Chapter 3

Question 1

An annuity pays £150 per year in arrears for 7 years. What is the present value of this annuity assuming a discount rate of 6%?
A£807.23 B£817.52 C£837.36 D£887.60

Answer 1

The correct answer is: C - £837.36
Explanation
Use the annuity formula to solve:
PV = PMT x 1/r x (1 - 1/(1+r)^n)
…where PV is the answer we seek, PMT is the payment received, r = 6% and n = 7 years.
PV = £150 x 1/0.06 x (1 - 1/(1.06)^7)
PV = £837.36

Question 2

1044207] The UK Corporate Governance Code contains provisions on the following, except:
AEnvironmental impact BDivision of responsibilities CComposition, Succession and Evaluation DRemuneration

Answer 2

The correct answer is: A - Environmental impact
Explanation
The UK Corporate Governance Code looks at:
Board leadership and company purpose,
Division of responsibilities,
Composition, succession and effectiveness
Audit, risk and internal control
Remuneration

Question 3

Shares in SpaceTravel plc have a standard deviation of 20%. Assuming the mean return is 15%, what is the chance of a return greater than 35% or less than -5%?
A32% B25% C15% D10%

Answer 3

The correct answer is: A - 32%
Explanation
Standard deviation is a measure of risk, but can be used as a predictor of expected returns. If there is a normal distribution of returns over a period of time, approximately 68% of those returns will fall within one standard deviation of the mean - this is not something to calculate, but a statistical fact.
With this in mind, if the standard deviation is 20% and the mean return is 15%, there is a 68% chance of future returns falling between -5% (mean - sd) and 35% (mean + sd). There must therefore be a 32% chance of returns falling outside that range.

Question 4

Which of the following represents the correct distinction between systematic and systemic risk?
ASystemic risk is concerned with interlinkages and interdependence. Systematic risk is the risk that is inherent in the aggregate market that cannot be mitigated and removed by diversification. BSystematic risk is concerned with interlinkages and interdependence. Systemic risk is the risk that is inherent in the aggregate market that cannot be mitigated and removed by diversification. CSystemic risk is concerned with the risk of failure of one entity in isolation. Systematic risk is the risk that is inherent in the aggregate market that cannot be mitigated and removed by diversification. DThere is no distinction between systemic and systematic risk, and represents the risk that is inherent in the aggregate market that cannot be mitigated and removed by diversification.

Answer 4

The correct answer is: A - Systemic risk is concerned with interlinkages and interdependence. Systematic risk is the risk that is inherent in the aggregate market that cannot be mitigated and removed by diversification.
Explanation
A systemic risk must not be confused with systematic risk as it is used in capital markets theory.
In finance and economics, systemic risk is often discussed in connection with the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system.
It can be defined as ‘financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries’.
Systemic risk tends to be associated more with interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market.
Systematic risk is plainly called market risk or the aggregate risk. It is the risk that is inherent in the aggregate market that cannot be mitigated and removed by diversification.
Systematic risks tend to be outside the power of most investors to predict, and often of the investment manager to protect against; however some types of investment are more vulnerable to systematic risk than others.

Question 5

A client has a tendency to assume that good things will happen to them when they have done everything right, but blames blame outside circumstances for the bad things that happen. What is the name of the behavioural finance trait that they are displaying?
AOptimism bias BOverconfidence CSelf-serving bias DInformation bias

Answer 5

The correct answer is: C - Self-serving bias

Explanation
Self-serving bias is the tendency for a person to assume that good things will happen to them when they have done everything right, but bad things will happen due to circumstances outside of their control. This bias results in a tendency to blame outside circumstances for the bad things, rather than taking personal responsibility.

Question 6

Which of the following risk measures do not assume holding a diversified portfolio?
ISharpe ratio
IITreynor ratio
IIIJensen’s Alpha
AI and II BI and III CII and III DI only

Answer 6

The correct answer is: D - I only
Explanation
The Sharpe measure uses total risk as it assumes that the portfolio is not diversified.

Question 7

Alison Dubois deposits £12,000 in a bank account paying an annual fixed rate of 11%. Assuming that she leaves this invested for exactly 10 years, what will the investment be worth on maturity?
A£34,073 B£33,073 C£32,073 D£31,073

Answer 7

The correct answer is: A - £34,073
Explanation
This is a basic compound interest calculation:
(12,000 x1.11^10) = £34,073

Question 8

A perpetuity pays £500 per year. What is the value of the perpetuity assuming a discount rate of 8%?
A£4,000 B£6,250 C£12,750 D£25,000

Answer 8

The correct answer is: B - £6,250
Explanation
Value of a perpetuity = Payment / Discount rate
Value = £500 / 0.08 = £6,250

Question 9

Which of the following measures of risk-adjusted performance allows a tracker fund to measure performance relative to a benchmark?
ASharpe ratio BTreynor ratio CInformation ratio DCAPM

Answer 9

The correct answer is: C - Information ratio
Explanation
The information ratio compares a fund’s performance against a benchmark.

Question 10

Which of the following is not a category of multi-factor model?
AMacroeconomic BTechnical CFundamental DStatistical

Answer 10

The correct answer is: B - Technical
Explanation
The three types of model are: fundamental, statistical and macro-economic

Question 11

A client wishes to invest in a risky product recommended by their colleague. When you ask them to explain the product, their explanation is very narrow and misses out key points. What is the name of the behavioural finance trait that they are displaying?
AGroupthink BOptimism bias CInformation bias DFraming effect

Answer 11

The correct answer is: D - Framing effect
Explanation
Framing – using an approach or description of the situation or issue that is too narrow. Also framing effect – drawing different conclusions based on how data is presented

Groupthink – when a consensus is reached among a group of individuals, but the consequences or alternatives of that decision are not subject to critical reasoning or evaluation. This is based on a common desire to not upset the balance of that group, in turn, avoiding conflict.

Information bias – the tendency to measure, collect or interpret key information inaccurately. Also called observation bias or measurement bias.

Optimism bias – the tendency to estimate that an outcome is positive, if the person making that judgement is in a good mood. Conversely to this, the pessimism bias is the tendency to estimate that an outcome is negative, if the person making that judgement is in a bad mood.

Question 12

What is the Framing

Answer 12

– using an approach or description of the situation or issue that is too narrow. Also framing effect – drawing different conclusions based on how data is presented

Question 13

What is the Groupthink

Answer 13

when a consensus is reached among a group of individuals, but the consequences or alternatives of that decision are not subject to critical reasoning or evaluation. This is based on a common desire to not upset the balance of that group, in turn, avoiding conflict.

Question 14

What is the Information bias

Answer 14

the tendency to measure, collect or interpret key information inaccurately. Also called observation bias or measurement bias.

Question 15

What is the optimism bias

Answer 15

the tendency to estimate that an outcome is positive, if the person making that judgement is in a good mood. Conversely to this, the pessimism bias is the tendency to estimate that an outcome is negative, if the person making that judgement is in a bad mood.

Question 16

Assuming inflation is 3% and the nominal return is 7%, what is an accurate estimate of the real rate of return?
A4.0% B3.98% C3.88% D3.78%

Answer 16

The correct answer is: C - 3.88%
Explanation
(1+nominal) = (1+ real) x (1+ inflation)
1.07 = (1+ real) x 1.03, so (1 + real) = 1.07/1.03 = 3.88%.

Question 17

Northern Bank are offering a monthly interest rate of 1.85%. What is the annual equivalent rate?
A27.6% B26.6% C25.6% D24.6%

Answer 17

The correct answer is: D - 24.6%
Explanation
The question give us the period rate. To turn it in to the annual equivalent rate (AER) we do the following:
(1+period rate)^n - 1
(1.0185^12) -1 = 24.6%.

Question 18

Which of the following is not an active bond strategy?
AAnomaly switching BImmunisation switching CIntermarket spread switching DPolicy switching

Answer 18

The correct answer is: B - Immunisation switching
Explanation
Immunisation is a passive strategy.

Question 19

The goal of an immunisation strategy is to protect a portfolio from which risk?
AEquity risk BInterest rate risk CCurrency risk DCredit risk

Answer 19

The correct answer is: B - Interest rate risk
Explanation
Immunisation’s aim is to protect against interest rate risk.

Question 20

Which of the following is not an assumption of the CAPM?
AAll participants can borrow and lend at the risk-free rate BAll participants have both systematic and non-systematic risk CNo taxes or transaction costs DAll participants have the same expectations

Answer 20

The correct answer is: B - All participants have both systematic and non-systematic risk
Explanation
The assumption should be that only systematic risk remains.

Question 21

What is the relationship between risk and reward?
ANegatively correlated BPositively correlated CUncorrelated DBicorrelated

Answer 21

The correct answer is: B - Positively correlated
Explanation
There is a positive correlation between risk and reward. To earn higher potential rewards you need to take higher potential risks.

Question 22

Which of the following best describes corporate governance?
AA mechanism to ensure the company is run in the best long term interests of the directors BA mechanism to ensure the company is run in the best short term interests of the shareholders CA mechanism to ensure the company is run in the best short term interests of the directors DA mechanism to ensure the company is run in the best long term interests of the shareholders

Answer 22

The correct answer is: D - A mechanism to ensure the company is run in the best long term interests of the shareholders
Explanation
Companies should have a long term view in the running of their business with a focus on the shareholders rather than the directors.

Question 23

An investor deposits £10,000 in a deposit account that pays a fixed interest rate of 4% per annum with interest compounded quarterly. What is the future value of this investment in four years time?
A£11,646 B£11,699 C£11,726 D£11,757

Answer 23

The correct answer is: C - £11,726
Explanation
FV = Deposit x (1 + r)^n
FV = £10,000 x (1.01)^16
FV = £11,725.79.

Question 24

The Explorer plc share price has just risen by 15%, whilst the overall market has risen by 12%. Which of the following is correct?
IThe Explorer plc beta is likely to be 1.25
IIExplorer plc has a high degree of systematic risk
AI only BII only CBoth DNeither

Answer 24

The correct answer is: C - Both
Explanation
A higher beta means a higher degree of systematic risk.

Question 25

How much would you need to invest now to earn £5,000 in year 3 and £6,000 in year 4 assuming a cost of capital of 10%?
A£8,254.65 B£7,854.65 C£7,654.65 D£7,454.65

Answer 25

The correct answer is: B - £7,854.65
Explanation
£5,000/(1.1)^3 + £6,000/(1.1)^4 = £3,756.57 + £4,098.08 = £7854.65.

Question 26

Which of the following risk measures is used to assess the accuracy of a multi-factor model?
ABeta BStandard Deviation CRisk / Reward Ratio Dr-squared

Answer 26

The correct answer is: D - r-squared
Explanation
The r-squared measures the accuracy of a model. A high r-square indicates an accurate model.

Question 27

Western Bank are offering a semi-annual interest rate of 4%. What is the AER?
A8.16% B8.06% C7.96% D7.86%

Answer 27

The correct answer is: A - 8.16%
Explanation
The question give us the period rate. To turn it in to the annual equivalent rate (AER) we do the following:
(1+period rate)^n - 1
(1.04^2) -1 = 8.16%.

Question 28

Which of the following is not a measure of total return?
ABeta weighted rate of return BHolding period yield CMoney weighted rate of return DTime weighted rate of return

Answer 28

The correct answer is: A - Beta weighted rate of return
Explanation
Beta weighted return may sound plausible but is not a return method.

Question 29

Calculate the present value of £50,000 in 7 years time using a cost of capital of 8%?
A£30,174 B£29,174 C£28,174 D£27,174

Answer 29

The correct answer is: B - £29,174
Explanation
This would require the use of a discounting formula:
Present value = terminal value/(1+r)^n = 50,000 / (1.08)^7 = £29,174.

Question 30

The best measure to use for the client’s risk where the investment in question is only part of their much larger equity portfolio is:
AStandard deviation BBeta CThe risk free rate DCovariance

Answer 30

The correct answer is: B - Beta
Explanation
The question indicates that the client has a diversified portfolio. The only risk they are therefore exposed to is SYSTEMATIC risk (measured by Beta).
NB: If the portfolio was not diversified - standard deviation would be the best measure of risk.

Question 31

An annuity pays £150 per year for seven years with the first payment starting today. Assuming a compound rate of 6% what is the future value of the annuity?
A£1,257.34 B£1,286,55 C£1,334.62 D£1,366.86
The correct answer is: C - £1,334.62
Explanation

Answer 31

Use the annuity formula to solve:
FV = PMT x [((1+r)^n)-1]/r x(1+r)
FV = £150 x ((1.06^7 -1) / 0.06 x 1.06)
FV = £1,334.62.

Question 32

Which of the following is the recommended approach for estimating total returns involving cash flows in or out of an investment fund?
AMoney weighted rate of return BTime weighted rate of return CInternal rate of return DInterim internal rate of return

Answer 32

The correct answer is: B - Time weighted rate of return
Explanation
Time weighted rate of return is the recommended method as it adjusts the return for cash flows into and out of the fund.

Question 33

Southern Bank are offering a savings account that pays interest quarterly. If the period rate is 3%, what is the AER?
A12.65% B12.55% C12.45% D12.35%

Answer 33

The correct answer is: B - 12.55%
Explanation
The question give us the period rate. To turn it in to the annual equivalent rate (AER) we do the following:
(1+period rate)^n - 1
(1.03^4) -1 = 12.55%.

Question 34

Which of the following is most accurate in describing the diversification effects of modern portfolio theory?
ASystematic risk is reduced and non-systematic risk remains BNon-systematic risk is reduced and systematic risk remains CBoth systematic risk and non-systematic risk are reduced DBoth systematic risk and non-systematic risk remain at the same levels

Answer 34

The correct answer is: B - Non-systematic risk is reduced and systematic risk remains
Explanation
Non-systematic risk (specific risk) is reduced and systematic risk remains.

Question 35

A portfolio manager has a liability in ten years time. She creates a portfolio of two assets one with a duration of 5 years and the other with a duration of 15 years. Which of the following best describes the portfolio?
ABullet portfolio BBarbell portfolio CLadder portfolio DDiversified portfolio

Answer 35

The correct answer is: B - Barbell portfolio
Explanation
She has a barbell portfolio i.e. one bond with a short duration and one with a long duration with the average duration matching the liability.

Question 36

The UK Corporate Governance Code sets out standards of good practice for issues such as;
AThe use of non-executive directors BThe contents of a Company’s advertising campaigns CListing requirements of the LSE DFCA regulations

Answer 36

The correct answer is: A - The use of non-executive directors
Explanation
The code sets out standards of good practice in relation to issues such as board composition and development, remuneration, accountability and audit and relations with shareholders.

Question 37

Which of the following is not one of the four theories of behavioural finance?
AProspect theory BRegret theory CAnchoring DFraming

Answer 37

The correct answer is: D - Framing
Explanation
Framing is not one of the four theories. The four theories: Prospect Theories, Regret Theory, Anchoring, Over-and-Under reaction.

Question 38

Which of the following is not a category of bias within behavioural finance theory?
AHindsight bias BCognitive bias CSurvivorship bias DConfirmation bias

Answer 38

The correct answer is: C - Survivorship bias
Explanation
Survivorship bias is linked to preformance evaluation issues rather than behavioural finance..

Question 39

A client focuses on nominal returns and ignores the effects of inflation. What is the name of the behavioural finance trait that they are displaying?
AOutcome bias BOmission bias CMoney illusion DSelective perception

Answer 39

The correct answer is: C - Money illusion
Explanation
Money illusion is about ignoring inflation.

Question 40

Regarding modern portfolio statistics, which of the following best describes R squared?
AA fund’s sensitivity in relation to a benchmark index BThe difference between a fund’s actual and expected performance CThe risk adjusted performance of a fund DThe percentage of a fund’s movement that is explained by the benchmark’s movement

Answer 40

The correct answer is: D - The percentage of a fund’s movement that is explained by the benchmark’s movement
Explanation
R squared ranges from 1 to 100, and reflects the percentage. An R squared of 100 means that the benchmark movements explain all the movements in the fund.

Question 41

he correct description of the correlation coefficient is that it represents:
AA measure of the total risk of an asset BA measure of the market risk of an asset CA measure of the extent that two assets move in tandem, not bound as a number DA measure of the extent that two assets move in tandem, bound between -1 and 1

Answer 41

The correct answer is: D - A measure of the extent that two assets move in tandem, bound between -1 and 1
Explanation
The correlation coefficient is a measure of the extent that two assets move in tandem, bound between -1 and -1. A correlation of +1 represents assets moving exactly together and -1 representing assets moving opposite to one another.

Question 42

Which of the following is not a passive bond strategy?
ACash matching BLadder portfolio CImmunisation DEnhanced indexing

Answer 42

The correct answer is: D - Enhanced indexing
Explanation
Enhanced indexing is a semi-active strategy.