Question

1. Stock prices and stand-alone risk The S&P 500 Index is one of the most commonly used benchmark indices for the U.S. equity markets. Consisting of 500 companies, it is a market value-weighted index. This means that each company's performance is reflected in the index, weighted by the ratio of the company's value to the total value of all the companies. Based on your understanding of P/E ratios, in which of the following situations would the average trailing P/E ratio (current price divided by earnings per share over the previous 12 months) of the S&P 500 Index be higher? O Forecast earnings for S&P 500 companies are expected to rise in the future. O Forecast earnings for S&P 500 companies are expected to fall in the future. You invest $100,000 in only one stock. To which kind of risk will you primarily be exposed? Portfolio risk Stand-alone risk Generally, investors would prefer to invest in assets that have: O A lower-than-average expected rate of return given the perceived risk. O A higher-than-average expected rate of return given the perceived risk.

Answer 1

1)

As Price is a function of future cash flows and cash flows again are a function of earnings, the increase is Price to earnings is due to increase in forecast earnings for the future.

Answer is a) Forecast earnings are expected to rise in future

2)

When invested only in one stock, the standalone risk is the highest as there are no benefits of diversification.

Answer is b) Standalone risk

3)

Investors always prefer an asset providing an expected return higher than average expected given the perceived risk. This is the concept of risk adjusted return.

Answer is b) A higher than average expected rate of return given the perceived risk