FP513 Investing Flashcards
All of the following correctly identify advantages of U.S. Treasury bills except
A) investors can tailor purchases to meet short-term goals and obligations.
B) investors are provided a high degree of safety.
C) they are not subject to default risk.
D) interest income is not subject to federal income tax.
D)
Explanation
Interest income from U.S. Treasury bills is taxed at ordinary federal income tax rates but is not subject to state income tax.
LO 1.3.1
Which of the following is NOT a characteristic of negotiable CDs?
A) Negotiable CDs are bought and sold in the secondary market at a market-determined price.
B) They are used as short-term drafts drawn to finance imports and exports.
C) They are deposits of $100,000 or more placed with commercial banks at a specified interest rate.
D) Negotiable CDs are bought most often by institutional investors rather than by individuals.
B)
Banker’s acceptances are short-term drafts drawn by a private company on a major bank used to finance imports and exports.
LO 1.3.1
Which of the following terms is considered early-stage business funding for the purpose of research and development of an idea?
A) Seed financing
B) Start-up financing
C) First-stage financing
D) Bridge financing
A) Explanation
Bridge financing is for firms that expect to go public within approximately one year. First-stage financing is for initial manufacturing and sales. Start-up financing is for product development and marketing for firms who have not sold products or services commercially.
LO 1.1.1
All of the following statements correctly describe certificates of deposit (CDs) except:
A) redemption prior to maturity typically results in an early withdrawal penalty.
B) CDs are eligible for FDIC coverage.
C) CDs are commonly referred to as time deposits.
D) CDs typically pay a variable interest rate based on the term of the certificate.
D). Explanation
CDs typically pay a fixed interest rate, with higher interest rates offered for longer-term certificates.
LO 1.3.1
Lloyd is a dealer in government securities. He has purchased government securities from another dealer, Fred, and has agreed to sell them back at a later date. From Lloyd’s perspective, which transaction has been executed?
A) Repurchase agreement
B) Reverse repurchase agreement
C) Commercial paper investment
D) Promissory note
B) Explanation
Lloyd, as the buyer, has entered into a reverse repurchase agreement, and Fred, as the seller, has entered into a repurchase agreement.
LO 1.3.1
All of the following correctly identify features of limited partnerships except
A) the limited partners may participate in the management of the partnership.
B) the limited partners have limited liability.
C) the general partner controls the business activities of the partnership.
D) the general partner determines when distributions are made to the limited partners.
A)
The disadvantages of limited partnerships include:
(1) they are generally riskier than bonds or exchange-traded equities;
(2) they are generally illiquid;
(3) limited partners cannot participate in the management; and
(4) the sale of partnership interest may be restricted. In addition, the general partner has unlimited liability.
LO 1.1.1
Which of the following statements best describes banker’s acceptances?
A) Promissory notes traded at a premium from their face value in the secondary market
B) Short-term drafts drawn by a private company on a major bank used to finance imports and exports
C) U.S. dollar-denominated deposits at banks outside the United States
D) Negotiable, short-term, unsecured promissory notes issued by large corporations
B) Explanation
Banker’s acceptances are typically traded at a discount from their face value in the secondary market. Eurodollars are U.S. dollar-denominated deposits at banks outside the United States.
LO 1.3.1
Greg calls his broker and tells her to sell his XYZ stock if it falls to $20, but he does not want less than $19.50 for his shares. What type of order should his broker recommend to sell the stock?
A) Limit order
B) Stop limit order
C) Good-till-canceled order
D) Market order
B) Explanation
The stop limit order turns into a limit order when triggered (both the stop order price and the limit order price are specified). However, this type of order will not guarantee execution if the stock leapfrogs below the $19.50 mark.
LO 1.2.1
Choose the risk that is attributable to cash and cash equivalents.
A) None of these because cash and cash equivalents are considered risk-free
B) Purchasing power risk
C) Marketability risk
D) Liquidity risk
B) Explanation
Cash and cash equivalents are subject to purchasing power (inflation) risk because they offer limited potential for growth.
LO 1.3.1
Identify which of the following statements regarding U.S. Treasury bills is CORRECT.
I. They are purchased at 50% of face value.
II. They are sold at auction in denominations ranging from $50 to $10,000.
III. They are not subject to the original issue discount (OID) taxation rules.
IV. They are sold with maturities up to two years.
A) I, II, and III
B) I and II
C) II and IV
D) III only
Explanation
D) U.S. Treasury bills are purchased at a discount to face value determined at auction. The lowest purchase amount is $100. They are not subject to the OID rules. T-bills have a maturity date of no more than one year.
LO 1.3.1
Select the market designed to facilitate the initial sale of securities to the public.
A) Third market
B) Primary market
C) Fourth market
D) Secondary market
B) Explanation
The purpose of the primary market is to facilitate the sale of initial public offerings (IPOs) of securities to the public.
LO 1.2.1
Robert owns 400 shares of Intel stock that he purchased several years ago for $60 per share. Intel’s current market price is $48 per share. On December 17, Robert decides to buy an additional 200 shares of Intel stock. On December 23, he decides to sell 200 shares that he purchased several years ago so that he can claim a loss on his current year’s tax return. Which of the following statements is true?
I. The loss will be disallowed, but Robert will have to reduce his tax basis in the shares he purchased on December 17 by the amount of the loss.
II. The loss will be disallowed; the transactions are illegal and tax penalties will be imposed.
III. The loss will be disallowed; the amount of the disallowed loss will be added to the cost basis of the shares purchased on December 17.
IV. The transaction is called a wash sale; wash sale rules apply when shares are sold for a loss and repurchased within 30 days before or after the sale date.
A) III and IV
B) IV only
C) II and IV
D) I only
A) Explanation
The transaction is a wash sale; losses are disallowed when substantially identical shares are repurchased within 30 days before or after a sale. The transaction is not illegal and no tax penalties are imposed on the transaction itself. The basis of the stock is adjusted for the disallowed loss.
LO 1.4.1
Which of the following statements regarding Eurodollar CDs is CORRECT?
I. Eurodollar CDs are obligations of non-U.S. banks.
II. Eurodollar CDs are more liquid than domestic CDs.
III. Eurodollar CDs offer a slightly higher yield than domestic CDs.
IV. Eurodollar CDs are only used to settle transactions in the U.S.
A) I only
B) II and IV
C) I and III
D) I, II, and III
Explanation
C) Statements II and IV are incorrect. Eurodollar CDs are less liquid than domestic CDs and are used to settle international transactions.
LO 1.3.1
Which of the following is an unsecured line of credit provided to a business typically to finance imports and exports?
A) Banker’s acceptance
B) Reverse repurchase agreement
C) Commercial paper
D) Negotiable CD
A) Explanation
A banker’s acceptance is an unsecured line of credit provided to a business customer, typically used to finance imports and exports.
LO 1.3.1
Which of the following statements best describes Eurodollars?
A) Deposits of $100,000 or more placed with commercial banks at a specified interest rate
B) Negotiable, short-term, unsecured promissory notes issued by large corporations
C) U.S. dollar-denominated deposits at banks outside the United States
D) Short-term drafts drawn by a private company on a major bank used to finance imports and exports
C)
Explanation
In addition, the average deposit is very large (in the millions) and has a maturity of less than six months.
LO 1.3.1
Limited partnerships are distinguished by which of the following?
I. The general partner controls the business activities of the partnership.
II. The limited partners participate in the business venture with limited liability.
III. The general partner determines when distributions are made to the limited partners.
IV. The limited partners may have difficulty selling their interests.
A) I, II, III, and IV
B) I and III
C) I, II, and III
D) II and IV
Explanation
All of these statements are correct. Limited partnerships are characterized by a partnership entity that consists of a general partner and limited partners.
LO 1.1.1
Aidan purchased 100 shares of MNO stock on margin three years ago when the stock price was $32 per share. Today MNO stock is selling for $42 per share. Over the past three years, MNO has paid total dividends of $1 per share.
Assuming Aidan’s broker requires an initial margin of 50% and charges 6% annual margin interest, calculate his holding period return for the three years.
A) 68.75%
B) 50.75%
C) 31.38%
D) 62.75%
B) Explanation
HPR = [(ending value – beginning value) +/– cash flows] ÷ initial investment
= {[($4,200 – $3,200) + $100] – [6% × 50% × $3,200 × 3]} ÷ $1,600 = 50.75%.
LO 1.2.1
Your client has just opened a margin account with your brokerage firm and purchased 500 shares of stock for $60 per share. The firm has a 55% initial margin and 35% maintenance margin policy. Calculate the stock price at which your client will receive a margin call.
A) $50.76
B) $41.54
C) $31.43
D) $27.00
B) Explanation
The client will receive a margin call when the price of the stock drops to $41.54, calculated as follows:
margin call = ($60 × 0.45) ÷ (1 – 0.35)
margin call = $27.00 ÷ 0.65 = $41.5385, or $41.54
LO 1.2.1
Which of the following statements describes the purpose of holding cash and cash equivalents?
I. They provide a totally risk-free investment that can safeguard the asset values of a retired individual.
II. They supply highly liquid investments that provide funds for financial emergencies.
A) II only
B) I only
C) Neither I nor II
D) Both I and II
A) Explanation
Cash and cash equivalents are highly liquid investments that are generally included in a client’s emergency fund. Because of their low returns, cash and cash equivalents are subject to purchasing power risk, making them inappropriate for protecting asset value.
LO 1.3.1
Settings
Arrange, in order, the steps required to complete a short sale transaction.
I. The investor repurchases the stock in the open market.
II. The investor replaces, or covers, the borrowed stock.
III. The investor uses a stockbroker to borrow the stock from another investor’s account.
IV. The investor sells the borrowed stock in the open market.
A) I, II, III, IV
B) IV, I, II, III
C) I, III, IV, II
D) III, IV, I, II
D) Explanation
To complete a short sale transaction, the investor uses a stockbroker to borrow the stock from another investor’s account, the investor sells the borrowed stock in the open market, the investor repurchases the stock in the open market, and finally, the investor replaces, or covers, the borrowed stock.
LO 1.2.1
When investment bankers absorb the loss on an initial public offering, which one of the following terms represents this type of offering?
A) Green shoes
B) Firm commitment
C) Best efforts
D) Secondary offering
Explanation
B) The answer is firm commitment. Firm commitment underwriting occurs when investment bankers purchase all shares from a company and resell them to the public at their own risk.
LO 1.1.1
The maintenance margin is
A) usually greater than the initial margin percentage.
B) the amount owed to the broker/dealer.
C) a requirement once the investor takes a margin account position.
D) not a factor in a margin call.
Explanation
C) The answer is a requirement once the investor takes a margin account position. The maintenance margin is the minimum required percentage of cash equity in the position.
LO 1.1.1
Equity investments made for the launch, early development, or expansion of a business are known as
A) leveraged buyouts.
B) venture capital.
C) mezzanine financing.
D) distressed debt investing.
Explanation
The answer is venture capital. Equity financing associated with the early development of a business is called venture capital. Mezzanine financing is provided for expansion and new products. Leveraged buyout financing is provided to allow management to buy all or part of a business; often used when a public company divests a division that it feels is no longer part of its long-term plans. Distressed debt is investing in the debt of companies that are in trouble or failing.
LO 1.1.1
Short selling is selling
A) borrowed securities.
B) stock owned for less than a year.
C)an odd lot.
D) against the advice of an investor’s broker.
Explanation
A) The answer is borrowed securities. To sell short, an investor must first borrow shares from the brokerage firm’s customers.
LO 1.1.1
A strategy where investors with relatively large amounts of money to invest purchase multiple certificates with varying terms to maturity is
A) swapping.
B) staging.
C) laddering.
D) bulleting.
Explanation
C) Laddering is the process of purchasing multiple CDs with staggered maturities, that are equally spaced, and with varying interest rates. As each CD matures, a CD is purchased with a maturity equal to the longest in the ladder. This strategy is used to manage interest rate risk.
LO 1.1.1
Which market is designed to facilitate the initial sale of securities to the public?
A) Third market
B) Secondary market
C) Primary market
D) Fourth market
Explanation
The answer is primary market. The purpose of the primary market is to facilitate the sale of initial public offerings (IPOs) of securities to the public.
LO 1.2.1
Alice uses a stockbroker to borrow shares of stock from another investor’s account and then sells the borrowed stock in the open market. She later repurchases the stock in the open market and replaces, or covers, the borrowed stock. Which type of transaction has Alice used in her account?
A) Wash sale
B) Zero-cost collar
C) Protective put
D) Short sale
Explanation
D) The answer is short sale. A short sale involves the sale and subsequent repurchase of borrowed shares, allowing an investor to take advantage of falling stock prices.
LO 1.2.1
Your client has owned ABC Corp. stock for several years, and it has risen in price to $46 per share. She wants to continue owning the stock as long as it is going up in price but wants to protect herself on the downside and get out of the position if the stock falls in value to $38 or less per share. In order to do this, she would need to place which kind of order?
A) Good-til-canceled sell order at $38
B) Good-til-canceled sell stop at $38
C) Good-til-canceled sell stop limit at $38
D) Day order to sell at $38
Explanation
B) The answer is good-til-canceled sell stop at $38. A good-til-canceled order is an order that will remain in effect until either it is executed or canceled. A good-til-canceled sell stop order becomes a market sell order when the market price drops below the stop price.
LO 1.2.1
Carly purchased $80,000 of JEM stock for $40 per share utilizing her margin account. She used $40,000 in her money market fund plus she borrowed $40,000 from her broker. She acquired a total of 2,000 shares of JEM stock. JEM stock is currently trading at $39.65 per share. Calculate the stock price that Carly would receive a margin call from her broker. Assume a maintenance margin requirement of 35% and an initial margin requirement of 50%.
A) $29.68
B) $30.50
C) $30.77
D) $30.23
Explanation
C) The answer is $30.77. Carly would receive a margin call when the stock fell to $30.77 per share.
Margin call = [(1 − initial margin percentage) ÷ (1 − maintenance margin)] × purchase price of the stock = [(1 – 0.50) ÷ (1 – 0.35)] × 40 = 30.7692, or $30.77.
LO 1.2.1
Cosmo has a margin account with a balance of $50,000 with a national broker-dealer. The initial margin requirement on this account is 50%. Cosmo is interested in purchasing shares of Aardvark Inc., which is currently selling at $40 per share.
Given the above information, calculate the number of shares of Aardvark that Cosmo can purchase on margin.
A) 1,250
B) 625
C) 2,000
D) 2,500
Explanation
D) The answer is 2,500. Cosmo can purchase 2,500 shares calculated as follows: $50,000 ÷ 50% initial margin = $100,000 of buying power. $100,000 ÷ $40/share = 2,500 shares.
LO 1.2.1
An investor holding a Treasury bill as of the date of maturity includes
A) the amount of the discount as ordinary income.
B) the amount of the discount as a capital gain.
C) the face value as a capital gain.
D) the discounted sales price as ordinary income.
Explanation
A) The answer is the amount of the discount as ordinary income.
An investor holding a Treasury bill as of the date of maturity includes the amount of the discount as ordinary income. An investor who sells the bill before maturity includes as ordinary income only a portion of the acquisition discount based on the total time he held the bill. The remaining portion is capital gain income.
LO 1.3.1
Identify which of the following statements pertaining to the various types of money market investments is CORRECT.
I. Commercial paper offers higher yields than T-bills.
II. Eurodollars are U.S. dollar-denominated deposits at banks outside of the United States.
III. Banker’s acceptances are short-term drafts drawn by a private company on a major bank to finance imports and exports.
IV. T-bills are subject to default risk and a lack of marketability.
A) IV only
B) II, III, and IV
C) II and IV
D) I, II, and III
Explanation
D) The answer is I, II, and III. T-bills are not subject to default risk and exhibit a high degree of marketability. As a result, the 90-day T-bill is often used as a proxy for the risk-free investment.
LO 1.3.1
Identify which of the following statements regarding money market deposit accounts (MMDAs) are NOT correct.
I. They are FDIC insured.
II. They offer unlimited check writing privileges.
III. They are primarily offered by open-end investment companies.
IV. They require a minimum balance.
A) I and IV
B) II and III
C) III and IV
D) I and II
Explanation
B) The answer is II and III.
MMDAs provide limited check writing privileges and are offered by banks and savings and loans. MMDAs require a minimum balance. Unlike money market mutual funds, MMDAs are FDIC insured.
LO 1.3.1
Which of the following statements best describes banker’s acceptances?
A) U.S. dollar-denominated deposits at banks outside the United States
B) Negotiable, short-term, unsecured promissory notes issued by large corporations
C) Promissory notes traded at a premium from their face value in the secondary market
D) Short-term drafts drawn by a private company on a major bank used to finance imports and exports
Explanation
D) The answer is short-term drafts drawn by a private company on a major bank used to finance imports and exports.
Banker’s acceptances are typically traded at a discount from their face value in the secondary market. Eurodollars are U.S. dollar-denominated deposits at banks outside the United States.
LO 1.3.1
Identify the incorrect statement regarding passbook savings accounts.
A) Depositors are permitted to withdraw their savings at any time without penalty
B) They offer a relatively low interest rate
C) They require a minimum balance of $500
D) Accounts are established with a commercial bank or savings and loan
Explanation
C) The answer is they require a minimum balance of $500. Passbook savings accounts do not require a minimum balance.
LO 1.3.1
Select the arrangement that is commonly used by dealers in government securities to satisfy short-term liquidity needs.
A) Banker’s acceptance
B) Negotiable CDs
C) Repurchase agreement
D) Commercial paper
Explanation
C) The answer is repurchase agreement. Dealers in government securities use repurchase agreements, or repos, to satisfy short-term liquidity needs.
LO 1.3.1
A money market mutual fund manager recently purchased negotiable, short-term, unsecured promissory notes issued by a number of large corporations for the portfolio. Select the type of investment the money manager purchased.
A) Banker’s acceptances
B) Repurchase agreements
C) Reverse repurchase agreements
D) Commercial paper
Explanation
D) The answer is commercial paper.
Commercial paper is usually issued in denominations of $100,000 or more and is a substitute for short-term bank financing. Commercial paper is normally sold at a discount and is rated for quality by a rating service.
LO 1.3.1
Which of the following statements regarding Eurodollar CDs is CORRECT?
I. Eurodollar CDs are obligations of non-U.S. banks.
II. Eurodollar CDs are more liquid than domestic CDs.
III. Eurodollar CDs offer a slightly higher yield than domestic CDs.
IV. Eurodollar CDs are only used to settle transactions in the U.S.
A) I and III
B) I, II, and III
C) I only
D) II and IV
Explanation
A) The answer is I and III.
Statements II and IV are incorrect. Eurodollar CDs are less liquid than domestic CDs and are used to settle international transactions.
LO 1.3.1
Choose the characteristic that does not apply to Eurodollars.
A) Maturities of less than six months
B) Dollar-denominated deposits
C) Issued by the U.S. Treasury
D) Interest earned is taxed as ordinary income in the year received
Explanation
C) The answer is issued by the U.S. Treasury. Eurodollars are issued by banks outside of the United States, not the U.S. Treasury.
LO 1.3.1
All of the following statements correctly explain money market securities except
A) money markets securities include short-term, highly liquid, relatively low-risk debt instruments sold by governments, financial institutions, and corporations to investors with temporary funds to invest.
B) Treasury bills are an example of a money market security and are used as a proxy for the risk-free rate of return.
C) money market mutual funds are used by investors as part of their emergency fund because the funds are extremely liquid.
D) all money market mutual funds are exempt from taxation on both the state and federal levels.
Explanation
D) The answer is all money market mutual funds are exempt from taxation on both the state and federal levels. Open-end investment companies offer both taxable and tax-exempt money market mutual funds. Only state specific money market mutual funds are exempt from taxation for the taxpayers in those specific states.
LO 1.3.1
Which asset is used to satisfy the short-term liquidity needs of dealers in government securities, when such dealers sell some of those securities to another dealer with an agreement to buy them back at a later date at an agreed-upon price?
A) Eurodollars
B) Banker’s acceptances
C) Repurchase agreements
D) Commercial paper
Explanation
C) The answer is repurchase agreements. Repurchase agreements are used by dealers in government securities. Because of their low risk and short maturities, they are frequently found in money market mutual funds.
LO 1.3.1
Which of the following would be held in a money market portfolio?
I. Treasury bill
II. Negotiable CDs
III. Commericial paper
A) II and III
B) I and II
C) I, II, and III
D) I only
Explanation
C) The answer is I, II, and III. All of these financial instruments would be held in a money market portfolio.
LO 1.3.1
Identify the features of U.S. Treasury bills (T-bills).
I. U.S. Treasury bills are default risk-free.
II. The 90-day T-bill rate is frequently used as the risk-free rate of return in the capital asset pricing model.
III. U.S. Treasury bills offer a low rate of return when compared to riskier alternatives.
IV. T-bills offer a high degree of marketability.
A) I only
B) II and IV
C) I, II, III, and IV
D) III and IV
Explanation
The answer is I, II, III, and IV.
U.S. Treasury bills are short-term government securities. Because of their lack of default risk and high degree of marketability, T-bills are often used as the proxy for a risk-free investment, an asset having the lowest level of risk among all available assets, in modern portfolio management theory.
LO 1.3.1
A wash sale is deemed to have occurred within which of the following time frames?
A) 30 days
B) 60 days
C) 61 days
D) 31 days
Explanation
The answer is 61 days. 30 days before + date of sale + 30 days after = 61 total days.
LO 1.4.1
Which of the following statements regarding wash sales is CORRECT?
I. A wash sale occurs if the taxpayer sells or exchanges stock or securities for a loss and, within 30 days before or after the date of the sale or exchange, acquires
similar securities.
II. The wash sale rules are easily avoided in the case of fixed-income securities by substituting a bond with the same or similar characteristics as long as it is issued by a different company.
A) Both I and II
B) II only
C) Neither I nor II
D) I only
Explanation
The answer is both I and II. Both of these statements describe characteristics of wash sales.
LO 1.4.1
Distributions of dividend and capital gains in cash to mutual fund investors
I. are fully taxable to the investor.
II. are added to the tax basis of the shares once taxes on the distributions are paid.
III. decrease the taxable gain or increase the loss on sale of the shares after taxes are paid.
IV. decrease the cost basis of the shares whether or not taxes are paid.
A) I and II
B) I only
C) IV only
D) I, II, and III
Explanation
The answer is I only.
If the dividends and capital gains are reinvested, the individual receives an increased tax basis. If the distributions are made in cash, there is no increase in the tax basis of the underlying securities.
LO 1.4.1
Which of the following statements regarding dividend and interest income is CORRECT?
I. Generally, income from U.S. government obligations is taxable on state income tax returns.
II. All dividend income is taxable to individuals on both federal and state income tax returns.
A) II only
B) I only
C) Both I and II
D) Neither I nor II
Explanation
The answer is II only. Statement I is incorrect. Generally, income from U.S. government obligations is not taxable on state income tax returns.
LO 1.4.1
Which of the following statements regarding net investment income is CORRECT?
I. A Medicare contribution tax is imposed on taxpayers with net investment income.
II. Net investment income is investment income reduced by certain deductible investment expenses.
A) Both I and II
B) Neither I nor II
C) I only
D) II only
Explanation
The answer is both I and II. Both of these statements regarding net investment income are correct.
LO 1.4.1
A client has $12,000 of capital gains and $15,000 of capital losses. How much unused loss is carried forward to the following tax year?
A) $3,000
B) $12,000
C) $15,000
D) $0
Explanation
D) The answer is $0. After netting capital gain and losses, the client has a net capital loss of $3,000. Because $3,000 of net losses can be deducted during any one tax year, there is no carryforward.
LO 1.4.1
Galen has come to his financial planner with questions about dividends he received on some of his stock this year. He has received $1,000 in qualified dividends paid in cash. He also has received stock dividends of $4,000, but without a cash dividend option. How much will Galen have to report as dividend income for the current year?
A) $1,000
B) $5,000
C) $0
D) $4,000
Explanation
The answer is $1,000. Only the dividends paid in cash to Galen that are reported as income. The stock dividends did not have a cash-dividend option and are not taxable.
LO 1.4.1
One advantage of convertible bonds is that they
A) have a higher coupon rate than the underlying stock’s dividend.
B) have higher coupon rates than straight coupon bonds.
C) are usually offered only by firms with high bond credit ratings.
D) offer the ability to buy the underlying stock at a discount.
A) Explanation
The coupon rate on the convertible bond is usually greater than the stock’s dividend yield because the stock usually pays little, if any dividends. This enables the investor to get a higher periodic cash flow while waiting for the stock to appreciate.
LO 2.2.1
Your client owns a ZIM Corporation convertible bond that has a coupon rate of 9% paid semiannually and matures in 10 years. Comparable debt yields 8% currently. The ZIM bond conversion price is $40 per share. The current market price of the underlying stock is $46. What is the conversion value of this convertible bond?
A) $1,223
B) $1,150
C) $1,000
D) $1,067
B) The answer is $1,150.
To immunize a bond portfolio over a specific investment horizon, an investor would do which of the following?
A) Match the maturity of each bond to the investment horizon.
B) Match the duration of each bond to the investment horizon.
C) Match the average weighted maturity of the portfolio to the investment horizon.
D) Match the average weighted duration of the bond portfolio to the investment horizon.
D) When a portfolio is immunized, its liabilities and expected future cash outflows are funded by making sure that the cash flow from investments (income and principal) will be there at the time that the cash outflow is needed. That is done by matching the duration, not the maturity, of the bond portfolio to the number of years until the cash outflow will occur. The duration of the portfolio as a whole should be matched, not the duration of each bond in the portfolio.
LO 2.3.1
Klaus Copenhagen’s objective is to receive income, and he is considering a preferred stock with a $1.50 dividend that is currently trading at $25. What would be the approximate price movement of this preferred stock if interest rates were to rise 1%?
A) –14%
B) –4%
C) –10%
D) –7%
A)
First, determine what the current interest rate is, $1.50 ÷ $25 = 0.06. Now, determine the percentage price movement if interest rates climb 1%—$1.50 ÷ 0.07 = $21.43. This is a decline of $3.57, or 14.28%.
LO 2.5.1
A convertible bond has a conversion price of $40 per share. At which one of the following combinations of values would it make sense for an investor to convert a convertible bond into shares of stock?
Stock Price. Bond Intrinsic Value. Conversion Value
A $32 $900 $800
B. $42 $1,100 $1,050
C. $38 $1,050 $950
D. $45 $1,100 $1,125
A) Option A
B) Option D
C) Option B
D) Option C
Explanation
B) Option D
At all other values, the bond’s intrinsic value is greater than the conversion value; a conversion under those circumstances means that the investor is automatically losing money on the conversion, excluding the fact that the convertible bond sells at a premium to its intrinsic value as a bond.
At a minimum, the conversion value should be greater than the bond intrinsic value for conversion to be considered.
LO 2.2.1
Bonds issued by state and local governments that are backed by the full faith and credit of the issuing government and repaid by the issuing municipality’s taxing power are categorized as
A) revenue bonds.
B) general obligation bonds.
C) tax anticipation notes.
D) revenue anticipation bonds.
B)
General obligation bonds (GOs) are the most secure of all municipal debt because they are backed by the full faith and credit of the issuer. Municipalities may increase taxes to make principal and interest payments on any debt issue; therefore, a voter referendum is usually required to approve their issuance.
LO 2.1.1
Identify the CORRECT statements regarding portfolio immunization.
I. A bond portfolio is said to be immunized from default risk and business risk when the duration of the portfolio is equal to the time horizon of the investor.
II. If the time horizon of an investor is 10 years, a simple way to protect against interest rate risk and reinvestment rate risk would be to fund the portfolio only with zero-coupon bonds with a 12-year term to maturity.
A) Both I and II
B) Neither I nor II
C) II only
D) I only
B)
Neither Statement I nor II is correct.
A bond portfolio is said to be immunized from interest rate risk and reinvestment rate risk when the duration of the portfolio is equal to the time horizon of the investor.
If the time horizon of an investor is 10 years, a simple way to protect against interest rate risk and reinvestment rate risk would be to fund the portfolio only with zero-coupon bonds with a 10-year term to maturity.
LO 2.3.1
The reason for using a ladder bond strategy is to
A) turn a paper loss into an actual loss.
B) lower interest rate risk.
C) magnify gains.
D) spread cash flows evenly over a given time horizon to eliminate default risk.
Explanation
B) For example, with a ladder bond strategy, instead of investing all money in a seven-year bond, an investor may divide the dollars among bonds with one, three, five, seven, and nine-year maturities. With this approach, instead of making a single bet on interest rates, the investor has both longer and shorter maturities, so that regardless of which way interest rates move the investor will not experience either great losses or great gains.
LO 2.3.1
A convertible bond has a 6.5% coupon rate, interest is paid semiannually, and the bond matures in five years. Comparable debt currently yields 7.5%. The bond is convertible into common stock at $25 per share. The current price of the stock is $28, and the current price of the convertible bond is $1,050. What is the investment value of the bond?
A) $958.94
B) $1,000.00
C) $968.95
D) $1,008.90
Explanation
A bond’s investment value is the same as its intrinsic value as a straight bond. Using an HP 10bII+ calculator, the bond price is determined by inputting the following keystrokes:
(END mode)
10, N
- 5 ÷, 2 I/YR
- 5, PMT
1000, FV
Solve for PV = –958.94, or $958.94.
LO 2.2.1
An investor pays a premium for a convertible bond because:
A) the investor is buying a straight bond and buying a call option.
B) the investor is buying a straight bond and selling a call option.
C) the investor is buying a straight bond and buying a put option.
D) the investor is buying a straight bond and selling a put option.
A) The investor is long the straight bond (bought) and long the call option (bought).
LO 2.2.1
Assume YC1 is an inverted yield curve and one year later all interest rates have decreased to where the new yield curve, YC2, is a normal yield curve. Which of the following provides information that can be interpreted from these yield curves?
I. Duration has decreased.
II. Duration has increased.
III. Treasury bill rates were lower than Treasury bond rates at the time of YC2.
IV. Inflation may have been high at the time of YC1.
A) II, III, and IV
B) I and IV
C) II and IV
D) I, III, and IV
Explanation
A) Market interest rates have decreased from YC1 to YC2. When market rates decrease, duration increases, because market interest rates and duration are inversely related. Treasury bills are short-term debt and Treasury bonds are long-term debt. When an inverted yield curve changes to a normal yield curve, short-term rates will decline more than long-term rates. An inverted yield curve normally occurs when inflation is high and the Fed fights inflation by raising short-term interest rates above long-term interest rates.
LO 2.4.1
A client has a cash need at the end of seven years. Which of the following investments might initially immunize the portfolio?
I. A nine-year maturity coupon bond
II. A seven-year maturity coupon Treasury note
III. A series of Treasury bills
A) I, II, and III
B) I only
C) II only
D) II and III
Your primary objective is to match duration to the cash need of seven years.
Treasury bills do not come close because the maturity of the bills is one year or less, meaning that the duration must be less than one year. A seven-year note must have a duration less than seven years because the note has a coupon; therefore, it is likely that the seven-year note duration will not be sufficient to match the duration of the need either. The duration of a 9 year bond with a coupon must be less than nine years. You can estimate that the duration of an intermediate-term bond might be about 80% of the bond’s maturity, or, in this case, about seven years. That is a close enough estimate to arrive at the answer to this question.
LO 2.3.1
Which of the following is CORRECT with respect to convertible bonds and convertible preferred stock if the value of the common stock rises?
A) The value of convertible bonds and convertible preferred stock declines.
B) The value of convertible bonds and convertible preferred stock rises.
C) The value of convertible bonds rises, but convertible preferred stock falls.
D) The value of convertible bonds falls, but convertible preferred stock rises.
Explanation
B) The value of any convertible will rise with a rise in the underlying common stock into which it can be converted. The convertibles will not necessarily have the same gain; it will depend on their premium and conversion terms.
LO 2.5.1
The reason for using a barbell bond strategy is to
A) maximize the potential capital gain in a bond portfolio.
B) increase interest rate risk.
C) decrease default risk.
D) offset price and reinvestment rate risk.
Explanation
D) The purpose for using a barbell strategy in a bond portfolio is to offset the opposite effects of interest rates on bond prices. If rates rise, short-term bonds can be reinvested at higher rates. If rates drop, long-term bonds are used to lock in rates.
LO 2.3.1
You want to generate additional income from your portfolio, and are considering purchasing either bonds or preferred stocks. Which of the following statements is NOT correct concerning the characteristics of bonds and preferred stocks?
A) Bonds are subject to more interest rate risk than preferred stocks.
B) In the event of a company’s bankruptcy, bondholders would be paid first ahead of preferred stock shareholders.
C) Bonds pay interest while preferred stocks pay dividends.
D) Corporations pay taxes on preferred stock dividends prior to distribution to preferred shareholders, whereas interest on bonds is a deductible expense.
Explanation
A) Because preferred stock does not have a maturity date, it is subject to more interest rate risk than bonds.
LO 2.5.1
Jennifer owns a state public purpose bond. She sells the bond and realizes a capital gain of $4,000. Prior to selling the bond, the total interest she had earned for the year was $99. Considering the sale and the interest amount, calculate the amount she must include in gross income.
A) $99
B) $3,001
C) $4,099
D) $4,000
D) Explanation
The interest on public purpose bonds is received tax-free by the holder. Only the capital gain realized on the sale is subject to income taxation.
LO 2.1.1
Emily will be retiring in a few months and would like some additional income to supplement her retirement benefits. A significant portion of her portfolio is in growth stocks, and she has some concern about how to structure the fixed-income portion of her portfolio.
Which of the following types of investments would be most appropriate for Emily?
A) A 20-year, 8%, A rated income bond
B) A “Z” tranche CMO
C) A medium duration, AA rated, high-coupon corporate bond
D) A high mortgage interest rate GNMA certificate selling at a premium, with a high prepayment experience
Explanation
C) Emily already owns higher-risk stocks and needs some additional income. As a retiree, she should not be invested in the higher-risk bonds in the other possible options.
A high mortgage interest rate GNMA certificate selling at a premium, with a high prepayment experience is not a good choice because monthly cash flows are highly unpredictable, and principal is being returned at a high rate.
A “Z” tranche CMO is not a good choice because it is similar to a zero-coupon bond.
A 20-year, 8%, A rated income bond is not appropriate because it is an income bond that will only pay interest when and if earned, so it is not a dependable source of income.
LO 2.3.2
The coupon rate or nominal yield of a bond is the stated annual interest rate that will be paid each period for the term of the bond. Select the statement that best describes how the coupon rate is stated.
A) As a percentage of the par value of the bond
B) As a percentage of the discount rate of the bond
C) As a percentage of the annuitized value of the bond
D) As a percentage of the intrinsic value of the bond
Explanation
A) The coupon rate is stated as a percentage of the par value.
LO 2.1.1
Identify which of these statements regarding revenue bonds is NOT correct.
I. They are secured by a specific pledge or property.
II. They are a type of full faith and credit bond.
III. Their interest is tax-exempt at the federal level.
IV. They are analyzed by the project’s ability to generate earnings.
A) I and III
B) I and II
C) II and IV
D) III and IV
Explanation
The answer is I and II.
Revenue bonds are not secured by property and are not a type of general obligation bond. They are only secured by user fees.
LO 2.1.1
Darla, a U.S. citizen and resident of Georgia, owns a 5% coupon corporate bond, a 4% coupon State of Georgia municipal bond, and a 3% coupon U.S. Treasury note. Darla’s marginal state income tax rate is 6% and federal tax rate is 24%. If Darla invested equal amounts in each of the three bonds, what is her after-tax rate of return on the portfolio?
A) 4.00%
B) 4.91%
C) 2.86%
D) 3.26%
Explanation
D) The answer is 3.26%.
Because the corporate bond is taxable by the state and the federal government, its after-tax return is 3.5% [5% × (1 – 0.30)].
The State of Georgia municipal is not taxable by either government entity.
The Treasury note is taxable by the federal government; therefore, its after-tax return is 2.28% [3% × (1 – 0.24)].
Averaging the three rates equals 3.26% [(3.5% + 4% + 2.28%) ÷ 3].
LO 2.1.1
Identify which of these statements regarding Treasury Inflation-Protected Securities (TIPS) is CORRECT.
A) The TIPS coupon rate is adjusted every 12 months based on changes in the Consumer Price Index (CPI).
B) A semiannual inflation rate is combined with the stated coupon rate to determine the TIPS interest rate for the next six months.
C) TIPS are issued at 50% of the par value with the par value being adjusted every six months for inflation.
D) The principal value is adjusted for inflation every six months based on the Consumer Price Index (CPI), and one-half of the stated coupon rate is paid semiannually on the inflation-adjusted principal value.
Explanation
D) The answer is the principal value is adjusted for inflation every six months based on the CPI, and one-half of the stated coupon rate is paid semiannually on the inflation-adjusted principal value. TIPS coupon rate stays the same for the life of the security, but the interest payment changes based on the inflation-adjusted principal or par value.
LO 2.1.1
Question #4 of 30
Question ID: 1239957
The state of Louisiana has a new municipal five-year bond issue offering a 4% coupon rate. Which of these is the greatest tax benefit investors would receive from purchasing this bond?
A) Georgia resident, 6% state income tax bracket, 24% federal income tax bracket
B) Florida resident, 0% state income tax bracket, 37% federal income tax bracket
C) Louisiana resident, 6% state income tax bracket, 35% federal income tax bracket
D) Mississippi resident, 6% state income tax bracket, 12% federal income tax bracket
Explanation
C) The answer is Louisiana resident, 6% state income tax bracket, 35% federal income tax bracket. The municipal bond interest is generally exempt from federal income tax, but is subject to both state and local taxes unless the bond is purchased by a resident of the issuing state. While the Florida resident is taxed at the highest federal tax rate and pays no state income tax, the overall tax savings is greatest for the Louisiana resident whose combined state and federal tax bracket is 41%.
LO 2.1.1
Sam holds a considerable amount of both Series EE and Series HH savings bonds. He is nearing retirement and likes the fact that his Series HH bonds pay interest semiannually and would like to exchange most of his Series EE bonds for Series HH bonds to increase his cash flow. Choose which of these statements regarding such an exchange is CORRECT.
A) Series EE bonds may no longer be exchanged for Series HH bonds.
B) Sam may exchange the bonds but will be subject to a three-month interest penalty.
C) Only Sam’s Series EE bonds issued prior to 2004 may be exchanged.
D) Sam may exchange the bonds but must recognize the Series EE accrued interest at the time of exchange.
Explanation
A) The answer is Series EE bonds may no longer be exchanged for Series HH bonds. Until September 2004 (when Series HH bonds were no longer issued by the Treasury), the exchange of EE bonds for HH bonds was a popular way of continuing the income tax deferral on the accrued interest portion of the EE bonds. Such changes are no longer possible.
LO 2.1.1
Select which of these statements regarding Treasury notes and Treasury bonds is CORRECT.
I. Both Treasury notes’ and bonds’ interest payments are income tax free at the state and federal level.
II. Treasury notes and bonds are considered default risk free.
III. If held for more than one year, interest paid on Treasury bonds is eligible for long-term capital gain treatment.
IV. Both Treasury notes and bonds are not traded in the secondary market.
A) II only
B) III and IV
C) I, III, and IV
D) I and II
Explanation
A) The answer is II only. Both Treasury notes and bonds are considered default risk free. Both obligations trade in the secondary market and pay interest, which is income tax free at both the state and local level, but taxed as ordinary income in the year earned at the federal level.
LO 2.1.1
Question #7 of 30
Question ID: 1239960
Identify the statement that best describes Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities).
A) A negotiable, short-term, unsecured promissory note issued by a regional government agency
B) A short-term draft drawn by a government agency on a major bank
C) A trust receipt issued by a U.S. government agency for shares of a domestic company purchased and held by a credit union
D) Zero-coupon bonds created by separating the semiannual coupon payments and the principal repayment portions of a U.S. Treasury note or bond
Explanation
D) The answer is zero-coupon bonds created by separating the semiannual coupon payments and the principal repayment portions of a U.S. Treasury note and bond. Although the securities underlying Treasury STRIPS are the U.S. government’s direct obligation, major banks and dealers perform the actual separation and trading.
LO 2.1.1
Select which of these is NOT a primary risk associated with a coupon-paying bond.
A) Purchasing power risk
B) Debenture risk
C) Interest rate risk
D) Default risk
Explanation
The answer is debenture risk. A coupon-paying bond is also subject to reinvestment rate risk.
LO 2.1.1
Tom owns a taxable investment that earns 8% interest annually. Tom pays taxes at a marginal rate of 24%. Calculate the after-tax rate of return that Tom will receive on this investment.
A) 6.30%
B) 6.08%
C) 2.24%
D) 6.25%
Explanation
The answer is 6.08%. The after-tax return is 8% × (1 − 0.24) = 6.08%.
LO 2.1.1
An investor would consider converting a convertible bond into common stock if the bond’s
A) yield to call is the same as a comparable municipal bond.
B) market price is less than the conversion value.
C) duration exceeds 10 years.
D) yield to maturity is less than its conversion premium.
Explanation
B) The answer is market price is less than the conversion value. An investor would consider converting a convertible bond into common stock if the bond’s conversion value exceeds its market price.
LO 2.2.1
Ellen Hyson purchased a BB rated convertible bond of TCD Corporation that has a 10% coupon and matures in nine years. Comparable debt (BB rated, nine years to maturity) yields 12%. The bonds are convertible at $32 per share of common stock, and the current market price of TCD common stock is $25.
What is the conversion value of this bond?
A) $916.25
B) $800.00
C) $893.50
D) $781.25
Explanation
D) The answer is $781.25. The conversion value = conversion ratio × market price of common stock. Therefore, the conversion value equals ($1,000 ÷ $32) × $25 = $781.25.
LO 2.2.1
Chuck Johnson owns a convertible bond that has a conversion price of $40 per share and a coupon of 5.5%. Interest is paid semiannually. The current market price of the stock is $41 per share. The investment value of the bond is $940, and the bond currently sells for a market price of $1,120. What is the downside risk of this bond?
A) $120
B) $180
C) $95
D) $85
Explanation
The answer is $180. The downside risk of a convertible bond is the dollar or percentage decline from the current market price of the convertible bond to the investment value of the bond: $1,120 - $940 = $180.
LO 2.2.1
George Jones owns a convertible bond that has a conversion price of $50 per share and an annual coupon rate of 6.0%. Interest is paid semiannually. The current market price of the stock is $51 per share. The investment value of the bond is $890, and the bond currently sells for a market price of $1,080.
What is the downside risk of this bond?
A) $210
B) $155
C) $130
D) $190
Explanation
The answer is $190. The downside risk of a convertible bond is the dollar or percentage decline from the current market price of the convertible bond to the investment value of the bond: $1,080 - $890 = $190.
LO 2.2.1
All of these are advantages of convertible bonds except
A) they offer a yield that is less than the yield on straight bonds with similar risk and maturities.
B) they lack the downside risk protection for investors.
C) they are normally not converted.
D) because they are not callable, convertible bonds must be held until maturity.
Explanation
A) The answer is they offer a yield that is less than the yield on straight bonds with similar risk and maturities.
Convertible bonds can be converted into a specified number of common shares at the option of the investor. Because of this option, they are sold at a premium over the price of comparable nonconvertible bonds. In other words, they offer a yield that is less than the yield on straight bonds with similar risk and maturities. When stocks sell for a price that is above the conversion price, convertible bonds sell for their stock values. However, convertible bonds have downside risk protection because they have the advantage of bonds. Most convertible bonds are converted. Also, most are callable, and companies often call their bonds to force conversion.
LO 2.2.1
An investor wants all of her bonds to mature in 10 years. She buys two bonds immediately, two bonds two years from now, and two more bonds four years from now. As a result, the bonds purchased immediately have a maturity of 10 years, the bonds purchased two years later have a maturity of eight years, and the bonds purchased four years later have a maturity of six years. Select the type of bond strategy she is using for her portfolio.
A) Bond barbell
B) Bond bullet
C) Bond swap
D) Bond ladder
Explanation
B) The answer is bond bullet. When using the bond bullet strategy, an investor purchases a series of bonds with similar maturities focused on one point in time. This strategy may be an effective method in matching duration to the cash needs of an investor.
LO 2.3.1
Question #16 of 30
Question ID: 1239996
Identify the statement that is NOT correct regarding bond ladders.
A) A laddered portfolio consists of a combination of long-term and short-term bonds.
B) Shorter maturity bonds in a laddered portfolio are more subject to price fluctuations than the longer maturity bonds.
C) A laddered portfolio will provide higher yields than a portfolio consisting entirely of short-term bonds.
D) When a bond matures, the investor can purchase another bond with a maturity that will maintain the original structure of the bond portfolio.
Explanation
B) The answer is shorter maturity bonds in a laddered portfolio are more subject to price fluctuations than the longer maturity bonds. The shorter maturity bonds in a laddered portfolio are less subject to price fluctuations than the longer maturity bonds because of their shorter duration.
LO 2.3.1
A transaction whereby an investor sells a bond for a loss, in order to reduce capital gains, while investing the proceeds of the sale in a bond of similar quality and maturity is considered
A) a tax swap.
B) a pure yield pickup swap.
C) a substitution swap.
D) an intermarket spread swap.
Explanation
The answer is a tax swap. A tax swap results in a tax savings generated by the realized loss.
LO 2.3.1
Which of these statements regarding the bond ladder strategy is CORRECT?
A) The bond ladder strategy is used to immunize a portfolio against interest rate risk.
B) The bond ladder strategy involves the purchase of a mixture of very long-term and very short-term bonds.
C) The bond ladder strategy is generally more aggressive than the barbell strategy.
D) A laddered portfolio will provide lower yields than a portfolio consisting entirely of short-term bonds.
Explanation
A) The answer is the bond ladder strategy is used to immunize a portfolio against interest rate risk. It is an investment strategy in which equal amounts of money are invested in a series of bonds with staggered maturities. The barbell strategy involves the purchase of a mixture of very long-term and very short-term bonds. The laddered portfolio will provide higher yields than a portfolio consisting entirely of short-term bonds. The barbell strategy is generally more aggressive than the ladder strategy because the barbell strategy only utilizes short-term and long-term bonds.
LO 2.3.1
If a bond is immunized against interest rate risk, a dollar decline in the bond’s price, resulting from rising interest rates, will be approximately offset by a dollar increase in the
A) income from coupons reinvested over the investment horizon.
B) price of comparable bonds in the market.
C) bond’s call price.
D) bond issuer’s common stock.
Explanation
A) The answer is income from coupons reinvested over the investment horizon. By investing in bonds that have a duration equal to the investor’s investment time horizon, any bond price/value changes caused by interest rate fluctuations will be approximately offset by changes in the interest earned on the reinvested coupons.
LO 2.3.1
Which of the following statements is CORRECT?
I. If an investor expects a decline in market interest rates, she should attempt to construct a portfolio of long maturity bonds with low coupon rates.
II. If the investor expects an increase in market interest rates, he should attempt to construct a portfolio of short maturity bonds with high coupon rates.
A) II only
B) Neither I nor II
C) Both I and II
D) I only
Explanation
The answer is both I and II.
The portfolio in Statement I will provide the investor with a portfolio that has the maximum interest rate sensitivity to take advantage of the capital gains experienced by bonds from the decrease in market interest rates.
The portfolio in Statement II will provide the investor with a portfolio that has the minimum interest rate sensitivity to minimize the capital losses experienced by bonds from the increase in market interest rates.
LO 2.3.2
Which one of these is CORRECT regarding preferred stock?
A) Preferred stock’s dividends are tax deductible for corporations.
B) Preferred stockholders have voting rights.
C) Preferred stock’s value is based on prevailing interest rates.
D) Failure to pay preferred stock dividends results in bankruptcy.
Explanation
C) The answer is preferred stock’s value is based on prevailing interest rates. The value for a preferred stock is its dividend divided by prevailing interest rates.
LO 2.5.1
An individual with a short-term investment time horizon would choose what type of bonds when interest rates are expected to rise?
A) High-yield bonds
B) Low-coupon, long-term bonds
C) Short-term bonds
D) Long-term bonds
Explanation
C) The answer is short-term bonds.
Long-term bonds are affected by interest rate changes more than short-term bonds. If interest rates are expected to rise, an investor should invest in short-term bonds until rates peak. Risk of default of high-yield bonds increases when rates rise.
LO 2.3.2
If an investor is looking to purchase bonds that are free from default risk, which of these should be purchased?
A) Municipal bonds
B) Revenue bonds
C) Corporate bonds
D) Government bonds
Explanation
The answer is government bonds. Unlike corporate, revenue, and municipal bonds, government bonds are free from default risk.
LO 2.3.2
Assume that the yield curve currently is shaped as shown in YC2 (INVERTED) and that you anticipate it will be shaped as shown in YC1 (NORMAL) one year from now.
Assuming that you want to maximize the opportunity for capital appreciation, which one of these investment strategies would you recommend for clients, based on the current and anticipated shapes of the yield curves?
A) Sell short-term bonds and buy long-term bonds
B) Sell long-term bonds and buy short-term bonds
C) Sell long-term bonds and buy intermediate-term bonds
D) Sell intermediate-term bonds and buy short-term bonds
Explanation
A) The answer is sell short-term bonds and buy long-term bonds. If interest rates are expected to fall soon, an investor should sell short-term bonds and buy long-term bonds to lock in the current higher interest rates offered by the long-term bonds.
LO 2.4.1
Choose the CORRECT statement regarding yield curve theories.
A) The liquidity preference theory holds that investors will pay a premium for shorter maturity bonds to avoid the higher interest rate risk associated with long-term bonds.
B) Unbiased expectations theory states that long-term rates consist of many short-term rates and that long-term rates will be the average of short-term rates.
C) The market segmentation theory relies on the laws of supply and demand for various maturities of borrowing and lending.
D) All of these statements are correct.
Explanation
The answer is all of these statements are correct. The term structure of interest rates theory has several iterations. Although unbiased expectations theory and market segmentation theory may be used to explain any shaped yield curve, the liquidity preference theory only explains a normal, upward-sloping yield curve.
LO 2.3.2
All of these statements correctly describe yield curves except
A) a flat yield curve occurs when the economy is peaking and, therefore, no change in future interest rates is expected.
B) a normal yield curve occurs during periods of economic expansion and generally predicts that market interest rates will rise in the future.
C) an inverted yield curve occurs when the Federal Reserve has tightened credit in an overheating economy.
D) a positive yield curve can signal an upcoming economic recession.
Explanation
The answer is a positive yield curve can signal an upcoming economic recession. A positive (or normal) yield curve occurs during periods of economic expansion and generally predicts that market interest rates will rise.
LO 2.4.1
According to the unbiased expectations theory of interest rates,
A) an upward sloping yield curve indicates that investors require a yield premium to invest in long-term securities.
B) investors require a higher yield on long-term bonds because they are riskier.
C) yields are a function of the supply and demand of funds in each maturity segment of the market.
D) the current long-term rate is the average of today’s short-term rate and expected future short-term rates.
Explanation
The answer is the current long-term rate is the average of today’s short-term rate and expected future short-term rates. The other statements relate to the liquidity premium theory and the market segmentation theory. Under the unbiased expectations theory, an upward sloping yield curve indicates increasing inflation expectations.
LO 2.4.1
The yield curve theory that states current long-term interest rates contain an implicit prediction of future short-term interest rates is known as
A) liquidity preference theory.
B) unbiased expectations theory.
C) market segmentation theory.
D) preferred habitat theory.
Explanation
B) The answer is unbiased expectations theory. The unbiased expectations theory states that long-term rates consist of many short-term rates and that long-term rates will be the average (or geometric mean) of short-term rates.
LO 2.5.1
Select the CORRECT statements concerning preferred stock.
I. Preferred stock is known as a hybrid security because it resembles both a fixed-income security and an equity instrument.
II. Preferred stock has a maturity date and pays interest similar to a bond.
III. A large portion of the preferred stock issued can be converted into corporate bonds.
IV. A company’s preferred stock may be cumulative where all unpaid dividends must be paid to the preferred shareholders before dividends can be paid to common shareholders.
A) I and II
B) I and IV
C) II, III, and IV
D) III and IV
Explanation
B) The answer is I and IV.
Preferred stock is considered a hybrid security. This type of stock has an infinite life span and pays dividends like an equity instrument. Similar to a debt security, the dividend amount is fixed and known in advance. Preferred stock may be cumulative.
LO 2.5.1
Which of these describe similarities between preferred stock and long-term bonds?
I. Both dividends and interest are tax-deductible expenses for the issuing corporations.
II. Both generally pay a fixed periodic payment.
III. Both preferred dividends and interest must be paid before common stock cash dividends are paid.
A) III only
B) I and III
C) II and III
D) I and II
Explanation
C) The answer is II and III.
Both preferred stock and long-term bonds generally pay a fixed periodic payment, and both preferred dividends and interest must be paid before common stock cash dividends are paid.
LO 2.5.1
Max bought 100 shares of PET Corporation stock 10 years ago. He paid $10 per share for the stock. The stock currently has a fair market value of $50 per share. Choose the CORRECT statement regarding Max’s stock.
A) If Max does not sell the stock this year, he will not have to pay taxes on the difference between the amount he paid for the stock and the current market price this year.
B) If Max sells the stock now, he must pay taxes on the full $5,000 he receives from the sale.
C) If Max sells the stock now, he must pay taxes on only half the amount he receives from the sale.
D) If Max does not sell the stock now, he must pay taxes on the difference between the amount he paid for the stock and the current market price, which will increase his basis in the stock.
Explanation
A) The answer is if Max does not sell the stock this year, he will not have to pay taxes on the difference between the amount he paid for the stock and the current market price this year.
If Max sells the stock today, he realizes the gain in the value of the stock and must pay taxes on the gain. The gain would equal the price at which Max sells the stock minus the original purchase price, or $40 per share. If the gain is not realized, Max has no tax liability for the increase in the value of the stock. Capital gains are only taxable when they are realized at the time of the sale.
LO 3.1.1
Identify the CORRECT statements regarding warrants.
I. Warrants give the owner the right to purchase a specified number of shares for a specified period at a specified price.
II. Warrants are typically written with a maturity date of nine months.
III. Warrants must include standardized terms required by the Options Clearing Corporation.
IV. Warrants are issued by a corporation rather than written by an individual.
A) I, II, III, and IV
B) I and II
C) III and IV
D) I and IV
Explanation
The answer is I and IV.
Warrants typically have a maturity date of several years, not months, and are customized to fit the needs of the issuing corporation.
LO 3.1.1
Select the investment that gives the shareholder a short-term opportunity to buy new shares of the new stock issue, thereby maintaining the shareholder’s respective overall percentage ownership in the corporation.
A) Warrants
B) Preferred stock
C) Call options
D) Rights
Explanation
The answer is rights.
Rights are a purchase option for stock that allows a shareholder the opportunity to buy shares of the new stock issue, thereby maintaining the overall percentage ownership in the corporation.
LO 3.1.1
Which of these is a correct justification for use of an investment in a client’s portfolio?
I. Blue chip common stocks because they provide a hedge against inflation
II. FNMA (Federal National Mortgage Association) securities because they are backed by the full faith and credit of the U.S. government
III. Aggressive growth stocks because they perform better during economic contractions
A) I and II
B) I only
C) II and III
D) I and III
Explanation
B) The answer is I only.
Stocks generally are considered an inflation hedge; in periods of hyper-inflation, this may not be true, but the question does not ask about periods of hyper-inflation. FNMA securities are not backed by the full faith of the government (the government did step in as a result of the credit crisis of 2008, but there has not been a commitment to permanently back FNMAs in the same way that GNMAs (Government National Mortgage Association) have historically been backed).
LO 3.1.1
Select the CORRECT statements regarding stock splits.
I. Following a stock split, an investor owns an increased percentage of the company.
II. Because of the increased number of shares an investor owns following a stock split, the stock split is a taxable event to the investor.
III. A stock split results in a downward adjustment in a shareholder’s per share basis.
IV. A reverse stock split reduces the total shares outstanding and increases the price per share.
A) II and IV
B) I and III
C) III and IV
D) I, II, III, and IV
Explanation
The answer is III and IV.
A stock split is not a taxable event to the investor. Following a stock split, the investor owns the same percentage of the company as before, but each share now represents a correspondingly smaller percentage.
LO 3.2.1
Identify the CORRECT statements regarding a 2-for-1 stock split.
I. The total market value of the outstanding stock decreases.
II. The total number of shares outstanding doubles.
III. The share price is reduced by one-half.
IV. The shareholder will own a higher proportion of the company.
A) I and III
B) II, III, and IV
C) I and II
D) II and III
Explanation
D) The answer is II and III.
In a 2-for-1 stock split, the number of outstanding shares is doubles and the share price is reduced by one-half. The total market value of the company’s stock and the shareholder’s interest remains the same.
LO 3.2.1
John has just been informed that his XYZ stock will be incurring a 2-for-1 stock split. Calculate how many additional shares John will acquire if he already owns 200 shares of XYZ.
A) 50
B) 100
C) 200
D) 400
Explanation
C) The answer is 200.
John will acquire 200 additional shares and therefore, will own a total of 400 shares of XYZ stock. In a stock split, the par value of each share of stock is reduced, and the number of shares is increased proportionately.
LO 3.2.1
Which of these statements correctly explains dividend reinvestment programs (DRIPs)?
I. They allow stockholders to reinvest their dividends in additional shares of stock.
II. They provide for automatic investing.
III. They provide cost savings to firms and shareholders.
IV. Reinvested dividends are not currently taxable to the investor.
A) II and III
B) I and II
C) I, II, and III
D) I, II, III, and IV
Explanation
The answer is I, II, and III.
Only statement IV is incorrect. The IRS treats reinvested dividends the same as cash dividends for tax purposes.
LO 3.2.1
Which of these statements regarding cash dividends is CORRECT?
I. All cash dividends paid to shareholders are tax deductible by the corporation.
II. Most dividends declared by a corporate board of directors of a domestic corporation are considered qualifying dividends and are permitted preferential tax treatment.
A) II only
B) Neither I nor II
C) I only
D) Both I and II
Explanation
The answer is II only.
Cash dividends paid by a corporation to the shareholders are not tax deductible. Qualifying (or qualified) dividend income may be treated at favorable long-term capital gain rates (0%, 15%, or 20%) if it meets certain criteria.
LO 3.2.1
RNO Mutual Fund invests in domestic debt and equity securities. The fund’s current bond holdings are valued at $63 million, and its equity holdings are valued at $85 million. RNO currently has 3 million outstanding shares; although it is not limited in the number of shares it may sell. Which of these statements is CORRECT?
A) RNO is a closed-end investment company.
B) RNO shares are traded on the major exchanges.
C) RNO shares are priced at $49.33 per share.
D) RNO is a money market mutual fund.
Explanation
The answer is RNO shares are priced at $49.33 per share.
Because RNO invests in both bonds and equities, it is not a money market mutual fund. RNO’s shares are valued at NAV, calculated as follows: ($63 million + $85 million) ÷ 3 million shares = $49.33 per share.
Mutual fund shares are sold and redeemed directly by the mutual fund company and do not trade on the major exchanges. RNO is an example of an open-end investment company.
LO 3.3.1
Which of the following statements regarding an open-end investment company (mutual fund) is CORRECT?
I. After the initial public offering, an open-end fund will generally not issue additional shares.
II. An open-end investment company is the most popular form of investment asset for small or individual investors.
A) II only
B) Neither I nor II
C) I only
D) Both I and II
Explanation
A) The answer is II only.
Statement I is incorrect. An open-end investment company can raise an unlimited amount of capital by continuously issuing new shares. After the initial public offering, a closed-end fund will generally not issue additional shares.
LO 3.3.1
Grace’s portfolio is comprised of 40% U.S. corporate bond fund, 50% U.S. growth and income equity fund, and 10% municipal bond fund. Grace would like to reduce her portfolio’s level of risk and maintain or improve return. Which of these could be recommended to Grace to achieve her goal?
I. Global equity fund
II. Biotechnology sector equity fund
III. Louisiana municipal bond fund
IV. Emerging market fund
A) III only
B) II, III, and IV
C) I only
D)I and IV
Explanation
The answer is I and IV.
Adding foreign investments could reduce her portfolio’s level of risk and possibly improve return. Foreign investments have a low correlation with U.S. securities and thus provide diversification benefits. Additional investment in U.S. equities or bonds will not provide as much diversification as international investing.
LO 3.3.1
All of these statements correctly describe types of investment companies EXCEPT
A) a unit investment trust is a type of investment company whose units are sold in the secondary market but not on the major exchanges.
B) a closed-end investment company is a type of company whose shares trade in the same manner as publicly traded stocks in the secondary market.
C) an exchange-traded fund is an investment that can be bought and sold throughout the trading day.
D) an open-end investment company is categorized as open-end because it is limited in the number of shares that are sold.
Explanation
The answer is an open-end investment company is categorized as open-end because it is limited in the number of shares that are sold.
An open-end investment company is the most popular form of investment for the small or individual investor. The investment company is categorized as open-end because it is not limited in the number of shares sold.
LO 3.3.1
Louis owns an investment that is an unmanaged portfolio in which the money manager initially selects the securities to be included in the portfolio and then holds those securities until they mature or the investment portfolio terminates. This statement best describes which type of investment?
A) Closed-end investment company
B) Unit investment trust
C) Open-end investment company
D) Hedge fund
Explanation
The answer is unit investment trust. A unit investment trust (UIT) is an investment company whose units are sold in the secondary market and is generally unmanaged, or passively managed as the money manager initially selects the securities to be included in the portfolio and then holds those securities until they mature or the UIT terminates.
LO 3.3.1
Select the type of mutual fund that generally focuses its investment objective in a narrow area such as natural resources, technology, or health care.
A) Growth funds
B) Balanced funds
C) Income funds
D) Sector funds
Explanation
The answer is sector funds.
Sector funds tend to limit their investments to one sector of the economy, such as natural resources, technology, or health care.
LO 3.3.1
All of these statements correctly identifies a separately managed account except
A) one advantage of a separately managed account is the ability to maintain an individual cost basis in the securities held in the account.
B) a separately managed account holds a diversified portfolio of securities managed by a professional money manager.
C) in a separately managed account, the investor owns 100% of the securities in the account.
D) a separately managed account is a privately offered pool of capital for wealthy, sophisticated investors.
Explanation
D) The answer is a separately managed account is a privately offered pool of capital for wealthy, sophisticated investors.
In a separately managed account, the money manager purchases securities on behalf of the individual investor, not as a pool of capital for numerous investors.
LO 3.3.1
Daniel has several investment company products within his retirement portfolio. One of these investments trades on an exchange, may trade at a premium or discount to its net asset value, and has a fixed capital structure. These features illustrate which of these investments?
A) Hedge fund
B) Open-end investment company
C) Closed-end investment company
D) Unit investment trust
Explanation
The answer is closed-end investment company.
A closed-end investment company (closed-end fund) is a type of company whose shares trade in the secondary market.
LO 3.3.1
During the current year, Peter sold 300 mutual fund shares for $23 per share. He had purchased these shares over several years as follows: 75 shares in year one for $13 per share; 100 shares in year two for $15 per share; 100 shares in year three for $17 per share; and 90 shares in year four for $12 per share. Before the sale of the shares, Peter specified to his broker the particular shares to be sold, and he received written confirmation of his selection from the broker. In specifying the specific shares he wanted to sell, Peter selected the shares that would produce the smallest amount of taxable gain on the sale. Calculate the cost basis of the shares selected and the amount of realized gain on the sale.
A) $4,000 cost basis, $2,900 gain on sale
B) $4,475 cost basis, $2,425 gain on sale
C) $4,319 cost basis, $2,581 gain on sale
D) $4,410 cost basis, $2,490 gain on sale
Explanation
The answer is $4,475 cost basis, $2,425 gain on sale. The highest cost shares are as follows: (100 × $17) + (100 × $15) + (75 × $13) + (25 × $12) = $4,475. The gain is $2,425 ($6,900 − $4,475).
LO 3.3.1
Which of the following methods can be used in determining the basis in a mutual fund when the shares were acquired at different times?
I. Specific identification
II. First in, first out (FIFO)
III. Average cost method
A) I, II, and III
B) II and III
C) I and III
D) II only
Explanation
The answer is I, II, and III. All of these can be used to make this determination.
LO 3.3.1
Choose the statement that is NOT a characteristic of a closed-end investment company (closed-end fund).
A) A closed-end fund typically redeems its shares as a courtesy to all shareholders.
B) Like common stocks, shares trade in the secondary market.
C) Shares may sell at a discount or premium to net asset value.
D) The fund manager of a closed-end fund may invest in less liquid securities than a manager of an open-end fund.
Explanation
The answer is a closed-end fund typically redeems its shares as a courtesy to all shareholders.
Generally, a closed-end investment company does not redeem its own shares. Closed-end fund shares trade in the same manner as publicly traded stocks, either on a stock exchange or over the counter.
LO 3.3.1
Choose the CORRECT statements regarding exchange-traded funds (ETFs) and hedge funds.
I. ETFs typically have higher annual expenses than mutual funds.
II. Most ETFs permit tax-free, in-kind redemptions.
III. ETFs can be either passively or actively managed.
IV. Hedge funds typically use margin and short-selling strategies.
A)I and IV
B) I, II, III, and IV
C) II, III, and IV
D) II and III
Explanation
The answer is II, III, and IV.
Because they mimic indexes, ETFs typically have lower annual expenses than mutual funds. Most ETFs permit in-kind redemptions, and such transactions are income tax free. Hedge funds rely heavily on borrowing strategies in an attempt to accomplish superior returns.
LO 3.4.1
Select the CORRECT statement regarding hedge funds.
A) Short sales by the fund are not allowed.
B) The fund is required to register with FINRA prior to soliciting potential clients.
C) Purchasers of hedge funds are required to be accredited investors.
D) Hedge fund managers are paid on a commission basis.
Explanation
The answer is purchasers of hedge funds are required to be accredited investors.
A hedge fund is an unregistered, privately offered, managed pool of capital for wealthy investors. In addition to short selling, a hedge fund will implement a wide array of risky trading strategies in order to exploit market inefficiencies. Hedge fund managers are paid based on fund performance.
LO 3.4.1
Identify those risks that pertain to hedge funds.
Overuse of leverage
Excessive short selling
Lack of transparency
Lack of regulation
A) II, III, and IV
B) I and IV
C) I, II, III, and IV
D) II and III
Explanation
The answer is I, II, III, and IV.
A hedge fund is subject to all these risks. In addition, hedge funds are usually subject to higher investment risk than other types of funds.
LO 3.4.1
Select the entity that issues guaranteed investment contracts (GICs).
A) Insurance companies
B) Credit unions
C) Commercial banks
D) Open-end investment companies
Explanation
The answer is insurance companies. GICs are issued by insurance companies. They are called guaranteed investment contracts because their rate of return is guaranteed by the insurance company for a fixed period. They are not guaranteed by the FDIC.
LO 3.4.1
An investor should choose index funds if he or she believes in
A) fundamental analysis.
B) specialized investing.
C) a passive investment strategy.
D) technical analysis.
Explanation
The answer is a passive investment strategy.
Index funds are used in a passive investment strategy. The purpose of an indexed portfolio is not to beat the targeted index (e.g., S&P 500 Index) but merely to match its long-term performance, less any management fees and administrative costs.
LO 3.4.1
Which of these statements correctly explains dollar cost averaging as a portfolio management technique?
I. This technique involves investing a specific amount into an investment vehicle, regardless of whether the recent trend in the investment has been up or down.
II. If prices decline, the fixed investment amount will purchase a greater quantity of the security.
III. For the long-term investor, the presumption is that prices will eventually rise, so a lower average price translates into greater profits.
IV. If prices rise, the fixed investment amount will purchase a greater amount of the security.
A) I, III, and IV
B) II and III
C) I and II
D) I, II, and III
Explanation
The answer is I, II, and III. Only statement IV is incorrect. If prices rise, the fixed investment amount will purchase a lower amount of the security. The effect of dollar cost averaging is to increase the number of shares gradually over a long period. Because more shares are acquired when the price of the stock or mutual fund declines, the average cost per share is reduced.
LO 3.5.1
To be on a corporation’s books as holder-of-record (and thus have a right to the next dividend payment), the investor must purchase stock
A) two business days before the record date.
B) before the declaration date.
C) three days before the payment date.
D) between the ex-dividend date and the record date.
Explanation
The answer is two business days before the record date.
Under the T+2 rules in effect, ex-dividend date is one day business prior to the record date. A trade made on the ex-dividend date will clear in two business days, one day after the record date. The investor will not be on the corporation’s record book as a shareholder unless the purchase is made at least two days before the record date.
LO 3.5.1
Under which of these circumstances will dollar cost averaging result in an average cost per share lower than the average price per share?
I. The price of the stock fluctuates over time.
II. A fixed number of shares is purchased regularly.
III. A fixed dollar amount is invested regularly.
IV. A constant dollar plan is maintained.
A) I, III and IV
B) I and III
C) II and III
D) I and II
Explanation
The answer is I and III.
Dollar cost averaging benefits the investor if the same amount is invested on a regular basis over a substantial period, during which the price of the stock fluctuates. A constant dollar plan is one in which the investor maintains a constant dollar value of securities in the investment portfolio.
LO 3.5.1
You are about to choose a new mutual fund to add to client portfolios. As you review the Morningstar reports for the funds you are considering, you have focused on each fund’s alpha as reported by Morningstar. Alpha tells you
A) a fund’s percentage return above the risk-free rate of return.
B) each fund’s performance relative to the S&P 500.
C) the difference between a fund’s realized return and its risk-adjusted expected return.
D) by what percentage a fund’s capital appreciation exceeded the capital appreciation of the average fund in its asset class.
Explanation
C) The answer is the difference between a fund’s realized return and its risk-adjusted expected return.
Alpha does not compare directly to the S&P 500, but rather to the fund’s expected return, which is risk-adjusted for the fund’s beta. The total return, not just the capital appreciation component, is used in the Jensen formula. The risk-adjusted required return is the risk-free rate plus the risk premium multiplied by the fund’s beta.
LO 3.6.1
Question #30 of 30
Question ID: 1240128
Two mutual funds have these performance statistics:
Fund E. Fund F
Three-year total return
16.5% 17.2%
Standard deviation
18.1 16.4
R-squared
81%. 87%
Sharpe ratio
.58 .68
Alpha
1.1 1.6
Which one of the two funds has the better risk-adjusted performance, and why?
A)Fund E, because its Sharpe ratio is lower.
B)Fund F, because its R-squared is higher.
C)Fund E, because its coefficient of variation is lower.
D)Fund F, because its alpha is higher.
Explanation
The answer is Fund F, because its alpha is higher.
In this case, the investor should choose the fund with the higher alpha. With an alpha of 1.6, Fund F exhibits the best risk-adjusted performance.
LO 3.6.1
All of the following are considered risks inherent with equity investments except
A) investment rate risk.
B) reinvestment rate risk.
C) market risk.
D) financial risk.
Explanation
Interest rate risk, market risk, business risk, and financial risk are all risks that impact equity investments. Reinvestment rate risk is a primary consideration for fixed-income investments.
LO 3.1.1
Gordon, age 40, wants to invest in a mutual fund that will provide capital appreciation. He wants a fund that will do as well as the overall market and has a low expense ratio, but he does not want to assume a high risk to achieve his objective. He is considering purchasing one of the following mutual funds:
Fund A: a growth mutual fund that has a beta of 1.10 and invests in medium- to high-grade common stock
Fund B: an index mutual fund that has a beta of 1.00 and invests in common stock that mirrors the S&P 500 Index
Which of these funds would best meet Gordon’s objective?
A) Fund A, because it can be expected to outperform the market and has an acceptable level of risk
B) neither alternative is appropriate for his objective
C) Fund A, because it invests in lower-risk stocks than Fund B
D) Fund B, because it has a beta of 1.00, has low expenses, and is less risky
Explanation
D) Fund B can be expected to do as well as the overall market, will have a low expense ratio, and is less risk, as measured by beta, than Fund A.
LO 3.6.1
Which of the following statements is CORRECT regarding exchange-traded funds (ETFs)?
A) They trade right at net asset value due to arbitrage transactions.
B) They are permitted to sample an index.
C) They can be exchanged for other ETFs in the same family.
D) They are usually tax-inefficient.
Explanation
B) Rather than buy every security in an index, some ETFs only sample the index, called representative sampling, especially when the index contains a very large number of issues.
LO 3.4.1
Which of the following are advantages of dividend reinvestment plans?
I. The investor avoids having to account for the cost basis of shares.
II. Discounts are available on stocks bought with dividends.
III. They are a convenient and low-cost way of accumulating shares of stock.
IV. Reinvested dividends are tax-deferred income.
A) I and II
B) I, II, and III
C) III and IV
D) II and III
Explanation
D) Option IV is an incorrect statement because dividends are not tax deferred.
They are taxable (potentially at preferential rates) as income at the time they are received. Option I is incorrect because cost basis is needed to compute taxable income when the shares are sold in the future.
LO 3.2.1
Which of the following statements are NOT correct regarding Barbara’s participation in the dividend reinvestment plan with First Mutual Growth Fund?
I. The amount of dividend reinvestment adds to Barbara’s tax basis in the fund.
II. Because they are directly reinvested in the fund, the reinvested dividends are not subject to current taxation.
III. Typically, additional shares purchased through dividend reinvestment plans do not incur a brokerage commission.
IV. The term dividend reinvestment refers to the strategy of receiving dividends in cash from one investment and reinvesting them in a different investment offering higher returns.
A) II and IV
B) I and II
C) III and IV
D) I and III
Explanation
A) Statements II and IV are incorrect.
Reinvested dividends are treated the same as dividends received in cash for tax purposes. The term dividend reinvestment refers to dividends that are reinvested directly into the investment from which they were initially earned.
LO 3.2.1
A middle-aged husband and wife have their portfolio currently invested in a diversified mix that includes long- and short-term bonds, savings account, certificates of deposit (CDs), and growth and value stock funds. They are not pleased with their stock investments, which seem to only be matching the market’s poor performance. Which of the following types of stock funds are they most likely invested in?
A) Index fund
B) Technology fund
C) Balanced fund
D) Bond fund
Explanation
A) An index fund would match the market’s performance. In a poor market, the technology fund would have even greater losses and the balanced fund should do better because of the bond mix.
LO 3.6.1
Which of the following is a type of growth mutual fund?
A) GNMA fund
B) Money market fund
C) Asset allocation fund
D) U.S. government fund
Explanation
An asset allocation fund is a type of growth fund. The other options are all considered income funds.
LO 3.3.1
A fund that invests in both U.S. stocks and international stocks is called
A) an asset allocation fund.
B) an international fund.
C) a balanced fund.
D) a global fund.
Explanation
A global fund invests in U.S. stocks and in international stocks.
Which of the following best represents a characteristic of balanced mutual funds?
A) They combine domestic and international securities.
B) They combine high- and low-risk stock.
C) They combine income and growth stock.
D) They combine debt and equity securities.
Explanation
D) Balanced funds can be securities that produce both income (dividends and interest) and capital gains. Income securities can be high-dividend paying stocks or bonds. Capital gains securities generally are stocks. Most balanced funds contain some combination of both stocks and bonds (often 60% stocks and 40% bonds).
LO 3.3.1
Which of the following statements concerning dollar cost averaging as a portfolio management technique are CORRECT?
I. This technique involves investing a specific amount into an investment vehicle, regardless of whether the recent trend in the investment has been up or down.
II. If prices decline, the fixed investment amount will purchase a greater quantity of the security.
III. For the long-term investor, the presumption is that prices will eventually rise, so a lower average price translates into greater profits.
IV. If prices rise, the fixed investment amount will purchase a greater amount of the security.
A) I, II, and III
B) II and III
C) I and II
D) I, III, and IV
Explanation
A) Only statement IV is incorrect. If prices rise, the fixed investment amount will purchase a lower amount of the security.
LO 3.5.1
Which of the following are characteristics of exchange-traded funds (ETFs)?
I. They may not be sold short.
II. They are generally tax-efficient.
III. Large investors known as authorized participants buy or sell shares on an “in-kind” basis.
IV. They usually trade at or near their net asset value.
A) II, III, and IV
B) I, II, and III
C) II and IV
D) I and III
LO 3.4.1
Explanation
A) ETFs trade like stock and can be sold short. They are tax-efficient, generally low cost, and large investors conduct trades by making in-kind exchanges, whereby they give or receive shares of stock that are in the fund. Generally ETFs trade near net asset value (NAV), if not at NAV.
An investor using a dollar cost averaging approach to buying a mutual fund will buy
A) the same number of shares regardless of which direction the NAV takes.
B) more shares when the NAV of the fund rises since the last purchase.
C) more shares when the NAV of the fund falls since the last purchase.
D) fewer shares when the NAV of the fund rises since the last purchase.
Explanation
C) The investor will purchase more shares when the NAV falls because the dollar amount invested remains the same.
LO 3.5.1
Chelsea purchases a warrant for $2 per share that gives her the right to buy 80 shares of XYZ stock at $20 per share for a period of five years from date of purchase. Assume XYZ stock goes up to $25 per share after three years and Chelsea exercises the warrant. What profit does she make on the 80 shares?
A) $210
B) $150
C) $180
D) $240
Explanation
D) profit = (gain on stock – cost of warrant) × number of shares; ($5/share – $2/share) × 80 shares = $240
LO 3.1.1
A client wants to buy a mutual fund that offers above-average dividend income, lower volatility than the average stock fund, and has some capital appreciation potential. Which of the following is the best recommendation under these criteria?
A) Asset allocation fund
B) Stock index fund
C) Small company fund
D) Equity income fund
Explanation
D) An equity income fund would fit these criteria by owning stocks of companies paying above-average dividends.
A stock index fund is too general a description in that it could own small company stocks that pay little, if any, dividends, and are more volatile than large company stocks. An asset allocation fund would own stocks, bonds, cash equivalents, precious metal stocks, and even currencies, so income would not necessarily be above-average.
LO 3.3.1
Which of the following is a general characteristic of hedge funds?
A) Little or no use of leverage
B) Full transparency and disclosure
C) Charge both a management fee and a carried interest fee
D) High marketability
Explanation
C) Hedge funds have few public disclosure requirements, may lack marketability, and use leverage.
LO 3.4.1
Holly and Jeff are a married couple who have recently retired and are no longer earning an income. They would like to change their asset allocation to provide more income in their retirement years. Which of the following investments should be recommended to help the couple in achieving their financial objectives?
I. Aggressive growth mutual fund
II. AA rated corporate bonds
III. Zero-coupon bonds
IV. Equity income mutual fund
A) I, II, and IV
B) II, III, and IV
C) II and IV
D) I and III
Explanation
Investments II and IV are the only two that will provide current income for the couple.
LO 3.6.1
A couple has noted they are aggressive risk-takers and want to allocate $10,000 from their savings account into investments. Currently, their portfolio is comprised of money market mutual funds and blue-chip stocks. Which of the following stocks would be the best addition for this couple to achieve their risk-taking attitude?
A) Semiconductor stock
B) Waste management stock
C) Domestic airline stock
D) Big box store stock
Explanation
A) The best choice for this couple would be a semiconductor stock; as a competitive and high-growth sector, semiconductors should add the appropriate degree of risk and return for this couple’s conservative portfolio. A big box store stock would be considered defensive, a waste management stock would be an income stock, and a domestic airline stock would be considered a cyclical stock.
LO 3.1.1
Long-term bond funds have
A) minimal purchasing power risk.
B) more interest rate risk than short-term bonds.
C) no interest rate risk.
D) no reinvestment rate risk.
Explanation
Long-term bonds have greater purchasing power risk than short-term bonds.
LO 3.3.1
A stock has a current market price of $48, expected earnings of $2.40, and an annual dividend of $.72. The stock historically has had a price-to-earnings (P/E) ratio range of 22 to 35. Which of the following are CORRECT statements about the stock’s P/E ratio, valuation, and possible future action?
I. P/E = 20
II. P/E = 67
III. Stock is overvalued, downward pressure expected
IV. Stock is undervalued, upward pressure expected
A) I and III
B) I and IV
C) II and III
D) II and IV
Explanation
B) The P/E ratio is 20, calculated as follows:
$48 ÷ $2.40 = 20.
When a stock exhibits a P/E ratio below the historical range, this could indicate the stock is undervalued in the market.
LO 4.3.2
Interest rate changes have the greatest effect on
A) long-term bonds.
B) staggered maturity bonds.
C) short-term bonds.
D) medium-term bonds.
Explanation
A) The rule-of-thumb approach to measuring the estimated price change of a bond is to multiply the bond’s duration by the estimated change in interest rates (for small rate changes—less than 1% or 100 basis points—only). Therefore, longer-term bonds have the greatest duration and the most price volatility.
LO 4.1.1
Which of the following are factors used in industry analysis for investment purposes?
I. Financial leverage
II. Government rules and regulations
III. Labor conditions
IV. Technological advances
A) I and II
B) II, III, and IV
C) I, II, and IV
D) III and IV
LO 4.2.1
Explanation
B) Option I is not a factor used for industry analysis, but rather for company analysis.
Company A and Company B are in the same industry and have approximately the same dollar amount of assets and operating income. Company A has a return on equity (ROE) of 28% and Company B has an ROE of 12%. Which of the following statements best identifies the major difference causing the disparity in ROE between Company A and Company B?
A) Company B has an extraordinary loss.
B) Company A has lower selling, general, and administrative (S, G, & A) expenses.
C) Company B has a higher level of depreciation expense than Company A.
D) Company A has more debt than Company B.
Explanation
D) Both depreciation expense and S, G & A expenses are used to obtain operating income, which is the same for both companies. Generally, the most significant factor in raising one company’s ROE above another company’s is the greater use of debt. The company having the greater percentage of debt, assuming the cost of the debt is less than the return earned from the debt proceeds, will have the highest ROE.
LO 4.2.2
Which one of the following statements CORRECTLY matches a technical indicator to the information it provides in signaling a change from a bear to a bull market?
A) Barron’s Confidence Index indicates that the yield differential between low-quality bonds and high-quality bonds is decreasing.
B) Odd lot purchases exceed sales.
C) A moving average chart indicates that actual prices have dropped through the average.
D) Most financial advisors become bullish.
Explanation
A) In a bull market, there is less fear so there is a lower spread between high-quality and lower-quality bonds.
LO 4.2.1
Al and Stacy have a long-term goal to retire in 20 years and have $1,000 per month that they would like to invest. They are currently in the top tax bracket but expect to be in a lower tax bracket at retirement. They have a moderate- to high-risk tolerance. Which of the following asset allocation strategies should be recommended to Al and Stacy?
A) Portfolio 3—$200 Balanced Fund, $200 S&P Index Fund, $300 Growth Fund, $300 Traditional IRA (U.S. Government Bond Fund)
B) Portfolio 2—$500 Bond Fund, $300 Growth Fund, $200 Balanced Fund
C) Portfolio 1—$300 Balanced Fund, $400 Growth Fund, $300 Roth IRA (U.S. Government Bond Fund
D) Portfolio 4—$100 Money Market Fund, $200 Balanced Fund, $200 Growth Fund, $200 S&P Index Fund, $300 Roth IRA (U.S. Government Bond Fund)
A)
Explanation
Because Al and Stacy are in the top tax bracket, they do not qualify for a Roth IRA, therefore eliminating portfolios 1 and 4. Portfolio 2 is too conservative for their risk tolerance and long-term goals.
LO 4.1.1
Identify basic assumptions pertaining to the constant growth dividend discount model.
I. The growth rate cannot be equal to or greater than the investor’s required rate of return.
II. The model assumes that the investor’s required rate of return is known and remains constant.
A) II only
B) Both I and II
C) I only
D) Neither I nor II
Explanation
B) The growth rate cannot be equal to or greater than the investor’s required rate of return or the denominator becomes meaningless.
The model assumes the required rate of return is constant.
LO 4.3.1
Which of the following statements is CORRECT regarding fundamental and technical analysis?
A) Technical analysis is considered to be valid only under the weak form of the efficient market hypothesis (EMH).
B) Fundamental analysis may provide better returns under the weak form of the efficient market hypothesis (EMH).
C) Top-down analysis starts with examining individual companies, and then examining the impact of the overall economy on that particular company.
D) An example of technical analysis would be an investor looking at debt-to-equity ratios and price-to-earnings ratios.
B)Explanation
Technical analysis is not considered valid under any of the three forms of the EMH. Ratio analysis fits with fundamental analysis techniques. Bottom-up analysis begins with identifying attractive individual companies for investment. Fundamental analysis may indeed allow for an investor to outperform the market, but only under the weak form of the EMH.
LO 4.2.1
A 7% coupon bond pays interest semiannually and has a duration of 12 (computed using semiannual compounding) and a maturity of 25 years. The bond sells for $1,100 and has a YTM of 6.2%. If the YTM is expected to increase by 50 basis points, by what percentage can the price of the bond be expected to change?
A) –5.82%
B) +5.82%
C) –5.65%
D) +5.65%
A)
Explanation
Because interest rates are expected to increase, the percentage change in price will be negative. Because semiannual compounding was used to compute duration, modified duration must be computed by using one-half the current YTM (3.1%). The computation using the formula is as follows.
ΔP P= −D×Δy 1+y = −12×0.005 1.031=−0.0582=−5.82% LO 4.1.2
Which of the following are NOT used in technical analysis?
A) Moving averages
B) Graphs
C) Supply and demand of stocks
D) Financial statement ratios
Explanation
D) Financial statement ratios are part of fundamental analysis.
LO 4.2.1
Which of the following statements regarding fundamental and technical analysis is CORRECT?
A) In top-down analysis, an investor would start by researching various industries, and then choose stocks within that industry.
B) Technical analysis is not considered valid under the efficient market hypothesis, because this type of analysis is attempting to predict future prices based on past price movement.
C) Fundamental analysis may result in better returns than the overall market under both the weak and semistrong forms of the efficient market hypothesis.
D) Investors looking for excellent companies to invest in may use bottom-up analysis, which is a form of technical analysis.
B)
Explanation
This is correct, as any form of EMH does not coexist with technical analysis.
LO 4.2.1
Kevin owns a $1,000 par value corporate bond with three years remaining until maturity. This bond is currently trading for $1,020.91. The bond has a coupon rate of 4.5% (annual coupon payments) and a current YTM of 3.75%. What is the duration of this bond?
A) 2.0910
B) 2.8741
C) 1.0067
D) 3.7500
B)
Explanation
Determine the duration of the bond.
Year. Cash Flow(CF) (PV) of CF PV × Year
- $45 $43.37 $43.37
- $45 $41.81 $83.62
- $1,045 $935.73 $2,807.19
$1,020.91 $2,934.18
Divide the sum in the last column ($2,934.18) by the total PV/market price of the bond ($1,020.91) to derive the duration of 2.8741 years.
For year 1, FV = 45, I/YR = 3.75, N = 1, solve for PV.
For year 2, change N to 2 without clearing your calculator and solve for PV.
For year 3, FV = 1,045, I/YR = 3.75, N = 3, solve for PV.
LO 4.1.2
Assume a $1,000 par value bond with 3 years until maturity is currently trading for $1,027.23. The bond has a coupon rate of 6% (annual coupon payments) and a current YTM of 5%. The bond has a duration of 2.51 years. Calculate what the new market price for the bond would be if the YTM changed from 5% to 4.5%.
A) $1,016.75
B) $1,032.36
C) $1,053.01
D) $1,041.23
Explanation
The new price of the bond should be $1,041.23.
FV = 1,000
PMT = 60
I/YR = 4.5
N = 3
Solve for PV = –1,041.2345, or $1,041.23
LO 4.1.1
Companies A and B have exactly the same dollar amount of assets and net income. Company A has a capitalization structure of 70% equity and 30% debt; Company B has a capitalization structure of 40% equity and 60% debt. Which of the following statements is CORRECT?
A) Company B has a higher return on equity (ROE) than Company A.
B) Company B has a higher return on assets (ROA) than Company A.
C) Company A has a higher earnings before interest, tax, depreciation, and amortization (EBITDA) than Company B.
D) Company A has a higher debt-to-equity ratio than Company B.
A) Explanation
All else being equal, a profitable company with a higher debt level will have a higher return on equity. If income is the same for both companies, then the only difference is the percentage of equity. With a lower equity, Company B will have a higher return on equity. EBITDA and ROA would be equal, and Company B has a higher debt-to-equity ratio.
LO 4.2.2
All of the following statements concerning convexity are CORRECT except
A) high-duration bonds have low convexity.
B) convexity is a measurement of the curvature of the price-yield relationship.
C) convexity is a measure of how much a bond’s price-yield curve deviates from the linear approximation of that curve.
D) convexity is likely to be greatest with low-coupon bonds, long-maturity bonds, and low-YTM bonds.
A)
Explanation
The determinants of both duration’s and convexity’s direction of impact is the same (maturity [direct relationship], coupon rate, and yield [both inverse relationships]). Therefore, high-duration bonds also have high convexity.
LO 4.1.2
Two stocks, in different industries, have the following characteristics:
Stock A Stock B
Market price. $27 $47
Dividend 5% None
Dividend 4.5% N/A
growth rate
Earnings $2.46 $2.14
per share
P/E ratio 11 22
Which of the following statements is true?
I. A comparison of the relative merits of the two stocks cannot be evaluated because the dividend growth model cannot be used for Stock B.
II. The average price-to-earnings (P/E) ratio of the industry of each stock is important to evaluate overvaluation or undervaluation.
III. The historic range of each stock’s P/E ratio is important to evaluate each stock’s relative value.
IV. Stock B is undervalued relative to Stock A because its P/E ratio is twice Stock A’s P/E ratio, yet its market price is less than twice Stock A’s market price.
A) I and IV
B) IV only
C) II and III
D) I only
C) Explanation
The dividend growth model is just one of many models that investment analysts use to estimate the intrinsic value of a company. Other models can be used if a company does not pay a dividend. Determining intrinsic value by comparing relative P/E ratios compared to relative market prices is not a valid approach to valuation.
LO 4.3.2
Which of the following statements concerning duration are CORRECT?
I. Duration is used to compare potential price volatility between bonds with different maturities and coupons.
II. Duration can be used to select bonds to immunize an investor against interest rate and reinvestment rate risks.
III. Duration time-weights the present value of a bond’s cash flows.
IV. Like yield to maturity, duration reflects the timing of repayment of principal upon maturity, not the timing and magnitude of interest payments made in the interim.
A) II, III, and IV
B) I, II, and III
C) I, II, and IV
D) I, III, and IV
B) Explanation
Bonds with longer durations have greater volatility than bonds with shorter durations. The time horizon of a goal should be matched with a bond’s duration rather than with its maturity. Duration does take into account all interest and principal payments, not just the final payment at maturity.
LO 4.1.2
Assuming Victor has a bond portfolio with duration of 8.6 years, identify the CORRECT statement.
A) Victor’s bond portfolio is properly immunized to reach financial goals with a time horizon of 6 years.
B) Victor’s bond portfolio is immunized if its average time to maturity matches the time horizon of his current liabilities.
C) Immunizing a bond portfolio involves balancing reinvestment rate risk with default risk.
D) Victor’s bond portfolio may be composed of $2,000 worth of 3-year, zero-coupon bonds and $8,000 worth of 10-year duration bonds.
D) Explanation
Victor’s bond portfolio is properly immunized to reach financial goals or pay liabilities when the goals’ time horizon matches the portfolio’s duration (8.6 years). Portfolio immunization balances reinvestment rate risk with interest rate risk.
Because zero-coupon bonds’ durations are equal to their time to maturity and portfolio duration is a weighted average, Victor’s portfolio could consist of $2,000 worth of 3-year zero-coupon bonds and $8,000 worth of 10-year duration bonds, calculated as follows: (20% × 3 years) + (80% × 10 years) = 8.6 years.
LO 4.1.2
What is the duration of a zero-coupon bond yielding 9%, maturing in 10 years, and selling for $422.41?
A) 8 years
B) 7 years
C) 10 years
D) 9 years
Explanation
Because the bond is a zero-coupon bond, the duration must be 10 years.
LO 4.1.2
C) Explanation
Because the bond is a zero-coupon bond, the duration must be 10 years.
LO 4.1.2
Juliet owns a PRT Inc. bond with a par value of $1,000. PRT is a AA rated bond maturing in seven years. Juliet receives $55 of interest income from PRT semiannually. Comparable debt, i.e., AA rated, seven-year maturity, yields 12%. The bond’s duration is five years.
Assume the Fed is concerned about inflation and increases the discount rate. As a consequence, market interest rates on seven-year AA rated bonds change from 12% to 13%. How will the price of Juliet’s bond change?
A) The price will increase by approximately 7%.
B) The price will decrease by approximately 5%.
C) The price will increase by approximately 5%.
D) The price will decrease by approximately 7%.
Explanation
B) When interest rates change by 1%, the approximate price change of a bond will be the bond’s duration multiplied by the rate change. The bond’s duration can be seven years only if it is a zero-coupon bond. No information in the facts states that it is a zero-coupon bond. The facts do state that the bond has a coupon. Therefore, its duration will be less than seven years. The only other indicated possibility is a five-year duration. So, a five-year duration multiplied by an interest rate change of 1% results in a price change of 5%. Because rates rose, the price of the bond must decrease.
LO 4.1.2
Calculate the present value of a five-year bond with a coupon rate of 5.50% (paid semiannually) if similar quality bonds are currently yielding 4.35%.
A) $929.47
B) $1,026.97
C) $950.32
D) $1,051.18
Explanation
D) The answer is $1,051.18.
The present value of the bond is $1,051.18, calculated as follows: N = 10 (5 × 2); I/YR = 2.175 (4.35% ÷ 2); PMT = 27.50 (5.50% × 1,000 ÷ 2); FV = 1,000; solve for PV = 1,051.18, or $1,051.18.
LO 4.1.1
LJM Corporation has a bond issue with a coupon rate of 8% and seven years remaining until maturity. Assuming a par value of $1,000 and semiannual coupon payments, calculate the intrinsic value of the bond if current market conditions justify a 10% required rate of return.
A) $1,033.32
B) $901.01
C) $941.58
D) $920.81
B) The answer is $901.01.
The intrinsic value of LJM’s bond is $901.01, calculated as follows: N = 14 (7 × 2); I/YR = 5 (10% ÷ 2); PMT = 40 (8% × $1,000 ÷ 2); FV = 1,000; solve for PV = 901.01, or $901.01.
LO 4.1.1
Which of these choices correctly illustrates the relationship between a bond’s price and various yields?
A) For a premium bond: coupon rate > yield to maturity > current yield
B) For a discount bond: yield to maturity > coupon rate > current yield
C) For a discount bond: coupon rate < current yield < yield to maturity
D) For a premium bond: current yield > yield to maturity > coupon rate
Explanation
C) The answer is for a discount bond: coupon rate < current yield < yield to maturity.
When a bond trades at a discount, its yield to maturity will be greater than its current yield, which will be greater than its coupon rate.
LO 4.1.1
Which of these statements correctly analyze a bond’s coupon rate?
I. If a bond’s coupon rate is higher than the market yield, the bond will sell for less than its par value.
II. If the bond’s coupon rate is higher than the market yield, the bond’s current yield is higher than its yield to maturity (YTM).
III. If a bond’s coupon rate is higher than the market yield, the bond will sell at a premium.
IV. The only circumstance in which a bond will sell at par is if the bond’s coupon rate is equal to the market yield.
A) I, II, and IV
B) II and III
C) II, III, and IV
D) I and II
LO 4.1.1
C) The answer is II, III, and IV.
Only statement I is incorrect. If a bond’s coupon rate is greater than the market yield, the bond will sell for more (at a premium) than its par value.
Amber purchased a bond for $1,038.90 exactly two years ago. At that time, the bond had a maturity of five years and a coupon rate of 10% (paid semiannually). Assuming the rates below are the prevailing rates for this type of bond at different maturities, calculate the price that Amber could sell her bond for today.
Maturities 1 year. 3 years. 5 years. 10 years 30 years
Interest rates 6% 7% 8.5% 10% 12%
A) $1,060.08
B) $1,078.73
C) $1,038.31
D) $1,079.93
Explanation
D) The answer is $1,079.93. Using the 3-year rate of 7% for the calculation:
FV = 1,000
I/YR = 3.5 (7 ÷ 2)
PMT = 50 (100 ÷ 2)
N = 6 (3 × 2)
PV = 1,079.9283, or $1,079.93
LO 4.1.1
Choose the CORRECT statements regarding convexity relationships.
I. Convexity has a direct relationship with coupon rate.
II. Convexity has an inverse relationship with yield to maturity.
III. Convexity has an inverse relationship with term to maturity.
IV. Convexity has a direct relationship with term to maturity.
A) II and IV
B) II and III
C) I and III
D) I only
A) Explanation
The answer is II and IV.
Convexity has an inverse relationship with coupon rate and a direct relationship with term to maturity. The higher the coupon, the lower the convexity. The longer the maturity the greater the convexity.
LO 4.1.2
Calculate the estimated change in the price of a bond with a present value of $987.56 and Macaulay duration of 4.8 years when its YTM changes from 7% to 6%.
A) –4.53%
B) +4.53%
C) +4.49%
D) –4.49
C) Explanation
The answer is +4.49%.
Given the inverse relationship between bond prices and market interest rates, the price of the bond must increase by 4.49%, calculated as follows:
ΔP/P = –4.8 × [(0.06 – 0.07) ÷ (1 + 0.07)] = 0.0449, or 4.49%.
LO 4.1.2
Which of these statements best describes the concept of bond duration?
A) Duration measures the extent to which two variables move together, either positively (together) or negatively (opposite).
B) Duration assumes the price of a bond will stay constant because the market price of the underlying stock stays constant.
C) Duration is the average weighted time it takes the bondholder to receive the interest and principal payments from a bond in present value dollars.
D) Duration is used as an estimate of the change in the price of a bond given a negative one percentage point change in mortgage rates.
Explanation
C) The answer is duration is the average weighted time it takes the bondholder to receive the interest and principal payments from a bond in present value dollars. Covariance measures the extent to which two variables move together, either positively (together) or negatively (opposite). Duration is a measure of the sensitivity of a bond’s price to changes in interest rates.
LO 4.1.2
Yvette is saving for her son’s college education. Her son is expected to start college in 8 years. Choose the bond portfolio that would most likely be immunized with respect to this goal.
A) Weighted average time to maturity of bonds is 6 years with coupon of 8%.
B) Weighted average time to maturity of bonds is 10 years with coupon of 0%.
C) Weighted average time to maturity of bonds is 8 years with coupon of 3%.
D) Weighted average time to maturity of bonds is 10 years with coupon of 5%.
D). Explanation
The answer is weighted average time to maturity of bonds is 10 years with coupon of 5%. To immunize the portfolio, the duration of the portfolio should match the investor’s time horizon. Coupon-paying bonds have durations that are less than their time to maturity. Zero-coupon bonds have durations equal to their time to maturity.
LO 4.1.2
Assume a 3-year, $1,000 par value corporate bond is currently trading for $959.53. The bond has a coupon rate of 4% (paid once per year) and a yield to maturity of 5.50%. Calculate the duration for this bond.
A) 1.4418 years
B) 3.4680 years
C) 2.8835 years
D) 3.5871 years
B)
Explanation
The answer is 2.8835 years. The duration for this bond is 2.8835 years, calculated as follows:
Year Cash Flow(CF) (PV) of CF PV × Year
1 40.00 37.91 37.91
2 40.00 35.94 71.88
3 1,040.00 885.68 2,657.04
959.53 2,766.83
To solve for the PV of a given CF (example Year 1): FV = 40, N = 1, PMT = 0, 5.5 = I/YR, solve for PV. Divide the sum in the last column (2,766.83) by the total PV/market price of the bond (959.53) to derive the duration of 2.8835 years.
LO 4.1.2
Identify which of these items is generally listed as current assets on a business balance sheet.
I. Cash
II. Goodwill
III. Taxes payable
IV. Accounts receivable
A) I and IV
B) I and III
C) I, II, and III
D) I and II
Explanation
A) The answer is I and IV.
Cash and accounts receivable are current assets. Taxes payable is a liability and goodwill is generally considered an intangible asset.
LO 4.2.1
All of these statements explain the attributes of technical analysis except
A) technical analysts rely heavily on financial ratios in their analysis of stocks.
B) technical analysts attempt to predict the future movement of stock prices based on past trends.
C) technical analysts rely on charts to predict the future prices of stocks.
D) technical analysts use terms such as “trendline,” “support,” and “resistance” in analyzing stocks.
A)
Explanation
The answer is technical analysts rely heavily on financial ratios in their analysis of stocks. Analysts do not rely on financial ratios in their analysis of stocks. Instead, they rely on charts of past price history and volume to predict future price movements.
LO 4.2.1
Choose the form of the efficient market hypothesis that supports technical analysis.
A) Weak
B) Strong
C) None of these
D) Semistrong
Explanation
C) The answer is none of these. The efficient market hypothesis is in direct contradiction to technical analysis because the efficient market hypothesis is founded on the notion that all historical price and volume data, which is used by technical analysts, is already accounted for in the current stock price.
LO 4.2.1
Financial leverage affects
A) risk to stockholders.
B) return on equity.
C) return on equity, earnings per share, and risk to stockholders.
D) earnings per share.
Explanation
C)
The answer is return on equity, earnings per share, and risk to stockholders.
ROE and earnings per share are magnified with leverage, and the risk to stockholders increases as a firm’s leverage increases.
LO 4.2.2
JEM Technologies, Inc. has assets of $500 million and $50 million in liabilities. For the past year the company earned $125 million, and paid out $50 million in dividends. Calculate the company’s return on equity (ROE).
A) 52%
B) 20%
C) 38%
D) 28%
Explanation
D) The answer is 28%.
$500,000,000 – $50,000,000 = $450,000,000 in equity. $125,000,000 profit ÷ $450,000,000 equity = 0.2778, or 28% ROE.
LO 4.2.2
Assume a company’s net income steadily increases each year and it needs additional capital to grow. Which of these financial management actions may help increase the company’s return on common equity (ROE)?
I. issuing stock warrants
II. issuing long-term bonds
III. issuing additional shares of common stock
IV. refinancing 11% bonds with 7% bonds
A) I and II only
B) I and III only
C) I and IV only
D) II and IV only
Explanation
D) The answer is II and IV only.
To increase ROE, the company would want to issue debt instead of equity. Warrants are an option to purchase additional equity that would increase the denominator of the equation. The issuance of additional shares of common stock does the same. Debt in place of equity can increase ROE, as can the reduction of interest expense, which increases the numerator of the equation.
LO 4.2.2
Amelia is considering buying shares of HSO stock valued at $50 per share. She forecasts the stock to trade in excess of $75 per share over the next three years. During this time, she expects to receive annual dividends of $4.50 per share. Given a 10% required rate of return, calculate the intrinsic value of the stock.
A) $50.00
B) $45.00
C) $46.50
D) $29.50
B) Explanation
The answer is $45.00. The intrinsic value of the stock is $45, using the perpetuity dividend discount model, calculated as follows: $4.50 ÷ 0.10 = $45.
LO 4.3.1
LOK stock is currently paying an annual dividend of $2.15 per share, which is expected to grow at a constant rate of 2% annually. Calculate the price for the stock if an investor’s required rate of return is 10%.
A) $19.94
B) $27.41
C) $17.17
D) $21.50
B) The answer is $27.41.
Using the constant growth dividend discount model, the stock has an intrinsic value of $27.41, calculated as follows: [$2.15 × (1 + 0.02)] ÷ (0.10 – 0.02) = $2.1930 ÷ 0.08 = $27.41.
LO 4.3.1
LFM Corporation has an estimated free cash flow to equity (FCFE) of $2.50 per share in the current year. Moreover, its FCFE is expected to grow at a constant rate of 2% per year. Assuming an institutional investor has a required rate of return of 6.5%, calculate the intrinsic value of LFM stock.
A) $56.67
B) $40.76
C) $55.56
D) $133.13
A) Explanation
The answer is $56.67.
The formula for the discounted free cash-flow model:
V = FCFE1 ÷ (r – g) = ($2.50 × 1.02) ÷ (0.065 - 0.02) = 2.55 ÷ 0.045 = 56.6667, or $56.67
LO 4.3.1
FER stock has a current dividend of $0.75 per share that has been growing at a rate of 1.25% per year. If an investor’s required rate of return is 15% and the stock is currently selling for $6.34 per share, determine whether the investor should purchase the stock.
A) Yes, the stock is undervalued using the perpetuity dividend discount model.
B) No, the stock is not a wise purchase based on the risk-return trade-off.
C) Yes, the stock is undervalued based on the constant growth dividend discount model.
D) No, the stock is overvalued based on the constant growth dividend discount model.
D) Explanation
The answer is no, the stock is overvalued based on the constant growth dividend discount model.
Based on the constant growth dividend discount model, the intrinsic value of the stock is $5.52, calculated as follows: [0.75 × (1 + 0.0125)] ÷ (0.15 – 0.0125) = 0.7594 ÷ 0.1375 = 5.5227, or $5.52.
Because FER is currently trading at a price of $6.34 per share, it is overvalued, and the investor should not buy the stock.
LO 4.3.1
An analyst’s report on Derjet Industries has provided the following corporate information:
Total assets $100,000,000 Total equity $50,000,000 Net income $12,500,000 Earnings per share $3.50 P/E ratio 2.2 Dividend growth rate 1.65%
Assuming an investor has a required rate of return of 15%, calculate the maximum price that should be paid for this stock in the secondary market.
A) $14.38
B) $35.46
C) $7.70
D) $25.83
Explanation
C) The answer is $7.70.
Calculate the intrinsic value of the stock using EPS and the P/E ratio, which is $7.70 ($3.50 × 2.2).
LO 4.3.1
CPM Corporation has a constant dividend of $3.50 per share. The same rate is expected to be paid into the future. The risk-free rate of return is 3.5%. If an investor requires a 10% rate of return, calculate the present value of the company’s stock.
A) $25.92
B) $35.00
C) $53.85
D) $10.00
Explanation
B) The answer is $35.00.
The present (intrinsic) value of this investment is $35 ($3.50 ÷ 0.10) using the no-growth (perpetuity) dividend discount model.
LO 4.3.1
Marcy may add 100 shares of LKM corporation stock to her investment portfolio. The stock recently paid a dividend of $1.85 per share. The dividend is expected to grow at a constant rate of 2.25% per year. Her required rate of return is 7%. The stock is currently trading for $35.75 per share. Determine whether she should purchase the stock and why.
A) Yes, the stock is undervalued based on an intrinsic value of $33.46.
B) No, the stock is overvalued based on an intrinsic value of $38.95.
C) No, the stock is overvalued based on an intrinsic value of $32.87.
D) Yes, the stock is undervalued based on an intrinsic value of $39.82.
Explanation
D) The answer is yes, the stock is undervalued based on an intrinsic value of $39.82. Using the constant growth dividend discount model, the intrinsic value of the stock is $39.82.
V = ($1.85 × 1.0225) ÷ (0.07 – 0.0225)
V = 1.8916 ÷ 0.04750
V = 39.8232, or $39.82
Based on this value, the stock is undervalued relative to its price in the secondary market.
LO 4.3.1
