CHAPTER 1

THE INVESTMENT SETTING

TRUE/FALSE QUESTIONS

(t) 1 The rate of exchange between certain future dollars and certain current dollars is
known as the pure rate of interest.

(t) 2 An investment is the current commitment of dollars over time to derive future
payments to compensate the investor for the time funds are committed, the
expected rate of inflation and the uncertainty of future payments.

(f) 3 The holding period return (HPR) is equal to the holding period yield (HPY) stated
as a percentage.

(f) 4 The geometric mean of a series of returns is always larger than the arithmetic mean
and the difference increases with the volatility of the series.

(f) 5 The expected return is the average of all possible returns.

(f) 6 Two measures of the risk premium are the standard deviation and the variance.

(f) 7 The variance of expected returns is equal to the square root of the expected
returns.

(f) 8 The coefficient of variation is the expected return divided by the standard deviation
of the expected return.

(f) 9 Nominal rates are averages of all possible real rates.

(f) 10 The risk premium is a function of the volatility of operating earnings, sales
volatility and inflation.

MULTIPLE CHOICE QUESTIONS

(a) 1 The basic trade-off in the investment process is
a) Between the anticipated rate of return for a given investment instrument
and its degree of risk.
b) Between understanding the nature of a particular investment and having the
opportunity to purchase it.
c) Between high returns available on single instruments and the diversification
of instruments into a portfolio.
d) between the desired level of investment and possessing the resources
necessary to carry it out.
e) None of the above.

(c) 2 The rate of exchange between future consumption and current consumption is
a) The nominal risk-free rate.
b) The coefficient of investment exchange.
c) The pure rate of interest.
d) The consumption/investment paradigm.
e) The expected rate of return.

(c) 3 The _________ the variance of returns, everything else remaining constant, the
_________the dispersion of expectations and the_________ the risk.
a) Larger, greater, lower
b) Larger, smaller, higher
c) Larger, greater, higher
d) Smaller, greater, lower
e) Smaller, greater, greater
(d) 4 The coefficient of variation is a measure of
a) Central tendency.
b) Absolute variability.
c) Absolute dispersion.
d) Relative variability.
e) Relative return.

(e) 5 The nominal risk free rate of interest is a function of

a) The real risk free rate and the investment's variance.
b) The prime rate and the rate of inflation.
c) The T-bill rate plus the inflation rate.
d) The tax free rate plus the rate of inflation.
e) The real risk free rate and the rate of inflation.

(c) 6 In the phrase "nominal risk free rate," nominal means

a) Computed.
b) Historical.
c) Market.
d) Average.
e) Risk adverse.

(c) 7 If a significant change is noted in the yield of a T-bill, the change is most likely
attributable to
a) A downturn in the economy.
b) A static economy.
c) A change in the expected rate of inflation.
d) A change in the real rate of interest.
e) A change in risk aversion.

(e) 8 The real risk-free rate is affected by a two factors;

a) The relative ease or tightness in capital markets and the expected rate of
inflation.
b) The expected rate of inflation and the set of investment opportunities
available in the economy.
c) The relative ease or tightness in capital markets and the set of investment
opportunities available in the economy.
d) Time preference for income consumption and the relative ease or tightness
in capital markets.
e) Time preference for income consumption and the set of investment
opportunities available in the economy.

(e) 9 Which of the following is not a component of the risk premium?

a) Business risk
b) Financial risk
 c) Liquidity risk
d) Exchange rate risk
e) Unsystematic market risk

(b) 10 The ability to sell an asset quickly at a fair price is associated with
a) Business risk.
b) Liquidity risk.
c) Exchange rate risk.
d) Financial risk.
e) Market risk.

(a) 11 The variability of operating earnings is associated with

a) Business risk.
b) Liquidity risk.
c) Exchange rate risk.
d) Financial risk.
e) Market risk.

(d) 12 The uncertainty of investment returns associated with how a firm finances its
investments is known as
a) Business risk.
b) Liquidity risk.
c) Exchange rate risk.
d) Financial risk.
e) Market risk.

(c) 13 What will happen to the security market line (SML) if the following events occur,
other things constant: (1) inflation expectations increase, and (2) investors become
more risk averse?
a) Shift up and keep the same slope
b) Shift up and have less slope
c) Shift up and have a steeper slope
d) Shift down and keep the same slope
e) Shift down and have less slope

(d) 14 A decrease in the market risk premium, all other things constant, will cause the
security market line to
a) Shift up
b) Shift down
c) Have a steeper slope
d) Have a flatter slope
e) Remain unchanged

(b) 15 A decrease in the expected real growth in the economy, all other things constant,
will cause the security market line to
a) Shift up
b) Shift down
c) Have a steeper slope
 d) Have a flatter slope
e) Remain unchanged

(b) 16 Unsystematic risk refers to risk that is

a) Un-diversifiable
b) Diversifiable
c) Due to fundamental risk factors
d) Due to market risk
e) None of the above

(c) 17 The security market line (SML) graphs the expected relationship between
a) Business risk and financial risk
b) Systematic risk and unsystematic risk
c) Risk and return
d) Systematic risk and unsystematic return
e) None of the above

(a) 18 Two factors that influence the nominal risk-free rate are;
a) The relative ease or tightness in capital markets and the expected rate of
inflation.
b) The expected rate of inflation and the set of investment opportunities
available in the economy.
c) The relative ease or tightness in capital markets and the set of investment
opportunities available in the economy.
d) Time preference for income consumption and the relative ease or tightness
in capital markets.
e) Time preference for income consumption and the set of investment
opportunities available in the economy.

(d) 19 Measures of risk for an investment include

a) Variance of returns and business risk
b) Coefficient of variation of returns and financial risk
c) Business risk and financial risk
d) Variance of returns and coefficient of variation of returns
e) All of the above

(c) 20 Sources of risk for an investment include

a) Variance of returns and business risk
b) Coefficient of variation of returns and financial risk
c) Business risk and financial risk
d) Variance of returns and coefficient of variation of returns
e) All of the above
 MULTIPLE CHOICE PROBLEMS

USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS

Assume you bought 100 shares of NewTech common stock on January 15, 2003 at $50.00 per
share and sold it on January 15, 2004 for $40.00 per share.

(d) 1 What was your holding period return?

a) -10%
b) -0.8
c) 25%
d) 0.8
e) -20%

(e) 2 What was your holding period yield?

a) -10%
b) -0.8
c) 25%
d) 0.8
e) -20%

USE THE FOLLOWING INFORMATION OR THE NEXT TWO PROBLEMS

Suppose you bought a GM corporate bond on January 25, 2001 for $750, on January 25, 2004
sold it for $650.00.

(d) 3 What was your annual holding period return?

a) 0.8667
b) -0.1333
c) 0.0333
d) 0.9534
e) -0.0466

(a) 4 What was your annual holding period yield?

a) -0.0466
b) -0.1333
c) 0.0333
d) 0.3534
e) 0.8667

USE THE FOLLOWING INFORMATION FOR THE NEXT FOUR PROBLEMS

The common stock of XMen Inc. had the following historic prices.
 Time Price of X-Tech
3/01/1999 50.00
3/01/2000 47.00
3/01/2001 76.00
3/01/2002 80.00
3/01/2003 85.00
3/01/2004 90.00

(b) 5 What was your holding period return for the time period 3/1/1999 to 3/1/2004?
a) 0.1247
b) 1.8
c) 0.1462
d) 0.40
e) 0.25

(b) 6 What was your annual holding period yield (Annual HPY)?
a) 0.1462
b) 0.1247
c) 1.8
d) 0.40
e) 0.25

(a) 7 What was your arithmetic mean annual yield for the investment in XMen
Industries.
a) 0.1462
b) 0.1247
c) 1.8
d) 0.40
e) 0.25

(d) 8 What was your geometric mean annual yield for the investment in XMen?
a) 0.25
b) 0.40
c) 1.8
d) 0.1247
e) 0.1462

USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS

You have concluded that next year the following relationships are possible:

Economic Status Probability Rate of Return

Weak Economy .15 -5%
Static Economy .60 5%
 Strong Economy .25 15%

(b) 9 What is your expected rate of return [E(Ri)] for next year?
a) 4.25%
b) 6.00%
c) 6.25%
d) 7.75%
e) 8.00%

(d) 10 Compute the standard deviation of the rate of return for the one year period.
a) 0.65%
b) 1.45%
c) 4.0%
d) 6.25%
e) 6.4%

(e) 11 Compute the coefficient of variation for your portfolio.

a) 0.043
b) 0.12
c) 1.40
d) 0.69
e) 1.04
 USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS

Assume that during the past year the consumer price index increased by 1.5 percent and the
securities listed below returned the following nominal rates of return.

U.S. Government T-bills 2.75%

U.S. Long-term bonds 4.75%

(d) 12 What are the real rates of return for each of these securities?
a) 4.29% and 6.32%
b) 1.23% and 4.29%
c) 3.20% and 6.32%
d) 1.23% and 3.20%
e) 3.75% and 5.75%

(c) 13 If next year the real rates all rise by 10 percent while inflation climbs from 1.5
percent to 2.5 percent, what will be the nominal rate of return on each security?
a) 1.24% and 1.52%
b) 1.35% and 3.52%
c) 3.89% and 6.11%
d) 3.52% and 3.89%
e) 1.17% and 6.11%

(c) 14 If over the past 20 years the annual returns on the S&P 500 market index averaged
12% with a standard deviation of 18%, what was the coefficient of variation?
a) 0.6
b) 0.6%
c) 1.5
d) 1.5%
e) 0.66%

(d) 15 Given investments A and B with the following risk return characteristics, which
one would you prefer and why?
Standard Deviation
Investment Expected Return of Expected Returns
A 12.2% 7%
B 8.8% 5%

a) Investment A because it has the highest expected return.

b) Investment A because it has the lowest relative risk.
c) Investment B because it has the lowest absolute risk.
d) Investment B because it has the lowest coefficient of variation.
e) Investment A because it has the highest coefficient of variation.

USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS

You are provided with the following information

 Nominal return on risk-free asset = 4.5%
Expected return for asset i = 12.75%
Expected return on the market portfolio = 9.25%

(b) 16 Calculate the risk premium for asset i

a) 4.5%
b) 8.25%
c) 4.75%
d) 3.5%
e) None of the above

(c) 17 Calculate the risk premium for the market portfolio

a) 4.5%
b) 8.25%
c) 4.75%
d) 3.5%
e) None of the above

USE THE FOLLOWING INFORMATION FOR THE NEXT FOUR PROBLEMS

Consider the following information

Nominal annual return on U.S. government T-bills for year 2000 = 3.5%
Nominal annual return on U.S government long-term bonds for year 2000 = 4.75%
Nominal annual return on U.S. large-cap stocks for year 2000= 8.75%
Consumer price index January 1, 2000 = 165
Consumer price index December 31, 2000 = 169

(a) 18 Compute the rate of inflation for the year 2000

a) 2.42%
b) 4.0%
c) 1.69%
d) 1.24%
e) None of the above

(d) 19 Calculate the real rate of return for U.S. T-bills

a) 2.26%
b) 1.81%
c) 0.5%
d) 1.05%
e) None of the above

(b) 20 Calculate the real rate of return for U.S. long-term bonds
a) 3.06%
b) 2.27%
c) 2.51%
d) 3.5%
 e) None of the above

(b) 21 Calculate the real rate of return for U.S. large-cap stocks
a) 7.06%
b) 6.18%
c) 4.75%
d) 3.75%
e) None of the above

USE THE FOLLOWING INFORMATION FOR THE NEXT FOUR PROBLEMS

Assume that you hold a two stock portfolio. You are provided with the following information on
your holdings

Stock Shares Price(t) Price(t+1)

1 15 10 12
2 25 15 16

(b) 22 Calculate the HPY for stock 1

a) 10%
b) 20%
c) 15%
d) 12%
e) 7%

(c) 23 Calculate the HPY for stock 2

a) 5%
b) 6%
c) 7%
d) 8%
e) 10%

(d) 24 Calculate the market weights for stock 1 and 2 based on period t values
a) 39% for stock 1 and 61% for stock 2
b) 50% for stock 1 and 50% for stock 2
c) 71% for stock 1 and 29% for stock 2
d) 29% for stock 1 and 71% for stock 2
e) None of the above

(a) 25 Calculate the HPY for the portfolio

a) 10.6%
b) 6.95%
c) 13.5%
d) 10%
e) 15.7%
 CHAPTER 1

ANSWERS TO PROBLEMS

1 HPR = Ending Value / Beginning Value = 40/50 = 0.8

2 HPY = HPR - 1 = (40/50) 1 = 0.8 - 1 = -0.2 = -20%

3 HPR = Ending Value/Beginning Value = $650.00/$750 = 0.8667

Annual HPR = (HPR)1/n = (0.8667)1/3 = 0.9534

4 HPR = Ending Value/Beginning Value = $650.00/$750 = 0.8667

Annual HPR = (HPR)1/n = (0.8667)1/3 = 0.9534

Annual HPY = Annual HPR - 1 = 0.9534 - 1 = -0.0466 = -4.66%

5 HPR = Ending Value/Beginning Value = 90/50 = 1.8

6 Annual HPR = (HPR)1/n = (1.8)1/5 = 1.1247

Annual HPY = Annual HPR - 1 = 1.1247 - 1 = 0.1247 = 12.47%

Time Price of X-Tech Return HPR

3/01/1999 50
3/01/2000 47 -0.0600 0.9400
3/01/2001 76 0.6170 1.6170
3/01/2002 80 0.0526 1.0526
3/01/2003 85 0.0625 1.0625
3/01/2004 90 0.0588 1.0588

7 Arithmetic Mean =

N
1 - 0.06 + 0.617 + 0.0526 + 0.0625 + 0.588
N
HPY
t 1
t =
5
= 0.1462

N
Geometric Mean ( HPRt )
1/ N
8 -1
t 1

(0.94)(1.617)(1.0526)(1.0625)(1.0588)
1/ 5
1
1.1247 - 1 = 0.1247 = 12.47%

9 E(Ri) = (0.15)(- 5) + (0.60)(5) + (0.25)(15) = 6%

10 = [(0.15)(-5 - 6)2 + (0.60)(5 - 6)2 + (0.25)(15 - 6)2]1/2 = 6.25%

11 CV = Standard Deviation of Returns/Expected Rate of Return

= 6.25/6 = 1.04

12 Real rate on T-bills = (1.0275 / 1.015) - 1 = 0.0123 = 1.23%

Real rate on bonds = (1.0475 /1.015) - 1 = 0.032 = 3.2%

13 The computations for the new real rates are:

Real rate on T-bills = 1.23 x 1.10 = 1.353%

Real rate on bonds = 3.2 x 1.10 = 3.52%
Nominal rate on T-bills = (1.01353)(1.025) - 1 = .03886 = 3.89%
Nominal rate on corporate bonds = (1.0352)(1.025) - 1 = .06108 = 6.11%

14 Coefficient of Variation = Standard Deviation of Returns/Expected Rate of Return

= 18% / 12% = 1.5

15 Coefficient of Variation = Standard Deviation of Returns/Expected Rate of

Return

CVA = 7% / 12.2% = 0.573

CVB = 5% / 8.8% = 0.568

Investment B has the lowest coefficient of variation and would be preferred.

16. Risk premium for asset i = 12.75 4.5 = 8.25%

17. Risk premium market portfolio = 9.25 4.5 = 4.75%

18. Rate of inflation = (169/165) 1 = .0242 = 2.42%

19. Real return on U.S. T-bills = (1.035/1.0242) 1 = .0105 = 1.05%

20. Real return on U.S. bonds = (1.0475/1.0242) 1 = .0227 = 2.27%

21. Real return on U.S. stocks = (1.0875/1.0242) 1 = .0618 = 6.18%

The table provided below can be used to obtain answers for 22 to 25.

Weighted
Stock Shares Price(t) MV(t) Price(t+1) MV(t+1) HPR HPY Weight HPY
1 15 10 150 12 180 1.2 0.2 0.29 0.058
2 25 15 375 16 400 1.07 0.07 0.71 0.048
525 580 0.106
22. HPY for stock 1 = (180/150) 1 = .2 = 20%

23. HPY for stock 2 = (400/375) 1 = .07 = 7%

24. Market weight for stock 1 = 150/525 = .29 = 29%

Market weight for stock 2 = 375/525 = .71 = 71%

25. Portfolio HPY = .29(.20) + .71(.07) = .106 = 10.6%

 CHAPTER 1 - APPENDIX

MULTIPLE CHOICE PROBLEMS

USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS

Your expectations from a one year investment in Wang Computers is as follows:

Probability Rate of Return

.15 -.10
.15 -.20
.35 .00
.25 .15
.10 .15

(d) 1A The expected return from this investment is

a) -0.0752
b) -0.0040
c) 0.00
d) 0.0075
e) 0.4545

(c) 2A The standard deviation of your expected return from this investment is
a) 0.001
b) 0.004
c) 0.124
d) 1.240
e) None of the above

(d) 3A The coefficient of variation of this investment is

a) -0.06
b) -0.65
c) 6.60
d) 16.53
e) 165.10
 CHAPTER 1 - APPENDIX

ANSWERS TO PROBLEMS

1A E(R) = (-0.10)(0.15) + (-0.20)(0.15) + (0.00)(0.35) + (0.15)(0.25) + (0.15)(0.10)

= 0.0075

2A 2 = (0.15)(-0.1-0.0075)2 + (0.15)(-0.2-0.0075)2 + (0.35)(.00-0.0075)2 +

(0.25)(0.15-0.0075) 2 + (0.10)(0.15 - 0.0075)2
= 0.015319

= 0.0153191/2 = 0.124

3A The coefficient of variation (CV) equals 0.124 / 0.0075 = 16.53