MBA 702
MODULE 3 EXAM
Questions and Answers | Latest Update| Pass Guaranteed
Question 1. Define 'risk' and 'return' as used in corporate finance.
Answer: Return is the total gain or loss an investor earns on an investment over a period,
usually expressed as a percentage of the amount invested. Risk is the possibility that the
actual return earned will differ from the expected return.
Rationale: Return captures the reward an investor expects for committing capital, while
risk captures the uncertainty or variability around that reward. Finance theory treats risk
as dispersion of possible outcomes around the expected value, not simply the chance of
loss — an investment can be 'risky' even if it sometimes pays more than expected, because
the deviation itself is what is priced.
Question 2. Distinguish between realized (historical) return and expected (ex-ante)
return.
Answer: Realized return is the actual return that was earned on an investment after the
fact, calculated from historical price and income data. Expected return is a forward-
looking estimate of the return an investor anticipates earning, based on a probability
distribution of possible future outcomes.
Rationale: Realized return is backward-looking and is a single, known number once the
period has passed. Expected return is the probability-weighted average of all possible
future returns and is never known with certainty in advance; it is the number analysts
and investors use for decision-making because investment decisions must be made before
outcomes occur.
Question 3. Write the formula for the expected return of a single asset given a
probability distribution of outcomes, and explain each term.
Answer: E(R) = Σ [Pi × Ri], where Pi is the probability of state i occurring and Ri is the
return in state i. You multiply each possible return by its probability of occurring and sum
the products across all states.
,Rationale: This formula is simply a probability-weighted average. States with a higher
chance of occurring pull the expected return closer to their own value. The sum of all
probabilities (Pi) must equal 1.0 for the expected value to be meaningful.
Question 4. What does standard deviation measure in the context of investment risk,
and why is it useful?
Answer: Standard deviation (σ) measures the dispersion of possible returns around the
expected return — essentially, how much actual returns are likely to vary from the
average. A higher standard deviation means a wider range of possible outcomes and
therefore greater risk.
Rationale: Standard deviation is the square root of the variance of returns. It is useful
because it puts risk in the same units as return (percentage), making it directly
comparable to expected return, and it is the most common statistical measure of total risk
in finance.
Question 5. A stock has a 30% chance of returning 20%, a 40% chance of returning
10%, and a 30% chance of returning -5%. Calculate the expected return.
Answer: E(R) = (0.30 × 20%) + (0.40 × 10%) + (0.30 × -5%) = 6% + 4% + (-1.5%) =
8.5%.
Rationale: Each outcome is weighted by its probability and the products are summed.
Because the probabilities (0.30 + 0.40 + 0.30 = 1.00) add to 100%, the result is a
properly weighted average expected return of 8.5%.
Question 6. Differentiate between systematic (market) risk and unsystematic (firm-
specific) risk.
Answer: Systematic risk is risk that affects the entire market or economy (e.g., interest
rate changes, recessions, inflation) and cannot be diversified away. Unsystematic risk is
risk specific to an individual company or industry (e.g., a lawsuit, a product recall, a labor
strike) and can be eliminated through diversification.
Rationale: The distinction matters because financial markets only compensate investors
for bearing systematic risk — since unsystematic risk can be removed for free by holding
a diversified portfolio, rational investors should not expect (and the market does not pay)
a reward for bearing risk that diversification could have eliminated.
, Question 7. Explain how diversification reduces portfolio risk.
Answer: Diversification reduces risk by combining assets whose returns do not move
perfectly together (i.e., are not perfectly positively correlated). When one asset performs
poorly, another may perform well, so the fluctuations partially offset each other, lowering
the overall volatility of the portfolio compared to holding a single asset.
Rationale: The risk-reduction benefit comes specifically from imperfect correlation
between asset returns. The lower the correlation coefficient between assets (approaching
-1), the greater the reduction in portfolio standard deviation, even though the portfolio's
expected return remains the simple weighted average of the individual expected returns.
Question 8. Why can diversification eliminate unsystematic risk but not systematic
risk?
Answer: Unsystematic risk arises from events unique to individual firms, so as more
securities are added to a portfolio, firm-specific shocks tend to cancel each other out.
Systematic risk stems from broad economic and market forces that affect nearly all
securities simultaneously in the same direction, so no amount of diversification can
cancel it out.
Rationale: This is why total risk (standard deviation) declines as a portfolio grows more
diversified, but it flattens out at a floor equal to the market's systematic risk — usually
reached with roughly 20-30 randomly selected stocks. Beyond that point, adding more
securities provides little additional risk reduction.
Question 9. Define the coefficient of variation (CV) and explain when it is a better
risk measure than standard deviation alone.
Answer: CV = Standard deviation ÷ Expected return. It measures risk per unit of
expected return. It is more useful than standard deviation alone when comparing
investments that have different expected returns, because it standardizes risk relative to
reward.
Rationale: Standard deviation alone can be misleading when comparing two investments
with very different expected returns — an investment with a higher standard deviation
but a much higher expected return may actually carry less risk per unit of return. CV
corrects for this by normalizing risk against reward.
MODULE 3 EXAM
Questions and Answers | Latest Update| Pass Guaranteed
Question 1. Define 'risk' and 'return' as used in corporate finance.
Answer: Return is the total gain or loss an investor earns on an investment over a period,
usually expressed as a percentage of the amount invested. Risk is the possibility that the
actual return earned will differ from the expected return.
Rationale: Return captures the reward an investor expects for committing capital, while
risk captures the uncertainty or variability around that reward. Finance theory treats risk
as dispersion of possible outcomes around the expected value, not simply the chance of
loss — an investment can be 'risky' even if it sometimes pays more than expected, because
the deviation itself is what is priced.
Question 2. Distinguish between realized (historical) return and expected (ex-ante)
return.
Answer: Realized return is the actual return that was earned on an investment after the
fact, calculated from historical price and income data. Expected return is a forward-
looking estimate of the return an investor anticipates earning, based on a probability
distribution of possible future outcomes.
Rationale: Realized return is backward-looking and is a single, known number once the
period has passed. Expected return is the probability-weighted average of all possible
future returns and is never known with certainty in advance; it is the number analysts
and investors use for decision-making because investment decisions must be made before
outcomes occur.
Question 3. Write the formula for the expected return of a single asset given a
probability distribution of outcomes, and explain each term.
Answer: E(R) = Σ [Pi × Ri], where Pi is the probability of state i occurring and Ri is the
return in state i. You multiply each possible return by its probability of occurring and sum
the products across all states.
,Rationale: This formula is simply a probability-weighted average. States with a higher
chance of occurring pull the expected return closer to their own value. The sum of all
probabilities (Pi) must equal 1.0 for the expected value to be meaningful.
Question 4. What does standard deviation measure in the context of investment risk,
and why is it useful?
Answer: Standard deviation (σ) measures the dispersion of possible returns around the
expected return — essentially, how much actual returns are likely to vary from the
average. A higher standard deviation means a wider range of possible outcomes and
therefore greater risk.
Rationale: Standard deviation is the square root of the variance of returns. It is useful
because it puts risk in the same units as return (percentage), making it directly
comparable to expected return, and it is the most common statistical measure of total risk
in finance.
Question 5. A stock has a 30% chance of returning 20%, a 40% chance of returning
10%, and a 30% chance of returning -5%. Calculate the expected return.
Answer: E(R) = (0.30 × 20%) + (0.40 × 10%) + (0.30 × -5%) = 6% + 4% + (-1.5%) =
8.5%.
Rationale: Each outcome is weighted by its probability and the products are summed.
Because the probabilities (0.30 + 0.40 + 0.30 = 1.00) add to 100%, the result is a
properly weighted average expected return of 8.5%.
Question 6. Differentiate between systematic (market) risk and unsystematic (firm-
specific) risk.
Answer: Systematic risk is risk that affects the entire market or economy (e.g., interest
rate changes, recessions, inflation) and cannot be diversified away. Unsystematic risk is
risk specific to an individual company or industry (e.g., a lawsuit, a product recall, a labor
strike) and can be eliminated through diversification.
Rationale: The distinction matters because financial markets only compensate investors
for bearing systematic risk — since unsystematic risk can be removed for free by holding
a diversified portfolio, rational investors should not expect (and the market does not pay)
a reward for bearing risk that diversification could have eliminated.
, Question 7. Explain how diversification reduces portfolio risk.
Answer: Diversification reduces risk by combining assets whose returns do not move
perfectly together (i.e., are not perfectly positively correlated). When one asset performs
poorly, another may perform well, so the fluctuations partially offset each other, lowering
the overall volatility of the portfolio compared to holding a single asset.
Rationale: The risk-reduction benefit comes specifically from imperfect correlation
between asset returns. The lower the correlation coefficient between assets (approaching
-1), the greater the reduction in portfolio standard deviation, even though the portfolio's
expected return remains the simple weighted average of the individual expected returns.
Question 8. Why can diversification eliminate unsystematic risk but not systematic
risk?
Answer: Unsystematic risk arises from events unique to individual firms, so as more
securities are added to a portfolio, firm-specific shocks tend to cancel each other out.
Systematic risk stems from broad economic and market forces that affect nearly all
securities simultaneously in the same direction, so no amount of diversification can
cancel it out.
Rationale: This is why total risk (standard deviation) declines as a portfolio grows more
diversified, but it flattens out at a floor equal to the market's systematic risk — usually
reached with roughly 20-30 randomly selected stocks. Beyond that point, adding more
securities provides little additional risk reduction.
Question 9. Define the coefficient of variation (CV) and explain when it is a better
risk measure than standard deviation alone.
Answer: CV = Standard deviation ÷ Expected return. It measures risk per unit of
expected return. It is more useful than standard deviation alone when comparing
investments that have different expected returns, because it standardizes risk relative to
reward.
Rationale: Standard deviation alone can be misleading when comparing two investments
with very different expected returns — an investment with a higher standard deviation
but a much higher expected return may actually carry less risk per unit of return. CV
corrects for this by normalizing risk against reward.
