CorporateFinance:TheCore(Berk/DeMarzo)

Chapter10-CapitalMarketsandthePricingofRisk

10.1AFirstLookatRiskandReturn

1)Whichofthefollowinginvestmentsofferedthehighestoverallreturnoverthepasteightyyears?
A)TreasuryBills
B)S&P500
C)Smallstocks
D)CorporateBonds
Answer:C
Explanation: A)
B)
C)
D)
Diff:1
Topic:10.1AFirstLookatRiskandReturn
Skill:Definition

2)Whichofthefollowinginvestmentshadthelargestfluctuationsoverallreturnoverthepasteightyyears?
A)Smallstocks
B)S&P500
C)CorporateBonds
D)TreasuryBills
Answer:A
Explanation: A)
B)
C)
D)
Diff:1
Topic:10.1AFirstLookatRiskandReturn
Skill:Definition

10.2CommonMeasuresofRiskandReturn
3)Whichofthefollowingstatementsisfalse?
A)Thevarianceincreaseswiththemagnitudeofthedeviationsfromthemean.
B)Thevarianceistheexpectedsquareddeviationfromthemean.
C)Twocommonmeasuresoftheriskofaprobabilitydistributionareitsvarianceandstandarddeviation.
D)Ifthereturnisrisklessandneverdeviatesfromitsmean,thevarianceisequaltoone.
Answer:D
Explanation: A)
B)
C)
D)Ifthereturnisrisklessandneverdeviatesfromitsmean,thevarianceisequaltozero.
Diff:1
Topic:10.2CommonMeasuresofRiskandReturn
Skill:Conceptual


4)Whichofthefollowingequationsisincorrect?
A)Var(R)= SD( R)

R PR ( R E [ R])2
C)Var(R)=
R PR ( R E [ R ])2
D)E[R]= R PR R
B)SD(R)=

Answer:A
Explanation: A)SD(R)=

Var ( R )

B)
C)
D)
Diff:2
Topic:10.2CommonMeasuresofRiskandReturn
Skill:Conceptual

Usethetableforthequestion(s)below.

ConsiderthefollowingprobabilitydistributionofreturnsforAlphaCorporation:
CurrentStock StockPricein
Price($)
OneYear($)
$35
$25
$25
$20

ReturnR
40%
0%
-20%

Probability
PR
25%
50%
25%

5)ThestandarddeviationofthereturnonAlphaCorporationisclosestto:
A)22.4%
B)19.0%
C)21.8%
D)19.4%
Answer:C
Explanation: A)
B)
C)E[R]=
R PR R =.25(40%)+.50(0%)+.25(-20%)=5%

Var(R)= R PR ( R E [ R ]) 2 =.25(.40-.05)2+.50(.00-.05)2+.25(-20-.05)2=.0475or
4.75%

SD(R)= Var ( R ) = .0475 =.2179or21.79%

D)
Diff:3
Topic:10.2CommonMeasuresofRiskandReturn
Skill:Analytical


10.3HistoricalReturnsofStocksandBonds

6)Whichofthefollowingstatementsisfalse?
A)Thestandarderrorprovidesanindicationofhowfarthesampleaveragemightdeviatefromthe
expectedreturn.
B)The95%confidenceintervalfortheexpectedreturnisdefinedastheHistoricalAverageReturnplusor
minusthreestandarderrors.
C)Wecanuseasecurityshistoricalaveragereturntoestimateitsactualexpectedreturn.
D)Thestandarderroristhestandarddeviationoftheaveragereturn.
Answer:B
Explanation: A)
B)The95%confidenceintervalfortheexpectedreturnisdefinedastheHistoricalAverage
Returnplusorminustwostandarderrors.
C)
D)
Diff:2
Topic:10.3HistoricalReturnsofStocksandBonds
Skill:Conceptual

7)Ifastockpaysdividendsattheendofeachquarter,withrealizedreturnsofR1,R2,R3,andR4eachquarter,
thentheannualrealizedreturniscalculatedas
A)
Rannual=
B)Rannual=(1+R1)(1+R2)(1+R3)(1+R4)
C)Rannual=(1+R1)(1+R2)(1+R3)(1+R4)-1
D)Rannual=R1+R2+R3+R4
Answer:C
Explanation: A)
B)
C)
D)
Diff:2
Topic:10.3HistoricalReturnsofStocksandBonds
Skill:Analytical

Usethetableforthequestion(s)below.

ConsiderthefollowingPriceandDividenddataforFordMotorCompany:
Date
December31,2004
January26,2005
April28,2005
July29,2005
October28,2005
December30,2005

Price($)
$14.64
$13.35
$9.14
$10.74
$8.02
$7.72

Dividend($)
$0.10
$0.10
$0.10
$0.10

8)AssumethatyoupurchasedFordMotorCompanystockattheclosingpriceonDecember31,2004andsold
itattheclosingpriceonDecember30,2005.Yourrealizedannualreturnisfortheyear2005isclosestto:
A)-45.1%
B)-44.5%
C)-48.5%
D)-47.3%
Answer:A
Price($)
Dividend($)
Return (1+ return)
Explanation: A)Date
December31,2004
January26,2005
April28,2005
July29,2005
October28,2005
December30,2005

$14.64
$13.35
$9.14
$10.74
$8.02
$7.72

$0.10
$0.10
$0.10
$0.10

TheProductof
(1+returns)-1=

-8.13%
-30.79%
18.60%
-24.39%
-3.74%

1
0.918716
0.692135
1.185996
0.756052
0.962594

1
0.918716
0.635875
0.754145
0.570173
0.548845

-0.45116

Thelastcolumninthetablecontainsthecummulativeproductof(1+returns)
B)
C)
D)
Diff:3
Topic:10.3HistoricalReturnsofStocksandBonds
Skill:Analytical

Usethetableforthequestion(s)below.

Considerthefollowingrealizedannualreturns:
S&P500
Realized
Return
23.6%
24.7%
30.5%
9.0%
-2.0%
-17.3%
-24.3%
32.2%
4.4%
7.4%

IBM
Realized
Return
46.3%
26.7%
86.9%
23.1%
0.2%
-3.2%
-27.0%
27.9%
-5.1%
-11.3%

YearEnd
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005

9)ThevarianceofthereturnsontheS&P500from1996to2005isclosestto:
A).0450
B).3400
C).1935
D).0375
Answer:D
Explanation: A)
B)
C)
R + R2 + ... + RN
R + R2 + ... + R10
D)
0.878
Rannual= 1
= 1
=
=8.8%
10
N
10
S&P500
Realized
YearEnd Return
(R-R)
1996
23.6%
14.78%
1997
24.7%
15.88%
1998
30.5%
21.68%
1999
9.0%
0.18%
2000
-2.0%
-10.82%
2001
-17.3%
-26.12%
2002
-24.3%
-33.12%
2003
32.2%
23.38%
2004
4.4%
-4.42%
2005
7.4%
-1.42%

(R-R)2
0.0218448
0.0252174
0.0470022
3.24E-06
0.0117072
0.0682254
0.1096934
0.0546624
0.0019536
0.0002016

Variance=SUMof(R-R)2/T-1=0.3405116/9=0.0378346
Diff:2
Topic:10.3HistoricalReturnsofStocksandBonds
Skill:Analytical

WS1)Supposethatyouwanttousethe10yearhistoricalaveragereturnontheS&P500toforecasttheexpected
futurereturnontheS&P500.The95%confidenceintervalforyourestimateoftheexpectreturnisclosestto:
A)-10.6%to28.2%
B)6.8%to10.7%
C)-37.0%to47.6%
D)4.9%to12.7%
Answer:D
Explanation: A)
B)
C)
R + R2 + ... + RN
D)
0.878
Rannual= 1
=
=8.8%
10
N
S&P500
Realized
YearEnd
Return
(R-R)
(R-R)2
1996
23.6%
14.78%
0.0218448
1997
24.7%
15.88%
0.0252174
1998
30.5%
21.68%
0.0470022
1999
9.0%
0.18%
3.24E-06
2000
-2.0%
-10.82% 0.0117072
2001
-17.3%
-26.12% 0.0682254
2002
-24.3%
-33.12% 0.1096934
2003
32.2%
23.38%
0.0546624
2004
4.4%
-4.42%
0.0019536
2005
7.4%
-1.42%
0.0002016
Variance=SUMof(R-R)2/T-1=0.3405116/9=0.0378346
Standarddeviation= Variance = 0.0378346 =0.1945112
Standarderror=StandardDeviation/T=0.1945112/10=.01945or1.95%
95%ConfidenceInterval=meanreturn+or-2standarderrors,so
lowerbound=.0878-2.0195=0.0488
upperbound=.0878+2.0195=.1268
Diff:3
Topic:10.3HistoricalReturnsofStocksandBonds
Skill:Analytical

10)Supposethatyouwanttousethe10yearhistoricalaveragereturnonIBMtoforecasttheexpectedfuture
returnonIBM.The95%confidenceintervalforyourestimateoftheexpectreturnisclosestto:
A)13.2%to19.5%
B)10.1%to22.7%
C)6.5%to26.3%
D)-15.1%to47.8%
Answer:B
Explanation: A)
R + R2 + ... + RN
B)
1.638
Rannual= 1
=
=16.45%
10
N

IBM
Realized
YearEnd
Return
(R-R)
(R-R)2
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005

46.3%
26.7%
86.9%
23.1%
0.2%
-3.2%
-27.0%
27.9%
-5.1%
-11.3%

29.85%
10.25%
70.45%
6.65%
-16.25%
-19.65%
-43.45%
11.45%
-21.55%
-27.75%

0.0891023
0.0105063
0.4963203
0.0044223
0.0264063
0.0386123
0.1887903
0.0131103
0.0464403
0.0770063

Variance=SUMof(R-R)2/T-1=0.9907165/9=0.1100796
Standarddeviation= Variance = 0.1100796 =0.3317825
Standarderror=StandardDeviation/T=0.3317825/10=.03318or3.32%
95%ConfidenceInterval=meanreturn+or-2standarderrors,so
lowerbound=.1638-2.0332=.101
upperbound=.1638+2.0332=.227
C)
D)
Diff:3
Topic:10.3HistoricalReturnsofStocksandBonds
Skill:Analytical

11)ThegeometricaverageannualreturnontheS&P500from1996to2005isclosestto:
A)9.75%
B)8.75%
C)7.10%
D)8.35%
Answer:C
Explanation: A)
B)
C)GeometricAverage= T (1 + R1 )(1 + R2 )....(1 + RT ) -1
=
D)

10

1.986857 -1=1.071067-1=0.071067

Diff:3
Topic:10.3HistoricalReturnsofStocksandBonds
Skill:Analytical

Usethetableforthequestion(s)below.

ConsiderthefollowingPriceandDividenddataforGeneralMotors:
Date
Price($)
Dividend($)
December31,2004
$40.06
February9,2005
$36.80
$0.50
May7,2005
$30.41
$0.50
August10,2005
$34.86
$0.50
November8,2005
$25.86
$0.50
December30,2005
$18.86

12)AssumethatyoupurchasedGeneralMotorsstockattheclosingpriceonDecember31,2004andsolditatthe
closingpriceonDecember30,2005.Calculateyourrealizedannualreturnisfortheyear2005.

Answer:Date
Price($) Dividend($)
Return
(1+ return)
December31,2004
$40.06
0.00%
1
1
January26,2005
$36.80
$0.50
-6.89%
0.931103
0.931103
April28,2005
$30.41
$0.50
-16.01%
0.839946
0.782076
July29,2005
$34.86
$0.50
16.28%
1.162775
0.909379
October28,2005
$25.86
$0.50
-24.38%
0.756168
0.687643
December30,2005
$18.86
-27.07%
0.729312
0.501506
TheProductof(1+returns)-1=-0.49849
Thelastcolumninthetablecontainsthecummulativeproductof(1+returns)
Diff:3
Topic:10.3HistoricalReturnsofStocksandBonds
Skill:Analytical

Usethetableforthequestion(s)below.
Considerthefollowingrealizedannualreturns:

Market Microsoft
Realized Realized
YearEnd
Return
Return
1996
21.2%
88.3%
1997
30.3%
56.4%
1998
22.3%
114.6%
1999
25.3%
68.4%
2000
-11.0%
-62.8%
2001
-11.3%
52.7%
2002
-20.8%
-22.0%
2003
33.1%
6.9%
2004
13.0%
9.2%
2005
7.3%
-0.9%

WS2)Supposethatyouwanttousethe10yearhistoricalaveragereturnontheMarkettoforecasttheexpected
futurereturnontheS&P500.Calculatethe95%confidenceintervalforyourestimateoftheexpectreturn.
R + R2 + ... + RN 1.093
Answer:
Rannual= 1
=
=10.93%
10
N
Market
Realized
YearEnd
Return
(R-R)
(R-R)2
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005

21.2%
30.3%
22.3%
25.3%
-11.0%
-11.3%
-20.8%
33.1%
13.0%
7.3%

10.23%
19.40%
11.35%
14.32%
-21.98%
-22.20%
-31.78%
22.21%
2.07%
-3.63%

0.0104625
0.03763
0.0128899
0.0205182
0.0483043
0.0492984
0.1009717
0.0493349
0.0004274
0.0013148

Variance=SUMof(R-R)2/T-1=0.3311521/9=0.0367947
Standarddeviation= Variance = 0.0367947 =0.1918194
Standarderror=StandardDeviation/T=0.1918194/10=.01918or1.92%
95%ConfidenceInterval=meanreturn+or-2standarderrors,so
lowerbound=.1093-2.0192=.0709or7.09%
upperbound=.1093+2.0192=.1477or14.77%
Diff:3
Topic:10.3HistoricalReturnsofStocksandBonds
Skill:Analytical

13)Supposethatyouwanttousethe10yearhistoricalaveragereturnonMicrosofttoforecasttheexpected
futurereturnonMicrosoft.Calculatethe95%confidenceintervalforyourestimateoftheexpectreturn.
R + R2 + ... + RN
Answer:
3.11
Rannual= 1
=
=31.1%
10
N

YearEnd
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005

Microsoft
Realized
Return
88.3%
56.4%
114.6%
68.4%
-62.8%
52.7%
-22.0%
6.9%
9.2%
-0.9%

(R-R)
57.24%
25.36%
83.53%
37.29%
-93.92%
21.66%
-53.04%
-24.19%
-21.92%
-32.02%

(R-R)2
0.3276925
0.0642878
0.6977065
0.1390502
0.8821468
0.0469291
0.281292
0.058501
0.0480275
0.1025221

Variance=SUMof(R-R)2/T-1=2.6481554/9=0.2942395
Standarddeviation= Variance = 0.2942395 =0.5424385
Standarderror=StandardDeviation/T=0.5424385/10=.0542or5.42%
95%ConfidenceInterval=meanreturn+or-2standarderrors,so
lowerbound=.311-2.0542=.2026or20.26%
upperbound=.311+2.0542=.4194or41.94%
Diff:3
Topic:10.3HistoricalReturnsofStocksandBonds
Skill:Analytical

10.4TheHistoricalTradeoffBetweenRiskandReturn
Usethetableforthequestion(s)below.
Considerthefollowingaverageannualreturns:
Investment
AverageReturn
SmallStocks
23.2%
S&P500
13.2%
CorporateBonds
7.5%
TreasuryBonds
6.2%
TreasuryBills
4.8%

14)Whatistheexcessreturnfortheportfolioofsmallstocks?
A)10.0%
B)15.7%
C)18.4%
D)17.0%
Answer:C
Explanation: A)
B)
C)
AverageReturn- Tbill
Investment
AverageReturn
Return
SmallStocks
23.2%
18.40%
S&P500
13.2%
8.40%
CorporateBonds
7.5%
2.70%
TreasuryBonds
6.2%
1.40%
TreasuryBills
4.8%
0.0%
D)
Diff:1
Topic:10.4TheHistoricalTradeoffBetweenRiskandReturn
Skill:Analytical

Usetheinformationforthequestion(s)below.

BigCureandLittleCurearebothpharmaceuticalcompanies.BigCurepresentlyhasapotentialblockbusterdrug
beforetheFoodandDrugAdministration(FDA)waitingforapproval.Ifapproved,BigCuresblockbusterdrugwill
produce$1billioninnetincomeforBigCure.LittleCurehas10separatelessimportantdrugsbeforetheFDAwaitingfor
approval.Ifapproved,eachofLittleCuresdrugswouldproduce$100millioninnetincomeforLittleCure.The
probabilityoftheFDAapprovingadrugis50%.

15)WhatisthestandarddeviationofBigCuresaveragenetincomefortheirnewblockbusterdrug?
A)$0
B)$1billion
C)$100million
D)$500million
Answer:D
Explanation: A)
B)
C)
D)expectedpayoff=probofpayoffamountifsuccessful
=.5$1billion=$500million
Standarddeviation=

=500million

Diff:2
Topic:10.5CommonVersusIndependentRisk
Skill:Analytical

16)ThestandarddeviationofLittleCuresaveragenetincomefortheirtennewdrugsisclosestto:
A)$50million
B)$25million
C)$16million
D)$500million
Answer:C
Explanation: A)
B)
C)expectedpayoff=probofpayoffamountifsuccessful
=.5$1billion=$500million
Standarddeviationforonedrug=
=50million
Standarddeviation(alldrugs)=SD(onedrug)/ number of drugs =50/ 10 =15.81million
D)
Diff:2
Topic:10.5CommonVersusIndependentRisk
Skill:Analytical

10.6DiversificationinStockPortfolios
17)Whichofthefollowingisnotadiversifiablerisk?
A)Theriskthatoilpricesrise,increasingproductioncosts
B)Theriskofaproductliabilitylawsuit
C)TheriskthattheCEOiskilledinaplanecrash
D)Theriskofakeyemployeebeinghiredawaybyacompetitor
Answer:A
Explanation: A)
B)
C)
D)
Diff:1
Topic:10.6DiversificationinStockPortfolios
Skill:Conceptual

10.7EstimatingtheExpectedReturn

18)SupposethatLuthersBetais0.9.Ifthemarketriskpremiumis8%andtherisk-freeinterestrateis4%,then
thenexpectedreturnforLutherstockis?
A)7.6%
B)11.6%
C)11.2%
D)12.9%
Answer:C
Explanation: A)
B)
C)E[R]=Rf+BetaRiskPremium=.04+.9.08=.112
D)
Diff:1
Topic:10.7EstimatingtheExpectedReturn
Skill:Analytical

Usetheinformationforthequestion(s)below.

Supposethatinthecomingyear,youexpectExxon-Mobilsticktohaveavolatilityof42%andabetaof0.9,andMercks
stocktohaveavolatilityof24%andabetaof1.1.Theriskfreeinterestrateis4%andthemarketsexpectedreturnis12%.

19)Whichstockhasthehighesttotalrisk?
A)Mercksinceithasalowervolatility
B)MercksinceithasahigherBeta
C)Exxon-Mobilsinceithasahighervolatility
D)Exxon-Mobilsinceithasalowerbeta
Answer:C
Explanation: A)
B)
C)
D)
Diff:1
Topic:10.8RiskandtheCostofCapital
Skill:Conceptual

20)ThecostofcapitalforaprojectwiththesamebetaasExxonMobilsstockisclosestto:
A)11.6%
B)11.2%
C)12.8%
D)7.6%
Answer:B
Explanation: A)
B)E[R]=Rf+BetaRiskPremium=.04+.9(.12-.04)=.112
C)
D)
Diff:1
Topic:10.8RiskandtheCostofCapital
Skill:Analytical