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Chapter 10

Risk and Return: Lessons from Market History

Multiple Choice Questions

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

10-1

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:

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.

10-2

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. Based on the period of 1926 through 2008, _____ have tended to outperform other

securities over the long-term.

A. U.S. Treasury bills

B. large company stocks

C. long-term corporate bonds

D. small company stocks

E. long-term government bonds

11. Which one of the following types of securities has tended to produce the lowest real rate

of return for the period 1926 through 2008?

A. U.S. Treasury bills

B. long-term government bonds

C. small company stocks

D. large company stocks

E. long-term corporate bonds

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 longterm government bonds.

E. the risk premium on large company stocks has exceeded the risk premium on small

company stocks.

10-3

13. Over the period of 1926 through 2008, 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. U.S. Treasury bills; small company stocks

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

14. Which one of the following is a correct ranking of securities based on their volatility over

the period of 1926 to 2008? Rank from highest to lowest.

A. large company stocks, U.S. Treasury bills, long-term government bonds

B. small company stocks, long-term corporate bonds, large company stocks

C. long-term government bonds, long-term corporate bonds, small company stocks

D. small company stocks, large company stocks, long-term corporate bonds

E. long-term corporate bonds, large company stocks, U.S. Treasury bills

15. Over the period of 1926 to 2008, small company stocks had an average return of __%.

A. 8.8

B. 10.2

C. 12.4

D. 14.6

E. 16.4

16. Over the period of 1926 to 2008, the average rate of inflation was _____%.

A. 2.0

B. 2.7

C. 3.1

D. 3.8

E. 4.3

10-4

17. The average annual return on long-term corporate bonds for the period of 1926 to 2008

was _____%.

A. 3.8

B. 5.8

C. 6.2

D. 7.9

E. 8.4

18. The average annual return on small company stocks was about _____ percentage points

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

2008.

A. 3

B. 5

C. 7

D. 9

E. 11

19. The average risk premium on U.S. Treasury bills over the period of 1926 to 2008 was

_____%.

A. 0.0

B. 1.6

C. 2.2

D. 3.1

E. 3.8

20. 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.

10-5

21. 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

22. The Zolo Co. just declared that it is increasing its 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.

23. 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

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.

10-6

25. 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

C. I, III, and IV only

D. I, II, and III only

E. I, II, III, and IV

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% for the period 1926 to 2008.

IV. had an average value of about 20% for the period 1926 to 2008.

A. I and III only

B. I and II only

C. II and III only

D. II and IV only

E. I and IV only

27. Estimates using the arithmetic average will probably tend to _____ values over the longterm while estimates using the geometric average will probably tend to _____ values over the

short-term.

A. overestimate; overestimate

B. overestimate; underestimate

C. underestimate; overestimate

D. underestimate; underestimate

E. accurately; accurately

10-7

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.

29. Capital market history shows us that the average return relationship from lowest to highest

between securities is:

A. inflation, corporate bonds, Treasuries, small company stocks, large company stocks.

B. Treasury bills, inflation, small company stocks, large company stocks.

C. Treasury bills, corporate bonds, government bonds, large common stocks, small company

stocks.

D. Treasury bills, government bonds, corporate bonds, large common stocks, small company

stocks.

E. There is no ordering.

30. How much of total world stock market capitalization is from the United States in 2008?

A. approximately 10%

B. approximately 25%

C. approximately 45%

D. approximately 57%

E. approximately 72%

31. In predicting the expected future return of the market, one of the dangers is that:

A. the past is not indicative of the future.

B. the past period measured is too short to get a reasonable estimate of the future.

C. the equity premium does not include the premium on debt.

D. A and B.

E. A and C.

10-8

32. The dollar value of the world stock market capitalization, from largest to smallest is:

A. Europe, United States, United Kingdom, Japan

B. United States, Japan, Europe, United Kingdom

C. United States, Europe, Japan, United Kingdom

D. Japan, United States, Europe, United Kingdom

E. Japan, United States, United Kingdom, Europe

33. Which country has the lowest stock market risk premium?

A. Denmark

B. Belgium

C. Switzerland

D. Spain

E. Norway

34. In estimating the future equity risk premium, it is important to include assumptions about:

A. the historical distribution of returns on derivative securities.

B. the future risk environment.

C. the amount of risk aversion of future investors.

D. A and B.

E. B and C.

35. 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. $0.40

B. $1.60

C. $2.10

D. $2.50

E. $3.70

10-9

36. 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. $1.24

B. $1.64

C. $40.00

D. $124.00

E. $164.00

37. 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. $5,703

B. $5,733

C. $5,753

D. $5,763

E. $5,853

38. 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%

B. 4.4%

C. 6.8%

D. 9.2%

E. 11.4%

39. Winslow, Inc. stock is currently selling for $40 a share. The stock has a dividend yield of

3.8%. How much dividend income will you receive per year if you purchase 500 shares of

this stock?

A. $152

B. $190

C. $329

D. $760

E. $1,053

10-10

40. 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%. Your capital gain was $6 a share. What was your dividend

yield on this stock?

A. 1.25%

B. 3.75%

C. 6.25%

D. 18.75%

E. 21.25%

41. 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. -$550

B. -$222

C. -$3

D. $550

E. $878

42. 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?

A. 4.06%

B. 4.23%

C. 4.68%

D. 8.55%

E. 8.91%

43. Today, you sold 200 shares of SLG, Inc. stock. Your total return on these shares is 12.5%.

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?

A. 4.80%

B. 5.00%

C. 6.67%

D. 7.59%

E. 11.67%

10-11

44. 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

45. 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%

B. -9.3%

C. -8.4%

D. 12.0%

E. 13.4%

46. 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%

47. A stock has an expected rate of return of 8.3% and a standard deviation of 6.4%. Which

one of the following best describes the probability that this stock will lose 11% or more in any

one given year?

A. less than 0.5%

B. less than 1.0%

C. less than 1.5%

D. less than 2.5%

E. less than 5%

10-12

48. A stock has returns of 3%, 18%, -24%, and 16% for the past four years. Based on this

information, what is the 95% probability range for any one given year?

A. -8.4 to 11.7%

B. -16.1 to 22.6%

C. -24.5 to 34.3%

D. -35.4 to 41.9%

E. -54.8 to 61.3%

49. A stock had returns of 8%, 14%, and 2% for the past three years. Based on these returns,

what is the probability that this stock will earn at least 20% in any one given year?

A. 0.5%

B. 1.0%

C. 2.5%

D. 5.0%

E. 16.0%

50. A stock had returns of 11%, 1%, 9%, 15%, and -6% for the past five years. Based on these

returns, what is the approximate probability that this stock will earn at least 23% in any one

given year?

A. 0.5%

B. 1.0%

C. 2.5%

D. 5.0%

E. 16.0%

51. A stock had returns of 8%, 39%, 11%, and -24% for the past four years. Which one of the

following best describes the probability that this stock will NOT lose more than 43% in any

one given year?

A. 84.0%

B. 95.0%

C. 97.5%

D. 99.0%

E. 99.5%

10-13

52. 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%

53. What are the arithmetic and geometric average returns for a stock with annual returns of

4%, 9%, -6%, and 18%?

A. 5.89%; 6.25%

B. 6.25%; 5.89%

C. 6.25%; 8.33%

D. 8.3%; 5.89%

E. 8.3%; 6.25%

54. 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%

55. A stock had returns of 6%, 13%, -11%, and 17% over the past four years. What is the

geometric average return for this time period?

A. 4.5%

B. 5.7%

C. 6.2%

D. 7.3%

E. 8.2%

10-14

56. 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%

57. You bought 100 shares of stock at $20 each. At the end of the year, you received a total of

$400 in dividends, and your stock was worth $2,500 total. What was your total return?

A. 20%

B. 45%

C. 50%

D. 90%

E. None of the above

58. You bought 100 shares of stock at $20 each. At the end of the year, you received a total of

$400 in dividends, and your stock was worth $2,500 total. What was your total dollar capital

gain and total dollar return?

A. $400; $500

B. $400; $900

C. $500; $900

D. $900; $2,500

E. None of the above

10-15

59. 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%

60. Excelsior share 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 total rate of return?

A. 4.17%

B. 6.25%

C. 10.42%

D. 104.67%

E. 110.42%

61. 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%

62. Kids Toy Co. has had total returns over the past five years of 0%, 7%, -2%, 10%, and

12%. What was the arithmetic average return on this stock?

A. 5.40%

B. 5.50%

C. 6.15%

D. 6.33%

E. 6.75%

10-16

63. The returns on your portfolio over the last 5 years were -5%, 20%, 0%, 10% and 5%.

What is the arithmetic average return?

A. 5.0%

B. 6.0%

C. 7.5%

D. 8.0%

E. 10.0%

64. If the expected return on the market is 16%, then using the historical risk premium on

large stocks of 8.6%, the current risk-free rate is:

A. 4.6%

B. 7.4%

C. 8.4%

D. 10.6%

E. 12.6%

65. The total annual returns on large company common stocks averaged 12.3% from 1926 to

2008, small company stocks averaged 17.4%, long-term government bonds averaged 5.8%,

while Treasury Bills averaged 3.8%. What was the average risk premium earned by long-term

government bonds, and small company stocks respectively?

A. 1.8%; 13.3%

B. 2.0%; 13.6%

C. 4.4%; 11.9%

D. 9.5%; 1.8%

E. None of the above

66. The returns on your portfolio over the last 5 years were -5%, 20%, 0%, 10% and 5%.

What is the standard deviation of your return?

A. 2.74%

B. 5.21%

C. 9.62%

D. 10.12%

E. 12.70%

10-17

67. Suppose you own a risky asset with an expected return of 12% and a standard deviation of

20%. If the returns are normally distributed, the approximate probability of receiving a return

greater than 32% is approximately:

A. 2%.

B. 5%.

C. 16%.

D. 33%.

E. 67%.

68. 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

69. The long term inflation rate average was 3.2% and you invested in long term corporate

bonds over the same period which earned 6.1%. What was the average risk premium you

earned?

A. 2.9%

B. 3.1%

C. 9.3%

D. 9.4%

E. None of the above

70. The market portfolio of common stocks earned 14.7% in one year. Treasury bills earned

5.7%. What was the real risk premium on equities?

A. 5.0%

B. 6.5%

C. 9.0%

D. 12.2%

E. 18.7%

10-18

71. You have a sample of returns observations for the Malta Stock Fund. The 4 returns are

7.25%, 5.6%, 12.5%, 1.0%. What is the average return and variance of these returns?

A. 6.50%; 16.9

B. 6.60%; 22.5

C. 6.60%; 4.75

D. 26.35%; 67.6

E. None of the above.

Essay Questions

72. 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?

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

suggest these lessons are correct?

10-19

74. 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 bank's 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?

75. Little John Industries sold for $1.90 on January 1 and ended the year at a price of $2.50. In

addition, the stock paid dividends of $0.20 per share. Calculate Little John's dividend yield,

capital gains yield, and total rate of return for the year.

76. You earned a total return of -5% on NoDotCom this year, earned -40% last year, and

earned 30% two years ago. Calculate both the three-year holding period return and the

average three year return.

10-20

Chapter 10 Risk and Return: Lessons from Market History Answer Key

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.

Topic: RISK PREMIUM

Type: DEFINITIONS

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.

Topic: VARIANCE

Type: DEFINITIONS

10-21

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.

Topic: STANDARD DEVIATION

Type: DEFINITIONS

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

Topic: NORMAL DISTRIBUTION

Type: DEFINITIONS

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

Topic: GEOMETRIC AVERAGE RETURN

Type: DEFINITIONS

10-22

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

Topic: ARITHMETIC AVERAGE RETURN

Type: DEFINITIONS

7. 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.

Topic: RISK PREMIUM

Type: DEFINITIONS

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.

Topic: TOTAL RETURN

Type: DEFINITIONS

10-23

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

Topic: HISTORICAL RECORD

Type: CONCEPTS

10. Based on the period of 1926 through 2008, _____ have tended to outperform other

securities over the long-term.

A. U.S. Treasury bills

B. large company stocks

C. long-term corporate bonds

D. small company stocks

E. long-term government bonds

Topic: HISTORICAL RECORD

Type: CONCEPTS

11. Which one of the following types of securities has tended to produce the lowest real rate

of return for the period 1926 through 2008?

A. U.S. Treasury bills

B. long-term government bonds

C. small company stocks

D. large company stocks

E. long-term corporate bonds

Topic: HISTORICAL RECORD

Type: CONCEPTS

10-24

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 longterm government bonds.

E. the risk premium on large company stocks has exceeded the risk premium on small

company stocks.

Topic: HISTORICAL RECORD

Type: CONCEPTS

13. Over the period of 1926 through 2008, 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. U.S. Treasury bills; small company stocks

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

Topic: HISTORICAL RECORD

Type: CONCEPTS

14. Which one of the following is a correct ranking of securities based on their volatility over

the period of 1926 to 2008? Rank from highest to lowest.

A. large company stocks, U.S. Treasury bills, long-term government bonds

B. small company stocks, long-term corporate bonds, large company stocks

C. long-term government bonds, long-term corporate bonds, small company stocks

D. small company stocks, large company stocks, long-term corporate bonds

E. long-term corporate bonds, large company stocks, U.S. Treasury bills

Topic: HISTORICAL RECORD

Type: CONCEPTS

10-25

15. Over the period of 1926 to 2008, small company stocks had an average return of __%.

A. 8.8

B. 10.2

C. 12.4

D. 14.6

E. 16.4

Topic: HISTORICAL RECORD

Type: CONCEPTS

16. Over the period of 1926 to 2008, the average rate of inflation was _____%.

A. 2.0

B. 2.7

C. 3.1

D. 3.8

E. 4.3

Topic: HISTORICAL AVERAGE RETURNS

Type: CONCEPTS

17. The average annual return on long-term corporate bonds for the period of 1926 to 2008

was _____%.

A. 3.8

B. 5.8

C. 6.2

D. 7.9

E. 8.4

Topic: HISTORICAL AVERAGE RETURNS

Type: CONCEPTS

10-26

18. The average annual return on small company stocks was about _____ percentage points

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

2008.

A. 3

B. 5

C. 7

D. 9

E. 11

Topic: HISTORICAL AVERAGE RETURNS

Type: CONCEPTS

19. The average risk premium on U.S. Treasury bills over the period of 1926 to 2008 was

_____%.

A. 0.0

B. 1.6

C. 2.2

D. 3.1

E. 3.8

Topic: RISK PREMIUM

Type: CONCEPTS

20. 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.

Topic: RISK PREMIUM

Type: CONCEPTS

10-27

21. 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

Topic: RISK PREMIUM

Type: CONCEPTS

22. The Zolo Co. just declared that it is increasing its 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.

Topic: DIVIDEND YIELD

Type: CONCEPTS

23. 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

Topic: VARIANCE

Type: CONCEPTS

10-28

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.

Topic: VARIANCE

Type: CONCEPTS

25. 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

C. I, III, and IV only

D. I, II, and III only

E. I, II, III, and IV

Topic: STANDARD DEVIATION

Type: CONCEPTS

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% for the period 1926 to 2008.

IV. had an average value of about 20% for the period 1926 to 2008.

A. I and III only

B. I and II only

C. II and III only

D. II and IV only

E. I and IV only

Topic: STANDARD DEVIATION

Type: CONCEPTS

10-29

27. Estimates using the arithmetic average will probably tend to _____ values over the longterm while estimates using the geometric average will probably tend to _____ values over the

short-term.

A. overestimate; overestimate

B. overestimate; underestimate

C. underestimate; overestimate

D. underestimate; underestimate

E. accurately; accurately

Topic: ARITHMETIC VS. GEOMETRIC AVERAGES

Type: CONCEPTS

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.

Topic: CAPITAL GAINS

Type: CONCEPTS

29. Capital market history shows us that the average return relationship from lowest to highest

between securities is:

A. inflation, corporate bonds, Treasuries, small company stocks, large company stocks.

B. Treasury bills, inflation, small company stocks, large company stocks.

C. Treasury bills, corporate bonds, government bonds, large common stocks, small company

stocks.

D. Treasury bills, government bonds, corporate bonds, large common stocks, small company

stocks.

E. There is no ordering.

Topic: CAPITAL MARKET RETURNS

Type: CONCEPTS

10-30

30. How much of total world stock market capitalization is from the United States in 2008?

A. approximately 10%

B. approximately 25%

C. approximately 45%

D. approximately 57%

E. approximately 72%

Topic: INTERNATIONAL EQUITY

Type: CONCEPTS

31. In predicting the expected future return of the market, one of the dangers is that:

A. the past is not indicative of the future.

B. the past period measured is too short to get a reasonable estimate of the future.

C. the equity premium does not include the premium on debt.

D. A and B.

E. A and C.

Topic: U.S. EQUITY RISK PREMIUM

Type: CONCEPTS

32. The dollar value of the world stock market capitalization, from largest to smallest is:

A. Europe, United States, United Kingdom, Japan

B. United States, Japan, Europe, United Kingdom

C. United States, Europe, Japan, United Kingdom

D. Japan, United States, Europe, United Kingdom

E. Japan, United States, United Kingdom, Europe

Topic: U.S. EQUITY RISK PREMIUM

Type: CONCEPTS

10-31

33. Which country has the lowest stock market risk premium?

A. Denmark

B. Belgium

C. Switzerland

D. Spain

E. Norway

Topic: U.S. EQUITY RISK PREMIUM

Type: CONCEPTS

34. In estimating the future equity risk premium, it is important to include assumptions about:

A. the historical distribution of returns on derivative securities.

B. the future risk environment.

C. the amount of risk aversion of future investors.

D. A and B.

E. B and C.

Topic: U.S. EQUITY RISK PREMIUM

Type: CONCEPTS

35. 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. $0.40

B. $1.60

C. $2.10

D. $2.50

E. $3.70

Dividend income = $.40 4 = $1.60

Topic: DOLLAR RETURNS

Type: PROBLEMS

10-32

36. 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. $1.24

B. $1.64

C. $40.00

D. $124.00

E. $164.00

Capital gains = ($45.13 - $43.89) 100 = $124

Topic: DOLLAR RETURNS

Type: PROBLEMS

37. 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. $5,703

B. $5,733

C. $5,753

D. $5,763

E. $5,853

Total dollar return = ($28.14 - $9.03 + $.10) 300 = $5,763

Topic: DOLLAR RETURNS

Type: PROBLEMS

10-33

38. 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%

B. 4.4%

C. 6.8%

D. 9.2%

E. 11.4%

Dividend per share = $322 200 = $1.61; Dividend yield = $1.61 $36.72 = 4.4%

Topic: DIVIDEND YIELD

Type: PROBLEMS

39. Winslow, Inc. stock is currently selling for $40 a share. The stock has a dividend yield of

3.8%. How much dividend income will you receive per year if you purchase 500 shares of

this stock?

A. $152

B. $190

C. $329

D. $760

E. $1,053

Dividend income = $40 .038 500 = $760

Topic: DIVIDEND YIELD

Type: PROBLEMS

10-34

40. 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%. Your capital gain was $6 a share. What was your dividend

yield on this stock?

A. 1.25%

B. 3.75%

C. 6.25%

D. 18.75%

E. 21.25%

Capital gains yield = $6 $32 = 18.75%; Dividend yield = 25% - 18.75% = 6.25%

Topic: DIVIDEND YIELD

Type: PROBLEMS

41. 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. -$550

B. -$222

C. -$3

D. $550

E. $878

Capital gain = ($38.75 - $41.50) 200 = -$550 (capital loss)

Topic: CAPITAL GAIN

Type: PROBLEMS

10-35

42. 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?

A. 4.06%

B. 4.23%

C. 4.68%

D. 8.55%

E. 8.91%

Cost = 300 $44.90 = $13,470;

Capital gains yield = ($14,040 - $13,470) $13,470 = 4.23%

Topic: CAPITAL GAIN

Type: PROBLEMS

43. Today, you sold 200 shares of SLG, Inc. stock. Your total return on these shares is 12.5%.

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?

A. 4.80%

B. 5.00%

C. 6.67%

D. 7.59%

E. 11.67%

Dividend yield = $280 (200 $28.50) = 4.91%;

Capital gains yield = 12.5% - 4.91% = 7.59%

Topic: CAPITAL GAIN

Type: PROBLEMS

10-36

44. 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

Total dollar return = ($22.20 - $21.20 + $.60) 1,200 = $1,920

Topic: TOTAL RETURN

Type: PROBLEMS

45. 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%

B. -9.3%

C. -8.4%

D. 12.0%

E. 13.4%

Total percentage return = ($49.30 - $54.90 + $.50 + $.50) $54.90 = -8.4% (loss)

Topic: TOTAL RETURN

Type: PROBLEMS

10-37

46. 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%

Average return = (.08 - .02 + .04 + .16) 4 = .065; Total squared deviation = (.08 - .065)2 +

(-.02 - .065)2 + (.04 - .065)2 + (.16 - .065)2 = .000225 + .007225 + .000625 + .009025 = .0171;

Standard deviation = (.0171 (4 - 1) = .0057 = .075498 = 7.5%

Topic: STANDARD DEVIATION

Type: PROBLEMS

47. A stock has an expected rate of return of 8.3% and a standard deviation of 6.4%. Which

one of the following best describes the probability that this stock will lose 11% or more in any

one given year?

A. less than 0.5%

B. less than 1.0%

C. less than 1.5%

D. less than 2.5%

E. less than 5%

Lower bound of 99% probability range = .083 - (3 .064) = -.109 = -10.9%;

Probability of losing 11% or more is less than 0.5%.

Topic: RETURN DISTRIBUTIONS

Type: PROBLEMS

10-38

48. A stock has returns of 3%, 18%, -24%, and 16% for the past four years. Based on this

information, what is the 95% probability range for any one given year?

A. -8.4 to 11.7%

B. -16.1 to 22.6%

C. -24.5 to 34.3%

D. -35.4 to 41.9%

E. -54.8 to 61.3%

Average return = (.03 + .18 - .24 + .16) 4 = .0325; Total squared deviation = (.03 - .0325)2 +

(.18 - .0325)2 + (-.24 - .0325)2 + (.16 - .0325)2 = .00000625 + .02175625 + .07425625 + .

01625625 = .112275; Standard deviation = (.112275 (4 - 1) = .037425 = .19346 =

19.346%; 95% probability range = 3.25% (2 19.346%) = -35.4 to 41.9%

Topic: RETURN DISTRIBUTIONS

Type: PROBLEMS

49. A stock had returns of 8%, 14%, and 2% for the past three years. Based on these returns,

what is the probability that this stock will earn at least 20% in any one given year?

A. 0.5%

B. 1.0%

C. 2.5%

D. 5.0%

E. 16.0%

Average return = (.08 + .14 + .02) 3 = 8%; Total squared deviation = (.08 - .08)2 + (.14 - .

08)2 + (.02 - .08)2 = .00 + .0036 + .0036 = .0072; Standard deviation = (.0072 (3 - 1) = .06

= 6%; Upper end of the 95% probability range = 8% + (2 6%) = 20%; Probability of

earning at least 20% in any one year is 2.5%.

Topic: RETURN DISTRIBUTIONS

Type: PROBLEMS

10-39

50. A stock had returns of 11%, 1%, 9%, 15%, and -6% for the past five years. Based on these

returns, what is the approximate probability that this stock will earn at least 23% in any one

given year?

A. 0.5%

B. 1.0%

C. 2.5%

D. 5.0%

E. 16.0%

Average return = (.11 + .01 + .09 + .15 - .06) 5 = 6%; Total squared deviation = (.11 - .06)2

+ (.01 - .06)2 + (.09 - .06)2 + (.15 - .06)2 + (-.06 - .06)2 = .0025 + .0025 + .0009 + .0081 + .

0144 = .0284; Standard deviation = (0.284 (5 - 1) = .0071 = .084; Upper end of the 95%

probability range = .06 + (2 .084) = 22.8%; Probability of earning more than 23% in any

one year is just slightly less than 2.5%.

Topic: RETURN DISTRIBUTIONS

Type: PROBLEMS

51. A stock had returns of 8%, 39%, 11%, and -24% for the past four years. Which one of the

following best describes the probability that this stock will NOT lose more than 43% in any

one given year?

A. 84.0%

B. 95.0%

C. 97.5%

D. 99.0%

E. 99.5%

Average return = (.08 + .39 + .11 - .24) 4 = 8.5%; Total squared deviation = (.08 - .085)2 +

(.39 - .085)2 + (.11 - .085)2 + (-.24 - .085)2 = .000025 + .093025 + .000625 + .105625 = .1993;

Standard deviation = .1993 (4 - 1) = .06643333 = 25.7747%; Lower bound of the 95%

probability range = 8.5% - (2 25.7747%) = -43.05; Probability of NOT losing more than

43% in any given year is 97.5%.

Topic: RETURN DISTRIBUTIONS

Type: PROBLEMS

10-40

52. 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%

Average return = (.14 + .22 - .16 + .02 + .10) 5 = 6.4%; Total squared deviation = (.14 - .

064)2 + (.22 - .064)2 + (-.16 - .064)2 + (.02 - 0.064)2 + (.10 - .064)2 = .005776 + .024336 + .

050176 + .001936 + .001296 = .08352; Standard deviation = .08352 (5 - 1) = .02088 =

14.45%; 68% probability range = 6.4% 14.45% = -8.05% to 20.85%; Answer is 68%.

Topic: RETURN DISTRIBUTIONS

Type: PROBLEMS

53. What are the arithmetic and geometric average returns for a stock with annual returns of

4%, 9%, -6%, and 18%?

A. 5.89%; 6.25%

B. 6.25%; 5.89%

C. 6.25%; 8.33%

D. 8.3%; 5.89%

E. 8.3%; 6.25%

Arithmetic average = (.04 + .09 - .06 + .18) 4 = 6.25%; Geometric return = (1.04 1.09 .

94 1.18).25 - 1 = 5.89%

Topic: ARITHMETIC AVERAGE

Type: PROBLEMS

10-41

54. 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%

Arithmetic average = (.21 + .08 - .32 + .41 + .05) 5 = 8.6%; Geometric return = (1.21 1.08

.68 1.41 1.05).20 - 1 = 5.6%

Topic: ARITHMETIC VS. GEOMETRIC AVERAGES

Type: PROBLEMS

55. A stock had returns of 6%, 13%, -11%, and 17% over the past four years. What is the

geometric average return for this time period?

A. 4.5%

B. 5.7%

C. 6.2%

D. 7.3%

E. 8.2%

Geometric average = (1.06 1.13 .89 1.17).25 - 1 = 5.7%

Topic: GEOMETRIC AVERAGE

Type: PROBLEMS

10-42

56. 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%

Return for year 2 = ($24.90 - $23.19 + $.23) $23.19 = 8.3657%; Return for year 3 = ($23.18

- $24.90 + $.24) $24.90 = -5.9438%; Return for year 4 = ($24.86 - $23.18 + $.25) $23.18

= 8.3261%; Geometric return = (1.083657 .940562 1.083261).3333 - 1 = 3.4%

Topic: GEOMETRIC AVERAGE

Type: PROBLEMS

57. You bought 100 shares of stock at $20 each. At the end of the year, you received a total of

$400 in dividends, and your stock was worth $2,500 total. What was your total return?

A. 20%

B. 45%

C. 50%

D. 90%

E. None of the above

$Invest = $20(100) = $2,000

$Return = ($2,500 + $400 - $2,000)/$2,000 = .45 = 45%

Topic: TOTAL RETURN

Type: PROBLEMS

10-43

58. You bought 100 shares of stock at $20 each. At the end of the year, you received a total of

$400 in dividends, and your stock was worth $2,500 total. What was your total dollar capital

gain and total dollar return?

A. $400; $500

B. $400; $900

C. $500; $900

D. $900; $2,500

E. None of the above

$CG = $2,500 - $2,000 = $500

$Total Return = CG + DIV = $500 + $400 = $900

Topic: CAPITAL GAIN AND TOTAL RETURNS

Type: PROBLEMS

59. 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%

%CG = ($25 - $24)/$25 = .04167 = 4.17%

Topic: CAPITAL GAIN RETURN

Type: PROBLEMS

10-44

60. Excelsior share 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 total rate of return?

A. 4.17%

B. 6.25%

C. 10.42%

D. 104.67%

E. 110.42%

% Total Return = [($25 + $1.50)/ $24] - 1 = .1041667 = 10.42%

Topic: TOTAL RETURN

Type: PROBLEMS

61. 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%

HPR = (1.10) (1.15) (1.12) = 1.4168 - 1 = 41.68%

Topic: HOLDING PERIOD RETURN

Type: PROBLEMS

10-45

62. Kids Toy Co. has had total returns over the past five years of 0%, 7%, -2%, 10%, and

12%. What was the arithmetic average return on this stock?

A. 5.40%

B. 5.50%

C. 6.15%

D. 6.33%

E. 6.75%

Arithmetic average = (0 + 7 - 2 + 10 + 12)/5 = 5.40%

Topic: RETURN AND STANDARD DEVIATION

Type: PROBLEMS

63. The returns on your portfolio over the last 5 years were -5%, 20%, 0%, 10% and 5%.

What is the arithmetic average return?

A. 5.0%

B. 6.0%

C. 7.5%

D. 8.0%

E. 10.0%

Arithmetic average = (-5 + 20 + 0 + 10 + 5)/5 = 6%

Topic: ARITHMETIC AVERAGE RETURN

Type: PROBLEMS

10-46

64. If the expected return on the market is 16%, then using the historical risk premium on

large stocks of 8.6%, the current risk-free rate is:

A. 4.6%

B. 7.4%

C. 8.4%

D. 10.6%

E. 12.6%

Risk-free rate = 16% - 8.6% = 7.4%

Topic: RETURNS

Type: PROBLEMS

65. The total annual returns on large company common stocks averaged 12.3% from 1926 to

2008, small company stocks averaged 17.4%, long-term government bonds averaged 5.8%,

while Treasury Bills averaged 3.8%. What was the average risk premium earned by long-term

government bonds, and small company stocks respectively?

A. 1.8%; 13.3%

B. 2.0%; 13.6%

C. 4.4%; 11.9%

D. 9.5%; 1.8%

E. None of the above

Long Term Government = 5.8% - 3.8% = 2.0%

Small Stocks = 17.5% - 3.8% = 13.7%

Topic: RISK PREMIUM

Type: PROBLEMS

10-47

66. The returns on your portfolio over the last 5 years were -5%, 20%, 0%, 10% and 5%.

What is the standard deviation of your return?

A. 2.74%

B. 5.21%

C. 9.62%

D. 10.12%

E. 12.70%

Standard Deviation = [(-.05 - .06)2 + (.20 - .06)2 + (0 - .06)2 + (.10 - .06)2 + (.05 - .06)2]/4 =

.0370/4 = .00925 = .09617 = 9.62%

Topic: STANDARD DEVIATION

Type: PROBLEMS

67. Suppose you own a risky asset with an expected return of 12% and a standard deviation of

20%. If the returns are normally distributed, the approximate probability of receiving a return

greater than 32% is approximately:

A. 2%.

B. 5%.

C. 16%.

D. 33%.

E. 67%.

Z = (32 - 12)/20 = 1; 32 is 1 standard deviation above the mean. The probability of being

within 1 standard deviation is approximately 68%; therefore, probability above the mean is

approximately 32%/2 = 16%.

Topic: RETURN PROBABILITIES

Type: PROBLEMS

10-48

68. 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

Average return = (5 + 8 - 12 + 15 + 21)/5 = 37/5 = 7.4%

HPR = [(1.05)(1.08)(.88)(1.15)(1.21)] - 1 = (1.3886) - 1 = .3886 = 38.9%

Topic: AVERAGE AND HOLDING PERIOD RETURNS

Type: PROBLEMS

69. The long term inflation rate average was 3.2% and you invested in long term corporate

bonds over the same period which earned 6.1%. What was the average risk premium you

earned?

A. 2.9%

B. 3.1%

C. 9.3%

D. 9.4%

E. None of the above

Average risk premium = 6.1% - 3.2% = 2.9%

Topic: AVERAGE RISK PREMIUM

Type: PROBLEMS

10-49

70. The market portfolio of common stocks earned 14.7% in one year. Treasury bills earned

5.7%. What was the real risk premium on equities?

A. 5.0%

B. 6.5%

C. 9.0%

D. 12.2%

E. 18.7%

Risk premium = 14.7% - 5.7% = 9.0%

Topic: RISK PREMIUM

Type: PROBLEMS

71. You have a sample of returns observations for the Malta Stock Fund. The 4 returns are

7.25%, 5.6%, 12.5%, 1.0%. What is the average return and variance of these returns?

A. 6.50%; 16.9

B. 6.60%; 22.5

C. 6.60%; 4.75

D. 26.35%; 67.6

E. None of the above.

Average return = (.0725 + .056 + .125 + .01)/4 = .2635/4 = .065875 = 6.6%

Variance = [(7.25 - 6.6)2 + (5.6 - 6.6)2 + (12.5 - 6.6)2 + (1 - 6.6)2]/3 = 67.5925/3 = 22.53

Topic: ARITHMATIC AVERAGE RETURN AND VARIANCE

Type: PROBLEMS

Essay Questions

10-50

72. 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 stocks

2. large company stocks

3. long-term corporate bonds

4. long-term government bonds

5. 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.

Type: ESSAYS

73. 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.

Topic: LESSONS

Type: ESSAYS

10-51

74. 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 bank's 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.

Type: ESSAYS

75. Little John Industries sold for $1.90 on January 1 and ended the year at a price of $2.50. In

addition, the stock paid dividends of $0.20 per share. Calculate Little John's dividend yield,

capital gains yield, and total rate of return for the year.

Dividend yield = $0.20/$1.90 = 10.53%

Capital gain = $0.60/$1.90 = 31.58%

Total return = 10.53% + 31.58% = 42.11%

Topic: RETURNS

Type: ESSAYS

76. You earned a total return of -5% on NoDotCom this year, earned -40% last year, and

earned 30% two years ago. Calculate both the three-year holding period return and the

average three year return.

3-year holding period return = (0.95) (0.60) (1.30) = 0.741 - 1 = -25.9%

Average three-year return = (-.05 + - .40 + .30)/3 = -.15/3 = -5%.

Type: ESSAYS

10-52

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