chapter 10 sol students
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Corporate Finance: The Core (Berk/DeMarzo) Chapter 10 - Capital Markets and the Pricing of Risk 10.1 A First Look at Risk and Return
1) Which of the following investments offered the highest overall return over the past eighty years? A) Treasury Bills B) S&P 500 C) Small stocks D) Corporate Bonds
Answer: C Explanation: A)
B) C) D)
Diff: 1 Topic: 10.1 A First Look at Risk and Return Skill: Definition
2) Which of the following investments had the largest fluctuations overall return over the past eighty years? A) Small stocks B) S&P 500 C) Corporate Bonds D) Treasury Bills
Answer: A Explanation: A)
B) C) D)
Diff: 1 Topic: 10.1 A First Look at Risk and Return Skill: Definition
10.2 Common Measures of Risk and Return 3) Which of the following statements is false?
A) The variance increases with the magnitude of the deviations from the mean. B) The variance is the expected squared deviation from the mean. C) Two common measures of the risk of a probability distribution are its variance and standard deviation. D) If the return is riskless and never deviates from its mean, the variance is equal to one.
Answer: D Explanation: A)
B) C) D) If the return is riskless and never deviates from its mean, the variance is equal to zero.
Diff: 1 Topic: 10.2 Common Measures of Risk and Return Skill: Conceptual
4) Which of the following equations is incorrect?
A) Var(R) = ( )SD R
[ ]B) SD(R) = 2( )R RP R E R× −∑[ ] 2( )R RP R E R× −∑C) Var(R) =
D) E[R] = R RP R×∑Answer: A Explanation: A) SD(R) = ( )Var R
B) C) D)
Diff: 2 Topic: 10.2 Common Measures of Risk and Return Skill: Conceptual
Use the table for the question(s) below. Consider the following probability distribution of returns for Alpha Corporation: Current Stock Price ($)
Stock Price in One Year ($) Return R
Probability PR
$35 40% 25% $25 $25 0% 50%
$20 -20% 25%
5) The standard deviation of the return on Alpha Corporation is closest to: A) 22.4% B) 19.0% C) 21.8% D) 19.4%
Answer: C Explanation: A)
B) C) E[R] = = .25(40%) + .50(0%) + .25(-20%) = 5% R RP R×∑
[ ]Var(R) = 2( )R RP R E R× −∑ = .25(.40 - .05)2 + .50(.00 - .05)2 + .25(-20 - .05)2 = .0475 or 4.75%
( )Var R .0475SD(R) = = = .2179 or 21.79% D)
Diff: 3 Topic: 10.2 Common Measures of Risk and Return Skill: Analytical
10.3 Historical Returns of Stocks and Bonds
6) Which of the following statements is false? A) The standard error provides an indication of how far the sample average might deviate from the
expected return. B) The 95% confidence interval for the expected return is defined as the Historical Average Return plus or
minus three standard errors. C) We can use a securityʹs historical average return to estimate its actual expected return. D) The standard error is the standard deviation of the average return.
Answer: B Explanation: A)
B) The 95% confidence interval for the expected return is defined as the Historical Average Return plus or minus two standard errors.
C) D)
Diff: 2 Topic: 10.3 Historical Returns of Stocks and Bonds Skill: Conceptual
7) If a stock pays dividends at the end of each quarter, with realized returns of R1, R2, R3, and R4 each quarter, then the annual realized return is calculated as A)
Rannual = B) Rannual = (1 + R1)(1 + R2)(1 + R3)(1 + R4) C) Rannual = (1 + R1)(1 + R2)(1 + R3)(1 + R4) - 1 D) Rannual = R1 + R2 + R3 + R4
Answer: C Explanation: A)
B) C) D)
Diff: 2 Topic: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical
Use the table for the question(s) below. Consider the following Price and Dividend data for Ford Motor Company: Date Price ($) Dividend ($)December 31, 2004 $14.64 January 26, 2005 $13.35 $0.10 April 28, 2005 $9.14 $0.10 July 29, 2005 $10.74 $0.10 October 28, 2005 $8.02 $0.10 December 30, 2005 $7.72
8) Assume that you purchased Ford Motor Company stock at the closing price on December 31, 2004 and sold it at the closing price on December 30, 2005. Your realized annual return is for the year 2005 is closest to: A) -45.1% B) -44.5% C) -48.5% D) -47.3%
Answer: A Explanation: A) Date Price ($) Dividend ($) Return (1 + return)
December 31, 2004 $14.64 1 1 January 26, 2005 $13.35 $0.10 -8.13% 0.918716 0.918716 April 28, 2005 $9.14 $0.10 -30.79% 0.692135 0.635875 July 29, 2005 $10.74 $0.10 18.60% 1.185996 0.754145 October 28, 2005 $8.02 $0.10 -24.39% 0.756052 0.570173 December 30, 2005 $7.72 -3.74% 0.962594 0.548845
The Product of (1 + returns) - 1 = -0.45116
The last column in the table contains the cummulative product of (1 + returns) B) C) D)
Diff: 3 Topic: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical
Use the table for the question(s) below. Consider the following realized annual returns:
Year End
S&P 500 Realized Return
IBM Realized Return
1996 23.6% 46.3% 1997 24.7% 26.7% 1998 30.5% 86.9% 1999 9.0% 23.1% 2000 -2.0% 0.2% 2001 -17.3% -3.2% 2002 -24.3% -27.0% 2003 32.2% 27.9% 2004 4.4% -5.1% 2005 7.4% -11.3%
9) The variance of the returns on the S&P 500 from 1996 to 2005 is closest to: A) .0450 B) .3400 C) .1935 D) .0375
Answer: D Explanation: A)
B) C) D) Rannual = 1 2 ... NR R R
N+ + +
= 1 2 10...10
R R R+ + + = 0.878
10 = 8.8%
Year End
S&P 500 Realized 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 = SUM of (R - R)2 / T - 1 = 0.3405116 / 9 = 0.0378346
Diff: 2 Topic: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical
WS1) Suppose that you want to use the 10 year historical average return on the S&P 500 to forecast the expected future return on the S&P 500. The 95% confidence interval for your estimate of the expect return is closest to: A) -10.6% to 28.2% B) 6.8% to 10.7% C) -37.0% to 47.6% D) 4.9% to 12.7%
Answer: D Explanation: A)
B) C) D) Rannual = 1 2 ... NR R R
N+ + +
= 0.87810
= 8.8%
Year End
S&P 500 Realized 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 = SUM of (R - R)2 / T - 1 = 0.3405116 / 9 = 0.0378346 Standard deviation = = Variance 0.0378346 = 0.1945112 Standard error = Standard Deviation / T = 0.1945112 / 10 = .01945 or 1.95% 95% Confidence Interval = mean return + or - 2 standard errors, so lower bound = .0878 - 2 × .0195 = 0.0488 upper bound = .0878 + 2 × .0195 = .1268
Diff: 3 Topic: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical
10) Suppose that you want to use the 10 year historical average return on IBM to forecast the expected future return on IBM. The 95% confidence interval for your estimate of the expect return is closest to: A) 13.2% to 19.5% B) 10.1% to 22.7% C) 6.5% to 26.3% D) -15.1% to 47.8%
Answer: B Explanation: A)
B) Rannual = 1 2 ... NR R RN
+ + + = 1.638
10 = 16.45%
Year End
IBM Realized Return (R - R) (R - R)2
1996 46.3% 29.85% 0.0891023 1997 26.7% 10.25% 0.0105063 1998 86.9% 70.45% 0.4963203 1999 23.1% 6.65% 0.0044223 2000 0.2% -16.25% 0.0264063 2001 -3.2% -19.65% 0.0386123 2002 -27.0% -43.45% 0.1887903 2003 27.9% 11.45% 0.0131103 2004 -5.1% -21.55% 0.0464403 2005 -11.3% -27.75% 0.0770063 Variance = SUM of (R - R)2 / T - 1 = 0.9907165 / 9 = 0.1100796 Standard deviation = = = 0.3317825 Variance 0.1100796Standard error = Standard Deviation / T = 0.3317825 / 10 = .03318 or 3.32% 95% Confidence Interval = mean return + or - 2 standard errors, so lower bound = .1638 - 2 × .0332= .101 upper bound = .1638 + 2 × .0332 = .227
C) D)
Diff: 3 Topic: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical
11) The geometric average annual return on the S&P 500 from 1996 to 2005 is closest to: A) 9.75% B) 8.75% C) 7.10% D) 8.35%
Answer: C Explanation: A)
B) C) Geometric Average = 1 2(1 )(1 )....(1 )T TR R R+ + + - 1
= 10 - 1 = 1.071067 - 1 = 0.071067 1.986857D)
Diff: 3 Topic: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical
Use the table for the question(s) below. Consider the following Price and Dividend data for General Motors: Date Price ($) Dividend ($)December 31, 2004 $40.06 February 9, 2005 $36.80 $0.50 May 7, 2005 $30.41 $0.50 August 10, 2005 $34.86 $0.50 November 8, 2005 $25.86 $0.50 December 30, 2005 $18.86
12) Assume that you purchased General Motors stock at the closing price on December 31, 2004 and sold it at the closing price on December 30, 2005. Calculate your realized annual return is for the year 2005. Answer: Date Price ($) Dividend ($) Return (1 + return)
December 31, 2004 $40.06 0.00% 1 1 January 26, 2005 $36.80 $0.50 -6.89% 0.931103 0.931103 April 28, 2005 $30.41 $0.50 -16.01% 0.839946 0.782076 July 29, 2005 $34.86 $0.50 16.28% 1.162775 0.909379 October 28, 2005 $25.86 $0.50 -24.38% 0.756168 0.687643 December 30, 2005 $18.86 -27.07% 0.729312 0.501506 The Product of (1 + returns) - 1 = -0.49849 The last column in the table contains the cummulative product of (1 + returns)
Diff: 3 Topic: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical
Use the table for the question(s) below. Consider the following realized annual returns:
Year End
Market Realized Return
Microsoft Realized 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) Suppose that you want to use the 10 year historical average return on the Market to forecast the expected future return on the S&P 500. Calculate the 95% confidence interval for your estimate of the expect return. Answer: Rannual = 1 2 ... NR R R
N+ + +
= 1. = 10.93% 09310
Year End
Market Realized Return (R - R) (R - R)2
1996 21.2% 10.23% 0.0104625 1997 30.3% 19.40% 0.03763 1998 22.3% 11.35% 0.0128899 1999 25.3% 14.32% 0.0205182 2000 -11.0% -21.98% 0.0483043 2001 -11.3% -22.20% 0.0492984 2002 -20.8% -31.78% 0.1009717 2003 33.1% 22.21% 0.0493349 2004 13.0% 2.07% 0.0004274 2005 7.3% -3.63% 0.0013148 Variance = SUM of (R - R)2 / T - 1 = 0.3311521 / 9 = 0.0367947 Standard deviation = = = 0.1918194 Variance 0.0367947Standard error = Standard Deviation / T = 0.1918194 / 10 = .01918 or 1.92% 95% Confidence Interval = mean return + or - 2 standard errors, so lower bound = .1093 - 2 × .0192 = .0709 or 7.09% upper bound = .1093 + 2 × .0192 = .1477 or 14.77%
Diff: 3 Topic: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical
13) Suppose that you want to use the 10 year historical average return on Microsoft to forecast the expected future return on Microsoft. Calculate the 95% confidence interval for your estimate of the expect return. Answer: Rannual = 1 2 ... NR R R
N+ + +
= 3.1110
= 31.1%
Year End
Microsoft Realized Return (R - R) (R - R)2
1996 88.3% 57.24% 0.3276925 1997 56.4% 25.36% 0.0642878 1998 114.6% 83.53% 0.6977065 1999 68.4% 37.29% 0.1390502 2000 -62.8% -93.92% 0.8821468 2001 52.7% 21.66% 0.0469291 2002 -22.0% -53.04% 0.281292 2003 6.9% -24.19% 0.058501 2004 9.2% -21.92% 0.0480275 2005 -0.9% -32.02% 0.1025221 Variance = SUM of (R - R)2 / T - 1 = 2.6481554 / 9 = 0.2942395 Standard deviation = = = 0.5424385 Variance 0.2942395Standard error = Standard Deviation / T = 0.5424385 / 10 = .0542 or 5.42% 95% Confidence Interval = mean return + or - 2 standard errors, so lower bound = .311 - 2 × .0542 = .2026 or 20.26% upper bound = .311 + 2 × .0542 = .4194 or 41.94%
Diff: 3 Topic: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical
10.4 The Historical Tradeoff Between Risk and Return Use the table for the question(s) below.
Consider the following average annual returns: Investment Average Return Small Stocks 23.2% S&P 500 13.2% Corporate Bonds 7.5% Treasury Bonds 6.2% Treasury Bills 4.8%
14) What is the excess return for the portfolio of small stocks? A) 10.0% B) 15.7% C) 18.4% D) 17.0%
Answer: C Explanation: A)
B) C) Average Return - Tbill Investment Average Return Return Small Stocks 23.2% 18.40% S&P 500 13.2% 8.40% Corporate Bonds 7.5% 2.70% Treasury Bonds 6.2% 1.40% Treasury Bills 4.8% 0.0%
D) Diff: 1 Topic: 10.4 The Historical Tradeoff Between Risk and Return Skill: Analytical
Use the information for the question(s) below. Big Cure and Little Cure are both pharmaceutical companies. Big Cure presently has a potential ʺblockbusterʺ drug before the Food and Drug Administration (FDA) waiting for approval. If approved, Big Cureʹs blockbuster drug will produce $1 billion in net income for Big Cure. Little Cure has 10 separate less important drugs before the FDA waiting for approval. If approved, each of Little Cureʹs drugs would produce $100 million in net income for Little Cure. The probability of the FDA approving a drug is 50%.
15) What is the standard deviation of Big Cureʹs average net income for their new blockbuster drug? A) $0 B) $1 billion C) $100 million D) $500 million
Answer: D Explanation: A)
B) C) D) expected payoff = prob of payoff × amount if successful
= .5 × $1 billion = $500 million
Standard deviation = = 500 million
Diff: 2 Topic: 10.5 Common Versus Independent Risk Skill: Analytical
16) The standard deviation of Little Cureʹs average net income for their ten new drugs is closest to: A) $50 million B) $25 million C) $16 million D) $500 million
Answer: C Explanation: A)
B) C) expected payoff = prob of payoff × amount if successful
= .5 × $1 billion = $500 million
Standard deviation for one drug= = 50 million = 50 / = 15.81 million Standard deviation(all drugs) = SD(one drug) / number of drugs 10
D) Diff: 2 Topic: 10.5 Common Versus Independent Risk Skill: Analytical
10.6 Diversification in Stock Portfolios 17) Which of the following is not a diversifiable risk?
A) The risk that oil prices rise, increasing production costs B) The risk of a product liability lawsuit C) The risk that the CEO is killed in a plane crash D) The risk of a key employee being hired away by a competitor
Answer: A Explanation: A)
B) C) D)
Diff: 1 Topic: 10.6 Diversification in Stock Portfolios Skill: Conceptual
10.7 Estimating the Expected Return
18) Suppose that Lutherʹs Beta is 0.9. If the market risk premium is 8% and the risk-free interest rate is 4%, then then expected return for Luther stock is? A) 7.6% B) 11.6% C) 11.2% D) 12.9%
Answer: C Explanation: A)
B) C) E[R] = Rf + Beta × Risk Premium = .04 + .9 × .08 = .112 D)
Diff: 1 Topic: 10.7 Estimating the Expected Return Skill: Analytical
Use the information for the question(s) below. Suppose that in the coming year, you expect Exxon-Mobil stick to have a volatility of 42% and a beta of 0.9, and Merckʹs stock to have a volatility of 24% and a beta of 1.1. The risk free interest rate is 4% and the markets expected return is 12%.
19) Which stock has the highest total risk? A) Merck since it has a lower volatility B) Merck since it has a higher Beta C) Exxon-Mobil since it has a higher volatility D) Exxon-Mobil since it has a lower beta
Answer: C Explanation: A)
B) C) D)
Diff: 1 Topic: 10.8 Risk and the Cost of Capital Skill: Conceptual
20) The cost of capital for a project with the same beta as Exxon Mobilʹs stock is closest to: A) 11.6% B) 11.2% C) 12.8% D) 7.6%
Answer: B Explanation: A)
B) E[R] = Rf + Beta × Risk Premium = .04 + .9 × (.12 - .04) = .112 C) D)
Diff: 1 Topic: 10.8 Risk and the Cost of Capital Skill: Analytical