Chapter 15 Introduction to the Portfolio Approach RQ Flashcards
A portfolio is equally allocated to three securities. Security A has an expected return of 12%. Security B has an expected return of 10%. Security C has an expected return of 6%. Calculate the expected return on the portfolio.
A. 8.25%.
B. 9.33%.
C. 13.13%.
D. 28%.
B. 9.33%.
The return on a portfolio is the weighted returns of the securities in the portfolio. The entire portfolio weight is always 100%. Equally split amongst 3 securities means each security has a weighting of (1/3) or 33.33%. (0.12 x 0.3333) + (0.10 x 0.3333) + (0.06 x 0.3333) = 0.039996 + 0.03333 + 0.019998 = 0.0933 or 9.33%
Larry purchased 100 GHI common shares at a price of $13 per share. Three months later, GHI common shares paid a dividend of $0.10 per share. Larry sold all of his 100 GHI common shares at a price of $14 per share. Calculate Larry’s rate of return for the GHI common shares.
A. 6.43%.
B. 6.92%.
C. 7.86%.
D. 8.46%.
D. 8.46%.
Percentage rate of return = [Cash Flow +/- (Ending Value - Beginning Value) / Beginning Value] ×100. For this question, the percentage rate of return = [$0.10 + ($14 – $13) / $13] x 100 = 8.46%.
Identify the security that typically has the highest risk-return relationship.
A. Common shares.
B. Treasury bills
C. Preferred shares.
D. Convertible debentures.
A. Common Shares.
Common shares have the highest risk-return relationship of the alternatives presented. Higher returns generally come at the expense of taking higher risks. A T-bill, for example, has very low risk, but at the same time has a small return. Common shares are typically more volatile in their price movements, which means the returns can be very high, but at the same time the risk of loss is also high.
Identify the risk that an investor will not be able to buy or sell a security quickly.
A. Default risk.
B. Liquidity risk.
C. Business risk.
D. Interest rate risk.
B. Liquidity risk.
Liquidity risk is the risk that an investor will not be able to buy or sell a security quickly enough due to limited buying or selling opportunities. This could prevent the investor from buying or selling at a fair price on short notice.
Choose the risk that cannot be diversified away in either equities or debt securities.
A. Security risk.
B. Non-security risk.
C. Systematic risk.
D. Non-systematic risk.
C. Systematic risk.
Systematic or market risk is the risk that pertains to being in each capital market. When stock market averages fall, most individual stocks in the market fall. When interest rates rise, nearly all individual bonds and preferred shares fall in value. Systematic risk cannot be diversified away; in fact, the more a portfolio becomes diversified, the more it ends up mirroring the market.
Select the diversification strategy that will reduce the risk of a portfolio.
A. Perfect negative correlation.
B. Increased systematic risk factor.
C. Decreased portfolio alpha.
D. Perfect positive correlation.
A. Perfect negative correlation.
Two securities, both of which are risky, but which are not perfectly positively correlated (i.e., negatively correlated) to each other, actually reduce or even eliminate risk when the two securities are looked at from a portfolio perspective, rather than as isolated, non-interactive holdings. Systematic risk refers to the risk of being invested, and cannot be diversified away; alpha refers to the excess return on a portfolio generated by a portfolio manager’s skill and is not a diversification strategy.
Choose the typical beta of a defensive industry stock.
A. Higher than one.
B. Higher than two.
C. Between one and two.
D. Lower than one.
D. Lower than one.
Since the industry does not fluctuate as much as the market, the beta for defensive industries must by definition be less than one.
Calculate a client’s real return if she earns 8% pre-tax return on an investment in a period of 3% inflation.
A. 3%.
B. 5%.
C. 8%.
D. 11%.
B. 5%.
Real return is calculated by subtracting the inflation rate from the nominal rate of return.
In this example, 8% - 3% = 5%
The S&P/TSX Composite Index rises by 6%. ABC Equity Fund has a beta of 2.2. Calculate the expected change in the value of ABC Equity Fund.
A. 1.2%.
B. 4.0%.
C. 8.2%.
D. 13.2%
D. 13.2%
Any security, or portfolio of stocks, that moves up or down to the same degree as the stock market has a beta of 1.0. Any security or portfolio that moves up or down more than the market has a beta greater than 1.0. If the S&P/TSX Composite Index rose 6%, an equity fund with a beta of 2.2 could be expected to advance by 13.2% (6% x 2.2).
Sharjeel purchases an equity fund at $20 per unit anticipating that the unit value will increase to $25 by the end of the year. Instead, the fund unit value increases to $24 but he receives $0.50 in dividends for each unit. Calculate the ex-ante rate of return.
A. 12.5%.
B. 20.0%.
C. 22.5%.
D. 25.0%.
D. 25.0%.
The ex-ante rate of return was ($25 - $20) / $20 = 25%. In the ex-ante formula, there was no cash flow included because Sharjeel was only anticipating a capital gain. If we were to calculate the ex-post rate of return, i.e. the actual rate of return Sharjeel received, it would be ($24 + $0.50 - $20) / $20 = 22.5%.
Identify a strategy to reduce the risk of investing in high-yield or junk bonds.
A. Invest only in bonds of companies that she knows well.
B. Invest in bonds with terms to maturity of greater than 10 years.
C. Invest only in bonds with short terms to maturity, e.g., less than 3 years.
D. Invest only in the contraction phase of the cycle when bond prices are increasing.
C. Invest only in bonds with short terms to maturity, e.g., less than 3 years.
High-yield bonds are non-investment grade products often called junk bonds. Bonds in this category should have a higher yield, but they face greater credit risk. To mitigate this risk, managers often invest in high-yield bonds that mature in less than three years.
Identify the style of management that focusses on identifying the current phase of the economic cycle, the direction the economy is headed in and the various sectors affected.
A. Value.
B. Growth.
C. Sector Rotation.
D. Credit quality.
C. Sector Rotation.
This form of growth investing applies a top-down approach which analyzes the prospects for the overall economy. Based on that assessment, the managers invest in the industry sectors expected to outperform. These managers typically buy large cap stocks to maximize their liquidity. They are not as concerned with individual stock characteristics. Their primary focus is to identify the current phase of the economic cycle, the direction the economy is headed and the various sectors affected. In other words, industry selection is more important than stock selection and the manager often tries to identify emerging themes.
Identify the shift that an industry rotation manager makes as she executes her investment strategy.
A. Growth and value investments.
B. Defensive and cyclical investments.
C. Fixed-income and equity investments.
D. Domestic and international investments.
B. Defensive and cyclical investments.
The most basic industry rotation strategy involves shifting back and forth between cyclical and defensive shares. During periods when stock prices are falling, companies that belong to cyclical industries tend to fall relatively faster than those companies that belong to defensive industries. Conversely, during periods when stock prices are rising, companies that belong to cyclical industries tend to rise relatively faster than those companies that belong to defensive industries.
Determine the largest typical contributor to the total return of a bottom-up investment manager’s portfolio.
A. Interest income.
B. Dividend income.
C. Capital gains appreciation.
D. Foreign exchange gains.
C. Capital gains appreciation.
A bottoms-up manager would be utilizing a growth focus to invest in equities. The growth style holds greater potential for capital appreciation because of faster earnings growth. More of the total return of the portfolio is derived from capital appreciation rather than more stable dividend income. Stocks in this type of portfolio usually have a lower dividend yield, or provide no dividend at all.
A growth manager is choosing between 4 different equities. Determine which of Stock A (high beta, high dividend yield); Stock B (low beta, high price/cash flow); Stock C (low dividend yield, high price-earnings ratio); or Stock D (low standard deviation, low price/book value) she would likely choose.
A. Stock A.
B. Stock B.
C. Stock C.
D. Stock D.
C. Stock C.
Typically, growth managers focus on current and future earnings of individual companies. Stocks in this type of portfolio usually have a lower dividend yield, high price-earnings ratios, high price/book value and high price/cash flow. Of the four securities, only Stock C has two characteristics that would be attractive to a growth manager.
