Module 2: Multiple Choice Questions
Last updated: 19/09/2025 11:27
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)
💡 You can also press Ctrl + P (or Cmd + P on Mac) to print or save your responses as a .pdf file.
⚠️ 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.
📘 Part 1 (until Midterm)
| Module | Chapter | Slides | T/F | MCQ | Numeric | Long |
|---|---|---|---|---|---|---|
| 2 | ch10 | 🎞️ | ✅ | ❓ | 🔢 | 📝 |
Select the correct answers.
✅ Correct: C. This statement correctly captures the historical risk-return tradeoff, where higher risk (volatility) is associated with higher expected return over long horizons.
✅ 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.
✅ 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.
✅ 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.
✅ 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).
✅ 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.
✅ 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.
✅ 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.
✅ 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.
✅ 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.
✅ Correct: B. Standard error = σ/√N = 19.8% / √107 ≈ 1.91%.
✅ Correct: B. Portfolio expected return = 0.25×14% + 0.75×6% = 8.0%.
This illustrates how combining risky and risk-free assets changes expected performance.
✅ Correct: D. Systematic risk cannot be eliminated by diversification.
✅ Correct: C. The portfolio invests equally in two assets: 0.5×4% + 0.5×12% = 8% expected return.
✅ Correct: C. Risk premium = 11.7% − 4.0% = 7.7%.
This shows the extra compensation investors demand for holding risky stocks relative to Treasury bills.
✅ Correct: D. Evidence from Chapter 10 shows that small stocks earned the highest average returns but also had the largest volatility.
This illustrates the fundamental principle that assets with greater risk tend to offer higher expected returns.
✅ Correct: A. E(Rp)=0.25×10%+0.75×14%=13%.
✅ Correct: D. Diversifiable risk is firm-specific like product recalls.
✅ Correct: A. 0.25×20%+0.75×8%=11%.
✅ Correct: C. Diversification reduces unsystematic (firm-specific) risk.
✅ Correct: C. Beta measures the stock’s systematic risk relative to the market.
✅ Correct: B. The geometric average is always less than or equal to the arithmetic average.
This gap increases with volatility.
For long-term horizons, the geometric mean is the appropriate measure of expected compound growth, while the arithmetic mean is better for short-run forecasts.
✅ Correct: C. Diversification reduces risk as long as correlation is less than +1.
When correlation = +1, no risk reduction occurs.
When correlation < 0, diversification can be especially powerful, potentially lowering risk more than either asset alone.
✅ Correct: C. The expected return of a portfolio is a weighted average of the expected returns of the assets that compose it, with the weights given by the relative share of each asset in the portfolio. This property highlights that expected return depends on allocation, not on correlations or volatilities.
✅ Correct: C. Diversifiable risk can be eliminated by holding a sufficiently diversified portfolio.
✅ Correct: C. Historical evidence shows that small stocks had both the highest average returns and the greatest volatility.
This illustrates the fundamental risk–return tradeoff emphasized in Chapter 10: assets that are riskier tend to offer higher expected returns.
✅ Correct: A. Negative correlation enhances diversification by reducing total variance.
✅ Correct: A. Expected return is the weighted average = 12%.
✅ Correct: C. Empirical evidence shows that daily stock returns are not perfectly normal:
they present volatility clustering (turbulent periods followed by calmer ones) and fat tails, meaning extreme movements occur more often than predicted by the normal distribution.
This is why models like ARCH/GARCH are often used to capture the time-varying nature of volatility.
✅ Correct: E. The Equity Risk Premium (ERP) represents the additional return investors demand for bearing systematic (non-diversifiable) risk.
Unlike unsystematic risk, which can be eliminated through diversification, systematic risk remains and is priced in equilibrium.
Importantly, ERP is not fixed: it rises during crises or high uncertainty (when investors are more risk averse) and falls during stable periods.
This dynamic relationship makes ERP central for cost of equity estimation, valuation, and risk management.
✅ Correct: B. Standard deviation reflects total return volatility.
✅ Correct: D. The Equity Risk Premium (ERP) is the compensation investors require for bearing the additional risk of equities relative to risk-free assets.
It is not constant: it fluctuates with economic conditions, investor sentiment, and market volatility.
During crises or high uncertainty, ERP typically rises, while in more stable periods it tends to decline.
✅ Correct: C. Stock volatility is not constant — it is time-varying.
Periods of market stress (e.g., crises) often show volatility spikes, followed by gradual normalization.
This property is known as volatility clustering, and it is central to risk modeling in finance (e.g., ARCH/GARCH models).
✅ Correct: D. The realized annual return is computed as:
((1+R_{annual}) = (1+0.05)(1+0.02)(1−0.03)(1+0.04) = 1.0889).
Thus, (R_{annual} ≈ 8.9%).
This illustrates how realized returns must account for compounding across subperiods.
✅ Correct: D. Beta is the slope coefficient from regressing an asset’s returns on market returns, capturing the asset’s sensitivity to systematic (non-diversifiable) risk. A higher beta implies greater exposure to market movements and thus a higher required return under CAPM, while diversification cannot eliminate this component of risk.
✅ Correct: D. CAGR = (()^{1/5} - 1 = (1.6105)^{0.2} - 1 = 10.0%).
This reflects the constant annual growth rate that would transform $100 into $161.05 over 5 years.
✅ Correct: D. Diversification lowers unsystematic (idiosyncratic) risk, but the magnitude of the benefit depends on asset correlations. If correlations are high, adding more assets has limited effect; if correlations are low, the reduction is stronger. Systematic risk, however, cannot be diversified away — it is inherent to all investments in the market. Thus, diversification improves portfolio efficiency but cannot eliminate the fundamental trade-off between risk and return.
✅ Correct: C. CAGR (geometric average return) reflects the annualized growth rate of an investment over multiple periods, incorporating the effect of compounding.
Unlike the arithmetic mean, it accounts for the sequence of gains and losses and typically produces a lower value when returns are volatile.
✅ Correct: A. With perfect correlation, portfolio return is just the weighted average, between 8% and 12%.
✅ Correct: D. The return is ((2 + 108)/100 - 1 = 0.10 = 10%).
This return combines the dividend yield (2/100 = 2%) and the capital gain rate (8/100 = 8%).
✅ Correct: D. Systematic risk is market-wide risk that diversification cannot eliminate.
✅ Correct: B. Diversification reduces unsystematic risk by combining assets whose returns are not perfectly correlated.
However, systematic risk, driven by market-wide factors, cannot be diversified away and remains present in any portfolio.
✅ Correct: C.
E[R] = 0.25×(−0.20) + 0.50×0.10 + 0.25×0.40 = −0.05 + 0.05 + 0.10 = 0.10 = 10%.
This calculation uses the historical average return as the best estimate of expected return.
✅ Correct: C. The market risk premium is defined as the excess return of the market portfolio over the risk-free rate, (E[R_m] - R_f).
It represents the reward investors demand for bearing systematic risk, and it is central to the CAPM equation.
✅ Correct: B. Systematic risk arises from economy-wide shocks (e.g., interest rate hikes, recessions, inflation) that affect all firms.
Idiosyncratic events such as lawsuits, fires, or competitive pressures are diversifiable risks that can be eliminated through holding a sufficiently large and diversified portfolio.
This distinction underpins the CAPM framework, where only systematic risk is priced.
✅ Correct: C. Finance theory (e.g., CAPM) predicts that higher systematic risk should be compensated with higher expected returns. However, when looking at historical data for individual stocks, the relationship is noisy and dispersed. Some risky stocks perform poorly, while others with lower volatility outperform, reflecting the limits of using past data as a predictor of expected returns.
✅ Correct: D.
Capital gain = (60 − 50)/50 = 20%.
Dividend yield = 2/50 = 4%.
Total return = 20% + 4% = 24%.
Thus, capital gain contributes 20 percentage points of the total return.
✅ Correct: C.
Diversification is powerful but limited: it eliminates unsystematic (firm-specific) risk, yet total portfolio risk converges to the non-diversifiable, systematic risk that depends on common factors such as the market portfolio. This insight is central to CAPM and explains why only systematic risk is priced in equilibrium.
✅ Correct: B. Diversification reduces firm-specific (unsystematic) risk.
✅ Correct: C. β = ρ×σi/σm = 0.7×30/20 = 1.05.
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