Fin 305/Man Tut 3 (Sampling: Chap.

5)
1)Assume that the equity risk premium is normally distributed with a population mean of
6% and a population standard deviation of 18%. Over the last four years, equity returns
(relative to the risk-free rate) have averaged −2.0%. You have a large client who is very
upset and claims that these poor results should never occur. Evaluate your client’s
concerns.

A. Construct a 95% confidence interval around the population mean for a sample of four-
year returns.
B. What is the probability of a −2.0 percent or lower average return over four years?

A. This is a small-sample problem in which the sample comes from a normal

population with a known standard deviation; thus we use the z-distribution in the
solution. For a 95 percent confidence interval (and 2.5 percent in each tail), the
critical z-value is 1.96. For returns that are normally distributed, a 95 percent
confidence interval is of the form critical z-value is 1.96. For returns that are
normally distributed, a 95 percent confidence interval is of the form.

2) Compare the standard normal distribution and Student’s t-distribution.

Basically, only one standard normal distribution exists, but many t-distributions
exist—one for every different number of degrees of freedom. The normal
distribution and the t-distribution for a large number of degrees of freedom are
practically the same. The lower the degrees of freedom, the flatter the t
distribution becomes. The t-distribution has less mass (lower probabilities) in the
center of the distribution and more mass (higher probabilities) out in both tails.
Therefore, the confidence intervals based on t-values will be wider than those
based on the normal distribution. Stated differently, the probability of being
within a given number of standard deviations (such as within +/- 1 standard
deviation or +/-2 standard deviations) is lower for the t-distribution than for the
normal distribution.

3) Find the reliability factors based on the t-distribution for the following confidence
intervals for the population mean (DF = degrees of freedom, n = sample size):
A. A 99 percent confidence interval, DF = 20.
B. A 90 percent confidence interval, DF = 20.
C. A 95 percent confidence interval, n = 25.
D. A 95 percent confidence interval, n = 16.
 A. For a 99 percent confidence interval, the reliability factor we use is t0.005; for
df = 20,
this factor is 2.845.
B. For a 90 percent confidence interval, the reliability factor we use is t0.05; for df
= 20,
this factor is 1.725.
C. Degrees of freedom equals n − 1, or in this case 25 − 1 = 24. For a 95 percent
confidence interval, the reliability factor we use is t0.025; for df = 24, this factor is
2.064.
D. Degrees of freedom equals 16 – 1= 15. For a 95 percent confidence interval,
the
reliability factor we use is t0.025; for df = 15, this factor is 2.131.

4) Assume that monthly returns are normally distributed with a mean of 1% and a sample
standard deviation of 4%. The population standard deviation is unknown. Construct a 95%
confidence interval for the sample mean of monthly returns if the sample size is 24.
Because this is a small sample from a normal population and we have only the
sample standard deviation, we use the following model to solve for the
confidence interval of the population mean:

5)
6) Although he knows security returns are not independent, a colleague makes the claim
that because of the central limit theorem, if we diversify across a large number of
investments, the portfolio standard deviation will eventually approach zero as n becomes
large. Is he correct?

No. First the conclusion on the limit of zero is wrong; second, the support cited
for drawing the conclusion (i.e., the central limit theorem) is not relevant in this
context.

7) Why is the central limit theorem important?

In many instances, the distribution that describes the underlying population is

not normal or the distribution is not known. The central limit theorem states that
if the sample size is large, regardless of the shape of the underlying population,
the distribution of the sample mean is approximately normal. Therefore, even in
these instances, we can still construct confidence intervals (and conduct tests of
inference) as long as the sample size is large (generally n> or= 30).

8) Suppose we take a random sample of 30 companies in an industry with 200 companies.

We calculate the sample mean of the ratio of cash flow to total debt for the prior year. We
find that this ratio is 23%. Subsequently, we learn that the population cash flow to total debt
ratio (taking account of all 200 companies) is 26%. What is the explanation for the
discrepancy between the sample mean of 23% and the population mean of 26%?
A. Sampling error.
B. Bias.
C. A lack of consistency.

A is correct. The discrepancy arises from sampling error. Sampling error exists
whenever one fails to observe every element of the population, because a sample
statistic can vary from sample to sample. As stated in the reading, the sample
mean is an unbiased estimator, a consistent estimator, and an efficient estimator
of the population mean. Although the sample mean is an unbiased estimator of
the population mean—the expected value of the sample mean equals the
population mean—because of sampling error, we do not expect the sample mean
to exactly equal the population mean in any
one sample we may take.

9) Alcorn Mutual Funds is placing large advertisements in several financial publications. The
advertisements prominently display the returns of 5 of Alcorn’s 30 funds for the past 1-, 3-,
5-, and 10-year periods. The results are indeed impressive, with all of the funds beating the
major market indexes and a few beating them by a large margin. Is the Alcorn family of
funds superior to its competitors?

No, we cannot say that Alcorn Mutual Funds as a group is superior to

competitors.Alcorn Mutual Funds’ advertisement may easily mislead readers
because the advertisement does not show the performance of all its funds. In
particular, Alcorn Mutual Funds is engaging in sample selection bias by
presenting the investment results from its best-performing funds only.

10) The best approach for creating a stratified random sample of a population involves:
A. drawing an equal number of simple random samples from each subpopulation.
B. selecting every kth member of the population until the desired sample size is reached.
C. drawing simple random samples from each subpopulation in sizes proportional to the
relative size of each subpopulation.

C is correct. Stratified random sampling involves dividing a population into

subpopulations based on one or more classification criteria. Then, simple random
samples are drawn from each subpopulation in sizes proportional to the relative
size of each subpopulation. These samples are then pooled to form a stratified
random sample.

11) A sample mean is computed from a population with a variance of 2.45. The sample size
is 40. The standard error of the sample mean is closest to:
A. 0.039.
B. 0.247.
C. 0.387.

12) As the t-distribution’s degrees of freedom decrease, the t-distribution most likely:
A. exhibits tails that become fatter.
B. approaches a standard normal distribution.
C. becomes asymmetrically distributed around its mean value.

A is correct. A standard normal distribution has tails that approach zero faster
than the t distribution.
As degrees of freedom increase, the tails of the t-distribution become less fat and
the t-distribution begins to look more like a standard normal distribution. But as
degrees of freedom decrease, the tails of the t-distribution become fatter.

13) For a sample size of 17, with a mean of 116.23 and a variance of 245.55, the width of a
90% confidence interval using the appropriate t-distribution is closest to:
A. 13.23.
B. 13.27.
C. 13.68.

Therefore, the interval spans 109.5943 to 122.8656, meaning its width is equal to
approximately 13.271. (This interval can be alternatively calculated as 6.6357 x
2).

14) For a sample size of 65 with a mean of 31 taken from a normally distributed population
with a variance of 529, a 99% confidence interval for the population mean will have a lower
limit closest to:
A. 23.64.
B. 25.41.
C. 30.09.

A is correct. To solve, use the structure of Confidence interval = Point estimate x

Reliability factor x Standard error, which, for a normally distributed population
with known variance, is represented by the following formula:

15) An increase in sample size is most likely to result in a:

A. wider confidence interval.
B. decrease in the standard error of the sample mean.
C. lower likelihood of sampling from more than one population.

B is correct. All else being equal, as the sample size increases, the standard error
of the sample mean
decreases and the width of the confidence interval also decreases.