Investments Flashcards

Question

When considering a diversified portfolio, which of the following is an appropriate measure of risk? a) Standard deviation. b) Beta. c) Covariance. d) Coefficient of determination. e) Correlation coefficient.

Answer 1

**Answer: B** Beta is an appropriate measure of risk for a diversified portfolio (one that has a high r²). Standard deviation is an appropriate measure of total risk for a nondiversified portfolio.

Answer 2

* R-squared is a measure of how much return is due to the market or what percentage of a security’s return is due to the market. * Calculate r-squared (r²) by squaring the correlation coefficient. * If mutual fund XYZ has a correlation coefficient of 0.80, then its r² is 0.64, which means 64% of fund XYZ’s return is due to the market. * R-squared (r²) also provides the investor insight into how well-diversified a portfolio is, because the higher the r-squared, the higher percentage of return from the market (systematic risk) and the less from unsystematic risk. * R-squared also tells the investor if Beta is an appropriate measure of risk. * If r-squared is greater than or equal to 0.70, then Beta is an appropriate measure of total risk. If r-squared is less than 0.70, then Beta is not an appropriate measure of total risk and standard deviation should be used to measure total risk.

Answer 3

**Answer: B** Correlation = 0.90, therefore, r-squared = 0.81. 81% of the return is due to the market and 19% is due to unsystematic risk.

Answer 4

**Answer: C** Index 3 is the appropriate benchmark to measure the performance of Sam’s portfolio against because Index 3 accounts for 95% (r-squared) of the return in Sam’s portfolio.

Answer 5

* The risk of a portfolio can be measured through determination of the interactivity of the standard deviation and covariance of securities in the portfolio. * The process also utilizes the weight of both securities involved, the deviations of the respective securities, and the correlation coefficient of the two securities. * This formula is also known as Portfolio Deviation Formula or Standard Deviation of a Two Asset Portfolio Inputs: * w_A = Weight of Asset A. * σ_A = The standard deviation of Asset A. * w_B = Weight of Asset B. * σ_B= The standard deviation of Asset B. * COV_AB = Covariance formula (on CFP® Exam formula sheet). Second formula in right column. Formula is on the CFP® Exam formula sheet, but it may not be necessary to use the formula: Can take (σ_Ax weight) + (σ_B x weight) and adjust downward to compensate for the correlation between the assets.

Answer 6

Systematic risk is the lowest level of risk one could expect in a fully diversified portfolio. It is inherent in the “system” as a result of the unknown element existing in securities that have no guarantees. PRIME * **P**urchasing Power Risk.\* * Purchasing power risk is the 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 or the day after. * Purchasing power risk impacts both equities and bonds * **R**einvestment Rate Risk.\* * Reinvestment rate risk is the risk that an investor will not be able to reinvest at the same rate of return that is currently being received. * Reinvestment rate risk mostly impacts bonds. * **I**nterest Rate Risk.\* * Interest rate risk is the 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. * **M**arket Risk. * Market risk impacts all securities in the short term because the short-term ups and downs of the market tend to take all securities in the same direction. * **E**xchange Rate Risk. * Exchange rate risk is the risk that a change in exchange rates will impact the price of international securities. \* = most likely to be tested

Answer 7

Unsystematic risk is the risk that exists in a specific firm or investment that can be eliminated through diversification. Through ownership of a number of different securities or investments, the investor can eliminate this risk and insulate their investments. ABCDEFG * **A**ccounting Risk * Accounting risk is the risk associated with an audit firm being too closely tied to the management of a company, for example: Arthur Andersen and Enron. * **B**usiness Risk\*\* * Business risk is the inherent risk a company faces by operating in a particular industry. For example, Halliburton faces much different risks in the oil industry than Microsoft does, which is primarily selling intellectual property and protecting copyrights. * **C**ountry Risk\*\* * Country risk is the risk a company faces by doing business in a particular country. For example, Halliburton faces unique risks doing business in Iraq. * **D**efault Risk\*\* * Default risk is the risk of a company defaulting on their debt payments. Default risk can be thought of as the likelihood of a firm being able to satisfy its debt obligations on time. * **E**xecutive Risk * Executive risk is the risk associated with the moral and ethical character of the management running the company. * **F**inancial Risk\*\* * Financial risk is the amount of financial leverage deployed by the firm. Financial leverage is the ratio of debt versus equity the firm has deployed, or the financial structure. The higher the percentage of debt deployed by the firm, the more risky. * **G**overnment/Regulation Risk\*\* * Government or regulation risk is the risk that tariffs or restrictions may be placed on an industry or firm that may impact the firm’s ability to effectively compete in an industry. \*\* = most likely to be tested

Answer 8

**Answer: C** Stock index funds and ETFs that track market indices are subject to systematic risk or market risk, since they attempt to achieve market-type returns. All others are examples of unsystematic, or diversifiable, risk.

Answer 9

**Answer: A** Nondiversifiable risks are systematic risk. Recall the mnemonic for systematic risk: PRIME risks.

Answer 10

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

Answer 11

The curve which illustrates the best possible returns that could be expected from all possible portfolios. * No portfolio on the efficient frontier is better than any other portfolio that lies on the efficient frontier. It actually depends on the investor’s risk tolerance when determining which portfolio is preferred on the efficient frontier. * The efficient frontier represents the most “efficient” portfolios in terms of the risk-reward relationship. An investor cannot achieve a portfolio that has a higher return for each level of risk. * Portfolios that lie beneath the efficient frontier are “inefficient” because there is a portfolio that provides more return for that level of risk. * The area above the efficient frontier is considered “unattainable.”

Answer 12

Constructed using selections made based on this highest level of return given an acceptable level of risk. * An indifference curve represents how much return an investor needs to take on risk. * If an investor is risk-averse, this investor will have a very steep indifference curve. This means the investor requires significantly more return to take on just a little more risk. * Alternatively, if an investor is risk-seeking, they will have a relatively flat indifference curve. This means the investor will not require a significant amount of return to take on more risk.

Answer 13

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

Answer 14

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

Answer 15

**Answer: B** A and B are both the same level of risk but B has a higher return. This leads one to believe that B is on the efficient frontier or at least more efficient than A. C and D both have the same level of return but C is less risky than D. Therefore C is more likely to be on the efficient frontier than is D.

Answer 16

**Answer: C** When designing a portfolio the most important variables are risk, return and covariance (how asset classes move relative to each other). Negatively correlated assets are not necessary to reduce risk; simply, assets with a correlation less than 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 17

* The Capital Market Line (CML) is the macro aspect of the Capital Asset Pricing Model (CAPM). It specifies the relationship between risk and return in all possible portfolios. * The 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. * The CML is not used to evaluate the performance of a single security. Inputs: * r_p = Required portfolio rate of return. * r_f = Risk-free rate of return. * r_m = Return on the market. * σ_m = Standard deviation of the market. * σ_p = Standard deviation of the portfolio. The CML formula is no longer on the formula sheet. You may be asked what measure of risk the CML uses, which is standard deviation. * The CML intersects the Y-axis at the risk-free rate because an investor with 100% of his assets in the risk-free asset will yield a return but experience no variability (standard deviation). * The CML runs tangent (touches in only one spot) with the efficient frontier at the “optimal portfolio” or the “tangency portfolio.” * Before the CML touches the efficient frontier the investor is said to have a security allocation made up of the optimal portfolio mix and is lending a portion of uninvested assets at the risk-free rate. * At the optimal portfolio, the investor is fully invested in that portfolio—he does not lend anything at the risk-free rate or borrow at that rate. * To the right of the optimal portfolio, the investor is said to have borrowed at the risk-free rate to fully invest all capital and borrowed funds in that portfolio. * As always, any portfolio above the efficient frontier/CML is unobtainable and any below is inefficient.

Answer 18

* The Capital Asset Pricing Model (CAPM) calculates the relationship of risk and return of an individual security using the Beta (b) as its measure for risk. * The CAPM formula is often referred to as the Security Market Line (SML) equation because its inputs and results are used to construct the SML. * The difference between the (r_m - r_f) is considered the market risk premium, that is how much an investor should be compensated to take on a market portfolio versus a risk-free asset. Inputs: * r_i = Required or expected rate of return. * r_f = Risk-free rate of return. * ß_i = Beta, which is a measure of the systematic risk associated with a particular portfolio. * r_m = Return of the market. * r_m - r_f = Market risk premium. You may be given the market risk premium rather than the return of the market. **Be sure to remember that the market risk premium is (r_m - r_f).** Fourth formula in the right column.

Answer 19

**Answer: C** r_i = r_f + (rm - rf)ßi = 0.03 + (0.09)1.5 = 16.5% Note: The risk premium is given in the question facts (r_m - r_f). We do not need to calculate it.

Answer 20

* The relationship between risk and return as defined by the CAPM and graphically plotted results in the Security Market Line (SML). * Both the CAPM and SML assume an investor should earn a rate of return at least equal to the risk-free rate of return. * The SML intersects the y-axis at the risk-free rate of return. * The SML uses Beta as its measure of risk, whereas the CML uses Standard Deviation as its measure of 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. * The SML may also be used with individual securities.

Answer 21

**Answer: A** The starting point on the CML/SML is a risk-free rate of return.

Answer 22

* A relative risk-adjusted performance measure. * Measures the excess return and the consistency provided by a fund manager, relative to a benchmark. * The higher the excess return (or Information Ratio) the better. * Excess return can be positive or negative depending on the fund’s performance relative to its benchmark. Inputs: * R_p = The portfolio’s actual return. * R_b = The return of the benchmark. * R_p – R_b = excess return * σ_A = Tracking error of active return (standard deviation of the difference between portfolio returns and index returns). Seventh formula in left column.

Answer 23

A risk-adjusted performance measure. It’s also a “relative” risk-adjusted-performance indicator, meaning one Treynor ratio needs to be compared to another Treynor ratio to provide meaning. * The Treynor Index uses the beta of a portfolio as its denominator, and the difference between the portfolio return and the risk-free return as the numerator. * It's a measure of how much return was achieved for each unit of risk. The higher the Treynor ratio, the better because that means more return was provided for each unit of risk. * It measures the 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, the unsystematic risk is already close to zero. * Treynor Index doesn’t indicate whether a portfolio manager has outperformed or underperformed the market. Inputs: * r_p = The realized return on the portfolio. * r_f = The risk-free rate of return. * ß_p = The beta of the portfolio. Fifth formula in the right column.

Answer 24

Answer: A Select the Growth Fund because it has a higher Treynor ratio. * Growth Fund Treynor = (0.12 - 0.03) / 1.2 = 0.075 * Index Fund Treynor = (0.09 - 0.03) / 1 = 0.06 Note the Index Fund Beta is 1 because it tracks the market.

Answer 25

Sharpe provides a measure of portfolio performance using a risk-adjusted measure that standardizes returns for their variability. The model measures reward to total variability, or total risk. Inputs: * r_p = realized return on the portfolio. * r_f = risk-free rate of return. * σ_p = standard deviation of the portfolio. The Sharpe Index is: * A risk-adjusted performance measure. It’s also a “relative” risk-adjusted-performance indicator, meaning one Sharpe ratio needs to be compared to another Sharpe ratio to provide meaning. * A measure of how much return was achieved for each unit of risk. The higher the Sharpe ratio, the better because that means more return was provided for each unit of risk. * Sharpe Index measures risk premiums of the portfolio relative to the total amount of risk in the portfolio. * The formula does not measure a portfolio manager’s performance against that of the market. Ninth formula in the left column (second to last)

Answer 26

**Answer: B** Because sector funds are not well-diversified the most appropriate risk measure to use is standard deviation. Recall the standard deviation is used for nondiversified portfolios and Beta is used for well-diversified portfolios. When evaluating both Sharpe and Treynor ratios, always select the fund that provides the highest Sharpe or Treynor ratio. The higher the Sharpe or Treynor, the more return for each unit of risk.

Answer 27

* The Jensen Index or Jensen’s Alpha is significantly different from Sharpe and Treynor in that the Jensen’s Alpha is capable of distinguishing a manager’s performance relative to that of the market and determining differences between realized or actual returns and required returns as specified by CAPM. * Treynor and Sharpe are calculations for providing a measure and ranking of relative performance. Jensen’s model attempts to construct a measure of absolute performance on a risk-adjusted basis. * An absolute performance measure simply means that looking at Jensen’s Alpha tells you something. * A positive Alpha indicates that the fund manager provided more return than was expected for the risk undertaken. * A negative Alpha indicates that the fund manager provided less return than was expected for the risk that was undertaken. * An Alpha of zero indicates that the fund manager provided a return equal to the return that was expected for the risk that was undertaken. Inputs: * r_p = realized portfolio return. * r_f= risk-free rate of return. * a_p = alpha, an intercept that measures the manager’s contribution to the portfolio return. * ßp = beta of the portfolio. rm = expected return on the market. Fifth formula in the left column.

Answer 28

**Answer: A** Since both portfolios are well-diversified, as indicated by r-squared, then evaluate the funds based on the risk-adjusted performance indicator that uses Beta. Since Alpha uses Beta as its measure of risk, the fund with the higher Alpha should be selected. Note: If the r-squared was less than 0.70, the funds would not be well-diversified, so standard deviation should be the risk measure. Only Sharpe uses standard deviation as its risk measure. Then fund B would have been appropriate.

Answer 29

**Answer: E** Standard deviation is a measure of volatility and variability. Standard deviation by itself is not a risk-adjusted performance indicator. For Sharpe to be meaningful, one Sharpe ratio needs to be compared to another Sharpe ratio. The Alpha ratio is calculated below: a_p = r_p - [r_f + (r_m - r_f)ßp] a_p = 0.19 - [0.03 + (0.08 - 0.03)2] 0.19 - 0.13 = 0.06 or 6%

Answer 30

**Answer: C** The calculation for alpha is the actual return of the fund less the expected return on the fund. The only time the alpha will equal the amount the fund beat the market is if the beta is one. Let’s just make up some numbers. Return on the portfolio is 8%, return on the market is 6%, the risk-free return is 2%, and beta is 1. a_p = r_p - [r_f + (r_m - r_f)ßp] a_p = 0.08 - [0.02 + (0.06 - 0.02)1] 0.08 - 0.06 = 0.02 or 2%

Answer 31

* Both Treynor and Alpha use Beta as the measure of risk; therefore, Treynor and Alpha are appropriate risk-adjusted performance indicators when considering a diversified portfolio. * A portfolio is considered diversified when r-squared is greater than or equal to 0.70. If r-squared is greater than or equal to 0.70 then Beta is a reliable measure of total risk; therefore, Treynor and Alpha are appropriate risk-adjusted performance measures. * A portfolio is considered not well-diversified when r-squared is less than 0.70. If r-squared is less than 0.70, then Beta is not an appropriate measure of total risk; therefore, standard deviation is an appropriate risk measurement. If standard deviation is an appropriate measure of risk, then using Sharpe as a risk-adjusted measurement is appropriate because Sharpe uses standard deviation as its measure of risk. * Sharpe and Treynor are relative performance measures. Relative means that you must compare one Sharpe or one Treynor to another. The higher the Sharpe or Treynor, the more return for each unit of risk. Always select the higher Sharpe or Treynor ratio. * When determining which fund performed better on a risk-adjusted basis, always rank the Sharpe or Treynor ratios, then select the highest. * Alpha is an absolute performance measure. A positive Alpha is good; a negative Alpha is bad. * Select which risk-adjusted performance measures to use based on r-squared. * If r-squared is \> 0.70, use Treynor and Alpha because both use Beta and a r-squared \> 0.70 indicates the portfolio is well-diversified and Beta is an appropriate measure of total risk. * If r-squared is \< 0.70, then the portfolio is not well-diversified so use Sharpe because it uses standard deviation as its measure of risk. Standard deviation is appropriate for portfolios that are not well-diversified. * If r-squared is too low, they are using wrong benchmark. Therefore IR doesn’t hold as true measure.

Answer 32

**Answer: C** Because the correlation is 0.80, the r-squared is 0.64. Only 64% of the return for fund ABC is due to the S&P 500. Therefore, 36% is due to unsystematic risk. Since Beta only measures market (systematic risk), too much return is due to unsystematic risk; therefore, Beta is not appropriate. Rule out Treynor and Jensen since both use Beta. Sharpe uses standard deviation, which measures total risk market (systematic) and unsystematic.

Answer 33

This formula is not on the provided formulas sheet.

Answer 34

This formula calculates the effective annual interest rate earned on an investment when the compounding occurs more often than once per year. Inputs: * i = i = stated annual interest rate * n = number of compounding periods Seventh formula on the right (EAR).

Answer 35

The arithmetic average (or mean) is also known as the simple average. It is the sum of all numbers divided by the number of observations. Eighth formula on the right (under EAR). Or, enter each value followed by the sigma plus key Σ+. once all are entered, downshift 7 (x, y)

Answer 36

This is the standard formula for finding the geometric mean for a set of observations, where a1, a2, a3, etc may represent a set of given stock prices over a period of time. Last formula on the right. Or, enter each number and multiply it by the following number. Once all are entered, downshift multiply (y^x), enter the number of values just multipled, downshift divide (1/x), =. A negative value under the radical makes the formula unusable, as we cannot take the n^th root of a negative number. A zero return also creates issues.

Answer 37

Multiply the price of each share by the number of shares at that price. Add the total for each type of share together. Divide by total number of shares.

Answer 38

You may not have to calculate dollar-weighted or time-weighted return, but you must know that mutual funds report on a time-weighted basis.

Answer 39

* APT asserts that pricing imbalances cannot exist for any significant period of time; otherwise investors will exploit the price imbalance until the market prices are back to equilibrium. * 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. * **Standard deviation** and **beta** are ***_not_*** inputs to the APT. * r_i = a₁ + b₁F₁ + b₂F₂ + b₃F₃ + e * Don’t memorize the formula, but do memorize the keywords: multi-factor model, sensitivity to those factors, and STD and Beta are not inputs.

Answer 40

Be sure to use next year’s dividend when determining the value of stock using the constant growth dividend formula. D₁ is the next expected dividend. It is calculated using the current dividend and dividend growth rate as follows: D₁=D₀(1 + g)

Answer 41

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

Answer 42

The relationship between the amount of earnings paid to shareholders in the form of a dividend, relative to earnings per share. * Typically, the higher the dividend payout ratio, the more mature the company. * A high dividend payout ratio may also indicate the possibility of the dividend being reduced. * A low dividend payout ratio may indicate that the dividend may increase, thereby increasing the stock price.

Answer 43

Measures the overall profitability of a company. There is a direct relationship between ROE, earnings and dividend growth.

Answer 44

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

Answer 45

* Financial statement analysis * Economic data

Answer 46

Answer: E Step 1: Calculate growth ``` N = 5 I = solve for = 8.02 PV = \<1.36\> PMT = 0 FV = 2.00 ``` Step 2: Use constant growth dividend formula. ($2.00 x 1.0802) / (0.12 - 0.0802) $54

Answer 47

**Answer: B** This question throws a few tricks at you. First you have to determine the amount of Shilo’s most recent dividend to extrapolate the dividends into the future. Next, you have this MLP investment. What’s that? Doesn’t matter. It is not relevant to the problem! Lastly, there are 3 different growth periods to contend with. ``` Div0 = EPS x (1 – Retention) = $12 x 0.40 = $4.80 Div1 = $4.80 x 1.07 = $5.14; Div2 = $5.14 x 1.07 = $5.50; Div3 = $5.50 x 1.07 = $5.89; Div4 = $5.89 x 1.05 = $6.18; Div5 = $6.18 x 1.05 = $6.49; Div6 = $6.49 x 1.03 = $6.68 ``` V = $6.68 / (0.08 – 0.03) = $133.60 [Orange Shift] [C All] 0 [CFj] 5.14 [CFj] 5.5 [CFj] 5.89 [CFj] 6.18 [CFj] 6.49 + 133.6 = [CFj] 8 [I/YR] [Orange Shift] [NPV] Answer: $114.04

Answer 48

**Answer: D** ROE = $2.00 / ($7,000,000 / 1,000,000) 28.5%

Answer 49

**Answer: D** Calculate the dividend for each company using the dividend yield formula, then compare the dividend to earnings per share. Dividend Yield = Dividend / Stock Price Dividend = Stock Price x Dividend Yield Company A = $20 x 10% = $2.00 vs. $2.00 in EPS Company B = $50 x 5% = $2.50 vs. $2.50 in EPS Company C = $30 x 8% = $2.40 vs. $2.40 in EPS Company D = $40 x 12% = $4.80 vs. $5.00 in EPS Room to increase the dividend!

Answer 50

**Answer: E** All three forms suggest that technical analysis will not help you achieve above-average market returns.

Answer 51

**Answer: A** The EMH asserts that investors cannot achieve above-average market returns; therefore, investors should take a passive investment strategy. Semi-strong does also reject fundamental and technical analysis, but does believe inside information will help out perform the market. Strong is the better choice in this question.

Answer 52

**Answer: B** Strategic asset allocation is the only active investment strategy.

Answer 53

No, EE Bonds are NOT marketable securities.

Answer 54

**Answer: D** I bonds adjust the interest paid for inflation, and TIPS adjust the par value for inflation. All other bonds provide no purchasing power risk protection.

Answer 55

Agency Bonds are not backed by the full faith and credit of the US government. GNMA is the exception to the rule: These bonds are backed by the full faith and credit of the US government.

Answer 56

1. General Obligation Bonds. 2. Revenue Bonds. 3. Private Activity Bonds. General Obligation Bonds * General obligation bonds are backed by the full faith, credit, and taxing authority of the municipality that issued the bond. Revenue Bonds * Revenue bonds are backed by the revenue of a specific project. * Revenue bonds are NOT backed by the full faith, credit, and taxing authority of the entity that issued the bond. Private Activity Bonds * Private activity bonds are used to finance construction of stadiums. Insured Municipal Bonds * The following companies insure municipal bonds: * American Municipal Bond Assurance Corp. (AMBAC) * Municipal Bond Insurance Association Corp. (MBIA) * If an insured municipal bond is in default, the insurance company will pay the interest and principal amounts.

Answer 57

The primary difference between Corporate Bond Risk and U.S. Government Bond Risk is that U.S. government bonds are not subject to default risk. Municipal bonds can be considered to have default risk unless they are insured. Corporate Bond Risk * Default Risk. * Reinvestment Rate Risk. * Interest Rate Risk. * Purchasing Power Risk. US Government Bond Risk * Reinvestment Rate Risk. * Interest Rate Risk. * Purchasing Power Risk.

Answer 58

* The “Tax-Equivalent Yield” (T.E.Y.) is the yield a taxable corporate bond would need to pay for the yield on a tax-exempt muni to be equivalent to a taxable corporate bond. * The “Tax-Exempt Yield” is the after-tax rate of return a taxable corporate bond pays. * If a bond is double or triple-tax-free, simply combine the federal, state, and local income tax rate. This is then used for the marginal tax rate in the formula. * To be double-tax-free, the bond holder must live in the state that issued the municipal bond. * To be triple-tax-free, the bond holder must live in the local municipality that issued the bond. Eighth down on the left (TEY). Inputs: * r = tax exempt yield * t = marginal tax rate We can restate the formula: Tax-Exempt Yield = Corporate Rate x (1 - Marginal Tax Rate) This formula is not provided on the formula sheet, but is the algebraic equivalent to the TEY formula provided

Answer 59

Answer: C TEY = 0.045 / (1 - 0.3825) = .0729 or 7.3% What if William does not itemize deductions, how would the answer change? TEY = 0.045 / [1 - (0.35 + 0.05)] = .075 or 7.5%

Answer 60

**Answer: B** 0.035 / (1 - .05) = 3.68% US Treasuries are exempt from state and local taxes only. Use the taxes you save in the equation.

Answer 61

**Answer: A** As the tax-free return increases, the ratio becomes bigger. If investors are able to earn a tax-free return that is very close to a taxable return, investors will always choose the tax-free return.

Answer 62

Answer: C Current Yield = Coupon Payment / Price of the Bond 0.08 = x / $900 $900 x 8% = $72 Coupon Rate Coupon Payment Par = 7.2%

Answer 63

**Answer: B** 5% discount to par = $1,000 par x 0.95 = $950 N = 7 x 2 = 14 i = ? PV = \<950\> PMT = (1,000 x 0.1125) / 2 = 56.25 FV = 1,000 solving -\> 6.16 x 2 = 12.34% on an annual basis

Answer 64

**Answer: E** Step 1: Calculate Selling Price Current Yield = Coupon Payment / Price of the Bond 0.10 = $90 / Price Price = $90 / 0.10 = $900 Step 2: Calculate Holding Period Return HPR = (Sales Price - Purcahse Price +/- Cash Flows) / Purchase Price ($900 - $880 + 90) / $880 = 12.5%

Answer 65

Answer: B N = 5 x 2 i = ? solving -\> 3.96 x 2 = 7.91% on an annual basis PV = PMT = ($1,000 x 0.12) / 2 FV = $1,050

Answer 66

Remember that when shopping, if you see a Discount “Call Mom’s Cell Now!” -\> Discounts (from highest to lowest) is yield to CALL, yield to Maturity, Current yield, and Nominal yield.

Answer 67

**Answer: A** Zero coupons generate phantom income. Held in an IRA avoids current taxation.

Answer 68

The unbiased expectations theory is related to the term structure of interest rates. The theory holds that today’s longer-term interest rates have embedded in them expectations about future short-term interest rates. More specifically, long-term rates are geometric averages of current and expected future shorter-term interest rates. ``` iR_N = Actual N-period rate today N = term to maturity, N = 1, 2, 3, ... ₁R₁ = Current one-year rate today E(_iR₁) = expected one-year rate at period i, where i = 1 to N. For example the one-year rate expected at year three would be: E(3r1) ``` Ninth on the right. The easier way to approach this formula is ... PV = -1 (for the -1 at the end of the formula) N = # of periods PV = (1 + return 1) x (1 + return 2) x ... (1 + return n) Solve for I/YR

Answer 69

Duration is the weighted average maturity of all cash flows. * 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. * Modified Duration is a bond’s price sensitivity to changes in interest rates. * A bond portfolio should have a duration equal to the investor’s time horizon to be effectively immunized. A zero-coupon bond will always have a duration equal to its maturity. As the coupon rate increases, the duration decreases. There is a direct relationship between duration and the term of a bond. As term increases or decreases, duration will increase or decrease. There is an inverse relationship between the coupon rate/yield to maturity and duration. Remember, coupon rate and yield to maturity are INterest rates and there is an INverse relationship. The IN should help keep it straight. Sixth on the left. Inputs: * y = Yield to Maturity of the Bond. * c = Coupon Rate of the Bond. * t = Number of Periods to Maturity. Note - adjust the y, c and t if compounding is semiannual. Simply divide y and c by 2 and multiply t by 2.

Answer 70

Inputs: * D = Duration. * y = Yield to Maturity. * Ay = Change in Interest Rates. * AP / P = % Price Change A = Delta symbol Sixth on the right.

Answer 71

**Answer: E** To immunize a portfolio, the duration must equal the time horizon. Bond B’s duration is too low and does not match the investor’s time horizon. Bond C is too long. The best answer is bond A.

Answer 72

**Answer: A** Answer A is the best answer because the 8-year maturity coupon bond will have a duration of less than 8 years, whereas the 10-year bond will be closer to 8 years. A 15-year zero-coupon bond will have a duration equal to 15 years.

Answer 73

**Answer: B** The bond with the smallest duration will be the least sensitive to changes in interest rates. The bond with the smallest duration will have the shortest term and highest coupon/YTM.

Answer 74

Answer: C The bigger duration of a bond, the more sensitive to changes in interest rates. By choosing the bond with the biggest duration, an investor will experience the biggest capital gain. The bond with the longest term and smallest coupon/YTM.

Answer 75

**Answer: C** Corporations receive a 50 or 65% deduction of dividends (preferred and common stock) based on percentage of ownership of the company paying the dividends (covered in tax) for tax years beginning after December 31, 2017.

Answer 76

CV = (PAR / CP) x Ps * Ps is the price of the common stock. * CP is the conversion price. * (1,000 / CP) is the conversion ratio or the number of shares the convertible can be converted into.

Answer 77

**Answer: C** CV = (1,000 / $40) x $35 CV = $875

Answer 78

Cash operating expenses does not include depreciation or amortization, which are not cash expenses. It also excludes payments on debt service since this is a financing expense, not an operating one. Simply take net income and add back depreciation and financing activities.

Answer 79

NAV = (Assets - Liabilities) / Shares Outstanding

Answer 80

Unit Investment Trusts (UITs) are passively managed and self-liquidating.

Answer 81

**Answer: D** Stock index funds are tax-efficient because they have a low turnover ratio. Stocks are not frequently added or removed from an index, which leads to low turnover and infrequent capital gains distributions.

Answer 82

American Depository Receipts (ADRs) do not eliminate exchange rate risk.

Answer 83

**Answer: D** Answer C is tempting, but not correct. ADRs trade in US dollars on the US markets, but the actual foreign shares are held in a domestic bank’s foreign branch and the exchange of currency happens there, so currency risk is still relevant.

Answer 84

Buying a Call.

Answer 85

Buying a Put.

Answer 86

Intrinsic Value * Call Option: Stock Price – Strike Price. * Put Option: Strike Price – Stock Price. Intrinsic value cannot be less than 0. It’s also critical to remember that intrinsic value cannot be less than zero.

Answer 87

**Answer: B** Call Option Intrinsic Value: Stock Price – Strike Price Intrinsic Value = $53 – $50 Intrinsic Value = $3 Time Component = $5 – $3 = $2

Answer 88

**Answer: C** Put Option Intrinsic Value: Strike Price – Stock Price Intrinsic Value = $50 – $40 Intrinsic Value = $10 Time Component = $13 – $10 = $3

Answer 89

**Answer: B** ***St:*** He doesn’t own the underlying stock, no gain or loss on the stock. ***O:*** Intrinsic value = Stock Price - Strike = $27 - $50 = $0 (Cannot have a negative intrinsic value) ***P:*** Premium paid = ***S:*** Shares = 200 Gain or Loss Equals: (0 + ) x 200 = $600 Loss.

Answer 90

**Answer: A** ***St:*** He doesn’t own the underlying stock, no gain or loss on the stock. ***O:*** Intrinsic value = Strike - Stock Price = $30 - $27 = $3 ***P:*** Premium paid = ***S:*** Shares = 300 Gain or Loss Equals: ($3 + ) x 300 = $600 Gain.

Answer 91

**Answer: B** ***St:*** He doesn’t own the underlying stock, no gain or loss on the stock. ***O:*** Intrinsic value = Stock Price - Strike = $27 - $20 = $7 (IMPORTANT NOTE - When SELLING a call, the investor would have to buy the call option to close out the position. You must calculate this as a LOSS of $7 per share because he would have to buy the option back.) ***P:*** Premium Received = $1 ***S:*** Shares = 500 Gain or Loss Equals: (+ $1) x 500 = $3,000 Loss.

Answer 92

**Answer: D** ***St:*** She doesn’t own the underlying stock, no gain or loss on the stock. ***O:*** Intrinsic value = Strike - Stock Price = $50 - $30 = $20 (IMPORTANT NOTE - When SELLING a put, the investor would have to buy the put option to close out the position. You must calculate this as a LOSS of $20 per share because she would have to buy the option back.) ***P:*** Premium Received = $3 ***S:*** Shares = 1,000 Gain or Loss Equals: ( + $3) x 1,000 = $17,000 Loss.

Answer 93

Buying a put. This is true whether it’s a put on a single stock or an index to protect a diversified portfolio of common stocks.

Answer 94

The Black Scholes Model is used to determine the value of a CALL option. * 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 variables have a ***direct*** relationship on the price of the option, except the strike price. As the strike price increases, the option decreases in value.

Answer 95

Attempts to value a PUT option based upon a call option.

Answer 96

Explains prices based upon the underlying asset price moving in two directions.

Answer 97

If the contract expires without being exercised, the premium paid is a short-term loss and the premium received is a short-term gain

Answer 98

**Answer: A** Call = Stock Price - Strike Price Call = $108 - $110 Call is out of the money, therefore, zero intrinsic value. Remember, intrinsic value cannot be less than zero. The $3.50 premium represents the time premium only.

Answer 99

**Answer: E** ***St:*** $35 - $30 = $5 per share ***O:*** Strike - Stock = $40 - $35 = $5 ***P:*** premium paid ***S:*** 100 Gain or Loss: ($5 + $5 + ) x 100 = $900.

Answer 100

**Answer: D** ***Call Option:*** St: $0 (doesn’t own the underlying stock) O: (Stock Price - Strike Price) = $45 - $50 = $0 (cannot have negative intrinsic value) P: premium paid S: N/A - Question asks about per share gain or loss Call Gain or Loss = $0 + $0 + = ***Put Option:*** St: $0 (doesn’t own the underlying stock) O: (Strike Price - Stock Price) = $40 - $45 = $0 (cannot have negative intrinsic value) P: premium paid S: N/A - Question asks about per share gain or loss Put Gain or Loss = $0 + $0 + =

Answer 101

**Answer: B** ***Call Option:*** St: $0 (doesn’t own the underlying stock) O: (Stock Price - Strike Price) = $60 - $50 = $10 P: premium paid S: N/A - Question asks about per share gain or loss Call Gain or Loss = $0 + $10 + = $4 Put Option: St: $0 (doesn’t own the underlying stock) O: (Strike Price - Stock Price) = $40 - $60 = $0 (cannot have negative intrinsic value) P: premium paid S: N/A - Question asks about per share gain or loss Put Gain or Loss = $0 + $0 + = Total Gain or Loss = Call Gain of $4 + Put Loss of $8 = $4 per share loss

Answer 102

**Answer: B** ***Call Option:*** St: $0 - Doesn’t own the underlying stock O: (Stock - Strike) = $30 - $50 = $0 (cannot have a negative intrinsic value) P: Premium paid S: N/A - Question asks about per share gain or loss Call Gain or Loss = $0 + $0 + = ***Put Option:*** St: $0 - Doesn’t own the underlying stock O: Strike - Stock = $40 - $30 = $10 P: Premium paid S: N/A - Question asks about per share gain or loss Put Gain or Loss = $0 + $10 + = $2 Total Gain or Loss = Call Loss of + Put Gain of $2 = $4 Loss Per Share

Answer 103

**Answer: D** By selling a call option, Theresa has given the buyer the right to buy a stock from her for $50 per share. Theoretically, the stock could go to infinity; therefore, Theresa would have to buy the stock at that price and then sell it to the option buyer at $50 per share. Therefore, Theresa’s loss potential is unlimited.

Answer 104

**Answer: B** Selling a naked call has the greatest loss potential. When selling a naked put, the most an investor could lose is the strike price because the stock could fall to zero and the investor would be forced to buy the stock at the strike price. Writing a covered call is relatively conservative because the option seller owns the underlying asset. Anytime an investor buys an option, the maximum loss is limited to the premium paid. When buying the underlying security, the maximum loss is the stock price paid.

Answer 105

**Answer: D** The fund manager is inherently long on the British Pound. To hedge the fund manager's risk, the manager should enter into an opposite position. The opposite position would be to short the British Pound. This is accomplished by selling a futures contract.