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Study Guide for Exam 3

by: Leosinh

Study Guide for Exam 3 FIN 323

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Exam 3
Principles of Finance
Dr. Shaorong Zhang
Study Guide
Math, finance
50 ?




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This 13 page Study Guide was uploaded by Leosinh on Monday April 4, 2016. The Study Guide belongs to FIN 323 at Marshall University taught by Dr. Shaorong Zhang in Spring 2016. Since its upload, it has received 20 views. For similar materials see Principles of Finance in Business at Marshall University.


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Date Created: 04/04/16
Study Guide Exam 3 : Chapter 10 and 11 and Exercise Answers. Chapter 10 : Some Lessons from Capital Market History Important More Important Most important Dollar Returns : If you buy an asset of any sort, your gain (or loss ) from that investment is called your return on investment. There are two components : 1) You may receive some cash directly while you own the investment. This is called the income component of your return. 2) The value of the asset you purchase will often change. In this case, you have a capitalgain or capital loss on your investment. The total dollar return on your investment is the sum of the dividend and the capital gain : Total dollar return = Dividend income + Capital gain ( or loss). Total cash if stock is sold = Initial Investment + Total Return The Historical record : 1) Large-company stocks. The large-company stock portfolio is based on the Standard & Poor’s 500 index , which contains 500 of the largest companies ( in terms of total market value of outstanding stock) in the United States. 2) Small-company stocks. This is a portfolio composed of stock of smaller companies, where “small” corresponds to the smallest 20 percent of the companies listed on the New York Stock Exchange, again as measured by market value of outstanding stock. 3) Long-term corporate bonds. This is a portfolio of high-quality bonds within 20 years to maturity. 4) Long-term U.S government bonds. This is a portfolio of U.S government bonds with 20 years to maturity. 5) U.S Treasury bills. This is based on Treasury bills ( T-bills for short ) with a one-month maturity. Average Returns : The first lesson. Calculating Average Returns : the obvious way to calculate the average returns on the different investments in Table 10.1 is simply to add up the yearly return and divide by 86. Risk Premiums : The difference between these two returns can be interpreted as a measure of the excess return on the average risky asset ( assuming the stock of a large U.S corporation has about average risk compared to all risky assets. The variability of returns : The second lesson. Frequency Distributions and Variability. Variance : the average squared difference between the actual return and the average return. Standard deviation : the positive square root of the variance. Normal distribution (or bell-curve) : a symmetric, bell-shaped frequency distribution that is completely defined by its average and standard deviation. More on average returns: Arithmetic versus Geometric Averages: The 0 percent is called the geometric average return. The 25 percent is called the arithmetic average return. The geometric average return answers: “ What was your average compound return per year over a particular period ?”. Calculating Geometric Average Returns: Capital market efficiency: Efficient capital market : market in which security prices reflect available information. Efficient markets hypothesis (EMH) : the hypothesis that actual capital markets, such as the NYSE , are efficient. Chapter 11 : Risk and Return. Important More Important Most important Expected Returns and Variances Expected Return : Return on risky asset expected in the future. Risk premium = Expected Return – Risk-free rate Portfolios : Portfolios is group of assets such as stocks and bonds held by an investor. Portfolio weight : percentage of a portfolio’s total value in a particular asset. Portfolio expected returns: Announcements, Surprises, And expected returns : Expected and Unexpected Returns : Total return = Expected return + Unexpected return ( R = E( R ) + U. Announcements and News : Announcement = Expected part + Surprise Risk : Systematic and Unsystematic. Systematic risk : a risk that influences a large number of assets. Also market risks. For example : GDP , Interest rates, inflation. Unsystematic risk : a risk that affects at most a small number of assets. Also unique or asset specific risk. Systematic and Unsystematic Components of Return R = E( R) + Systematic portion + Unsystematic portion. Diversification and Portfolio Risk : The principle of diversification : spreading an investment across a number of assets will eliminate some, but not all, of the risk. Unsystematic risk is essentially eliminated by diversification, so a relatively large portfolio has almost no unsystematic risk. Diversification and systematic risk : Total risk = Systematic risk + Unsystematic risk. Systematic risk and beta : Systematic risk principle : the expected return on a risky asset depends only on that assets’ systematic risk. The expected return on an asset depends only on that asset’s systematic risk. Measuring Systematic Risk Beta coefficient : amount of systematic risk present in a particular risky asset relative to that in an average risky asset. The Security Market Line : The Reward-to-Risk Ratio The basic argument  The reward-to-risk ratio must be the same for all the assets in the market. The Security Market Line : The security market line (SML) : positively slopped straight line displaying the relationship between expected return and beta. Market risk premium : slope of the SML, the difference between the expected return on a market portfolio and the risk-free rate. The Capital Asset Pricing Model : (CAPM ) : equation of the SML showing the relationship between expected return and beta. 1) The pure time of money 2) The reward for bearing systematic 3) The amount of systematic risk. Exercises : 1 The variance is the average squared difference between which of the following ? A Actual return and average return B Actual return and (average return/ N-1) C Actual return and the real return D Average return and the standard deviation E Actual return and the risk-free rate 2 Which one of the following is defined as the average compounded return earned per year over a multiyear period? A.Geometric average return B.Variance of returns C.Standard deviation of returns D.Arithmetic average return E.Normal distribution of returns 3) Which one of the following could cause the total return on an investment to be a negative rate? A.Constant annual dividend amount B.Increase in the annual dividend amount C.Stock price that remains constant over the investment period D.Stock price that declines over the investment period E.Stock price that increases over the investment period 4) New Labs just announced that it has received a patent for a product that will eliminate all flu viruses. This news is totally unexpected and viewed as a major medical advancement. Which one of the following reactions to this announcement indicates the market for New Labs stock is efficient? A. The price of the New Labs stock remains unchanged. B. The price of New Labs stock increases rapidly and then settles back to its pre-announcement level. C. The price of New Labs stock increases rapidly to a higher price and the remains at that price D. All stocks quickly increase in value and then all but New Labs fall back to their original values. E. The value of all stocks suddenly increase and then level off at their higher values. 5) Over the period of 1926-2011: A. the risk premium on large-company stocks was greater than the risk premium on small-company stocks. B. the risk premium on long-term government bonds was zero percent. C. the risk premium on stocks exceeded the risk premium on bonds. D. U.S Treasury Bills had a negative risk premium. 6) If the financial markets are efficient then: A. stock prices should remain constant. B. stock prices should increase or decrease slowly as new events are analyzed and the information is absorbed by the markets. C. an increase in the value of one security should be offset by a decrease in the value of another security. D. stock prices will only change when an event actually occurs, not at the time the event is anticipated. E. stock prices should only respond to unexpected news and events. 7) Dan is a chemist for ABC, a major drug manufacturer. Dan cannot earn excess profits on ABC stock based on the knowledge he has related to his experiments if the financial markets are : A. weak form efficient B. Strong form efficient C. Semistrong form efficient D. efficient at any level E. aware that the trader is an insider. 8) Mary owns a risky stock and anticipates earning 16.5 percent on her investment in that stock. Which one of the following best describes the 16.5 percent rate ? A. Expected return B. Real return C. Market rate D. Systematic return E. Risk premium. 9) Which one of the following describes systemic risk ? A. Risk that affects a large number of assets. B. An individual security’s total risk C. Diversifiable risk D. Asset specific risk E. Risk unique to a firm’s management. 10) The systematic risk principle states that the expected return on a risky asset depends only on which one of the following? A. Unique risk B. Diversifiable risk C. Asset-specific risk D. Market risk E. Unsystematic risk. 11) The security market line is a linear function that is graphed by plotting data points based on the relationship between which two of the following variables ? A. Risk-free rate and beta. B. Market rate of return and beta C. Market rate of return and the risk-free rate. D. Risk-free rate and the market rate of return E. Expected return and beta. 12) A stock is expected to return 13 percent in an economic boom, 10 percent in a normal economy, and 3 percent in recessionary economy. Which one of the following will lower the overall expected rate of return on this stock ? A. An increase in the rate of return in a recessionary economy B. An increase in the probability of an economic boom C. A decrease in the probability of a recession occurring D. A decrease in the probability of an economic boom E. An increase in the rate of return for a normal economy 13) Which one of the following is the vertical intercept of the security market line? A. Market rate of return. B. Individual security rate of return C. Market risk premium D. Individual security beta multiplied by the market risk premium E. Risk-free rate. 14) Worth While Entertainment has common stock with a beta of 1.46. The market risk premium is 9.1 percent and the risk-free rate is 4.6 percent. What is the expected return on this stock? A. 16.31 percent B. 16.67 percent C. 17.40 percent D. 18.03 percent E. 18.18 percent 15) The risk-free rate is 4.2 percent and the expected return on the market is 12.3 percent. Stock A has a beta of 1.2 and an expected return of 13.1 percent. Stock B has a beta of 0.75 and an expected return of 11.4 percent. Are these stocks correctly priced? Why or why not? A. No, stock A is underpriced and stock B is overpriced. B. No, stock A is overpriced and stock B is underpriced. C. No, stock A is overpriced but stock B is correctly priced D. No, stock A is underpriced but stock B is correctly priced. E. Yes, both stocks are correctly priced.


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