EXERCISES ON CHAPTER FIVE

Question #1

For the last four years, the returns for XYZ Corporation's stock have been 10.4%,
8.1%, 3.2%, and 15.0%. The equivalent compound annual rate is:

A. 9.2%.
B. 9.1%.
C. 8.9%.
Explanation

(1.104 × 1.081 × 1.032 × 1.15)0.25 − 1 = 9.1%

Question #2

There is a 40% chance that an investment will earn 10%, a 40% chance that the
investment will earn 12.5%, and a 20% chance that the investment will earn 30%.
What is the mean expected return and the standard deviation of expected
returns, respectively?

A. 17.5%; 5.75%.
B. 15.0%; 7.58%.
C. 15.0%; 5.75%.
Explanation

Mean = (0.4)(10) + (0.4)(12.5) + (0.2)(30) = 15%

Variance = (0.4)(10 − 15)2 + (0.4)(12.5 − 15)2 + (0.2)(30 − 15)2 = 57.5

Standard deviation = √57.5 = 7.58

Question #3

The returns for individual asset since established are shown below:
Year Return (%)
1 1.3
2 1.4
3 2.2
4 3.4
5 1.7
What is the population standard deviation of the returns for this asset?

A. 0.56%.
B. 1.71%.
C. 0.77%.
Explanation

The population standard deviation equals the square root of the sum of the squares
of the position returns less the mean return, divided by the number of entities in the
population.

Year Return (%) (Return - Mean)2

1 1.3 0.49
2 1.4 0.36
3 2.2 0.04
4 3.4 1.96
5 1.7 0.09
Mean 10.0/5 = 2.0 Sum = 2.94
Std. Dev. = (2.94/5)0.5 = 0.77%

Question #4

If stock X's expected return is 30% and its expected standard deviation is 5%, Stock
X's expected coefficient of variation is:

A. 0.167.
B. 1.20.
C. 6.0.
Explanation

The coefficient of variation is the standard deviation divided by the mean: 5 / 30

= 0.167.
Question #5

Trina Romel, mutual fund manager, is taking over a poor performing fund from a
colleague. Romel wants to calculate the return on the portfolio. Over the last five
years, the fund's annual percentage returns were: 25, 15, 12, -8, and -14.

Determine if the geometric return of the fund will be less than or greater than the
arithmetic return and calculate the fund's geometric return:

Geometric Return Geometric compared to Arithmetic

A. 4.96% less than

B. 4.96% greater than
C. 12.86% greater than
Explanation

The geometric return is calculated as follows:

[(1 + 0.25)(1 + 0.15)(1 + 0.12)(1 - 0.08)(1 - 0.14)]0.20 – 1 = 0.4960, or 4.96%.

The geometric return will always be less than or equal to the arithmetic return. In this
case the arithmetic return was 6%.

Question #6

Annual Returns on ABC Mutual Fund

Yr1 Yr2 Yr3 Yr4 Yr5 Yr6 Yr7 Yr8 Yr9 Yr10
11.0% 12.5% 8.0% 9.0% 13.0% 7.0% 15.0% 2.0% -16.5% 11.0%
What are the arithmetic mean return and the geometric mean return,
respectively, for ABC Mutual Fund for the period Year 1 to Year 10?

A. 7.2%; 5.6%.
B. 8.2%; 6.8%.
C. 7.2%; 6.8%.
Explanation

Arithmetic mean = (11 + 12.5 + 8 + 9 + 13 + 7 + 15 + 2 − 16.5 + 11) / 10 = 7.20

Geometric mean = (1.11 × 1.125 × 1.08 × 1.09 × 1.13 × 1.07 × 1.15 × 1.02 × 0.835 ×
1.11)0.1 − 1 = (1.932)0.1 – 1 = 1.068 – 1 = 0.068 or 6.8%
Question #7

An investor is considering two investments. Stock A has a mean annual return of

16% and a standard deviation of 14%. Stock B has a mean annual return of 20%
and a standard deviation of 30%. Calculate the coefficient of variation (CV) of
each stock and determine if Stock A has less dispersion or more dispersion relative
to B. Stock A's CV is:
A. 1.14, and thus has less dispersion relative to the mean than Stock B.
B. 0.875, and thus has less dispersion relative to the mean than Stock B.
C. 1.14, and thus has more dispersion relative to the mean than Stock B.
Explanation

CV stock A = 0.14 / 0.16 = 0.875

CV stock B = 0.30 / 0.20 = 1.5
Stock A has less dispersion relative to the mean than Stock B.
Question #8
An investor has a portfolio with 10% cash, 30% bonds, and 60% stock. If last year's
return on cash was 2.0%, the return on bonds was 9.5%, and the return on stock
was 25%, what was the return on the investor's portfolio?

A. 36.50%.
B. 18.05%.
C. 22.30%.
Explanation

Find the weighted mean of the returns. (0.10 × 0.02) + (0.30 × 0.095) + (0.60 × 0.25) =
18.05%

Question #9

A stock had the following returns over the last five years: 15%, 2%, 9%, 44%, 23%.
What is the respective geometric mean and arithmetic mean for this stock?

A. 0.18%; 18.6%.
B. 17.76%; 18.6%.
C. 17.76%; 23.0%.
Explanation

Geometric mean = [(1.15)(1.02)(1.09)(1.44)(1.23)]0.2 − 1 = 1.17760 = 17.76%.

Arithmetic mean = (15 + 2 + 9 + 44 + 23) / 5 = 18.6%.

Question #10

If the historical mean return on an investment is 2.0% and the standard deviation
is 8.8%, what is the coefficient of variation (CV)?
A. 1.76.
B. 6.80.
C. 4.40.
Explanation

The CV = the standard deviation of returns / mean return or 8.8% / 2.0% = 4.4.

Question #11

An investor has the following assets:

 $5,000 in bonds with an expected return of 8%.

 $10,000 in equities with an expected return of 12%.
 $5,000 in real estate with an expected return of 10%.
What is the portfolio's expected return?
 A. 10.50%.
B. 10.00%.
C. 11.00%.
Explanation

Expected return is the weighted average of the individual expected values. The
expected return is: [(5,000) × (10.00) + (5,000) × (8.00) + (10,000) × (12.00)] / 20,000 =
10.50%.

Question #12

Given the following annual returns, what are the geometric and arithmetic mean
returns, respectively?

2002 2003 2004 2005 2006

15% 2% 5% -7% 0%

A. 2.75%; 5.80%.
B. 1.45%; 3.00%.
C. 2.75%; 3.00%.
Explanation

Geometric Mean: (1.15 × 1.02 × 1.05 × 0.93 × 1.0)0.2 − 1 = 1.14540.2 − 1 = 2.75%

Arithmetic Mean: (15% + 2% + 5% − 7% + 0%) / 5 = 3.00%

Question #13

Given the following annual returns, what are the population variance and
standard deviation, respectively?

2000 2001 2002 2003 2004

15% 2% 5% -7% 0%

A. 51.6; 7.2.
B. 32.4; 5.7.
C. 64.5; 8.0.
Explanation

The population variance is found by taking the mean of all squared deviations from
the mean.

[(15 − 3)2 + (2 − 3)2 + (5 − 3)2 + (-7 − 3)2 + (0 − 3)2] / 5 = 51.6

The population standard deviation is found by taking the square root of the
population variance. 51.6 = 7.2

Question #14

An analyst collected the following data for three possible investments.

Stock Price Today Forecast Price* Dividend Beta

Alpha 25 31 2 1.6
Omega 105 110 1 1.2
Lambda 10 10.80 0 0.5
*Expected price one year from today.

The expected return on the market is 12% and the risk-free rate is 4%. According
to the security market line (SML), which of the three securities is correctly priced?

A. Lambda.
B. Omega.
C. Alpha.
Explanation

In the context of the SML, a security is underpriced if the required return is less than
the holding period (or expected) return, is

overpriced if the required return is greater the holding period (or expected) return,
and is correctly priced if the required return equals the holding period (or expected)
return.

Here, the holding period (or expected) return is calculated as: (ending price -
beginning price + any cash flows / dividends) / beginning price. The required return
uses the equation of the SML: risk free rate + Beta × (expected market rate − risk free
rate).

 For Alpha: ER = (31 - 25 + 2) / 25 = 32%, RR = 4 + 1.6 × (12 − 4) = 16.8%. Stock is

underpriced.
 For Omega: ER = (110 - 105 + 1) / 105 = 5.7%, RR = 4 + 1.2 × (12 − 4) = 13.6%. Stock
is overpriced.
 For Lambda, ER = (10.8 - 10 + 0) / 10 = 8%, RR = 4 + 0.5 × (12 − 4) = 8%. Stock is
correctly priced.

Question #15

The expected rate of return is 2.5 times the 12% expected rate of return from the
market. What is the beta if the risk-free rate is 6%?
A. 5.
B. 3.
 C. 4.
Explanation

 30 = 6 + β (12 - 6)
 24 = 6β
 β=4
Question #16

The beta of stock D is -0.5. If the expected return of Stock D is 8%, and the risk-free
rate of return is 5%, what is the expected return of the market?

A. -1.0%.
B. +3.0%.
C. +3.5%.
Explanation

E(R)Stock = RFR + (RMT − RFR ) × Beta ,

R = [8 − 5 + (-0.5 × 5)] / -0.5 = 0.5 / -0.5 = -1%
Question #17

The expected rate of return is 1.5 times the 16% expected rate of return from the
market. What is the beta if the risk free rate is 8%?

A. 3.
B. 4.
C. 2.
Explanation

 24 = 8 + β (16 − 8)
 24 = 8 + 8β
 16 = 8β
 16 / 8 = β
 β=2
Question #18

Adeline Bass is a member of an investment club. At the next meeting, she is to

recommend whether or not the club should purchase the stocks of CS Industries
and MG Consolidated. The risk-free rate is at 6% and the expected return on the
market is 15%. Prior to the meeting, Bass gathers the following information on the
two stocks:
 CS Industries MG Consolidated
Current Market Value $25 $50
Expected Market Value in One Year $30 $55
Expected Dividend $1 $1
Beta 1.2 0.80
Bass should recommend that the club:

A. purchase both stocks.

B. purchase MG only.
C. purchase CS only.
Explanation

In the context of the SML, a security is underpriced if the required return is less than
the holding period (or expected) return, is overpriced if the required return is greater
than the holding period (or expected) return, and is correctly priced if the required
return equals the holding period (or expected) return.

Here, the holding period (or expected) return is calculated as: (ending price -
beginning price + any cash flows / dividends) /beginning price. The required return
uses the equation of the SML: risk free rate + Beta × (expected market rate − risk-
free rate).

For CS Industries: ER = (30 - 25 + 1) / 25 = 24%, RR = 6 + 1.2 × (15 − 6) = 16.8%. Stock is

underpriced - purchase.

For MG Consolidated: ER = (55 - 50 + 1) / 50 = 12%, RR = 6 + 0.80 × (15 − 6) = 13.2%.

Stock is overpriced - do not purchase.

Question #19

What is the expected rate of return on a stock that has a beta of 1.4 if the market risk
premium is 9% and the risk-free rate is 4%?

A. 13.0%.
B. 11.0%.
C. 16.6%.

Explanation

Using the security market line (SML) equation: 4% + 1.4(9%) = 16.6%.

Question #20

Which of the following statements about a stock's beta is CORRECT? A beta

greater than one is:
A. risky, while a beta less than one is risk-free.
 B. undervalued, while a beta less than one is overvalued.
C. riskier than the market, while a beta less than one is less risky than the
market.
Explanation

Beta is a measure of the volatility of a stock. The overall market's beta is one. A
stock with higher systematic risk than the market will have a beta greater than
one, while a stock that has a lower systematic risk will have a beta less than one.
Question #21

Beta is least accurately described as:

A. a standardized measure of the total risk of a security.

B. a measure of the sensitivity of a security's return to the market return.
C. the covariance of a security's returns with the market return, divided by the
variance of market returns.
Explanation

Beta is a standardized measure of the systematic risk of a security. β = Covr,MKT /

σ2MKT . Beta is multiplied by the market risk premium in the CAPM: E(Ri) = RFR +
β[E(RMRK) - RFR].
Question #22

Mason Snow, CFA, is an analyst with Polari Investments. Snow's manager has
instructed him to put only securities that are undervalued on the buy list. Today, Snow
is to make a recommendation on the following two stocks: Bahre (with an expected
return of 10% and a beta of 1.4) and Cubb (with an expected return of 15% and a
beta of 2.0). The risk-free rate is at 7% and the market premium is 4%.

Snow places:

A. only Cubb on the list.

B. only Bahre on the list.
C. neither security on the list.

Explanation

In the context of the SML, a security is underpriced if the required return is less than
the holding period (or expected) return, is overpriced if the required return is greater
the holding period (or expected) return, and is correctly priced if the required return

equals the holding period (or expected) return.

Here, the holding period (or expected) return is calculated as: (ending price -
beginning price + any cash flow or dividends) / beginning price. The required return
uses the equation of the SML: risk free rate + Beta × (expected market rate - risk free
rate).

For Bahre: ER = 10% (given), RR = 0.07 + (1.4)(0.11-0.07) = 12.6%. Stock is overpriced -

do not put on buy list.

For Cubb: ER = 15%, (given) RR = 0.07 + (2.0)(0.11-0.07) = 15%. Stock is correctly

priced - do not put on buy list (per Snow's manager).

Question #23

Luis Green is an investor who uses the security market line to determine whether
securities are properly valued. He is evaluating the stocks of two companies, Mia
Shoes and Video Systems. The stock of Mia Shoes is currently trading at $15 per share,
and the stock of Video Systems is currently trading at $18 per share. Green expects
the prices of both stocks to increase by $2 in a year. Neither company pays dividends.
Mia Shoes has a beta of 0.9 and Video Systems has a beta of (-0.30). If the market
return is 15% and the risk-free rate is 8%, which trading strategy will Green employ?

Mia Shoes Video Systems

A. Sell Buy
B. Buy Buy
C. Buy Sell

Explanation

The required return for Mia Shoes is 0.08 + 0.9 × (0.15-0.08) = 14.3%. The forecast
return is $2/$15 = 13.3%. The stock is overvalued and the investor should sell it. The
required return for Video Systems is 0.08 - 0.3 × (0.15-0.08) = 5.9%. The forecast return
is $2/$18 = 11.1%. The stock is undervalued and the investor should buy it.