Please mark the following as either True or False ___ For a given set of possibl

Question

Please mark the following as either True or False

___ For a given set of possible cash flows, as the required risk premium for a project increases, its price must decrease to entice investors to purchase the asset.

(Hint: What is the price and expected return (premium) relation?)

___ Eurodollars are dollar-denominated deposits at banks in European countries or European branches of American banks.

___ Except for Treasury bills, money market securities are not free of default risk.

___ Standard & Poor’s 500 is a broadly based index of 500 firms and it is a price-weighted index.

___ If an asset’s returns come from a normal distribution, then the relation between its arithmetic and

geometric averages are: E[arithmetic average] = E[geometric average] – 0.52.

___ Relative to a buy and hold strategy, average arithmetic returns overstate the return on a portfolio.

Explanation / Answer

1. TRUE. Price is the discounted value of the future cash flows. Increase in required return means increase in Discounted rate, thus, the Price will reduce.

2. TRUE. The given definition is correct about the Eurodoller. It means deposites in Europeon countries which are denominated in dollars or deposites in Europeon banks' branches in America.

3. TRUE. Treasury Bill is the only oney market instrument which is considered as free of default risk since it is directly issued by the US government and it is generally believed in Finance that government caanot be a defaulter.

4. TRUE. S&P includes 500 stocks which is a Price weighted index in which each stock's weight is proportionate to its market.

5. TRUE. The given formula is correctly showing the relationship between Arithmatic return and Geometric return.

6. TRUE. Arithmetic return always shows the inflated return, thus, it is not considered a good indicator of true return. For example $100 purchased shares gives return 100% in first year and -50% in second year. Arithmetic return will still show there is an 25% return in 2 years while the reality is there is 0% return.

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