Chapter 10

Risk and Return: Lessons from Market History

Multiple Choice Questions

1. The excess return required from a risky asset over that required from a risk-free asset is called the:

A. risk premium.
B. geometric premium.
C. excess return.
D. average return.
E. variance.

2. The average squared difference between the actual return and the average return is called the:

A. volatility return.
B. variance.
C. standard deviation.
D. risk premium.
E. excess return.

3. The standard deviation for a set of stock returns can be calculated as the:

A. positive square root of the average return.

B. average squared difference between the actual return and the average return.
C. positive square root of the variance.
D. average return divided by N minus one, where N is the number of returns.
E. variance squared.

4. A symmetric, bell-shaped frequency distribution that is completely defined by its mean and standard
deviation is the _____ distribution.

A. gamma
B. Poisson
C. bi-modal
D. normal
E. uniform

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5. The average compound return earned per year over a multi-year period is called the _____ average return.

A. arithmetic
B. standard
C. variant
D. geometric
E. real

6. The return earned in an average year over a multi-year period is called the _____ average return.

A. arithmetic
B. standard
C. variant
D. geometric
E. real

7. The excess return you earn by moving from a relatively risk-free investment to a risky investment is called
the:

A. geometric average return.

B. inflation premium.
C. risk premium.
D. time premium.
E. arithmetic average return.

8. The capital gains yield plus the dividend yield on a security is called the:

A. variance of returns.
B. geometric return.
C. average period return.
D. current yield.
E. total return.

9. A portfolio of large company stocks would contain which one of the following types of securities?

A. stocks of the firms which represent the smallest 20% of the companies listed on the NYSE
B. U.S. Treasury bills
C. long-term corporate bonds
D. stocks of firms included in the S&P 500 index
E. long-term government bonds

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10. Based on the period of 1926 through 2011, _____ have tended to outperform other securities over the long-
term.

A. U.S. Treasury bills

B. large company stocks
C. long-term corporate bonds
D. small company stocks
E. long-term government bonds

11. Which one of the following types of securities has tended to produce the lowest real rate of return for the
period 1926 through 2011?

A. U.S. Treasury bills

B. long-term government bonds
C. small company stocks
D. large company stocks
E. long-term corporate bonds

12. On average, for the period 1926 through 2011:

A. the real rate of return on U.S. Treasury bills has been negative.
B. small company stocks have underperformed large company stocks.
C. long-term government bonds have produced higher returns than long-term corporate bonds.
D. the risk premium on long-term corporate bonds has exceeded the risk premium on long-term government
bonds.
E. the risk premium on large company stocks has exceeded the risk premium on small company stocks.

13. Over the period of 1926 through 2011, the annual rate of return on _____ has been more volatile than the
annual rate of return on _____.

A. large company stocks; small company stocks

B. U.S. Treasury bills; small company stocks
C. U.S. Treasury bills; long-term government bonds
D. long-term corporate bonds; small company stocks
E. large company stocks; long-term corporate bonds

14. Which one of the following is a correct ranking of securities based on their volatility over the period of 1926
to 2011? Rank from highest to lowest.

A. large company stocks, U.S. Treasury bills, long-term government bonds

B. small company stocks, long-term corporate bonds, large company stocks
C. long-term government bonds, long-term corporate bonds, small company stocks
D. small company stocks, large company stocks, long-term corporate bonds
E. long-term corporate bonds, large company stocks, U.S. Treasury bills

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15. Over the period of 1926 to 2011, small company stocks had an average return of ____%.

A. 8.8
B. 10.2
C. 12.4
D. 14.6
E. 16.5

16. Over the period of 1926 to 2011, the average rate of inflation was _____%.

A. 2.0
B. 2.7
C. 3.1
D. 3.8
E. 4.3

17. The average annual return on long-term corporate bonds for the period of 1926 to 2011 was ________%.

A. 3.8
B. 5.8
C. 6.4
D. 7.9
E. 8.4

18. The average annual return on small company stocks was about _____ percentage points greater than the
average annual return on large-company stocks over the period of 1926 to 2011.

A. 3
B. 5
C. 7
D. 9
E. 11

19. The average risk premium on U.S. Treasury bills over the period of 1926 to 2011 was _____%.

A. 0.0
B. 1.6
C. 2.2
D. 3.1
E. 3.8

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20. Which one of the following is a correct statement concerning risk premium?

A. The greater the volatility of returns, the greater the risk premium.
B. The lower the volatility of returns, the greater the risk premium.
C. The lower the average rate of return, the greater the risk premium.
D. The risk premium is not correlated to the average rate of return.
E. The risk premium is not affected by the volatility of returns.

21. The risk premium is computed by ______ the average return for the investment.

A. subtracting the inflation rate from

B. adding the inflation rate to
C. subtracting the average return on the U.S. Treasury bill from
D. adding the average return on the U.S. Treasury bill to
E. subtracting the average return on long-term government bonds from

22. The Zolo Co. just declared that it is increasing its annual dividend from $1.00 per share to $1.25 per share. If
the stock price remains constant, then:

A. the capital gains yield will decrease.

B. the capital gains yield will increase.
C. the dividend yield will increase.
D. the dividend yield will also remain constant.
E. neither the capital gains yield nor the dividend yield will change.

23. Which of the following statements are correct concerning the variance of the annual returns on an
investment?

I. The larger the variance, the more the actual returns tend to differ from the average return.
II. The larger the variance, the larger the standard deviation.
III. The larger the variance, the greater the risk of the investment.
IV. The larger the variance, the higher the expected return.

A. I and III only

B. II, III, and IV only
C. I, III, and IV only
D. I, II, and III only
E. I, II, III, and
IV

24. The variance of returns is computed by dividing the sum of the:

A. squared deviations by the number of returns minus one.

B. average returns by the number of returns minus one.
C. average returns by the number of returns plus one.
D. squared deviations by the average rate of return.
E. squared deviations by the number of returns plus one.

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25. Which of the following statements concerning the standard deviation are correct?

I. The greater the standard deviation, the lower the risk.

II. The standard deviation is a measure of volatility.
III. The higher the standard deviation, the less certain the rate of return in any one given year.
IV. The higher the standard deviation, the higher the expected return.

A. I and III only

B. II, III, and IV only
C. I, III, and IV only
D. I, II, and III only
E. I, II, III, and
IV

26. The standard deviation on small company stocks:

I. is greater than the standard deviation on large company stocks.

II. is less than the standard deviation on large company stocks.
III. had an average value of about 33% for the period 1926 to 2011.
IV. had an average value of about 20% for the period 1926 to 2011.

A. I and III only

B. I and II only
C. II and III only
D. II and IV only
E. I and IV only

27. Estimates using the arithmetic average will probably tend to _____ values over the long-term while
estimates using the geometric average will probably tend to _____ values over the short-term.

A. overestimate; overestimate
B. overestimate; underestimate
C. underestimate; overestimate
D. underestimate; underestimate
E. accurately; accurately

28. A capital gain occurs when:

A. the selling price is less than the purchase price.

B. the purchase price is less than the selling price.
C. there is no dividend paid.
D. there is no income component of return.
E. never, as they cannot exist.

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29. Capital market history shows us that the average return relationship from lowest to highest between
securities is:

A. inflation, corporate bonds, Treasuries, small company stocks, large company stocks.
B. Treasury bills, inflation, small company stocks, large company stocks.
C. Treasury bills, corporate bonds, government bonds, large common stocks, small company stocks.
D. Treasury bills, government bonds, corporate bonds, large common stocks, small company stocks.
E. There is no ordering.

30. How much of total world stock market capitalization is from the United States in 2011?

A. Approximately 10%
B. Approximately 25%
C. Approximately 45%
D. Approximately 57%
E. Approximately 72%

31. In predicting the expected future return of the market, one of the dangers is that:

A. the past is not indicative of the future.

B. the past period measured is too short to get a reasonable estimate of the future.
C. the equity premium does not include the premium on debt.
D. the past is not indicative of the future and the past period measured is too short to get a reasonable
estimate of the future.
E. the past is not indicative of the future and the equity premium does not include the premium on debt.

32. The dollar value of the world stock market capitalization, from largest to smallest is:

A. Europe, United States, United Kingdom, Japan.

B. United States, Japan, Europe, United Kingdom.
C. United States, Europe, Japan, United Kingdom.
D. Japan, United States, Europe, United Kingdom.
E. Japan, United States, United Kingdom, Europe.

33. Which country has the lowest stock market risk premium?

A. Denmark
B. Belgium
C. Switzerland
D. Spain
E. Norway

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34. In estimating the future equity risk premium, it is important to include assumptions about:

A. the historical distribution of returns on derivative securities.

B. the future risk environment.
C. the amount of risk aversion of future investors.
D. the historical distribution of returns on derivative securities and the future risk environment.
E. the future risk environment and the amount of risk aversion of future investors.

35. One year ago, you purchased a stock at a price of $32.50. The stock pays quarterly dividends of $.40 per
share. Today, the stock is worth $34.60 per share. What is the total amount of your dividend income to date
from this investment?

A. $0.40
B. $1.60
C. $2.10
D. $2.50
E. $3.70

36. Six months ago, you purchased 100 shares of stock in ABC Co. at a price of $43.89 a share. ABC stock pays
a quarterly dividend of $.10 a share. Today, you sold all of your shares for $45.13 per share. What is the
total amount of your capital gains on this investment?

A. $1.24
B. $1.64
C. $40.00
D. $124.00
E. $164.00

37. A year ago, you purchased 300 shares of IXC Technologies, Inc. stock at a price of $9.03 per share. The
stock pays an annual dividend of $.10 per share. Today, you sold all of your shares for $28.14 per share.
What is your total dollar return on this investment?

A. $5,703
B. $5,733
C. $5,753
D. $5,763
E. $5,853

38. You purchased 200 shares of stock at a price of $36.72 per share. Over the last year, you have received total
dividend income of $322. What is the dividend yield?

A. 3.2%
B. 4.4%
C. 6.8%
D. 9.2%
E. 11.4%

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39. Winslow, Inc. stock is currently selling for $40 a share. The stock has a dividend yield of 3.8%. How much
dividend income will you receive per year if you purchase 500 shares of this stock?

A. $152
B. $190
C. $329
D. $760
E. $1,053

40. One year ago, you purchased a stock at a price of $32 a share. Today, you sold the stock and realized a total
return of 25%. Your capital gain was $6 a share. What was your dividend yield on this stock?

A. 1.25%
B. 3.75%
C. 6.25%
D. 18.75%
E. 21.25%

41. You just sold 200 shares of Langley, Inc. stock at a price of $38.75 a share. Last year you paid $41.50 a
share to buy this stock. Over the course of the year, you received dividends totaling $1.64 per share. What is
your capital gain on this investment?

A. -$550
B. -$222
C. -$3
D. $550
E. $878

42. You purchased 300 shares of Deltona, Inc. stock for $44.90 a share. You have received a total of $630 in
dividends and $14,040 in proceeds from selling the shares. What is your capital gains yield on this stock?

A. 4.06%
B. 4.23%
C. 4.68%
D. 8.55%
E. 8.91%

43. Today, you sold 200 shares of SLG, Inc. stock. Your total return on these shares is 12.5%. You purchased
the shares one year ago at a price of $28.50 a share. You have received a total of $280 in dividends over the
course of the year. What is your capital gains yield on this investment?

A. 4.80%
B. 5.00%
C. 6.67%
D. 7.59%
E. 11.67%

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44. Six months ago, you purchased 1,200 shares of ABC stock for $21.20 a share. You have received dividend
payments equal to $.60 a share. Today, you sold all of your shares for $22.20 a share. What is your total
dollar return on this investment?

A. $720
B. $1,200
C. $1,440
D. $1,920
E. $3,840

45. Eight months ago, you purchased 400 shares of Winston, Inc. stock at a price of $54.90 a share. The
company pays quarterly dividends of $.50 a share. Today, you sold all of your shares for $49.30 a share.
What is your total percentage return on this investment?

A. -10.2%
B. -9.3%
C. -8.4%
D. 12.0%
E. 13.4%

46. A stock had returns of 8%, -2%, 4%, and 16% over the past four years. What is the standard deviation of
this stock for the past four years?

A. 6.3%
B. 6.6%
C. 7.1%
D. 7.5%
E. 7.9%

47. A stock has an expected rate of return of 8.3% and a standard deviation of 6.4%. Which one of the following
best describes the probability that this stock will lose 11% or more in any one given year?

A. less than 0.5%

B. less than 1.0%
C. less than 1.5%
D. less than 2.5%
E. less than 5%

48. A stock has returns of 3%, 18%, -24%, and 16% for the past four years. Based on this information, what is
the 95% probability range for any one given year?

A. -8.4 to 11.7%
B. -16.1 to 22.6%
C. -24.5 to 34.3%
D. -35.4 to 41.9%
E. -54.8 to 61.3%

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49. A stock had returns of 8%, 14%, and 2% for the past three years. Based on these returns, what is the
probability that this stock will earn at least 20% in any one given year?

A. 0.5%
B. 1.0%
C. 2.5%
D. 5.0%
E. 16.0%

50. A stock had returns of 11%, 1%, 9%, 15%, and -6% for the past five years. Based on these returns, what is
the approximate probability that this stock will earn at least 23% in any one given year?

A. 0.5%
B. 1.0%
C. 2.5%
D. 5.0%
E. 16.0%

51. A stock had returns of 8%, 39%, 11%, and -24% for the past four years. Which one of the following best
describes the probability that this stock will NOT lose more than 43% in any one given year?

A. 84.0%
B. 95.0%
C. 97.5%
D. 99.0%
E. 99.5%

52. Over the past five years, a stock produced returns of 14%, 22%, -16%, 2%, and 10%. What is the probability
that an investor in this stock will NOT lose more than 8% nor earn more than 21% in any one given year?

A. 34%
B. 68%
C. 95%
D. 99%
E. 100%

53. What are the arithmetic and geometric average returns for a stock with annual returns of 4%, 9%, -6%, and
18%?

A. 5.89%; 6.25%
B. 6.25%; 5.89%
C. 6.25%; 8.33%
D. 8.3%; 5.89%
E. 8.3%; 6.25%

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54. What are the arithmetic and geometric average returns for a stock with annual returns of 21%, 8%, -32%,
41%, and 5%?

A. 5.6%; 8.6%
B. 5.6%; 6.3%
C. 8.6%; 5.6%
D. 8.6%; 8.6%
E. 8.6%; 6.3%

55. A stock had returns of 6%, 13%, -11%, and 17% over the past four years. What is the geometric average
return for this time period?

A. 4.5%
B. 5.7%
C. 6.2%
D. 7.3%
E. 8.2%

56. A stock had the following prices and dividends. What is the geometric average return on this stock?

A. 3.2%
B. 3.4%
C. 3.6%
D. 3.8%
E. 4.0%

57. You bought 100 shares of stock at $20 each. At the end of the year, you received a total of $400 in
dividends, and your stock was worth $2,500 total. What was your total return?

A. 20%
B. 45%
C. 50%
D. 90%
E. None of these

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58. You bought 100 shares of stock at $20 each. At the end of the year, you received a total of $400 in
dividends, and your stock was worth $2,500 total. What was your total dollar capital gain and total dollar
return?

A. $400; $500
B. $400; $900
C. $500; $900
D. $900; $2,500
E. None of these

59. Excelsior shares are currently selling for $25 each. You bought 200 shares one year ago at $24 and received
dividend payments of $1.50 per share. What was your percentage capital gain this year?

A. 4.17%
B. 6.25%
C. 10.42%
D. 104.17%
E. 110.42%

60. Excelsior share are currently selling for $25 each. You bought 200 shares one year ago at $24 and received
dividend payments of $1.50 per share. What was your total rate of return?

A. 4.17%
B. 6.25%
C. 10.42%
D. 104.67%
E. 110.42%

61. The prices for IMB over the last 3 years are given below. Assuming no dividends were paid, what was the 3-
year holding period return? Given the following information: Year 1 return = 10%, Year 2 return = 15%,
Year 3 return = 12%.

A. 12.3%
B. 13.9%
C. 15.8%
D. 41.7%
E. 46.5%

62. Kids Toy Co. has had total returns over the past five years of 0%, 7%, -2%, 10%, and 12%. What was the
arithmetic average return on this stock?

A. 5.40%
B. 5.50%
C. 6.15%
D. 6.33%
E. 6.75%

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63. The returns on your portfolio over the last 5 years were -5%, 20%, 0%, 10% and 5%. What is the arithmetic
average return?

A. 5.0%
B. 6.0%
C. 7.5%
D. 8.0%
E. 10.0%

64. If the expected return on the market is 16%, then using the historical risk premium on large stocks of 8.6%,
the current risk-free rate is:

A. 4.6%
B. 7.4%
C. 8.4%
D. 10.6%
E. 12.6%

65. The total annual returns on large company common stocks averaged 12.3% from 1926 to 2011, small
company stocks averaged 17.4%, long-term government bonds averaged 5.8%, while Treasury Bills
averaged 3.8%. What was the average risk premium earned by long-term government bonds, and small
company stocks respectively?

A. 1.8%; 13.3%
B. 2.0%; 13.6%
C. 4.4%; 11.9%
D. 9.5%; 1.8%
E. None of these

66. The returns on your portfolio over the last 5 years were -5%, 20%, 0%, 10% and 5%. What is the standard
deviation of your return?

A. 2.74%
B. 5.21%
C. 9.62%
D. 10.12%
E. 12.70%

67. Suppose you own a risky asset with an expected return of 12% and a standard deviation of 20%. If the
returns are normally distributed, the approximate probability of receiving a return greater than 32% is
approximately:

A. 2%.
B. 5%.
C. 16%.
D. 33%.
E. 67%.

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68. The return pattern on your favorite stock has been 5%, 8%, -12%, 15%, 21% over the last five years. What
has been your average return and holding period return over the last 5 years?

A. 4.5%; 6.5%
B. 7.4%; 38.9%
C. 7.4%; 7.76%
D. 7.4%; 76.73%
E. None of these

69. The long term inflation rate average was 3.2% and you invested in long term corporate bonds over the same
period which earned 6.1%. What was the average risk premium you earned?

A. 2.9%
B. 3.1%
C. 9.3%
D. 9.4%
E. None of these

70. The market portfolio of common stocks earned 14.7% in one year. Treasury bills earned 5.7%. What was
the real risk premium on equities?

A. 5.0%
B. 6.5%
C. 9.0%
D. 12.2%
E. 18.7%

71. You have a sample of returns observations for the Malta Stock Fund. The 4 returns are 7.25%, 5.6%, 12.5%,
1.0%. What is the average return and variance of these returns?

A. 6.50%; 16.9
B. 6.60%; 22.5
C. 6.60%; 4.75
D. 26.35%; 67.6
E. None of these.

72. One year ago, you purchased a stock at a price of $33. The stock pays quarterly dividends of $.60 per share.
Today, the stock is worth $35.2 per share. What is the total amount of your dividend income to date from
this investment?

A. $0.60
B. $1.80
C. $2.40
D. $3.00
E. $3.20

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73. Six months ago, you purchased 100 shares of stock in ABC Co. at a price of $43.26 a share. ABC stock pays
a quarterly dividend of $.10 a share. Today, you sold all of your shares for $46.71 per share. What is the
total amount of your capital gains on this investment?

A. $0.4
B. $40
C. $45
D. $345
E. $385

74. A year ago, you purchased 300 shares of IXC Technologies, Inc. stock at a price of $10.05 per share. The
stock pays an annual dividend of $.10 per share. Today, you sold all of your shares for $29.32 per share.
What is your total dollar return on this investment?

A. $8,781
B. $8,796
C. $8,811
D. $8,832
E. $8,921

75. You purchased 300 shares of stock at a price of $37.23 per share. Over the last year, you have received total
dividend income of $351. What is the dividend yield?

A. 3.14%
B. 3.26%
C. 3.39%
D. 4.50%
E. 10.20%

76. Winslow, Inc. stock is currently selling for $60 a share. The stock has a dividend yield of 2.5%. How much
dividend income will you receive per year if you purchase 800 shares of this stock?

A. $20
B. $60
C. $1,200
D. $1,380
E. $1,560

77. One year ago, you purchased a stock at a price of $60 a share. Today, you sold the stock and realized a total
return of 30%. Your capital gain was $8 a share. What was your dividend yield on this stock?

A. 4.5%
B. 5.0%
C. 5.5%
D. 6.0%
E. 6.5%

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78. A stock had returns of 7%, 9%, -3%, and 5% over the past four years. What is the standard deviation of this
stock for the past four years?

A. 4.5%
B. 6.4%
C. 6.7%
D. 7.2%
E. 7.5%

79. What are the arithmetic and geometric average returns for a stock with annual returns of 5%, 8%, -3%, and
16%?

A. 6.5%; 6.28%
B. 6.5%; 9.21%
C. 9.3%; 6.28%
D. 9.3%; 9.21%
E. 10.25%; 8.31%

Essay Questions

80. What securities have offered the highest average annual returns over the last several decades? Can we
conclude that return and risk are related in real life?

81. What are the lessons learned from capital market history? What evidence is there to suggest these lessons
are correct?

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
82. Suppose you have $30,000 invested in the stock market and your banker comes to you and tries to get you to
move that money into the bank's certificates of deposit (CDs). He explains that the CDs are 100%
government insured and that you are taking unnecessary risks by being in the stock market. How would you
respond?

83. Little John Industries sold for $1.90 on January 1 and ended the year at a price of $2.50. In addition, the
stock paid dividends of $0.20 per share. Calculate Little John's dividend yield, capital gains yield, and total
rate of return for the year.

84. You earned a total return of -5% on NoDotCom this year, earned -40% last year, and earned 30% two years
ago. Calculate both the three-year holding period return and the average three year return.

10-18
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
 10-19
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.