Business Finance 11th Edition Peirson Test Bank

Business Finance 11th Edition Peirson
Test Bank
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Chapter 07 Testbank
Student: ___________________________________________________________________________
1. Which distribution is a list of the possible dollar returns from the investment together with the probability of each
return?
A. Normal distribution.
B. Probability distribution.
C. Both Normal distribution and Probability distribution.
D. utility function.
2. Variance is best defined as:
A. difference of opinion in expected returns.

B. the mean of the squared deviations from the expected value.
C. the median difference between the most probable outcome and least probable outcome.
D. the difference between the expected return and the actual return.
3. Which distribution can be fully described by its expected value and standard deviation?
D. None of the given options.
4. Which investor attaches decreasing utility to each increment in wealth?
A. A risk-seeking investor.
B. A risk-neutral investor.
C. A risk-averse investor.
D. All of the given options.
5. Which investor attaches equal utility to each increment in wealth?
B. A risk-averse investor.
C. A well diversified investor.
D. A risk-neutral investor.
6. An investor's preferences regarding expected return and risk can be illustrated using:
A. yield curves.
B. a normal distribution.
C. indifference curves.
D. an efficient portfolio.
7. Which investor has a positive attitude towards expected return and a negative attitude towards risk?
A. A risk-averse investor.
C. A risk-seeking investor.
D. A well-diversified investor.
8. Portfolio theory was initially developed by:
A. Fama (1970).
B. Markowitz (1952).
C. Modigliani and Miller (1958).
D. Sharpe (1950).
9. Assume two securities A and B. The correlation coefficient between these two securities can be written as:
A.
B.
C.
D.
10. Which type of risk is unique to a firm and may be eliminated by diversification?
A. Macro risk.
B. Unsystematic risk.
C. Systematic risk.
D. Total risk.
11. Which statement best describes the market portfolio?
A. Portfolio of all traded assets in the universe.

B. Portfolio of all assets weighted according to their market capitalisation.
C. Portfolio of all risky assets weighted according to their value.
D. Portfolio of all risky assets weighted according to their market capitalisation.
12. The capital market line:
A. describes the equilibrium risk-return relationship for efficient portfolios.

B. describes the equilibrium risk-return relationship for all portfolios.
C. describes the equilibrium risk-return relationship for riskless portfolios.
D. describes the equilibrium risk-return relationship for risky portfolios.
13. A security market line:
A. explains the co-variance between the returns on the risky asset and the market portfolio.
B. explains the co-variance between the returns on the risky asset and a riskless asset.
C. is a graphical representation of the CAPM.
D. is a graphical representation of the CML.
14. Examine the following probability distribution:
The expected value from this is:
A. $3500
B. $4000
C. $3000
D. $2500
The range and standard deviation of the distribution are:
A. $4000 and $1095.45, respectively.

B. $1095.45 and $4000, respectively.
C. $5000 and $1095.45, respectively.
D. $4000 and $2000, respectively.
The mean, range and standard deviation are:
A. 0.06, 0.10 and 0.0693, respectively.

B. 0.06, 0.08 and 0.0693, respectively.
C. 0.06, 0.08 and 0.022, respectively.
D. 0.07, 0.10 and 0.022, respectively.
17. It is often assumed that an investment's distribution of returns follows a normal distribution because:
A. investment distributions are not usually bell shaped.

B. the expected value is the weighted average expected return from an investment.
C. the expected value gives a measurement of risk.
D. it enables an investment to be described by its expected value and standard deviation.
18. What would be the shape of the probability distribution for completely certain returns?
A. A vertical line.
B. Bell shaped but with a high peak.
C. A horizontal line.
D. Two or more vertical lines.
19. What would be the shape of the probability distribution for completely uncertain returns?
A. Horizontal line above the x axis.

B. Vertical line.
C. Horizontal line along the x axis.
D. Bell-shaped but very flat.
20. Which statement best describes the attitude of investors towards risk?
A. Investors may behave as though they are risk seekers for small investments.
B. Investors behave as though they are risk averse for investments of significant size.
C. For a risk-averse investor, the standard deviation of the return distribution is a relevant measure of risk.
D. All of the given answers.
21. The benefit of diversification to an investor is the reduction of:
A. brokerage costs.
B. brokerage costs and risk.
C. risk.
D. research time.
22. Which of the following statements is true?
A. Two assets that are perfectly negatively correlated can produce a portfolio with zero variance.
B. Adding an asset to a portfolio by random selection will reduce the risk of a portfolio.
C. Adding a riskless security to a portfolio will increase its overall risk.
D. The amount of risk reduction that can be achieved by adding a new security to an existing portfolio increases as
the correlation between the expected returns of the new security and the expected returns on the existing portfolio
increases.
23. Which of the following investments does a rational investor prefer?
A. Investment A: E(R) = 10%, = 3%

B. Investment B: E(R) = 10%, = 5%
C. Investment C: E(R) = 11%, = 3%
D. None of the given options, as a rational investor would require more information from which to make a decision.
24. Suppose that the returns on an investment are normally distributed with an expected return of 8% and standard
deviation of 4%. What is the likelihood of making a negative return? (Hint: the area under a curve for 1 std dev is
34.13%, 2 std dev is 47.73% and 3 std dev is 49.87%).
A. 47.73%
B. 34.13%
C. 15.87%
D. 2.27%
deviation of 5%. What is the likelihood of making a positive return? (Hint: the area under a curve for 1 std dev is
34.13%, 2 std dev is 47.73% and 3 std dev is 49.87%.)
A. 84.13%
B. 2.27%
C. 97.73%
D. 15.87%
deviation of 3%. What is the likelihood of receiving a return that is equal to or less than 19%? (Hint: the area under a
curve for 1 std dev is 34.13%, 2 std dev is 47.73% and 3 std dev is 49.87%.)
A. 97.73%
B. 84.13%
C. 15.87%
D. 2.27%
27. Suppose you have the choice between two investments – one that pays fixed interest of 4% p.a., and another whose
returns are normally distributed with an expected return of 10% and standard deviation of 3%. What is the likelihood
of receiving a return on the second investment that is equal to or greater than that which can be received from the
first investment? (Hint: the area under a curve for 1 std dev is 34.13%, 2 std dev is 47.73% and 3 std dev is
49.87%.)
A. 97.73%
B. 84.13%
C. 65.87%
D. 52.27%
28. A risk-averse investor attaches:
A. increasing utility to each increment in wealth.

B. decreasing utility to each increment in wealth.
C. increasing utility to each increment in risk.
D. no utility to each increment in risk.
29. A risk-neutral investor attaches:

C. decreasing utility to each increment in risk.
D. equal utility to each increment in wealth.
30. A risk-seeking investor attaches:

B. increasing utility to each decrement in risk.
D. decreasing utility to each increment in wealth.
31. Which of the following two investments would a risk seeker choose: Investment A with an expected outcome of
$1000 and standard deviation of $500, or Investment B with an expected outcome of $1000 and standard deviation
of $200?
A. Investment A because if Investment B is chosen the expected utility from the increase in spread of expected
returns below $1000 outweighs the expected utility from the increase in spread of expected returns above $1000.
B. Investment A because it offers the chance of more wealth.
C. Investment A because the downside risk is greater.
D. Investment B because the downside risk is less.
32. Risk aversion implies that:
A. an investor will prefer a higher expected return than a lower expected return.
B. an investor will refuse to bear any risk at all.
C. an investor will tolerate extra risk if it is expected that the return will compensate them for bearing it.
D. an investor will be indifferent to the level of risk providing that the expected return is identical.
33. Two important assumptions of portfolio theory are:
A. returns from investments are normally distributed and investors seek to minimise transaction costs.
B. returns from investments are normally distributed and investors are risk averse.
C. returns on a portfolio are normally distributed and investors are risk averse.
D. the standard deviation of returns on a portfolio is normally distributed and investors are risk averse.
34. Calculate the expected return from a portfolio consisting of three securities with the following expected returns and
weights:
A. 0.114%
B. 12%
C. 11.4%
D. 36%
35. The variance of a portfolio does not depend on:
A. the proportion of the current market value of the portfolio constituted by each security.
B. the variance of the possible returns of each security.
C. the total market value of the portfolio.
D. the correlation between possible returns on the securities held in the portfolio.
36. An ‘efficient' portfolio is one that:
A. combines assets whose returns are not perfectly correlated.

B. offers the highest expected return for a given level of risk.
C. holds a proportion of all possible assets.
D. combines many diverse assets.
37. Increasing the amount of wealth in Asset A whilst maintaining the entire wealth invested in a portfolio consisting of
two assets only, A and B (assume that the expected return and standard deviation of both assets are A: 0.10 and
0.03, and B: 0.15 and 0.05, respectively):
A. will increase the expected return of the portfolio.

B. may reduce the variance of the portfolio regardless of the correlation coefficient between Assets A and B.
C. will decrease the expected return of the portfolio, but the expected return will be closer to 15% than before.
D. will decrease the expected return of the portfolio, but the expected return will still be greater than if the portfolio
consisted of Asset A only.
38. The efficient frontier:
A. includes those portfolios that offer the maximum expected return for a given level of risk.
B. combines those assets in a portfolio that offer the highest expected return for a given level of risk.
C. includes the portfolio of all possible assets.
D. combines portfolios that offer the maximum level of expected return for a given amount of wealth invested.
39. According to portfolio theory, which of the following assumptions is not essential to the equilibrium pricing of risky
assets?
A. All investors have the same estimate of expected returns and variance of expected returns on each asset.
B. All investors have a common single-period time horizon for investment decisions.
C. All assets are traded in perfect markets.
D. All investors can sell short assets (sell an asset first and then purchase later).
40. Systematic risk represents:
A. diversifiable risk.
B. risk that is unavoidable.
C. risk that is diversifiable.
D. none of the options given.
41. Which of the following is not an example of unsystematic risk?
A. Changes in the level of interest rates.

B. The chief executive officer resigns.
C. A legal suit against a company for environmental pollution.
D. The development of a new product line.
42. What is the expected return on an asset with a beta of 2.0, if the risk-free rate of interest is 5% and the expected
return on the market portfolio is 10%?
A. 12.5%
B. 20%
C. 10%
D. 15%
43. Beta is a measure of the extent to which:
A. the returns on the stock market as a whole change over time.

B. a security's risk can be eliminated by proper diversification.
C. the returns on a given stock move with the stock market.
D. a security's risk can be eliminated by random diversification.
44. From the following information, calculate the expected return and standard deviation of a portfolio that consists of
60% of Security A (expected return of 0.10 and standard deviation of 0.03) and 40% of Security B (expected return of
0.20 and standard deviation of 0.05), assuming the co-variance between A and B is -0.0012.
A. E(R) = 0.152, σ = 0.161

B. E(R) = 0.138, σ = 0.012
C. E(R) = 0.14, σ = 0.085
D. E(R) = 0.14, σ = 0.012
45. The relationship between the required rate of return for a security and market risk is:
A. non-linear.
B. linear.
C. denoted by the capital market line.
D. concave.
46. The straight line passing through the risk-free rate of return on the vertical axis and the expected return–standard
deviation point for the market portfolio is known as the:
A. security market line.

B. capital market line.
C. characteristic line.
D. efficient frontier.
47. Which of the following is typically used in empirical studies as a proxy for the market portfolio?
A. Consumer price index.

B. All Ordinaries Accumulation Index.
C. Treasury notes.
D. GDP.
48. A popular measure of risk in corporate finance called the value at risk (VaR), which is defined as:
A. the best return from a high risk investment.

B. the worst loss that is possible under normal market conditions.
C. the worst possible loss under any market conditions.
D. the worst return from a low risk investment.
49. The Fama–French three-factor model of expected returns includes the following three factors:
A. the market risk premium, the size of firms and the risk free rate.
B. the risk free rate, the market risk premium and price earnings ratios.
C. the market risk premium, the size of firms and book-to-market ratios.
D. the market risk premium, the risk free rate and book-to-market ratios.
50. After adjusting for risk, the returns to a portfolio can differ from the benchmark portfolio as a result of:
A. asset allocation.
B. market timing.
C. random events.
D. all of the given answers.
51. An investor would like to evaluate the performance of her portfolio using the Sharpe ratio. The past year realised
return and standard deviation of returns of the portfolio, the benchmark portfolio, given by the S&P/ASX share price
index, and government bonds are:
Has the portfolio:
A. underperformed relative to the benchmark.

B. outperformed the market benchmark on a risk-adjusted basis.
C. underperformed the market benchmark on a risk-adjusted basis.
D. outperformed the Government Bonds.
52. An investor would like to evaluate the performance of her portfolio using the Treynor ratio. The past year realised
return and systematic risk of the portfolio, the benchmark portfolio, given by the S&P/ASX share price index, and
government bonds are:
Has the portfolio:

53. Which of the following is NOT a portfolio performance measure?
A. Jensen's beta.
B. The Sharpe ratio.
C. The Treynor Ratio.
D. Jenson's alpha.
54. Mehra and Prescott (1985) showed that a long-term risk premium such as that found in the US, Canada, the UK and
Australia:
A. exceeds 3% p.a.
B. does not exceed 3% p.a.
C. can be explained by standard models of risk and return.
D. cannot be explained by standard models of risk and return.
55. Claus and Thomas (2001) use forecasts by security analysts and conclude that the market risk premium is
approximately:
A. 2% p.a.
B. 3% p.a.
C. 4% p.a.
D. 1% p.a.
56. Fama and French (2002) use the dividend growth model and conclude that the market risk premium is now of the
order of:
A. 2% p.a.
B. 1% p.a.
C. 3% p.a.
D. 5.5% p.a.
57. Standard deviation is measured as the _______________ of variance.
________________________________________
58. A risk __________ investor will make their investment decision purely on the return generated by a project.
________________________________________
59. The _____________________ plots the relationship between the expected return and beta of a security.
________________________________________
60. The _______________ is a curve that includes all portfolios with the highest return for a given level of risk.
________________________________________
61. The Fama–French three-factor model of asset pricing attempted to improve the CAPM by integrating variables that
measured a firm's size and its ___________________.
________________________________________
62. In order to benchmark the performance of a portfolio it is important to compare it to a portfolio of

___________________.
________________________________________
63. Where two securities are perfectly positively correlated, there is no reduction in unsystematic risk through
diversification.
True False
64. The typical utility-to-wealth function for a risk-seeking investor is upward sloping.
True False
65. Portfolio theory, as initially developed by Markowitz (1952), assumes that the returns from investments are normally
distributed.
True False
66. A well-diversified portfolio should have a beta significantly less than one.
True False
67. The Capital Asset Pricing Model (CAPM) assumes that all securities are priced according to their unsystematic risk.
True False
68. Beta is calculated by finding the co-variance between the return on the asset and the return on the market and
dividing it by the variance of the return on the market.
True False
69. If an asset has a beta of 0.8, this indicates that the expected return of the asset should be greater than the market
portfolio.
True False
70. The Fama–French three-factor model of expected returns indicates a linear relationship according to the size of the
firm and book-to-market ratios.
True False
71. A simple performance benchmark is to compare the return of a well diversified portfolio of domestic shares to the
S&P/ASX200 Index.
True False
72. Explain the difference between systematic and unsystematic risk.
73. What are the two components of expected return in the CAPM?
74. Explain the key differences between the Capital Market Line and the Security Market Line.
Has the portfolio:
76. You are considering investing in ZIN mining corp. Research into the company suggests that the company will
achieve one of three possible returns over the next 12 months. The possible returns along with the probability of
each are listed in the following table.
a. What is the expected return of ZIN?

b. What is the standard deviation of returns of ZIN?
You also consider the stock WMC, which has an expected return of 15% and a standard deviation of 4%. If you
create a portfolio with 60% weight on ZIN and 40% WMC and the correlation coefficient is 0.8, then:
c. What is the expected return of this portfolio?
d. What is the risk of the portfolio?
Chapter 07 Testbank Key
1. Which distribution is a list of the possible dollar returns from the investment together with the probability of each
return?
D. utility function.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
EQUIS: Apply knowledge
Graduate Attributes: Problem-solving
Learning Objective: 07-01 Understand how return and risk are defined and measured
Section: 7.2 Return and risk
2. Variance is best defined as:
A. difference of opinion in expected returns.

B. the mean of the squared deviations from the expected value.
C. the median difference between the most probable outcome and least probable outcome.
D. the difference between the expected return and the actual return.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
3. Which distribution can be fully described by its expected value and standard deviation?
D. None of the given options.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
4. Which investor attaches decreasing utility to each increment in wealth?
C. A risk-averse investor.
D. All of the given options.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
Learning Objective: 07-02 Understand the concept of risk aversion by investors
Section: 7.3 The investor's utility function
5. Which investor attaches equal utility to each increment in wealth?
B. A risk-averse investor.
C. A well diversified investor.
D. A risk-neutral investor.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
6. An investor's preferences regarding expected return and risk can be illustrated using:
A. yield curves.
B. a normal distribution.
C. indifference curves.
D. an efficient portfolio.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
7. Which investor has a positive attitude towards expected return and a negative attitude towards risk?
A. A risk-averse investor.
C. A risk-seeking investor.
D. A well-diversified investor.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
8. Portfolio theory was initially developed by:
A. Fama (1970).
B. Markowitz (1952).
C. Modigliani and Miller (1958).
D. Sharpe (1950).
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
Learning Objective: 07-03 Explain how diversification reduces risk
Section: 7.5 Portfolio theory and diversification
9. Assume two securities A and B. The correlation coefficient between these two securities can be written as:
A.
B.
C.
D.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
Learning Objective: 07-04 explain the concept of efficient portfolios
10. Which type of risk is unique to a firm and may be eliminated by diversification?
A. Macro risk.
B. Unsystematic risk.
C. Systematic risk.
D. Total risk.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
11. Which statement best describes the market portfolio?
A. Portfolio of all traded assets in the universe.

B. Portfolio of all assets weighted according to their market capitalisation.
C. Portfolio of all risky assets weighted according to their value.
D. Portfolio of all risky assets weighted according to their market capitalisation.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
Learning Objective: 07-08 Explain the relationship between returns and risk proposed by the capital asset pricing model
Section: 7.6 The pricing of risky assets
12. The capital market line:
A. describes the equilibrium risk-return relationship for efficient portfolios.

B. describes the equilibrium risk-return relationship for all portfolios.
C. describes the equilibrium risk-return relationship for riskless portfolios.
D. describes the equilibrium risk-return relationship for risky portfolios.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
Learning Objective: 07-07 explain why systematic risk is important to investors
13. A security market line:
A. explains the co-variance between the returns on the risky asset and the market portfolio.
B. explains the co-variance between the returns on the risky asset and a riskless asset.
C. is a graphical representation of the CAPM.
D. is a graphical representation of the CML.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
The expected value from this is:
A. $3500
B. $4000
C. $3000
D. $2500
AACSB: Analytic
Blooms: Application
Difficulty: Medium
The range and standard deviation of the distribution are:
A. $4000 and $1095.45, respectively.

B. $1095.45 and $4000, respectively.
C. $5000 and $1095.45, respectively.
D. $4000 and $2000, respectively.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Hard
The mean, range and standard deviation are:
A. 0.06, 0.10 and 0.0693, respectively.

B. 0.06, 0.08 and 0.0693, respectively.
C. 0.06, 0.08 and 0.022, respectively.
D. 0.07, 0.10 and 0.022, respectively.
AACSB: Analytic
Blooms: Application
Difficulty: Hard
17. It is often assumed that an investment's distribution of returns follows a normal distribution because:
A. investment distributions are not usually bell shaped.

B. the expected value is the weighted average expected return from an investment.
C. the expected value gives a measurement of risk.
D. it enables an investment to be described by its expected value and standard deviation.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
18. What would be the shape of the probability distribution for completely certain returns?
A. A vertical line.
B. Bell shaped but with a high peak.
C. A horizontal line.
D. Two or more vertical lines.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
19. What would be the shape of the probability distribution for completely uncertain returns?
A. Horizontal line above the x axis.

B. Vertical line.
C. Horizontal line along the x axis.
D. Bell-shaped but very flat.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
20. Which statement best describes the attitude of investors towards risk?
A. Investors may behave as though they are risk seekers for small investments.
B. Investors behave as though they are risk averse for investments of significant size.
C. For a risk-averse investor, the standard deviation of the return distribution is a relevant measure of risk.
D. All of the given answers.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
21. The benefit of diversification to an investor is the reduction of:
A. brokerage costs.
B. brokerage costs and risk.
C. risk.
D. research time.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
22. Which of the following statements is true?
A. Two assets that are perfectly negatively correlated can produce a portfolio with zero variance.
B. Adding an asset to a portfolio by random selection will reduce the risk of a portfolio.
C. Adding a riskless security to a portfolio will increase its overall risk.
D. The amount of risk reduction that can be achieved by adding a new security to an existing portfolio increases
as the correlation between the expected returns of the new security and the expected returns on the existing
portfolio increases.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
23. Which of the following investments does a rational investor prefer?
A. Investment A: E(R) = 10%, = 3%

B. Investment B: E(R) = 10%, = 5%
C. Investment C: E(R) = 11%, = 3%
D. None of the given options, as a rational investor would require more information from which to make a
decision.
AACSB: Analytic
Blooms: Application
Difficulty: Medium
deviation of 4%. What is the likelihood of making a negative return? (Hint: the area under a curve for 1 std dev is
34.13%, 2 std dev is 47.73% and 3 std dev is 49.87%).
A. 47.73%
B. 34.13%
C. 15.87%
D. 2.27%
AACSB: Analytic
Blooms: Application
Difficulty: Hard
deviation of 5%. What is the likelihood of making a positive return? (Hint: the area under a curve for 1 std dev is
34.13%, 2 std dev is 47.73% and 3 std dev is 49.87%.)
A. 84.13%
B. 2.27%
C. 97.73%
D. 15.87%
AACSB: Analytic
Blooms: Application
Difficulty: Hard
deviation of 3%. What is the likelihood of receiving a return that is equal to or less than 19%? (Hint: the area
under a curve for 1 std dev is 34.13%, 2 std dev is 47.73% and 3 std dev is 49.87%.)
A. 97.73%
B. 84.13%
C. 15.87%
D. 2.27%
AACSB: Analytic
Blooms: Application
Difficulty: Hard
27. Suppose you have the choice between two investments – one that pays fixed interest of 4% p.a., and another
whose returns are normally distributed with an expected return of 10% and standard deviation of 3%. What is the
likelihood of receiving a return on the second investment that is equal to or greater than that which can be
received from the first investment? (Hint: the area under a curve for 1 std dev is 34.13%, 2 std dev is 47.73% and
3 std dev is 49.87%.)
A. 97.73%
B. 84.13%
C. 65.87%
D. 52.27%
AACSB: Analytic
Blooms: Application
Difficulty: Hard
28. A risk-averse investor attaches:

C. increasing utility to each increment in risk.
D. no utility to each increment in risk.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
29. A risk-neutral investor attaches:

D. equal utility to each increment in wealth.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
30. A risk-seeking investor attaches:

B. increasing utility to each decrement in risk.
D. decreasing utility to each increment in wealth.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
31. Which of the following two investments would a risk seeker choose: Investment A with an expected outcome of
$1000 and standard deviation of $500, or Investment B with an expected outcome of $1000 and standard
deviation of $200?
A. Investment A because if Investment B is chosen the expected utility from the increase in spread of expected
returns below $1000 outweighs the expected utility from the increase in spread of expected returns above
$1000.
B. Investment A because it offers the chance of more wealth.
C. Investment A because the downside risk is greater.
D. Investment B because the downside risk is less.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
32. Risk aversion implies that:
A. an investor will prefer a higher expected return than a lower expected return.
B. an investor will refuse to bear any risk at all.
C. an investor will tolerate extra risk if it is expected that the return will compensate them for bearing it.
D. an investor will be indifferent to the level of risk providing that the expected return is identical.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
33. Two important assumptions of portfolio theory are:
A. returns from investments are normally distributed and investors seek to minimise transaction costs.
B. returns from investments are normally distributed and investors are risk averse.
C. returns on a portfolio are normally distributed and investors are risk averse.
D. the standard deviation of returns on a portfolio is normally distributed and investors are risk averse.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
34. Calculate the expected return from a portfolio consisting of three securities with the following expected returns and
weights:
A. 0.114%
B. 12%
C. 11.4%
D. 36%
AACSB: Analytic
Blooms: Application
Difficulty: Medium
35. The variance of a portfolio does not depend on:
A. the proportion of the current market value of the portfolio constituted by each security.
B. the variance of the possible returns of each security.
C. the total market value of the portfolio.
D. the correlation between possible returns on the securities held in the portfolio.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
36. An ‘efficient' portfolio is one that:
A. combines assets whose returns are not perfectly correlated.

B. offers the highest expected return for a given level of risk.
C. holds a proportion of all possible assets.
D. combines many diverse assets.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
Learning Objective: 07-05 understand the importance of covariance between returns on risky assets in determining the risk of a portfolio
37. Increasing the amount of wealth in Asset A whilst maintaining the entire wealth invested in a portfolio consisting
of two assets only, A and B (assume that the expected return and standard deviation of both assets are A: 0.10
and 0.03, and B: 0.15 and 0.05, respectively):
A. will increase the expected return of the portfolio.

B. may reduce the variance of the portfolio regardless of the correlation coefficient between Assets A and B.
C. will decrease the expected return of the portfolio, but the expected return will be closer to 15% than before.
D. will decrease the expected return of the portfolio, but the expected return will still be greater than if the
portfolio consisted of Asset A only.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Hard
38. The efficient frontier:
A. includes those portfolios that offer the maximum expected return for a given level of risk.
B. combines those assets in a portfolio that offer the highest expected return for a given level of risk.
C. includes the portfolio of all possible assets.
D. combines portfolios that offer the maximum level of expected return for a given amount of wealth invested.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
Learning Objective: 07-05 understand the importance of covariance between returns on risky assets in determining the risk of a portfolio
39. According to portfolio theory, which of the following assumptions is not essential to the equilibrium pricing of risky
assets?
A. All investors have the same estimate of expected returns and variance of expected returns on each asset.
B. All investors have a common single-period time horizon for investment decisions.
C. All assets are traded in perfect markets.
D. All investors can sell short assets (sell an asset first and then purchase later).
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
40. Systematic risk represents:
A. diversifiable risk.
B. risk that is unavoidable.
C. risk that is diversifiable.
D. none of the options given.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
Learning Objective: 07-06 explain the distinction between systematic and unsystematic risk
41. Which of the following is not an example of unsystematic risk?
A. Changes in the level of interest rates.

B. The chief executive officer resigns.
C. A legal suit against a company for environmental pollution.
D. The development of a new product line.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
Learning Objective: 07-06 explain the distinction between systematic and unsystematic risk
42. What is the expected return on an asset with a beta of 2.0, if the risk-free rate of interest is 5% and the expected
return on the market portfolio is 10%?
A. 12.5%
B. 20%
C. 10%
D. 15%
AACSB: Analytic
Blooms: Application
Difficulty: Medium
43. Beta is a measure of the extent to which:
A. the returns on the stock market as a whole change over time.

B. a security's risk can be eliminated by proper diversification.
C. the returns on a given stock move with the stock market.
D. a security's risk can be eliminated by random diversification.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
44. From the following information, calculate the expected return and standard deviation of a portfolio that consists of
60% of Security A (expected return of 0.10 and standard deviation of 0.03) and 40% of Security B (expected
return of 0.20 and standard deviation of 0.05), assuming the co-variance between A and B is -0.0012.
A. E(R) = 0.152, σ = 0.161

B. E(R) = 0.138, σ = 0.012
C. E(R) = 0.14, σ = 0.085
D. E(R) = 0.14, σ = 0.012
AACSB: Analytic
Blooms: Application
Difficulty: Hard
Learning Objective: 07-04 explain the concept of efficient portfolios
45. The relationship between the required rate of return for a security and market risk is:
A. non-linear.
B. linear.
C. denoted by the capital market line.
D. concave.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
46. The straight line passing through the risk-free rate of return on the vertical axis and the expected return–standard
deviation point for the market portfolio is known as the:
A. security market line.

B. capital market line.
C. characteristic line.
D. efficient frontier.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
47. Which of the following is typically used in empirical studies as a proxy for the market portfolio?
A. Consumer price index.

B. All Ordinaries Accumulation Index.
C. Treasury notes.
D. GDP.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
48. A popular measure of risk in corporate finance called the value at risk (VaR), which is defined as:
A. the best return from a high risk investment.

B. the worst loss that is possible under normal market conditions.
C. the worst possible loss under any market conditions.
D. the worst return from a low risk investment.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
section: EMPTY
49. The Fama–French three-factor model of expected returns includes the following three factors:
A. the market risk premium, the size of firms and the risk free rate.
B. the risk free rate, the market risk premium and price earnings ratios.
C. the market risk premium, the size of firms and book-to-market ratios.
D. the market risk premium, the risk free rate and book-to-market ratios.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
Learning Objective: 07-09 Understand the relationship between the capital asset pricing model and models that include additional factors
Section: 7.7 Additional factors that explain returns
50. After adjusting for risk, the returns to a portfolio can differ from the benchmark portfolio as a result of:
A. asset allocation.
B. market timing.
C. random events.
D. all of the given answers.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
51. An investor would like to evaluate the performance of her portfolio using the Sharpe ratio. The past year realised
return and standard deviation of returns of the portfolio, the benchmark portfolio, given by the S&P/ASX share
price index, and government bonds are:
Has the portfolio:

AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
Learning Objective: 07-11 Distinguish between alternative methods of appraising the performance of an investment portfolio
Section: 7.8 Portfolio performance appraisal
Has the portfolio:

AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
53. Which of the following is NOT a portfolio performance measure?
A. Jensen's beta.
B. The Sharpe ratio.
C. The Treynor Ratio.
D. Jenson's alpha.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
54. Mehra and Prescott (1985) showed that a long-term risk premium such as that found in the US, Canada, the UK
and Australia:
A. exceeds 3% p.a.
B. does not exceed 3% p.a.
C. can be explained by standard models of risk and return.
D. cannot be explained by standard models of risk and return.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
55. Claus and Thomas (2001) use forecasts by security analysts and conclude that the market risk premium is
approximately:
A. 2% p.a.
B. 3% p.a.
C. 4% p.a.
D. 1% p.a.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
56. Fama and French (2002) use the dividend growth model and conclude that the market risk premium is now of the
order of:
A. 2% p.a.
B. 1% p.a.
C. 3% p.a.
D. 5.5% p.a.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
57. Standard deviation is measured as the _______________ of variance.
square root
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
58. A risk __________ investor will make their investment decision purely on the return generated by a project.
neutral
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
59. The _____________________ plots the relationship between the expected return and beta of a security.
security market line
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
60. The _______________ is a curve that includes all portfolios with the highest return for a given level of risk.
efficient frontier
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
61. The Fama–French three-factor model of asset pricing attempted to improve the CAPM by integrating variables
that measured a firm's size and its ___________________.
book-to-market value
AACSB: Analytic
Blooms: Knowledge
Difficulty: Hard
62. In order to benchmark the performance of a portfolio it is important to compare it to a portfolio of

___________________.
similar risk
AACSB: Analytic
Blooms: Knowledge
Difficulty: Hard
63. Where two securities are perfectly positively correlated, there is no reduction in unsystematic risk through
diversification.
TRUE
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
64. The typical utility-to-wealth function for a risk-seeking investor is upward sloping.
TRUE
AACSB: Analytic
Blooms: Knowledge
Difficulty: Easy
65. Portfolio theory, as initially developed by Markowitz (1952), assumes that the returns from investments are
normally distributed.
TRUE
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
66. A well-diversified portfolio should have a beta significantly less than one.
FALSE
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
67. The Capital Asset Pricing Model (CAPM) assumes that all securities are priced according to their unsystematic
risk.
FALSE
AACSB: Analytic
Blooms: Knowledge
Difficulty: Hard
68. Beta is calculated by finding the co-variance between the return on the asset and the return on the market and
dividing it by the variance of the return on the market.
TRUE
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
69. If an asset has a beta of 0.8, this indicates that the expected return of the asset should be greater than the
market portfolio.
FALSE
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
70. The Fama–French three-factor model of expected returns indicates a linear relationship according to the size of
the firm and book-to-market ratios.
TRUE
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
71. A simple performance benchmark is to compare the return of a well diversified portfolio of domestic shares to the
S&P/ASX200 Index.
TRUE
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
72. Explain the difference between systematic and unsystematic risk.
Unsystematic risk is attributable to firm specific factors and can be eliminated by diversification. Systematic risk
affects all assets in the same way and is a result of economy wide factors.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
EQUIS: Communicate
73. What are the two components of expected return in the CAPM?
The first is the risk free rate of return and the second is the risk premium that depends on the assets beta and the
market risk premium.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
EQUIS: Communicate
74. Explain the key differences between the Capital Market Line and the Security Market Line.
The CML plots the relationship between total risk (measured by standard deviation) and expected return efficient
portfolios. The SML plots the relationship between risk and expected return for all assets and portfolios, where
risk is measure by beta.
AACSB: Analytic
Blooms: Knowledge
Difficulty: Medium
EQUIS: Communicate
Has the portfolio:
AACSB: Analytic
Blooms: Knowledge
Difficulty: A Easy
Difficulty: B Hard
Difficulty: C Medium
Difficulty: D Medium
76. You are considering investing in ZIN mining corp. Research into the company suggests that the company will
achieve one of three possible returns over the next 12 months. The possible returns along with the probability of
each are listed in the following table.
a. What is the expected return of ZIN?

b. What is the standard deviation of returns of ZIN?
You also consider the stock WMC, which has an expected return of 15% and a standard deviation of 4%. If you
create a portfolio with 60% weight on ZIN and 40% WMC and the correlation coefficient is 0.8, then:
c. What is the expected return of this portfolio?
d. What is the risk of the portfolio?
AACSB: Analytic
Blooms: Knowledge
Difficulty: A Medium
Difficulty: B Medium
Difficulty: C Medium
Difficulty: D Hard
Chapter 07 Testbank Summary
Category # of Questions
AACSB: Analytic 76
Blooms: Application 10
Blooms: Knowledge 66
Difficulty: A Easy 1
Difficulty: A Medium 1
Difficulty: B Hard 1
Difficulty: B Medium 1
Difficulty: C Medium 2
Difficulty: D Hard 1
Difficulty: D Medium 1
Difficulty: Easy 25
Difficulty: Hard 11
Difficulty: Medium 38
EQUIS: Apply knowledge 73
EQUIS: Communicate 3
Graduate Attributes: Problem-solving 76
Learning Objective: 07-01 Understand how return and risk are defined and measured 17
Learning Objective: 07-02 Understand the concept of risk aversion by investors 14
Learning Objective: 07-03 Explain how diversification reduces risk 6
Learning Objective: 07-04 explain the concept of efficient portfolios 2
Learning Objective: 07- 2
05 understand the importance of covariance between returns on risky assets in determining the risk of a portfolio
Learning Objective: 07-06 explain the distinction between systematic and unsystematic risk 2
Learning Objective: 07-07 explain why systematic risk is important to investors 4
08 Explain the relationship between returns and risk proposed by the capital asset pricing model
09 Understand the relationship between the capital asset pricing model and models that include additional factors
11 Distinguish between alternative methods of appraising the performance of an investment portfolio
Section: 7.2 Return and risk 15
Section: 7.3 The investor's utility function 13
Section: 7.5 Portfolio theory and diversification 18
Section: 7.6 The pricing of risky assets 20
Section: 7.7 Additional factors that explain returns 3
Section: 7.8 Portfolio performance appraisal 6

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Business Finance 11th Edition Peirson

2. Variance is best defined as:

A. difference of opinion in expected returns.

4. Which investor attaches decreasing utility to each increment in wealth?

5. Which investor attaches equal utility to each increment in wealth?

8. Portfolio theory was initially developed by:

11. Which statement best describes the market portfolio?

A. Portfolio of all traded assets in the universe.

12. The capital market line:

A. describes the equilibrium risk-return relationship for efficient portfolios.

13. A security market line:

14. Examine the following probability distribution:

The expected value from this is:

The range and standard deviation of the distribution are:

A. $4000 and $1095.45, respectively.

16. Examine the following probability distribution:

The mean, range and standard deviation are:

A. 0.06, 0.10 and 0.0693, respectively.

A. investment distributions are not usually bell shaped.

A. Horizontal line above the x axis.

21. The benefit of diversification to an investor is the reduction of:

22. Which of the following statements is true?

23. Which of the following investments does a rational investor prefer?

A. Investment A: E(R) = 10%, = 3%

28. A risk-averse investor attaches:

A. increasing utility to each increment in wealth.

29. A risk-neutral investor attaches:

A. increasing utility to each increment in wealth.

A. increasing utility to each increment in wealth.

32. Risk aversion implies that:

33. Two important assumptions of portfolio theory are:

36. An ‘efficient' portfolio is one that:

A. combines assets whose returns are not perfectly correlated.

A. will increase the expected return of the portfolio.

38. The efficient frontier:

40. Systematic risk represents:

A. Changes in the level of interest rates.

43. Beta is a measure of the extent to which:

A. the returns on the stock market as a whole change over time.

A. E(R) = 0.152, σ = 0.161

A. security market line.

A. Consumer price index.

A. the best return from a high risk investment.

Has the portfolio:

A. underperformed relative to the benchmark.

Has the portfolio:

A. underperformed relative to the benchmark.

53. Which of the following is NOT a portfolio performance measure?

62. In order to benchmark the performance of a portfolio it is important to compare it to a portfolio of

72. Explain the difference between systematic and unsystematic risk.

Has the portfolio:

a. What is the expected return of ZIN?

2. Variance is best defined as:

A. difference of opinion in expected returns.

5. Which investor attaches equal utility to each increment in wealth?

8. Portfolio theory was initially developed by:

11. Which statement best describes the market portfolio?

A. Portfolio of all traded assets in the universe.