Sample exam #1 - solutions
Question 1.
A stock is trading at $25 per share on October 1, $20 per share on November 1, and $30 per share
on December 1. At the end of November, a dividend of $3 per share is paid.
What is the rate of return for the month of October?
A. -25%
B. -20%
C. 20%
D. 25%
Answer: B
(20-25)/25 = -0.20
Question 2.
Refer again to Question 1. What is the rate of return for the month of November?
A. 10%
B. 15%
C. 50%
D. 65%
Answer: D
($30+$3-$20)/$20=0.65
Question 3.
Refer again to Question 1. What is the arithmetic average rate of return for the two months?
A. 15%
B. 23%
C. 35%
D. 43%
Answer: B
(-20%+65%)/2=22.5
Question 4.
Refer again to Question 1. What is the geometric average rate of return for the two months?
A. 15%
B. 23%
C. 35%
D. 43%
Answer: A
1/2
[(1-0.2)*(1+0.65)] – 1 = 0.1489
Question 5.
Refer again to Question 1. How much money was made by an investor who invested $1000 in the
stock on October 1 and liquidated the investment on December 1?
A. $20
B. $120
C. $220
D. $320
Answer: D
$1000*(1-0.2)*(1+0.65) - $1000 = $320
Alternatively, you can reason in this way: for $1000, the investor bought 40 shares of stock
at $25 per share. At the end of the two months, they were worth 40*$30=$1200, and the
investor also received 40*$3=$120 in dividends, i.e. $1320 in total, hence the investor
earned $1320-$1000=$320 from the stock.
Question 6.
Which of the securities listed below is typically the most risky:
A. Corporate bond
B. Corporate stock
C. Government bond
D. Treasury bill
Answer: B
See lecture notes
Question 7.
An investment has a 0.2 chance of generating a -50% return, a 0.3 chance of generating a 0%
return, and a 0.5 chance of generating a 40% return. What is the expected return on this
investment?
A. 10%
B. 20%
C. 30%
D. 40%
Answer: A
0.2*(-50%)+0.3*(0%)+0.5*40%=10%
Question 8.
Refer again to question 7. What is the variance of return for this investment?
A. 0.09
B. 0.10
C. 0.12
D. 0.16
Answer: C
0.2*(-50%-10%)^2 + 0.3*(0%-10%)^2 + 0.5*(40%-10%)^2
= 0.2*3600(%^2) + 0.3*100(%^2) + 0.5*900(%^2)
= 720(%^2) + 30(%^2) + 450(%^2)
= 1200 (%^2) = 1200/(100^2) = 0.12
Question 9.
Refer again to question 7. What is the standard deviation of return for this investment?
A. 30%
B. 35%
C. 40%
D. 45%
Answer: B
1/2
0.12 = 0.346
Question 10.
Over the course of ten years, an investment had one year with a 60% return, two years with a
-20% return, three years with a 0% return, and four years with a 30% return.
Based on this information only, what is the expected annual return on this investment?
A. 11%
B. 12%
C. 13%
D. 14%
Answer: D
[1*60%+2*(-20%)+3*0%+4*30%]/10 = 14%
Question 11.
Refer again to Question 10. Based on this information only, what is the standard deviation of
annual return for this investment?
A. 24%
B. 25%
C. 26%
D. 27%
Answer: C
Var(r) = [1*(60%-14%)^2+2*(-20%-14%)^2+3*(0%-14%)^2+4*(30%-14%)^2]/(10-1)
= 6040(%^2)/(10-1) = 0.6711
1/2
Stdev (r)= 0.6711 = 0.259 = 25.9%
Question 12.
Investments F, G, and H have expected returns equal to 7%, 9%, and 13%, betas equal to 1.0, 1.4,
and 2.2, and standard deviations of returns equal to 20%, 40%, and 40%, respectively. Investment
F is uncorrelated with both G and H, and the correlation between G and H is 0.5. Portfolio P
consists of a 50% investment in F, a 25% investment in G, and a 25% investment in H. What is
the expected return of portfolio P?
A. 8%
B. 9%
C. 10%
D. 11%
Answer: B
0.5*7%+0.25*9%+0.25*13% = 9%
Question 13.
Refer again to Question 13. What is the standard deviation of returns of portfolio P?
A. 20%
B. 25%
C. 30%
D. 35%
Answer: A
Using the portfolio variance formula,
Var = 0.5^2*20^2 + 0.25^2*40^2 + 0.25^2*40^2
+ 2*0.25*0.25*0.5*40*40
=100+100+100+100 = 400 (%^2)
St. Dev = 20%
Question 14.
Refer again to Question 13. What is the beta of portfolio P?
A. 1.0
B. 1.4
C. 1.8
D. 2.2
Answer: B
0.5*1.0+0.25*1.4+0.25*2.2 = 1.4
Question 15.
Refer again to Question 13. If stocks F, G, and H are fairly priced according to the CAPM, what is
the market risk premium?
A. 2%
B. 3%
C. 4%
D. 5%
Answer: D
The CAPM states that E(Ri) = Rf + beta * MRP,
So for the three stocks we have
F: 7% = Rf + 1.0 * MRP
G: 9% = Rf +1.4 * MRP
H: 13% = Rf + 2.2 * MRP
Any two equations can be used to solve for MRP, e.g. subtracting the equation for F from
the one for G, we get
2% = 0.4 * MRP
So MRP = 2% / 0.4 = 5%
Question 16.
Refer again to Question 13. If stocks F, G, and H are fairly priced according to the CAPM, what is
the risk-free rate?
A. 2%
B. 3%
C. 5%
D. 7%
Answer: A
As in the preceding question, need to solve the system of equations
F: 7% = Rf + 1.0 * MRP
G: 9% = Rf +1.4 * MRP
H: 13% = Rf + 2.2 * MRP
Since MRP=5%, then substituting this value e.g. into the equation for F, we get 7% = Rf +
1.0 * 5%, so Rf = 2%.
Question 17.
The standard deviation of the market return is 18%, the standard deviation of stock J’s return is
36%, and the beta of stock J is 0.8. What is the correlation between the return of stock J and the
market?
A. 0.1
B. 0.2
C. 0.3
D. 0.4
Answer: D
From the formula for beta, we have
0.8 = corr (J,M) * ( 36% / 18% )
corr (J,M) =0.8/2 = 0.4
Question 18.
According to the CAPM, which of the following statements is correct:
A. all investments have the same expected return
B. beta is proportional to the risk-free rate
C. expected return is proportional to systematic risk
D. the market portfolio has a lower expected return than the risk-free asset
Answer: C
See lecture notes.
Question 19.
BBB Inc., a real estate company, has estimated its cost of debt to be 10% and its cost of equity to
be 15%. The company’s debt is worth €2bn and its equity is worth €3bn. BBB is considering
spending €10m immediately to build an apartment complex. After two years, it expects to sell it for
€15m (on average). This is a typical project for BBB. What is the project’s net present value?
A. €1.7m
B. €3.3m
C. €3.9m
D. €5.0m
Answer: A
This is a typical project for BBB, so BBB’s company cost of capital applies. The NPV then
2
equals 15/1.13 -10=1.747
Question 20.
Which of the following was not covered in the course:
A. Distinction between residual and systematic risks.
B. Historical performance of the world’s largest stock markets.
C. Portfolio performance evaluation with multi-factor models.
D. Using historical data to estimate investment risk.
Answer: C
A, B, and D are parts of the course. Portfolio performance evaluation with multi-factor
models is not.
AACSB Question Solutions
Question 1.
In a faraway country, over a period of many years, Treasury bills averaged a 2% annual return,
Treasury bonds 4%, corporate bonds 6%, and stocks 8%.
Based on this information only, what is the equity risk premium?
A. 2%
B. 4%
C. 6%
D. 8%
Answer: C
8%-2%=6%
Question 2.
Look at the graph below. Portfolios A, B, C and D contain only two assets: stock X and stock Y.
Which portfolio has the highest proportion of stock X?
A. A
B. B
C. C
D. D
Answer: A
Can see the answer by analogy with the
Carrefour-Michelin example, i.e. from the
geometry of the investment opportunity set of
two-stock portfolio. Alternatively, from the
fact that the expected return of a two-stock portfolio is a weighted average of the two
stocks’ expected returns.
Question 3.
What is the expected return of a stock with a beta of 1.5 if the market risk premium is 4%, and the
risk-free rate is 2%?
A. 6%
B. 7%
C. 8%
D. 9%
Answer: C
2% + 4% * 1.5 = 8%
Question 4.
Which of the following statements correctly completes this sentence:
The more diversified a portfolio is, …
A. … the less unique risk it contains.
B. … the more unique risk it contains.
C. … the lower its beta is.
D. … the higher its beta is.
Answer: A
See lecture.
Question 5.
BBB Inc., a real estate company, has estimated its cost of debt to be 10% and its cost of equity to
be 15%. The company’s debt is worth €2bn and its equity is worth €3bn. What is BBB’s cost of
capital?
A. 11%
B. 12%
C. 13%
D. 14%
Answer: C
10%*2/(2+3)+15%*3/(2+3)=13%
