sample midterm 2a solution - Economics 136 Financial...

Economics 136. Financial Economics
Sample midterm 2A, suggested solution, Fall 2009
1. True or false. (25 points, 5 each)
(i) False. The risk of the call option on Google may be di ff erent from the risk of the put
option on Microsoft, and hence the two investments may have di ff erent expected returns.
(ii) True. a high ROE means that money is more productive inside the company. There-
fore shareholder value and stock price are higher if earnings are retained and reinvested.
(iii) False. High dividend-price ratios predicted high (positive) subsequent price growth.
(iv) False. This comparison su ff ers from survivorship bias: the worst performing funds
were likely closed down before 2005. Hence even if mutual funds have no ability in picking
stocks, we expect the return of funds surviving to 2005 to be higher than that of the index.
(v) True. A broad stock portfolio like the S&P500 has reduced return variance due to
the bene fi ts of diversi fi cation. When many stocks are held in a portfolio, the low returns
of some of them are cancelled by the high return of others, reducing risk.