Chapter 3 Practice Question Answers
- 1. Answer: A. The exchange rate of 125 L/USD is in terms of lek per dollar. A quote in terms of foreign currency units per dollar is called a quote in European terms (even if the other currency is not European). A quote in American terms would be in dollars per lek and is equal to one divided by the quote in European terms. In this case, we get 1 / (125 L per USD) = 0.0080 USD/L.
- 2. Answer: A. Unlike the cash market, where some currencies’ exchange rates are quoted in American terms and some are quoted in European terms, all foreign exchange futures contracts are quoted in American terms.
- 3. Answer: B. Systematic risk is the risk that the entire securities market will drop, dragging with it the performance of an individual stock or portfolio. The risk that the value of a security within the portfolio will decline due to factors specific to the issuer of that security is called unsystematic risk. When two stocks are highly correlated, their unsystematic risks are very similar.
- 4. Answer: B. Systematic risk is the risk that the entire securities market will be impacted by disruptions in the world economy. Systematic risk cannot be reduced by diversifying one’s portfolio because these changes affect everyone. Unsystematic risk applies to the risk that a specific security will decline in price due to factors specific to the issuer or to that industry. Unsystematic risk can be reduced by picking a diversified portfolio of uncorrelated stocks.
- 5. Answer: A. When used to represent the market, broad-based indices such as the Russell 1000 are assumed to have a beta of 1.0. The beta of a portfolio would be determined from the betas of each stock within it as measured against this benchmark.
- 6. Answer: C. Risk-free return is the expected return from a risk-free security, such as a Treasury bill. Risk premium is the additional return investors expect to earn in compensation for a security’s risk.
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