Investment Practice Exam Flashcards
Municipal bonds are frequently insured. One of the insurers is the:
a) Federal Insurance Guarantee Corporation.
b) Resolution Trust Corporation.
c) Associated Municipal Bond Corporation.
d) Municipal Insurance Group.
e) Municipal Bond Insurance Association.
Answer: E
Municipal Bond Insurance Association insures municipal bonds.
Jennifer is optimistic about the long-term growth of her Widget stock. The stock, however, currently priced at $58, has made a sharp advance in the last week, and she wants to lock in a minimum price in case the shares drop. What might Jennifer do?
a) Buy $55 call options.
b) Sell $55 call options.
c) Buy $55 put options.
d) Sell $55 put options.
Answer: C
Anytime an investor wants to “lock-in” a minimum price or profit, the appropriate answer is to buy a put. Buying a call is the same as buying the stock and taking a long position. Selling a call will only result in a
maximum gain equal to the premium and provides no downside protection. Selling a put will only result in a maximum gain equal to the premium as well.
In May 1993, Joe Edd bought a tax-exempt original issue discount (OD) bond. Which of the following statements apply?
- The bond basis increases at a set rate each year.
- The difference between the maturity value and the original issue discount price is the OID.
- The bond’s earnings are treated as exempt-interest income.
- The bond was issued at a discount to its par value.
a) 2 and 3.
b) 1 and 4.
c) 1, 2, and 4.
d) 3 only.
e) 1, 2, 3, and 4.
Answer: E
An original issue discount bond is sold at a discount to par value. As it matures, the price of the bond increases until the price reaches the par value. The OID is the difference between its maturity value and the original issue discount price. Since this bond is tax-exempt, the earnings are treated as tax-exempt interest income.
Harry Ingram purchased ten listed bonds (Widget Corp 8.00s 10/1/21) on June 30, 2017, at a market-asked price of 95. His transaction cost from the trade was $100. He paid his broker $9,800 as a consequence of the trade. He asks you to explain the details of his purchase. You reply that:
- His purchase cost included $9,500 for the bonds, $100 for broker commission, and $200 as mark-up by the trade specialist.
- His broker will report $400 on Form 1099-INT as 2017 taxable interest on these bonds. His taxable interest income from the bonds for 2017 was $400.
- His purchase cost included $9,500 for the bonds, $100 for broker commission, and $200 as accrued interest.
- His broker reported $400 on Form 1099-INT as 2017 taxable interest on these bonds. His taxable interest income from the bonds for 2017 was $200.
- His purchase cost included $9,500 for the bonds, $100 for broker commission, and $200 charged in error by the brokerage house.
a) 3 and 4.
b) 1 and 2.
c) 1 and 4.
d) 2 and 3.
e) 2 and 5.
Answer: A
$9.500 Price of the Bonds
100 Commission
200 ($9,800 - $9,500 - $200) Accrued Interest Entitled to a Deduction
$9,800 Interest for the six months will be 8% x $1,000 x (6÷12) = $400
Harry will receive the full $400 coupon payment on October 1, and the broker will report on Form 1099-INT this amount as paid to him. When Harry files his taxes, he will include the $400 of interest income on Schedule B and will adjust (deduction) for the $200 of accrued interest paid to the seller, resulting in a net amount of $200 taxed to Harry.
The standard deviation of the returns of a portfolio of securities will be _____ the weighted average of the standard deviation of returns of the individual component securities.
a) Equal to.
b) Less than.
c) Greater than.
d) Less than or equal to (depending upon the correlation between securities).
e) Less than, equal to, or greater than (depending upon the correlation between securities).
Answer: D
The standard deviation of the returns of a portfolio will equal the weighted average of the standard deviation of returns when the correlation is equal to one. Anytime correlation is less than one, then the standard deviation of the returns will be less than the weighted average of the standard deviation of returns.
According to fundamental analysis, which phrase best defines the intrinsic value of a share of common stock?
a) The par value of the common stock.
b) The book value of the common stock.
c) The liquidating value of the firm on a per-share basis.
d) The stock’s current price in an inefficient market.
e) The discounted value of all future dividends.
Answer: E
The intrinsic value is what an investor thinks the stock is worth based upon discounted future cash flows of the stock.
Municipal bonds backed by the income from specific projects are known as
a) Income bonds.
b) Revenue bonds.
c) General obligation bonds.
d) Debenture bonds.
e) Project bonds.
Answer: B
Revenue bonds are backed by income from a specific project. Income bonds are only paid when income reaches a certain level. General obligation bonds are backed by the full faith and credit of the municipality issuing the bonds. Debenture bonds are unsecured corporate bonds. There is no such thing a municipal project bond.
A call option with a strike price of 110 is selling for 3 when the underlying stock’s market price is 108. The intrinsic value of the call is:
a) 0
b) 1.
c) 2.
d) 3.
e) -2.
Answer: A
The formula for the intrinsic value of a call option is Stock Price - Strike Price.
Intrinsic value = 108 - 110 = <2>. However, the intrinsic value of an option can never be less than zero. The best answer is A.
If the market risk premium were to increase, the value of a common stock (everything else being equal) would:
a) Not change because this does not affect stock values.
b) Increase to compensate the investor for increased risk.
c) Increase due to higher risk-free rates.
d) Decrease to compensate the investor for increased risk.
e) Decrease due to lower risk-free rates.
Answer: D
If the market risk premium increases, stock prices will decrease to provide investors with compensation for the increased risk associated with the market risk premium increasing.
Which of the following is/are characteristics of a municipal bond unit investment trust?
- Additional securities are not added to the trust.
- Shares may be sold at a premium or discount to the net asset value.
- Shares are normally traded on the open market (exchanges).
- The portfolio is self-liquidating.
a) 1 only.
b) 1 and 4
c) 2 and 3.
d) 2 and 4.
e) 1,2, 3, and 4.
Answer: B
Municipal bond unit investment trusts are passively managed and self-liquidating. The bonds are held until maturity, and the proceeds are then dispersed to the investors. Once the assets are purchased, no other assets are added to the trust.
American depository receipts (ADRs) are used to:
- Finance foreign exports.
- Eliminate currency risk.
- Sell US securities in overseas markets.
- Trade foreign securities in US markets.
a) 1 and 3.
b) 1 and 4.
c) 2 and 4.
d) 4 only.
e) 1, 2, and 4.
Answer: D
Bankers’ acceptance is used to finance exports and imports. ADRs do not eliminate currency or exchange rate risk. ADRs represent foreign securities, and ADRs are traded in the US ADRs are also denominated in US dollars.
Which combination of the following statements about bond swaps is true?
- A substitution swap is designed to take advantage of a perceived yield differential between similar bonds concerning coupons, ratings, maturities, and industry.
- Rate anticipation swaps are based on forecasts of general interest rate changes.
- The yield pickup swap is designed to change the cash flow of the portfolio by exchanging similar bonds that have different coupon rates.
- The tax swap is made to substitute capital gains for the current yield.
a) 1, 2, and 3.
b) 1 and 3.
c) 2 and 4.
d) 4 only.
e) 1, 2, 3, and 4.
Answer: A
All statements are true except that a tax swap is meant to offset bonds with capital gains and losses.
The following set of newly issued debt instruments was purchased for a portfolio:
• Treasury bond
• Zero-coupon bond
• Corporate bond
• Municipal bond
The respective maturities of these investments are approximately equivalent.
Which one of the investments in the preceding set would be subject to the most significant relative amount of price volatility if interest rates were to change quickly?
a) Treasury bond.
b) Zero-coupon bond.
c) Corporate bond.
d) Municipal bond.
Answer: B
Zero-coupon bonds will have the most extended duration because the duration will equal the term. Bonds with the highest duration are the most price-sensitive to changes in interest rates.
Which of the following best describes the investment characteristics of a high-quality long-term municipal bond?
a) High inflation risk; low default risk.
b) Low inflation risk; high market risk.
c) Low inflation risk; low default risk.
d) High inflation risk; high market risk.
Answer: A
All bonds are subject to inflation risk, which is in the form of purchasing power risk. Long-term bonds are subject to more inflation/purchasing power risk than shorter-term bonds. There is no inflation protection because the coupon payments remain constant throughout the bond term. As inflation increases, the investor has less purchasing power. Municipal bonds have a low default risk because the issuing municipality may raise taxes to repay the bondholders.
Jasmine has a significant paper profit in her Amalgamated Corporation shares, currently 46. She is happy with the stock but realizes that a good thing cannot go on forever. If she is willing to sell at 50, what strategy could you recommend?
a) Buy $50 call options.
b) Sell $50 call options.
c) Buy $50 put options.
d) Sell $50 put options.
Answer: B
This question is a bit tricky. Because she is happy with the stock, she may be willing to continue holding the stock. By selling a call option, she has the opportunity to participate in the additional appreciation of the stock before being called out of the stock. If she buys a put option with a strike price of $50, she would be paying $4 (50-46) in intrinsic value. She really isn’t selling the stock at $50 with the put option because she had to pay extra for an “in the money” put option. Buying a call is a similar position to buying more stock, or taking a long position.
