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Chapter 10 - Risk and Return: Lessons from Market History

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

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Chapter 10 - Risk and Return: Lessons from Market History

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.

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Chapter 10 - Risk and Return: Lessons from Market History

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

12. On average, for the period 1926 through 2008:


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.

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Chapter 10 - Risk and Return: Lessons from Market History

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

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Chapter 10 - Risk and Return: Lessons from Market History

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.

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Chapter 10 - Risk and Return: Lessons from Market History

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

24. 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.

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Chapter 10 - Risk and Return: Lessons from Market History

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

26. 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% 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

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Chapter 10 - Risk and Return: Lessons from Market History

28. 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.

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.

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Chapter 10 - Risk and Return: Lessons from Market History

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

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Chapter 10 - Risk and Return: Lessons from Market History

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

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Chapter 10 - Risk and Return: Lessons from Market History

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%

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Chapter 10 - Risk and Return: Lessons from Market History

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%

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Chapter 10 - Risk and Return: Lessons from Market History

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%

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Chapter 10 - Risk and Return: Lessons from Market History

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%

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Chapter 10 - Risk and Return: Lessons from Market History

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

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Chapter 10 - Risk and Return: Lessons from Market History

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%

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Chapter 10 - Risk and Return: Lessons from Market History

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%

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Chapter 10 - Risk and Return: Lessons from Market History

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%

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Chapter 10 - Risk and Return: Lessons from Market History

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?

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Chapter 10 - Risk and Return: Lessons from Market History

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.

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Chapter 10 - Risk and Return: Lessons from Market History

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

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.

Difficulty level: Easy


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.

Difficulty level: Easy


Topic: VARIANCE
Type: DEFINITIONS

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Chapter 10 - Risk and Return: Lessons from Market History

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.

Difficulty level: Easy


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

Difficulty level: Easy


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

Difficulty level: Medium


Topic: GEOMETRIC AVERAGE RETURN
Type: DEFINITIONS

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Chapter 10 - Risk and Return: Lessons from Market History

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

Difficulty level: Easy


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.

Difficulty level: Easy


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.

Difficulty level: Easy


Topic: TOTAL RETURN
Type: DEFINITIONS

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Chapter 10 - Risk and Return: Lessons from Market History

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

Difficulty level: Easy


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

Difficulty level: Easy


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

Difficulty level: Easy


Topic: HISTORICAL RECORD
Type: CONCEPTS

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Chapter 10 - Risk and Return: Lessons from Market History

12. On average, for the period 1926 through 2008:


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.

Difficulty level: Medium


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

Difficulty level: Medium


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

Difficulty level: Easy


Topic: HISTORICAL RECORD
Type: CONCEPTS

10-25

Chapter 10 - Risk and Return: Lessons from Market History

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

Difficulty level: Medium


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

Difficulty level: Medium


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

Difficulty level: Medium


Topic: HISTORICAL AVERAGE RETURNS
Type: CONCEPTS

10-26

Chapter 10 - Risk and Return: Lessons from Market History

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

Difficulty level: Medium


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

Difficulty level: Medium


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.

Difficulty level: Medium


Topic: RISK PREMIUM
Type: CONCEPTS

10-27

Chapter 10 - Risk and Return: Lessons from Market History

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

Difficulty level: Medium


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.

Difficulty level: Medium


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

Difficulty level: Medium


Topic: VARIANCE
Type: CONCEPTS

10-28

Chapter 10 - Risk and Return: Lessons from Market History

24. 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.

Difficulty level: Medium


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

Difficulty level: Medium


Topic: STANDARD DEVIATION
Type: CONCEPTS

26. 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% 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

Difficulty level: Medium


Topic: STANDARD DEVIATION
Type: CONCEPTS

10-29

Chapter 10 - Risk and Return: Lessons from Market History

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

Difficulty level: Medium


Topic: ARITHMETIC VS. GEOMETRIC AVERAGES
Type: CONCEPTS

28. 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.

Difficulty level: Easy


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.

Difficulty level: Medium


Topic: CAPITAL MARKET RETURNS
Type: CONCEPTS

10-30

Chapter 10 - Risk and Return: Lessons from Market History

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%

Difficulty level: Medium


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.

Difficulty level: Medium


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

Difficulty level: Medium


Topic: U.S. EQUITY RISK PREMIUM
Type: CONCEPTS

10-31

Chapter 10 - Risk and Return: Lessons from Market History

33. Which country has the lowest stock market risk premium?
A. Denmark
B. Belgium
C. Switzerland
D. Spain
E. Norway

Difficulty level: Medium


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.

Difficulty level: Medium


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

Difficulty level: Easy


Topic: DOLLAR RETURNS
Type: PROBLEMS

10-32

Chapter 10 - Risk and Return: Lessons from Market History

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

Difficulty level: Medium


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

Difficulty level: Medium


Topic: DOLLAR RETURNS
Type: PROBLEMS

10-33

Chapter 10 - Risk and Return: Lessons from Market History

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%

Difficulty level: Medium


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

Difficulty level: Medium


Topic: DIVIDEND YIELD
Type: PROBLEMS

10-34

Chapter 10 - Risk and Return: Lessons from Market History

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%

Difficulty level: Medium


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)

Difficulty level: Medium


Topic: CAPITAL GAIN
Type: PROBLEMS

10-35

Chapter 10 - Risk and Return: Lessons from Market History

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%

Difficulty level: Medium


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%

Difficulty level: Medium


Topic: CAPITAL GAIN
Type: PROBLEMS

10-36

Chapter 10 - Risk and Return: Lessons from Market History

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

Difficulty level: Medium


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)

Difficulty level: Medium


Topic: TOTAL RETURN
Type: PROBLEMS

10-37

Chapter 10 - Risk and Return: Lessons from Market History

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%

Difficulty level: Medium


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%.

Difficulty level: Challenge


Topic: RETURN DISTRIBUTIONS
Type: PROBLEMS

10-38

Chapter 10 - Risk and Return: Lessons from Market History

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%

Difficulty level: Challenge


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%.

Difficulty level: Challenge


Topic: RETURN DISTRIBUTIONS
Type: PROBLEMS

10-39

Chapter 10 - Risk and Return: Lessons from Market History

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%.

Difficulty level: Challenge


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%.

Difficulty level: Challenge


Topic: RETURN DISTRIBUTIONS
Type: PROBLEMS

10-40

Chapter 10 - Risk and Return: Lessons from Market History

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%.

Difficulty level: Challenge


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%

Difficulty level: Medium


Topic: ARITHMETIC AVERAGE
Type: PROBLEMS

10-41

Chapter 10 - Risk and Return: Lessons from Market History

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%

Difficulty level: Medium


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%

Difficulty level: Medium


Topic: GEOMETRIC AVERAGE
Type: PROBLEMS

10-42

Chapter 10 - Risk and Return: Lessons from Market History

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%

Difficulty level: Medium


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%

Difficulty level: Easy


Topic: TOTAL RETURN
Type: PROBLEMS

10-43

Chapter 10 - Risk and Return: Lessons from Market History

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

Difficulty level: Medium


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%

Difficulty level: Medium


Topic: CAPITAL GAIN RETURN
Type: PROBLEMS

10-44

Chapter 10 - Risk and Return: Lessons from Market History

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%

Difficulty level: Easy


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%

Difficulty level: Medium


Topic: HOLDING PERIOD RETURN
Type: PROBLEMS

10-45

Chapter 10 - Risk and Return: Lessons from Market History

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%

Difficulty level: Easy


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%

Difficulty level: Easy


Topic: ARITHMETIC AVERAGE RETURN
Type: PROBLEMS

10-46

Chapter 10 - Risk and Return: Lessons from Market History

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%

Difficulty level: Easy


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%

Difficulty level: Medium


Topic: RISK PREMIUM
Type: PROBLEMS

10-47

Chapter 10 - Risk and Return: Lessons from Market History

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%

Difficulty level: Medium


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%.

Difficulty level: Medium


Topic: RETURN PROBABILITIES
Type: PROBLEMS

10-48

Chapter 10 - Risk and Return: Lessons from Market History

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%

Difficulty level: Medium


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%

Difficulty level: Easy


Topic: AVERAGE RISK PREMIUM
Type: PROBLEMS

10-49

Chapter 10 - Risk and Return: Lessons from Market History

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%

Difficulty level: Easy


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

Difficulty level: Medium


Topic: ARITHMATIC AVERAGE RETURN AND VARIANCE
Type: PROBLEMS

Essay Questions

10-50

Chapter 10 - Risk and Return: Lessons from Market History

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.

Topic: HISTORICAL RETURNS


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

Chapter 10 - Risk and Return: Lessons from Market History

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.

Topic: RISK AND RETURN


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%.

Topic: HOLDING PERIOD RETURNS


Type: ESSAYS

10-52