Investment Planning Flashcards

Question

What is Familiarity?

Answer 1

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

Answer 2

* 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.

Answer 3

* 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.

Answer 4

* 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.

Answer 5

* 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.

Answer 6

* 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.

Answer 7

* 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.

Answer 8

* 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).

Answer 9

* 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.

Answer 10

* 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.

Answer 11

* *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)

Answer 12

* 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.

Answer 13

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

Answer 14

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.

Answer 15

**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

Answer 16

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.

Answer 17

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.

Answer 18

**ρ:** It is the Correlation Coefficient Exam questions will usually just say “correlation" **σ:** It is the Standard Deviation **COV:** It is the Covariance

Answer 19

**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).

Answer 20

1. Beta 2. Standard Deviation 3. r²tells 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.

Answer 21

Alpha and Treynor use Beta. Sharpe uses standard deviation.

Answer 22

**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.

Answer 23

**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).**

Answer 24

* 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**

Answer 25

**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_p = realized return on the portfolio. r_f = risk-free rate of return. σ_p = standard deviation of the portfolio. ```

Answer 26

* **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__p _- r__f_)_ (β_p) Where: ``` r_p = The realized return on the portfolio. r_f = The risk-free rate of return. β_p = The beta of the portfolio. ```

Answer 27

* **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_p** = realized **portfolio return**. r_f = risk-free rate of return. a_p = alpha, an intercept that measures the manager’s contribution to portfolio return. β_p = beta of the portfolio. r_m = expected return on the market. ```

Answer 28

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).

Answer 29

\*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%

Answer 30

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.

Answer 31

* *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%**

Answer 32

_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%

Answer 33

**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

Answer 34

**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. D₁ = 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).

Answer 35

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.

Answer 36

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.

Answer 37

**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.

Answer 38

**EXAM: NOT ON FORMULA SHEET - MEMORIZE** * *Return on Equity =** **_Earnings Per Share_** * *Stockholders Equity per Share** -Measures the profitability of a company

Answer 39

**$2.00 ÷ ($7M ÷ $1M) = 28.5%** * *Return on Equity =** **_Earnings Per Share_** * *Stockholders Equity per Share** -Measures the profitability of a company

Answer 40

**Dividend Yield = Dividend ÷ Stock Price** It is the annual dividend as a percentage of the stock price

Answer 41

* **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.

Answer 42

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

Answer 43

Strong Semi-Strong Weak Inside Info N Y Y -------------------------------------------------------------------- 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.**

Answer 44

* **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)

Answer 45

**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.

Answer 46

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.

Answer 47

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

Answer 48

* 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

Answer 49

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

Answer 50

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

Answer 51

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

Answer 52

* **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).

Answer 53

* 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.

Answer 54

**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+.

Answer 55

**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

Answer 56

_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.**

Answer 57

* 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._**

Answer 58

* **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.”_**

Answer 59

* 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 60

**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”**

Answer 61

* _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).

Answer 62

* 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

Answer 63

* _U.S. dollar denominated_ debt securities issued or guaranteed by NON-U.S. entities * Negligible currency risk

Answer 64

* 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

Answer 65

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).** * _TI_**_P_**_S_ 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).**

Answer 66

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.

Answer 67

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.

Answer 68

**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