Studying market history can reward us by demonstrating that:

there is a reward for bearing risk

the greater the potential reward is, the greater the risk

Compound annual averages are usually ______ arithmetic averages.

geometric averages are usually ____ arithmetic averages.

smaller than

The ______ mean is the best estimate of next year's return.

Arithmetic

If the annual stock market returns for Berry Company were 19 percent, 13 percent, and -8 percent, what
was the arithmetic mean for those 3 years?
Reason: 
Mean = (.19 + .13 - .08)/3 = 8%

If stock GHI has returns of 10% and 15% over 2 years, the compound annual average rate of
return can be calculated by:
[(1.10)(1.15)]0.5 -1

Arrange the following investments from lowest historical risk premium to highest historical risk
premium.
1. Us treasury bills
2. Government bonds
3. Common stocks

OR

U.S. Treasury Bills, Long-term corporate bonds, large-company stocks, small company stocks

Which measure of return is best for making unbiased estimates of future returns?
The arithmetic average return

The __________ average should be used to make estimates of the opportunity cost of capital.
arithmetic

The ______ mean is the best estimate of next year's return.

arithmetic
From 1900 to 2014, the U.S. had the world's ______ highest market risk premium.
8th

What is the arithmetic average return for a stock that had annual returns of 8%, 2% and 11% for
the past 3 years?
7%

The average return on the stock market can be used to ___.

compare stock returns with the returns on other securities

If stock GHI has returns of 10% and 20% over 2 years, the compound annual average rate of
return can be calculated by:
[(1.10)(1.20)]0.5 -1

If stock GHI has returns of 6%, and -2% over 2 years, the GEOMETRIC Average rate of return is ____.
[(1.06)(0.980]^5-1 = 1.92%

The risk premium is the difference between risky returns and ______ returns.
risk-free

Which of the following are true about the historical equity risk premiums of the countries studied
by Dimson, Marsh, and Staunton?
Switzerland had the lowest equity risk premium

-Germany had the highest equity risk premium

True or false: Changes in dividend yields are excellent predictors of long-term required returns.
False

The average return on the stock market can be used to ___.

compare stock returns with the returns on other securities

Which of the following statements are true about variance?

Variance is a measure of the squared deviations of a security's return from its expected return.
Standard deviation is the square root of variance.

The ____________ is the difference between risky returns and risk-free returns.
risk premium

The square of the standard deviation is equal to the ____.

variance

The dividend yield for a one-year period is equal to the annual dividend amount divided by the
____.
beginning stock price

Which of the following statements are true about expected return?

The expected return can be calculated as the average of the returns in previous periods.
The actual return can be higher or lower than the expected return.
The expected return reflects an estimate that can be based on sophisticated forecasts of future
outcomes.

Rank the following in order from the lowest variance to the highest variance over the time period
from 1900-2014.
1. Treasury bills
2. Government bonds
3. Common stocks

What is variance?
A measure of the squared deviations of a security's return from its expected return

The standard deviation is the ______ of the variance.

square root
The standard deviation for common stock returns from 1900 to 2017 was:
19.7%

The standard deviation for common stock returns from 1900 to 2014 was:
19.9%

True or false: Market risk will impact all securities in a portfolio equally.

As more securities are added to a portfolio, what will happen to the portfolio's total specific risk?
It may eventually be eliminated.
It is likely to decrease.

What is expected return?

The return that an individual expects to earn over the next period.
It is the return that an investor expects to earn on a risky asset in the future.

What is the main purpose of holding a diversified portfolio?

To reduce total risk by spreading investment dollars across various assets

What is likely to happen to the total specific risk of a portfolio when we add new securities to a
portfolio?
The total specific risk of the portfolio will decrease.

What is specific risk?

It is a risk that affects a single asset or a small group of assets.

True or false: Market risk will impact all securities in a portfolio equally.
False

True or False: Systematic risk will impact all securities in every portfolio equally.
False
True or false: It is possible for the specific risk of a portfolio to be reduced to zero.
True
A firm faces many risks. Which of the following are examples of specific risks faced by a firm?
The death of the CEO
A hostile takeover attempt by a competitor

Which of the following are examples of market risk?

-An increase in the corporate tax rate

-An increase in the Federal funds rate

What is the impact on market risk when securities are added to a portfolio?
It will not change.

True or false: A well-diversified portfolio will eliminate all risks.

False

What is market risk?

It is a risk that threatens all businesses and cannot be diversified away.

Which of the following types of risk is not reduced by diversification?

Market risk

Which of the following are examples of specific risk?

Changes in management
Labor strikes

Why can an investor holding a well-diversified portfolio of securities ignore the specific risk of
individual securities?
Because specific risk should be eliminated or reduced through diversification

What happens to the expected returns of the existing securities in your portfolio if new securities
are added to your portfolio?
The expected returns of existing securities will not change.
Which type of risk does not change as we add more securities to a portfolio?
Market risk
Systematic risk

True or false: A well-diversified portfolio will reduce some specific risks.

True

What is the expected return of a portfolio consisting of stocks A and B if the expected return is 10 percent
for A and 15 percent for B? Assume you are equally invested in both the stocks.
Reason: 
.5 × 10% + .5 × 15% = 12.5%

__________ is not reduced by basic diversification.

Market risk

Which of the following statements are true about correlation?

Correlation is related to covariance.
Correlation measures the interrelationship between the returns of two securities.

If the variance of a portfolio increases, then the portfolio standard deviation will _____.
increase

Diversification is possible as long as the correlation between securities is ____.

less than +1
Reason: 
As long as the securities within the portfolio are not perfectly positively correlated, some
diversification benefit is realized.
All of the following are needed in order to compute the variance of a portfolio consisting of two
stocks, A and B, except
The variance of the stock market index
What is needed in order to compute the variance of a portfolio consisting of two stocks, A and B?
• The market value, in dollars, of the investment in stocks A and B
• The variances of stocks A and B
• The covariance between stocks A and B

What is the return on a portfolio that consists of: $50,000 in an index fund, $30,000 in a bond fund, and
$20,000 in a foreign stock fund? The expected returns are 7 percent, -3 percent, and 18 percent,
respectively.
Reason: 
.5 × 7% + .3 × -3% + .2 × 18% = 6.2%

The standard deviation of a portfolio of two securities will be less than the weighted average of
the standard deviation of the two securities when the correlation between the two securities ____.
is less than one

What is the impact on the variance of a two-asset portfolio if the covariance between the two
securities is negative?
The variance will decrease.

If the variance of a portfolio is .0025, what is the standard deviation?

Reason: 
σp= .0025.5 = .05, or 5%

The variance of the return on a portfolio with many securities is _______ dependent on the
covariances between the individual securities than on the variances of the individual securities.
More

What does beta measure?

It measures the risk of a security in relation to the overall market.

Which of the following are needed in order to compute the variance of a portfolio consisting of
two stocks, A and B?
The market value, in dollars, of the investments in stocks A and B
The variances of stocks A and B
The covariance between stocks A and B
By definition, what is the beta of the average asset equal to?
One

If a security's expected return is equal to the expected return on the market, its beta must be
____.
One

In a two-asset portfolio, a ________ covariance of returns between the two securities will lead to
the greatest reduction in the variance of the portfolio.
Negative

What is Stock B's beta if the covariance between stock B and the market is 3.75, and variance of
the market is 2.5?
1.5

True or false: Investors will pay extra for firms that diversify.
Fasle

The concept that present values can be added because the firm value is just the sum of its parts is
called ____________.
value additivity

What is the beta for stock A if the covariance between stock A and the market is 1.5 and the
variance of the market is 2.5?
Reason: 
1.5/2.5 = .6