[Solved] Risk and return analysis MCQ [Free PDF] - Objective Question Answer for Risk and return analysis Quiz - Download Now! (2024)

1. Non-conventional capital budgeting
2. International currency arbitrage
3. Foreign exchange market
4. Multinational capital budgeting

The correct answer is Multinational capital budgeting.

Key PointsPolitical risk management typically falls within the purview of multinational capital budgeting. When a company operates in multiple countries, it faces political risks that can affect its operations, cash flows, and profitability. Multinational capital budgeting involves assessing and managing these risks as part of the decision-making process for investments and projects in different countries.

Political risk includes factors such as changes in government policies, regulations, geopolitical instability, and other political events that can impact a company's financial performance. Multinational companies need to consider these risks when making capital budgeting decisions to ensure that they can navigate and mitigate potential challenges associated with political uncertainties in various regions.

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1. A only
2. A and B
3. A and C
4. B and C

The correct answer isA only.

Key Points

• Risk and uncertainty analysis involves assessing the potential risks and uncertainties associated with a project or decision. It aims to quantify the probability of different outcomes and their associated impacts. This analysis helps decision-makers understand the potential risks involved and make informed decisions based on a comprehensive assessment of the uncertainties they face.
• Option B is incorrect because risk and uncertainty analysis does not aim to eliminate all potential risks and uncertainties. Instead, it focuses on understanding and managing them effectively.
• Option C is incorrect because risk and uncertainty analysis is not solely focused on the negative aspects and potential losses. It considers both the potential risks and opportunities associated with a project or decision.
• Option D is incorrect because risk and uncertainty analysis is a valuable tool in decision-making, despite the challenges of predicting and quantifying risks and uncertainties accurately. It provides insights into the potential impacts of different scenarios and helps decision-makers assess the trade-offs involved.

Therefore, the most appropriate answer is option a) A only.

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1. (A), (B), (D), (E) Only
2. (B), (C), (D), (E) Only
3. (A), (B), (C), (D) Only
4. (C), (D), (E) Only

Key Points

Exchange rate -

• An exchange rate is the cost of exchanging one currency for another between nations or economic zones.
• It is used to determine the relative value of various currencies and is crucial in determining trade and capital flow dynamics.

Important Points

1. Current/Non-Current method -

• Current assets and liabilities with maturities of one year or less are translated at the current exchange rate.
• Noncurrent assets and liabilities are converted using the previous exchange rate that was in effect at the time the asset or liability was recorded in the books.
• If the local currency appreciates, a foreign subsidiary with current assets in excess of current liabilities will incur a translation gain.

2.Monetary/Non-monetary method -

• All monetary balance sheet accounts of a foreign subsidiary, such as cash, notes payable, accounts payable, and marketable securities, are converted at the current exchange rate using this method.
• The remaining nonmonetary balance sheet accounts and shareholder equity are converted at the exchange rate in effect at the time the account was recorded.
• This method is based on the idea that monetary accounts are similar in that their value is equivalent to a sum of money, the value of which varies with changes in exchange rates.

3.Temporal method -

• The temporal method converts current and noncurrent monetary accounts, such as receivables, payables, and cash, at the current exchange rate.
• The other balance sheet accounts are converted at the current rate if they are carried out on the books at current value.
• If they are performed in the past, they are converted into the historical rate of exchange that existed at the time.

4.Current Rate method -

• Except for stockholder's equity, all balance sheet accounts are converted at the current exchange rate using this method.
• On the dates the items are recognized, the income statement items are converted at the current exchange rate.

Hence, option 3 (A), (B), (C), (D) Onlyis correct answer.

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1. ​(A) - (III), (B) - (IV), (C) - (II), (D) - (I)
2. (A) - (I), (B) - (II), (C) - (III), (D) - (IV)
3. (A) - (IV), (B) - (III), (C) - (II), (D) - (I)
4. (A) - (I), (B) - (IV), (C) - (III), (D) - (II)

The correct answer is(A) - (I), (B) - (II), (C) - (III), (D) - (IV)

Key PointsEconomic exposure, also sometimes called operating exposure, is a measure of the change in the future cash flows of a company as a result of unexpected changes in foreign exchange rates (FX). Economic exposure cannot be easily mitigated because it is caused by the unpredictable volatility of currency exchange rates.

Translation exposure (also known as translation risk) is the risk that a company's equities, assets, liabilities, or income will change in value as a result of exchange rate changes. When a firm denominates a portion of its equities, assets, liabilities, or income in a foreign currency, translation risk occurs.

Transaction exposure, defined as a type of foreign exchange risk faced by companies that engage in international trade, exists in any worldwide market. It is the risk that exchange rate fluctuations will change the value of a contract before it is settled. This exposure pertains to the exposure due to an actual transaction taking place in business involving foreign currency. This can also be called transaction risk.

Operating exposure refers to how exchange rate changes can impact on a firm's future cash flows and consequently affect the firm's value. The cash flows may be contractual or anticipated.

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1. Variability of rates of return from average rate of return as derived in the form of standard deviation
2. Variability of rates of return from average rate of return as derived in the form of median
3. Comparison of return from investment with industry returns
4. Comparison of return from investment with competitor's return

The correct answer isVariability of rates of return from average rate of return as derived in the form of standard deviation.

Key PointsInvestment risk-Investment risk refers to the possibility that a financial investment will not perform as anticipated or that its actual return will differ from that anticipated.

Important PointsThe degree of volatility, or the discrepancy between actual returns and average (anticipated) returns, serves as a proxy for risk.

The standard deviation is the name given to this variation. Investments that have higher volatility and higher standard deviations (showing greater dispersion from the average) are riskier ones.

Variability of returns:

Variability of returns;risk can be considered “good”— that is, when the results are better than expected (higher returns)—or “bad”—that is, when the results are worse than expected (lower returns).

Standard Deviation:The standard deviation measures the variability of possible returns and is represented by the lower-case Greek symbol sigma(σ).

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Risk and return analysis Question 6

1. 1
2. 2
3. 3
4. 4

Risk and return analysis Question 6 Detailed Solution

The Capital Asset Pricing Model (CAPM)is developed by Sharpe, Linter, and Mossin. The CAPM describes the relationship between risk and expected return, and serves as a model for the pricing of risky securities. CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return then the investment should not be undertaken.

The main insights of CAPM are :

1. Investors need to be rewarded for systematic risk (β)only because unsystematic risk can be reduced to zero through diversification of the investment portfolio.
2. A security’s systematic risk is measured by beta value.
3. The required rate of return on a security depends on the riskless rate of interest the market risk premium and the security’s beta value.

Formula:R= rf + ß (rm - rf)

where, R= Expected rate of return, rf = Risk free rate, rm = Market rate of return, ß= Project beta (systematic risk)

R = 6 + 1.5 (10 - 6) = 12%

Therefore,If the risk - free return (Rf) is 6%, Beta value (β) is 1.5 and market rate of return (Km) is 10%, the expected rate of return would be 12%

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Risk and return analysis Question 7

1. ​(A) - (III), (B) - (IV), (C) - (II), (D) - (I)
2. (A) - (I), (B) - (II), (C) - (III), (D) - (IV)
3. (A) - (IV), (B) - (III), (C) - (II), (D) - (I)
4. (A) - (I), (B) - (IV), (C) - (III), (D) - (II)

Risk and return analysis Question 7 Detailed Solution

The correct answer is(A) - (I), (B) - (II), (C) - (III), (D) - (IV)

Key PointsEconomic exposure, also sometimes called operating exposure, is a measure of the change in the future cash flows of a company as a result of unexpected changes in foreign exchange rates (FX). Economic exposure cannot be easily mitigated because it is caused by the unpredictable volatility of currency exchange rates.

Translation exposure (also known as translation risk) is the risk that a company's equities, assets, liabilities, or income will change in value as a result of exchange rate changes. When a firm denominates a portion of its equities, assets, liabilities, or income in a foreign currency, translation risk occurs.

Transaction exposure, defined as a type of foreign exchange risk faced by companies that engage in international trade, exists in any worldwide market. It is the risk that exchange rate fluctuations will change the value of a contract before it is settled. This exposure pertains to the exposure due to an actual transaction taking place in business involving foreign currency. This can also be called transaction risk.

Operating exposure refers to how exchange rate changes can impact on a firm's future cash flows and consequently affect the firm's value. The cash flows may be contractual or anticipated.

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Risk and return analysis Question 8

1. Non - conventional capital budgeting
2. International currency arbitrage
3. Foreign exchange market
4. Multinational capital budgeting

Risk and return analysis Question 8 Detailed Solution

Capital budgeting is the process a business undertakes to evaluate potential major projects or investments. Construction of a new plant or a big investment in an outside venture are examples of projects that would require capital budgeting before they are approved or rejected.

1. As part of capital budgeting, a company might assess a prospective project's lifetime cash inflows and outflows to determine whether the potential returns that would be generated meet a sufficient target benchmark. The capital budgeting process is also known as investment appraisal.
2. The original decision to undertake an investment in a particular foreign country may be determined by a mix of strategic, behavioral, and economic decisions.'
3. The specific project, as well as reinvestment decisions – should be justified by traditional financial analysis.
4. Multinational capital budgeting, like traditional domestic capital budgeting, focuses on the cash inflows and outflows associated with prospective long-term investment projects.
5. Multinational capital budgeting is capital budgeting for a foreign project using the same theoretical framework as domestic capital budgeting.

1. Political risk management comes in the ambit of Multinational capital budgeting.
2. For each project, political risk must be evaluated, because the cash flows can be severely affected by the changes in the political environment.
3. The changes in the government would change the political philosophy thereby leading to a new economic environment.
4. An extreme form of risk is the ‘risk of expropriation’ and repatriation. In the case of expropriation, the projects and the parent’s cash flows tend to change drastically because in this case the funds are blocked in the country of the project.
5. The political stability of a country directly impacts borrowing costs, taxes, and regulation for businesses.
6. Kickbacks and other forms of corruption have serious repercussions for MNCs. For example, Turkey has experienced a number of economic and political setbacks that raised the cost of borrowing for the national government. Corruption allegations, tight lending conditions, and financial volatility within the country made it more challenging for corporate entities to operate there effectively.

Thus, option 4 is the correct answer.

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Risk and return analysis Question 9

1. CAPM analysis
2. SWOT analysis
3. Capital gearing
4. EVA analysis

Risk and return analysis Question 9 Detailed Solution

CAPM Analysisis suitable for risk-return analysis in financial decisions.

Explanation:

Capital Asset Pricing Model (CAPM)

1. The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk andexpected returnfor assets, particularly stocks.
2. CAPM is widely used throughout finance for pricing riskysecuritiesand generating expected returns for assets given the risk of those assets and the cost of capital.

CAPM is calculated according to the following formula:Ra = Rrf + [Ba x ( Rm - Rrf )]

Where:

• Ra= Expected return on a security
• Rrf = Risk-free rate
• Ba= Beta of the security
• Rm = Expected return of the market

Note: “Risk Premium” = (Rm – Rrf)

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Risk and return analysis Question 10

1. \(\rm \dfrac{Periodic \ cash \ receipts \ + \ Capital \ gains}{Purchase \ Price \ of\ the\ security}\)
2. \(\rm \dfrac{Periodic \ cash \ receipts \ + \ Capital \ gains}{Current \ Market\ Price \ of\ the\ security}\)
3. \(\rm \dfrac{Periodic \ cash \ receipts }{Current \ Market\ Price \ of\ the\ security}\)
4. \(\rm \dfrac{Periodic \ cash \ receipts \ - \ Capital \ gains}{Purchase \ Price \ of\ the\ security}\)

Risk and return analysis Question 10 Detailed Solution

Total return, when measuring performance, is the actual rate of return of an investment or a pool of investments over a given evaluation period.Total return includes interest, capital gains, dividends, and realized distributions. The total return is expressed as a percentage of the amount invested.The totalreturn is a strong measure of an investment’s overall performance.

Important Points

∴Total Return On A Security =\(\rm \dfrac{Periodic \ cash \ receipts \ + \ Capital \ gains}{Purchase \ Price \ of\ the\ security}\)

Thus, option 1 is the correct answer.

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Risk and return analysis Question 11

1. a) and b) only
2. b) and c) only
3. b) and d) only
4. a), b) and c) only

Risk and return analysis Question 11 Detailed Solution

Though the term risk has got different connotations from different angles, it can be defined as the potential that events, expected or unexpected may have an adverse impact onearnings or capital or both.Risk and expected return are positively related; higher the risk, higher the expected return, and vice versa.

1. Transaction Exposure:

• This arises when a company is importing or exporting.
• If the exchange rate moves between agreeing on the contract in a foreign currency and paying or receiving the cash, the amount of home currency paid or received will alter, making those future cash flows uncertain.
• For instance, An Indian person has to make a payment to a person residing in the US after 3 months.
• Now, since foreign exchange rates are volatile, there is a chance that the Indian currency will weaken or the US currency will strengthen on the day of paymentcausing a loss to the Indian person.
• Transaction exposure is inherent in all foreign currencies denominated contractual transactions.
• Thus, statementA is correct.

2.Translation Exposure

• Itrefers to the amount of risk facing the firm as a result of the need to translate financial statements prepared in one currency into statements in another currency.
• This is particularly true for multinational firms which must consolidate their financial results at the end of the year.
• The accounting framework is the legally required form in which companies must report operating results and financial condition to shareholders.
• The financial statements contain information of interest to various other parties viz lenders, debtors, regulators.
• Thus, the translation of subsidiary accounts for consolidation into parent accounts faces translation exposure and may pose serious implications for the parent company.
• For instance,If the subsidiary is in a country whose currency weakens, the subsidiary’s assets will be less valuable in the consolidated accounts.
• Thus, statementB is correct.

3.Economic exposure

• Itrelates to 'cash flow' risks.
• Thus, economic exposure has an impact on the valuation of a firm.
• Economic (competitiveness) risk is concerned with threats from changes in real exchange rates to the competitiveness of costs.
• The sensitivity of a business to competitiveness risk depends on its elasticity of demand.
• Competitiveness risk is a long term problem. For example, the business is a single hotel, and the home currency becomes uncompetitive, fewer tourists will come and the hotel will lose business.
• Some authors like Adler and Dumas (1984) and Wihlborg (1987) treat currency risk as one element of the wider concept of macroeconomic threats to real (inflation-adjusted) cash flows.
• Theeconomic risks may include exchange rate fluctuations, a shift in government policy or regulations, political instability, or the introduction ofeconomicsanctions.
• Thus, statementC is correct.

4.Operational risk

• According to the Basel Committee, Operational risk is defined as “the risk of loss resulting from inadequate or failed processes, people and systems or external events.
• This risk is associated with human error, system failures, and inadequate procedures and controls.” According to Laylock (1998) “Operational risk is the potential for adverse fluctuations in the profit-and-loss statement or the cash flow of the firm due to effects that are attributable to customers, inadequately defined controls, system or control failures, and unmanageable events.”
• Since operating exposure hasan impact on the firm's future operating revenues or future operating costs, statementD is incorrect.

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Risk and return analysis Question 12

1. (A), (B), (D), (E) Only
2. (B), (C), (D), (E) Only
3. (A), (B), (C), (D) Only
4. (C), (D), (E) Only

Risk and return analysis Question 12 Detailed Solution

Key Points

Exchange rate -

• An exchange rate is the cost of exchanging one currency for another between nations or economic zones.
• It is used to determine the relative value of various currencies and is crucial in determining trade and capital flow dynamics.

Important Points

1. Current/Non-Current method -

• Current assets and liabilities with maturities of one year or less are translated at the current exchange rate.
• Noncurrent assets and liabilities are converted using the previous exchange rate that was in effect at the time the asset or liability was recorded in the books.
• If the local currency appreciates, a foreign subsidiary with current assets in excess of current liabilities will incur a translation gain.

2.Monetary/Non-monetary method -

• All monetary balance sheet accounts of a foreign subsidiary, such as cash, notes payable, accounts payable, and marketable securities, are converted at the current exchange rate using this method.
• The remaining nonmonetary balance sheet accounts and shareholder equity are converted at the exchange rate in effect at the time the account was recorded.
• This method is based on the idea that monetary accounts are similar in that their value is equivalent to a sum of money, the value of which varies with changes in exchange rates.

3.Temporal method -

• The temporal method converts current and noncurrent monetary accounts, such as receivables, payables, and cash, at the current exchange rate.
• The other balance sheet accounts are converted at the current rate if they are carried out on the books at current value.
• If they are performed in the past, they are converted into the historical rate of exchange that existed at the time.

4.Current Rate method -

• Except for stockholder's equity, all balance sheet accounts are converted at the current exchange rate using this method.
• On the dates the items are recognized, the income statement items are converted at the current exchange rate.

Hence, option 3 (A), (B), (C), (D) Onlyis correct answer.

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Risk and return analysis Question 13

1. Bond yield
2. Risk immunization
3. Term structure of interest rates
4. Yield to maturity

Risk and return analysis Question 13 Detailed Solution

Key Points

Investment Horizon:

• The holding period of the portfolio by investor is known as investment horizon.
• It corresponds to the level of risk that an investor is ready to assume.
• Investment horizons play a crucial role in portfolio management because they let investors decide how long they will hold their investments to make up for the risks they accept.

Important Points

Term structure of interest rates:

• The term "interest rate structure" refers to the relationship between an investor's expected return on bonds and their investment horizon.
• The graph that shows the correlation between interest rates (or yields on bonds) and a variety of different maturities is known as the interest rate structure.
• The term structure of interest rates plays a significant role in every economy. It enables easy comparison of yields depending on time and anticipates the future trajectory of rates.

Thus, the correct answer isTerm structure of interest rates.

Additional Information

Bond Yield:

1. The amount of return an investor receives on a bond is known as the bond yield. The term "required yield" describes the yield that a bond issuer must provide in order to attract investors. The yield is the amount of money that investors make.
2. The yield on a bond is calculated by dividing its coupon payments by its market price. Briefly put:

• As bond prices rise, bond yields decrease.
• When interest rates decline, bond prices increase, and bond yields decrease.
• In contrast, higher interest rates lead to a decline in bond prices and an increase in bond yields.

Risk immunisation:

• Multi-period immunisation is a risk-mitigation tactic that balances the duration of assets and liabilities, minimizing the long-term impact of interest rates on net value.
• Pure immunisation refers to investing a portfolio for a specified return over a predetermined amount of time, irrespective of any external variables, such as changes in interest rates.

Yield to maturity:

• Yield to maturityis the overall return an investor can anticipate from bond investments, assuming the investor holds the bond to maturity and reinvests all bond proceeds in the same security.
• Bonds are the only thing that falls under this concept because equities don't have a maturity date. Total interest earned on the bond over the years divided by the bond's face value equals yield to maturity.

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Risk and return analysis Question 14

1. A, B and E only
2. B, D and E only
3. A, D and E only
4. A, B, C and D only

Risk and return analysis Question 14 Detailed Solution

Cash flows refer to the operational turnover of a business and its ability to generate revenues.

Key Points

Investors prefer current (near) cashflows over the future (distant) cashflows for the following reasons:

• Inflation and value erosion.
  • It utilises the concept of the time value of money (TVM) that statesa sum of money is worth more now than in the future.
  • Inflation is a rise in the average cost of goods and services over time.
  • Rising inflation erodes the purchasing power of a bond's future (fixed) coupon income, reducing the present value of its future fixed cash flows.
  • Hence, the impact inflation has on the time value of money is thatit decreases the value of a moneyover time, which makes investors to rely on current cash flows rather than future cash flows.
• Risk aversion and avoidance.:
  • Risk aversion is a preference for lower returns with known risks rather than higher returns with unknown risks, whereasrisk avoidanceis an approach that eliminates any exposure toriskthat poses a potentialloss.
  • Risk aversion and risk avoidance impact the psychological behaviour of investors, and hence It is one of the big reasons why current cashflows are preferred by them
• Liquidity preferences:
  • Liquidity preference is the demand for money.
  • According to Keynes, the demand for liquidity is determined by three motives, which are,transactional motives, precautionary motives, and speculative motives.
  • The theory suggests that cash is the most accepted liquid asset, and more liquid investments are easily cashed in for their full value.
• Return generation and value protection:
  • Areturnis a change in the price of an asset, investment, or project over time, which may be represented in terms of a price change or percentage change.
  • "Value protection" meansthe lump sum to protect underlying monetary assets, which will be payable at the maturity date.
  • Those investors who seek return generation and value protection mostly try to invest in the assets for a certain time period, which can offerthem future cashflows.

Therefore,the current answer isA, B, C and D only.

Additional Information

​​​Risk appetite and tolerance:

• Risk appetite is the amount of risk an organisation is willing to accept to achieve its objectives, whereasrisk tolerance is the acceptable deviation from the organization's risk appetite.
• ​​​Risk appetite and tolerance impact the investment decisions of the investor.

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Risk and return analysis Question 15

1. Both the statement I and II are correct.
2. Both the statement I and II are incorrect.
3. Statement I is correct, but II is incorrect.
4. Statement II is correct, but I is incorrect.

Risk and return analysis Question 15 Detailed Solution

Statement I: When the two securities returns are perfectly positively correlated, the risk of their portfolio is just a weighted average of the individual risks of the securities. In such a case, diversification does not provide risk reduction but only risk averaging.

Explanation:

1. A perfectly positive correlation means that 100% of the time, the variables in question move together by the exact same percentage and direction.
2. When security returns are perfectly positively correlated, the correlation coefficient between the two securities will be +1.
3. The returns of the two securities willmove up or down together, then the portfolio happens to be undiversified which does not provide risk reduction but only risk averaging. Thus, the statement I is correct.

Statement II: Total risk of a portfolio of two risk securities can be completely eliminated when their returns are perfectly negatively correlated and their proportionate holdings in the portfolio are inversely related to the relative individual risks of the securities.

Explanation:

1. Other things equal, the smaller the correlation between two assets, the smaller will be the risk of a portfolio of long positions in the two assets.
2. When security returns are perfectly negativelycorrelated, the correlation coefficient between the two securities will be -1.
3. The two returns will always move in exactly opposite directions making the portfolio diversified which helps to eliminate risk. Thus, statement II is correct.

Thus, option 1 is the correct answer.

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