5.2 Financial Risk and Return Flashcards
The risk of loss because of fluctuations in the relative value of foreign currencies is called
A. Expropriation risk.
B. Multinational beta.
C. Exchange rate risk.
D. Undiversifiable risk.
C. Exchange rate risk.
When amounts to be paid or received are denominated in a foreign currency, exchange rate fluctuations may result in exchange gains or losses. For example, if a U.S. firm has a receivable fixed in terms of units of a foreign currency, a decline in the value of that currency relative to the U.S. dollar results in a foreign exchange loss.
The type of risk that is not diversifiable and affects the value of a portfolio is
A. Purchasing-power risk.
B. Market risk.
C. Nonmarket risk.
D. Interest-rate risk.
B. Market risk.
Prices of all stocks, even the value of portfolios, are correlated to some degree with broad swings in the stock market. Market risk is the risk that changes in a stock’s price will result from changes in the stock market as a whole. Market risk is commonly referred to as nondiversifiable risk.
The marketable securities with the least amount of default risk are
A. Federal government agency securities.
B. U.S. Treasury securities.
C. Repurchase agreements.
D. Commercial paper.
B. U.S. Treasury securities.
The marketable securities with the lowest default risk are those issued by the federal government because they are backed by the full faith and credit of the U.S. government and are therefore the least risky form of investment.
Which of the following classes of securities are listed in order from lowest risk/opportunity for return to highest risk/opportunity for return?
A. U.S. Treasury bonds; corporate first mortgage bonds; corporate income bonds; preferred stock.
B. Corporate income bonds; corporate mortgage bonds; convertible preferred stock; subordinated debentures.
C. Common stock; corporate first mortgage bonds; corporate second mortgage bonds; corporate income bonds.
D. Preferred stock; common stock; corporate mortgage bonds; corporate debentures.
A. U.S. Treasury bonds; corporate first mortgage bonds; corporate income bonds; preferred stock.
The general principle is that risk and return are directly correlated. U.S. Treasury securities are backed by the full faith and credit of the federal government and are therefore the least risky form of investment. However, their return is correspondingly lower. Corporate first mortgage bonds are less risky than income bonds or stock because they are secured by specific property. In case of default, bondholders can have the property sold to satisfy their claims. Holders of first mortgages have rights paramount to those of any other parties, such as holders of second mortgages. Income bonds pay interest only in the event the corporation earns income. Thus, holders of income bonds have less risk than shareholders because meeting the condition makes payment of interest mandatory. Preferred shareholders receive dividends only if they are declared, and the directors usually have complete discretion in this matter. Also, shareholders have claims junior to those of debtholders if the enterprise is liquidated.
Systematic risk explains why
A. Stock values move in different directions.
B. Diversification increases overall risk.
C. Diversification reduces overall risk.
D. Stock values tend to move in the same direction.
D. Stock values tend to move in the same direction.
Systematic risk, also called market risk, is the risk faced by all firms. Changes in the economy as a whole, such as the business cycle, affect all players in the market. Since all firms are affected by systematic risk, all of their stock values move somewhat in the same direction.
Risk factors that cannot be eliminated through diversification include which of the following?
I. Interest-rate fluctuations
II. General price-level changes
III. New product development
IV. Management turnover
A. I, II, and III only.
B. II, III, and IV only.
C. I and II only.
D. I, II, III, and IV.
C. I and II only.
Unsystematic risk is sometimes referred to as diversifiable risk. Since individual securities are affected differently by economic conditions, this risk can be offset through portfolio diversification. Interest-rate fluctuations and general price-level changes are both examples of systematic risk and cannot be eliminated through diversification.
How is return on investment calculated?
Return on investment = Amount received – Amount invested
How is rate of return calculated?
Rate of return = Return on investment ÷ Amount invested
A stock began the year with a stock price of $60 per share. In the middle of the year, it had a 3-for-2 stock split. The stock ended the year with a price of $50 per share. No dividends were paid. What total return did investors earn on the stock during this year?
A. 30%
B. -20%
C. 25%
D. 15%
C. 25%
The 3-for-2 stock split would revalue the beginning of the year stock price. There are now three shares at x stock price for every two at $60:
3x = 2 × $60
3x =$120
x = $40
The stock appreciated $10 to $50 by year end. Therefore, the return was 25% ($10 increase ÷ $40 beginning of year stock price).
When purchasing temporary investments, which one of the following best describes the risk associated with the ability to sell the investment in a short period of time without significant price concessions?
A. Interest-rate risk.
B. Purchasing-power risk.
C. Financial risk.
D. Liquidity risk.
D. Liquidity risk.
Liquidity risk is the possibility that an asset cannot be sold on short notice for its market value. If an asset must be sold at a high discount, it is said to have a substantial amount of liquidity risk.
The following information pertains to Bala Co. for the year ended December 31:
Sales $600,000
Income 100,000
Capital investment 400,000
Which of the following equations should be used to compute Bala’s return on investment?
A. (4/6) x (1/6) = ROI
B. (6/4) x (1/6) = ROI
C. (4/6) x (6/1) = ROI
D. (6/4) x (6/1) = ROI
B. (6/4) x (1/6) = ROI
ROI equals capital turnover (sales/investment) times the profit margin (income/sales). Thus, Bala’s ROI can be represented by [($600,000 / $400,000) x ($100,000 / $600,000)].
The following information pertains to Andrew Co. for the year ended December 31:
Sales $720,000
Operating income 120,000
Average capital investment 480,000
Which one of the following formulas generates Andrew’s return on investment?
A. (480,000 / 720,000) x (120,000 / 720,000)
B. (720,000 / 480,000) x (120,000 / 720,000)
C. (480,000 / 720,000) x (720,000 / 120,000)
D. (720,000 / 480,000) x (720,000 / 120,000)
B. (720,000 / 480,000) x (120,000 / 720,000)
ROI equals capital turnover (sales divided by investment) times the operating profit margin (operating income dividend by sales). Therefore, Andrew’s ROI is 25% [($720,000 / 480,000) x (120,000 / 720,000)].
A U.S. company currently has domestic operations only. It is considering an equal-size investment in either Canada or Britain. The data on expected rate of return and the risk associated with each of these proposed investments are given below.
Proposed Investment
British Investment
* Expected Rate of Return 22%
* Standard Deviation 10%
Canadian Investment
* Expected Rate of Return 28%
* Standard Deviation 15%
The expected rate of return on the company’s current, domestic only, business is 20% with a standard deviation of 15%. Using the above data and the correlation coefficients, the company calculated the following portfolio risk and return (based on a ratio of 50% U.S. domestic operations and 50% international operations).
Proposed Investment
U.S. and Britain
* Expected Rate of Return 21%
* Standard Deviation 3%
U.S. and Canada
* Expected Rate of Return 24%
* Standard Deviation 15%
The company plans to select the optimal combination of countries based on risk and return for the domestic and international investments taken together. Because the company is new to the international business environment, it is relatively risk averse. Based on the above data, which one of the following alternatives provides the best risk-adjusted return to the firm?
A. Do not undertake either investment.
B. Unable to determine based on data given.
C. Undertake the British investment.
D. Undertake the Canadian investment.
C. Undertake the British investment.
A risk-averse company will select the investment with the lesser risk. Thus, by choosing to invest in Britain, the overall rate of return will increase from 20% to 21%, and risk, based on the standard deviation, will decline from 15% to 3%. This gives a better return per unit of risk as compared to the Canadian investment.
