual returns and the average return.
c. total difference between the average squared returns and the risk-free return.
d. average squared difference between the actual returns and the risk-free return.
e. average difference between the actual squared returns and the risk-free return.
NORMAL DISTRIBUTION
7. The frequency distribution, which is completely defined by its average and standard
deviation,
is referred to as a(n):
a. normal distribution.
b. variance distribution.
c. expected rate of return.
d. average geometric return.
e. average arithmetic return.
RISK-FREE RATE
8. The rate of return earned on a U.S. Treasury bill is referred to as the:
b. deflated rate of return.
c. risk-free rate.
d. expected rate of return.
e. market rate of return.
ARITHMETIC AVERAGE RETURN
9. The arithmetic average return is the:
a. summation of the returns for a number of years divided by the number of years minus
one.
b. compound total return for a period of years divided by the number of years in the
period.
c. average compound return earned per year over a multiyear period.
d. average squared return earned in a single year.
e. return earned in an average year over a multiyear period.
GEOMETRIC AVERAGE RETURN
10. The geometric average return is the:
a. summation of the returns for a number of years divided by the n th root where n equals
the
number of years.
b. compound total return for a period of years divided by the number of years in the
period.
c. average compound return earned per year over a multiyear period.
d. average squared return earned in a single year.
e. return earned in an average year over a multiyear period.
CAPITAL GAIN
11. The value which is equal to the ending price of a security minus the beginning price is
called
the:

a.
b.
c.
d.
e.

dividend yield.
capital gain or loss.
arithmetic dollar return.
geometric dollar return.
total dollar return.

12. The reward for bearing risk is called the:
b. average return.
c. total return.
d. geometric return.
e. real return.
TIME VALUE OF MONEY
13. The risk-free rate which is paid as compensation for waiting is referred to as the:
a. real rate of return.
b. average real return.
c. financial reward.
d. time value of money.
e. total dollar return.
14. The fact that higher returns are associated with higher standard deviations is known as
the:
a. real return factor.
b. geometric relationship.
d. market capitalization.
e. market variance.
STANDARD DEVIATION
15. The square root of the variance is called the:
a. geometric return.
b. standard deviation.
c. normal distribution.
d. frequency distribution.
e. dispersion.
NORMAL DISTRIBUTION
16. Another name for a normal distribution is the:
b. bell curve.
c. geometric dispersion.
d. average tendency.

e.

## time value continuum.

II. CONCEPTS
TOTAL PERCENTAGE RETURN

17. Jeff purchased a stock for \$21 and later sold it for \$27. He also received a dividend of
\$1.40.
The total percentage return on his investment is computed as:
a. \$27 \$21.
b. \$27 \$21 + \$1.40.
c. (\$27 \$21) / \$27.
d. (\$27 \$21 + \$1.40) / \$21.
e. (\$27 \$21 + \$1.40) / \$27.
DIVIDEND AND CAPITAL GAIN YIELDS
18. The dividend yield on a stock will be _____ and the capital gains yield will be _____.
a. positive; either positive or zero
b. positive; positive
c. positive; negative, positive, or zero
d. positive or zero; positive or zero
e. positive or zero; negative, positive, or zero
CAPITAL GAINS
19. Capital gains are included in the return on an investment:
a. on an annual basis.
b. whenever the investment is sold and the capital gain is realized.
c. whenever dividends are paid.
d. whenever they occur, whether or not the investment is sold.
e. only if the investment incurs a loss in value or is sold.
MARKET CAPITALIZATION
20. If you multiply the number of shares of outstanding stock for a firm by the price per
share, you
are computing the firms:
a. equity ratio.
b. total book value.
c. market share.
d. market capitalization.
e. time value.
HISTORICAL RISK
21. Which one of the following had the narrowest bell curve for the period 1926-2005?
a. large-company stocks
b. long-term corporate bonds
c. long-term government bonds
d. small-company stocks
e. U. S. Treasury bills
HISTORICAL RISK
22. Which one of the following had the greatest volatility for the period 1926-2005?
a. large-company stocks
b. U.S. Treasury bills
c. long-term government bonds
d. small-company stocks
e. long-term corporate bonds

HISTORICAL RISK
23. Which one of the following had the lowest standard deviation of returns for the period
19262005?
a. large-company stocks
b. U.S. Treasury bills
c. long-term government bonds
d. intermediate-term government bonds
e. long-term corporate bonds
HISTORICAL RETURNS
24. Which one of the following had the highest average return for the period 1926-2005?
a. large-company stocks
b. U.S. Treasury bills
c. long-term government bonds
d. small-company stocks
e. long-term corporate bonds
HISTORICAL RETURNS
25. Which one of the following has historically produced a return which is closest to the
inflation
rate?
a. large-company stocks
b. long-term corporate bonds
c. long-term government bonds
d. U.S. Treasury bills
e. intermediate-term government bonds
HISTORICAL RETURNS
26. Inflation, as measured by the Consumer Price Index, was highest during the period:
a. 1935-1938.
b. 1947-1950.
c. 1978-1981.
d. 1986-1989.
e. 1996-1999.
HISTORICAL RETURNS
27. Large-company stocks produced the highest rates of return during the period:
a. 1946-1949.
b. 1966-1969.
c. 1984-1987.
d. 1990-1993.
e. 1995-1998.
HISTORICAL RETURNS
28. Which category(ies) of investments had an annual rate of return that exceeded 100
percent for
at least one year during the period 1926-2005?
a. only large-company stocks
b. both large-company and small-company stocks
c. only small-company stocks

d.
e.

## corporate bonds, large-company stocks, and small-company stocks

No category earned an annual return in excess of 100 percent.

HISTORICAL RETURNS
29. For the period 1801-2001, gold:
a. outperformed stocks, bonds, and inflation.
b. outperformed inflation and U.S. Treasury bills.
c. outperformed bonds and underperformed stocks.
d. outperformed U.S. Treasury bills and underperformed bonds.
e. underperformed stocks, bonds, and U.S. Treasury bills.
HISTORICAL RETURNS
30. The greatest one-day percentage decline in the Dow-Jones Industrial Average occurred
on:
a. October 19, 1987.
b. October 28, 1929.
c. October 18, 1937.
d. December 12, 1914.
e. December 18, 1899.
31. Which one of the following had the highest risk premium for the period 1926-2005?
a. U.S. Treasury bills
b. long-term government bonds
c. large-company stocks
d. small-company stocks
e. intermediate-term government bonds
32. Historically, the higher the risk premium, the ______ the average return, and the _____
the
standard deviation of the returns.
a. higher; higher
b. higher; lower
c. lower; higher
d. lower; lower
e. There is no relationship between the risk premium and the average return.
PROBABILITY RANGES
33. The 95 percent probability range of a normal distribution is defined as the mean plus or
minus
_____ standard deviation(s).
a. one
b. two
c. three
d. four
e. five
PROBABILITY RANGES
34. The mean plus or minus one standard deviation defines the _____ percent probability
range of a

a.
b.
c.
d.
e.

normal distribution.
50
68
82
90
95

NORMAL DISTRIBUTION
35. The mean return on large-company stocks for a ten-year period is equal to:
a. the arithmetic average return for the period.
b. the geometric average return for the period.
c. the total return for the period divided by N 1.
d. zero.
e. one.R
ISK AND RETURN
36. If you want to increase the potential annual return on your investments, you will need
to:
a. increase your investment in bonds and lower your investment in stocks.
b. increase your investment in U.S. Treasury bills and lower your investment in corporate
bonds.
c. increase your portfolios level of risk.
d. reduce the expected variability of your returns.
e. reduce the standard deviation of your returns.
RISK AND RETURN
37. Which one of the following statements is correct?
a. U.S. Treasury bills have a risk premium equal to one percent.
b. Large-company stocks have historically been more risky than small-company stocks.
c. The mean is a measure of volatility.
d. A risky asset will always earn a greater annual rate of return than a riskless asset.
e. There is a direct relationship between risk and return.
RISK AND RETURN
38. The wider the distribution of an investments returns over time, the _____ the expected
rate of
return and the ______ the standard deviation of returns.
a. higher; higher
b. higher; lower
c. lower; higher
d. lower; lower
e. The distribution of returns does not affect the expected rate of return.
RATES OF RETURN
39. Which one of the following represents the best method of measuring the return on an
investment?
a. nominal dollar return
b. real dollar return
c. absolute dollar return
d. percentage return
e. variance return

## GEOMETRIC VERSUS ARITHMETIC AVERAGE

40. A stock has varying annual rates of return over a 10-year period and a positive
geometric
average return for the period. Given this, you know the arithmetic average return will
be:
a. positive but less than the geometric average return.
b. less than the geometric return and could be negative, zero, or positive.
c. equal to the geometric average return.
d. either equal to or greater than the geometric average return.
e. greater than the geometric average return.
GEOMETRIC VERSUS ARITHMETIC RETURNS
41. The geometric return on an asset is approximately equal to the arithmetic return:
a. plus one-half the standard deviation.
b. plus one-half the variance.
c. minus one-half the standard deviation.
d. minus one-half the variance.
e. times one-half.

BLUMES FORMULA
42. The purpose of Blumes formula is to:
a. predict future rates of return.
b. convert an arithmetic rate of return into a geometric rate of return.
c. convert a geometric average rate of return into an arithmetic average rate of return.
d. measure past performance in a consistent manner.
e. compute the historical mean return over a multi-year period of time.
STOCK QUOTE
43. A stock is quoted at 26.32, up .20. The current stock price is _____ and the prior days