3. Investment Planning - All Questions and Comprehensive Course Exam Flashcards

Question 1

Q

Lesson 1. Fixed Income Securities

Course 3. Investing Planning

Question 2

Q

Match the key terms to the correct description.
Par
Coupon
Maturity
Call
* Ability of the borrower to payoff loan earlier than maturity.
* Length of the loan.
* Interest payments for the loan.
* Face value of the loan.

Answer

A

Par - Face value of the loan.
Coupon - Interest payments for the loan.
Maturity - Length of the loan.
Call - Ability of the borrower to payoff loan earlier than maturity.

Question 3

Q

Which of the following would typical fixed-income securities investors seek?
* Par
* Call Provision
* Maturity
* Coupon

Answer

A

Coupon
* Most bond investors are seeking a steady income generated from the coupon payments.
* Investors of high-yield bonds may also be seeking capital appreciation from the high volatility associated with those types of bonds.
* Par is the principal amount that investors will receive at maturity.
* Call provisions are more of an advantage for issuers.
* Maturity is the length of time before a fixed-income security will come due.

Question 4

Q

Which of the following contribute to the movement in the market price of a fixed-income security?
* Inflation
* Interest rates
* Coupon rates
* Call provision

Answer

A

Interest rates
* The movement of interest rates can cause existing fixed-income securities to be worth more or less than their original par value.
* Inflation causes the purchasing power of the future payments to decrease and affects the real return of the investment.
* Coupon rates are set when the issue is created.
* Call provision gives issuers the right to pay off their debt before maturity.

Question 5

Q

Assume an investor is considering purchasing a money market instrument with a $1,000,000 denomination quoted with a discount rate of 1.5%. Identify the investor’s real interest rate.
* 1.50%
* 1.52%
* 9.85%
* 0.15%

Answer

A

1.52%
* The investor will purchase the security for $985,000 ($1,000,000 x 0.985).
* The bank discount bases which is the investor’s real interest rate = $15,000 (discount rate x denomination)/$985,000 (purchase price) = 1.52%.

Question 6

Q

What does an investor seek when they purchase money market instruments? (Select all that apply)
* Potentially high returns from aggressive growth.
* A liquid investment that can be sold quickly at fair value.
* High quality investments with low risk.
* A long-term investment.

Answer

A

A liquid investment that can be sold quickly at fair value.
High quality investments with low risk.
* Money market instruments are fixed-income securities that are highly liquid. Since many businesses use them for business transactions, they are constantly traded in the secondary market as cash equivalents. Since they are issued in high denominations, the issuers typically have low credit risk. Their shorter-term maturity also partially shields them from interest rate risk. Since there is less risk associated with them, they would not provide a high return. The relatively lower return makes them less likely to overcome inflation risk than other securities for long-term investing.

Question 7

Q

Match the money market instrument to the correct description.
Commercial Paper
Bankers’ Acceptance
Certificate of Deposit
Repo
* Agreement to sell and repurchase assets
* Used for facilitating international trade
* Short-term promissory notes
* Large deposits with banks

Answer

A

Commercial Paper - Short-term promissory notes
Bankers’ Acceptance - Used for facilitating international trade
Certificate of Deposit - Large deposits with banks
Repo - Agreement to sell and repurchase assets

Question 8

Q

You own a 9-month T-Bill ($1,000 face value) with a discount rate of 3% that matures in 180 days. If you were to sell this T-Bill today, how much would you receive?
* $977.50
* $1,000
* $992.50
* $985

Answer

A

$985
* If your T-Bill were sold today, you would receive $985, calculated as follows:
$1,000 × [1 – ((180 ÷ 360) × 0.03)] = $985

Question 9

Q

Example (T-Bond/TIPS Side-by-side)

Let us compare the yield available on 10-year Treasury Bond to a TIPS equivalent. If the CPI is 3%, a 10-year Treasury Bond yielding 6.5% would have an approximate real yield (nominal yield minus inflation, or 6.5% - 3.0%) of 3.5%.
This means a 10-year TIPS should be paying __ ____??____ __%.

Answer

A

This means a 10-year TIPS should be paying 3.5%.

Question 10

Q

Example (The Logistics of TIPS)

An investor buys $100,000 of TIPS bearing a 3.5% coupon. For the next 6 months, the inflation rate averages 3% per year.
What will be the coupon payment made to the investor?

Answer

A

The coupon rate (3.5% in this case) is fixed.
The principal is adjusted every six months to reflect the inflation rate.

In this case the principal would be increased to $101,500 ($100,000 X 0.03 ÷ 2), and, therefore, the payment of the first coupon would be $1,776.25 ($101,500 X 0.035 ÷ 2).

Question 11

Q

What makes U.S. Government issued fixed-income securities safe relative to other issuers? (Select all that apply)
Inflation Protection
Stability of Government
Interest Rate Risk Protection
Power of Taxation
Prepayment Protection

Answer

A

Stability of Government
Power of Taxation
* U.S. Government Securities are either direct obligations that are required to be paid by either tax collecting or refunding, or they are backed by the full faith of the government. The government’s stability makes it less likely to default than less stable governments or borrowers of the private sector. Not all U.S. government issued securities are protected against inflation risk. All fixed-income securities are subject to interest rate risk, some more than others. And Government backed mortgage pass-throughs such as GNMAs and CMOs are susceptible to prepayment risks.

Question 12

Q

Match the type of U.S. Treasury on the left to the correct maturity.
T–Notes
T–Bonds
T–Bills
* 52 weeks or less
* 1 – 10 years
* 10 – 30 years

Answer

A

T–Bills - 52 weeks or less
T–Notes - 1 – 10 years
T–Bonds - 10 – 30 years

Question 13

Q

Bonnie, a resident of Ohio, has an effective tax rate of 36%. If risk was not an issue for Bonnie, which of the following choices would provide her the highest yield?
* Disney 30-year bond paying 7%
* Ohio 30-year GO municipal bond paying 5%
* 30-year T-bond paying 6%
* Ohio 30-year revenue municipal bond paying 5.5%

Answer

A

Ohio 30-year revenue municipal bond paying 5.5%
* The TEY for the revenue municipal bond = 0.055 ÷ (1 - 0.36) = 0.0859% (8.59%) which is a higher yield than the other choices. The TEY for the GO municipal bond = 7.81% which is still a higher equivalent yield than the taxable T-bond and Disney Bond.

Question 14

Q

Describe Tax Equivalent Yield (TEY) and it’s formula

Answer

A

The Tax Equivalent Yield (TEY) helps investors determine whether or not they are better off investing in the lower yielding but tax-free municipal bond or in a higher-yielding taxable bond.

TEY = Tax free rate ÷ (1- Marginal tax bracket)

Question 15

Q

What part of the municipal bond is tax-exempt at the federal level?
* Premium
* Discount
* Coupon
* Capital Appreciation

Answer

A

Coupon
* Coupon payments from municipal securities are tax-exempt from federal taxes.
* Premium and discount are ways to compare the price of the bond to its original price.
* Any capital appreciation that is recognized is taxable for municipal bonds.

Question 16

Q

Which of the following statements concerning municipal bonds are true? (Select all that apply)
* General obligation bonds are backed by the full faith of the issuing municipality.
* Revenue bonds are backed by the full faith of the issuing municipality.
* General obligations bonds are backed by the full extent of the municipality’s taxation power.
* Revenue bonds are backed by the entity’s incoming sales.

Answer

A

General obligation bonds are backed by the full faith of the issuing municipality.
General obligations bonds are backed by the full extent of the municipality’s taxation power.
Revenue bonds are backed by the entity’s incoming sales.
* General obligation bonds are more conservative because they are backed by the full faith and power of the municipality, namely the full extent of its taxing power.
* Revenue bonds are funded by the revenue generated by the designated project, authority, or agency. They are more risky because they are not backed by the full of faith and power of the municipality.

Question 17

Q

Match the items used to collateralize a bond with the matching them.
Mortgage
Collateral Trust
Equipment
Debenture
* Nothing
* Stocks
* Factory
* Machines

Answer

A

Mortgage - Factory
Collateral Trust - Stocks
Equipment - Machines
Debenture -Nothing

Question 18

Q

Example (Conversion Price Calculation)

If a convertible bond has a conversion ratio of 20 shares of stock per bond, then the conversion price would be equal to: __ ____??____ __/share.
As a result, it would only be beneficial for the bondholder to convert if the stock price __ ____??____ __.

Answer

A

If a convertible bond has a conversion ratio of 20 shares of stock per bond, then the conversion price would be equal to: $1000 ÷ 20 shares = $50/share.
As a result, it would only be beneficial for the bondholder to convert if the stock price rises above $50.

Exam Tip: Scenario-based questions may appear asking when it would be beneficial for a bondholder to convert bonds into stock.

Question 19

Q

If a bond’s conversion ratio is 50 shares of stock per bond and the price of the stock is $30, would it be beneficial for the bondholder to convert?
* Yes
* No
* Not enough information provided.

Answer

A

Yes
* If a stock is a suitable investment for the investor, then it would make sense to convert.
* Since the conversion price is $1,000/50, or, $20 per share, the investor can convert and sell the shares for $30, earning a $10 profit or $500 ($10 x 50 shares).

Question 20

Q

Why would an issuer decide to issue a corporate bond with collateral such as equipment or buildings? (Select all that apply)
* Increase coupon rate
* Decrease coupon rate
* Fund the coupon payments
* Lower risk of issue
* Increase quality of issue

Answer

A

Decrease coupon rate
Lower risk of issue
Increase quality of issue
* Adding collateral to a bond issue lowers the risk of the bond, which increases the quality of the issue and lowers investor’s demand for risk premium or coupon rate.
* Collateralized bonds would not increase coupon rate nor would it help to pay for the coupons.

Question 21

Q

Identify correct statement(s) regrading the following bond listing: (Select all that apply)
GE 6 1/2 25; 98 1/8
* Bond is trading at discount.
* Bond is trading at premium.
* Bond is paying annual coupon rate of $6.50.
* Bond is paying annual coupon of $650.
* Bond is paying coupon of $65.

Answer

A

Bond is trading at discount.
Bond is paying coupon of $65.
* Based on the listing, the 6½ coupon GE bond due in 2025 is trading at $981.25 = $1,000 X 98.125%.
* Since $981.25 is less than $1,000 or par, then the bond is trading at a discount.
* The coupon rate is $65 = $1,000 X 6.5%.

Question 22

Q

Exam 1. Fixed Income Securities

Question 23

Q

Julian purchased a AAA-rated corporate bond with a 6.25% coupon at par. One year later, prevailing coupons on bonds of similar quality and time to maturity are 5.75%.
Julian’s bond can be categorized as a __ ____??____ __.
* par bond
* zero-coupon bond
* premium bond
* discount bond

Answer

A

premium bond
* When interest rates decrease below the stated interest of the debt (the coupon rate), the security will be worth more since new debt pays less interest. Therefore, the market price for the debt would be above par value, otherwise known as a premium bond.

Question 24

Q

Identify all Eurodollar CDs features: (Select all that apply)
* Denominated in U.S. dollars
* Issued by U.S. banks
* Negotiable
* Non-negotiable
* Issued by foreign banks
* Denominated in Euros

Answer

A

Denominated in U.S. dollars
Issued by foreign banks
Negotiable
* Eurodollar CDs are large, short-term CDs denominated in U.S. dollars and issued by banks outside the United States.
* In addition, Eurodollar CDs are negotiable, meaning that they can be traded.

Question 25

Q

Which of the following securities would be considered a money market security?
* Four-year AAA-rated bond
* Common Stock
* Preferred Stock
* Bankers’ Acceptance

Answer

A

Bankers’ Acceptance
* Money market securities are short-term instruments that typically mature in less than a year.

Question 26

Q

If prevailing rates are 5%, a bond with a 4% coupon is likely trading at __ ____??____ __.
* high-yield
* discount
* par
* premium

Answer

A

discount
* Rates have risen forcing the price of existing bonds lower (discount).

Question 27

Q

Calculate the Taxable Equivalent Yield of a Jersey City general obligation bond with a 5.27% yield when the taxpayer’s highest marginal tax rate is 22%.
* 11.59%
* 5.27%
* 6.76%
* 7.95%

Answer

A

6.76%
* The Tax Equivalent Yield (TEY) helps investors determine whether or not they are better off investing in the lower yielding but tax-free municipal bond or in a higher-yielding taxable bond.
TEY = Tax free rate ÷ (1- Marginal tax bracket)
0.0527 ÷ (1- 0.22) =
0.0527 ÷ 0.78 = 0.06756, or 6.76% (rounded)

Question 28

Q

If a bond’s conversion ratio is 75 shares of stock per bond and the price of the stock is $12.75, would it be beneficial for the bondholder to convert?
* Yes
* No
* Not enough information provided.

Answer

A

No
* Since the conversion price is $1,000/75, or, $13.34 per share, the investor can convert and sell the shares for $12.75. This would create a $0.59 loss per share or a total loss of $44.25 ($0.59 x 75 shares).
* Because the conversion would result in a loss, the bondholder should not convert.

Question 29

Q

What is adjusted on a Treasury Inflation Protected Security (TIPS) to accommodate for changes in inflation?
* Principal
* Interest
* Maturity
* Coupon

Answer

A

Principal
* TIPS’ principal is adjusted every six months to reflect the inflation rate.

Question 30

Q

Oran purchased a FMIC bond at par. Using the FIMC bond listing below, calculate the current yield on Oran’s bond.
Bond - FMIC 7 25
Volume - 10
Close - 922
Net Change - +1/2
* 8.25%
* 7.00%
* 7.59%
* 8.95%

Answer

A

7.59%
* The Current Yield on Oran’s bond is calculated as follows:

Annual Coupon Payment = Par x Coupon
= $1,000 x 0.07 = $70
Current Yield = Annual Coupon Payment ÷ Market Price
$70 ÷ $922 = 7.59%

Question 31

Q

A convertible bond can be converted into __ ____??____ __.
* the common stock of the issuer
* cash
* the new bonds of the issuer
* the preferred stock of the issuer

Answer

A

the common stock of the issuer
* Convertible bonds can be converted into the common stock of the issuer.

Question 32

Q

What is the taxable equivalent yield (TEY) of a municipal bond paying 4.25% for an investor in the 28% marginal tax bracket?
* 5.90%
* 4.25%
* 2.76%
* 6.30%

Answer

A

5.90%
* TEY = r(1 − t)
TEY = 0.0425 / (1 - 0.28) = 0.0425/0.72 = 0.059 = 5.90%

Question 33

Q

A municipal bond backed by the taxing authority of the issuer is known as a __ ____??____ __.
* revenue bond
* general obligation bond
* convertible bond
* industrial development bond

Answer

A

general obligation bond
* General obligation bonds are backed by the full faith and credit of the issuer. If the issuer were to miss a principal or interest payment, they would raise taxes to meet the obligation.

Question 34

Q

A corporation is planning to issue bonds to finance a project. Current rates are relatively high and the company feels that rates will be lower in the future, however, they can’t wait to raise the capital. What type of bond is the company likely to issue?
* Convertible Bond
* Callable Bond
* Putable Bond
* Premium Bond

Answer

A

Callable Bond
* The company will likely issue callable bonds so they can take advantage of the future low rates and refinance the debt.

Question 35

Q

When interest rates increase above the coupon rate of a bond, the bond price __ ____??____ __.
* remains the same
* increases
* decreases
* none of these

Answer

A

decreases
* When interest rates increase above the stated interest of the debt (the coupon rate), then new debt will be paying a higher rate than the existing debt. Therefore, in order for the existing debt to be as appealing to buyers in the secondary market, its market price must decrease below par value, otherwise known as a discount bond.

Question 36

Q

Lesson 2. Equities

Course 3. Investing Planning

Question 37

Q

Match the descriptions with the corresponding common shareholder.
Voting
Preemptive
Information
Dividends
* Regulation enforces full disclosure of all material and relevant information
* Maintain the same amount of control when company issues new shares
* Receive a share of the company’s profits
* The right to influence/control the company increases proportionately with the number of shares owned

Answer

A

Voting - The right to influence/control the company increases proportionately with the number of shares owned
Preemptive - Maintain the same amount of control when company issues new shares
Information - Regulation enforces full disclosure of all material and relevant information
Dividends - Receive a share of the company’s profits

Question 38

Q

Match the price or value to the correct definition or formula.
Par Value
Book Value
Bid Price
Ask Price
* The price that buyers pay for a stock.
* The price that sellers receive for a stock.
* Retained Earnings + Common Stock + Capital Contributed in Excess of Par
* The value of Common Stocks listed in Shareholder’s Equity

Answer

A

Par Value - The value of Common Stocks listed in Shareholder’s Equity
Book Value - Retained Earnings + Common Stock + Capital Contributed in Excess of Par
Bid Price - The price that sellers receive for a stock.
Ask Price - The price that buyers pay for a stock.

Question 39

Q

For any holding period, stocks will outperform all other investment vehicles.
* False
* True

Answer

A

False
* Stocks typically outperform other investments in the long run. However, stocks carry a lot of risk for shorter holding periods. Stock prices can drop below your original purchase and you would have received a better return from a bank CD or something less volatile within the same short-term holding period.

Question 40

Q

Identify the main characteristics of common stock. (Select all that apply)
* It is a security that represents ownership in a corporation.
* Holders may elect a board of directors and vote on corporate policy.
* Common shareholders have priority rights to a company’s assets.
* First in line to receive company profits.

Answer

A

It is a security that represents ownership in a corporation.
Holders may elect a board of directors and vote on corporate policy.
* Common stock is a security that represents ownership in a corporation. Holders of common stock elect board of directors and vote on corporate policy. They have rights to the company’s assets and earnings only after all preferred shareholders and debt holders have been paid in full.

Question 41

Q

Choose the correct statement(s). (Select all that apply)
* Cyclical stocks perform well when the economy is booming.
* Growth stocks consistently pay dividends from their earnings.
* Blue chip stocks are traded in the OTC market and are very volatile.
* Blue chip stocks are considered small cap stocks because of their size.
* Defensive stocks may perform better in economic downturns.

Answer

A

Cyclical stocks perform well when the economy is booming.
Defensive stocks may perform better in economic downturns.
* Cyclical stocks’ performance correlates with the economy. Defensive stocks are less sensitive to the movement of the economy. Growth stocks tend to keep earnings as retained earnings rather than paying dividends. Blue chip stocks are from large and well-established companies, therefore are likely to be traded in the NYSE as conservative large cap stocks.

Question 42

Q

Select the primary reason for an investor to purchase preferred stock.
* Right to vote
* Current income from dividends
* High potential return
* Callable feature

Answer

A

Current income from dividends
* The biggest benefit to investing in preferred stocks is their promise to pay dividends. Only some preferred stocks have the right to vote. Since some preferred stocks are likely to be called or converted, the potential capital appreciation is limited. The call feature is an advantage for the issuer, compensated through higher yield than non-callable shares, but would not be the most attractive feature to a preferred stock.

Question 43

Q

Match the description to the type of preferred stock.
Cumulative
Non-cumulative
Adjustable
Convertible
* Dividend rate changes
* Does not receive dividends in arrears
* Can exchange shares for common stock
* Receive dividends in arrears

Answer

A

Cumulative - Receive dividends in arrears
Non-cumulative - Does not receive dividends in arrears
Adjustable - Dividend rate changes
Convertible - Can exchange shares for common stock

Question 44

Q

Johnny has a warrant for shares of the Coffee Company with an exercise price of $5 per share. The share price of the Coffee Company is now $10 per share. What is(are) the best course(s) of action for Johnny? (Select all that apply)
* Buy the stock at $10 per share
* Sell the warrant
* Exercise the warrant
* Do nothing

Answer

A

Sell the warrant
Exercise the warrant
* If the market price of the underlying stock exceeds that of the warrant’s exercise price, the warrant holder would benefit from selling the warrant or exercising the warrant, then selling the shares at the open market.

Question 45

Q

Identify the purpose of issuing rights.
* Pay debt
* Honor preemptive rights
* Lower financing expense
* Exercise a call

Answer

A

Honor preemptive rights
* A right is issued to give existing shareholders a chance to purchase shares of a new issue of stock before they are available to the public.
* It honors the preemptive right of shareholders.
* Rights are not related to paying debt, lowering interest expense or being callable.

Question 46

Q

Warrants and rights are both similar to what type of investment vehicle?
* Stock
* Bond
* Money Market
* Call Option

Answer

A

Call Option
* Warrants and rights are both similar to call options in that they give the holder the right to purchase shares of the underlying security at a stated price.
* Warrants and rights derive their value from the underlying security.
* They do not resemble stocks, bonds or money market instruments.

Question 47

Q

The DJIA, one of the most widely followed indices, is a price-weighted index.
* False
* True

Answer

A

True
* The DJIA, one of the most widely followed indices, is a price-weighted index. It involves the prices of 30 stocks that generally represent large-size firms.
* Dow Jones calculates stock market indices for each of several countries as well as an Asia/Pacific index and two World Indices, one with and one without the United States.

Question 48

Q

Which of the following methods are used to calculate the S&P 500 index?
* Price Weight
* Equal Weight
* Value weighting or capitalization weighting
* Geometric

Answer

A

Value weighting or capitalization weighting
* S&P 500 uses the value weight method to calculate its index.
* This method adjusts for the weight of each stock’s market value within the composite along with their prices.
* Price Weight method is used by the DJIA. Its divisor must be adjusted to compensate for the lack of value weighting.
* Equal Weight looks at today’s price relative to that of the previous day’s. This method is employed by the Value Line Composite (Arithmetic) Index.
* The Value Line Composite (Geometric) Index uses the geometric method to determine its value.

Question 49

Q

Exam 2. Equities

Question 50

Q

Which of the following is a characteristic of a warrant?
* Issued by the firm
* Cannot be traded after issuance
* Provides the holder the right to sell shares
* Very short expiration

Answer

A

Issued by the firm
* Warrants are issued by the firm and allow the holder the ability to purchase additional shares of the company’s stock.

Question 51

Q

A Japanese company’s stock performance would be best compared with the __ ____??____ __ for benchmarking purposes.
* S&P 500
* Wilshire 5000
* Nikkei
* DJIA

Answer

A

Nikkei
* It is important to match the appropriate index with a particular stock or a portfolio of stocks.
* The Nikkei index that is comprised of companies listed on the Japanese stock exchange, would be the best alternative for a Japanese company.

Question 52

Q

The Dow Jones Industrial is a __ ____??____ __ index.
* capitalization-weighted
* value-weighted
* price-weighted
* broad-based market capitalization-weighted

Answer

A

price-weighted
* The Dow Jones Industrial is a price-weighted index. The DJIA takes into consideration only the price of the stocks rather than the market value of the company.

Question 53

Q

The exercise price is typically set above the stock’s market price at issuance for a __ ____??____ __ and below it for a __ ____??____ __.
* warrant; right
* right; warrant

Answer

A

warrant; right
* The exercise price is typically set above the stock’s market price at issuance for a warrant and below it for a right.

Question 54

Q

Which of the following benchmarks are price-weighted?
* Standard and Poor’s 500 (S&P 500)
* Value Line Index
* Dow Jones Industrial Average (DJIA)
* NASDAQ

Answer

A

Dow Jones Industrial Average (DJIA)
* The DJIA is the only price-weighted index.

Question 55

Q

Owners of __ ____??____ __ preferred stock are entitled to a fixed rate of cash dividends.
* money market
* cumulative
* participating
* convertible

Answer

A

participating
* Owners of participating preferred stock are entitled to a fixed rate of cash dividends. They may receive higher than normal dividend payments if the company turns a larger than expected profit.

Question 56

Q

The __ ____??____ __ of a stock is dependent on the demand and supply of its shares.
* intrinsic value
* par value
* book value
* market value

Answer

A

market value
* The market value of a stock is dependent on the demand and supply of its shares.

Question 57

Q

A common stock is split 2-for-1, if a holder has 125 shares worth $30 each, how many shares at what price will the shareholder have post-split?
* 250 shares worth $30 each
* 125 shares worth $60 each
* 125 shares worth $15 each
* 250 shares worth $15 each

Answer

A

250 shares worth $15 each
* A 2-for-1 stock split will double the number of shares and halve the value per share. The total value of the shares remains the same, in this case $3,750.
* $3,750 ÷ 250 (doubled shares) = $15 per share

Question 58

Q

A common stock is split 2-for-1, if an investor holds 300 shares worth $15,000, what is the value of their holdings after the split?
* $15,000
* $30,000
* $7,500
* Cannot determine from the information provided.

Answer

A

$15,000
* After a split, the total value of an investor’s holdings will remain the same.

Question 59

Q

__ ____??____ __ stocks are common stocks that are issued by large companies with solid dividend growth records.
* Growth
* Blue chip
* Income
* Value

Answer

A

Blue chip
* Blue chip stocks are common stocks that are issued by large companies with solid dividend growth records.
* Examples of blue chip stocks include Apple (NASDAQ:AAPL) and Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B).

Question 60

Q

Identify the type of preferred stock that pays shareholders missed dividends first.
* Cumulative Preferred
* Participating Preferred
* Non-Cumulative Preferred
* Adjustable-Rate Preferred

Answer

A

Cumulative Preferred
* Cumulative preferred stock gives the owner the right to accumulate dividend payments skipped due to financial problems.

Question 61

Q

Each of the following are benefits of stock investing EXCEPT:
* Marketability
* Risk Reduction
* Long-Term Return
* First Liquidation Priority

Answer

A

First Liquidation Priority
* Good stocks tend to outperform all other investment vehicles over longer holding periods.
* Stock investing is a necessity for outpacing inflation for long-term investment objectives.
* Unsystematic risks can be reduced through common stock diversification.
* A healthy secondary market ensures that you may find buyers for most common stocks.
* In the event of liquidation, however, holders of common stock are paid last.

Question 62

Q

Which of the following is NOT a stockholder right?
* Voting Rights
* Right to Convert to Fixed Income
* Right to Sell
* Right to Receive Dividends

Answer

A

Right to Convert to Fixed Income
* There is no conversion right for stockholders.

Question 63

Q

Existing stockholders the right-of-first-refusal on any new stock the corporation issues and are guaranteed the right to maintain their previous fraction of total outstanding shares and prevents dilution of ownership control.
This stockholder right is referred to as __ ____??____ __.
* preemptive right
* voting right
* right to information
* right to buy and sell

Answer

A

preemptive right
* The preemptive right grants existing stockholders the right-of-first-refusal on any new stock the corporation issues.
* This means that existing investors are guaranteed the right to maintain their previous fraction of total outstanding shares and prevents dilution of ownership control.

Question 64

Q

Dividends are paid to shareholders that hold the stock on the __ ____??____ __ date.
* payment
* ex-dividend
* record
* declaration

Answer

A

record
* Dividends are only paid to shareholders on record as of the record date.

Answer 61

A

Primary Market
* IPOs are traded initially on the primary market.

Answer 62

A

Right to Buy/Sell
Priority to Dividends
Right to Information
Dividend Arrears

Preferred Stock
* Right to Information
* Right to Buy/Sell
* Dividend Arrears
* Priority to Dividends

Answer 63

A

secondary
* NYSE, AMEX, and the OTC are a part of the secondary market.

Answer 64

A

owner
* Common stock represents ownership in a firm.

Answer 65

A

Bond Value
* Market, book, and par values are all valuation methods.

Answer 66

A

NAV Per Share
(Assets – Liabilities) ÷ Shares Outstanding = NAV

So the total assets of the investment company at the end of the day was $300 = ($10 x 10 shares) + ($20 x 10 shares).
If the investment’s total liabilities for the day was $50, then the net asset value would be $250 = $300 - $50.
The per share NAV is $12.50 ($250 / 20 shares) at the close of the day.

Answer 67

A

The ability to save money on transaction costs and get a better price of securities
The ability to sell shares back to an issuer who stands ready to buy them back
The ability to lower risk by investing in a greater variety of securities at once
* Investing in mutual funds provides investors with many benefits. For instance, by investing in more than one company, the fund increases its diversification, creating less risk for investors. Investing in mutual funds is also more cost efficient, and provides individual investors with both volume discounts and exposure to a wider variety of stocks. Another benefit to investors is that open-end funds stand ready to buy back sahres, making it easy fo investors to sell their shares.

Answer 68

A

Minimal transaction costs
Marketability
Flexibility
Service
* The advantages of mutual funds are diversification, professional management, minimal transaction costs, marketability, flexibility, and service.
* Distributed capital gains from mutual funds could lead to unplanned tax payments.

Answer 69

A

True
* When calculating the net asset value of securities, the total liabilities of a mutual fund are deducted from the market value of all securities owned. The difference is then divided by the number of shares issued. NAV is an important measure of how investment companies perform.

Answer 70

A

It is a premium
Its demand is greater than its supply
* The Fund is at premium because its market price is greater than its NAV. Therefore, its demand is greater than its supply.

Answer 71

A

secondary market
* Closed-end funds are traded in the secondary market after the initial public offering.
* When the company is initially offered, it is sold in the primary market.
* From then on, the shares are traded through brokers in the open market. The fund company/issuer can only engage in the trading of its shares through the secondary market.

Answer 72

A

Supply and demand
* In the case of a closed-end fund, the fund’s price is determined by its supply and demand in the open (secondary) market.
* The net asset value becomes a benchmark to tell whether or not the shares are trading at a discount or premium.
* The public offering price is the price that the shares are originally offered to the market from the fund.

Answer 73

A

The effective dividend yield will be greater than the equivalent open-end fund.
The investor’s overall return may be more than the equivalent open-end fund.
* Since the fund is selling at a discount, $1/$9 (closed-end fund) is a greater dividend yield than $1/$10 (open-end fund).
* Holding all other factors the same, as the price of the shares increases, the return will be greater for the lower cost basis of the discounted closed-end shares.

Answer 74

A

Japan Fund
* The Japan Fund is more aggressive because the risks associated with Japan specifically cannot be diversified away by investing in companies of other countries.
* An International Fund can spread country specific risks among several countries.

Answer 75

A

Closed-end funds are traded in the secondary market.
Open-end funds are limitless in the number of new shares they issue.
* Closed-end funds are traded in the secondary market whereas open-ended funds are bought and sold from the issuer.
* Open-end funds can issue as many shares as they choose assuming they can find appropriate investments in which to invest.
* Closed-end funds issue a finite number of shares.

Answer 76

A

Front Load - Commission collected when purchasing a fund
CDSC - Commission collected when selling fund before certain holding period, proceeds go to distributor
12b-1 - Fee to cover marketing expenses
Redemption Fee - Charge for leaving fund before certain holding period, proceeds go back to the pool

Answer 77

A

Acme Money Fund - Safety and liquidity
Massachusetts Municipal Bond Fund - Tax-free income
S&P Index Fund - Long-term growth by mimicking the performance of the market
Jackson Internet Fund - Long-term growth by investing in stocks of one industry

Answer 78

A

Average returns earned by the fund over various time periods.
Hypothetical returns of $10,000 investment over a specific period.
Percentile ranks of the fund’s average return relative to all mutual funds.
* Performance figures can show historical trends and allow investors to know how well the fund has performed in the past. Hypothetical $10,000 investments can help investors to understand the historic performance figures. By comparing historic performance of a fund to its peers and its benchmark, investors can see how well the fund managers did against other funds with similar objectives. Historic performance is not indicative of future returns.

Answer 79

A

Projected returns for the next 12 months
* Morningstar’s Mutual Fund analysis compares a fund’s average ratings with the average rating of an index and a peer group. The rating is risk-adjusted to factor in the downside risk of the fund. The rating does not project future returns of any kind.

Answer 80

A

False
* There are several caveats to the Morningstar ratings. Morningstar categories are sometimes more broad and may match some funds against others that do not have the same investment approach.
* Morningstar also uses limited number of indexes for benchmark. The indices used may not be the best benchmark for some funds.

Answer 81

A

Rent
Property Value
Mortgage
Revenue generated from property
* REITs generate return to investors from income and gains associated with the underlying properties. A REIT that owns apartment buildings will pass the rent to investors as income. A REIT that owns mortgages will pass mortgage payments to investors. A REIT that owns equity in properties will pass the profits of the property. A change in the property value would increase the price of the REIT that owns it. REITs invest in real estate and therefore would not own equipment.

Answer 82

A

False
* Limited partners will receive profits before tax. They are able to deduct losses from operations from their income tax that are proportionate to their investment.
* However, their limited liability is dependent on their passivity in general partners’ management decisions.

Answer 83

A

Funds of Funds
* A Funds of Funds invests in a variety of other hedge funds. Risk is controlled through the diversification of holding other funds.

Answer 84

A

Arbitrage/Relative Value Funds

Arbitrage/Relative Value Funds
* Investment Strategy: Seek out basic mispriced securities.
* Use of Leverage: A high degree of leverage is used to capitalize on otherwise small pricing differences.
* Risk Control: Necessary to eliminate broad market risk in order to capitalize on relative mispricing.

Answer 85

A

Money Market - Fund Safety and liquidity
Los Angeles Municipal - Bond Fund Tax-free income
S&P Index Fund - Long-term growth by mimicking the performance of the market
Valley Technology Fund - Long-term growth by investing in stocks of one industry

Answer 86

A

$18.34

NAV Per Share
(Assets – Liabilities) ÷ Shares Outstanding = NAV
($750 - $200) ÷ 30 = $18.34

Answer 87

A

Taxes
* When mutual funds sell securities within their portfolios for a profit, the majority of the capital gain is distributed to the shareholders. There is a lack of control of the holding period, so the distributed gains can have more short-term gains (which are taxed as income) than long-term gains (which are taxed at a lower fixed percentage).
* Therefore, taxation is a potential disadvantage of mutual fund investing.

Answer 88

A

Service Quality
* Mutual funds can provide you with a number of services including book-keeping services, checking accounts and automatic systems which help you to add or withdraw from your account, as well as buy or sell over the phone or the Internet.
* Thus, service is an advantage of mutual fund investing.

Answer 89

A

Class B
* Typically, Class B shares of a fund are shares with CDSC charge plus a 12b-1 fee.
* After the CDSC’s term is up, the Class B share may convert to Class A shares.

Answer 90

A

asset allocation
* Asset allocation funds attempt to time the market but in doing so, focus on total return instead of current income.
* The most significant type of an asset allocation funds are target funds.
* These funds are targeted to a specific time horizon (e.g., PQR Mutual Fund 2025).
* Target funds are of particular interest for retirement and college funding goals.

Answer 91

A

90%
* As long as 90% of their income is distributed to shareholders, that income is free from taxation for the REIT.
* At least 75% of a REIT’s assets and income must be derived from real estate equity or mortgages.

Answer 92

A

Writer - The person selling the contract
Buyer - The person selling the contract
Premium - The price of the contract
Underlying Asset - The contract derives its value from this

Answer 93

A

Ben would not exercise the option.
* If the price remained below $50, then Ben would not exercise the option. Wilma would make $300, the premium for the contract while Ben would lose $300 plus transaction costs.

Answer 94

A

Daily marking-to-market procedure
Margin requirements
* A futures contract is replaced every day by adjusting the equity in the investor’s account and drawing up a new contract that has a purchase price equal to the current settlement price. The daily marking-to-market procedure, coupled with margin requirements, results in the clearinghouse’s always having a security deposit of sufficient size to protect it from losses owing to the actions of the individual investors.

Answer 95

A

Write a put
Buy a call
Buy a future

Answer 96

A

Write a call
Buy a put
Sell a future

Answer 97

A

True
* An option is a contract between two people where one person grants the other person the right to buy a specific asset at a specific price within a specific time period. There are two parties to the contract, the seller, who agrees to sell an asset to another, the buyer, at an agreed price before the expiration of a certain date.

Answer 98

A

Buy a call option on the stock
Write a put option on the stock
* If the price of a stock is expected to rise, then you would want to buy a call or write (sell) a put option. Buying a call option would give you the option to buy the stock at a set price. If the price of the stock increases, you will be able to buy it at a cheaper price.
* Put options allow the writer to sell you shares at a set price. If the price of the shares increases, the buyer would not exercise the contract because he or she can sell the shares at a higher price in the market.
* Writers of calls and buyers of puts expect the price to fall.

Answer 99

A

$1,000
* A July wheat futures contract for 5,000 bushels at $4 per bushel would have a total purchase price of $20,000. If the initial margin requirement is 5%, buyer and seller would each have to make a deposit of $1,000 (0.05 X $20,000).

Answer 100

A

$1,300
* If the maintenance margin is roughly 65% of initial margin, then the investor must have equity equal to or greater than 65% of the initial margin, or $2,000(0.65) = $1,300.

Answer 101

A

Exchanges begin trading a new set of options on a given stock every three months.
Newly created options have roughly nine months before they expire.
Exchanges may decide to introduce long-term options or LEAPS.
Exchanges may decide to allow customized options or FLEX options for flexible exchange options.
* In options trading, exchanges begin trading a new set of options on a given stock every three months. The newly created options have roughly nine months before they expire, and options might be introduced in January, April, July, and October, with expiration dates in, respectively, September, December, March, and June.
* The exchange might decide to introduce long-term options also called LEAPS by the exchanges for long-term equity anticipation securities that expire as far into the future as two years.
* The exchange might also decide to allow the creation of customized options called FLEX options for flexible exchange options, that have exercise prices and expiration dates of the investor’s choosing.
* Daily marking to market is a practice used for futures contracts.

Answer 102

A

True
* The OCC has to see that the writer is able to fulfill the terms of the contract. The exchanges where the options are traded have set margin requirements, to relieve the OCC of this concern.
* In the case of a call, shares are to be delivered by the writer in return for the exercise price.
* In the case of a put, cash is to be delivered in return for shares.
* In either case the net cost to the option writer will be the absolute difference between the exercise price and the stock’s market value at the time of exercise.
* The OCC is at risk if the writer is unable to bear this cost. It has a system known as “margin” to protect itself from the actions of the writers.

Answer 103

A

There are two basic types of annuities:
* Fixed
* Variable

Exam Tip: If annuity payments continue beyond the life expectancy noted on IRS Table V, all income generated from the annuity is considered taxable income.

Answer 104

A

Liquidation period. When benefit is distributed through lump sum or annuity
Fixed annuity. Principal is always guaranteed while interest rate is guaranteed for a brief period, then becomes changeable
Accumulation Period. Principal builds through investments and returns on investments reinvested
Variable annuity. A mutual fund with an insurance wrapper

Answer 105

A

Principal invested in a portfolio of securities.
Future worth depends on the portfolio’s financial performance.
* The value of a variable annuity is dependent on market performance of a specified investment fund.
* The principal is invested in a portfolio of securities.
* The value of a variable annuity increases or decreases with the changing value of the underlying securities.
* The future worth of the annuity will depend on the portfolio’s financial performance. If it does poorly, you could lose some or the entire principal.

Answer 106

A

Long-term growth
* Guaranteed Investment Contracts (GICs) are conservative by nature. Funds made up of GICs are sometimes called stable funds. They are ideal for very conservative objectives such as a temporary holding place, safe haven, or nearing distributions.
* They are not suitable for long-term growth because they do not provide sufficient yield to outpace inflation in the long-run.

Answer 107

A

Revival - nostalgic trend led to a resurgence of interest in collecting beanie babies
Limited edition - limited number were produces
Retired - production ceased for the particular version
* The change in price of a collectible is driven by basic micro-economic factors. Price will increase due to scarcity caused by limited editions, discontinued versions, and increase in demand while quantity supplied remained the same. The premise of an Internet auction such as eBay runs on the basis of price movements caused by supply and demand.

Answer 108

A

True
* The IRS allows owners of income-producing property certain deductions, which result in tax savings.

Answer 109

A

Correct Answer: A., B. and D.
* Explanation: There are certain advantages of holding gold coins, bullion and certificates.
* Gold companies stock provides a current return in the form of annual dividends.
* Gold coins can be stored in bank safe deposit boxes. They are standardized in weight and purity and can be purchased anywhere.
* Commissions on gold certificates are lower than bullion or coins.

Answer 110

A

Correct Answer: B. and C.
* Explanation: A major draw for investing in real estate is the income the property can generate coupled with the opportunity for capital gains. The tax advantages that were available in the past are largely gone or are on the way out. Investment in real estate is illiquid. If you sell your property holdings, it may take months to find a buyer, and there’s no guarantee that you’ll actually get what you feel is a fair price. In addition, overbuilding in some areas has actually resulted in a decline of property prices. The bottom line is that real estate investment is not well suited to the novice investor.

Answer 111

A

Correct Answer: A. and D.
* Explanation: ADRs are certificates issued by U.S. banks that represent ownership in shares of foreign company stocks. They provide investors access into foreign companies that they otherwise may not be able to.
* Regulation requires companies to follow Generally Accepted Accounting Principles to report financial information in order to qualify as ADRs.
* They lower the overall risk of a portfolio because their low correlation to the movement of U.S. markets.

Answer 112

A

The return on physical assets is normally negatively correlated with returns on financial assets.
* Inflation, while bearish to stocks and bonds, may be beneficial for collectibles. That John would not be subject to the same elements of risk attributable to the stock market is a good answer, but the correct answer is better.

Answer 113

A

A receipt for shares of a foreign-based corporation.

Answer 114

A

For enjoyment.
* With the exception of dealers, an investor who invests in collectibles realizes a gain subject to long-term capital gains rates of 28% upon sale (if held long-term). Acquisition and commissions are relatively high compared to alternative investments. Prices change frequently and unpredictably due to their markets.

Answer 115

A

Generally
* Most (but not all) ADRs satisfy the IRS definition of a “qualified foreign corporation”. Most ADRs fit the Internal Revenue Code, but some ADRs do not meet the definition.

Answer 116

A

Buying S&P 500 Index calls
* If the large-cap market were to rise, the manager could profit from increased prices by buying calls.

Answer 117

A

Selling a naked call.
* If the price of the stock rises, the seller of the naked call is forced to buy the stock at the higher market price in order to supply it to the option buyer. This is the riskiest option because the stock may rise without limit.

Answer 118

A

The annuity is tax-deferred.
* This contract is owned by a natural person (Bob). Taxation is deferred.

Answer 119

A

III, IV
* Collectibles and natural resource funds are negatively correlated with the market.
* The collectible may be perfect with her style of living.
* The index option is correlated.
* The puts may expire.
* The global fund includes US stocks.

Answer 120

A

ADR holders receive foreign tax credits for income tax paid to a foreign country.
* ADR holders cannot vote for the Board of Directors. Dividends are declared in local currencies but are paid in U.S. dollars.

Answer 121

A

II
* If the client sells a call, he will receive premium income, but the stock may be called away. A stop-limit order is a specialized order in which a limit order and a stop order are combined. A stop-limit order to sell must have a stop-limit price below the security’s market price.
* Example: “Sell 100 GM 70 stop-limit.” Once the stock sells at or below $70, the order becomes a limit order to sell 100 shares at $70.
* Limit orders can also be placed on the buy side. The put protects the downside risk.

Answer 122

A

Change the manufacturer process
CEO charged with unethical business practices
Leverage buy out
* Business specific risks are uniquely associated with the company or entity issuing the security. Change is processes may increase short-term expenses but improve a company’s efficiency in production in the lon-term. A company being bought out can be beneficial (company is broken up and sold in pieces). Charges for any illegal activities or business practices can be detrimental for the company’s stock.

Answer 123

A

False
* Market risk is associated with overall market movements, not just changes in interest rate.
* The interest rate risk is, in fact, associated specifically with changes in the market interest rate.

Answer 124

A

Interest rates are decreasing
* When interest rates decrease, it gives a company incentive to exercise its right to call its outstanding bonds and issue new bonds in the current interest environment. This helps to lower the interest expense for the company and allow it to use the money on other things. Therefore when interest rates rise, companies would not call its debt because its existing interest expense is lower than current rates. Inflation and exchange rates have no direct relationship with the decision to call a bond issue.

Answer 125

A

Business Risk - Can be caused by management decisions
Liquidity Risk - Inability to find a buyer at a fair market price
Financial Risk - Associated with the use of debt by firms
Sovereign Risk - Subject to foreign country seizing investment

Answer 126

A

The correlation coefficient squared is called the coefficient of determination, “R2”, or “R-squared.” R-squared measures the portion of the asset’s performance that can be attributed to the returns of the overall market. Since the correlation of coefficient’’s value is between -1 and 1, R-squared’s values can only be between 0 and 1 (the square of anything less than zero will equal a positive number).
If R-squared = 1, then the asset’s return is perfectly correlated with the return of the market.
If R-squared = 0, then the asset’s return has nothing to do with the market’s return.
The closer to one that an asset’s R-squared value is, the more reliable its beta. if an asset’s R-squared is below .7, then Beta and everything that uses Beta (like the Treynor ratio and Jensen’s Alpha) would be a meaningless statistic.

Answer 127

A

Montaigne Fund
* The Montaigne Fund is more likely to outperform the market during an expansion. With an R2 of 0.24, Lamarck Fund’s Beta is not reliable. As a result, the Montaigne Fund is more likely to outperform the market due to its reliable R2 of 0.89, and a Beta of 1.04 that suggests that it will outperform the market.

Answer 128

A

Covariance Formula:
Multiply the standard deviation of asset I, by the standard deviation of asset J.
And then multiply by the correlation between asset I and J

Numbers will be provided. Just multiply.

Real trick with covariance is understanding what it actually measures.
Used in finance to measure how 2 assets change in value in comparison to one another

Answer 129

A

Used in finance to measure how 2 assets change in value in comparison to one another

Positive – move in tandem
* Ex. Hot Summer – high temperatures, high usage of AC

Negative – move in opposite directions
* Ex. Hot Summer – sales down in coat sales, sales high for AC

Answer 130

A

Modern Portfolio Theory – portfolio managers will actually seek out negative correlated assets as a way to diversify their holdings and hedge their bets.
* When one loses, another would gain.

Two big problems with relying on covariance are:
1. Past performance does not predict future results.
2. Covariance only tells us that the 2 assets will move in the same direction.
It does not tell us how closely they will follow each other.
* One asset could increase by 5% and the other by 50% or 500%.
* Without more information, we won’t be able to make full use of that data.

That’s when we need to incorporate correlation.

Answer 131

A

The standard deviation equals the square root of the variance.

Answer 132

A

The variance of an asset’s rates of return is a statistic that measures the asset’s wideness.
The variance is represented by the symbols s2 and VAR(r).

Answer 133

A

68% probability that the actual return you will obtain next year, will be plus / or minus one standard deviation from the mean (expected return).
95% of the time, the actual return will be plus / or minus two standard deviations from the mean; and finally,
99% of the time, the actual return will be plus / or minus three standard deviations from the mean.
These ranges (68%, 95%, and 99%) are referred to as confidence intervals.

Answer 134

A

1 dev – 68% = 34% + 34%
2 dev – 95% = 13.5% + 13.5%
3 dev – 99.7% = 2.35% + 2.35%

Answer 135

A

Correlation is a statistical measure that offers advisors information on the direction that assets move in relation to one another.
Correlation shows the strength of a relationship between two variables and is expressed numerically by the correlation coefficient.
The correlation coefficient’s values range between -1.0 and 1.0.
Understanding how to calculate the correlation coefficient as well as what it can tell us about an investment portfolio is key to success on both the CFP exam as well as a career as a CFP.

Answer 136

A

Correlation – part of the co-variance formula
Adjust the co-variance formula to make the Correlation formula
+1 – they behave exactly the same, ex. S&P 500 ETF and S&P 500
-1 – they behave completely opposite. When one goes up, the other goes down by the exact same amount, ex. Shorting a security
0 – no relationship

Good to balance holdings in a portfolio

Answer 137

A

The beta coefficient is an index of undiversifiable (market, systematic) risk. You can rank betas from different assets to compare the undiversifiable risk of the assets.
Since the beta of the market (Bm) equals 1, if the beta of the investment (Bi)= 1, then the asset has the same volatility as the market.
If Bi > 1, then the rates of return from the asset are more volatile than the returns from the market and the asset is classified as an aggressive asset. The return will be higher than the market if the market return increases. However, if the market return decreases, then the asset’s return will decrease more.
If Bi < 1, then the asset is a defensive asset. Its rates of return are less volatile than the market’s. The asset will earn a positive return when the market return increases, but not as much. Similarly, when the market does poorly, it will do less poorly than the market.

Answer 138

A

An investment’s total risk, measured by its variance of returns, can be partitioned into two components:
* Unsystematic or Diversifiable risk
* Systematic or Nondiversifiable risk

By rearranging the characteristic line, you can attribute the returns that are diversifiable vs. nondiversifiable.

Total Return
Bi (rm, t) + (ai, t + ei, t) = ri, t

Undiversifiable + Diversifiable = Total Return of Period for Asset

Answer 139

A

The percentage of total risk that is diversifiable can be measured by subtracting the coefficient of determination or R-squared from one.

The percentage of total risk that is nondiversifiable can be measured by the coefficient of determination or R-squared.

Answer 140

A

0.616
* The nondiversifiable portion would be the R2 or the correlation coefficient-squared (0.785)2 = 0.616, or 61.6%.
* Therefore, 61.6% of Coca-Cola’s return for that period is based on the, nondiversifiable, systematic risk.

Answer 141

A

Systematic/Non-diversifiable
* Purchasing Power Risk (Inflation Risk)
* Reinvestment Rate Risk
* Interest Rate Risk
* Market Risk
* Exchange Rate Risk

Answer 142

A

Unsystematic/Diversifiable
* Business Risk
* Financial Risk
* Credit (Default) Risk
* Regulation Risk
* Sovereignty Risk

Answer 143

A

Expected rate of return
* The expected rate of return is defined as the weighted average of various rates of return in one probability distribution.
* Alpha is the value on the vertical axis where the characteristic line intersects that axis, while beta measures the slope of one asset’s characteristic line.
* Systematic risk is that portion of a stock’s risk that cannot be eliminated through diversification.

Answer 144

A

Characteristic line
* The characteristic line is a simple linear regression used to measure an investment’s beta and residual variance.
* The standard deviation is the square root of the variance.
* Undiversifiable risk is that portion of a stock’s risk or variability that cannot be eliminated through diversification.
* The correlation coefficient is a goodness-of-fit statistic that measures how well the data points fit a regression line.

Answer 145

A

The degree of risk associated with asset
* Variance represents the amount of risk associated with an asset.
* The higher the value (the wider the distribution) the more likely the actual return will vary from the expected return.
* Covariance describes the relationship between two or more assets.
* The characteristic line identifies the diversifiable and undiversifiable risks.

Answer 146

A

A stock with R-squared of 70% has a return that was mostly caused by systematic risk.
A stock with alpha of .04 had a better return than the market.
* R-square represents the portion of return attributed to undiversifiable or systematic risk.
* Positive alpha values represent a better return than market, while negative ones denote that the market performed better.
* If beta is greater than 1, then the stock is aggressive and if it is less than 1, then the stock is defensive.
* The closer to 1 R-squared is, the more correlated to the market it is.

Answer 147

A

If beta is greater than 1, then the stock is aggressive.

If it is less than 1, then the stock is defensive.

Answer 148

A

True
* The closer to 1 R-squared is, the more correlated to the market it is.

Answer 149

A

the distribution is skewed to the right and will have fat tails
* A positively skewed distribution is skewed to the right and a negatively skewed distribution is skewed to the left.
* Excess kurtosis greater than 0 describes a Leptokurtic distribution and will have fat tails.

Answer 150

A

Lose 24%
* 10% x 2.4 = 24%

Answer 151

A

Liquidity risk

Answer 152

A

I, II, III
* Answers IV and V are the risk level quantification of Beta.

Answer 153

A

Stock #2

HP 12C
8 Σ +
12 Σ +
16 Σ +
8 CHS Σ +
g key, x̄ (0 key)
g key, S (. key)

Stock #1 has a mean of 5.75% and a standard deviation 7.59%.

Answer 154

A

-1.84% to 13.34%
* Mean = 5.75%, SD = 7.59%

1σ = 5.75% - 7.59% = -1.84%
1σ = 5.75% + 7.59% = 13.34%

Answer 155

A

II
* At this time very little credit, marketability, and default risk exists.

Answer 156

A

0% to 32%
* 16% ± 16%

Answer 157

A

15.75%
* 15% x 1.05 = 15.75%

Answer 158

A

The U.S. dollar was revalued.
* By definition, the U.S. dollar was revalued.
* Revaluation refers to an increase in the currency’s value.

Answer 159

A

Non-diversifiable risk
* The S&P index would have a systematic risk.
* Actually, all of the other answers refer to unsystematic risk (diversifiable risk).

Answer 160

A

I, III, IV
* The stocks must have low positive correlations.
* Fifteen stocks in differing industries such as Microsoft, Exxon, Merck, Ford, GE, etc. will greatly reduce unsystematic risk.
* All technology stocks provide little risk reduction.
* A strike is a business risk (or an unsystematic risk).

Answer 161

A

Equal to the weighted beta.
* By definition, a portfolio beta is the weighted average of each security in the portfolio and its beta.

Answer 162

A

Systematic risk
* A portfolio with a beta of +1 is one that moves in the same direction and at the same rate as the market.
* Therefore the portfolio only has market risk which is also known as systematic risk.

Answer 163

A

I, II
* III, IV, V refer to standard deviation.

Answer 164

A

HPR=(PE+D−PB) / PB
Where:
PE = price in the end of the period
PB = price at the beginning of the period
D = any dividend, interest, or cash flow paid.

Holding period is defined as the length of time over which an investor is assumed to invest a given sum of money.
* The holding period return has a major weakness because it does not consider the time or how long it took to earn the return.
* When this procedure is applied, the performance of a security can be measured by comparing the value obtained in this manner at the end of the holding period with the value at the beginning.
* Please note that in the formula below, any coupon (from a bond), interest, dividend, or any other cash flow received from the investment does not assume reinvestment.
* Any reinvestment (like capital gains distributions and dividends from a mutual fund) would be imbedded in the ending value (P1) and the separate addition of theses payments would overstate the return.

Answer 165

A

$540 - $400 ÷ $400 = 0.35 = 35%

Answer 166

A

$1,000 - $875 + $420 ÷ $875 = 62.3%

In reference to point (1), this could have been asked as a capital appreciation and income yield component: $1,000 - $875 / $875 = 14.3% (Capital gain component) and $420 (7 coupon payments x $60) divided by $875 = 48%.
The two together would sum to the total of 62.3%.

Answer 167

A

($3,200 + $400 - $2,000) ÷ $2,000 =
0.80 or 80%

Answer 168

A

Growth & Income Fund
* The Growth & Income Fund had the best holding period return.
* Growth & Income Fund = ($5,699 - $4,000) ÷ $4,000 = 0.42, or 42%
* Growth Fund = ($2,782 - $2,000) ÷ $2,000 = 0.39, or 39%
* Small Company Fund = ($3,127 - $2,500) ÷ $2,500 = 0.25, or 25%

Answer 169

A

The arithmetic average rate of return is a summary of a great deal of information and provides a good way to compare the performance of different investments. The arithmetic mean return (AM), an average of historical one-period rates of return, is computed as follows:

AM=a1+a2+a3+…+an / n
where n denotes the terminal time period.

The arithmetic mean of historical annual returns must be measured over a representative sample period. A representative sample might cover one complete business cycle, measured from either peak to peak, or from trough to trough.

For example, Kerry held an S&P Index Fund for three years. Her returns during that time were 20%, -10%, and 5% respectively. What was her arithmetic mean return?
(.2)+(−.1)+(.05)3
= .05 or 5%

Practitioner Advice: Arithmetic mean is less telling because the standard deviation of the period can vary significantly — the price of the investment could have been very volatile during that period. If so, then the return is not reflective of the movement of the investment during that time.

Answer 170

A

10.36%

Keystrokes (HP 12C)
0.80 ENTER 1.40 x 1.20 x 3 1/x yx 1 -

The calculator returns:
0.10357, which is also expressed as 10.357%

Answer 171

A

After Tax Return = Total Return (1 - tax bracket)

Taxes can take away from return as well. It is important to consider how much is paid in taxes on investment gains when evaluating how much you have really earned.
For example, if your investments yield long-term capital gains of $1,000, then 15% of the long-term gains, or $150, is due to the IRS as Federal tax on the gains. Depending on the state you live in, there could be an additional amount due for state taxes as well.

Answer 172

A

31.05%
* Jed’s after tax return is equal to his taxable return times reciprocal of his tax bracket.
* 45%(1-0.31)=
* 31.05%

Answer 173

A

(1+r)(1+i)−1
Where:
r= rate of return
i= rate of inflation

In times of changing prices, the nominal return (dollars received) on an investment may be a poor indicator of the real return (also known as the real rate) obtained by the investor. This is because part of the additional dollars received from the investment may be needed to recoup the investor’s lost purchasing power due to inflation. As a result, adjustments to the nominal return are needed to remove the effect of inflation in order to determine the real return. Frequently, the consumer price index (CPI) is used for this purpose.

For example, let’s assume the rate of investment return over some time period is 9%. Over that same time persiod, inflation averaged 3%. One could estimate that the inflation adusted rate of return would be 6% (9%-3%). However, it is important to be exact as small differences in return estimates can lead to large differences in dollars over time. If we apply the formula, we will find the actual inflation adjusted rate of return:

(1+.09)(1+.03)−1 = .05825 or 5.83%
While the .17% difference between the estimated and the actual inflation adjusted returns may seem insignificant, when applied to dollars over a long period of time it can lead to big differences.

Answer 174

A

43.85%
* The $550 dividend was reinvested at a price of $11.00, increasing the number shares owned to 1,050. ($550 / $11.00 = 50 shares).
* Therefore, the value of the dividend is imbedded in the ending account value of $14,385 ($13.70 x 1,050 shares).
* In this case, the HPR would simply be the price at the end, minus the price at the beginning, divided by the price at the beginning. Plugging in the numbers, the calculation yields:
* {($14,385 - $10,000) / $10,000}
* = .4385 = 43.85%

Answer 175

A

Assuming that the fund’s interest is not reinvested, the price at the end of the year was lower than the beginning
The interest was assumed to have been reinvested
* The total return for the fund was 2%, which was comprised of a 4% loss of principal, and a 6% interest payment.
* Using the HPR formula, and assuming a starting value of $1,000, we would calculate the total return as
* ($960 + $60 - $1,000) / $1,000 = 2%.

Answer 176

A

9%
* The arithmetic mean return (AMR), an average of historical one-period rates of return, is computed as follows:
* AMR = [10+(-1)+15 +12]/4 = 9%

Answer 177

A

8.8%
* The geometric mean return from this 4-year investment is calculated as follows:
* GMR = [(1.10)(.99)(1.15) (1.12)]^.25 = 8.8%

Answer 178

A

YTM is based on maturity date of the bond
YTC is based on first callable date
* YTM is the yield to the maturity date of the bond. The YTC is the yield up to the first date that the yield can be called. The appropriate yield to choose for callable bonds may be the lower of the YTC and YTM. YTC cannot be determined for a non-callable bond.

Answer 179

A

The bond is held to maturity; coupons are reinvested immediately at YTM; all payments are received on time.
The bond is a zero coupon bond and is held to maturity; par payment is received on time.
* For YTM to be realized, the bond must be held to maturity, the issuer must make full payments of coupon and par on time, and the cash flows must be reinvested immediately at YTM.
* Pure-discount (zero coupon) bonds do not have cash flows to reinvest, so if held to maturity, the holder earns YTM.

Answer 180

A

Corporate Bond
* The tax equivalent yield for the municipal bond at Molly’s tax bracket is 7.638%.
* Although it is higher than the bond fund, it is not as high as the corporate bond.
* If Molly was basing her decision purely on how much yield she would receive, the corporate bond would be the best investment choice.

Answer 181

A

Yield to maturity = 6%
* After computing the two different yields, you must select the lower yield for investment decision-making purposes, because that return represents the minimum yield that the investor can expect to earn.

Answer 182

A

Yield to maturity is higher for a premium bond than for a discount bond.
* YTM does depend on whether the bond is selling at a premium or a discount.
* YTM is less for a premium bond because the premium is amortized over the remaining years to maturity, so less money is available for compounding.
* If a bond is selling at a premium, then the nominal yield is divided by a larger price to obtain the current yield, therefore the current yield would be lower.
* If the bondholder reinvests cash flows at a rate below YTM, there will be less interest to compound.
* Bond equivalent yield makes a pure discount bond’s yield equivalent to a coupon paying bond.

Answer 183

A

3.108%

The return for first half year = ($19,178 - $20,000)/$20,000 = -.0411.
The return for second half year = ($25,998 – $19,178 – $5,000) /($19,178 + $5,000) = .075275.
The time-weighted return = [(1-.0411)(1+.075275)-1] = .03108 or 3.108%.

Answer 184

A

The return is strongly influenced by the size and timing of the cash flows.
The investment manager typically has no control over the deposits and withdrawals.
* In general, the dollar-weighted return method of measuring a portfolio’s return for purposes of evaluation is regarded as inappropriate.
* The reason behind this view is that the return is strongly influenced by the size and timing of the cash flows (namely, deposits and withdrawals), over which the investment manager typically has no control.

Answer 185

A

2.5%
* Return
= [(1+.025)(1+.017)(1-.036)(1+.02)]-1
= 2.5%.

Answer 186

A

Returns of investments with similar risk
Historic returns of the investment
Average returns of a relevant market
Personal required rate of return
Average returns of company’s industry index
* To determine how an investment performed, the returns should be compared to the returns of: a client’s personal objectives, other investments of similar risks, the benchmark market index, the relevant industry index, and the investment’s own past performance.

Answer 187

A

yield to maturity (YTM)
* The rate of return on bonds that is most often quoted for investors is the yield to maturity (YTM), which is defined as the discount rate that equates the present value of all the bond’s future cash flows with its current market price (purchase price). The YTM is the compounded rate of return of a bond.

Answer 188

A

standard deviation
* The arithmetic mean is less informative as a metric because the standard deviation of the period can vary significantly; the price of the investment could have been very volatile during that period. If so, then the return is not reflective of the movement of the investment during that time.

Answer 189

A

114%

Holding Period return is calculated by taking the total profit and dividing it by the cost.
Buying the stock for $70 and selling it for $130 results in a gain of $60.
Plus, a dividend of $20 results in a total profit of $80.
$80 divided by an original cost of $70 results in a 114% holding period return.
(20 + (130 - 70)) ÷ 70 = 114%

Answer 190

A

dollar-weighted
* Difficulties are encountered when deposits or withdrawals occur sometime between the beginning and end of the period. One method that has been used for calculating a portfolio’s return in this situation is the dollar-weighted return (or internal rate of return).
* Dollar-weighted return is what an investor should use to determine how well their investment performed.

Answer 191

A

1.94%

Inflation-adjusted rate of return:
[(1.05 ÷ 1.03) – 1] x 100 = 1.9417 = 1.94%

Answer 192

A

geometric mean return
* The compound average rate of return (geometric return) is similar to the arithmetic mean return, except the geometric return, because it does take compounding into account, will always be less than the arithmetic return.
* The compound average rate of return is also called the geometric mean return (GMR), where the GMR is computed over n successive time periods.

Answer 193

A

Time-weighted return
* Time-weighted return is the only acceptable method to display the results of a portfolio manager’s performance.
* The time-weighted return on a portfolio only concerns itself with the portfolio appreciation or depreciation in value from one period to the next.
* That is, all cash flows into and out of the fund are totally disregarded from the return data.

Answer 194

A

reinvestment
* Many corporate bonds, as well as some government bonds, are callable by the issuers, typically after some deferred call period.
* Since bonds would only be called when interest rates are lower, all of the remaining cash flows are exposed to reinvestment risk.

Answer 195

A

10.26%

The equation for the TEY is:
TEY = r ÷ (1 - t)
Where:
r = tax-free yield
t = Investor’s marginal tax bracket
8 ÷ (1 - 0.22) = 8 ÷ 0.78 = 10.26%

Answer 196

A

80%

Holding Period return is calculated by taking the total profit and dividing it by the cost.
Buying the stock for $50 and selling it for $80 results in a gain of $30.
Plus, a dividend of $10 results in a total profit of $40.
$40 divided by an original cost of $50 results in a 80% holding period return.
(10 + (80 - 50)) ÷ 50 = 80%

Answer 197

A

NPV = PV of Future Cash Flows - Purchase Price

Answer 198

A

A positive NPV means that the present value of all the expected cash inflows is greater than the cost of making the investment.
Conversely, a negative NPV means that the present value of all the expected cash inflows is less than the cost of making the investment.

Answer 199

A

The following shows how the equation for determining the one-period rate of return is derived by rearranging the equation so that it is equal to the time value model:
r = (Terminal value - Present value)/Present value
r = (Terminal value/Present value) - 1
(1 + r) = Terminal value/Present value
(Present value)(1 + r) = Terminal value

Answer 200

A

Present value =
(Terminal value)/(1 + r)

Answer 201

A

k = Rf + bi(Rm - Rf)

k = Market Capitalization Rate
Rf = Risk-Free Return
bi = Beta for security (how closely the security correlates with movements of the market)
(Rm - Rf) = Risk Premium: the difference between the market return and the risk free return.

Answer 202

A

The following are created based on a combination of risk premiums to compute a security’s Required Rate of Return (Cost of Capital):
* For Treasury bills, k = 4.5%
* For Treasury notes, k = 5.5%
* For Treasury bonds, k = 5.9%
* For corporate bonds, k = 6.3%
* For large-cap stocks, k = 13.0%
* For small-cap stocks, k = 14.5%

Answer 203

A

Present value, or PV = CF1/(1+k)1 + CF2/(1+k)2 + CFT/(1+k)T

This valuation model says that the value of a series of cash flows equals the discounted present value of all future cash flows.
* CF stands for cash flow (either inflows or outflows). The cash flows could be cash dividends from a common stock, coupon interest from a bond, rent from a piece of real estate, the asset’s selling price, or other cash flows.
* The subscripts and exponents are time period indicators. The terminal time period, when the cash flow occurs, is denoted T. These cash flows are expected to arrive at the end of successive time periods denoted t = 1, t = 2, t = 3,…., t = T.
* The term k represents the required rate of return that is appropriate for the investment.

Answer 204

A

PV = [CF1/(1+k)1]+[CF2/(1+k)2]+[CFT/(1+k)T]

= [$2/(1.145)1] + [$3/(1.145)2] + [$40/(1.145)2]

= $1.7467 + $2.2883 + $30.5105 = $34.5455

Brenda makes a wealth-maximizing decision to buy the stock if she can get it for less than $34.5455

Keystrokes
0 g CF0 2 g CFj 43 g CFj 14.5 i f NPV
The calculator returns: 34.5455

Answer 205

A

PV = [CF1/(1+k)1]+[CF2/(1+k)2]+[CFT/(1+k)T]

= [$2/(1.145)1] + [$3/(1.145)2] + [$40/(1.145)2]

= $1.7467 + $2.2883 + $30.5105 = $34.5455

Brenda makes a wealth-maximizing decision to buy the stock if she can get it for less than $34.5455

Keystrokes
0 g CF0 2 g CFj 43 g CFj 14.5 i f NPV
The calculator returns: 34.5455

Answer 206

A

PV = DIV 0 (1+g) / (k−g)
= $3 (1.03) / (.13 – .03)

= $30.90

Based on these calculations Jana decides not to buy the stock because it is overpriced by $51.50 – $30.90 = $20.60 per share.

Answer 207

A

PV = DIV0 / k
= $4.50/.13
= $34.615

The stock’s perpetual stream of constant cash dividends is worth $34.615 per share.

Alex maximizes his wealth by deciding not to buy the stock, because it is overpriced by $50 - $34.62 = $15.38 per share.

Answer 208

A

Sustainable growth rate =
(1 – Payout ratio)ROE

The following are sources of growth rates: historical average, industry average, and sustainable growth rate*.

Answer 209

A

P=∑∞t=1 Ct / (1+k∗)t

Again, since k* will be compounded over t periods, time has a significant influence over the internal rate of return.

Calculating the internal rate of return (IRR) associated with the investment is similar to the NPV method and offers an alternate method for making investment decisions.

The IRR for a given investment is the discount rate that makes the NPV of the investment equal to zero. To compute the IRR, the NPV is set equal to zero, and the discount rate, which is unknown, is then calculated.

The decision rule for IRR involves comparing the investment’s IRR (denoted by k) with the required rate of return for an investment of similar risk (denoted by k). Specifically, the investment is viewed favorably if k greater than k, and unfavorably if k* less than k. As with NPV, the same decision rule applies if either a real asset or a financial asset is being considered for possible investment.

PRACTITIONER ADVICE
In comparing the NPV and IRR methods, the NPV method is superior in that the underlying assumption in the calculation is the opportunity to reinvest future cash flows at the investors required return. IRR however, makes the unrealistic assumption that the investor has an opportunity to reinvest at the IRR! This difference is significant, and the ramifications are such that given a choice on these methods, the NPV should always be used.

Answer 210

A

FVn = PV(1+k)^n

FVn = the future value of the investment at the end of n years
n = the number of years during which the compounding occurs
k = the annual interest rate, and
PV = the present value, or the current value in today’s dollars.

The value of an investment at a future point in time is called future value. To derive the future value, we do not look at the present value of future cash flow through discounting. Instead, we look at the future value of investment through compounding.

The future value of an investment for any number of years can be calculated using the following equation, where:

Again, time influences future value through compounding. Time also allows for compounding of inflation rate to erode away the purchasing power of the investment. The inflation adjusted compounding rate or the real rate is equal to:

Real rate = [(1 + interest rate)/(1 + inflation rate)] – 1

For example, if a stock investment is expected to yield 11% on average over the next 10 years and the inflation rate is expected to average 4% during the same time, then the real rate = (1.11/1.04) - -1 = .0673 or 6.73%. The real rate can be used for the compounding rate to solve for the future value of the investment to show the return net of inflation.

Answer 211

A

An alternative method for calculating the real interest rate is to subtract the inflation rate from the nominal return (as a whole number), and then dividing that amount by 1 plus the inflation rate.
Using the same example above,
11 - 4 = 7. Then 7/1.04 = 6.73.

This is the real (or inflation adjusted) return, and is already expressed in the correct format for your calculator. The other method requires you to convert the decimal expression to a whole number.

Answer 212

A

Cash flows are discounted backward to calculate the PV.
Cash flows are compounded forward to calculate the FV.
* The future values of cash flows are discounted backward to calculate the present value.
* This valuation method can be used to compare the present value of an investment to its current market price.
* The initial investment and expected cash flows can also be compounded forward to determine the future value of an investment.

Answer 213

A

$944.98
* 5(2) = N;
* 6.3/2 = I;
* 1000 = FV;
* 50/2 = PMT;
* PV = -944.98 or $944.98.

Answer 214

A

$13,426

Real rate = [(1 + interest rate)/(1 + inflation rate)] - 1
= (1.11/1.04) - 1 =
6.73% FV =
$7,000(1 + .0673)^10 = $13,426

Answer 215

A

It is the present value of future cash flows minus the purchase price of an investment.
* When the cost of an investment is deducted from its present value (PV) of the future inflows, net present value (NPV) is obtained.
* NPV = PV of Future Cash Flows – Purchase Price

Answer 216

A

Cash flows characterizing a typical bond involve the payment of a lump sum on a stated date. This payment is known as the bond’s principal or par value.
Most corporate bonds will have a par value of $1,000.

Answer 217

A

Cash flows characterizing a typical bond involve the payment of a lump sum on a stated date. This payment is known as the bond’s principal or par value.
Most corporate bonds will have a par value of $1,000.
If the market price of a bond is greater than its par value, the bond is said to be selling at a premium.
If the market price of a bond is less than its par value, the bond is said to be selling at a discount.

Answer 218

A

Par Value
* Market price = Par value
* Yield-to-maturity = Coupon rate

Discount Value
* Market price < Par value
* Yield-to-maturity > Coupon rate

Premium Value
* Market price > Par value
* Yield-to-maturity < Coupon rate

Answer 219

A

Specifically, the formula for a bond’s duration D is
D = (1+y/ y) − (1+y) + T(c−y)c[(1+y)T−1]+y
* where c denotes coupon,
* T denotes the number of compounding periods to maturity, and
* y denotes the market rate of interest which can easily be determined by calculating the bond’s yield-to-maturity.

There are three variables that determine a bond’s duration: Coupon rate, market interest rate, and the number of compounding periods until maturity.
* Note that “price” is not a determinant in calculating duration.
* Price is a function of the market rate of interest.

Answer 220

A

Par
Principal
* Cash flows characterizing a typical bond involve the payment of a lump sum on a stated date. This lump sum payment is known as the bond’s principal or par value.

Answer 221

A

False
* The second bond-pricing theorem states that if a bond’s yield does not change over its life, then the size of its discount or premium will decrease as its life gets shorter.

Answer 222

A

False
* When yields change, most bond prices also change, but some react more than others do.
* Bonds with the same maturity date can react differently to a given change in yields. However, the percentage change in a bond’s price is related to its duration. So the prices of two bonds that have the same duration will react similarly to a given change in yields.

Answer 223

A

a premium
* If the market price of a bond is greater than its par value, the bond is said to be selling at a premium.
* Conversely, if the market price of a bond is less than its par value, the bond is said to be selling at a discount.

Answer 224

A

time value
* One way of valuing an investment is to use the discounted present value model, which assumes that money has time value.
* This assumption is relevant because borrowers pay interest to lenders to induce them to make loans. Interest is the rent on borrowed money. It causes money to have a terminal value in the future that differs from its present value. The discounted present value model can be used to help you estimate the value of securities like stocks, bonds, or even rental property.

Answer 225

A

convexity
* The relationship between bond prices and yields is referred to as convexity.
* Although this is true for standard types of bonds, the degree of curvature is not the same for all bonds. Instead, it depends on, among other things, the size of the coupon payments, the life of the bond, and its current market price.

Answer 226

A

Present Value of Future Cash Flows
* When the cost of an investment is deducted from PV, Net Present Value (NPV) is obtained.
* Net Present Value (NPV) = PV of Future Cash Flows - Purchase Price

Answer 227

A

Internal Rate of Return
* IRR stands for Internal Rate of Return.

Answer 228

A

duration
* Duration is a measure of the “average maturity” of payments associated with a bond.
* More specifically, it is a weighted average of the length of time until the remaining payments are made.

Answer 229

A

higher than
* The true price of the bond will always be higher than the modified duration estimate. This is due to the convex shape of the price/yield function.

Answer 230

A

equal to zero
* The IRR for a given investment is the discount rate that makes the NPV of the investment equal to zero.
* To compute the IRR, the NPV is set equal to zero, and the discount rate, which is unknown, is then calculated.

Answer 231

A

a discount
* If the market price of a bond is less than its par value, the bond is said to be selling at a discount.
* If the market price of a bond is greater than its par value, the bond is said to be selling at a premium.

Answer 232

A

Dividend Discount Model
* The Dividend Discount Model (DDM), is a specific valuation model where you assume a constant dividend with no future growth (known as a perpetuity).

Answer 233

A

Call premium when the bond is called early.

Most bond investors obtain three types of cash flows:
* periodic coupon interest payments,
* reinvestment of those coupon payments, and
* repayment of principal when the bond matures.

While some bonds have a call premium, it is not a typical cash flow for most bonds.

Answer 234

A

Market Price
* There are three variables that determine a bond’s duration: Coupon rate, market interest rate, and the number of compounding periods until maturity. Note that “price” is not a determinant in calculating duration. Price is a function of the market rate of interest.

Answer 235

A

If the intrinsic value – purchase price = a positive number (or if NPV > 0), then the bond is underpriced or undervalued and the bond should be purchased.
If the intrinsic value – purchase price = a negative number (or if NPV < 0), then the bond is overpriced or overvalued and the bond should not be purchased.

Answer 236

A

$9,632.00
* PV = $550(PVIFA 5.5%,10) + $10,000 (PVIF 5.5%,10) or 10000 FV, 550 PMT, 10N, 6 I, PV = $9,632.00.

Answer 237

A

$924.06
* PV $60 (PVIFA 9%,3) + $10,000 (PVIF 9%,3) or, using a financial calculator, 1000 FV, 60 PMT, 3 N, 9 I, PV = $924.06. Note that - $25.94 is the net present value of the bond, or the difference between the value of the bond and the purchase price. (NPV = V-P). Therefore, this bond is overpriced and should not be bought.

Answer 238

A

Implied return
* The present value of expected dividends can be calculated for a given required rate of return. However, many investment firms use a computerized trial and error procedure to determine the discount rate that equates the present value of the stock’s expected dividends with its current price. Sometimes this long-run internal rate of return is referred to as the security’s implied return.

Answer 239

A

$1978.13
* The first step is to establish a cash flow line: Time / Cash Flows 0 / (10,000) 1 / 3,000 2 / 3,000 3 / 3,000 4 / 3,000 5 / 3,000
* Keystrokes: 10000 CHS g CFo 3000 g CFj 5 g Nj 8 i f NPV
* The Calculator Returns: 1,978.13
* The Project should be accepted since the NPV is positive.

Answer 240

A

The stock is an unfavorable investment
* Since k^ is less than k, or the IRR is less than the appropriate discount rate, the stock is an unfavorable investment. There is not enough information to determine whether or not the net present value is positive or negative.

Answer 241

A

Undervalued
* V = $2.00 ÷ 0.10 = $20.
* Since the price of the share is trading currently at $18.50, Mountainside Electric Company stock is undervalued by $1.50 per share, according to the zero growth dividend model.

Answer 242

A

V=$26
Overvalued
* V=$1(1+.04)/(.08-.04)=$26. $29-$26=$3.
* The stock is $3 overvalued.

Answer 243

A

12%
* Assuming that a stock is fairly valued if its dividend is growing at a constant rate, the internal rate of return can be found by solving the intrinsic value equation for k * = (D2/V)+g = [($3X 1.06)/ $53] + 0.06 = .12 or 12%.

Answer 244

A

-$1.08
* DT+1 = D3 = $3(1 + 0.10) = $3.30. VT- = $2/(1+.15)^1 + $3/(1+0.15)^2 = $4.01. VT+ = $3.30/(0.15-0.10)(1+0.15)^2= $49.91. V = $4.01 + $49.91 = $53.92. With a current stock price of $55 per share, NPV = -$1.08. The company appears to be fairly priced. That is, A&B Co. is not significantly mispriced because V and P are nearly of equal size.

Answer 245

A

Zero-growth Model - Dividend will remain the same amount forever.
Constant-growth Model - Dividend will grow at the same rate forever.
Multiple-growth Model - Dividend will have different amounts until time T, then it will have the same growth rate forever.

Answer 246

A

Undervalued
* Calculate payout ratio=($2/$4)=50%.
* According to the equation indicating the normal price/earnings ratio=[(0.5)(1+0.06)]/(0.10-0.06)=13.25.
* This is more than Rock Rulez Guitar’s actual price/earnings ratio of=$38/$4=9.50, which means the stock is undervalued.

Answer 247

A

Payout Ratio
Expected Earnings
* Dt = (Pt)(Et); dividends are replaced by the payout ratio multiplied by expected earnings.
* When solving for the normal price/earnings ratio, the expected earnings is divided into the intrinsic value.

Answer 248

A

Stock’s P/E = 20
Stock’s V/E = 21.2
* Payout ratio = ($2/$2.50) = 80%.
* V/E = [(0.80)(1+0.06)]/(0.10 – 0.06) = 21.2.
* This is greater than Jameson and Sons Company’s actual price/earnings ratio of $50/$2.50 = 20.
* This means stock of Jameson and Sons Company’s is undervalued, but not by much.

Answer 249

A

10.60
* Payout ratio = $4/$8 = 50%
* V/E = .50(1.06)/.05 = 10.60

Answer 250

A

The dividend payout ratio is low
* Assuming that no new capital is obtained externally and no shares are repurchased, the portion of earnings not paid to stockholders as dividend will be used to pay for the firm’s new investments. The portion not paid out is the retention ratio. Growth rate depends on the proportion of earnings that are retained and the average return on equity for the earnings that are retained.

Answer 251

A

The more free cash flow, the lower the price/free cash flow (P/FCF) ratio would be.
Low price to free cash flow ratios are favorable.

Answer 252

A

The explosion in Internet stocks forced investors to look for ways to value companies with lots of potential, but no earnings. Moreover, many investors do not trust net earnings anymore, since they are often manipulated through write-offs and other creative accounting practices. Sales are much harder to disguise.
The price/sales ratio is the company’s price divided by its sales (or revenue). This value is arrived by dividing revenue by the number of shares outstanding, and then dividing the revenue per share into the price per share. But because the sales number is rarely expressed as a per-share figure, it’s easier to divide a company’s total market value by its total sales for the last 12 months.
Price/Sales works well in analyzing large-cap companies, whose sales are so great, that it is closer to their market capitalization.
The ratio is less appropriate for service companies like banks or insurers that don’t really have sales.
Most value investors set their P/S hurdle at 2 and below when looking for undervalued situations. Again, with ratios, it is better to compare a company’s P/S value to its competitors and its own history.

Answer 253

A

The PEG ratio helps quantify this idea. PEG stands for price/earnings growth and is calculated by dividing the P/E by the projected earnings growth rate. So if a company has a P/E of 15, and analysts expect its earnings will grow 10% annually over the next few years, its PEG = 1.5.
A PEG above 1 would indicate that the company is trading at a premium to its growth rate.
Therefore, a favorable PEG would be below 1.
If a company has a P/E of 20 times its earnings, but its peers have P/E of 10 times, it may appear that the company is expensive relative to its peers. However, if the company’s growth rate is at 25% while its competitors are averaging 8%, then the company’s PEG is .80 while its competitors are at 1.25. This will lead to the conclusion that the company’s expected growth rate makes it more attractive than its competitors even though it had a higher P/E.
PEG ratio works better for smaller or growth companies because they are effected by growth rate more than large and more mature companies.
The one drawback is that the ratio is dependent on earnings estimates, which are less reliable than free cash and revenue.
If a company does not pay dividends, it will have a greater PEG ratio.

Answer 254

A

PRACTITIONER ADVICE:
Most of the ratios will not need to be memorized because the name of the formula usually guides your calculation.
* The word “margin” usually means sales in the denominator
* The word “turnover” usually means sales in the numerator.

Answer 255

A

P/FCF is free from accounting assumptions and P/E is not
* Because Price/Free Cash Flow is net of non-cash accounting assumptions, it gives a clearer picture of how well a company can reinvest in itself, pay down its debt, or pay out dividends.

Answer 256

A

12.25%
* The growth rate is return on equity times the retention ratio.
* Since the firm is paying out 12.5% of its earnings ($0.90 / $7.20) then it is retaining 87.5% of its earnings.
* The ROE of 14%, multiplied by 87.5% (.14 x .875) equals .1225 or 12.25%.

Answer 257

A

Price/Sales Ratio

Answer 258

A

Price/Book Value Ratio

Answer 259

A

Price/Earnings Growth Ratio

Answer 260

A

7.36
* P/E = (D1/E1)/(k-g) =
* ($1.03/$2.00)/(0.10 - 0.03)
* = 7.36

Answer 261

A

$200,000
* The current ratio was 2.5 to 1 and the current liabilities were $200,000 before the equipment purchase.
* Using a current ratio of 2.5 to 1, this implies that current assets were $500,000.
* Since cash (a major component of current assets) was used to buy the equipment, current assets are reduced to $400,000.
* Working capital is current assets minus current liabilities.
* After the purchase, working capital amounted to $400,000 - $200,000 = $200,000. Please note that a fixed asset does not affect current assets.

Answer 262

A

semi-annual
* Most bonds make semi-annual interest payments.
* Every 6 months investors will receive half of their annual coupon payment.

Answer 263

A

Zero-Growth Model
* The Zero-Growth Model assumes that future dividends will remain at a fixed dollar amount.
* That is, the dollar amount of dividends per share that were paid over the past year (D0) will also be paid over the next year (D1), the year after that (D2), the year after that (D3), and so on.

Answer 264

A

Multiple-Growth Model
* Under the Multiple-Growth Model, the focus is on a time in the future (denoted by T), after which dividends are expected to grow at a constant rate (g).

Answer 265

A

Yield to Maturity (YTM)
* The most common rate used when discounting a bond’s value is the Yield to Maturity (YTM) which is the total return anticipated on a bond if the bond is held until it matures.

Answer 266

A

dividends
* The cash flows associated with an investment in common stock are the dividends expected to be paid on the shares purchased.

Answer 267

A

Constant-Growth Model
* The Constant-Growth Model assumes that dividends will grow from period to period at the same rate, forever.

Answer 268

A

intrinsic value
* Once investment analysts calculate a required rate of return, it is easy to compute various values required for determining the Multiple Growth Model. The intrinsic value of a company is forecasted based on these figures.

Answer 269

A

Fast Ratio

Liquidity ratios provide information about the liquidity or short-term debt paying ability of the firm. Examples include:
* Working Capital = current assets - current liabilities
* Current Ratio = current assets ÷ current liabilities
* Quick Ratio = (current assets - inventory) ÷ current liabilities. (This ratio is also known as the acid test.)
* Cash Ratio = (cash + marketable securities) ÷ current liabilities

Answer 270

A

zero

In computing the IRR, the NPV is set to zero and the discount rate becomes unknown, so the discount rate has to be calculated.
The IRR for a given investment is defined as the discount rate that makes the NPV of the investment equal to zero.

Answer 271

A

positive
* The Net Present Value (NPV) equation can be used to determine whether or not an investment is worthwhile.
* An investment is viewed favorably if its NPV is positive or neutral and unfavorably if its NPV is negative.

Answer 272

A

22%
* Portfolio Expected Return =
* ($20,984 - $17,200) ÷ $17,200
* = 0.22, or 22%

Answer 273

A

22%
* Portfolio Expected Return = The sum of the contribution to portfolio expected returns =
* 3.77% + 10.01% + 8.22%
* = 22%

Answer 274

A

Asset D has a return of 17%; beta=1.25; standard deviation=21%
* Based on the information provided, the risk assessment investment statistic under the CAPM that details relative efficiency is Coefficient of Variation, which is Standard Deviation, divided by return. Since the risk measure is the numerator, the lower the result the better the risk-return relationship; that is, it is more efficient.
* The CV for asset D is 1.235 which is the lowest. Simply, for every unit of return (for which Asset D has 17), there is 1.235 units of risk. Asset A, B, and C have CV of 1.286, 1.4 and 1.263, respectively.

Answer 275

A

Expected returns and standard deviations
* According to Markowitz, the investor should view the rate of return associated with any portfolio by considering the random variables of expected (or mean) value and standard deviation.

Answer 276

A

Risk-averse
* It is assumed that investors are risk-averse, which means that the investor will choose a portfolio with a smaller standard deviation.
* Risk-averse investors are willing to forego some expected terminal wealth (that is, accept lower expected returns) in exchange for less risk.

Answer 277

A

8%
* The investment in IBM is 50% of the portfolio, so the return of 20% times the portfolio weight of 50% yields a contribution to the portfolio return of 10% (50% weight x 20% return).
* Calculate the same for Texaco (30% weight x -10% return = -3%), and
* the same for Motorola (20% weight x 5% return = 1%).
* Adding the three together generates the portfolio return
* (10% + -3% + 1% = 8%).

Answer 278

A

Less than zero
* When the correlation coefficient is greater than zero, it indicates the securities in the portfolio are moving in tandem.
* Whereas, when the correlation coefficient is zero, the movement of one security in comparison to the other in the portfolio is not predictable.
* When the correlation coefficient is less than zero, the movement of one security as against the other is exactly opposite, indicating the most diversified situation.

Answer 279

A

CAPM-based measures of portfolio performance are:
* Sharpe ratio
* Treynor ratio
* Jensen’s ratio

Each one of these measures provides an estimate of a portfolio’s risk-adjusted performance, thereby allowing the client to see how the portfolio performed relative to other portfolios and relative to the market.

Answer 280

A

Ranking portfolios’ returns averaged over several years is oversimplified because such rankings ignore risk. Thus, what is needed is an index of portfolio performance, which is determined by both the return and the risk.

William F. Sharpe devised the reward-to-variability index of portfolio performance, denoted SHARPEp. This defines a single parameter portfolio performance index that is calculated from both the risk and return statistics.

Answer 281

A

Dow Jones Industry Average (DJIA) 30 of the largest U.S.-based companies
Standard & Poor’s 500 (S&P 500) 500 U.S.-based companies. Widely accepted as the standard index to benchmark against for large cap U.S. stocks. According to the S&P, 97% of money managers and pension funds are indexed against the S&P 500.
Wilshire 5000 Contains of 6,500 U.S.-based companies. Considered the broadest index for U.S. Stocks.
Russell 2000 Commonly used as a benchmark for small company portfolios. The capitalization ranges from approximately $1.3 billion to $128 million.
NASDAQ Typically, a benchmark for technology companies and mid-size companies.

Answer 282

A

Alternative portfolios that could have been chosen instead of the one chosen
* Comparing the returns obtained by the investment manager with appropriate alternative portfolios that could have been chosen for investment helps evaluate portfolio performance.
* In selecting the benchmark portfolio, the client should be certain that they are relevant, feasible, and known in advance, meaning that they should represent alternative portfolios that could have been chosen for investment instead of the portfolio being evaluated.

Answer 283

A

Dollar-weighted returns
* The dollar-weighted return (or internal rate of return) is the method that helps in situations when deposits or withdrawals occur sometime between the beginning and end of the period.

Answer 284

A

Modern Portfolio Theory
* Understanding how risk-averse investors construct portfolios to optimize expected returns against market risk is best described as Modern Portfolio Theory (MPT).

Answer 285

A

14.27%

The expected return is solved by adding the proportionate weighting of each component’s expected contribution:
* Adam Stock. 33% x 15% = 0.0495
* Brendan Stock. 22% x 11% = 0.0242
* Jerry Stock. 25% x 6% = 0.015
* Mike Stock. 20% x 27% = 0.054

Answer 286

A

non-satiation
* The assumption that investors, given the same level of risk, will always choose the portfolio with the greatest return is known as non-satiation.

Answer 287

A

the Correlation Coefficient
* Only the correlation coefficient has a standardized scale.

Answer 288

A

Negatively correlated securities
* Negatively correlated securities will have the most diversifying benefit.

Answer 289

A

Security A
* The question is asking about the coefficient of variation or standard deviation divided by the expected return.

A = 0.11 ÷ 0.15 = 0.733
B = 0.12 ÷ 0.07 = 1.71
C = 0.22 ÷ 0.23 = 0.956
Security A has the most efficient return.

Answer 290

A

0.017934
* COVij = ρijσiσjCOVij
* = 0.61 × 0.14 × 0.21
* COVij = 0.017934

Answer 291

A

perfectly positively correlated
* These securities would have a correlation coefficient of 1.0 and be considered perfectly positively correlated.

Answer 292

A

18.47%
σp=((0.67×0.23)2+(0.33×0.12)2+2(0.67)(0.33)(0.01987))√=
σp=(0.02375+0.00157+0.00879)‾‾
‾‾‾√=
σp=0.03411‾‾‾‾‾‾‾‾√
=σp=0.1847=18.47%

Answer 293

A

17.13%
* σp=((0.45×0.27)2 + (0.55 × 0.16)2 + 2(0.45)(0.55)(0.01382))‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾
* ‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾√ =σp= (0.01476 + 0.00774 + 0.00684)‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾
* ‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾‾√=σp= 0.02934‾‾‾‾‾‾‾‾√=σp=0.1713=17.13%

Answer 294

A

8.18%
* The return for the dollar-cost averaging investment was

($4,327 - $4,000) ÷ $4,000 =
8.175%, or 8.18% (rounded).

Answer 295

A

They choose between these options based on their expectations of the direction of the yield curve.
* Those investors who anticipate the yield curve to become steeper will use a bullet strategy.
* Those who expect the yield cure to flatten will pick the barbell.
* Those who are neutral or uncertain will buy a ladder.

Answer 296

A

A barbell is a strategy of holding more bonds at the short and long end of the yield curve with intermediate bonds being underweighted.
This allows a portfolio’s price to match the volatility of an intermediate-term liability.
When there is a likelihood that the Federal Reserve will loosen monetary policy in the near term, a barbelled portfolio may increase a bond portfolio’s return.
High-yield municipal and corporate bonds have two advantages that can be utilized in a barbelled portfolio.
First, high-yield bonds help diversify a portfolio. Their performance is largely isolated from what’s happening with government interest rates because their yields depend almost entirely on default risk.
Second, compared to equity alternatives, they are often undervalued. If the yield curve continues to flatten, the return on a barbelled portfolio is optimized.

Answer 297

A

A bullet-structured portfolio benefits when the yield curve is expected to steepen.
A bullet structure usually weighs heavier around intermediate term assets.
A bulleted maturity tends to outperform a barbell structure when the yield curve steepens because in a rising rate environment, intermediate-term securities usually hold up better than long-term securities.
Also, in a declining interest-rate environment, intermediate securities produce significantly greater price appreciation than do short-term securities.

Answer 298

A

Dollar Cost Averaging
* Dollar cost averaging is the practice of purchasing a fixed dollar amount of stock at specified intervals. The logic behind dollar cost averaging is that by investing the same dollar amount each period instead of buying in one lump sum, you’ll be averaging out price fluctuations by buying more shares of common stock when the price is lowest, and fewer shares when the price is highest.

Answer 299

A

The reinvestments will have a dollar cost average effect on the account.
The reinvested amounts will purchase additional shares.
* Reinvestment of dividends and distributed capital gains is a method to purchase additional shares rather than taking the amounts as cash.
* Since it is a purchase on a regular basis, it is gives the effect of dollar cost averaging.
* The cost basis of the account will change because the additional shares will be purchased at different share prices.
* Although the client does not take the money out of the account, the dividends and distributed gains are still taxable.

Answer 300

A

Short-term yield is lower than long-term yield.
A portfolio with a ladder strategy is best suited to this environment.
* A ladder structure will be the most beneficial in a normal upward sloping yield curve indicating higher yield at longer maturities, with a stable interest rate environment.
* Barbells work better in a flat yield curve while
* bullet works better for a steep yield curve.

Answer 301

A

Stock price is on the rise
* Dollar cost averaging can help investors lower their overall average cost per share in most market conditions except for when the stock price is continuously increasing.
* In that case, the investor would have been better off investing everything at the lower price in the beginning.

Answer 302

A

Head and Shoulders Top has three successive peaks, forms after an uptrend, and is viewed as a sell signal.
* A head and shoulders reversal pattern forms after an uptrend, and its completion marks a trend reversal. A technician would view this price pattern as a distinct sell signal.

Head and Shoulders Bottom has three successive troughs, forms after a downtrend, and is viewed as a buy signal.
* As a major reversal pattern, the head and shoulders bottom forms after a downtrend, and its completion marks a change in trend. A technician would view this price pattern as a distinct buy signal.

Answer 303

A

Yes
* If the market was efficient, the difference between the returns should be approximately zero.
* Since all three methods yield significant differences between buy day and sell day returns, it can be said that technical analysis would have made a difference during this period.

Answer 304

A

First - Region (e.g. Europe or Pacific rim)
Second - Country (e.g. Germany or Japan)
Third - Industry (e.g. Technology or healthcare services)
Fourth - Company (e.g. IBM or Tyco)

Answer 305

A

Rates go above cap
* A collar is beneficial when the rate goes above the cap.

Answer 306

A

Sells securities that are doing well
Buys securities that are doing poorly
* Contrarians invest in a manner that is completely opposite to momentum investors.
* They tend to buy stocks that have had recent bad news and sell the ones that have recently performed well.

Answer 307

A

20.2
* Zero coupon bonds have a duration that equals its maturity.
* (40%)(10)+(60%)(27) = 20.2

Answer 308

A

Market Timing - Buy and Hold
Momentum - Contrarian
Passive - Active
Technical Analysis - Fundamental Analysis

Answer 309

A

True
* The only instance where dollar cost averaging will not work is if the stock or stock fund’s price continues to rise and never drops. If that was the case and your client had a lump sum to invest, it would have been cheaper to buy it in the beginning.

Answer 310

A

Hold a high-beta portfolio when the expected market return is greater than the risk-free return.

A market-timer structures a portfolio to have a relatively high beta when he expects the market to rise and a relatively low beta when a market drop is anticipated. In other words, a market timer will:
* Hold a high-beta portfolio when Expected Market Return > Risk-free Return, and
* Hold a low-beta portfolio when Expected Market Return < Risk-free Return.

Answer 311

A

Under dollar-cost averaging, stock investments are made at random intervals.
* Dollar-cost averaging is the practice of purchasing a fixed dollar amount of stock or stock funds at specified (not random) intervals.

Answer 312

A

Charting
* Charting a stock’s price is a tool used by technical analysts, not for fundamental analysis.

Answer 313

A

Company Financial Statements
* Technical analysts are not concerned with the fundamental prospects of a firm. In fact, what the company does, what they make, their relative market share, etc., is all unimportant information according to a technician.

Answer 314

A

Bullet structure
* A bullet-structured portfolio benefits when the yield curve is expected to steepen.
* A bullet structure usually weighs heavier around intermediate-term assets.

Answer 315

A

Ladder structure
* A ladder structure is a portfolio of bonds that mature at regular intervals throughout the various maturities of the yield curve.
* To perpetuate a ladder structure, as each bond matures, the proceeds are used to purchase a bond that will mature at the next interval after the one with the longest maturity in the portfolio.

Answer 316

A

Under a dividend reinvestment plan (DRIP), automatically reinvested dividends are not subject to current taxation.
* Under a dividend reinvestment plan (DRIP), the reinvested dividends are subject to current taxation and become part of the investor’s cost basis.

Answer 317

A

A small company aggressive growth fund
* A small company aggressive growth fund is actively managed, not passive.

Answer 318

A

Barbell structure
* A barbell is a strategy of holding more bonds at the short and long end of the yield curve with intermediate bonds being underweighted.
* This allows a portfolio’s price to match the volatility of an intermediate-term liability.

Answer 319

A

Yes
* Yes. A client could have multiple investment goals, each with its own time horizon.
* For example, in creating a financial plan, you may discover that your client wants to retire in 35 years, pay for her son’s college education in 18 years, and buy a new home in 5 years. Each of these is a different goal carrying a different time horizon.

Answer 320

A

Money Market Fund
* Liquidity needs such as emergency funding or a temporary place to hold some money must be met by liquid asset.
* Money market mutual funds are the most liquid investments in the list.
* The low eating of the high yield bond makes it tough to sell.
* Foreign stocks may be harder to sell than domestic ones, especially from emerging markets.
* Land and shares to a partnership are typically classified as illiquid investments as well.

Answer 321

A

Reference point for risk objectives
Measure performance against
Reference point for return objectives
* Funds are professionally managed based on a previously determined strategy. Investors do not get to choose which securities should be purchased or sold.

Answer 322

A

Highest potential risk and reward - 10% money market instruments, 10% bonds, 80% stocks
Higher potential risk and reward - 10% money market instruments, 20% bonds, 70% stocks
Conservative potential risk and reward - 20% money market instruments, 30% bonds, 50% stocks
Most conservative potential risk and reward - 25% money market instruments, 60% bonds, 15% stock

Answer 323

A

True
* SAA is the asset mix that is intended to accomplish investment objectives over the long run.
* TAA is designed to deviate from SAA when temporary market conditions make it profitable to do so.

Answer 324

A

The plots on the line are the most efficient.
Plot below the line – achievable, but not efficient.
Plot above the line – not achievable at all.

Answer 325

A

Plotting out Mean variance optimization – investor is getting an optimal amount of return given a unit of risk they’re willing to take
* T bills 6% and Stocks 14% (higher return, higher risk)
* Risk averse will plot on left and lower end of curve
* Risk tolerant will plot on right and upper end of curve

Answer 326

A

Strategic Asset Allocation - Derive long-term asset allocation weights
Tactic Asset Allocation - Change in weights to meet temporary market conditions
Dynamic Asset Allocation - Change in weights to meet a change in investor’s circumstances
Integrated Asset Allocation - Optimize based on investment goals and market conditions

Answer 327

A

Technical analysts
* Technical analysts study historical market data. They prepare graphs of stock prices and study statistics in hopes of discerning patterns that will repeat themselves in the future. Technical analysts typically analyze dozens of different assets and market indexes, but they typically prepare their forecasts for one asset or one market index at a time.

Answer 328

A

Integrated asset allocation
* Integrated asset allocation considers the investor’s goals and policies and capital market conditions, and then uses these data as inputs to some kind of optimizer.
* The optimizer’s solution becomes the new inputs that are reconsidered along with the investor’s latest goals and policies and most recent market conditions when revising the asset allocation.

Answer 329

A

Involves selecting the classes of assets in which funds will be invested.
* The asset allocation decision involves selecting the classes of assets, rather than the specific securities, in which to invest. It needs to be based on the objectives and constraints of the investor, which may not be investing to offer the highest expected return. It must be revisited regularly to ensure that the objectives and constraints are still being met and to make any necessary changes if the objectives and constraints are modified due to changes in the investor’s circumstances.

Answer 330

A

First - Gain understanding of the client’s goals, circumstances and risk tolerance.
Second - Create and agree upon an investment policy, then forecast expected risk and return.
Third - Allocate funds.
Fourth - Review performance and make changes as necessary.

Answer 331

A

Technical
* Technical analysis is involved with short-term predictions of security price movements based on past patterns of prices and trading volumes, and then makes recommendations concerning the timing of purchases and sales of stocks.

Answer 332

A

Mis-priced securities
* Financial analysts are active mangers who focus their research efforts on analyzing company financial statements. Such research permits an analyst to better understand a company’s business operations, as well as the characteristics of securities, group of securities, and which securities might be mis-priced.

Answer 333

A

Security selection
* Security selection is a component of the investment process where assets are identified for investment and the proportion of funds to invest in each of the assets is determined. The investment manager makes a forecast of expected returns, standard deviations, and co-variances for all available securities. This results in the identification of the optimal portfolio.

Answer 334

A

$3,000
* If the sale of stock results in a net loss, then it can be deducted up to $3,000 per year. If the amount of the loss is greater than $3,000, the investor can carry that amount to future tax years and continue to deduct up to $3,000 per year.

Answer 335

A

4.76%

Tax equivalent yield = Tax-exempt rate ÷ (1 – Tax bracket).
0.03 ÷ (1 - 0.37)
0.03 ÷ 0.63 = 0.0476, or 4.76%

Answer 336

A

on the efficient frontier
* The most efficient portfolios lie directly on the efficient frontier.

Answer 337

A

Statistics for individual foreign and domestic stocks.
* In preparing forecasts for asset allocation Investment managers typically overlook individual stocks, individual bonds, and individual pieces of real estate, and focus instead on the categories of homogeneous assets.

Answer 338

A

Reallocation of existing assets.
* Reallocation of existing assets would occur at a later step and is not considered in Step 1.

Answer 339

A

Lifecycle asset allocation
* Lifecycle asset allocation attempts to address the client’s portfolio asset allocation based on the typical needs of a person in a similar lifecycle stage.

Answer 340

A

I only
* Every Markowitz efficient portfolio:
* has the maximum expected return available at its level of risk, and
* the minimum risk at its level of expected return.

Answer 341

A

Adviser fee structure disclosures
* The purpose of a written investment policy statement carefully sets forth the client’s investment goals and policies. Adviser compensation is discussed at the commencement of the engagement and is not part of the written investment policy statement.

Answer 342

A

Rose: 37% marginal federal income tax bracket
* The investor in the highest federal income tax bracket has the highest taxable equivalent yield because they experience the highest tax savings by holding the municipal bond.

Answer 343

A

Small company stock funds
* Small company stick funds would be expected to have the greatest volatility.

Answer 344

A

Stock Index Funds
* In a perfectly efficient market, there is no opportunity to gain abnormal returns beyond the market. Therefore, a stock index fund would produce the most returns possible.

Answer 345

A

A weak form efficient market
* A weak form efficient market exists when the market prices reflect only previous or historical information.
* In a semi-strong efficient market, the market prices reflect all public information.
* A strong form or perfectly efficient market exists when the market prices reflect everything that is knowable. This includes both historical and public information in addition to other information.

Answer 346

A

Historical information
Public information
Inside information of the company
Additional information that is more difficult to obtain
* A strong form or perfectly efficient market exists when the market prices reflect everything that is knowable. This includes both historical and public information in addition to other information. Knowable information also includes inside information of the company. However, this must be used only in a legally approved manner.

Answer 347

A

True
* The random walk model is a situation in which changes in the value of a random variable are independent and identically distributed.
* When applied to common stocks, it refers to a situation in which security price changes are independent and identically distributed. This means that the size of a security’s price change, from one period to the next, can be viewed as being determined by the spin of a roulette wheel.

Answer 348

A

Under or overvaluation of securities can be expected.
Abnormal profits can be made by using a set of information to formulate buying and selling decisions.
Investors must make full and accurate use of the available information set.
* In an efficient market it is impossible to make abnormal profits by using a particular set of information to formulate buying and selling decisions. That is, investors should expect to make only normal profits by earning a normal rate of return on their investments. An efficient market is defined as one in which every security’s price equals its investment value at all times. In an efficient market, a set of information is fully and immediately reflected in market prices.

Answer 349

A

Professional investors should fare no better in stock selection than the uninformed investors.
* In a perfectly efficient market, prices always reflect investment value, and hence, professional investors do not have an edge over ordinary investors when it comes to stock selection. Therefore, investors need not rely on investment advisors or analysts for pricing decisions.

Answer 350

A

Were most often lucky
* Though some investment advisors or analysts may display impressive performance records, it is merely due to luck or chance. Their past performance cannot be relied upon as a basis for predicting their future performance.

Answer 351

A

False
* Analysts may be able to show abnormal returns on their gross returns, but these gains will be offset by the increased cost incurred in using special data and analytical software.
* The resulting net returns will show that they have earned a fair return and nothing more.

Answer 352

A

The net return of passive and active managers will be similar
Active managers’ returns will be offset by cost to acquire information and make frequent trades
* Active managers may be able to find better returns, but their costs for information and transactions will offset any additional gains. This will result in a similar net return for both passive and active managers.

Answer 353

A

Event - The speed with which the price adjusts to the equilibrium after an event, such as announcement of a stock split
Patterns - Seeking for consistent repetition of abnormal gains
Performance - Seeking investment managers who can consistently earn abnormal returns.

Answer 354

A

The existence of market “anomalies” has been discovered.
* Various market “anomalies” have been discovered in tests of a semi-strong form market. Securities with certain characteristics or during certain time periods appear to produce abnormally high returns.
* The help of an active portfolio manager aware of such anomalies would help an investor. It is in highly efficient markets, such as the U.S., that analysts have incorporated information quickly and accurately. In weak form markets technical analysis based on past records has proved to be ineffective.

Answer 355

A

Event studies
* Event studies reveal how fast security prices react to release of information.
* Pattern searches and performance tests are methods used for testing other aspects of market efficiency.
* Inside information is not used in testing for market efficiency.

Answer 356

A

Stocks tend to open below their Friday closing prices on Monday.
* The day-of-the-week effect shows that returns on Monday are lower and in the negative.
* The January effect and size effect indicate the other regularities.
* No regularity has been found stating that small firms have lower returns on Monday.

Answer 357

A

Purchase stocks of Deltapro in late December or earlier.
Purchase stocks of Instapro in early February or later.
* Market anomalies suggest that Jack Jones should:
* purchase stocks of small firms (Deltapro) in late December or earlier;
* sell stocks of small firms (Softpro) in mid-January or later;
* purchase stocks of large firms (Instapro) in early February or later;
* and sell stocks of large firms (Techpro) in late December or earlier.

Answer 358

A

False
* In addition to the size effect, the January effect and the day-of-the-week effect also exist in Japan. This also includes the interrelationship between the January effect and size effect.

Answer 359

A

Value managers
* Value managers tend to invest in stocks issued by corporations that have low rates of earnings growth, high current yields, and low P/E ratios.
* Growth managers tend to invest in stocks issued by firms with high rates of earnings growth, low current yields, and high P/E ratios.

Answer 360

A

None of these
* None of the forms of the efficient market theory consider technical analysis to be worthwhile.
* Each assumes all technical analysis is already incorporated into the security’s current FMV.

Answer 361

A

Random walk
* Random walk is, in general, a situation in which changes in the value of a random variable are independent and identically distributed. When applied to common stocks, it refers to a situation in which security price changes are independent and identically distributed.

Answer 362

A

Stock D, rated 1 by Value Line with a return last year of 6%
* Stocks ranked 1 or 2 are forecasted to outperform the market over the next 6 to 12 months.
* Stocks ranked 3 are expected to return amounts that mirror the general market average, and
* stocks ranked 4 or 5 are expected to underperform the stock market returns over the next 6 to 12 months.

Answer 363

A

small-firm effect
* Empirical studies showing that the stocks issued by small companies earned higher rates of return, on average, than stocks issued by large companies are referred to as the small-firm effect.

Answer 364

A

Weak form
* Under the weak form of efficient market theory technical analysis is not considered worthwhile but this form considers fundamental analysis to remain worthwhile.

Answer 365

A

Insider information
* The semi-strong form of the efficient market theory does not consider technical analysis and fundamental analysis worthwhile but does consider insider information worthwhile in determining the current FMV of a security.

Answer 366

A

Strong form
* The strong form considers insider information worthless and already reflected in the security’s FMV.

Answer 367

A

neglected firm effect
* Basically, these stocks are “below the radar screen” and have been proven to be a method for investors to outperform the general stock market.

Answer 368

A

Technical analysis
* Technical analysis focuses on historical information on a company that would be available from libraries, bookstores, computer databases, and the Internet. This information represents past data.
* Technical analysts rely on past performance data that would lead to security selection.

Answer 369

A

Highly-testable calculation: The Capital Asset Pricing Model (CAPM)
Security Market Line (SML) is simply CAPM expressed in a graphic form
Likely will have to calculate
One of the provided formulas – be able to recognize it by sight and recognize that’s what they’re asking for in the question
Order of operations:
Rm – Rf: market return minus the risk-free return
Multiply by beta
Add to risk free return
And that would be CAMP – risk free return

Answer 370

A

(rm – rf)
* The ‘market risk premium’ is the difference between the market return and the risk-free rate [i.e., (rm – rf)].
* This is the premium given to investors for taking on systematic risk.
* When multiplied by ß, it becomes the ‘stock risk premium.’

Answer 371

A

Taxes and transaction costs reduce market liquidity.
* The assumption regarding taxes and transactions costs under CAPM is that they are irrelevant. It is not assumed that they reduce market liquidity.
* The CAPM also assumes that investors are risk averse and therefore prefer portfolios with lower standard deviations. Other assumptions are that assets are infinitely divisible and that investors may borrow or lend at a single risk-free rate.

Answer 372

A

12.8%
* The expected rate of return
* = 4% + (12.0 – 4) (1.1)
* = 12.8%.

Answer 373

A

Is not owned by investors
Has an equilibrium price of zero
Has a market value of zero
* The market portfolio is the risky portfolio held by all investors. Therefore, a security that is not part of the market portfolio is not attractive to the risk-averse investor.
* An important feature of the CAPM is that in equilibrium each security must have a nonzero proportion in the composition of the tangency portfolio.
* That is, no security can, in equilibrium, have a proportion in the portfolio that is zero.
* Hence, the market portfolio is a set of securities that can be freely owned by investors.

Answer 374

A

Market risk - The portion of a security’s total risk that is related to movements in the market portfolio and hence to the beta of the security.
Non-market risk - The portion of a security’s total risk that is related to events specific to the security and not to the movements in the market portfolio.
Risk-free rate of return - In the CAPM world, the expected return of a security with a beta of zero equals this rate of return.
Total risk of a security - It is composed of market risk and non-market risk.

Answer 375

A

10.4%
* The one factor model for this security is
* r = .04+(.8)(.08)
* =10.4%

Answer 376

A

Investors will take advantage of arbitrage opportunities thus eliminating them.
Arbitrage has fewer assumptions than the CAPM.
* The logic behind APT is that investors will observe and take advantage of arbitrage opportunities and eliminate them.
* When all arbitrage possibilities have been eliminated, the equilibrium expected return on a security will be a linear function of its sensitivities to the factors.

Answer 377

A

Differential pricing
* Investors who take advantage of differential pricing for the same physical asset or security engage in the arbitrage process.
* Abnormal returns, low stock price and volatility of stock do not figure in the arbitrage process.

Answer 378

A

Inflation
Term structure of interest rates
Corporate earnings and dividends
* The most commonly identified factors that affect expected returns are indicators of aggregate economic activity, inflation and interest rates. Researchers have not identified the price of gold as a factor.

Answer 379

A

Betas are determined with respect to the preferences of noise traders.
Determining Beta is difficult because the preferences of noise traders change over time.
Beta is determined using both utilitarian and value-expressive measures.
* BAPM is based on the interaction between information traders and noise traders, while CAPM only considers information traders.
* CAPM uses utilitarian factors in determining supply and demand for a stock, while BAPM also considers value-expressive measures.

Answer 380

A

Behavioral finance recognizes the contributions of standard finance.
Behavioral finance considers how investors act and feel.
Mental accounting is a key concept of “prospect theory.”
* Investors, assumed to be “rational” under the standard finance view, do not make mistakes using these standard finance models.

Answer 381

A

Cognitive Errors - Investors make mistakes.
Biased Expectations - Investors are overly confident in their ability.
Mental Accounting - Investors segment their money into separate accounts.
Loss Aversion - Investors are more risk adverse when faced with gains and less risk adverse when faced with losses.

Answer 382

A

C - P = S - PV(X)
C = S - PV(X) + P (Tip: Add P to each side to isolate C)
C = S - [ X / (1+r) T ] + P (Tip: Present value of the strike price.)
C = 22 - [20 / (1.015)(30/365)] + 3
C = 22 - [20 / 1.0012] + 3
C = 22 - [19.98] + 3
C = $5.02

Answer 383

A

Delta - Delta measures the impact of a change in the underlying stock price on the value of a stock option. Delta is positive for a call option and negative for a put option.
* A $1 change to the stock price is approximately equivalent to change in option price by delta dollars.

Eta - Eta measures the percentage impact of a change in the stock price on the option value. Eta is positive for a call option and negative for a put option.
* A 1% change to the stock price is approximately equivalent to change in option price by eta%.

Vega - Vega measures the impact of a change in the volatility of the stock on the stock option. Vega is positive for both a call option and a put option.
* A 1% change to the stock’s standard deviation is approximately equivalent to change in option price by vega.

Gamma - Gamma measures delta’s sensitivity to a stock price change.
* A $1 change in the stock price causes the delta to change by approximately the amount of gamma.

Theta - Theta measures the option price sensitivity to a change in time till expiration.
* A one-day change to time to expiration will cause the option price to change approximately by theta.

Rho - Rho measures the option price sensitivity to a change in interest rate.
* A 1% change to the interest rate will cause the option price to change approximately by rho.

TEST TIP: Since the Black-Scholes-Merton-Merton Model is calculated using computer software in real life, it is not as important to know the equation or how to calculate options prices using this model as it is to know how changes in various components of the model affect the price of the option.

Answer 384

A

The option pricing model factors listed below illustrate how changes in certain variables will affect the price of puts and calls.
* Price: Change of share price beyond the parity will affect the price of calls and puts inversely.
* As the price of the stock increases, the call premium increases and the put premium decreases.
* If the stock price decreases, the opposite will occur.

Time: The longer the time to expiration, the higher the premium of a call and a put option. However, the put premium will level out while the call premium will continue to rise.
Risk: Will affect put and call premiums the same way (directly). The higher the standard deviation, the higher the premium.
Interest: Will have an inverse relationship with calls and puts. As interest rates increase, call premiums will increase but put premiums will decrease.

Answer 385

A

BOPM
* The binomial option pricing model assumes that stock prices will attain one of two possible known prices at the end of each of a finite number of periods.
* The Black-Scholes-Merton model is a continuous time model.
* The CAPM and APT are not option pricing models.

Answer 386

A

Time remaining before expiration
Risk-free rate of return
Stock volatility
* The Black-Scholes-Merton formula shows that the fair value of an option is determined by the following five factors: stock price, exercise price, risk-free rate, life of the option and the volatility of the common stock. It does not consider taxes and transaction costs as a factor in determining the fair value of an option.

Answer 387

A

Both options have the same exercise prices and the same expiration dates
* The payoff from buying a put option on a stock and a share of the stock will be the same as buying a call option on the stock and a risk-free bond.
* This is under the assumption that both options have the same exercise price and expiration date.
* This is called put-call parity.

Answer 388

A

Pay dividends over the life of the option
* One limitation of the Black-Scholes-Merton model is that it can only be applied to options that will not pay dividends over the life of the option.
* The other limitation is that it is applicable only to European options and not to American options.

Answer 389

A

13.50%

The formula for CAPM is ri = rf + (rm – rf) βi
* (rm – rf) is referred to as the “market premium”
* The CAPM for CAP Corporation is ri
* = 0.01 + 0.10(1.25)
* .0.01 + 0.125
* = 0.1350 or 13.50%

Answer 390

A

There is significant nonfactor risk.
* There is negligible nonfactor risk in an arbitrage portfolio.

Answer 391

A

purchase
* A call option that is found to be selling for substantially less than its Black-Scholes-Merton value is a candidate for purchase, whereas
* one that is found to be selling for substantially more is a candidate for writing.

Answer 392

A

1.2247
The formula for CAPM is ri = rf + (rm – rf) βi
* ri = 0.011 + (0.10 – 0.011) βi
* 0.12 = 0.011 + 0.0890(βi)
* 0.12 - 0.011 = 0.089(βi)
* 0.109 / 0.089 = 0.089(βi) /0.089
* 1.2247 = (βi)

Answer 393

A

put-call parity
* The relationship between the market prices of a call and a put on a given stock that have the same exercise price and expiration date is known as the Put-Call Parity.
* Given the price of a call for a security, you can determine the price of a put for the same security with the same expiration date and strike price.

Answer 394

A

The risk factor used in the capital market line (CML) is Beta.
* The distinguishing feature of the capital market line is that the denominator is the standard deviation of the market.
* This will help you recognize the capital market line equation on the CFP® exam.

Answer 395

A

Capital Asset Pricing Model
* SML is a graphical depiction of the CAPM and plots risks relative to expected returns.
* It is an equilibrium relationship between the expected return and covariance with the market portfolio for all securities and portfolios.
* The slope of the SML is the risk premium on the market portfolio.

Answer 396

A

12.25%
The formula for CAPM is ri = rf + (rm – rf) βi
* CAPM for CAP Corporation is
* ri = 0.01 + (0.10 – 0.01)1.25
* 0.01 + 0.1125
* = 0.1225, or 12.25%

Answer 397

A

Yes
* The expected return for CAP Corporation meets the investor’s required rate of return.

The formula for CAPM is ri = rf + (rm – rf) βi
* ri = 0.01 + (0.10 – 0.01)1.60
* 0.01 + 0.1440
* = 0.1540 or 15.40%

Answer 398

A

Binomial option pricing model
* The binomial option pricing model can be used to estimate the fair value of a call or put option.

Answer 399

A

market premium
* In the CAPM formula, (rm - rf) is often referred to as the “market premium.”

Answer 400

A

No
* The expected return for CAP Corporation does not meet the investor’s required rate of return.

The formula for CAPM is ri = rf + (rm – rf) βi
* ri = 0.01 + (0.10 – 0.01)1.50
* 0.01 + 0.1350
* = 0.145 or, 14.50%

Answer 401

A

Round Lot - 200 shares
Odd Lot - 65 shares
Mixed Lot - 369 shares
Block trade - 10,000 shares

Answer 402

A

It is a round lot
It is a day order
It is a limit order
* Since the size was a multiple of 100, the order was a round lot.
* Execution within the same day is a day order.
* The specified ceiling price of $49/share makes it a limit order.

Answer 403

A

Time to fill the order
* The investor needs to specify a time limit within which the broker should attempt to fill the order.

Answer 404

A

Stop-limit order
* Natasha can use a stop-limit order to activate a market order at a certain price, and then limit the transaction from going beyond an unwanted price.

Answer 405

A

Fill-or-kill
* Fill-or-kill orders are those that get cancelled if the broker is unable to fully execute them immediately.

Answer 406

A

76.67%
* Initial purchase was for $2,000.
* At 65% initial margin, $1,300 was paid in cash and $700 was a loan.
* When assets increase to $3,000, the loan is still $700 and the equity is $2,300.
* The actual margin = $2,300/$3,000
* =76.67%.

Answer 407

A

The break-point formula yields the lowest possible price where the margin level is still acceptable. Any price below this however, will result in a margin call.

This break-point form is: [(1 - I.M.) / (1 - M.M)] x Ps
Where:
I.M. = initial margin requirement (%)
M.M. = maintenance margin requirement (%)
Ps = purchase price of the stock

[(1 - .50) / (1 - .30)] x $100.128
= $71.52
Any closing price below $71.52 will generate a margin call.

Formula is: Market value x (1 - M.M,) = maximum debt allowable.
Then subtract this amount from current debt amount to determine margin call.

= $60,000, multiplied by (1 - .30)
= $42,000 = maximum debt allowable.
The current debt amount was 50% of the original transaction of $100,128 or $50,064.
Therefore, the margin call = $50,064 - $42,000 = $8,064.

Answer 408

A

If she buys those shares in a margin account with an initial margin of 60%, then she would pay $3,000 for them.
If the price went to $60/share, then Donna’s return for the cash account is ($6,000 - $5,000)/$5,000 = 20%.
But if she bought the shares in a margin account, then her return would be ($6,000 - $5,000)/$3,000 = 33%.
Therefore, through leverage, Donna can earn a greater return on her margin account.

Answer 409

A

Yes
* Actual Margin = Equity ÷ Margin Value
* = $4,000 ÷ $12,000
* = 33.3%.
* Since 33.3% is less than 40% a margin call will be made for the account.

Answer 410

A

Yes

The short sale proceeds = $10,000

Initial margin = $6,000
Therefore, the loan amount = $11,400
The actual maintenance is 40.35%.

Mei will receive a margin call and she has to either add cash or securities, or buy back stock to pay off part of her short position.

Answer 411

A

Hypothecation
* When opening a margin account with a brokerage firm, an investor must sign a hypothecation agreement. This agreement grants the brokerage firm the right to pledge the investor’s securities as collateral for bank loans, provided that securities are purchased using a margin account.
* Most brokerage firms also expect investors to allow them to lend their securities to others who wish to sell them short.

Answer 412

A

Initial margin requirement
* The minimum percentage of the purchase price that must come from the investor’s own funds is known as the initial margin requirement.

Answer 413

A

A short sale
* Most investors buy securities first and sell them later.
* But with short selling, investors sell securities first and then buy them back later.
* If VJ short sells Hermes Wireless shares, he will be borrowing the securities to sell to someone, then when the prices drop, he will buy the shares back and return the shares to the original lender.

Answer 414

A

$57.14
* The maintenance margin is 30% = $12,000 (500 x 80 x 0.30).
* The initial margin provides a price movement of ± 50% i.e. up to $20,000. Therefore, beyond a price volatility of ± $12,000, the broker is likely to give an additional margin call.
* When the total value of the stock falls to $28,000 (initial investment – maintenance margin), the broker will ask for a margin call. So he calls for the highest price that allows him not to go beyond $28,000.
* At the price of $57.14 (500 x 57.14 = 28,570) the broker is likely to give margin call, since the total value of the shares is only $28,570.

Answer 415

A

Aggregated
* An investor with a margin account can purchase multiple securities on margin account or may short sell securities. The investor can also purchase some on margin and short sell others. To determine whether the account is under-margined, restricted, or over-margined depends on how the transactions are aggregated.

Answer 416

A

Liability re-evaluation done every day
* With multiple short sales, it is the liabilities that are re-evaluated on the basis of current market prices, because the short seller’s liabilities are shares whose market values are changing every day.

Answer 417

A

True

Ivy’s Total Assets = $12,750 (Cash from Minnetonka sale=$25/shr x 100 shrs = $2,500; Initial margin = 0.50 x$25/shr x 100 shrs = $1,250; Market value of St. Louis Park stock = $45/shr x200 shrs = $9,000).
To remain unrestricted based on the short sale of Minnetonka stock, Ivy must have deposited in the margin account:100 shrs x $36/shr x (1 + 0.50) = $5,400.
To remain unrestricted based on the margin purchase of St.Louis Park stock, Ivy must have deposited in the margin account: (200 shrs x $40/shr x 0.50)/(1 - 0.50) = $8,000.
Thus to remain unrestricted in aggregate, Ivy’s margin account must be worth at least $13,400.
But Ivy actually has assets worth $12,750, so the account is restricted as of June 30.

Answer 418

A

ADR
* The best way to buy an individual stock is to buy an ADR.

Answer 419

A

$1,500
* Required equity: 35% of $50 = $17.50

Current equity: Current stock price – loan amount = $50 - $40 = $10 per share
Required equity – current equity = $17.50 - $10 = $7.50 deficit
$7.50 x 200 = $1,500

Answer 420

A

$15,000
* The margin portion refers to the equity (the portion that is paid for already).
* A 60% initial margin requirement for a $25,000 stock purchase requires $15,000 (60% x $25,000) be deposited.

Answer 421

A

$61.54
Debt ÷ (1 – maintenance margin)
40 ÷ (1 - 0.35) = $61.54

Answer 422

A

Market order
* If an investor puts in a market order, it would be irrelevant to put time constraints around the order because it is supposed to be filled at whatever the market price is at the time the order is made.

Answer 423

A

II, III, IV
* An employee would not be considered an insider unless the employee had access to key information.

Answer 424

A

Good-till-canceled order
* Open orders or “good-till-canceled” orders remain in effect until they are either filled or canceled by the investor.
* However, during the time period before the order has been filled, the orders typically expire in 1 to 2 months and need to be reconfirmed.

Answer 425

A

Assets are increased by $5,000
* On the day of the purchase, Amy’s assets increased by $5,000.
* While not part of this question, Amy’s liabilities increased by $2,000 on the date of purchase.

Answer 426

A

the account marked to the market
* The daily calculation of the actual margin in an investor’s account is known as having the account marked to the market.
* At the time of the margin purchase, the actual margin and the initial margin are the same.
* However, after the purchase, the actual margin can be either greater than or less than the initial margin.

Answer 427

A

Fill-or-kill order
* Fill-or-kill orders are canceled if the broker is unable to fully execute them immediately.

Answer 428

A

As a percentage of assets under management.
* In exchange for an annual fee equal to a percentage of assets under management, a broker creates an investment plan, finds professional money managers to execute it, and waives all commissions for any trading that takes place in the account.

Answer 429

A

100
* In general, a round lot means that the order is for 100 shares, or a multiple of 100 shares.
* Odd lot orders generally are for 1 to 99 shares.

Answer 430

A

Maria will sell the shares at the market for $48 and make the difference between the current price and the strike price plus premium, or
* $48 - $40 - $5 = $3 X 100 shares
* = $300.

Maria could have decided to sell the option to another party rather than make the election to exercise.

Answer 431

A

II only
* Maria would not exercise the option and Sanjey would make a profit equivalent to the premium ($500).
* Note: Maria has the right to exercise the option just to receive the shares, although she would lose money in the process.

Answer 432

A

She will make the difference between the current price and the strike price plus premium, or
* $80 - $65 - $10 = $5 X 100 shares
* = $500.

Anastasia could also have decided to sell the option to another party rather than exercise it.

Answer 433

A

False
* The adverse movement of the price of the underlying stock need not adversely affect the option buyer because they cannot lose any more than their option premiums.
* Thus, their situation is not risky. Instead, they enjoy limited liability.

Answer 434

A

Decrease in the announced dividend
Increase in the price of the underlying stock
Increase in the volatility of the underlying stock
* Increase in price of underlying stock, volatility or riskiness of the stock and lower cash dividends are factors that increase the market value of a call option.
* As the expiration date gets closer, the option value decreases.

Answer 435

A

$2
* The exercise value of the option for the buyer of the call will be the market price less the strike price and premium.
* It would be a profit of
* ($35 - $30 - $3) = $2.

Answer 436

A

$57
* The buyer of a put option would exercise the option on the last day of the option’s life if the exercise price is greater than the market price of the stock. The breakeven point for the put is $57.
* So as long as Moonstar Company’s stock price is $60 or less, Diego will exercise the put or sell it for a premium before expiration.

Answer 437

A

Short Straddle
Short Strangle
* A short straddle or a short strangle position will profit from small price movements around the exercise price.
* A long straddle or a long strangle position will profit by large price movements.

Answer 438

A

Long strangle is a debit transaction.
Premiums are received in a short strangle.
* Long strangle is a debit transaction because no premiums from writing options are received.
* Short strangle is a credit transaction because premiums are received.

Answer 439

A

Writing naked
Writing uncovered
Writing against cash
* If the call writer does not own the underlying stock on which the option is written, it is referred to as writing naked, writing against cash or writing uncovered.
* This is in contrast to covered call writing, where the writer owns the underlying stock and is thus covered against potential loss.
* Naked call options can increase leveraged returns as well as losses.

Answer 440

A

Sell call
Buy put

THE FOLLOWING TABLE REPRESENTS WHAT BUYERS AND WRITERS HOPE FROM OPTIONS:

BUYER

SELLER

CALL

Price of stock to increase

Price of stock to decrease

PUT

Price of stock to decrease

Price of stock to increase

Answer 441

A

Both I and II
* For a zero-cost collar, an investor buys a put (portfolio insurance) and also sells (or writes) a call option.
* The “collar” is formed by the premium obtained from writing the call or the premium paid for the protection afforded by buying the put, combined with the long position in the underlying stock.

Answer 442

A

An increase in the underlying stock price.

Increase Time Until Expiration & Increase Variance of Underlying Asset
* Increase Put AND Call Premium

Increase in Underlying Stock Price & Increase in Interest Rates
* Increase Call Premium
* Decrease Put Premium

Increase in Exercise Price
* Decrease Call Premium
* Increase Put Premium

Answer 443

A

Sell put
* The only way to generate income from an options strategy is to function as the seller.
* Therefore, if the investor expects the price of the stock to increase and wants income, the only option is to sell a put.

Answer 444

A

An increase in the exercise price.

Increase Time Until Expiration & Increase Variance of Underlying Asset
* Increase Put AND Call Premium

Increase in Underlying Stock Price & Increase in Interest Rates
* Increase Call Premium
* Decrease Put Premium

Increase in Exercise Price
* Decrease Call Premium
* Increase Put Premium

Answer 445

A

price volatility
* The buyer of a long straddle believes the underlying stock has the potential for enough price fluctuations to make the straddle profitable before it expires.

Answer 446

A

Horizontal spreads
* Horizontal spreads include those combinations of options having different expiration dates but the same exercise price. They are called horizontal spreads because different options that all have the same exercise prices are listed in horizontal rows in the newspapers. Horizontal spreads are also called time spreads and calendar spreads.

Answer 447

A

The market capitalization of the underlying stock.

A call option contract specifies four items:
* The company whose shares can be bought.
* The number of shares that can be bought.
* The purchase price for those shares, known as the exercise price or strike price.
* The date when the right to buy expires, known as the expiration date.

Answer 448

A

Call buyer’s gain or loss = Intrinsic value of call - Call option’s premium
Call writer’s intrinsic gain = Intrinsic value of call writer’s position + Call option’s premium
Put buyer’s intrinsic gain = Intrinsic value of the put - Put option’s premium
Put writer’s gain = Intrinsic value of put writer’s position + Price of put

Answer 449

A

Naked Call Writing
* The naked call buyer’s gains equal the naked call writer’s losses.
* As the price goes beyond the exercise price, the naked writer’s loss will increase proportionately.
* Writing naked calls is risky if the optioned security is likely to rise in price.

Answer 450

A

$6,691.13
* Carlos’ before tax accumulation would be
* = 5,000(1+.06)^5 or
* $6,691.13

Answer 451

A

$3,935.15

Here is how to solve the question algebraically:
3250 [1 + (0.06 x 0.65)]^5
3250 [1 + (0.039)]^5
3250 [1.039]^5
3250 [1.2108]
3935.1483

That said, there is actually a much easier method to solve this question! Here is how to solve using Time Value of Money (TVM):
6 x 0.65 = 3.90 I/YR
5 N
3250 +/- PV
Solve FV 3935.1483

Answer 452

A

$8,611.20
* Francois’ after tax accumulation would be
* =2,000(1.10)^20(1-.36) or
* $8,611.20.

Answer 453

A

Pension Model
* The Pension Model gives the future value of an investment in a qualified retirement plan when before-tax dollars are invested.
* The three other models, Current Model, Deferred Model and Tax Exempt Model, give the future value of an investment when after tax-dollars are invested.

Answer 454

A

The before-tax rate of returns (BTROR) is constant over time
The BTRORs are equal across models
Tax rates must be equal and constant over time
* After-tax dollars are invested in both the models.
* However, the Deferred Model always outperforms the Current Model when the BTRORs and tax rates are constant over time and equal across both models.
* This is because the earnings on the investment grow at BTROR and the investors are taxed at the end of the investment horizon.

Answer 455

A

State and local government obligations
Roth IRAs
* State and local government obligations such as municipal bonds, as well as Roth IRAs, are classic examples of the Exempt Model.

Answer 456

A

AAA-rated bond issue from a blue-chip company is sold at a loss and the investor purchases another AA-rated bond from a different blue-chip company.
* A AA-rated bond issue from a blue-chip company is sold at a loss and the investor purchases another AA-rated bond from a different blue-chip company.
* Unless the investor purchases back the same exact bond or bond fund, it is difficult to violate the wash sale rule with fixed income.
* Since the bond is issued from different companies, loss associated with the blue-chip to blue-chip transaction would not be subject to the wash sale rules.

Answer 457

A

Index Funds
* Index funds have the lowest turnover ratio because the manager would not sell any of the stocks in the portfolio except when the benchmark index changes its composition.
* Tax-efficient or tax-managed funds try not to have too many short-term trades, but they will harvest losses in a down market to use later to offset capital gains.

Answer 458

A

Unrealized
* The capital gain that Stella makes on her asset is unrealized because she has not exchanged her assets and no tax is due on the unrealized capital gain. Also a change in the market value of a capital asset is not relevant for tax purposes until it is realized as a capital gain (or loss) by sale or exchange.

Answer 459

A

8.82%
* In general, the taxable equivalent yield of a tax-exempt bond is given by:

Taxable bond yield = tax-exempt bond yield ÷ (1 - t).
Thus a taxable bond has to offer 8.82% [6.00 ÷ (1 - 0.32)] before-tax interest rates to be considered equivalent in value to the 6% municipal bond.

Answer 460

A

Lot 4: cost $55 per share
* Although lot 3 would be ideal to reflect the largest return because it cost the cheapest, lot 4 would be more appropriate for tax management because it costs the most.

Answer 461

A

Joint Tenants WROS
* Joint tenants WROS is simply a type of property ownership that does not give the owners any tax advantages. All the other account types give the owners either tax-deferred or tax-exempt growth.

Answer 462

A

All gains and income are taxed as ordinary income when distributed
* Capital gains and dividends grow tax-deferred and are not taxed until the owner takes distributions from the account. At that point, any dollars that were pre-taxed or deducted from taxes, including any gains and income, will be taxed as the owner’s ordinary income.

Answer 463

A

Ohio Tax Free Bond Fund
Mississippi state direct obligation bonds
Annuities
* Tax-exempt securities such as tax-free funds and municipal bonds, money market instruments, and annuities are not appropriate for tax-advantaged accounts because there is already a tax advantage associated with them.
* The tax advantages from tax-exempt securities already result in a lower nominal return, so there is no additional advantage of holding them in a tax-advantaged account.

Answer 464

A

tax-exempt
* In a Roth IRA, if the investor allows his investment to stay for the required period, the earnings go from tax-deferred to tax-exempt.

Answer 465

A

Municipal bonds

The current model gives the future value of an investment having the following characteristics:
Only after-tax dollars are invested.
* The earnings on the investment are taxed annually (currently), thus the reinvested earnings grow at the after-tax rate of return.
* Common examples of investments taxed this way are savings accounts, money market funds, and taxable bonds (if the investor reinvests the after-tax earnings annually).

Municipal bonds are tax-exempt and do not meet the criteria.

Answer 466

A

One AA-rated bond issue from a blue-chip company is sold at a loss and the investor purchases another AA-rated bond from a different blue-chip company.
* One AA-rated bond issue from a blue-chip company is sold at a loss and the investor purchases another AA-rated bond from a different blue-chip company.
* Unless the investor purchases back the same exact bond or bond fund, it is difficult to violate the wash sale rule with fixed income. Since the bond is issued from different companies, loss associated with the blue-chip to blue-chip transaction would not be subject to the wash sale rules.

Answer 467

A

Both I and II
* When you buy a market discount bond, you can choose to accrue the market discount over the period you own the bond and include it in your income currently as interest income. If you do not make this choice, the following rules generally apply.
* You must treat any gain when you dispose of the bond as ordinary interest income, up to the amount of the accrued market discount.
* You must treat any partial payment of principal on the bond as ordinary interest income, up to the amount of the accrued market discount.

Answer 468

A

$7,590.64

Here is how to solve the question algebraically:
$6,750 [1 + (0.0525 x 0.76)]3
$6,750 [1 + (0.0399)]3
$6,750 [1.0399]3
$6,750 [1.1245]
$7,590.6420

Here is how to solve using Time Value of Money (TVM):
5.25 x 0.76 = 3.90, I/YR
3, N
6,750, +/-, PV
Solve for FV = 7,590.6420

Answer 469

A

Municipal Bond
* To compare the bond options, the taxable equivalent yield must be calculated for the municipal bond using the following formula (using this formula makes the comparison with the other bond options ‘apples-to-apples’):

TEY = Tax-Free Yield ÷ (1 – Marginal Tax Bracket)
For the municipal bond, TEY = 5.20 ÷ (1 – 0.32) = 7.65%
As a result, the municipal bond offers the highest yield of the three options and Jerome should select that one above the taxable bond options.

Answer 470

A

higher
* Tax-deferred bonds such as government bonds, Series EE/E savings bonds, municipal bonds, and certain zero-coupon bonds generally yield a return somewhere close to that of taxable bonds, provided the investor is in the higher tax brackets.
* Investors in higher tax brackets may wish to take advantage of tax-exempt interest from municipal bonds.

Answer 471

A

Bond #2

Bond #1 before-tax accumulation = $3,000(1 + 0.04)10 = $4,440.73

Bond #2 before-tax accumulation = $3,000(1 + 0.055)8 = $4,604.06

Bond #3 before-tax accumulation = $3,000(1 + 0.0375)11 = $4.497.70

Bond #4 before-tax accumulation = $3,000(1 + 0.07)6 = $4,502.19

Answer 472

A

Tax-efficient funds
Passively managed index funds
* There are two types of mutual funds that have low turnover rates.
* Passively managed index funds have low turnover by design because they only sell a stock when it is no longer on the index that the fund is mimicking.
* Tax-managed or tax-efficient funds purposely invest in stocks that the managers feel they will buy and hold for a few years, therefore lowering the turnover ratio.

Actively managed funds and growth funds generally have higher turnover ratios.

Answer 473

A

$12,886
* Jon’s before tax accumulation
* = $7,500(1 + 0.07)8
* = $12,886.40 or,
* $12,886 (rounded)

Answer 474

A

T-Notes
T-Bonds
* U.S. government bonds such as treasury notes and bonds and agency bonds are direct obligations of the U.S. government and have income that is exempt from state taxes.

Answer 475

A

Treasury bonds
Agency bonds
Inflation-protection bonds
* The interest on Treasury bonds and agency bonds is taxable for federal income tax purposes, but not state and city income taxes.
* The interest on inflation-protection bonds is also subject to federal tax but is deferred until maturity.
* Municipal bonds are tax-exempt.

Answer 476

A

Not subject to taxes
* Municipal zero coupon bonds are not subject to any taxes if held to maturity.
* If Joan had bought a U.S Treasury zero coupon bond, then she would have had to declare the discount annually through accretion as income.

Answer 477

A

Inflation-protection bonds
* The redemption values of inflation-protection bonds are adjusted semi-annually to reflect the rate of inflation in the previous six months.

Answer 478

A

False.
* Even when dividends are not paid out in cash they are taxed as ordinary income.

Answer 479

A

300 shares at $10.50/share
* The shares that provides the greatest capital loss or the least capital gains should be the ones identified to be sold first. Therefore the lot with $10.50/share would be sold first because the lot can provide a $0.50-loss per share. The $9.50/share lot would be next to be sold in order to offset the remaining 100 shares because it only provides $.50 gain rather than the $8.50 gain from the $1.50/share lot.

Answer 480

A

On the date the original owner died.
* If the person received the stock as an inheritance, the starting basis is the value of the stock on the date the original owner died. This is called a stepped-up basis.

Answer 481

A

Share Identification
* Specific share identification allows investors to limit capital gains by identifying shares that cost the most to be sold first.

Answer 482

A

July 30
* The cost basis begins the day Janis exercises the warrants.

Answer 483

A

FIFO - Sell the shares that were purchased first; advantage occurs when the market prices have dropped
Specific Share Identification - Sell the shares that were the most expensive first
Average Cost - Combine all purchases and divide by the number of shares owned; great for accounts with many purchases

Answer 484

A

They can be bought only from redeeming agents of the Treasury department.
Interest on savings bonds is exempt from state and local income tax.
* Savings bonds are non-marketable securities. They may be sold or bought from an issuing and redeeming agent authorized by the Treasury Department. They are registered securities and are owned by the person named on them. The interest earned on U.S. Savings Bonds is exempt from state and local income tax.

Answer 485

A

$1,250
* The expected return is the life expectancy in years times the annual distributions or 20x250x12 = $60,000.
* The exclusion ratio is the cost of the annuity divided by the expected return = 0.4167.
* The annual exclusion amount is the exclusion ratio times the annual distribution amount or
* 0.4167 x 250 x 12 = $1,250.

Answer 486

A

The partners pay taxes on profits
The partners use losses as credits
* A limited partnership is a pass-through entity where all the partnership’s profits and losses are passed on to the partners.

Answer 487

A

Both I and II
* Mutual funds can distribute dividends and capital gains, both types are taxable. The amount of distribution depends on the nature of the fund. Income-oriented funds, such as bond funds, tax-free bond funds, and money market instruments, will pay a monthly amount.

Answer 488

A

taxable
* The IRS considers any annual appreciation in value or undistributed interest from zero-coupon bonds to be taxable.
* This income is commonly known as phantom income.

Answer 489

A

specific identification
* The specific share identification implies that specific shares are used to apply against the shares sold.
* This method is the best method for tax purposes because the investor has absolute control over how much gain from a sale would be recognized.

Answer 490

A

capital gains
* Distributions to shareholders are taxable only to the extent they are made from either the corporation’s current earnings and profits or accumulated earnings and profits.
* Distributions in excess of the basis are classified as capital gains.

Answer 491

A

Both I and II
* Any interest received from a municipal bond is free of federal income tax. This is a major advantage for municipal bonds versus other taxable bonds.
* Usually, the state government also does not tax the interest payments on these bonds, as long as the person lives in the state in which the bonds were issued.

Answer 492

A

$2,708

Life expectancy = 24.0 years

The expected return = $122,400 (24.0 years x ($425 x 12 months))
The exclusion ratio = 0.5310 ($65,000 ÷ $122,400)
The excluded (tax-free) amount = $2,708 (0.5310 (exclusion ratio) x $5,100 (annual income))

Answer 493

A

$5
* Stock splits occur when companies split their shares so that the number of shares a shareholder has will increase.
* In Maritza’s case, the three-for-one stock split will result in her receiving 3 shares for each of her 400 shares of WEB, or 3 x 400 = 1,200 shares.
* Maritza’s pre-split basis was $15/share for a total basis in WEB of $15 x 400 = $6,000.

To calculate the post-split basis, divide the new number of shares by the total basis:
$6,000 ÷ 1,200 = $5/share

Answer 494

A

Schedule K-1
* Schedule K-1 shows the partner’s share of the income or loss from a partnership and is mailed within the first three months of the year.

Answer 495

A

FIFO
* The first-in, first-out (FIFO) method is the default method that the IRS will assume a taxpayer is following unless otherwise specified in a statement attached to the income tax return.

Answer 496

A

$14.00

According to the single category average cost method, Barney would take an average of the purchase prices and divide it by the total number of shares owned:
200 shares at $14.50 = $2,900
150 shares at $11 = $1,650
200 shares at $15.75 = $3,150
Total cost = $7,700
Total shares = 550

Average cost per share = $7,700 ÷ 550 = $14.00

Answer 497

A

-9.43% to 20.93%

Mean = 5.75%
SD = 7.59%
2σ = 5.75% - (7.59% + 7.59%) = -9.43%
2σ = 5.75% + (7.59% + 7.59%) = 20.93%

Answer 498

A

Commercial Paper

Commercial Paper Features:
* Denominations of $100,000 or more
* Maturities of up to 270 days
* Large institutional investors
* Terms are non-negotiable
* Issuer may prepay the note

Answer 499

A

Funding any project which will be supported only by the full faith and credit of the state or local agency.

Revenue Bonds are backed by revenues from a designated project, authority, or agency or by the proceeds from a specific tax. Such bonds are only as creditworthy as the enterprise associated with the issuer. Revenue bonds may be issued for the following reasons:
* financing publicly owned utilities,
* financing quasi-utilities, like transportation,
* financing by levying a tax on properties that benefit from the expenditure, for example a new sewer system, and
* Industrial Development Bonds are used to finance the purchase or construction of industrial facilities

General Obligation Bonds are issued by state and local agencies and are backed by the full faith and credit of the agency.

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