Investment planning Flashcards

Question 1

Q

Holding period return (HPR)

Answer

A

(Ending Value-Beginning Value) + Income / Beginning Value

Dividends received: add to numerator
Margin interest paid: subtract from numerator
If question mentions after-tax gain or loss, taxes paid are subtracted from numerator.
When purchasing securities on margin, include only equity in the trade in the denominator.

Question 2

Q

Forms of Underwriting: Best Efforts

Answer

A

Underwriter agrees to sell as much as possible of the offering, risk of issue not selling resides with firm (unsold shares return to company)

Question 3

Q

Forms of Underwriting: Firm Commitment

Answer

A

Underwriter agrees to buy entire issuance of stock from the company, may make a spread (e.g., buy for $18 and sell for $20).
Risk that an issuance may not sell stays with the underwriter.

Question 4

Q

Prospectus

Answer

A

Outlines risks, management team, business operations, fees, and expenses.
Must be issued by investment company prior to selling shares to investor.

Question 5

Q

Red Herring

Answer

A

Preliminary prospectus issued before SEC approval, used to determine investors’ interest in the security

Question 6

Q

10K Report

Answer

A

Annual report of financial statements filed with the SEC. 10K is audited.

Question 7

Q

10Q Report

Answer

A

Quarterly report filed with the SEC - NOT audited

Question 8

Q

Annual Report

Answer

A

Sent directly to shareholders

Contains message from Chairman of the Board on the progress in the past year and outlook for coming year

Question 9

Q

Liquidity

Answer

A

How quickly something can be turned into cash, with little or no price concession. Short term investment assets are considered liquid:
CDs
money market accounts
high-yield savings accounts
government bonds
Treasury bills

Question 10

Q

Marketability

Answer

A

Exists where there is a ready-made market for something. Marketable investments include:
Stocks
Bonds
Mutual funds
Exchange traded funds
Treasury Bills
Money Market instruments

Question 11

Q

Market Order

Answer

A

Timing and speed of execution are more important than price

Appropriate for stocks that are not thinly traded

Question 12

Q

Limit Order

Answer

A

Price at which trade is executed is more important than timing
Most appropriate for stocks that are extremely volatile and are not frequently traded

Question 13

Q

Stop Order

Answer

A

When the price hits a certain level, the order becomes a market order, stock is sold at that price or lower. Primary risk: investor may receive significantly less than anticipate if market is moving too quickly.

Question 14

Q

Stop-Limit or Stop-Loss-Limit Order

Answer

A

Investor sets 2 prices:
(1) stop-loss price - once this is reached, the order turns into a limit order
(2) limit price - investor will not sell below the second price
Risk: if market moves quickly, order may not fill and investor will be left with stock at significantly lower price.
Appropriate for investors with a significant gain built into the stock, but who may not want to sell during period of significant volatility.

Question 15

Q

Short selling

Answer

A

Selling at a higher price, in the hopes of purchasing the stock back at a lower price (goal: sell high, buy low)
Investor makes profit when asset’s price decreases in value.
Must have margin account to protect against appreciation of the stock.
No time limit on how long investor can maintain the short position.
Dividends paid by the company must be covered by the short seller.

Question 16

Q

Initial Margin

Answer

A

Amount of equity an investor must contribute to enter a margin transaction
Reg T set initial margin at 50% and established by the Federal Reserve
Can be more restrictive based on the volatility of a stock
Assume 50% on the exam unless stated otherwise in the question

Question 17

Q

Maintenance Margin

Answer

A

Minimum amount of equity required before a margin call

Question 18

Q

Margin position

Answer

A

Current equity position of the investor

Question 19

Q

Margin call

Answer

A

Loan / 1 - Maintenance Margin

Question 20

Q

Sample calculation: How much equity must an investor contribute, when a stock price falls below the stock price and the investor will receive a margin call?

Bob purchased 100 shares of Starbucks trading at $50 per share with an initial requirement of 75% and a maintenance margin of 35%. The price fell below $15. How much equity must Bob contribute?

Answer

A

Required Equity:
Stock price: $15
Maint. Margin: x 0.35
Required Equity: $5.25

Question 21

Q

Sample calculation: How much equity must an investor contribute, when a stock price falls below the stock price and the investor will receive a margin call?

Bob purchased 100 shares of Starbucks trading at $50 per share with an initial requirement of 75% and a maintenance margin of 35%. The price fell below $15. How much equity must Bob contribute?

Answer

A

Required Equity:
Stock price: $15
Maint. Margin: x 0.35
Required Equity: $5.25

Question 22

Q

Sample calculation: How much equity must an investor contribute, when a stock price falls below the stock price and the investor will receive a margin call?

Bob purchased 100 shares of Starbucks trading at $50 per share with an initial requirement of 75% and a maintenance margin of 35%. The price fell below $15. How much equity must Bob contribute?

Answer

A

Required Equity Actual Equity
Stock price: $15 Stock Price: $15
Maint. Margin: x 0.35 Debt: $12.50
Required Equity: $5.25 Actual Equity: $2.50

$5.25 - $2.5 = $2.75 per share = $275 in total

Question 23

Q

Research Reports: Value Line

Answer

A

Ranks STOCKS on a scale of 1 to 5 for timeliness and safety
Ranking of 1 represents the highest ranking for timeliness and safety (signal to buy)
Ranking of 5 represents lowest ranking (signal to sell)

Question 24

Q

Research Reports: Morningstar

Answer

A

Ranks mutual funds, stocks, and bonds using 1 to 5 stars (primarily MUTUAL FUNDS!)
1 star represents lowest ranking, 5 stars represent highest ranking

Question 25

Q

Dividend Dates

Answer

A

Dividends are declared by the BOD and typically paid quarterly
Ex-Dividend Date
Date of Record

Question 26

Q

Ex-Dividend Date

Answer

A

Date the stock trades without a dividend
If you sell the stock on the ex-dividend date, you will receive the dividend
If you buy the stock on or after the ex-dividend date, you will NOT receive the dividend
Ex-dividend is ONE BUSINESS DAY before the date of record
Remember: EX-Date trades without dividend

Question 27

Q

Date of Record

Answer

A

Date on which you must be a registered shareholder in order to receive the dividend
= ONE BUSINESS DAY after the ex-dividend date
Investor must purchase the stock 2 business days prior to the date of record in order to receive the dividend
Purchases made on ex-dividend date will not receive the dividend; to receive the dividend, an investor must purchase the stock prior to the ex-dividend date or 2 business days before the date of record

Question 28

Q

Types of Dividends

Answer

A

Cash dividends: Qualified dividends receive capital gains tax treatment
A cash dividend is taxed upon receipt

Stock dividends: not taxable to shareholder until stock is sold

Question 29

Q

Stock splits

Answer

A

Increase shares and reduce stock price:

2-for-1 split for 100 shares at $50 per share results in 200 shares at $25 per share

3-for-2 split for 100 shares at $60 per share results in 150 shares at $40 per share

Question 30

Q

Securities Act of 1933

Answer

A

Regulates issuance of new securities (Primary Market) - IPOs

Requires that new issues are accompanied with prospectus before being purchased

Question 31

Q

Securities Act of 1934

Answer

A

Regulates secondary market and trading of securities

Created SEC to enforce compliance with security regulations and laws

Question 32

Q

Investment Company Act of 1940

Answer

A

Authorized SEC to regulate investment companies

3 types of investment companies: Open, Closed, UITs

Question 33

Q

Investment Advisors Act of 1940

Answer

A

Required investment advisors to register with the SEC or state

Question 34

Q

Securities Investors Protection Act of 1970

Answer

A

Established SPIC to protect investors from losses resulting from brokerage firm failures
Does not protect investors from incompetence or bad investment decisions

Question 35

Q

Insider Trading and Securities Fraud Enforcement Act of 1988

Answer

A

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

Question 36

Q

Money Market Securities

Answer

A

Treasury bills
Commercial paper
Bankers Acceptance
Eurodollars

Question 37

Q

Treasury Bills

Answer

A

Issued in varying maturities up to 52 weeks
Denominations in $100 increments through Treasury Direct up to $5 million per auction. Larger amounts available through a competitive bid

Question 38

Q

Commercial paper

Answer

A

Short-term loans between corporations
Maturities of 270 days or less
Does not have to register with the SEC
Denominations of $100,000
Sold at discount

Question 39

Q

Bankers Acceptance

Answer

A

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

Question 40

Q

Eurodollars

Answer

A

Deposits in foreign banks that are denominated in US dollars

Question 41

Q

Investment Policy Statement

Answer

A

Establishes
(a) client’s objectives: required return, risk tolerance
(b) limitations on investment manager (time horizon, liquidity needs, taxes, laws and regulations, circumstances unique to the client)
Used to measure investment manager’s performance
Does NOT include investment selection

Remember: IPS establishes RR TT LL U - risk, return, taxes, timeline, liquidity, legal, unique circumstances

Question 42

Q

Market Averages and Indices

Answer

A

Dow Jones Industrial Average:
Simple Price-Weighted Average
Does not incorporate market capitalization

S&P 500:
Value-Weighted index
Incorporates market capitalization

Russell 2000:
Value-Weighted index of the smallest capitalization stocks in the Russell 3000

Wilshire 5000:
Broadest Value-Weighted index measuring performance of over 3000 stocks

EAFE:
Value-Weighted index tracking stocks in Europe, Australia, Asia, Far East

Question 43

Q

Standard Deviation

Answer

A

Measures risk and variability of returns
The higher the SD, the higher the riskiness of the investment
Measures TOTAL RISK of an UNDIVERSIFIED portfolio
Probability of returns: 68% = 1 x SD; 95% = 2 x SD; 99% = 3 x SD (add or subtract to mean return)

Question 44

Q

Calculating Standard Deviation

Answer

A

Dan has 2 stocks in his portfolio with the following returns over the past 5 years:
A: 10%, 13%, 8%, -2%, 14%
B: 6%, -3%, 4%, -5%, 7%
Calculate the SD for both stocks:

10 Σ+ 13 Σ+ 8 Σ+ 2+/-Σ + 14 Σ, Orange Shift Sx, Sy
6 Σ+ 3+/- Σ+ 4 Σ+ 5+/-Σ + 7 Σ, Orange Shift Sx, Sy
A= 6.3875%
B= 5.4498%
A is more risky because SD is higher

Question 45

Q

What is the total expected return for the following portfolio?
Expected Return Probability
10% 30%
15% 60%
18% 10%

Answer

A

Answer: 13.80%

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

Question 46

Q

Coefficient of Variation

Answer

A

CV= Standard Deviation / Average Return

Useful in determining which investment has more relative risk when investments have different average returns

Tells us probability of actually experiencing a return close to the average return

The higher the coefficient of variation the more risky an investment per unit of return.

If 2 investments have the same return, go with the higher Standard Deviation to determine the higher risk investment.

Question 47

Q

Normal Distribution

Answer

A

used in probability analysis of expected returns around an average return
average (expected) outcome in the middle X
symmetrical curve
50% probability of a return > X
50% probability of a return < X

Standard deviation σ measures variance around that expected return

probability of a return falling within +/- 1 σ of the average is 68%
probability of a return falling within +/- 2 σ of the average is 95%
probability of a return falling within +/- 3 σ of the average is 99%

Question 48

Q

Lognormal Distribution

Answer

A

appropriate when investor is considering a dollar amount or portfolio value at a point in time

Question 49

Q

Skewness

Answer

A

Refers to the extent to which a distribution is not symmetrical.

Positively skewed distributions may have outliers in the upper, or right tail (“skewed to the right”)
Stock markets tend to be positively skewed.

Negatively skewed distributions have many outliers in the lower, or left tail (“skewed left”).

Commodity returns tend to be skewed.

Question 50

Q

Kurtosis

Answer

A

Describes when a distribution is more or less peaked than a normal distribution.

Refers to the variation of returns:
Normal distribution: mesokurtic
Little variation of returns: distribution has high peak = positive kurtosis (Leptokurtosis) - slender (e.g., Treasuries)
Widely dispersed returns: low peak = negative kurtosis (Platykurtosis) - broad

Question 51

Q

Mean Variance Optimization

Answer

A

Process of adding risky securities to the portfolio but keeping the expected return the same, finding the balance of combining asset classes that provide the lowest variance as measured by standard deviation.

Question 52

Q

Monte Carlo Simulation

Answer

A

Spreadsheet simulation that gives probabilistic distribution of events occurring, e.g., what is the probability of running out of money in retirement with a client who has a withdrawal rate of 3%, 4%, 5%. Monte Carlo simulation adjusts assumptions and returns the probability of an event occurring depending upon the assumption.

Question 53

Q

Covariance

Answer

A

measure of 2 securities combined in their interactive risk, i.e., how price movements between the 2 are related to each other

measures relative risk

If correlation coefficient is known, or a given, covariance is calculated as the deviation of investment A times the deviation of investment B times the correlation of investment A to investment B:

COV AB = (σA) (σB) (ρAB)
ρ= correlation coefficient
σ = Standard deviation

Question 54

Q

Correlation Coefficient

Answer

A

Correlation and Covariance measure movement of one security relative to that of another, both are RELATIVE measures.

ρAB = Cov AB /(σA) (σB)

Correlation ranges from +1 to -1 and provides insight into strength and direction 2 assets move relative to each other:
Correlation of +1 denotes perfectly positive correlation to each other
Correlation of -1 denotes perfectly negative correlation
Correlation of 0 denotes that assets are completely unrelated
Diversification benefits (risk reduced) begin anytime correlation is LESS than 1

Question 55

Q

Investment Risk - Define:

Risk
Total Risk
Systematic Risk
Unsystematic Risk

Answer

A

Risk = experiencing an outcome different than the expected outcome

Total risk = Systematic + Unsystematic Risk, measured by STANDARD VARIATION

Systematic Risk cannot be eliminated through diversifying the portfolio, measured by BETA

Unsystematic Risk can be eliminated through diversifying the portfolio (aka “firm-specific risk”)

Question 56

Q

Systematic / Non-diversifiable / Market / Economy based risk - Components

Answer

A

PRIME:

Purchasing Power Risk
Reinvestment Risk
Interest Rate Risk
Market Risk
Exchange Rate Risk

Question 57

Q

Unsystematic / Diversifiable / Unique / Company Specific Risk - Components

Answer

A

ABCDEFG:

Accounting Risk 
Business Risk
Country / Sovereignty Risk
Default or Credit Risk
Executive Risk
Financial Risk
Government / Regulation Risk

Question 58

Q

Risk and Return

Answer

A

The higher the standard variation, the greater the variance around the expected return.
Investments with greater standard deviation (higher risk!) require greater expected return. (e.g.: common and preferred stock, junk bonds, options, futures, forwards, small cap and growth-oriented funds)
Investments with lower standard deviation will typically provide lower returns, but provide limited downside risk. (e.g., cash, MMKT securities, Treasury securities, investment grade bonds)

Question 59

Q

Factors influencing investor’s capacity for risk

Answer

A

Time horizoin
Liquidity needs
Total investable assets

Question 60

Q

Risk/Return Relationship

Answer

A

Potential return and Risk in order from LOW to HIGH:

Treasury Bills (cash alternatives)
CDs (cash alternatives)
Government Bonds
Corporate Bonds
Preferred Stocks
Common Stocks
Options & Futures

Question 61

Q

Beta Coefficient

Answer

A

= measure of systematic (market) risk

measures individual security’s volatility relative to that of the market

best used to measure volatility of a diversified portfolio (one that has a high r2

Beta of the market = 1
Stock with Beta of 1 is expected to mirror the market in terms of direction, return, and fluctuation
Stock with a Beta >1 means it fluctuates more than the market, and greater risk is associated with that security
Stock with a Beta <1 indicates it fluctuates less relative to market movements.
→ The greater the Beta Coefficient of a security, the greater the systematic risk associated with that security.

NOTE: The BETA of an INDEX Fund is always 1 because it tracks the market!

Question 62

Q

Calculation of Beta

Answer

A

βi = COVim / σ²m = (ρim) (σ) / σm

COVim = (σi) (σm) (ρim)
σ²m = Variance of the market
σm = SD of the market
σi = SD of the individual security
ρim = correlation coefficient between individual security and market

Beta can also be calculated in the following way:

Security risk premium / Market Risk premium
Example: If a fund has a return of 20% and the market has a return of 10%, the beta would be 20 / 10 = 2.
If a fund has a return of 5% and the market has a return of 10%, the beta would be 5 / 10 = 0.5.

Question 63

Q

Coefficient of Determination - R-Squared (r2)

Answer

A

measures what percentage of a security’s return is due to the market

Calculate Coefficient of Determination by squaring correlation coefficient :
Example: If mutual fund XYZ has a correlation coefficient of 0.80, its coefficient of determination is 0.64, which means 64% of the fund’s return is due to the market.

R-squared also provides insight into how well-diversified a portfolio is: the higher R-squared, the higher percentage of return from the market (systematic risk) and less from unsystematic risk.

R-squared tells the investor if Beta is an appropriate measure of risk: if R-squared ≥ 0.70, Beta is an appropriate measure of total risk. If R-squared ≤ 0.70, use Standard Deviation instead to measure total risk.

Question 64

Q

Sample Calculation Correlation of Determination

Answer

A

Mutual Fund XYZ has a 5-year return of 12%, with a standard deviation of 15%. Fund XYZ has a Beta of 1.4 with a correlation of 0.90 to the S&P 500. What percent of the return from Fund XYZ is due to the S&P 500?

a) 90%
b) 81%
c) 19%
d) 10%

81% - answer B: 0.90 = r, thus R-squared = 0.81 or 81%. 81% is due to the market, and 19% is due to unsystematic risk.

A mutual fund has a correlation coefficient of 0.80. What percent of return is due to unsystematic risk?
R Squared = 0.64 or 64% is due to systematic risk, thus 36% is due to unsystematic risk!

Answer 65

A

Can be measured through determination of the interactivity of the standard deviation and covariance of securities in the portfolio.
“Portfolio Deviation Formula” or “Standard Deviation of a Two Asset Portfolio” utilizes the weight of both securities involved, the deviations of the respective securities, and the correlation coefficient of the two securities
(see Formula sheet)

Alternative possibility:

Take simple weighted average of the standard deviation of a portfolio, then choose the answer that is the next lower one than the average (e.g., SD 10.5% and 23.8%, equal weight of 50% → (10.5x 50) + (23.8x50) = 17.5%
Answer choices: 10.8%, 13.7%, 18.45, 20.5% → choose 13.7%

Answer 66

A

Acceptance by an investor of a given level of risk while maximizing expected return objectives.

When designing a portfolio the most important variables are risk, return and covariance (how asset classes relate to each other).
Negatively correlated assets are not necessary to reduce risk, simply assets with a correlation < 1 are necessary.
Diversifying across asset types is more effective by combining stocks and bonds.
The efficient frontier is very sensitive to the risk and return input variables.

Answer 67

A

Curve illustrates optimal amount of return for a unit of risk taken.
Uses standard deviation for risk measure.

All points on the efficient frontier are deemed equally efficient.
Where you plot on the curve is determined by risk tolerance.
Portfolios below the efficient frontier are inefficient because there is a portfolio that provides more return for that level of risk.
Area above the efficient frontier is considered unattainable.

Answer 68

A

Occurs when an investor’s indifference curve is tangent to the efficient frontier.

Answer 69

A

Constructed using selections made based on highest level of return given an acceptable level of risk.

Risk averse investor will have steep indifference curve. This investor requires significantly more return to take on just a little more risk.

A risk tolerant investor will have a flat indifference curve. This investor will not require a significant amount of return to take on more risk.

Answer 70

A

The one selected from all efficient portfolios: the point at which an investor’s indifference curve is tangent to the efficient frontier represents the investor’s optimal portfolio.

Investors seek the highest return attainable at any level of risk.
Investors want the lowest level of risk at any level of return.
Investors are assumed to be risk-averse.

Answer 71

A

Macro aspect of the Capital Asset Pricing Model (CAPM)
Specifies the relationship between risk and return in all possible portfolios.

CML becomes the new efficient frontier, mixing in the risk-free asset with a diversified portfolio.
A portfolio’s returns should be on the CML.
Inefficient portfolios are below the CML.
CML is NOT used to evaluate performance of a single security.
CML uses STANDARD DEVIATION to measure risk.

Rp =rf + σp (rm - rf) / σm

where:
Rp = portfolio return
rf = risk free rate
σp = standard deviation of portfolio returns
rm = market return
σm = standard deviation of market returns

Answer 72

A

Calculates the relationship of risk and return of an individual security using Beta as its measure for risk.
Often referred to as the Security Market Line (SML) equation because its inputs and results are used to construct the SML.
The difference between (rm - rf) is considered the market risk premium, i.e., how much an investor should be compensated to take on a market portfolio vs. a risk-free asset.

quantifies expected return
quantifies required ROR
plots the SML

ri = rf + (rm - rf) βi

ri = required or expected ROR
rf = risk free ROR
βi = Beta, systematic risk of the portfolio
rm = return of the market
rm - rf = market risk premium

Exam tip: sometimes the market risk premium will be given rather than the return of the market.

stock premium = (rm - rf) βi

Answer 73

A

The relationship between risk and return as defined by the CAPM and graphically plotted results in the SML.

Both the CAPM and the SML assume an investor should at least earn a ROR equal to the risk-free rate of return.

The SML intersects the y-axis at the risk-free rate of return.
SML uses BETA to measure risk, CML uses SD to measure risk.

If a portfolio provides a return ABOVE the SML, it would be considered undervalued and should be purchased.
If a portfolio provides a return BELOW the SML, it would be considered overvalued and should not be purchased.
SML may be used with individual securities.

Answer 74

A

Relative risk-adjusted performance measure

Measures EXCESS RETURN and the CONSISTENCY provided by a fund manager, relative to a benchmark.

The higher the excess return (Information Ratio) the better

Excess return can be positive or negative depending on the fund’s performance relative to its benchmark.

IR = (Rp - Rb) / σA

Rp = portfolio’s actual return
Rb = benchmark return
Rp - Rb = excess return
σA = tracking error of active return (standard deviation of the difference between portfolio returns and index returns)

Answer 75

A

Tp = (rp - rf) / βp

rp = realized return of the portfolio
rf = risk free return
βp = beta of the portfolio

Measures risk-adjusted performance of a portfolio manager
Relative risk-adjusted performance indicator, i.e., one Treynor ratio needs to be compared to another to provide meaning

ONLY appropriate when R² > 0.70

Measures how much return was achieved for each unit of risk; higher Treynor ratio means more return was provided for each unit of risk. Measures reward achieved relative to the level of systematic risk (as defined by Beta) - accomplished by standardizing portfolio returns for volatility.

Treynor justifies use of the model on the assumption that in a well-diversified portfolio, unsystematic risk is always close to zero.

Treynor Index does not indicate whether a portfolio manager has outperformed or underperformed the market.

EXAM TIP: Use for well-diversified portfolios because Treynor uses Beta!

Answer 76

A

Risk adjusted performance measure that measures reward to total variability or total risk (standard deviation):

Sp = (rp - rf) / σp

rp = realized portfolio return
rf = risk free return
σp = standard deviation of the portfolio

Relative risk adjusted performance indicator, thus needs to be compared to another Sharpe ratio to provide meaning

ONLY appropriate when R² < 0.70
When R² is low, you need to consider all risks and would use standard deviation as the risk statistic.

Measure of how much return was achieved for each unit of risk; the higher the Sharpe Ratio the better (more return was achieved for each unit of risk).
Measures risk premiums of the portfolio relative to the total amount of risk in the portfolio.
Does NOT measure a portfolio manager’s performance against that of the market.

EXAM TIP: Use for non-diversified portfolios because Sharpe uses Standard Deviation.

Answer 77

A

Differs from Treynor and Sharpe in that it can distinguish a manager’s performance relative to that of the market and determine differences between realized (actual) returns and required returns as specified by CAPM.

While Treynor and Sharpe provide measure for relative performance, Jensen’s Model measures absolute performance on a risk-adjusted basis.

Positive Alpha → fund manager provided more return than expected for risk taken

Negative Alpha → fund manager provided less return than expected for risk undertaken

Alpha = 0 → fund manager provided return equal to expected return for risk taken

quantifies risk-adjusted return

αp = rp - [rf + (rm - rf) βp]

rp = realized portfolio return
rf = risk-free return
rm = expected return on the market
βp = beta of portfolio
αp = measure of portfolio manager's contribution to the return

The higher the alpha, the better the performance. Negative alphas indicate managers who have underperformed the market on a risk-adjusted basis.
Only when BETA = 1, ALPHA = amount a fund beat the market!

Answer 78

A

Both TREYNOR and ALPHA use Beta as measure of risk, thus, Treynor and Alpha are appropriate risk-adjusted performance indicators for a DIVERSIFIED portfolio, i.e., when R squared ≥ 0.70.

When R squared ≤ 0.70, the portfolio is not well diversified, thus Standard Deviation is an appropriate risk-adjusted measurement, thus using SHARPE is appropriate.

EXAM TIP: if exam doesn’t give you R Squared, select Sharpe!

Answer 79

A

Calculates effective annual interest rate earned on an investment when compounding occurs more often than once a year

EAR= (1 + i/n)^n -1

i = stated annual interest rate  
n = number of compounding periods

Example: Effective annual rate of 10% compounded quarterly:
(1+ 0.10/4)^4-1 = 10.38%

Answer 80

A

AM = (a1 + a2 + a3 + an) / n

OR on calculator:
a1 Σ+ a2 Σ+ a3 Σ+ an Σ+, Orange shift x̄, ȳ

ignores compounding effect over time

Answer 81

A

Time weighted compounded rate of return:
GM = n√(1 + r1) * (1 + r2) * (1 + r3) − 1

(May not be appropriate for a time series of asset returns due to possibility of a zero or negative return and due to compounding)

Answer 82

A

of a share price:
(Σ (# of shares x price per share)) / total # of shares

of portfolio return or weighted Beta (same calculation):
Σ((%weight A x %return A) + (%weight B x %return B) +(%weight N x %return N))

Answer 83

A

Used to evaluate capital projects and capital expenditures that will result in differing cash flows over the useful life or investment period.
The method discounts future cash flows at an appropriate discount rate and allows the present value of the inflows to be compounded to the present value of the outflows.
Discount rate = investor’s required ROR.

NPV = deterministic: if NPV = positive, investor would make the investment (actual return > required return), if negative, investor would not make the investment (actual return < required ROR); if NPV = 0, return meets required return, investor should make investment.

NPV = PV of Cash Flows - Initial Cost

+/- Initial cost = CF0
If sold in last year, add sales price to last year cash flow.
Solve for NPV

Answer 84

A

IRR allows financial planner to compare computed rate to required ROR
The method discounts future cash flows at an appropriate method used to determine the exact discount rate to equalize cash inflows and cash outflows of a specific investment or project.

IRR = discount rate that sets the NPV formula equal to zero

IRR calculation assumes reinvestment rate = IRR

Accept project where IRR > required ROR

YTM and YTC are examples of IRR calculation.

Can be thought of as a compounded rate of return.
IRR should be calculated when you have uneven cash flows and you are asked to calculate a compounded rate of return.

If NPV is positive, IRR > Discount Rate
If NPV is negative, IRR < Discount Rate
If NPV = 0, IRR = Discount Rate

NPV is considered superior model to IRR when comparing investment projects of unequal lives.
Investing at the required ROR is more reasonable than at the IRR.
With changes of more than 2 inflows or outflows in an investment project there will be only one NPV, however, multiple IRRs.

If NPV and IRR suggest two different investment projects, select the project with the higher positive NPV!

Answer 85

A

Calculates IRR using investor’s cash flows:

Bob purchases 1 share of DIS for $50. One year later the stock pays a $4 dividend, and Bob purchases an additional share for $65. Bob sold the stock one year later for $75/share. What was Bob's dollar weighted return?
Period          Cash Flow
   0                    +/- 50
   1                     +/- 61
   2                     150
IRR = 22.63%

Answer 86

A

Bob bought 100 shares of CISCO at $20/share; initial margin was 60%, he was charged 10% margin interest annually. After 1 year he sold the shares at $30/share. What is his HPR?

(3000 - (2000 x 0.6) - (2000 x 0.4 x 0.1) - (2000 x 0.4)) / (2000 x 0.6)

Where:
2000 x 0.6 = initial equity
2000 x 0.4 x 0.1 = margin interest paid
2000 x 0.4 = to be paid back

Answer 87

A

Bob bought 100 shares of CISCO at $20/share; initial margin was 60%, he was charged 10% margin interest annually. After 1 year he sold the shares at $30/share. Bob is in the 35% tax bracket and his LT capital gains tax rate is 15%. What is his after tax HPR?

(3000 - (2000 x 0.4) - ((2000 x 0.6) x (1 - 0.15)) - ((2000 x 0.4) x (1 - 0.35)) - ) / (2000 x 0.6)

Where: 
2000 x 0.6 = initial equity
2000 x 0.4 = to be paid back
(2000 x 0.6) x (1 - 0.15) = LTCG tax
(2000 x 0.4) x (1 - 0.35) = interest income tax

Answer 88

A

pricing imbalances cannot exist for a significant period of time, otherwise, investors will exploit the price imbalance until market prices are back to the equilibrium
attempts to take advantage of pricing imbalances
multi-factor model that attempts to explain return based on factors
anytime a factor has a value of zero, that factor has no impact on the return
inputs are factors, such as inflation, risk premiums, expected returns, and their sensitivity to those factors
Standard deviation and Beta are NOT input variables to the APT

Answer 89

A

Mutual funds report on a time-weighted basis.

Answer 90

A

Convert US Dollars to foreign currency to determine the cost
Compute the return, typically using HPR
Convert foreign currency back to US Dollars

Example:
100 shares in Intl. Easy Co. @ £12.75 when currency rate is $1.50/£ with transaction costs of £25.
Cost in £ = £12.75 x 100 + £25 = £1,300
Cost in $ = £1,300 x $1.50 =$1,950

If stock price increases to £17.50 a share, transaction cost to sell are £25 and currency rate is now$1.55/£, what is the gain in US dollars? 37.12% (HPR) or $723.75

Answer 91

A

The Constant Growth Dividend Discount Model values a company’s stock by discounting the future stream of cash flows.

V = D1 / (r-g)

r = required ROR
g = dividend growth rate
D1 = next expected dividend

Calculated using current dividend and dividend growth rate as follows: D1 = D0 (1+g)

Answer 92

A

r = (D1 / P) + g
P = market price or value

If the required ROR decreases, the stock price increases.
If the dividend is expected to increase, the stock price will increase.
If the required ROR increases, the stock price will decrease.
If the dividend is expected to decrease, the stock price will decrease.

Sample calculation:

current annual dividend = $2/share
5 years ago the dividend was $1.36/share
Dividend is expected to grow at the same compound annual rate as the past 5 years.
Required ROR = 12%
Expected return on the market portfolio = 14%
What is the value of a share of common stock using the constant dividend growth model?

N = 5
PV = +/-1.36
FV = 2
Solve for I/YR: 8.02%

V = D1 / (r-g)
2 (1.0802) / (0.12 - 0.0802) = $54.28

Answer 93

A

Normal / Upward sloping yield curve: short term rates are lower than long term rates

Flat: short and long term rates are similar

Inverted / Negative sloping: short term rates are higher than long term rates

(An inversion of the yield curve is indicative of a looming recession. Long-term investors will settle for lower yields.)

Answer 94

A

business cycle - longer end of the curve is a market rate and predicts anticipated economic conditions

Fed policy - short end of the curve is very sensitive to Fed policy (e.g., if fed aggressively increases the discount rate and predictions are keeping the longer end of the curve down, an inverted curve will likely be the result)

Answer 95

A

bond’s coupon payments (PMT) (assume semi-annual compounding: payment per period is half of the coupon)

market rate of interest for comparable bonds (I/YR)

amount of time remaining to maturity (N)

maturity / par value (assuming $1,000) (FV)

(Solve for PV to get the bond’s intrinsic value)

Answer 96

A

Provide for exchange of capital and credit in the economy

Money Markets - short term debt instruments

Capital Markets - long term debt and equity instruments; consist of Primary and Secondary Markets

Answer 97

A

New securities issued and sold to the public for the first time

registered with the SEC and sold to clients through IPO process
issuing firm = recipient of proceeds
Primary Markets and issues = regulated by Securities Act of 1933

Answer 98

A

previously issued securities trade among investors

issuing company not directly involved
Secondary Markets and issues = regulated by the Securities Act of 1934
2 forms of Secondary Markets:
1. Organized Exchange (NYSE)
2. OTC (NASDAQ)

Answer 99

A

Stock market = efficient, all stocks reflect relevant information and are priced in equilibrium.
Investors who accept EMT would be passive investors and buy only index funds

Strong Form
Semi Strong Form
Weak Form

Answer 100

A

Investor has no access to
Technical Analysis
Fundamental Analysis
Insider Information

Answer 101

A

Investor has
Access to Inside Information

No Access to Fundamental or Technical Analysis

Answer 102

A

Investor has

Access to Insider Information and Fundamental Analysis

No Access to Technical Analysis

Answer 103

A

Cannot be explained away by EMT

Low P/E effect
Small Firm effect
Neglected Firm effect
January effect
Value Line Phenomenon

Answer 104

A

global standard for fund performance

based solely on appreciation or depreciation of a portfolio from period to period

Answer 105

A

coupon yield

Answer 106

A

annual coupon / current market price

Answer 107

A

YTM and YTC are calculated in similar ways. When asked which yield is appropriate to make an investment decision, choose the lower one (= YTW)

Answer 108

A

Intrinsic value of the existing bond goes up

Answer 109

A

time to recoup your money on a bond investment (= effective maturity)

used to estimate changes in bond prices based on hypothetical changes in prevailing rates (a 1% change in rates would lead to roughly a % change in bond’s price equal to duration expressed as a percent)

Answer 110

A

Weighted average of the Present Values of the future cash flows of a bond / bond portfolio

always stated in years

for income producing bonds, duration will always be shorter than maturity

for Zero Coupon bonds, duration = maturity

Duration increases with maturity

higher coupon → lower duration

Duration = linear estimate, tends to overestimate risks from rising interest rates and underestimate benefits from lowering interest rates

Answer 111

A

It immunizes those assets, thus, significantly reduces purchasing power and reinvestment rate risks for the assets

Answer 112

A

Rate Decrease leads to Price Increase
Rate Increase leads to Price Decrease

A 1% change in rates roughly equals a % change in bond’s price that is equal to the duration expressed as a percent.

Short end of the curve will not move too much with rate changes.
Long end of the curve will move significantly with rate changes.

The LONGER the duration and the LOWER the coupon, the MORE SENSITIVE to rate changes.

The SHORTER the duration and the HIGHER the coupon, the LESS SENSITIVE to rate changes.

(If asked to calculate price change in portfolio, multiply percentage change in price by $$ in portfolio.)

Answer 113

A

The day of acquisition is excluded

the day of disposal is included

Answer 114

A

returns:
20%, 15%, -9%, 34%, -16%
What percentage of the time would you expect a return between-12% and -32.8%?

20 Σ+
15 Σ+
9, +/- Σ+
34 Σ+
16, +/- Σ+
Shift, 7 (x,y) - mean
Shift, 8 (sx, sy) - SD

Answer 115

A

Sharpe Treynor Jensen’s Alpha

What? risk adjusted return risk adjusted return excess return

When? R² < 0.70 R² > 0.70 R² > 0.70

Value relative relative absolute

Relevant Standard Beta Beta
Risk Statistic Deviation

Answer 116

A

investors cannot deduct losses from sales or trades of stock or securities in a wash sale unless the loss was incurred in the ordinary course of their business as a dealer in stock or securities

Wash sale: occurs when taxpayer realizes a loss on the sale of a security and acquires a substantially identical security within a 61-day period (30 days prior to the trade date to 30 days after the trade date)

Substantially identical:

bonds: unless exact same bond or bond fund is purchased, it is difficult to violate the wash sale rule with fixed income
stocks that trigger “substantially identical”: convertible bond (can convert to same stock that was sold for a loss); purchase a call option that can be exercised into the same stock that was sold for a loss

Wash sale ramifications:

loss on sold security will be disallowed
disallowed loss will be added to basis of new securities purchased
when new (replacement) securities are sold (via higher cost basis), loss will be allowed eventually

Answer 117

A

Example:
Patrick bought 1000 shares of BIF
Current dividend $4.00
Dividends are expected to grow 5% annually for the next 3 years
After 3 years, BIF dividends are projected to grow at 4%
Patrick’s required ROR = 8%
What is the valuation of BIF stock?

Step 1:
D1 = D0 x (1+g) = 4.20
D2 = D1 x (1+g) = 4.41
D3 = D2 x (1+g) = 4.63

Step 2:
(4.63 x 1.04) / (0.08 - 0.04) = 120.38 + 4.63 = 125.01

Step 3:
Solve for NPV
8 I/YR
0 CF0
4.2 CF1
4.41 CF2
125.01 CF3
Shift, NPV = 106.91

Answer 118

A

Buyer = holder, long
Seller = writer, short

Buyer of the contract has the right (or option) to do the following:

call contract: right to purchase shares
put contract: right to sell shares

Seller of the contract has the obligation to do the following:

call contract: obligation to sell shares
put contract: obligation to buy shares

The buyer of the contract pays the seller a premium to enter the contract.
Premium is $ per share.
Premium presents:
    - maximum possible loss for buyer
    - maximum possible gain for seller

All contracts will stipulate:

- exercise price
- expiration date

All contracts cover 100 of the underlying stock.

Value comes from favorable difference between market price of the stock and the exercise price of the contract,
- know as “in the money”:
- for a call favorable difference is when MP > EP
- for a put favorable difference is when MP < EP
If there is no favorable difference, option is “out of the money”.
If MP = EP, option is “at the money”.

Options Clearing Corporation (OCC) guarantees the performance of both parties.
- eliminates counterparty risk

Both the buyer and the seller of an option can be bullish or bearish on the underlying stock.

Options Strategies
Long Straddle↓ Short Straddle ↓

                Buy (hold)                Sell (write)

Call Bull ↑ Bear ↓
Spreads

Put Bear ↓ Bull ↑
Spreads

To arrive at the profit net the premium paid from the current gain!

Answer 119

A

The premium is the price the option buyer pays to the option seller to establish the option contract.

premium is paid on a per-share basis
2 basic variables and 5 expanded variables that determine an option’s price:
- intrinsic value: market price of underlying stock
exercise price of option contract
Time premium: risk-free rate of return
time to expiration
variability of underlying stock (as measured by standard deviation)

The greater any or all of the 3 expanded variables, the greater the time premium
Time premium is greatest at the creation of the contract and approaches $0 at the expiration of the contract.
Intrinsic value can never be less than $0.

Options Premiums

Option Type Total Premium EP MP Intrinsic Value Time Premium
Call $5 $30 $32 $2 $3
Call $4 $60 $58 $0 $4
Call $8 $20 $25 $5 $3
Put $7 $45 $44 $1 $6
Put $2 $75 $85 $0 $2
Put $6 $90 $92 $0 $6

Intrinsic Value calculations:
Intrinsic Value for Call options: COME: Call Option = Market Value - Exercise Price
Intrinsic Value for Put option: POEM: Put Option = Exercise Price - Market Value

Answer 120

A

Used to hedge existing stock position or to speculate on stock without owning it

Covered call writing: Long the underlying stock - short the call
- Only considered covered if you own enough shares to cover all contracts sold
- Used to generate income for portfolio
Naked call writing: does not own underlying stock - short the call
- unlimited risk for writer
Protective put: Long the stock - long the put
- portfolio insurance
Protective call: Short the stock - long the call
- used to protect a short position in the stock
Covered put: Short the stock - short a put
- writer uses the stock put to cover their short stock position
Collar (Zero cost collar): Long the stock - long the put - short the call
- put is used to protect against a stock price decrease, call premium used to
offset cost of the put
Straddle: Long a put and a call on the same underlying stock with the same
expiration date and strike price
- used to capitalize in volatility regardless of the direction
Spread: involves purchasing and selling same type of contract
- benefit from stability (i.e., minimum moves in underlying stock’s price)

Answer 121

A

Agreement to buy or sell a specific amount of commodity, a currency, or a financial instrument at a particular price on a stipulated future date.

Spot price = current market value of the item in today’s market (e.g., melt value of gold)

Futures contract allows speculation and hedging on the spot price at some point in the future (almost all contracts are settled through an offsetting contract, not through physical delivery)

Futures contracts are standardized

Clearinghouse acts as intermediary that guarantees performance of both parties involved in the contract and eliminates counterparty risk.

Using futures for hedging strategies:

long position: if you own something you are long (e.g., corn farmer is long corn)
short position: if you have to buy something, you are short (e.g., construction company that needs to build is short lumber)
Short hedge: anyone who is long needs a short hedge (selling a futures contract establishes a short hedge)
Long hedge: anyone who is short needs a long hedge (buying a futures contract establishes a long hedge)

Forward contracts are different in that they are not standardized (can take any form the parties agree to) and are not executed through a clearinghouse, thus cary counterparty risk

Answer 122

A

If Sri’s T-Bill were sold today, he would receive $990.83, calculated as follows:

Face Value × [1 - ((Days to Maturity ÷ 360) X Yield)] = Current Price

$1,000 × [1 – ((120 ÷ 360) × 0.0275)] = $990.83

Answer 123

A

Since the conversion price is $1,000/75, or, $13.34 per share, the investor can convert and sell the shares for $12.75. This would create a $0.59 loss per share or a total loss of $44.25 ($0.59 x 75 shares).

Because the conversion would result in a loss, the bondholder should not convert.

Answer 124

A

When interest rates decrease below the stated interest of the debt (the coupon rate), the security will be worth more since new debt pays less interest. Therefore, the market price for the debt would be above par value, otherwise known as a premium bond.

Answer 125

A

Payout Ratio and Expected Earnings

Dt = (Pt)(Et); dividends are replaced by the payout ratio multiplied by expected earnings. When solving for the normal price/earnings ratio, the expected earnings is divided into the intrinsic value.

Answer 126

A

Divide standard deviation by return to determine Coefficient of Variation. This tells us the unit of risk per unit of return. The lowest one is the most efficient portfolio!

Answer 127

A

Short-term yield is lower than long-term yield
A ladder structure will be the most beneficial in a normal upward sloping yield curve indicating higher yield at longer maturities, with a stable interest rate environment.

(Barbells work better in a flat yield curve while bullet works better for a steep yield curve.)

Answer 128

A

A collar is beneficial when the rate goes above the cap.

Answer 129

A

Integrated asset allocation considers the investor’s goals and policies and capital market conditions, and then uses these data as inputs to some kind of optimizer. The optimizer’s solution becomes the new inputs that are reconsidered along with the investor’s latest goals and policies and most recent market conditions when revising the asset allocation.

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