Investment Planning

Question 1

Describe the following types of orders:

• Market Order
• Limit Order
• Stop Order
• Stop Limit/Stop-Loss Limit Order

Answer 1

• *Market Order**: An order to buy or sell at the current best available price.
• generally when speed of execution is preferred over price
• most appropriate for stocks that are NOT thinly traded
• *Limit Order**: An order to buy or sell at a specified price or better.
• there is no assurance of execution.
• most appropriate for stocks that are extremely volatile or ARE thinly traded
• *Stop Order**: An order to buy or sell at the market price after the stock has traded at or through a specified “stop” price. If the stock reaches that price, the order becomes a market order.
• the primary risk is that the investor may receive significantly less than anticipated (when selling) if the market is moving too quickly/stock gaps down.
• *Stop Limit/Stop-Loss Limit Order**: An order to buy or sell at the limit price (or better) after the stock has traded at or through a specified “stop” price. If the stock reaches that price, the order will only execute at the limit price or better.
• there is no assurance of execution. If an investor was trying to sell the stock and the price of the stock was declining fast, the investor may be left with the stock now at a significantly lower price due to their limit price.
• Appropriate for investors with a significant gain built into the stock (but may not want to sell the stock during significant volatility based on short-term news).

Question 2

Initial Margin Requirement

Maintenance Margin

Answer 2

INITIAL MARGIN
The federal reserve established Regulation T, which set the initial margin at 50%

-The initial margin can be more restrictive based on volatility of stock. Assume 50% on the exam unless otherwise stated in the question.

Ex: To purchase 100 shares of Starbucks trading at $50 (on margin), the investor would need to place 100 x $50 x 0.75% = $3,750 in his account. He would then borrow on loan, (100 x $50 x 0.25% =$1,250).

• *MAINTENANCE MARGIN**
• The minimum amount of equity required before a margin call

Margin Position (how to find out how much equity the investor currently has)
Equity / Fair Market Value = Margin Position
Equity = Current stock price - Loan

Question 3

What is the Margin Call Formula?

MEMORIZE - NOT ON EXAM FORMULA SHEET

Answer 3

Margin Call = Loan ÷ (1 - Maintenance Margin)

Loan = % of stock price borrowed on loan. If the maintenance margin was 60%, the loan amount would automatically be 40% of the stock price.

-When the price falls below the stock price at which an investor would receive a margin call, the investor must contribute equity to restore their position

Ex: Lisa Purchased 500 Shares of XYZ stock trading at $40/share, with an initial margin requirement of 60% and a maintenance margin of 30%. At what price would Lisa receive a margin call?
Her initial loan was:
$40 x 40% = $16 or $40 x (1 - 0.60)
$16 ÷ (1 - 0.30) or $16 ÷ 0.70
=22.86

Question 4

Research Reports

Value Line and Morningstar

• *Which types of investments do they primarily rank?**
• *What are the rankings and when do they signal to buy or sell?**

Answer 4

• *Value Line**
• Ranks primarily stocks on a scale of 1 to 5 for timeliness and safety
• A ranking of 1 represents the highest rating (SIGNAL TO BUY)
• A ranking of 5 represents the lowest rating (SIGNAL TO SELL)
• *Morningstar**
• Ranks primarily mutual funds on a scale of 1 to 5 stars
• A ranking of 1 represents the LOWEST ranking, whereas 5 represents the HIGHEST ranking

Question 5

What is the relationship (in number of days) between the “ex-dividend date” and “date of record”?

Answer 5

TIP: “During EX-DATES, you’re EXCLUDED from receiving dividends”

Remember T+2. If you needed to be on the list of shareholders eligible for a dividend by the Date of Record, you would have to buy the stock at least 2 days before so that the transaction would settle in time.

June 2nd: Must purchase the stock before this date or today to receive the dividend
June 3rd: Ex-Dividend Date
June 4th: Date of Record

• An investor must purchase the stock before the ex-dividend date or 2 business days prior to the date of record.
• The ex-dividend date is one business day prior to the date of record.

Question 6

Characteristics of the Securities Act of 1933

Characteristics of the Securities Act of 1934

Answer 6

Securities Act of 1933:

• Regulates the issuance of new securities (Primary Market).
• Requires new issues are accompanied with a prospectus before being offered.

Securities Act of 1934:

• Regulates the secondary market and trading of securities.
• Created the SEC to enforce compliance with security regulations and laws.

Question 7

Characteristics of the Investment Company Act of 1940

Characteristics of the Investment Advisers Act of 1940

Answer 7

Investment Company Act of 1940:

• Authorized the SEC to regulate investment companies.
• Three types of investment companies: Open, Closed and Unit Investment Trusts.

Investment Advisers Act of 1940:

• This act required investment advisors to register with the SEC or state.
• To register with the SEC, an advisor must file form ADV.
• Less than $100 million in assets, register with the state.
• Greater than $110 million, register with the SEC.
• Between 100M and 110M AUM has the choice to register with the state or SEC.

Question 8

Characteristics of the Securities Investors Protection Act of 1970

Characteristics of the Insider Trading and Securities Fraud Enforcement Act of 1988

Answer 8

Securities Investors Protection Act of 1970:

• Established the SIPC to protect investors for losses resulting from brokerage firm failures.
• This act does not protect investors from incompetence or bad investment decisions.

Insider Trading and Securities Fraud Enforcement Act of 1988:

• Defines an insider as anyone with information that is not available to the public.
• Insiders cannot trade on that information.

Question 9

Treasury Bills (Maturities and Denominations)

Answer 9

• Maturities of varying lengths, 52 weeks or less.
• Denominations of $100.
• Sold at a discount to par value.

Question 10

Characteristics of Commercial Paper

Answer 10

• Short term loans between corporations.
• Maturities of 270 days or less.
• Not registered with the SEC.
• Commercial paper has denominations of $100,000 and are sold at a discount.

Question 11

Characteristics of Bankers Acceptance

Answer 11

• Facilitates imports/exports.
• Maturities of 9 months or less.
• Can be held until maturity or traded.

Question 12

Eurodollars

Answer 12

Deposits in foreign banks that are denominated in US dollars.

Question 13

What are the 2 objectives and 5 constraints covered in an Investment Policy Statement?

Answer 13

TIP: The “Risk and Return TURTL” or ”RRTTLLU”

RRTTLLU: Objectives are risk and return. Constraints are time horizon, taxes, legal/regulations, liquidity, unique circumstances.

IPS establishes “RR TURTL” → Risk & Return objectives and Time horizon, Unique circumstances, Regulations/legal, Taxes and Liquidity are the constraints.

*The IPS does NOT include investment selection

Question 14

Price-Weighted Average

• Characteristics
• Examples

Answer 14

Characteristic: Only takes stock price into consideration when calculating the average (vs. weighted which would take into account the percent allocation of the position within the portfolio).

Example: Dow Jones Industrial Average DJIA

Question 15

Value-Weighted Index

• Characteristics
• Examples

Answer 15

Characteristic: Takes market capitalization (shares outstanding x price) into account.

Examples: S&P 500, Russell 2000, Wilshire 5000 and EAFE

Question 16

What is Overconfidence?

What does Overconfidence lead to?

Answer 16

• Overconfidence suggests that investors overestimate their ability to successfully predict future market events through both the data gathering and analysis processes.
• Overconfidence leads to:
  
  • Increased risk taking
  • Overtrading

Question 17

What is Hindsight Bias?

What does Hindsight Bias lead to?

Answer 17

• Hindsight bias is a form of overconfidence related to an investor’s belief that they had predicted an event that, in fact, they did not predict.
• Hindsight bias leads to:
  
  • Complicated clients wanting to know why their advisors did not anticipate events that the client “knew” would happen.

Question 18

What is Cognitive Dissonance?

What does Cognitive Dissonance lead to?

Answer 18

• Cognitive dissonance is also a form of overconfidence because an investor’s memory of past performance is better than the actual results.
• Cognitive dissonance leads to:
  • Minimizing or forgetting past losses
  • Exaggerating past gains

Ex: “Your best friend Alex came to your house party for the football game. During the game he starts telling you about his amazing portfolio performance. He tells you about several positions that experienced double digit returns in a matter of days. He says that he lost on a few but not very much. Impressed you decide to invest some money with him. What behavioral finance bias does your friend Alex portray?” *Cognitive Dissonance

Question 19

What is Anchoring?

What does Anchoring lead to?

Answer 19

• Anchoring represents the investor’s inability to objectively review and analyze new information. The investor is “anchored” to the first information they reviewed.
• Anchoring leads to:
  
  • Returns or results that are different than the investor expected.
  • Buying securities that have fallen in value because it “must” get back up to that recent high.

Question 20

What is Belief Perseverance?

What does Belief Perseverance lead to?

Answer 20

• Belief perseverance is similar to anchoring in that people are unlikely to change their views given new information. It is a rejection of information that could disprove their belief.
• Barberis and Thaler (2002) said, “At least two effects appear to be at work. First, people are reluctant to search for evidence that contradicts their beliefs. Second, even if they find such evidence, they treat it with excessive skepticism.”
• Belief perseverance leads to:
  
  • Avoiding changes to their belief in an investment, even though new information contradicts their original premise for investing.
  • Sticking to a flawed approach.

Question 21

What is Regret Avoidance (Disposition Effect)?

What does Regret Avoidance (Disposition Effect) lead to?

Answer 21

• Regret avoidance, also known as the disposition effect, causes investors to take action (or inaction) in hopes of minimizing any regret.
• Regret avoidance leads to:
  • Selling winners too soon
  • Holding onto losers for too long

Question 22

What is Herd Mentality?

What does Herd Mentality lead to?

Answer 22

• Herd mentality is the process of buying what and when others are buying and selling.
• Herd mentality leads to:
  • Buying high
  • Selling low

Question 23

What is Naïve Diversification?

Answer 23

• Naïve diversification, which is the process of investing in every option available to the investor.
  
  • This is common with 401(k) or other employer sponsored retirement plans.
  • A plan participant thinks they are adequately diversified if they invest an equal amount in all the funds.
  • Also known as 1/n diversification.

Question 24

What is Representativeness?

Answer 24

• Representativeness is thinking that a good company is a good investment without regard to an analysis of the investment.

Question 25

What is Familiarity?

Answer 25

• Familiarity causes investment in companies that are familiar, such as an employer.
  
  • Clearly this can cause devastating effects on a portfolio (e.g. Enron).

Question 26

What is Availability Heuristic

Answer 26

• When a decision maker relies upon knowledge that is readily available in his or her memory, the cognitive heuristic known as “availability” is invoked
  
  • May cause investors to overweight recent events or patterns while paying little attention to longer term trends.

Question 27

What is Bounded Rationality?

Answer 27

• When individuals make decisions, their rationality is limited by the available information, the cognitive limitations of their minds, and the time available to make the decision.
  • Investors may satisfice or seek a satisfactory solution rather than an optimal one.
  • Having additional information does not lead to an improvement in decision making due to the inability of investors to consider significant amounts of information.

Question 28

What is Confirmation Bias?

Answer 28

• When people tend to filter information and focus on information that supports their opinions.
• Similar to Belief Perseverance, however belief perseverance doesn’t involve using information to confirm a belief, but the rejection of information that could disprove it.
  • Consequences include investors clinging to preconceived notions about their investments while discounting any information that contradicts these ideas.

Question 29

What is Gambler’s Fallacy?

Answer 29

• Investors often have incorrect understanding of probabilities which can lead to faulty predictions.
  
  • Investors may sell stock when it has been successful in consecutive trading sessions because they may not believe the stock is going to continue its upward trend.

Question 30

What is the Illusion of Control Bias?

Answer 30

• The tendency for people to overestimate their ability to control events; it occurs when someone feels a sense of control over outcomes that they clearly do not influence.

Question 31

What is Prospect Theory (Loss-Aversion Theory)?

Answer 31

• Prospect theory says that investors value gains and losses differently and will base their decisions on perceived gains rather than perceived losses.
  
  • Investors will choose perceived gains because losses cause a greater emotional impact.
  • Leads to investors having an unwillingness to sell a losing investment, in the hopes that it will turn around.

Question 32

What is the Similarity Heuristic?

Answer 32

• Used when investors make decisions or judgements based on similarity between current situations and other situations (even though the situations may have very different outcomes).

Question 33

What is Recency Bias?

Answer 33

• Occurs when priority and attention are given to current occurrences and events as opposed to consideration of long-term trends.
  
  • Often times leads investors to believe that recent events will continue to repeat themselves, or if time has passed, one may believe that the events are unlikely to occur again.

Question 34

Characteristics of Monte Carlo Simulation

Answer 34

• A spreadsheet simulation that gives a probabilistic distribution of events occurring.
• It then adjusts the assumptions and comes up with the probability of an event occurring depending upon the assumption.
• Allows for “what if” scenarios and sensitivity analysis if variables such as inflation or savings rate change.

Question 35

Covariance Formula

Answer 35

• *COV_AB = (σ_A)(σ_B)(ρ_AB)**
• *σ = Standard deviation**
• *ρ = Correlation coefficient**

It will be useful if you are provided the Correlation Coefficient and need to calculate the standard deviation of a two asset portfolio.

This formula is provided on the CFP Board formula sheet.

Covariance is a measure of RELATIVE risk.

Used in the standard deviation of a two asset portfolio:

σρ = √(W_A)²(σ_A)² + (W_B)²(σ_B)² + (2)(W_A)(W_B)(COV_AB)

Question 36

Characteristics of Correlation Coefficient and R²

Answer 36

• Correlation ranges from +1 to -1 and provides the investor with insight as to the strength and direction two assets move relative to each other.
• A correlation of +1 denotes that two assets are perfectly positively correlated.
• A correlation of 0 denotes that assets are completely uncorrelated.
• A correlation of -1 denotes a perfectly negative correlation.
• Diversification benefits (when risk is reduced) begin anytime correlation is less than 1.
  (More diversification benefits are received when correlation is equal to -1, but diversification BEGINS when correlation is less than 1).
• *R²**
• Use the Correlation Coeffient (R) to solve the coefficient of determination or R².
• R² tells you the how much percentage of a security’s return is due to the market (and 100 - R²=how much percentage of a security’s return is due to unsystematic risk).
• When an R² is 0.70 or greater, then Beta is an appropriate measure of total risk. If it is less than, Standard Deviation should be used.

Question 37

What are the distribution percentages of a normal distribution?

Answer 37

• 68% = +/- 1 standard deviation
• 95% = +/- 2 standard deviation
• 99% = +/- 3 standard deviation

Question 38

Which of the following assets is more risky?

Stock A: 10%, 13%, 8%, -2%, 14%

Stock B: 6%, -3%, 4%, -5%, 7%

Answer 38

This question is asking for you to calculate the standard deviation and select the asset with the higher standard deviation (the one with more risk).

Stock A=6.3875%
Stock B=5.4498%

Therefore, stock A is more risky.

Question 39

Shantele has been looking at mutual funds and her advisor tells her about a great fund with the following expected returns. What is the likelihood that those returns will be realized?

Expected Return__Probability of Return
10% 30%
15% 60%
18% 10%

Answer 39

Total expected return is 13.8%

(10% x 30%) + (15% x 60%) + (18% x 10%)

The calculation is simply the sum of all expected returns multiplied by their respective probabilities

Question 40

What are the Systematic Risks?

Answer 40

TIP: “PRIME”

• *P = Purchasing Power***
• *R = Reinvestment Rate***
• *I = Interest Rate***
• *M = Market Risk**
• *E = Exchange Rate**

Systematic Risks are non-diversifiable risks (as measured by Beta). It is the lowest level of risk in a fully diversified portfolio. It is inherent in the “system” as there is always an unknown element existing in securities that have no guarantees.

*Most likely to be tested on

• *Purchasing Power**: Risk that ( 1 ) inflation will erode the amount of goods and services that can be purchased, and (2) a dollar today cannot purchase the same amount of goods and services tomorrow.
• This type of risk impacts both equities AND bonds.
• *Reinvestment Rate**: Risk that an investor will not be able to reinvest at the same rate of return that is currently being received.
• This type of risk mostly impacts bonds.
• *Interest Rate**: Risk that changes in interest rates will impact the price of both equities and bonds.
• There is an inverse relationship between interest rates and both equities and bonds.

Question 41

What are the Unsystematic Risks?

Answer 41

TIP: “ABCDEFG”

• *A = Accounting Risk** (Not on exam - useful for mnemonic) Think Enron.
• *B = Business Risk****
• *C = Country Risk****
• *D = Default Risk****
• *E = Executive Risk** (Not on exam - useful for mnemonic)
• *F = Financial Risk****
• *G = Government/Regulation Risk****

Unsystematic risks are diversifiable risks.

**Most likely tested on the exam

Business Risk: The inherent risk a business faces by operating in a particular industry.

Country Risk: The risk a company faces by doing business in a particular country. E.g. Halliburton faces unique risks doing business in Iraq.

Default Risk: Risk of a company defaulting on their debt payments. Can be thought of as the likelihood of a firm being able to satisfy its debt obligations on time.

Financial Risk: Is the amount of financial leverage deployed by the firm. Financial leverage is the ratio of debt vs. equity the firm has deployed. The higher the percentage of debt deployed, the more risky.

Government/Regulation Risk: Risk that tariffs or restrictions may be placed on an industry or firm that may impact its ability to compete in an industry.

Question 42

What is this symbol?
ρ

What is this symbol?
σ

What is this symbol?
COV

Answer 42

ρ: It is the Correlation Coefficient
Exam questions will usually just say “correlation”

σ: It is the Standard Deviation

COV: It is the Covariance

Question 43

What does Beta measure?

What would a Beta of 1 mean?

What would a Beta higher than 1 mean?

What would a Beta of less than one mean?

What would the Beta be for an index fund?

Answer 43

Beta is a measure of the volatility or systematic risk of a security or portfolio, compared to the market as a whole.

A beta of 1 would mean that it tracks the market and would be expected to mirror it in terms of the direction, return and fluctuation.

A beta higher than one would mean that it will fluctuate more than the market and there will be greater risk associated with that particular security.

A beta less than one would mean that it will fluctuate less than the market.

The beta for an index fund will be 1 (because an index fund is built to track a specific fund / mirror it in terms of direction, return and fluctuation).

Question 44

1. When considering a diversified portfolio, which of the following is an appropriate measure of risk?
2. When considering the total risk for a nondiversified portfolio, which of the following is an appropriate measure of risk?

Standard Deviation
Beta
Covariance
Coefficient of determination
Correlation coefficient

3. What does an r² of 0.70 tell an investor?

Answer 44

1. Beta
2. Standard Deviation
3. r² tells an investor how much market risk there is. 100-market risk = unsystematic risk (that can be diversified). It can show how diversified a portfolio is. It can also tell an investor if Beta is an appropriate tool for measuring total risk. If the Beta is less than 0.70, then standard deviation should be used.

Beta is an appropriate measure of risk for a diversified portfolio (one that has a high r²). A higher r², 0.70 and above means that Beta is an appropriate measure of total risk. If it is less than 0.70, then Standard deviation is an appropriate measure of total risk and it is considered a nondiversified portfolio.

Question 45

What risk measures do the following risk adjusted performance measures use:

• Alpha
• Treynor
• Sharpe

Answer 45

Alpha and Treynor use Beta. Sharpe uses standard deviation.

Question 46

What measure of risk does the CML use?

Answer 46

CML uses standard deviation

CML is the Capital Market Line and is the line that intersects at the optimal portfolio point of the efficient frontier.

It is a tool used to determine the appropriate asset allocation (percentages allocated to the risk-free asset and to the market portfolio) for the investor.

Question 47

What is the CAPM formula?

What is the Market Risk Premium?

Answer 47

r = r_f + β(r_m - r_f)

Where:

r = The required rate of return (or expected return)
r_f = The risk-free rate of return.
β = Beta, which is a measure of the systematic risk associated with a particular portfolio.
r_m = The return of the market.
r_m - r_f = The market risk premium.

(r_m - r_f) is the Market Risk Premium

EXAM: The CAPM formula is on the exam sheet and you will need to use it. You may be asked to calculate an expected or required rate of return using the CAPM. You may be given the market risk premium rather than the return of market. Be sure to remember that the market risk premium is (r_m - r_f).

Question 48

Describe the SML and what measure of risk is used.

Answer 48

• The SML represents the tradeoff between systematic risk and return for a security.
• The intersection of the SML on the y-axis represents a risk free rate of return.
• The SML also graphically represents the CAPM.
• Beta is the risk measure used (systematic or non-diversifiable risk).
• It is used to determine the appropriate expected (benchmark) returns for securities

Question 49

What are some characteristics of the Sharpe ratio?

Answer 49

TIP: SHARPE IS “STANDARD” (It uses Standard Deviation)

• The Sharpe Ratio uses Standard Deviation and therefore should only be used in a non-diversified portfolio
• The Sharpe ratio is a risk-adjusted PERFORMANCE MEASURE. (How much of your return is generated above the return that could have been earned in a risk-free investment).
• Sharpe is a relative risk adjusted measure, so you must compare one Sharpe to another.
• A higher Sharpe ratio the better (where more return was provided per unit of risk).
• Sharpe does NOT use beta so if the R-Squared is less than 0.70, use the Sharpe ratio.

S_p = (r_p -r_f) ÷ (σ_p)

Where:

r<sub>p</sub> = realized return on the portfolio.
r<sub>f</sub> = risk-free rate of return.
σ<sub>p</sub> = standard deviation of the portfolio.

Question 50

What are some characteristics of the Treynor ratio?

Answer 50

• Treynor uses BETA (therefore only captures the systematic risk; and should only be used to compare funds that are fully diversified).
• *Treynor ratio is a risk-adjusted PERFORMANCE MEASURE (How much of your return is generated above the return that could have been earned in a risk-free investment)**
• Treynor is a relative risk adjusted measure, so you must compare one Treynor to another.
• The higher the Treynor the better (where more return was provided per unit of risk).
• Treynor is appropriate to use when r-squared is equal to or greater than .70. (the .70 indicates that a portfolio is diversified and that Beta is an appropriate measure of risk).

T_p = (r_<u>p</u> - r_<u>f</u>)
(β_p)

Where:

r<sub>p</sub> = The realized return on the portfolio.
r<sub>f</sub> = The risk-free rate of return.
β<sub>p</sub> = The beta of the portfolio.

Question 51

What are some characteristics of Jensen’s Alpha?

Answer 51

• Alpha is an absolute measure of risk, therefore you can look at it and it tells you something. (You don’t have to run the Alpha calculation
• A positive Alpha is good (manager outperformed). A negative Alpha is bad (manager underperformed). An alpha of zero means the manager performed as well as the benchmark.
• Alpha also tells how much excess return was actually earned, based upon the amount of return expected for the risk undertaken.
• Alpha uses Beta
• The only time the alpha will equal the amount the fund beat the market is if the beta is 1.

a_p = r_p - [r_f + β_p(r_m - r_f)]

Where:

**r<sub>p</sub>** = realized **portfolio return**.
r<sub>f</sub> = risk-free rate of return.
a<sub>p</sub> = alpha, an intercept that measures the manager’s contribution to portfolio return.
β<sub>p</sub> = beta of the portfolio.
r<sub>m</sub> = expected return on the market.

Question 52

Christos is evaluating two mutual funds to purchase. Which fund would you recommend?

Fund A: Standard Deviation=12%, R-Squared=0.92, Alpha=2.0, Sharpe=1.2
Fund B: Standard Deviation=13%, R-Squared=0.90, Alpha=1.8, Sharpe=1.5

A: Fund A because it has a higher Alpha
B. Fund A because it has a lower standard deviation
C: Fund B because it has a higher Sharpe
D: Fund B because it has a higher standard deviation

Answer 52

Answer: A

Since both portfolios are well-diversified (R-Squared is over 0.70), then we must evaluate the funds based on a performance indicator that uses Beta. Alpha uses Beta whereas Sharpe uses the standard deviation.

If the R-Squared was less than 0.70, the funds would not be well diversified, so standard deviation would be used and therefore we would select the fund with the highest Sharpe ratio (Fund B).

Question 53

Holding Period Return Formula
*NOT ON THE FORMULA SHEET - NEED TO MEMORIZE*

Answer 53

*There is a type of HPR formula on the exam sheet but it’s tedious. The one below is easier and should be memorized:

• *HPR = Selling Price - Purchase Price +/- Cashflows**
• *Purchase Price or Equity**

Cashflow items to consider:

• *Dividends received:** will be added as a +cashflow
• *Margin interest paid:** will be subtracted as a -cashflow
• *Taxes paid:** Taxes, like margin interest will be subtracted as a -cashflow **(only do this if the question asks for the after-tax gain/loss. The taxes will be computed based on the dividends received and any capital gain on the sale, short-term vs. long-term).
• *Purchased securities on margin:** You will also include the total cost of the securities (the amount you borrowed) as a subtraction from the sales proceeds. The borrowed amount is a -cashflow.

EX: BJ Bought 100 Shares of Cisco at $20/share, with an initial margin of 60%. He was charged 10% margin interest annually. One year later he sold the stock for $30/share. What was BJ’s holding period?

• *Sale Price** = BJ sold the stock for $30/share = $30
• *-Purchase Price** = What BJ initially deposited on margin or $20/share x 60% = $12
• *Cash flows (+/-)**
• *-Borrowed amount:** what must be paid back: 40% of $20 = $8
• *-Interest paid** = BJ paid 10% annually to borrow on margin. He borrowed 40% of the $20 stock ($8) and 10% annual interest on $8 is $0.80.

$30 – $12 – $8 – $0.80 = $9.20

BJ’s equity was what he deposited on margin to receive the shares ($20 x 60%) = $12

$9.20 / $12 = .7667 or 77%

Question 54

What is the Geometric Average formula?

Answer 54

ⁿ√[(1 + r₁)(1 + r₂)…(1 + r_n)] - 1 x 100

Where:

r = return for a given period of time
n = number of periods

Provided on the CFP Board formula sheet.

Question 55

What is geometric mean of the following: 43, 45, 40, 52, 49?

What is the geometric mean of the following: 12%, 5%, -2%

Answer 55

• *Calculator Keys:**
• *43 Enter**
• *45 X**
• *40 X**
• *52 X**
• *49 X**
• *5 SHIFT [1/x] SHIFT [y^x]**

Answer: 45.6024

• *Calculator Keys:**
• *1.12 Enter**
• *1.05 X**
• *.98 X** (1 - .02)
• *3 SHIFT [1/x] SHIFT [y^x]**
• *1 [-]**
• *100 X**

Answer: 4.8%

Question 56

How does a time-weighted vs dollar-weighted return differ?

Answer 56

Time-weighted:

• Time-weighted returns are based upon the security’s cash flow.
• Mutual funds report on a time-weighted basis.

Dollar-weighted:

• Dollar-weighted returns take an investor’s cash flow into consideration.
• Investors report returns on a dollar-weighted basis.

EXAM: MUTUAL FUNDS REPORT ON A TIME-WEIGHTED BASIS

Example of a time-weighted return:
Bob purchases 1 share of DIS for $50. One year later the stock pays a dividend of $4, and Bob purchases an additional share for $65. Bob sold the stock one year later for $75 per share. What was Bob’s time weighted-return?

Period 0 - ($50)
Period 1 - $4
Period 2 - $75
IRR=26.54%

Question 57

Arbitrage Pricing Theory (APT)

Answer 57

EXAM: Do NOT memorize the formula. MEMORIZE THE KEYWORDS: multi factor model, sensitivity to those factors and standard deviation & beta are NOT inputs.

• APT is a multi factor model that attempts to explain return based on factors. Anytime a factor has a value of zero, then that factor has no impact on return.
• APT attempts to take advantage of pricing imbalances.
• Inputs are factors (f) such as inflation, risk premium, and expected returns and their sensitivity (b) to those factors.

r_i = a₁ + b₁F₁ + b₂F₂ + b₃F₃ + e

Question 58

What is the Constant Growth Dividend formula?

Answer 58

EXAM: FORMULA ON EXAM SHEET. *REMEMBER TO USE NEXT YEAR’S DIVIDEND
*D₁₌D₀(1 + growth rate)

Be sure to use next year’s dividend when determining the value of stock using the constant growth dividend formula.

V = D₁ ÷ (r-g)

Where:

r = The required rate of return.
g = The dividend growth rate.
D<sub>1</sub> = Next period’s dividend.

If D₁ is not provided, you can use D₀, which is this year’s dividend multiplied by the growth rate provided. D(1+g).

Question 59

What is the PEG Ratio?

Answer 59

PEG = Stocks P/E Ratio ÷ 3 to 5 Year Growth Rate in Earnings

• The PEG Ratio provides insight to determine if the P/E Ratio is expanding faster/slower than the firm’s growth rate in earnings.
• If the PEG ratio > 1, then the investor is paying more for the stock than is perhaps justified by earning growth. The stock may be overvalued.
• If the PEG ratio < 1, then investors are paying less for the stock than is perhaps justified by earning growth. The stock may be undervalued.
• If the PEG ratio = 1, then investors are paying a fair value because the P/E ratio is in line with the earnings growth rate.

Question 60

What is the P/E Ratio?

Answer 60

P/E = Price per Share
EPS

OR

Price per Share = P/E x EPS

The P/E Ratio measures how much investors are willing to pay for each dollar in earnings.

Question 61

What is the Dividend Payout Ratio?

EXAM: NOT ON FORMULA SHEET - MEMORIZE

Answer 61

EXAM: NOT ON FORMULA SHEET - MEMORIZE

Dividend Payout Ratio = Common Stock Dividend
Earning Per Share

Determines percentage of earnings paid out in dividends to shareholders.

Question 62

What is the Return on Equity formula?

EXAM: NOT ON FORMULA SHEET - MEMORIZE

Answer 62

EXAM: NOT ON FORMULA SHEET - MEMORIZE

• *Return on Equity =** Earnings Per Share
• *Stockholders Equity per Share**

-Measures the profitability of a company

Question 63

Cole’s Cars Inc. has the following information, what is the return on equity?

EPS: $2
Common Stock Dividend: $1
Preferred Stock Dividend: $0.50
Sales: $5M
Shares Outstanding: $1M
Total Equity: $7M

Answer 63

$2.00 ÷ ($7M ÷ $1M) = 28.5%

• *Return on Equity =** Earnings Per Share
• *Stockholders Equity per Share**

-Measures the profitability of a company

Question 64

What is the Dividend Yield Formula?

Answer 64

Dividend Yield = Dividend ÷ Stock Price

It is the annual dividend as a percentage of the stock price

Question 65

What does Fundamental Analysis consider?

Answer 65

• Financial statement analysis and economic data
• Financial statement analysis through ratio analysis.
• Economic data such as GDP, inflation and interest rates.
• Provides a method for determining a securities price based upon future cash flows.

Question 66

What do technicians consider in their analysis?

Answer 66

• Charting
• Market Volume
• Short Interest
• Odd Lot Trading
• The Dow Theory
• Breadth of the Market
• Advance Decline Line

Question 67

Three Forms of the Efficient Market Hypothesis

Answer 67

Strong Semi-Strong Weak

Fundamental N N Y
———————————————————————
Technical N N N

Weak Form

• *Price reflects all historical price data**
• *Advantage through: fundamental analysis & inside information**
• Asserts - historical will not help an investor achieve above average market returns.
• Rejects - technical analysis

Semi-Strong Form

• *Price reflects all public information**
• *Advantage through: inside information**
• Asserts - both historical and public information will not help investors achieve above average market returns.
• Rejects - both technical and fundamental analysis.

Strong Form

• *Price reflects all information**
• *Advantage through: NONE, passive investment strategy is best (index funds)**
• Asserts - historical, public and private information will not help investors achieve above average market returns.
• Suggests - stock prices reflect all available information and react immediately to any new information.

Market anomalies do not support the hypothesis in any of the three forms.

Question 68

Describe the characteristics of Series EE Bonds

Answer 68

• NOT marketable securities (sold by US Treasury).
• Interest is paid when the bond is redeemed.
• Sold at face value.
• No state/local tax. Federal tax when redeemed (but can be tax-free if used for education expenses)

Question 69

Agency Bonds

• Characteristics
• Exception to the rule

Answer 69

EXAM TIP: Know that Agency Bonds are NOT backed by the full faith and credit of the US Government. Know the exception to the rule–GNMA bonds ARE backed by the full faith and credit of the U.S. Government.

• Agency bonds are not backed by the full faith and credit of the U.S. government. They are a moral obligation of the U.S. government.
• Exception to the rule - GNMA bonds are backed by the full faith and credit of the U.S. Government.

Question 70

Three Types of Municipal Bonds

Answer 70

1. General Obligation Bonds – backed by the taxing authority of the municipality that issued the bonds
2. Revenue Bonds – backed by the revenues to be generated by the project for which the bond was issued (e.g. – toll roads).
3. Private Activity Bonds PABS – used to fund private activities such as stadiums.

Municipal bonds are nontaxable at the federal, state, and local level if you live in the issuing state.

Question 71

What companies insure municipal bonds?

Answer 71

• American Municipal Bond Assurance Corp. (AMBAC)
• Municipal Bond Insurance Association Corp. (MBIA)

Question 72

What is the primary difference between Corporate Bond Risk and US Government Bond Risk?

Answer 72

• Corporate Bonds have default risk
• US Government Bonds do NOT have default risk (they are guaranteed)
• Muni Bonds also have default risk unless they are insured

Question 73

What companies insure municipal bonds?

Answer 73

American Municipal Bond Assurance Corp (AMBAC)
Municipal Bond Insurance Association (MBIA)

Question 74

Formulas for Tax-Equivalent & Tax-Exempt Yields

Answer 74

Tax-Equivalent Yield = Tax-Exempt Yield
(1 – Marginal Tax Rate)

Tax-Exempt Yield = (Corporate Rate) x (1 – Marginal Tax Rate)

If the bond is double or triple tax free, combine the federal, state and local income tax rate. Use that for the marginal tax rate. To be DOUBLE tax free, the bond holder must live in the state that issued the bond. To be TRIPLE tax free, the bond holder must live in the state AND local municipality that issued the bond.

Hint: if you are given the taXable rate, you multiply (Tax has an X).

Question 75

When is the coupon rate < current yield on a bond?

When is the current yield > the yield to call on a bond?

When is the yield to maturity > the current yield on a bond?

When is the yield to call < the yield to maturity on a bond?

Answer 75

When bond is sold at a discount

When bond is sold at a premium

When bond is sold at a discount

When bond is sold at a premium

Question 76

Characteristics of the Liquidity Preference Theory

When is a yield curve inverted?

Answer 76

• Investors are willing to accept a lower yield on short term bonds because of their preference for liquidity.
• Results in a normal yield curve (an upward sloping yield curve which is up and to the right).
• An inverted yield curve happens when inflation is expected to be lower in the future. Long term rates will be lower than short-term rates, resulting in an inverted yield curve (sloping down and to the right).

Question 77

Characteristics of Bond Duration

Answer 77

• It measures a bond’s price sensitivity to changes in interest rates.

When we say, “The duration of the bond is 4 years,” we mean: “If the interest rate on the bond goes up by 1%, the bond’s price will decline by 4%.”

Duration is quoted in “years.”

If a bond has a semi-annual period, we convert duration to years before quoting it (a duration of 8 semi-annual periods is 4 years)

• The bigger the duration, the more price sensitive or volatile the bond is to interest rate changes.
• Duration is the moment in time the investor is immunized from interest rate risk and reinvestment rate risk.
• It’s the weighted average time until an investor receives all the coupon payments and principal.
• A bond portfolio should have a duration equal to the investor’s time horizon to be effectively immunized.

Question 78

Relationship between Duration, Term, Coupon, and YTM

Answer 78

TIP: “Coupon rate and YTM are INterest rates and there is an INverse relationship”

DIRECT relationship: Term is parallel to duration

• As term increases, duration will increase
• As term decreases, duration will decrease

INVERSE Relationship: Coupon Rate and YTM are INverse to Duration period

• As the coupon rate increases+, duration decreases-. As the coupon rate decreases-, duration increases+.
• As yield to maturity increases+, duration decreases-. As yield to maturity decreases-, duration increases+.

Question 79

Net Operating Income (NOI) formula and Value of Real Estate formula using NOI

Answer 79

NOI = Net operating expenses

Capitalized Value/property evaluation formula = NOI ÷ Capitalization Rate

Operating income does not include depreciation, amortization, or payments on debt service. These are considered FINANCING EXPENSES.

-Used to determine how much an investor is willing to pay for a piece of property

Question 80

What are three types of investment companies and their characteristics?

Answer 80

Closed End

• Have a fixed market capitalization.
• A specific number of shares are issued and no new shares are issued by the fund.
• Shares trade at a premium or discount to NAV.

Open End
* Unlimited number of shares. Shares are bought and redeemed directly from the fund.
* Shares trade at NAV
* NAV = (Assets - Liabilities)
Shares Outstanding

• *Unit Investment Trusts (UIT’s)**
• Typically a fixed income trust managed by a trustee.
• Issues “units,” not shares and sold back to the UIT at NAV.
• They are passively managed and self-liquidating.

Question 81

American Depository Receipts (ADRs)

Answer 81

• ADR’s are foreign stock held in domestic banks’ foreign branch.
• Capital gains in ADRs include currency fluctuation.
• Dividends are paid in US dollars.
• ADRs do not eliminate exchange rate risk OR currency risk.

Question 82

When does an investor:

Buy a call?

Buy a put?

Answer 82

• Buy a Call: Anytime the exam asks which option will provide the investor with the maximum gains if the stock price appreciates the right answer is “Buying a Call.”
• Buy a Put: If the exam asks about maximizing gains if the stock price falls, or you want to “protect profits” or “lock in gains,” the right answer is “Buying a Put.”

Question 83

Time Value Formula for:

Intrinsic Value formula for:

• Call Option
• Put Option

Answer 83

• Call Option: Stock Price – Strike Price (SP-XP)
• Put Option: Strike Price – Stock Price (XP-SP)

Note - Intrinsic value cannot be less than 0. If you get a negative number, select 0 as the answer on the exam.

Time Value = Premium - Intrinsic Value

Answer 84

TIP: “St O P S”

St=Stock gain or loss (if you own the underlying stock)
O=Option gain/loss (intrinsic value)
P=Premium paid or received
S=Shares controlled

Gain or Loss Equals (Intrinsic Value +/- Premium) x Shares = Total gain or loss

When “selling” a call or put, the seller must buy the option contract to close out the position. This means that the intrinsic value is going to be negative, unless it is “0”

Question 85

Characteristics of Option Pricing Models

• Black Scholes
• Put/Call Parity
• Binomial Pricing

Answer 85

• Black Scholes Variables
• IN V 3 S T
  IN = Interest (RF)
  V=Volatility
  3= Exercise Price (INVERSELY related)
  S=Stock Price
  T=Time
• The Black Scholes Model considers the following variables: Current price of the underlying asset. Time until expiration. The risk-free rate of return. Volatility of the underlying asset. (All the above have a direct relationship). The XP does NOT have a direct relationship. If the XP increases, the option decreases in value.
• Put/Call Parity: Attempts to value a PUT option based upon a call option.
• Binomial Pricing Model: Explains prices based upon the underlying asset price moving in two directions. (Bi- meaning TWO. The stock can only move in two directions).

Question 86

What is Bond Duration?

Answer 86

• Duration indicates price sensitivity to interest rate changes. Duration is also the average time it takes an investor to recoup his/her original investment from the cash flows of the bond.
• Duration is a function of its: current price, time to maturity, yield to maturity, coupon rate
• The longer a bond’s maturity, the longer the duration (because it takes more time to receive full payment). The shorter a bond’s maturity, the shorter the duration (because it takes less time to receive full payment)
• The duration of any bond that pays a coupon will be less than its maturity, because some amount of coupon payments will be received before the maturity date.
• The lower a bond’s coupon, the longer its duration (because less payment is received before final maturity). The higher a bond’s coupon, the shorter its duration (because more payment is received before final maturity)
• Zero coupon bonds have a duration equal to their maturity.
• The longer the duration, the more the bond’s price will drop as interest rates rise (longer durations create more sensitivity to interest rate changes – meaning bond prices will react more). e.g. if investors were anticipating interest rates falling, they would flock to long duration bonds to get the amplified upside of bond prices rising. This could be longer YTM bonds and bonds with smaller coupon rates.
• The shorter the duration, the less the bond’s price will drop as interest rates rise (shorter durations create less sensitivity to interest rate changes – meaning bond prices will react less).

From a classmate: so the higher the duration, the more amplified the effect will be (good or bad) on bond prices. If rates rise and prices fall, lower duration means your loss won’t be as bad. But if rates fall and prices rise, you want the higher duration so you experience more of the upside

Question 87

Yankee Bonds

Answer 87

• U.S. dollar denominated debt securities issued or guaranteed by NON-U.S. entities
• Negligible currency risk

Question 88

What is the semi-variance of a portfolio?

Answer 88

• It is the return below the mean
• It is also known as the “downside risk” of a portfolio
• Client’s may prefer to know this as they are generally more sensitive to the loss potential of a portfolio vs. upside potential

Question 89

What are the notable differences between TIPS and I Bonds?

Answer 89

Both I Bonds and TIPS offer an inflation hedge through: principal protection and purchasing power protection. Both are subject to FEDERAL income tax (exempt from state/local tax).

• TIPS are Treasury Inflation-Protected Securities.
• The “P” in TIPS stands for “principal” in that it is the portion of the security that is being adjusted due to increasing/decreasing inflation.
• investors will owe federal tax on the interest earned as well as on the increase on the principal value even though they will not receive the adjusted principal value until actual maturity of the bond. (AKA phantom income, like with zero coupon bonds or STRIPS)
• Principal is adjusted and the coupon rate is paid at a fixed rate. Because the fixed rate is applied to the adjusted principal, interest payments will rise or fall with inflation rates.
• I Bond yield is as a combined fixed and variable (inflation) rate. This composite rate is paid when the bond is redeemed.
• The variable portion of the I Bond’s yield is based on the CPI-U and adjusted every 6 months.
• Interest can be deferred and paid all at once when the bond is redeemed.
• The coupon rate is changing/variable.
• I Bonds can also be redeemed for higher education with tax advantages (all or a portion of the interest may be federal income tax free).

Question 90

Bond Convexity

Answer 90

EXAM TIP: “CONVEXITY IS MY FRIEND”

• Convexity describes the ACTUAL relationship between bond price and changes in interest rate. Duration considers a linear relationship between bond prices/changes in interest rates. In reality, as interest rates rise/fall, duration consistently overestimates the amount of price decline associated with a large upward move in interest rates. Duration also underestimates the amount of price increase associated with a large drop in interest rates.
• The greater a bond’s convexity, the greater the price gains when interest rates fall, and the less the bond prices falls when interest rates increase.

Question 91

How does an investor immunize a bond portfolio over a specific investment horizon?

1. Match the maturity of each bond to the investment horizon.
2. Match the duration of each bond to the investment horizon.
3. Match the average weighted maturity of the portfolio to the investment horizon.
4. Match the average weighted duration of the bond portfolio to the investment horizon.

Answer 91

4. Match the average weighted duration of the bond portfolio to the investment horizon.

Duration, not maturity is used to immunize a portfolio. The average weighted duration rather than the duration of each specific bond is used for successful portfolio immunization.

Question 92

XYZ company anticipates paying the following dividends, starting next year: Year 1: 2.25 Year 2: 2.75 Year 3: 3.01 After the third year, they anticipate dividends growing at 6%. If Diego’s required rate of return is 12%, how much would he be willing to pay for this stock?

1. $35.08
2. $40.07
3. $44.20
4. $47.38

Answer 92

Solution: The correct answer is C.

Step #1: Apply the constant growth dividend formula to value the stock as of year 3. V = 3.01(1.06) ÷ (.12 - .06) V = 53.18 Step #2: Use uneven cash flows to determine the NPV of the stock at time period zero (today). CF0 = 0 CF1 = 2.25 CF2 = 2.75 CF3 = 3.01 + 53.18 = 56.19 I = 12 NPV = ? Answer: $44.20