Investment Planning Flashcards
Which of the following best describes a long hedge position?
The investor is short the underlying commodity and short the futures contract.
The investor is long the underlying commodity and long the futures contract.
The investor is short the underlying commodity and long the futures contract.
The investor is long the underlying commodity and short the futures contract.
Solution: The correct answer is C.
A long position in a futures contract is when the investor buys a futures contract. A short position in a futures contract is when the investor sells a futures contract. A long hedge means that the investor owns (buys) the futures contract to insure a certain price of a commodity that he or she does not yet own. Hedging is taking an opposite futures position than the investor’s inherent underlying position.
Developing cash flow projections and valuations for real estate can be difficult due to:
A lack of comparable figures for other properties in the area.
Changes in demographic and economic variables.
Different financing methods amongst prospective purchasers.
A lack of standardized methods for objectively evaluating an investment in a market that is considered inefficient.
Solution: The correct answer is B.
Cash flow projections and comparable equity capitalization rates are easily obtained for a valid comparison. The difficulty is one of the unpredictability of changes in economics and demographics which directly impact values. Real estate valuation models such as one using net operating income, adjust for variations in real estate financing.
A yield curve normally is upward sloping because:
Long-term rates must be higher to compensate for higher expected future tax rates.
Long-term bonds are, by their nature, more risky than short-term bonds.
Higher long-term rates reflect inflationary expectations.
Short-term bonds have a lower level of event risk.
Solution: The correct answer is B.
Short-term rates are lower because of the lower risk associated with them. The longer an investment ties up an investor’s capital, the higher the rate must be to offset this risk. Inflation expectations may be lower in the future, resulting in a downward (inverted) sloping yield curve.
Higher inflationary expectation is a driving force for an inverted yield curve as the Fed raised short term rates faster than the long term rates adjust to the higher risk. The “natural” position is an upward slope, which indicates a more “normal” environment.
repurchase agreement
a long term corporate debt obligation with a claim against securities rather than against physical assets
Michael currently owns one stock, ABC Company, in his portfolio. XYZ Company has the same expected rate of return as ABC Company, and has a low correlation to ABC Company. If the investor adds XYZ Company to his portfolio:
A. The expected return of the portfolio will increase, and the standard deviation of the portfolio will increase.
B. The expected return of the portfolio will increase, and the standard deviation of the portfolio will decrease.
C. The expected return of the portfolio will decrease, and the standard deviation of the portfolio will remain the same.
D. The expected return of the portfolio will remain the same, and the standard deviation of the portfolio will decrease.
Solution: The correct answer is D.
Since both expected rates of return are the same, the portfolio expected rate of return will remain the same. Since Stock B has a low correlation to Stock A, the addition of Stock B to the portfolio will reduce the portfolio standard deviation.
Which of the following is NOT a premium factor that would be considered part of the nominal rate of interest?
Economic premium.
Default premium.
Liquidity premium.
Risk free rate of interest.
Solution: The correct answer is A.
There is no such thing as an economic premium. All of the other premiums added to the risk free rate equal the nominal (or stated) rate.
Keep in mind that return is made up of risk premium plus the risk-free rate. The risk premium is added to the risk free rate to compensate investors for additional risk. There is no true risk-free rate, so the treasury rate is used in it’s place.
Mark is the 100% owner of Widget Manufacturing, Inc. (WMI). The WMI 401(k) plan covers 35 employees with 70% of the employees under age 40. Employee turnover is high. Mark wants to retire in 20 years at age 65. Mark has a medium tolerance for volatility within his investments. The market value of the 401(k) is $4,000,000 and Mark is the trustee and manages the investments. The portfolio consists of the following assets: - 10% short-term CDs with staggered maturity date. - 20% limited partnership interest in a private commercial real estate project which generates a high income yield. - 40% in a brokerage account invested in four stocks. - 30% in long-term government bonds with staggered maturity dates. You have been retained to evaluate the appropriateness of the portfolio. Which of the following statements best describes the portfolio?
Short-term certificates of deposit have a fixed maturity date and therefore are not appropriate for liquidity purposes.
The brokerage account investments are not adequately diversified.
The investment in the limited partnership may be subject to unrelated business taxable income and therefore is inappropriate.
Overall, the asset classes selected by the plan are sufficiently diversified and therefore minimize overall portfolio volatility.
I and II only.
II and III only.
I, II and III only.
II, III and IV only.
Solution: The correct answer is D.
Statement “I” - Short-term CDs are an appropriate choice for liquidity needs due to fixed value of the vehicle and short maturity periods. Statement “IV” - Even though the current investments within the asset classes are not properly positioned, the asset class allocation would, under Modern Portfolio Theory, reduce overall volatility to the plan.
Herkimer Green has just inquired about purchasing callable bonds. You explain what this means, and you also explain the negative aspects for investors with regard to callable issues. These include:
The uncertainty about the amount of payments to be made to the bondholders. The price risk for the investor. The inflation risk to the bondholder. The reinvestment risk faced by the bond investor. The investor's liquidity risk. I only. II and III only. I and IV only. II, IV and V only
Solution: The correct answer is C.
Price risk is not a callable bond concern; in fact, often when called a premium is paid. Inflation risk, where the purchasing power of the bond is affected might seem like a good choice, but because the bond is being held to call in this case, it is not a concern and liquidity risk is eliminated. When the bond is called, an investor does not need to worry about selling the bond.
An investor may use options on debt instruments to protect against:
Interest rate risk.
Reinvestment rate risk.
Default risk.
Call risk.
Solution: The correct answer is A.
Put options that lock in the price at which the security may be sold may be used to protect an investor from a drop in bond prices caused by rising interest rates.
Options are derivatives. They derive their value from an underlying investment. Reinvestment risk, default risk, and call risk have no associated value. Interest rates do have an associated value.
Which of the following is NOT a premium factor that would be considered part of the nominal rate of interest?
Economic premium.
Default premium.
Liquidity premium.
Risk free rate of interest.
Solution: The correct answer is A.
There is no such thing as an economic premium. All of the other premiums added to the risk free rate equal the nominal (or stated) rate.
Keep in mind that return is made up of risk premium plus the risk-free rate. The risk premium is added to the risk free rate to compensate investors for additional risk. There is no true risk-free rate, so the treasury rate is used in it’s place.
Which of the following option strategies would be considered the most risk?
Buying a call.
Buying a put.
Selling a covered call.
Selling a put.
Solution: The correct answer is D.
Buying a put or call option limits the investor’s loss to the premium paid. With a covered call, the investor owns the underlying stock, which offsets any loss associated with selling the call. Selling a put is the most risky of the strategies listed because the stock could fall to zero.
The form of technical analysis that utilizes Advances and Declines (also known as Breadth of the Market) as an indicator is known as:
Price Indicator.
Volume Indicator.
Market Indicator.
Charting Indicator.
Solution: The correct answer is A.
Advances and declines deal with price. Volume indicates the number of shares traded. Market indicators deal with directions of the market and related averages. Charts are used as indicators and in some instances, do not use price but rather movements.
If the risk/return performance of a stock lies above the Security Market Line, the stock is said to have a:
Positive correlation coefficient.
Positive alpha.
Positive expected return.
Positive covariance.
Solution: The correct answer is B.
Performance of a stock below the SML is a negative alpha. Again, the Jensen formula can be used for this calculation.
You are faced with several fixed income investment options. Which of these bonds has the greatest reinvestment rate risk?
A U.S. Treasury bond with an 11.625% coupon, due in five years with a price of $1,225.39 and a yield to maturity of 6.3%.
A U. S. Treasury strip bond (zero-coupon) due in five years with a price of $735.12 and a yield to maturity of 6.25%.
A corporate B-rated bond with a 9.75% coupon, due in five years with a price of $1,038.18 and a yield to maturity of 8.79%.
A corporate zero coupon bond due in 5 years with a price of $750 and a yield to maturity of 5.9%.
Solution: The correct answer is A.
This is due to the high coupon and lack of similar rates currently.
A good visual to use in the bond chart in Lesson 6 under Yield Summary. If the YTM is currently 6.3% on an 11.625% coupon bond, the bond is trading at a premium, meaning investors are willing to pay more to purchase that bond than new ones issued at par with the current coupon rate (much lower than 11.625%).
The bond investment strategy of “riding the yield curve” involves:
Investing equal amounts in short-term and long-term bonds.
Investing equal amounts in each of several maturity periods.
Investing either short-term or long-term to take advantage of anticipated interest rate changes.
Selling bonds with unrealized losses and replacing them with similar bonds.
Solution
Solution: The correct answer is C.
Riding the yield curve refers to the purchase of debt instruments in anticipation of fluctuations in the rates of return on both long and short-term instruments. Rising rates of interest require repositioning a portfolio in advance of the rise in order to avoid significant price drops. These moves are based on anticipated changes in the yield curve.
