Module 2: Multiple Choice Questions

For students

Last updated: 17/08/2025 09:46

The questions are based on or inspired by the following references:

• Berk & DeMarzo, Corporate Finance, 5th ed. (2020)
  
• Brealey & Myers, Principles of Corporate Finance, 13th ed. (2020)

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💡 You can also press Ctrl + P (or Cmd + P on Mac) to print or save your responses as a .pdf file.

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⚠️ These exercises are powered by AI-assisted technologies and may contain occasional formatting or logic errors. Please report any issues you encounter so I can improve the experience.

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📘 Part 1 (until Midterm)

Module	Chapter	Slides	T/F	MCQ	Numeric	Long
2	ch10	🎞️	✅	❓	🔢	📝

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Answer the following questions based on the discussions in class.

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Q1.

Based on historical data, which statement correctly describes the relationship between risk and return for different asset classes?

A. T-Bills offered the highest long-term returns due to their low volatility.
B. Small stocks had the highest returns and the lowest price fluctuations.
C. Assets with higher volatility, such as small stocks, have historically commanded a higher return premium over the long run.
D. Corporate Bonds consistently outperformed the S&P 500 in terms of both return and risk.
E. All risky asset classes outperformed T-Bills in every single year.

✅ Correct: C. This statement correctly captures the historical risk-return tradeoff, where higher risk (volatility) is associated with higher expected return over long horizons.

Q2.

Which of the following statements correctly distinguishes between variance and standard deviation as measures of risk?

A. Variance is the square root of the standard deviation.
B. Variance is generally easier to interpret because its units are squared percentage points.
C. Standard deviation is generally easier to interpret because it is in the same units as the expected return.
D. Both measures are identical and can be used interchangeably to describe total risk.
E. Variance measures systematic risk, while standard deviation measures unsystematic risk.

✅ Correct: C. The primary reason standard deviation is often preferred for interpretation is that its units (e.g., %) are the same as the return itself, unlike variance, which is in squared units.

Q3.

Which of the following events is an example of systematic (non-diversifiable) risk?

A. A pharmaceutical firm fails to get regulatory approval for a new drug.
B. An unexpected increase in the benchmark interest rate by the Central Bank.
C. A competitor launches an innovative product that captures market share.
D. A labor strike halts production at a single factory.
E. The CEO of a major tech company unexpectedly resigns.

✅ Correct: B. Changes in the interest rate affect the cost of capital and valuations for nearly all companies in the market, making it a systematic risk.

Q4.

What does a stock’s beta (β) measure?

A. The stock’s total risk, including both market and firm-specific factors.
B. The sensitivity of the stock’s return to fluctuations in the company’s own earnings.
C. The stock’s average historical return compared to the market.
D. The sensitivity of the stock’s return to the movements of the overall market (systematic risk).
E. The probability that the stock will outperform the market return in a given year.

✅ Correct: D. This is the precise definition of beta: it quantifies how much of a stock’s risk is due to broad market factors that cannot be diversified away.

Q5.

An investor’s realized return over a period is composed of which two key components?

A. Systematic return and unsystematic return.
B. The risk-free rate and the risk premium.
C. The dividend yield and the capital gain rate.
D. The arithmetic average and the geometric average.
E. Beta and volatility.

✅ Correct: C. The total realized return is the sum of income received from dividends (dividend yield) and the appreciation in the asset’s price (capital gain rate).

Q6.

The primary reason that a portfolio’s risk declines as more stocks are added is that:

A. The systematic risk of each new stock is cancelled out by the systematic risk of existing stocks.
B. Only stocks with negative betas are added, which reduces market volatility.
C. The firm-specific (unsystematic) risks of each company, which are independent, tend to average out.
D. The portfolio’s expected return decreases, making it inherently less risky.
E. The government offers insurance for portfolios holding more than 50 stocks.

✅ Correct: C. This is the core principle of diversification. Positive and negative events affecting individual companies (unsystematic risk) tend to cancel each other out in a large portfolio, leaving only the systematic risk that affects all firms.

Q7.

What is the main limitation of using standard deviation (volatility) as a risk measure for a single stock in the context of a diversified portfolio?

A. Standard deviation is too difficult to calculate for individual stocks.
B. Standard deviation does not distinguish between upside and downside risk.
C. Standard deviation measures total risk, including diversifiable risk that is not relevant to a diversified investor.
D. Standard deviation is only applicable to bonds, not stocks.
E. Standard deviation assumes the expected return is always zero.

✅ Correct: C. For an investor who already holds a diversified portfolio, the relevant risk of a new stock is its contribution to the portfolio’s risk (its systematic risk), not its total risk. Standard deviation includes diversifiable risk, which is irrelevant in this context.

Q8.

If a stock has a beta of 0.7, what can be expected of its behavior?

A. The stock is 30% more volatile than the market.
B. The stock will move in the opposite direction of the market.
C. The stock is completely independent of market movements.
D. The stock has 70% systematic risk and 30% unsystematic risk.
E. The stock tends to be 30% less volatile than the market.

✅ Correct: E. A beta of less than 1 indicates that the stock is, on average, less sensitive to market movements. A beta of 0.7 suggests that for every 1% move in the market, the stock tends to move 0.7% in the same direction.

Q9.

When using a stock’s historical average return to estimate its future expected return, a wider 95% confidence interval implies which of the following?

A. The historical returns have been consistently high.
B. The stock is guaranteed to be a poor investment in the future.
C. The calculation of the historical average return is mathematically incorrect.
D. There is more uncertainty about the true value of the expected return.
E. The stock has very low historical volatility.

✅ Correct: D. A wider confidence interval is caused by a larger standard error, which in turn is caused by higher historical volatility or fewer data points. This indicates that our estimate of the average return is less precise, reflecting greater uncertainty about the true underlying expected return.

Q10.

Why do investors demand a risk premium for systematic risk but not for unsystematic risk?

A. Because systematic risk is easier to measure and therefore to price.
B. Because unsystematic risk can be eliminated for “free” through diversification.
C. Because only systematic risk affects the cash flows of companies.
D. Because unsystematic risk is, on average, always positive for returns.
E. Because systematic risk is insured by government agencies.

✅ Correct: B. The fundamental logic is that the market does not reward investors for bearing a risk that they can eliminate on their own. Since unsystematic risk can be diversified away, there is no premium associated with it.