Lesson 2: Risk and Return Flashcards
All of the following statements concerning risk are correct EXCEPT:
A) Country risk, or political risk, is the variability in a security’s returns resulting from the instability of a country’s economy or government.
B) Financial risk is associated with the use of equity as part of a company’s capital structure.
C) Market risk is the variability in a security’s returns resulting from fluctuations in the overall market.
D) Business risk is the risk associated with the industry or environment in which a business operates.
The correct answer is (B).
Options (A), (C), and (D) are true statements.
Option (B) is false because financial risk deals with debt as part of a capital structure, not equity.
Which of the following regarding average returns is (are) correct?
I. The geometric mean is equivalent to the time-weighted return.
II. The arithmetic mean is the average return for a series of returns and always will be greater than or equal to the geometric mean.
A) I only
B) II only
C) Both I and II
D) Neither I nor II
The correct answer is (C).
Both statements are correct.
Assume that the 3-month return for Hartfield stock is 3 percent. What is the annualized return for Hartfield?
A) 13.20%
B) 12.55%
C) 12.00%
D) 11.85%
The correct answer is (B).
Annualized return = (1.03)⁴ − 1 = 12.55%
Warren Buffet famously said, “You only find out who is swimming naked when the tide goes out.” The quote, in part, means that when the equity market is increasing, it hides many of the weaknesses of businesses. In this quote, what type of risk does the rising and falling tide represent?
A) Interest rate risk
B) Market risk
C) Business risk
D) Financial risk
The correct answer is (B).
The increase or decrease in the market has an impact on most companies. This risk is referred to as market risk.
Ira bought 10,000 shares of LeLe at $40 per share. Two years later, she sold the stock for $80 per share. LeLe declared and paid a special dividend of $4 per share during the period Ira held the stock. What was Ira’s holding period return (HPR)?
A) 10%
B) 55%
C) 100%
D) 110%
The correct answer is (D).
HPR = (Income received + Change in price) / Beginning Price HPR = [$4 + ($80 - $40)] / $40 HPR = [$4 + $40] / $40 HPR = $44 / $40 HPR = 110%
Nate invested in the Not-So-Good mutual fund 5 years ago. His returns were -5 percent, -8 percent, -5 percent, -6 percent, and -8 percent, respectively. What is the arithmetic average return over the 5 years?
A) -8%
B) -6.4%
C) 0%
D) 6.4%
The correct answer is (B).
Arithmetic average = (-5% - 8% - 5% - 6% - 8%) / 5 = -6.4%.
The return on a certain derivative security is usually small and positive. But, in rare cases, its returns is very large and negative. How would you describe the distribution of this return?
A) Positively skewed
B) Negatively skewed
C) Platykurtic
D) Leptokurtic
The correct answer is (B).
A distribution with a small number of extremely low observatives is said to have a negative skew.
Kevin invested $1.5 million in Fish N’ Chips, trading at a market value of $35 per share. A year later, the market value climbed to $40 per share and Kevin invested another $500,000. And, a year after that, the market value dropped to $38 per share. What was Kevin’s time-weighted return?
A) 2.92%
B) 4.20%
C) 5.84%
D) 8.57%
The correct answer is (B).
Time-weighted return can be solved using the CFj button on your calculator:
CF0 = <35>
CF1 = 0
CF2 = 38
SHIFT
IRR/YR
Your calculator will then show 4.20%.
John Enterprises (JE) has an average return of 3 percent with a standard deviation of 6 percent. Assuming the returns are normally distributed, what is the probability that JE will have a return greater than 9 percent?
A) 2.5%
B) 16%
C) 34%
D) 66%
The correct answer is (B).
Nine percent is one standard deviation to the right of the mean. Because its returns are normal, 68 percent will be between +1 and -1 standard deviations from the mean. Meanwhile, 16 percent of returns will be even greater than +1 standard deviations from the mean while another 16 percent of returns will be even less than -1 standard deviations from the mean.
Which of the following stocks would be considered the most defensive?
A) ABC has a beta of 0.5.
B) DEF has a beta of 1.0.
C) GHI has a beta of 1.5.
D) JKL has a beta of 100.
The correct answer is (A).
The beta of the market is 1.0. A stock with a beta between 0 and 1.0 will be less volatile than the market and, therefore, defensive. A stock with a beta greater than 1.0 will be more volatile than the market.
