Module 5 Alternative Investments and Derivatives

Question 1

An investor who is interested in developing a portfolio of collectibles should probably do which one of these?

A)
Buy relatively inexpensive collectibles
B)
Avoid buying through knowledgeable dealers
C)
Specialize in a type of collectibles
D)
Diversify over a variety of types of collectibles

Answer 1

c The answer is specialize in a type of collectibles. Specializing in a type of collectible would give an investor a better knowledge of that collectible and its market direction and worth.

LO 5.4.1

Question 2

A wheat farmer would hedge by _____________ wheat futures; a bread manufacturer would hedge by ________________ wheat futures; a speculator would _________ a wheat futures contract if he believes the price of wheat may rise; and a speculator would __________ a wheat futures contract if he believes the price of wheat may fall.

A)
shorting; buying; short; buy
B)
buying; shorting; short; buy
C)
buying; shorting; buy; short
D)
shorting; buying; buy; short

Answer 2

d The answer is shorting; buying; buy; short. A wheat farmer would hedge by shorting wheat futures; a bread manufacturer would hedge by buying wheat futures; a speculator would buy a wheat futures contract if he believes the price of wheat may rise; and a speculator would short a wheat futures contract if he believes the price of wheat may fall.

LO 5.3.1

Question 3

Which of these are characteristics of foreign currency exchange?

When a strong foreign currency is converted into U.S. dollars, more dollars are received than if the foreign currency had stayed stable or declined.
An increase in the supply of a currency results in its devaluation.
A U.S. investor in foreign assets would want the U.S. dollar to strengthen against foreign currencies after the assets are purchased.
When the U.S. dollar weakens against a foreign currency, the total return increases to a U.S. investor holding stocks denominated in that currency.
A)
I, II, and IV
B)
II and IV
C)
I and III
D)
II, III, and IV

Answer 3

a The answer is I, II, and IV. When an investor has money invested in a foreign stock, the investor should want the dollar to decline relative to the foreign currency so that a currency gain occurs in addition to the security gain. Currencies are subject to the same supply/demand rules that apply to goods and services and to the money supply. Increasing supply results in decreasing price of the currency.

LO 5.5.2

Question 4

Which of the following statements regarding a straddle is CORRECT?

An investor who writes a short straddle expects that the underlying stock’s price will not change or change very little.
A straddle is an options strategy combining the use of a call option and a put option with different exercise prices and expiration dates.
A)
II only
B)
Neither I nor II
C)
Both I and II
D)
I only

Answer 4

d The answer is I only. A straddle is an options strategy combining the use of a call option and a put option with the same exercise price and expiration date.

LO 5.2.2

Question 4

A collateralized mortgage obligation (CMO) differs from other mortgage-backed securities in that the cash flows associated with the CMO’s pool of underlying mortgages are divided into repayment periods known as

A)
pre-retirement provisions.
B)
conversion privileges.
C)
tranches.
D)
guaranteed remittance provisions.

Answer 4

c A CMO differs from mortgage-backed securities in that the cash flows associated with the CMO’s pool of underlying mortgages are divided into repayment periods known as tranches.

LO 5.1.1

Question 5

Which of these statements describing real estate limited partnerships (RELPs) is CORRECT?

A)
Income attributed to limited partners is considered passive income for income tax purposes.
B)
Interests in RELPs are generally traded in the secondary market.
C)
An individual may be the sole owner of a RELP.
D)
Limited partners have limited management responsibilities.

Answer 5

a The answer is income attributed to limited partners is considered passive income for income tax purposes. Real estate limited partnerships (RELPs) are composed of at least two partners. Limited partners do not have any management responsibilities, and income attributed to them is treated as passive income by the IRS. RELPs are not publicly traded.

LO 5.1.1

Question 5

Choose the statement that best describes a real estate investment trust (REIT).

A)
A REIT is an agreement between two parties to make or take delivery of a specified amount of a financial asset at a future time, place, and unit price.
B)
A REIT is a self-liquidating, flow-through entity that invests exclusively in real estate mortgages or mortgage-backed securities.
C)
A REIT is a closed-end investment company investing in real estate, short-term construction loans, or mortgages.
D)
Similar to open-end investment companies, REITs are redeemed directly by the issuer at a price determined by the investment company minus a sales commission.

Answer 5

c The answer is a REIT is a closed-end investment company investing in real estate, short-term construction loans, or mortgages. Similar to closed-end investment companies, some REITs are publicly traded on the exchanges and can sell at premiums or discounts to net asset value. Also, REIT investors achieve diversification and marketability that is generally lacking with real estate limited partnerships (RELPs).

LO 5.1.1

Question 5

Which of these is a disadvantage of a REIT investment?

A)
Double taxation of REIT income
B)
A lack of knowledgeable professionals as managers
C)
No flow-through of tax benefits
D)
No limited liability for the REIT shareholder

Answer 5

c The answer is no flow-through of tax benefits. Tax losses cannot be passed on to REIT investors.

LO 5.1.1

Question 6

If a U.S. resident buys a Japanese bank stock that subsequently rises in price, while the Japanese currency strengthens relative to the U.S. currency, which of these situations is most likely to occur when the investor sells the stock at a gain?

A)
The net gain will be decreased due to the currency change.
B)
The net gain will be increased due to the currency change.
C)
The net gain will be the same regardless of the currency change.
D)
None of these.

Answer 6

b The answer is the net gain will be increased due to the currency change. Strong Japanese currency means a weak U.S. currency, which increases the net gain on the transaction.

LO 5.5.2

Question 6

Which of the following is CORRECT with regard to the purchasers of gold futures contracts?

A)
They have less speculative positions.
B)
They are considered to be unleveraged positions.
C)
They do not have to meet margin requirements.
D)
They run the risk of government intervention altering the supply and demand for gold.

Answer 6

d Government intervention has always been an issue for gold. The price was fixed for years and Americans were forbidden from owning gold. Although this has changed, the possibility of government intervention does exist. These positions are very speculative and are highly leveraged and risky.

LO 5.4.1

Question 7

Which of these statements regarding basic option positions is CORRECT?

A)
If an investor sells a put, the maximum loss is the exercise price less the amount of premium received.
B)
If an investor buys a put, the maximum gain is unlimited.
C)
If an investor sells a call, the maximum loss is the amount of the premium received.
D)
If an investor buys a call, the maximum loss is unlimited.

Answer 7

a The answer is if an investor sells a put, the maximum loss is the exercise price less the amount of premium received. If an investor buys a put, the maximum gain is the exercise price less the premium paid. If an investor sells a naked call, the maximum loss is unlimited. If an investor buys a call, the maximum loss is the premium paid.

LO 5.2.1

Question 8

Which statement regarding single-country, closed-end funds is NOT correct?

A)
After the initial public offering, the fund will generally not issue additional shares.
B)
Capital appreciation is the primary objective of single-country funds.
C)
Single-country funds trade at the fund’s NAV.
D)
Professional management of the fund and portfolio diversification within the selected market are available with single-country funds.

Answer 8

c Single-country funds are closed-end funds and, like other closed-end funds, generally trade at a discount to NAV.

LO 5.5.1

Question 8

Which of these combinations of events is likely to cause the largest loss on a transaction for a German investor who invests in a Japanese stock?

Gain/Loss on Japanese Stock Gain/Loss on Euro vs. Yen
A 5% gain 10% devaluation of euro vs. yen
B 5% loss 10% revaluation of euro vs. yen
C 5% gain 10% revaluation of euro vs. yen
D 5% loss 10% devaluation of euro vs. yen
A)
Option B
B)
Option D
C)
Option C
D)
Option A

Answer 8

a The answer is Answer Choice A, which is Option B. One of the options with the 5% loss on the stock is likely to provide the largest loss if there also is a loss on the currency translation. When a German investor buys a Japanese stock, he or she wants the euro to depreciate against the yen; therefore, a revaluation of the euro vs. the yen will cause a currency loss in addition to the stock loss, providing the greatest overall loss.

LO 5.5.2

Question 9

Which of the following are reasons an investor might buy a stock index call option instead of an individual stock call option?

A)
It reduces the level of systematic risk.
B)
It is the best way to be fully diversified against unsystematic risk.
C)
The investor wants to hedge his existing stock portfolio against a market decline.
D)
The investor is more confident about the performance of an individual stock than the market as a whole.

Answer 9

b Buying an index option means the risk associated with any one company (business risk) is avoided. An index option can be used to participate in a broad market advance, but still has systematic risk. One would buy a put to hedge against a market decline.

LO 5.2.2

Question 9

Due to an inheritance, Danielle now owns a large position in XYZ stock. She is concerned that the stock may decline in the upcoming months while she is deciding what to do with the investment. What type of investment strategy could her financial planner propose to protect the stock from substantial downside risk?

A)
Purchase a put option
B)
Write a call option
C)
Zero-cost collar
D)
Purchase an index future

Answer 9

a Due to an inheritance, Danielle now owns a large position in XYZ stock. She is concerned that the stock may decline in the upcoming months while she is deciding what to do with the investment. What type of investment strategy could her financial planner propose to protect the stock from substantial downside risk?

A)
Purchase a put option
B)
Write a call option
C)
Zero-cost collar
D)
Purchase an index future

Question 9

The portfolio manager of XYZ Insurance Co. is considering the use of Treasury bond futures to hedge the portfolio of the company. XYZ has a Treasury bond portfolio worth over $500 million.

Into what type of hedge position should XYZ enter, and why?

A)
A long hedge: The company should buy Treasury bond futures contracts because it is hedging against higher interest rates.
B)
A short hedge: The company should sell Treasury bond futures contracts because it is hedging against higher interest rates.
C)
A short hedge: The company should sell Treasury bond futures contracts because it is hedging against lower interest rates.
D)
A long hedge: The company should buy Treasury bond futures contracts because it is hedging against lower interest rates.

Answer 9

b If interest rates rise, there is a loss on the cash side (i.e., bond prices drop); however, there is a gain on the futures side because the short position can be covered at a lower price. When you own something and want to hedge, you must short; when you are short something and want to hedge, you must buy.

LO 5.3.1

Question 9

The exercise price of a put is $25 and the market price of the stock is $18. Which of the following statements is true?

A)
The put is a covered put.
B)
The put is in the money.
C)
The put is out of the money.
D)
The put is a naked put.

Answer 9

b An investor who purchases a put option makes a profit only if the market price of the stock is lower than the exercise (strike) price of the option. Until the market price drops below the strike price, the option is said to be out of the money. It is in the money when the market price drops below the strike price. This put is in the money by $7.

LO 5.2.1

Question 10

A 35-unit apartment complex has 20 one-bedroom and 15 two-bedroom apartments renting for $450 and $600 per month, respectively.

Laundry income:

$2,000 per year

Vacancy and collection losses:

9% of potential gross income (PGI)

Operating expenses:

Property taxes

$16,000

Property insurance

$4,000

Management fee

$6,200

Utilities

$11,700

Accounting/legal

$2,400

Advertising/license

$2,700

Repairs and maintenance

$8,500

Snow removal/security

$2,500

Miscellaneous

$1,000

No major repairs are expected over the next five years.
Cost of the project is $1.7 million. Land is valued at $300,000 and improvements at $1.4 million. Improvements will be depreciated using the straight-line method over 27.5 years. Assume the property is purchased on January 1 of the year so that a full year’s depreciation is allowed in year 1.
A mortgage of $1.2 million is available at 9% for 30 years (annual payments), fully amortized.
The investor’s marginal tax bracket is 24%.
Calculate the net operating income (NOI) for the apartment complex for the next year.

A)
$143,380
B)
($15,529)
C)
$92,471
D)
$141,560

Answer 10

a The key to this problem is to recognize that interest expense and depreciation are not included in expenses when calculating NOI. The calculation is as follows: Gross rental income of $216,000 plus other income of $2,000 equals potential gross income (PGI) of $218,000. Subtract vacancy and collection losses (9%) of $19,620 to arrive at effective gross income of $198,380. Subtract operating expenses of $55,000, resulting in net operating income (NOI) of $143,380.

LO 5.1.1

Question 10

The minimum price at which an option will trade on an exchange is identified as the

A)
exercise price.
B)
future value.
C)
premium.
D)
intrinsic value.

Answer 10

d The answer is intrinsic value. The minimum price at which an option will trade on an exchange is known as the intrinsic value.

LO 5.2.1

Question 10

Identify the CORRECT statement concerning international investing.

A)
The addition of foreign securities to a portfolio may result in increased portfolio risk due to the different movements of foreign markets and U.S. markets.
B)
Foreign markets are usually mature and offer no growth advantages.
C)
Information is not as readily available on foreign investments.
D)
The rates of return on foreign securities have always been less than those available from U.S. markets.

Answer 10

c The answer is information is not as readily available on foreign investments. Foreign markets offer economies of scale and growth opportunities. Investors may earn higher returns in foreign markets, particularly if they are less efficient than U.S. markets. Including foreign securities in an investment portfolio may lower risk through greater diversification.

LO 5.5.1

Question 11

Assume an option writer buys a stock for $75 and immediately sells a call option on the stock for a premium of $5 at a strike price of $75. What is the maximum gain to the call writer and the maximum loss to the call buyer?

Maximum Gain to Call Writer

Maximum Loss to Call Buyer

A

$5

$80

B

$80

$5

C

$80

$80

D

$5

$5

A)
Option C
B)
Option A
C)
Option B
D)
Option D

Answer 11

d The maximum gain for the option writer is the call premium received; the maximum loss for the option buyer is the call premium paid.

LO 5.2.2

Question 11

All of these statements correctly describe international investing except

A)
one method to engage in international investing is through American depositary receipts.
B)
international investing offers diversification and potentially higher returns.
C)
an emerging market is a market in a highly developed foreign economy with stable political and social institutions.
D)
an international investor faces the additional risks of foreign currency risk and country risk.

Answer 11

c The answer is an emerging market is a market in a highly developed foreign economy with stable political and social institutions. Emerging markets are markets in lesser developed countries.

LO 5.5.1

Question 12

If a U.S. resident buys a Japanese auto stock that subsequently rises in price while the Japanese currency weakens relative to the U.S. currency, which one of these situations is most likely to occur when the investor sells the stock at a gain?

A)
The net gain will be increased due to the currency change.
B)
The net gain will be the same regardless of the currency change.
C)
The net gain will be decreased due to the currency change.
D)
None of these.

Answer 12

c The answer is the net gain will be decreased due to the currency change. A strong U.S. currency decreases the gain from a sale of a foreign stock.

LO 5.5.2

Question 13

Interest in gold as an investment increases during periods of which of these?

A)
Deflation
B)
Economic or political uncertainty
C)
Economic growth
D)
Recession

Answer 13

b The answer is economic or political uncertainty. Economic or political uncertainty causes the demand for gold to grow.

LO 5.4.1

Question 13

The daily limit of a commodity futures contract is the maximum

A)
percentage by which the futures price can increase from the previous day.
B)
price increase or decrease relative to the settlement price the previous day.
C)
number of contracts allowed to be traded that day.
D)
amount by which the maintenance margin can change per day.

Answer 13

This is the definition of the daily limit.

LO 5.3.1

Question 13

Which of the following are advantages of investing internationally?

Some international markets are less efficient than U.S. markets.
International mutual funds do not have the exchange rate risks of individual foreign stocks.
Due to lower correlations with U.S. stocks, foreign stocks can lower total portfolio risk.
Investors in foreign securities avoid U.S. tax on realized capital gains.
A)
I and III
B)
I and II
C)
I, III, and IV
D)
II and IV

Answer 13

a Foreign markets have far fewer analysts following their stocks than do U.S. markets, and the information available from many foreign companies is less readily available to investors, making these markets less efficient than U.S. markets. Portfolio standard deviation is highly dependent on the covariance of returns. The covariance of foreign stocks with U.S. stocks is relatively low, serving to lower the standard deviation of the portfolio into which such stocks are placed. Exchange rate risk is a constant threat to a foreign stock or bond investment in any form, including mutual funds. Foreign security income is taxed first in the country of origin and then again in the United States. U.S. taxpayers can take a foreign tax credit on their U.S. return for the taxes paid to other countries.

LO 5.5.1

Question 13

Which of these statements correctly illustrates basic option positions?

A)
If an investor writes a put, the maximum loss is the exercise price less the amount of premium received.
B)
If an investor buys a call, the maximum loss is unlimited.
C)
If an investor writes a call, the maximum loss is the amount of premium paid.
D)
If an investor buys a put, the maximum gain is unlimited.

Answer 13

a Explanation
The answer is if an investor writes a put, the maximum loss is the exercise price less the amount of premiums received. If an investor buys a put, the maximum gain is the exercise price less the amount of premium paid. If an investor writes a call, the maximum loss is unlimited. If an investor buys a call, the maximum loss is the premium paid.

LO 5.2.1

Question 13

Which of the following statements are true regarding risk and return for tangible investments?

Unsystematic risk tends to be high with most forms of tangible assets.
High cash flows from collectibles create annual taxable events.
The illiquid nature of the investments makes them suitable for income-seeking investors.
The capital gains rate on collectibles is greater than that of other investments.
A)
I and IV
B)
I and II
C)
II and III
D)
I only

Answer 13

a Generally, collectibles do not provide an investor with predictable cash flows. Therefore, they would not be suitable for an income-seeking investor.

LO 5.4.1

Question 13

Lisa is considering investing in timberland. She owns a portfolio of stocks, bonds and money market securities. Relative to her existing portfolio, the primary benefit of the timberland investment is most likely

A)
the investment horizon is longer than that of stocks and bonds, balancing the duration of the portfolio.
B)
timber is a renewable resource so Lisa can profit from the land for many years.
C)
low correlation between traditional asset returns and timberland returns.
D)
timber values are tied to cyclical industries.

Answer 13

c The answer is low correlation between traditional asset returns and timberland returns. Timberland returns exhibit low correlation with stock and bond returns. This is generally cited as the key advantage to investing in timber. However, it is difficult to measure the returns to illiquid assets such as timber so the low correlation may be more a function of poor measurement of returns and less a function of true uncorrelated or negatively correlated returns. Cyclicality and a long investment horizon are disadvantages of timberland investments. Timber is a renewable resource but that would not be the key advantage in a traditional asset portfolio.

LO 5.4.1

Question 14

George owns 1,000 shares of XYZ stock. Based on recent analyst projections and George’s own research, he believes XYZ’s price will remain flat over the next few months. Accordingly, which strategy would George likely employ if one of his objectives was to increase his portfolio’s income stream?

A)
Sell 10 XYZ call option contracts
B)
Buy a warrant
C)
Buy 10 XYZ put option contracts
D)
Buy an index future

Answer 14

a This is known as the covered call strategy and is used to increase the income of the portfolio when the price of the underlying stock is expected to remain flat for a period of time. Assuming the price of the underlying stock continues to remain flat, there is little chance of the option being exercised and the stock being called away.

LO 5.2.2

Question 14

Trey is considering the purchase of American depositary receipts (ADRs). He is looking to further diversify his portfolio. Which of these is NOT a feature of this type of investment vehicle?

A)
ADRs are denominated and pay dividends in U.S. dollars.
B)
Information regarding the foreign company is easily attainable.
C)
They are not subject to exchange rate, or currency, risk.
D)
ADRs are both liquid and marketable.

Answer 14

c The answer is they are not subject to exchange rate, or currency, risk. Even though ADRs are denominated in U.S. dollars, they are subject to exchange rate, or currency, risk.

LO 5.5.1

Question 15

Which of the following best illustrates characteristics of mortgage and equity real estate investment trusts (REITs)?

Mortgage REITs

Equity REITs

A

Generates capital gains

Generates interest income

B

Generates rental income

Generates capital gains

C

Similar to a bond fund

Similar to a stock fund

D

Also known as a FREIT

Also known as a hybrid REIT

A)
Option A
B)
Option B
C)
Option C
D)
Option D

Answer 15

c Equity REITs own property and receive all income from the property rentals, making them more like a stock fund; they also are more volatile than mortgage REITs, and they provide more capital gain opportunity then do mortgage REITs. Mortgage REITs own the mortgages used to finance real estate properties, making them more like a bond fund.

LO 5.1.1

Question 15

Options with expiration dates more than two years out are categorized as

A)
LEAPS.
B)
GICs.
C)
CMOs.
D)
REMICs.

Answer 15

a Explanation
The answer is LEAPS. Long-term equity anticipation securities (LEAPS) are options with expiration dates extending beyond two years.

LO 5.2.1

Question 15

Currently it costs $1.47 in U.S. dollars to purchase one Eurodollar. If a U.S. investor purchases euros, what would be the result for this investor if the exchange rate were to be 0.70 euros per U.S. dollar when the euros were converted back into U.S. dollars?

A)
The U.S. investor would have made money, because the U.S. dollar has been revalued.
B)
The U.S. investor would have lost money, because the U.S. dollar has been devalued.
C)
The U.S. investor would have lost money, because the U.S. dollar has been revalued.
D)
The U.S. investor would have made money, because the U.S. dollar has been devalued.

Answer 15

c The key here is to compare apples to apples and state the currency rate from the same perspective. You are given how many U.S. dollars are needed to purchase a euro ($1.47), so calculate how many euros you would receive for one U.S. dollar:

1/ $1.47 = 0.6803 euros per U.S. dollar

You are told the rate has changed to 0.70 euros per U.S. dollar, and before it was 0.68 euros per U.S. dollar. This means the investor needs to spend more euros for one U.S. dollar—so the euro is worth less (devaluation), and the U.S. dollar is worth more (revaluation). In order to make money on a currency transaction, the home currency (the U.S. dollar in this case) needs to go down (devaluation), and the foreign currency needs to go up (revaluation). The opposite has happened in this case, so the U.S. investor has lost money because the U.S. dollar has gone up in value (revalued).

LO 5.5.2

Question 16

Baylor stock is currently selling for $63 per share. A put option for this security with an exercise price of $65 per share can be purchased for $4 per share. The option expires in three months. Which of these statements best describes this option?

A)
In-the-money
B)
Out-of-the-money
C)
At-the-money
D)
By-the-money

Answer 16

a The answer is in-the-money. A put option is in-the-money when the exercise price is greater than the market price of the underlying security. A put option is out-of-the-money when the market price is greater than the exercise price.

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Question 16

One of the characteristics of real estate investment trusts (REITs) is that they generally

A)
offer new shares continually to investors.
B)
reinvest most of their income.
C)
pay federal income tax on their earnings.
D)
have a high degree of marketability.

Answer 16

d Most real estate investments are not readily marketable. Therefore, an investor in real estate can generally expect some difficulty in converting a property to cash if cash is needed quickly. However, a REIT securitizes real estate properties, thereby allowing REIT investors to easily sell REIT shares in the open market. REITs must flow through at least 90% their income to investors; therefore the investors and not the REITs pay tax on these distributions.

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Question 17

Which of the following statements assessing derivative securities is CORRECT?

A call option is at the money when the exercise price is less than the market price of the stock.
A put option is at the money when the exercise price is greater than the market price of the stock.
Buyers of calls are betting that the price of the underlying common stock will rise, making the call option more valuable.
Put buyers are betting that the price of the underlying common stock will decline, making the put option more valuable.
A)
II and III
B)
III and IV
C)
I, II, and IV
D)
I and II

Answer 17

b Statements I and II are incorrect because both call and put options are at the money when the exercise price equals the market price of the stock.

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Question 18

You are about to recommend international mutual funds to your clients. Which of the following are characteristics of investing internationally?

International markets are less efficient than U.S. markets.
International mutual funds have the exchange rate risks of individual foreign stocks.
Due to lower correlations with U.S. stocks, foreign stocks can lower total portfolio risk.
Investors in foreign securities avoid U.S. tax on realized capital gains.
A)
I and III
B)
I and II
C)
II, III, and IV
D)
I, II, and III

Answer 18

d Foreign markets have fewer analysts following stocks than do U.S. markets, and the information available from many foreign companies is minimal, making these markets less efficient than U.S. markets. The covariance of foreign stocks, especially small-cap and emerging market stocks, with U.S. stocks is relatively low, serving to lower the standard deviation of the portfolio in which such stocks are placed. Exchange rate risk is a systematic risk with foreign investments. Foreign income is taxed first in the country of origin and then again in the United States; U.S. taxpayers can take a foreign tax credit for taxes paid to other countries.

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Question 19

Foreign markets have fewer analysts following stocks than do U.S. markets, and the information available from many foreign companies is minimal, making these markets less efficient than U.S. markets. The covariance of foreign stocks, especially small-cap and emerging market stocks, with U.S. stocks is relatively low, serving to lower the standard deviation of the portfolio in which such stocks are placed. Exchange rate risk is a systematic risk with foreign investments. Foreign income is taxed first in the country of origin and then again in the United States; U.S. taxpayers can take a foreign tax credit for taxes paid to other countries.

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Answer 19

a The answer is investors receive a variable cash flow from the underlying real estate mortgages. Investors who own REMICs receive a specified cash flow from the underlying pool of mortgages. REMICs are self-liquidating pass-through entities that invest exclusively in mortgages and mortgage-backed securities. REMICs frequently issue bonds in the form of collateralized mortgage obligations, which divide payment streams into tranches. Investors in Tranche A receive principal payments first, which reduces their interest rate risk, when compared to other tranche investors.

LO 5.1.1

Question 20

Alex owns a put option with an exercise price of $51. The underlying stock is currently trading at $48 in the secondary market. Assuming the put option is currently trading at $6 and has three months until expiration, calculate the intrinsic value of the put option.

A)
-$400
B)
$100
C)
$300
D)
-$600

Answer 20

c The answer is $300. The price the put option is currently trading at in the secondary market and the premium paid for the put option are both ignored when determining the intrinsic value of the put option. The two factors that matter are the exercise price of the put option and the price that the underlying stock is currently trading at in the secondary market. Therefore, the intrinsic value of this put option is $300 ($51 − $48 × 100 shares), which is the exercise price of the put option minus the price the underlying stock is currently trading at in the secondary market multiplied by 100 shares. Each option contract represents 100 shares of the underlying stock.

LO 5.2.1

Question 20

Why would financial planners recommend their clients purchase natural resources for their investment portfolios?

Diversification
Low degree of risk
Positive correlation with other financial assets
Pass through of certain tax benefits including depletion
A)
II and III
B)
I, II, III, and IV
C)
I and IV
D)
II, III, and IV

Answer 20

c The answer is I and IV. Statements II and III are incorrect. Investments in natural resources offer investors a high degree of risk and a negative correlation with other financial assets.

LO 5.4.1

Question 21

Which of these statements regarding option pricing models is CORRECT?

The binomial option pricing model assumes that the price of the option will change constantly because the market price of the underlying security also changes constantly.
The Black-Scholes option valuation model is designed to determine the price of an American call option.
The Black-Scholes option valuation model assumes that the price of the option will change in discrete increments on the basis of movements (up or down) in the price of the underlying stock.
The binomial model assumes the call option being valued has an exercise price of $100.
A)
IV only
B)
II, III, and IV
C)
I, II, and III
D)
I and IV

Answer 21

a The answer is IV only. The Black-Scholes option valuation model assumes that the price of the option will change constantly because the market price of the underlying security also changes constantly and is designed to determine the price of a European call option. The binomial option pricing model assumes that the price of the option will change in discrete increments on the basis of movements (up or down) in the price of the underlying stock.

LO 5.2.1

Question 21

All of these are disadvantages of investing in foreign securities except

A)
strong correlation with U.S. securities.
B)
changes in foreign government or government policies.
C)
lack of complete information about foreign companies.
D)
fluctuations in the value of currencies.

Answer 21

a The answer is strong correlation with U.S. securities. Foreign securities are not highly correlated with U.S. securities and thus offer opportunities to further reduce the portfolio volatility. Changes in the value of a foreign currency can increase or reduce the return from a securities portfolio.

LO 5.5.1

Question 22

You are about to invest in foreign mutual funds and have decided to invest in country funds as opposed to a single diversified international mutual fund. Your single biggest concern is the fact that the U.S. dollar has been rising dramatically against the currency of this country. Which of the following points is most important?

A)
The foreign currency should be fully hedged.
B)
If the U.S. mutual funds hold only large-cap stocks, the foreign funds should include only small-cap stocks.
C)
The correlation between the foreign market and the U.S. market should be as high as possible.
D)
The correlation between the foreign market and the U.S. market should be as low as possible.

Answer 22

a To achieve the greatest diversification benefits of investing in foreign securities, or any securities for that matter, the correlation coefficients between the two markets should be as low as possible—generally close to zero or negative, but hedging the foreign currency will eliminate exchange rate risk and allow the investor to focus only on the fundamentals of investing in that country’s stock market. Diversifying with different investment styles and market caps is important, but not as critical to addressing his primary concern of the rising dollar.

LO 5.5.1

Question 23

American Depositary Receipts (ADRs) are used to

finance foreign exports.
eliminate currency risk.
sell U.S. securities in overseas markets.
trade foreign securities in U.S. markets.
A)
I, II, and III
B)
I and IV
C)
IV only
D)
II and IV

Answer 23

c The answer is IV only. ADRs are used to trade foreign securities in the United States. ADRs are trust receipts issued by a U.S. bank for shares of a foreign company that are held by a foreign branch of the bank. ADRs are legal claims against the equity interest that the bank holds. ADRs do not eliminate currency risk.

LO 5.5.1

Question 24

Which of the following statements regarding the variables in the Black/Scholes European call option pricing model is CORRECT?

An increase in the price of the underlying stock decreases the value of the European call option.
An increase in the variability of the price of the underlying stock decreases the value of the European call option.
An increase in the risk-free rate increases the value of the European call option.
An increase in the time to expiration decreases the value of the European call option.
A)
III only
B)
I, II, and IV
C)
III and IV
D)
II and III

Answer 24

a An increase in the price of the underlying stock and/or the variability in the price of the underlying stock increases the value of the European call option. An increase in the time to expiry also increases the value of the European call option.

LO 5.2.1

Question 24

A major source of systematic risk when investing in foreign securities is exchange rate risk. To minimize the effect of exchange rate risk, an investor can hedge with currency futures.

Which of the following illustrate appropriate times for an investor who owns a foreign security to hedge?

The foreign security is expected to rise in price and the dollar is expected to fall relative to the foreign currency.
The foreign security is expected to remain relatively stable in price and the dollar is expected to fall relative to the foreign currency.
The foreign security is expected to fall in price and the dollar is expected to rise relative to the foreign security.
The foreign security is expected to fall in price and the dollar is expected to remain relatively stable relative to the foreign security.
A)
III only
B)
II only
C)
I and III
D)
I and IV

Answer 24

a A hedge should be initiated if the U.S. dollar is expected to rise; it is not needed if the dollar is expected to fall or remain relatively stable.

LO 5.5.2

Question 25

Which of the following is NOT an advantage of purchasing American Depositary Receipts (ADRs)?

A)
They eliminate exchange rate risk.
B)
Transactions are done on an organized exchange in the United States.
C)
Foreign taxes withheld can be claimed as a credit to offset income taxes on dividends received.
D)
They allow U.S. investors to buy foreign country stock denominated in dollars.

Answer 25

a ADRs are priced in U.S. dollars and therefore have exchange rate risk.

LO 5.5.1

Question 26

Which of the following statements correctly explain real estate investing?

Real estate allows investors to use substantial leverage when acquiring property.
Real estate may be used as a hedge against inflation.
Real estate offers high liquidity to investors.
Real estate owned can be used as collateral for loans and offers investors tax write-offs.
A)
III only
B)
I, II, and IV
C)
I and II
D)
II, III, and IV

Answer 26

b Only statement III is not correct. Real estate is an illiquid investment and involves high transaction costs.

LO 5.1.1

Question 27

Which of these statements regarding index options is NOT correct?

A)
Investors often buy call index options to hedge against the risk of a decline in the value of their long positions in stocks.
B)
When exercised, index options result only in cash settlement.
C)
Index options allow investors to earn a return associated with the movements in the market.
D)
Investors can profit from a decline in the stock market by purchasing a put index option.

Answer 27

a The answer is investors often buy call index options to hedge against the risk of a decline in the value of their long positions in stocks. Investors purchase put index options to hedge their long positions in stocks. A decline in stock prices causes the value of their long portfolios to decline. This loss is offset by the gain in the value of the option.

LO 5.2.2

Question 28

Which of the following are risks associated with tangible assets?

Price fluctuations
Higher front-end costs
Loss from fraud and theft
Lack of liquidity and marketability
A)
I, II, III, and IV
B)
III and IV
C)
I and II
D)
I and IV

Answer 28

a All of these are potential risks from investing in nonfinancial assets.

LO 5.4.1

Question 28

An investor might use a stock index option instead of an individual stock option if the investor

A)
is proficient at stock selection.
B)
wants to reduce the level of market risk.
C)
wants to avoid business risk.
D)
wants to reduce the level of systematic risk.

Answer 28

c The answer is wants to avoid business risk. Buying an index option means the risk associated with any one company (business risk) is avoided. An index option can be used to protect against market or sector swings, and the investor need not be concerned with individual companies.

LO 5.2.2

Question 28

Which of the following factors should be considered when investing in antiques?

Supply
Marketability
Inflation
Dealer reputation
A)
I, III, and IV
B)
I, II, III and IV
C)
III and IV
D)
I and II

Answer 28

b The antique/collectibles markets are inefficient, where supply is frequently limited, making supply an important consideration. Some rare and famous antiques may be in great demand and be marketable; for many, however, no, or a limited, market and demand may exist. Rising inflation generally encourages investors to purchase tangibles. Dealer reputation is important in the collectibles market to minimize fraud.

LO 5.4.1

Question 29

Your client is considering the purchase of an apartment complex with the following anticipated financial characteristics:

Mortgage = 8% for 30 years, amortized monthly, with financing available for 70% of value
Cost recovery period = 27.5 years (residential rental)
Potential gross income (PGI) (year 1) = $1,500,000
Vacancy rate = 8% of PGI
Operating expenses = 30% of PGI
Capitalization rate = 9%
Based on this information, what is the maximum price you would advise your client to pay?

A)
$9,400,000
B)
$10,333,333
C)
$16,666,667
D)
$11,666,667

Answer 29

b The calculation is as follows: Potential gross income (PGI) of $1,500,000 less vacancy losses of $120,000 equals effective gross income of $1,380,000. Subtract operating expenses of $450,000, resulting in net operating income (NOI) of $930,000. Value = $930,000 ÷ 0.09 = $10,333,333.

LO 5.1.1

Question 30

Two months ago, an investor purchased a call option trading for $3 with an exercise price of $30. The stock’s market price was $32. What was the time value of the call option?

A)
$6
B)
$2
C)
$1
D)
$3

Answer 30

c time value = option premium − intrinsic value = option premium − (stock’s market price − exercise price) = $3 − ($32 − $30) = $1

LO 5.2.1

Question 30

Choose the REITs that are used to finance real estate ventures that develop property or finance construction.

A)
Mortgage REITs
B)
Hybrid REITs
C)
Equity REITs
D)
Government REITs

Answer 30

a The answer is mortgage REITs. Mortgage REITs are in the business of financing real estate ventures. They make loans to develop property or finance construction.

LO 5.1.1

Question 30

Which of these strategies is considered a protective strategy?

A)
Purchasing a hedge fund
B)
Buying a put option on a stock already owned
C)
Buying stock index futures
D)
Purchasing a call option on a stock already owned

Answer 30

b The answer is buying a put option on a stock already owned. A protective strategy limits downside risk. The purchase of a put option on a stock that is already owned reduces downside risk. If the price of a stock declines, the value of the put option increases and protects an investor holding a long position in the underlying stock.

LO 5.2.2

Question 31

Gold mining stocks are approximately how volatile in comparison to U.S. large-cap stocks?

A)
Twice as volatile
B)
Equally volatile
C)
Cannot be determined
D)
Half as volatile

Answer 31

a The answer is twice as volatile. Gold mining stocks are roughly twice as volatile as large-cap U.S. stocks.

LO 5.4.1

Question 32

John sells a naked call option for a $3 premium. The call option has an exercise price of $20. Which of these statements is CORRECT?

A)
John’s maximum gain is $3.
B)
The option will not be exercised until the market price is $17.
C)
The call will likely not be exercised while the stock is trading at $23.
D)
John’s loss is limited to $20.

Answer 32

a The answer is John’s maximum gain is $3. John’s maximum loss is unlimited. Because the call option was written as a naked call option, the seller (John) will have to buy the stock at the prevailing market price if the call option is exercised by the buyer. The buyer would exercise the call option when the stock price exceeds $20. Any price level over $20 begins to reduce the call option buyer’s potential loss, and at $23 the seller and buyer break even.

LO 5.2.1

Question 33

Which of the following are characteristics of collectibles investments that distinguish them from financial investments?

The market is relatively inefficient.
The capital gain is taxed at a maximum rate of 20%.
There are large spreads between bid and ask prices.
There is little liquidity risk.
A)
II, III, and IV
B)
I and III
C)
I, II, III, and IV
D)
I, II, and III

Answer 33

b Which of the following are characteristics of collectibles investments that distinguish them from financial investments?

The market is relatively inefficient.
The capital gain is taxed at a maximum rate of 20%.
There are large spreads between bid and ask prices.
There is little liquidity risk.
A)
II, III, and IV
B)
I and III
C)
I, II, III, and IV
D)
I, II, and III

Question 34

Mary is traveling to Europe and has $1,000 (U.S.) that she wants to convert to euros. The current exchange rate is 0.90 euros = $1 (U.S.). How many euros will she receive in this exchange?

A)
1,111
B)
900
C)
2,000
D)
1,800

Answer 34

b The answer is 900. Determine the cost in U.S. dollars to purchase one euro:

1 / 0.90 = $1.1111

Then,

$1,000 ÷ $1.1111 = 900 euros

or

$1,000 × 0.90 = 900 euros

LO 5.5.2

Question 34

Open interest is

A)
the number of unexecuted buy and sell orders for a particular commodity pending at the end of trading each day on a commodity exchange.
B)
the number of futures contracts outstanding for a commodity on any given trading day.
C)
the rate of interest charged on the difference between the market value of a commodity contract and the amount of margin on deposit in a customer’s account.
D)
a technical indicator, used only with financial futures, that indicates the dollar amount of bonds expected to be delivered at contract expiration.

Answer 34

b The answer is the number of futures contracts outstanding for a commodity on any given trading day. Open interest is reported daily in the financial press. Traders like to be in the most active months of a contract for liquidity purposes.

LO 5.3.1

Question 35

Fred Smith, your client, has consulted you regarding increasing the overall yield on his portfolio while simultaneously reducing his risk exposure to the stock market. You have suggested real estate investment trusts (REITs) and explain that there are several different kinds of REITs. Which of the following accurately describe the characteristics of equity REITs?

Earn rental income from leasing properties they own
Earn interest income from mortgages on real estate properties
Are designed to be liquidated in a specific future year
Are similar to open-end mutual funds
A)
II only
B)
I and II
C)
I, III, and IV
D)
I only

Answer 35

d Mortgage REITs receive interest income from mortgages they own. Finite life REITs liquidate in a future year. REITs are closed-end funds.

LO 5.1.1

Question 35

Reasons for investing in real estate include all of these except

A)
relatively constant cash flow.
B)
potential tax shelter.
C)
potential long-term appreciation.
D)
liquidity.

Answer 35

d The answer is liquidity. Real estate is an illiquid investment. Real estate offers the ability to shelter an investment’s cash flow. Income real estate provides a relatively dependable source of cash flow. Real estate offers investors an excellent source of long-term capital appreciation.

LO 5.1.1

Question 36

Which of these is a reason why tangible assets are an excellent addition to an investment portfolio?

A)
Low cost of buying tangible assets
B)
Tax benefits
C)
High liquidity of the investments
D)
Low correlations with financial assets

Answer 36

d The answer is low correlations with financial assets. Tangible assets have low correlations with financial assets.

LO 5.4.1

Question 37

An investor who creates a long straddle most likely expects the underlying security to

A)
decrease in volatility.
B)
increase in volatility.
C)
increase in price.
D)
remain near its current price.

Answer 37

b The answer is increase in volatility. Long straddle profits if the volatility of the underlying security increases more than is reflected in current option prices, which would increase the value of both the call option and the put option. Either a significant increase or a significant decrease in the underlying price would benefit the holder of a long straddle. If the investor was expecting only an increase in price, long call would be a better choice of investment (as the premium paid on the long put would be a waste).

LO 5.2.2

Question 37

What is the intrinsic value of a put option with an exercise price of $45, when the stock is selling for $40?

A)
$4
B)
$5
C)
$1
D)
$50

Answer 37

b intrinsic value of a put option = (exercise price − market price) = ($45 − $40) = $5

LO 5.2.1

Question 37

Which of these best describes a futures contract?

A)
A futures contract is a self-liquidating, flow-through entity that invests exclusively in mortgage-backed securities.
B)
A futures contract is a derivative characterized by low risk and the potential for high return.
C)
A futures contract is an agreement between two parties to make or take delivery of a specified amount of a commodity or financial asset at a future time, place, and unit price.
D)
A futures contract seeks to invest in an industry sector or index that is undervalued, but is expected to rise in value in the future.

Answer 37

c The answer is a futures contract is an agreement between two parties to make or take delivery of a specified amount of a commodity or financial asset at a future time, place, and unit price. To complete the futures contract, delivery of the commodity or asset may be made, but more often, the buyer (or holder) simply purchases an offsetting contract and cancels the original position.

LO 5.3.1

Question 38

All of these correctly express risks associated with an investment in undeveloped land except

A)
the land may be adversely rezoned.
B)
the investor may not be able to obtain permits to build on the land.
C)
an investment in undeveloped land always guarantees a short-term profit.
D)
access to the land may be restricted.

Answer 38

c The answer is that an investment in undeveloped land always guarantees a short-term profit. An investment in undeveloped land is made with the expectation that the land will eventually provide a significant, future capital return over the long run.

LO 5.1.1