Chapter 3: Principles of Investment Risk and Return Flashcards
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
C. £1,334.62
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.
The UK Corporate Governance Code sets out standards of good practice for issues such as;
A. The use of non-executive directors
B. The contents of a Company’s advertising campaigns
C. Listing requirements of the LSE
D. FCA regulations
A. The use of non-executive directors.
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.
Which of the following is not a measure of total return?
A. Beta weighted rate of return
B. Holding period yield
C. Money weighted rate of return
D. Time weighted rate of return
A. Beta weighted return may sound plausible but is not a return method.
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?
A. Bullet portfolio
B. Barbell portfolio
C. Ladder portfolio
D. Diversified portfolio
B. Barbell portfolio
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.
Which of the following is NOT a category of multi-factor model?
A. Macroeconomic
B. Technical
C. Fundamental
D. Statistical
B. The three types of models are: fundamental (earnings, dividend yield) statistical (stock market indices) and macro-economic (inflation, interest rates, employment).
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?
A. Optimism bias
B. Overconfidence
C. Self-serving bias
D. Information bias
C. Self-serving bias.
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.
Reference: Chapter 3 Section 3.6.1
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:
A. Standard deviation
B. Beta
C. The risk free rate
D. Covariance
B. Beta.
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.
The UK Corporate Governance Code contains provisions on the following, except:
A. Environmental impact
B. Division of responsibilities
C. Composition, Succession and Evaluation
D. Remuneration
A. Environmental impact
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
Which of the following risk measures do not assume holding a diversified portfolio?
I. Sharpe ratio
II. Treynor ratio
III. Jensen’s Alpha
A. I and II
B. I and III
C. II and III
D. I only
D. I only.
The Sharpe measure uses total risk as it assumes that the portfolio is not diversified.
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?
A. Groupthink
B. Optimism bias
C. Information bias
D. Framing effect
D. Framing.
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.
Which of the following is the recommended approach for estimating total returns involving cash flows in or out of an investment fund?
A. Money weighted rate of return
B. Time weighted rate of return
C. Internal rate of return
D. Interim internal rate of return
B. Time weighted rate of return is the recommended method as it adjusts the return for cash flows into and out of the fund.
Which of the following is not an active bond strategy?
A. Anomaly switching
B. Immunisation switching
C. Intermarket spread switching
D. Policy switching
B. Immunisation is a passive strategy.
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
B. £6,250
Value of a perpetuity = Payment / Discount rate
Value = £500 / 0.08 = £6,250
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%?
A. 32%
B. 25%
C. 15%
D. 10%
A. 32%.
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.
The Explorer plc share price has just risen by 15%, whilst the overall market has risen by 12%. Which of the following is correct?
I. The Explorer plc beta is likely to be 1.25
II. Explorer plc has a high degree of systematic risk
A. I only
B. II only
C. Both
D. Neither
C. A higher beta means a higher degree of systematic risk.
