Investments

Question 1

Describe the structure of modern financial markets and how formed

Answer 1

Financial Markets =

1) Money Markets - short term debt instruments
2) Capital Marktes - stocks, bond other equities
2a) Primary Market - IPOs; created by Securities Act of ‘33
2b) Secondary Market - Trades; Created by Securities Act ‘34
- Exchanges: NYSE, CBOE
- OTC: NASDAQ

Question 2

Name different forms of Efficient Market Theory and associated attributes

Answer 2

Efficient Market Theory = All information is known and priced into market by investors (passive)

Weak Form = Technical (historical) info is available and priced into stock but fundamental (public) and insider information is not and can be used for advantage of active investor

Semi-Strong Form = Technical (historical and Fundamental (public) info is available and priced into stock but inside info is not and could be used for advantageous gains: may be passive or active investor where legal

Strong Form = Technical, Fundamental and Insider info is available to all investors..and therefore market can not be outperformed: passive investor

Question 3

What is random walk theory and key elements

Answer 3

The behavior of stock closely resembles a random walk based on
- prices of stock are unpredictable but not arbitrary
- any given moment prices are the best incorporation of all available info and reflect true value of security
- prices are in equilibrium
- changes in price and volume reflect changing needs of investors

Question 4

What is Duration, how does it function and what are some key attributes

Answer 4

Duration is the time to recoup investment based on PV of cash flows; Is always expressed in years and will usually be less than maturity.

High Coupon rate = Lower Duration
Low Coupon rate = Higher Duration
Zero Coupon rate = Years to Maturity and Duration same

Used to estimate change in bond prices based on hypothetical change in prevailing rates: 1% change in rate results in % change in bond price that is equal to duration in (%)

Tends to overestimate risk from rising interest rates and underestimate benefit from falling interest rates.

Matching the duration of fixed income portfolio to investor time horizon “immunizes” the assets from purchasing power and reinvestment rate risk due to ability to recoup investment value over life of duration

Question 5

Covered call

Answer 5

Long the stock and short the call; Used to generate income when stock is in trading range and investor wants to retain ownership of stock

Question 6

Naked call

Answer 6

Investor does not own the stock and shorts the call; Used when writer ok to bear unlimited risk

Question 7

Protective Put

Answer 7

Long the stock and long the put; Used as portfolio insurance

Question 8

Protective Call

Answer 8

Short the stock and long the call (opposite of Protective Put); Used to protect a short position in the stock

Question 9

Covered Put

Answer 9

Short the stock and short a put; Used when writer uses the stock put to cover short stock position

Question 10

Collar/Zero Cost Collar

Answer 10

Long the stock, long a put and short a call by selling a call option at an exercise price slightly higher than the current stock price to create a premium AND buys a put option that is below the current stock price, with the premium dollars created when selling the call used to pay for the put options. This is used when investor owns the stock but wants to protect the downside risk without paying entire cost of put options

Question 11

Straddle (long)

Answer 11

Long Put and Long Call on same stock with same expiration date and exercise price. Used when investor expects volatility but unsure in which direction….or in either/both directions

Question 12

Straddle (long)

Answer 12

Long Put and Long Call on same stock with same expiration date and exercise price. Used when investor expects volatility but unsure in which direction….or in either/both directions

Question 13

Straddle (short)

Answer 13

Investor sells/shorts Put and Call on same stock with same expiration date and exercise price. Used when investor does not expect volatility and hope to keep premiums with little movement of stock price in either/ both directions

Question 14

Spread

Answer 14

Purchasing and selling the same type of contract, where investor benefits from stable price fluctuations with minimum moves in either direction (see short straddle)

Question 15

What are the different types of risk

Answer 15

Systemic and Unsystemic

Question 16

What are systemic risks

Answer 16

PRIME

Purchasing power
Reinvestment
Interest rate
Market
Exchange rate

Question 17

What are unsystemic risks

Answer 17

Business
Regulatory
Financial
Default / credit
Sovereignty

Question 18

Describe the Bond See Saw (Ladder) relationship

Answer 18

When Bonds trading at a premium, rates decrease from:
- Coupon Rate –>Current Yield –> YTM –> YTC

When Bonds trading at a discount, rates increase from:
- Coupon Rate –>Current Yield –> YTM –> YTC

When Bonds trading at par, rates are same for CR, CY, YTM and higher for YTC.

YTC is worst rate with premium and best rate with discount

Question 19

Describe Bond Strategy: Tax Swap

Answer 19

Selling a bond with a gain and a bond with a loss to offset each other or selling a bond with a loss and buying a new bond

Question 20

Describe Bond Strategy: Barbells

Answer 20

Owning both short term and long term bonds so that when interest rates moves, only either short or long term position needs to be sold and restructured

Question 21

Describe Bond Strategy: Laddered Bonds

Answer 21

Purchasing bonds with varying maturities and as each matures purchase a new one with longer maturities than remaining in portfolio, thereby reducing interest rate risk since bonds held to maturity

Question 22

Describe Bond Strategy: Bullets

Answer 22

Purchasing primarily zero coupon, Treasuries and corporate bonds that mature in/around same time with little payments until lump sum payment at maturity; Used to offset a balloon payment on a future liability

Question 23

How do you determine conversion value for a convertible bond

Answer 23

Divide the Par Value by the conversion price and multiply by market price of the common stock

Question 24

What is formula for determining property valuation/calculating NOI

Answer 24

Capitalized Value = Net Operating Income / Capitalization Rate where Cap Rate = NOI/ Cost

NOI = Gross Rental Receipts
+ Non Rental Income
- Vacancy and Collection Losses
= Effective Gross Income
- Total Expenses
= Net Income
+ Interest, Depreciation and Amortiz expense (not operating)
= NOI

Question 25

What is a better measurement to evaluate project returns and why: IRR or NPV

Answer 25

NPV is a better method for evaluating projects than the IRR method. The NPV method:

• Employs more realistic reinvestment rate assumptions.
• Is a better indicator of profitability and shareholder wealth.
• Mathematically will return the correct accept-or-reject decision regardless of whether the project experiences non-normal cash flows or if differences in project size or timing of cash flows exist.

Question 26

What is difference between strategic and tactical asset allocation

Answer 26

Strategic asset allocation is concerned with allocating the wealth of a client among various asset classes, consistent with the clients’ investment objectives, time horizons and risk preferences.

Tactical asset allocation is concerned with shifting wealth between asset classes to take advantage of expected price level changes (timing) arising from broad movements in the business cycle.

Question 27

What is the best option strategy for offsetting potential drop in price of held shares

Answer 27

Buying a put option is like insurance against a drop in price.

Remember, from the buyer’s perspective, “Call up” . . . “Put down”!! (This may be a helpful mnemonic device.) The opposite is true for option sellers.

Question 28

What are key elements of following option strategies and when used:

Spread

Strip

Strap

Straddle

Answer 28

In a “spread”, a put and call are purchased on the same security with same time but the prices are different. When expect prices to be volatile

In a “strip”, two puts and one call are purchased with the same price and time; A strip is a bearish market-neutral strategy that pays off relatively more when the underlying asset declines than when it rises. A strip is essentially a long straddle, but instead utilizes two puts and one call instead of one of each.

In a “strap”, two calls and one put are purchased with price and time the same. A strap is a bullish market-neutral strategy that pays off relatively more when the underlying asset increases more than when it declines.

In a “straddle”, a put and a call are purchased on the same security, at the same exercise price, for the same period of time; Used when expect price to move but uncertain which way (expect volatility but unsure direction); If buy then long straddle, if sell than short straddle

Question 29

Define the following :

Banker’s Acceptance.

Repurchase Agreements.

Forward Contracts.

Commercial Paper.

Answer 29

Banker’s acceptance are paper traded between banks such as letters of credit to facilitate international trade.

Repurchase agreements are money market securities sold at a discount with an agreement to purchase them back at a higher price later on.

Forward contracts are agreements to transact in the future

Commercial Paper are short-term debt securities issued by corporations in the open market usually less than 270 days maturity to avoid the necessity of SEC registration

Question 30

Which of the statements below correctly describes the potential price volatility of the following five bonds?

I Bond A: A-rated; 7% coupon; matures in 10 years.

II Bond B: A-rated; 6% coupon; matures in 12 years.

III Bond C: A-rated; 7% coupon; matures in 12 years.

IV Bond D: A-rated; 5% coupon; matures in 15 years.

V Bond E: A-rated; 6% coupon; matures in 15 years.

I Bond A has greater potential for price fluctuations than Bond C.

II Bond D has greater potential for price fluctuations than Bond E.

III Bond C has greater potential for price fluctuations than Bond B.

IV Bond D has greater potential for price fluctuations than Bond B.

A. I and II only.
B. II and IV only.
C. III and IV only.
D. I, II, and IV only.

Answer 30

Solution: The correct answer is B.

Choice “I” (Bonds A and C) have the same coupon, but Bond A has a shorter maturity therefore less volatility. Choice “II” (Bonds D and E) both mature in 15 years, but Bond D’s lower coupon makes it more volatile. Choice “III” (Bonds C and B) both have the same maturity, but Bond B’s lower coupon means it is more volatile. Choice “IV” (Bonds B and D) is a true statement due to both coupon and maturity.

Question 31

Your client has asked you to assist her in examining possible additions to her bond portfolio. She has expressed a desire to minimize risk at this stage in her planning process, and to assure income beginning at the point of her retirement, and lasting throughout. She has a tentative retirement date in seven years at age 65. She will then have an eighteen year life expectancy. Which of the following is an appropriate addition to her current portfolio?

I 25-year AAA-rated corporate bonds with a seven-year maturity.

II 20 year AAA-rated municipal bonds with a seven-year duration.

III 25-year AAA-rated corporate zeroes with a seven-year duration.

IV 20-year US Treasury zeroes with a seven-year maturity.

V 25-year AAA-rated corporate bonds with a seven-year duration.

A. I, III and V only.
B. II, III and V only.
C. III and IV only.
D. V only.

Answer 31

The correct answer is D.

The client is looking for income to begin in 7 years. Therefore anything maturing in 7 years will not provide that income. Zeroes provide no income. She wants something out 25 years, not 20 years. Thus, option “V” is the only appropriate answer.

Question 32

Describe components of each of the following bond investment strategies

Bond ladder strategy.

Immunizing the portfolio.

Bond swap strategy.

Bond barbell strategy.

Riding the Yield Curve

Bullets

Answer 32

Bond laddering consists of periodic maturities including short term, intermediate and long term bonds.

Immunizing the portfolio uses duration rather than maturity as a measure of position for implementing the strategy.

Bond-swap strategies trade different and varied maturities to meet the objective of the portfolio.

Bond barbell strategy involves both very long-term bonds and very short-term bonds for a portfolio, and very few intermediate-term bonds

Riding the yield curve refers to the purchase of debt instruments in anticipation of fluctuations in the rates of return on both long and short-term instruments. Rising rates of interest require repositioning a portfolio in advance of the rise in order to avoid significant price drops. These moves are based on anticipated changes in the yield curve.

Bullets provide very little payments initially, then a lump sum at a specified date in the future, with most bonds maturing around same time. Most often used with zero coupon, treasuries and zero coupon corp bonds since little coupon payment then big payout in order to time with ballon payment due on a future debt

Question 33

What are key features of a bond swaps:
- Substitution
- Rate Anticipation
- Yield Pickup
- Tax

Answer 33

A substitution swap is designed to take advantage of anticipated and potential yield differentials between bonds that are similar with regard to coupons, rating, maturities, and industry.

Rate anticipation swaps utilize forecasts of general interest rate changes.

The yield pickup swap is designed to alter the cash flow of the portfolio by exchanging similar bonds having different coupon rates.

The tax swap replaces bonds with offsetting capital gains and losses

Question 34

Which of the following best describes a long hedge position?

A. The investor is short the underlying commodity and short the futures contract.

B. The investor is long the underlying commodity and long the futures contract.

C. The investor is short the underlying commodity and long the futures contract.

D. The investor is long the underlying commodity and short the futures contract.

Answer 34

Solution: The correct answer is C.

A long position in a futures contract is when the investor buys a futures contract. A short position in a futures contract is when the investor sells a futures contract. A long hedge means that the investor owns (buys) the futures contract to insure a certain price of a commodity that he or she does not yet own. Hedging is taking an opposite futures position than the investor’s inherent underlying position.

Question 35

What does Alpha measure?

Answer 35

Alpha is the fund’s actual return minus the risk adjusted expected return, as measured by CAPM.

The alpha of a security may be calculated using the Jensen Model.

Question 36

Given a diversified mutual fund performance data, which measurement is best risk-adjusted performance measure and why

Answer 36

If a fund is diversified, use the Treynor model and the result there is arrived at by dividing the (return-risk free rate) by the beta. For un diversified with correlation squared or R2 <0 use Sharpe by dividing risk premium return by standard deviation

Question 37

What do preemptive rights allow?

Answer 37

Preemptive rights allow the shareholder to purchase additional shares to retain the same percent ownership they had prior the secondary offering.

For example. 100 shares outstanding, and you own 10 shares, or 10% of the company. The company does a secondary offering which brings their outstanding shares to 200 shares. Your 10% ownership is now, 5% (10 shares / 200 shares). If you purchase and additional 10 shares, for a total of 20 shares, you retain your 10% ownership (20 shares / 200 shares).

Question 38

If the market risk premium were to increase, the value of common stock (everything else being equal) would:

A. NOT change because this does NOT affect stock values.
B. Increase in order to compensate the investor for increased risk.
C. Increase due to higher risk-free rates.
D. Decrease in order to compensate the investor for increased risk.

Answer 38

Solution: The correct answer is D.

A need for higher return to meet the onset of higher risk would drive the price of a security down (all other things being equal).

Using an example where rm is 14% and rf is 3%, and a beta of 1.1, the required return under the SML is:

r = .03 + (.14-.03)1.1 = 15.10%

Then let’s assume the most recent dividend is $2 and the growth rate is 7%. The price of the stock using the constant growth model is

V= (2 x 1.07)/(.1510 - .07) = $26.42

Now let’s increase the rm to 15%. Using the SML:

r = .03 + (.15-.03)1.1 = 16.20%

The new price under the constant growth model is:

V = (2x1.07)/(.1620 - .07) = $23.26

Question 39

How do you calculate the conversion value of a convertible bond

Answer 39

CV = (PAR ÷ Cp) x Ps

Cp = $ conversion price: PAR / shares (1,000 / x = y)
Ps = Price of the stock

Question 40

How do you determine R2 and what does it mean relative to stock portfolio and appropriate risk measurement to use

Hint..whenever correlation coefficient is given in a question to determine which measure to use

Answer 40

R2 = correlation coefficient squared

When r-squared is greater than or equal to .70, then the portfolio is well diversified and Beta is an appropriate measure of total risk and Treynor is used to compare returns of 2 or more portfolios.

When r-squared less than ,70 then the portfolio is not diversified and Standard Deviation is appropriate measure of total risk with Sharpe ratio used to compare returns of 2 or more portfolios

Question 41

If given list of stock prices year by year and asked to determine geometric mean of returns, what is best method to do so

Answer 41

Use holding period /dollar weighted return based on TVM by plugging in PV, FV, N-1 yrs and solve for i

Question 42

What is the formula for evaluating the value of the firm if gross revenue, net income and capitalization rate are known

Answer 42

Divide the capitalization rate factor into the net earnings to arrive at the estimated firm value

Question 43

Define the following Financial Behaviors:

anchoring.

overconfidence.

regret avoidance.

representativeness.

cognitive dissonance.

loss aversion.

risk aversion.

Belief perseverance.

Herd mentality.

Hindsight bias.

Naive Diversification

Familiarity

Answer 43

Anchoring results in buying securities that have fallen in value because it “must” get back up to that recent high.

Overconfidence is an overestimation of one’s ability to perform a specific task and is a bias that can lead to irrational risk taking as well as overtrading.

Regret avoidance, also known as the disposition effect, causes investors to take action (or inaction) in hopes of minimizing any regret. In investments, it leads people to sell winners too soon and to hold on to losers too long.

Representativeness is thinking that a good company is a good investment without regard to an analysis of the investment.

Cognitive dissonance is a form of overconfidence because an investor’s memory of past performance is better than the actual results.

Loss aversion notes that people more strongly prefer to avoid losses than to seek gains.

Risk aversion is not considered to be a behavioral bias. Rather, risk aversion is an assumption of traditional financial analysis based on the precepts of rational, utility-maximizing economic theory.

Belief perseverance is similar to anchoring in that people are unlikely to change their views given new information.

Herd mentality is the process of buying and selling what and when others are buying and selling.

Hindsight bias is a form of overconfidence related to an investor’s belief that they had predicted an event that, in fact, they did not predict.

Naïve diversification is the process of investing in every option available.

Familiarity leads to over investment in companies that are familiar, such as employers.

Question 44

In the mutual fund industry, name the different fees and what each covers (3)

Answer 44

12b1 fees are used for marketing and distribution costs.

All other costs, such as legal, accounting and analysis are paid through Fund Management fees.

Commissions are paid using either a front load or a back load.

Question 45

What is a DRIP

Answer 45

DRIPs, which are also known as dividend reinvestment programs, gives shareholders the option of reinvesting the amount of a declared dividend into additional shares, which are bought directly from the company. Because shares purchased through a DRIP typically come from the company’s own reserve, they are not marketable through stock exchanges. Shares must be redeemed directly through the company, also. This is often favorable with shareholders and helps company raise capital

Question 46

What are the 2 different movements of US Dollar compared to another foreign currency and how defined

Answer 46

Devaluation - When a foreign currency falls in value against the dollar

Appreciation or Revaluation - When a foreign currency rises in value against the dollar

Question 47

What are the different theories associated with the Yield Curve (3)

Answer 47

Expectations Theory - attempts to explain the yield curve based upon future rates of inflation

Liquidity preference states that investors prefer liquidity, therefore, short-term money pays less.

The market segmentation theory states that supply and demand explain at various maturities the shape of the yield curve.

Question 48

Compare Time Weighted vs Dollar Weighted returns

Answer 48

time-weighted return is only concerned about the security’s cash flow, not the investors. TWR is looking at the performance from start to end, not the investors performance. In this case of an investor buying additional stock in subsequent years TWR is only looking at one share from start to end, including all years of dividends.

If include multiple purchases, this would be the investors return, which would be dollar weighted return.

While you use the same uneven cash flow and IRR keys on the calculator for both time weighted and dollar weighted return, it is the inputs that distinguish if the result will represent a time vs. dollar weighted return. To achieve the dollar weighted return, any subsequent purchase would have to be taken into account in the calculator keystrokes (ie..CFj)

Question 49

What is a Guaranteed Investment Contract

Answer 49

Issued by insurance companies with a guaranteed rate of return for a period of time, whereby the yield is higher than Treasury securities

Question 50

What is relationship between duration, term and interest rate/yields of a bond

Answer 50

Duration is the weighted avg maturity of al cash flows - the moment in time the investor is immunized from interest rate and reinvestment rate risk

As term increases or decreases, duration will increase of decrease concurrently; There is an inverse relationship between coupon rate/yield to maturity and duration; such that coupon and YTM are INterest rates that have INverse relationship with duration (coupon rates/YTM increase, duration decreases; as duration decreases become less volatile - price sensitive to interest changes ; Zero coupon has duration equal to maturity.

Question 51

Name 3 types of investment companies

Answer 51

Closed End
Open End
Unit Investment Trust

Question 52

What are key characteristics of each type of investment company

Answer 52

Closed End Funds:
- Fixed initial market cap with only specific number of shares sold
- Use leverage by issuing preferred stock and bonds by issuing senior securities (to common stock with lower payout priority)
- Trade shares along other public company stocks throughout the day on organized exchange
- Sold at premium or discount to NAV
- Can be either diversified from at least 75% of fund, no more than 5% in any 1 company and no more than 10% of company ownership or Non diversified (not diversified), with Non
- Diversified Closed End most risky of 4 types of mgmt company funds

Open End Funds
- Unlimited number of shares as long as buyer for issued shares
- Buy only common stock / equity positions
- Do not trade shares with other investors throughout day but rather bought/sold to open end fund and settled at end of day at day end NAV
- Can be either diversified or non diversified with Diversified Open End fund the least risky

Unit Investment Trust
- Can be equity or fixed income but usually fixed
- Managed by trustee, no investment manager
- Are self liquidating, passive mgmt and no trading of assets within trust
- Issued as units vs shares
- Units sold back to UIT at NAV, but very thinly traded secondary market

Question 53

What is a rate anticipation swap strategy, when interest rates are low and expected to rise in the near future

Answer 53

.When interest rates are expected to rise, an investor should sell long-term bonds and reinvest the proceeds at a higher coupon rate once interest rates rise.

Question 54

What is timeline for wash sales

Answer 54

In order for the wash sale rules to apply, the taxpayer must purchase substantially identical securities within 30 days before or after the date of sale. The purchase of the call option occurred more than 30 days after the sale of the stock.

Question 55

How are IRA impacted by wash sales

Answer 55

Same as brokerage accounts and even sold an repurchased in between two such that If a taxpayer sells stock or securities for a loss and repurchases substantially identical securities in his or her IRA within 30 days, the “wash sale” rules will apply.

Question 56

What are key risks of mortgage backed securities (CMOs)

Answer 56

Lack of a definite maturity date (you won’t know if mortgages are paid off early ahead of time) and uncertain cash flows (due to possible early payoffs) are the elements of risk in mortgage-backed securities.

Question 57

Jack Rich has an investment portfolio equally divided among the following funds: Energy sector fund, Bond Unit Investment Trust (25-year average maturity), and a Money Market fund. He is a buy-and-hold investor. Which of the following risks is his portfolio exposed to and WHY??

Business risk.
Interest rate risk.
Political risk
Purchasing power risk.
A. I and III only.
B. II and IV only.
C. I, II and III only.
D. III and IV only.

Answer 57

The correct answer is D.

Interest rate risk does not affect a bond investor if he or she holds the securities to maturity. This is how unit investment trusts are structured. The energy sector will be directly impacted by regulatory influences of a political nature.

Question 58

Question
Assume that your client puts $10,000 into a credit union account now, plus five annual deposits of $2,000, beginning in one year. All deposits earn 6.75% interest per year. How much will be in the account at the end of 10 years?

Answer 58

$35,081

Question 59

If the Tingeys’ taxable savings account is increased to $385,000 and is invested in an index fund that returns 12% before .5% in annual expenses, how much would be available for withdrawal, net of taxes, on April 1st, fourteen years from now? Assume no distributions are made by the fund.

Answer 59

$1,438,000

PV = $385,000, N = 14, and I/YR = 11.5. FV = $1,767,000. The account would be worth $1,767,000. For an index fund, the gain is taxed as capital gain, and the amount of the gain is $1,767,000 – $385,000 = $1,382,000. The $1 million gain on the sale of the fund will place the Tingeys in the highest tax bracket, and the maximum capital gains rate is 23.8% for long-term gains, (20% capital gain rate + 3.8%)

Medicare Tax on investment income, so the tax due upon withdrawal will be .238 × $1,382,000 = $328,916 ($329,000 rounded). The net amount available will be $1,438,000.