Module 3 Equity Investments and Managed Assets Flashcards
An investor using a dollar cost averaging approach to buying a mutual fund will buy
A)
more shares when the NAV of the fund rises since the last purchase.
B)
fewer shares when the NAV of the fund falls since the last purchase.
C)
the same number of shares regardless of which direction the NAV takes.
D)
more shares when the NAV of the fund falls since the last purchase.
d The investor will purchase more shares when the NAV falls because the dollar amount invested remains the same.
LO 3.5.1
Max bought 100 shares of PET Corporation stock 10 years ago. He paid $10 per share for the stock. The stock currently has a fair market value of $50 per share. Choose the CORRECT statement regarding Max’s stock.
A)
If Max does not sell the stock now, he must pay taxes on the difference between the amount he paid for the stock and the current market price, which will increase his basis in the stock.
B)
If Max sells the stock now, he must pay taxes on the full $5,000 he receives from the sale.
C)
If Max does not sell the stock this year, he will not have to pay taxes on the difference between the amount he paid for the stock and the current market price this year.
D)
If Max sells the stock now, he must pay taxes on only half the amount he receives from the sale.
c The answer is if Max does not sell the stock this year, he will not have to pay taxes on the difference between the amount he paid for the stock and the current market price this year. If Max sells the stock today, he realizes the gain in the value of the stock and must pay taxes on the gain. The gain would equal the price at which Max sells the stock minus the original purchase price, or $40 per share. If the gain is not realized, Max has no tax liability for the increase in the value of the stock. Capital gains are only taxable when they are realized at the time of the sale.
LO 3.1.1
Which of these statements about closed-end funds is CORRECT?
A)
Closed-end shares are purchased from and sold by the fund company.
B)
Investors in closed-end shares can profit from changes in the discount to NAV.
C)
Closed-end funds have 12b-1 fees.
D)
Closed-end funds continuously offer new shares to the public.
b The answer is investors in closed-end shares can profit from changes in the discount to NAV. When the discount shrinks, an investor can profit even if the NAV of the underlying portfolio does not change.
LO 3.3.1
An investor has a portfolio diversified among many different asset classes. If there was an immediate need for cash, which of the following would probably be the most liquid?
A)
Cash value from a universal life insurance policy
B)
CDL Common Stock Mutual Fund
C)
QRS Money Market Mutual Fund
D)
XYZ International Stock Mutual Fund
The answer is QRS Money Market Mutual Fund. Money market funds generally come with a check-writing privilege offering investors the opportunity to convert the asset to cash at once. Although all mutual funds are readily redeemable, under the investment company Act of 1940, the fund has seven days to redeem. One must request the cash value from the insurance company.
LO 3.3.1
Select the CORRECT statement regarding hedge funds.
A)
Hedge fund managers are paid on a commission basis.
B)
Purchasers of hedge funds are required to be accredited investors.
C)
Short sales by the fund are not allowed.
D)
The fund is required to register with FINRA prior to soliciting potential clients.
b The answer is purchasers of hedge funds are required to be accredited investors. A hedge fund is an unregistered, privately offered, managed pool of capital for wealthy investors. In addition to short selling, a hedge fund will implement a wide array of risky trading strategies in order to exploit market inefficiencies. Hedge fund managers are paid based on fund performance.
LO 3.4.1
Which of the following is a potential pitfall of mutual fund investing?
A)
Investing in a fund with low annual operating expenses
B)
Buying a fund ranked number one if the fund is misclassified
C)
Purchasing a fund immediately after a distribution of income and capital gains
D)
Buying a fund with a good long-term record with the same manager during the entire period
b Explanation
A number-one ranking can be obtained if a fund is misclassified with lower-risk funds.
LO 3.6.1
Which of the following best represents a characteristic of balanced mutual funds?
A)
They combine debt and equity securities.
B)
They combine high- and low-risk stock.
C)
They combine domestic and international securities.
D)
They combine income and growth stock.
a Balanced funds can be securities that produce both income (dividends and interest) and capital gains. Income securities can be high-dividend paying stocks or bonds. Capital gains securities generally are stocks. Most balanced funds contain some combination of both stocks and bonds (often 60% stocks and 40% bonds).
LO 3.3.1
Grace’s portfolio is comprised of 40% U.S. corporate bond fund, 50% U.S. growth and income equity fund, and 10% municipal bond fund. Grace would like to reduce her portfolio’s level of risk and maintain or improve return. Which of these could be recommended to Grace to achieve her goal?
Global equity fund
Biotechnology sector equity fund
Louisiana municipal bond fund
Emerging market fund
A)
I and IV
B)
III only
C)
I only
D)
II, III, and IV
a The answer is I and IV. Adding foreign investments could reduce her portfolio’s level of risk and possibly improve return. Foreign investments have a low correlation with U.S. securities and thus provide diversification benefits. Additional investment in U.S. equities or bonds will not provide as much diversification as international investing.
LO 3.3.1
Dave and Pam Larson, ages 65 and 63, respectively, recently retired. They successfully saved for their retirement throughout their careers using a low-risk approach. They would like to restructure their investments to have current income now to travel in their leisure time.
Which of the following investment alternatives would be appropriate for the Larsons’ goal?
Equity income mutual fund shares
Aggressive growth mutual fund shares
Newly issued U.S. government bonds
GNMA fund shares
A)
I, III, and IV
B)
II, III, and IV
C)
I, II, and III
D)
I, II, and IV
a The answer is I, III, and IV. Aggressive growth mutual funds have a primary objective of capital appreciation and pay out little to no dividends. This investment would not provide the Larsons with their desired current income. The remaining investment alternatives all fit within the Larsons’ risk tolerance.
LO 3.3.1
Which combination of the following statements is true regarding the investment strategy known as dollar cost averaging?
Invests the same dollar amount each month over a period of time
Purchases the same number of shares each month over a period of time
Lowers average cost per share over a period of time (assuming share price fluctuations)
Invests the same dollar amount each month to protect the investment from loss of capital
A)
II and III
B)
I and III
C)
I and II
D)
I, II, III, and IV
b Dollar cost averaging means buying varying shares with the same number of dollars, whereas share averaging means buying the same number of shares with varying dollars. The purpose of using dollar cost averaging is to lower the average price paid for a stock as a consequence of taking advantage of price fluctuations, especially when the stock price moves downward in a temporary correction. The strategy may lower the average cost, but does not protect against losses, especially if the stock is on a strong downward trend instead of the more normal upward trend.
LO 3.5.1
If ABC Fund pays regular dividends, offers a high degree of safety of principal, and appeals especially to investors in the higher tax brackets, ABC is a(n)
A)
money market fund.
B)
aggressive growth fund.
C)
corporate bond fund.
D)
municipal bond fund.
d The answer is municipal bond fund. Municipal bonds are considered second only to U.S. government securities in terms of safety. Furthermore, whenever you see a question about an investor in a high tax bracket, always look for the answer choice with municipal bonds; the tax-free income is the key.
LO 3.3.1
Select the type of mutual fund that generally focuses its investment objective in a narrow area such as natural resources, technology, or health care.
A)
Sector funds
B)
Growth funds
C)
Income funds
D)
Balanced funds
a
The difference between a convertible bond and a bond with warrants is that
A)
a convertible bond has an embedded call option, and a bond with warrants does not.
B)
when warrants are exercised, a portion of the issuer’s debt is replaced with equity; when convertible bonds are exercised, a portion of the issuer’s debt is replaced with equity.
C)
a bond with warrants has an embedded put option, and a convertible bond has an embedded call option.
D)
when warrants are exercised, the issuer receives equity capital from the warrants in addition to the original debt from the bond with warrants; when convertible bonds are converted, the bond is replaced with stock.
d Explanation
The answer is when warrants are exercised, the issuer receives equity capital from the warrants in addition to the original debt from the bond with warrants; when the convertible bonds are converted, the bond is replaced with stock. The issuer receives new equity upon exercise of the warrants, which is in addition to the initial debt received from the bonds; upon conversion of the convertible bond, the bond is retired and stock is issued in its place.
LO 3.1.1
Harry invests in a money market mutual fund to provide funds for investment opportunities and emergencies. However, he is concerned about the potential disadvantages of placing too much money into this type of fund. Which of these is NOT an advantage of money market mutual funds?
A)
Ease of redemption
B)
Safety of principal
C)
High rates of return
D)
Diversification
c The answer is high rates of return. Money market mutual funds invest in highly liquid short-term instruments. They have significantly lower risk and lower returns when compared to investing in stocks.
LO 3.3.1
Which of the following statements is CORRECT regarding hedge funds?
A)
A fund of hedge funds will have a higher minimum investment requirement than a hedge fund.
B)
They often make extensive use of derivatives.
C)
The fund manager’s fee is usually 10% of the hedge fund’s profits.
D)
They are available for any investor with $500,000 of net worth.
b Hedge funds may employ a variety of investment strategies in an attempt to achieve a superior return for investors and, as such, can be conservative investments or very aggressive investments.
LO 3.4.1
An investor should choose index funds if he or she believes in
A)
specialized investing.
B)
fundamental analysis.
C)
technical analysis.
D)
a passive investment strategy.
d The answer is a passive investment strategy. Index funds are used in a passive investment strategy. The purpose of an indexed portfolio is not to beat the targeted index (e.g., S&P 500 Index) but merely to match its long-term performance, less any management fees and administrative costs.
LO 3.4.1
Which of the following occurs when a 10% stock dividend is paid?
A)
The stock’s par value is decreased.
B)
The stock’s price is increased.
C)
The firm’s equity is increased.
D)
The firm’s retained earnings decrease.
d The retained earnings are debited for the amount of the stock dividend and common stock and paid in capital are credited. The firm’s equity and par value are unchanged. The stock price will drop by the amount of the dividend.
LO 3.2.1
Under which of these circumstances will dollar cost averaging result in an average cost per share lower than the average price per share?
The price of the stock fluctuates over time.
A fixed number of shares is purchased regularly.
A fixed dollar amount is invested regularly.
A constant dollar plan is maintained.
A)
I and III
B)
II and III
C)
I and II
D)
I, III, and IV
a The answer is I and III. Dollar cost averaging benefits the investor if the same amount is invested on a regular basis over a substantial period, during which the price of the stock fluctuates. A constant dollar plan is one in which the investor maintains a constant dollar value of securities in the investment portfolio.
LO 3.5.1
Which of the following statements concerning dollar cost averaging as a portfolio management technique are CORRECT?
This technique involves investing a specific amount into an investment vehicle, regardless of whether the recent trend in the investment has been up or down.
If prices decline, the fixed investment amount will purchase a greater quantity of the security.
For the long-term investor, the presumption is that prices will eventually rise, so a lower average price translates into greater profits.
If prices rise, the fixed investment amount will purchase a greater amount of the security.
A)
I and II
B)
I, III, and IV
C)
I, II, and III
D)
II and III
Only statement IV is incorrect. If prices rise, the fixed investment amount will purchase a lower amount of the security.
LO 3.5.1
Which of the following is true of warrants?
A)
There are incentives for investors to purchase the corporation’s preferred stock
B)
They are incentives for investors to purchase futures contracts
C)
They increase the cost of capital necessary to float an issue
D)
They allow for customization of terms among all potential investors
d The answer is they allow for customization of terms among all potential investors. Warrants are essentially customized (not standardized) call options issued to meet the needs of both the issuing corporation and the investor.
LO 3.1.1
Long-term bond funds have
A)
no reinvestment rate risk.
B)
minimal purchasing power risk.
C)
more interest rate risk than short-term bonds.
D)
no interest rate risk.
c Long-term bonds have greater purchasing power risk than short-term bonds.
LO 3.3.1
To be on a corporation’s books as holder-of-record (and thus have a right to the next dividend payment), the investor must purchase stock
A)
before the declaration date.
B)
between the ex-dividend date and the record date.
C)
two business days before the record date.
D)
three days before the payment date.
c The answer is two business days before the record date. Under the T+2 rules in effect, ex-dividend date is one day business prior to the record date. A trade made on the ex-dividend date will clear in two business days, one day after the record date. The investor will not be on the corporation’s record book as a shareholder unless the purchase is made at least two days before the record date.
LO 3.5.1
A financial reporter notices that the quoted price of one investment company’s shares is at a 22% discount from the NAV. From this information, it can be deduced that the company is likely which of the following?
A)
Contractual plan of a mutual fund
B)
Open-end investment company
C)
Unit investment trust
D)
Closed-end investment company
d The answer is closed-end investment company. If the selling price of an investment company is less than the NAV, the fund is likely a closed-end investment company.
LO 3.3.1
Which of the following statements is CORRECT regarding exchange-traded funds (ETFs)?
A)
They are usually tax-inefficient.
B)
They can be exchanged for other ETFs in the same family.
C)
They are permitted to sample an index.
D)
They trade right at net asset value due to arbitrage transactions.
c Rather than buy every security in an index, some ETFs only sample the index, called representative sampling, especially when the index contains a very large number of issues.
LO 3.4.1
