Module 7 Measures of Investment Returns Flashcards
Assuming Von made a $10,000 investment four years ago that presently has a value of $31,500, calculate the geometric mean return over the four-year investment period.
A)
57.50%
B)
33.22%
C)
53.75%
D)
78.75%
b The answer is 33.22%. An investment growing from $10,000 to $31,500 over a four-year period has a geometric mean return equal to 33.22%, calculated as follows:
PV = −10,000
FV = 31,500
N = 4
Solve for I/YR = 33.2225, or 33.22%
LO 7.1.1
An investor who owns a sector fund that has substantial unsystematic risk and would like to know how a portfolio manager performed on a risk-adjusted basis would use which of the following indicators?
A)
Sharpe ratio
B)
Treynor ratio
C)
Jensen’s alpha
D)
Beta
a Sharpe uses standard deviation and assumes the portfolio is not well diversified and measures total risk.
LO 7.2.1
Cindy has been an active investor for many years. She currently has a money market mutual fund and several equity mutual funds. She wants to maximize her return on an intermediate-term bond and plans to hold the bond to maturity.
Which of these two bonds would be more appropriate for Cindy, and why?
Bond 1: callable at par value; BBB rated; coupon = 6%; matures in six years; selling for $863; duration = 5.16
Bond 2: callable at par value; A rated; coupon = 10%; matures in four years; selling for $1,103; duration = 3.5
Bond 1, because it is selling for a discount and is less likely to be called.
Bond 1, because it has a higher yield to maturity than Bond 2.
Bond 2, because its higher coupon gives it a better total return.
Bond 2, because it has a higher yield to maturity than Bond 1.
A)
II only
B)
I and II
C)
III and IV
D)
I only
b Explanation
The answer is I and II. Below are the TVM inputs used on the financial calculator for each bond.
YTM for Bond 1:
PV = -$863
FV = $1,000
PMT = $1,000 x 6% = $60 / 2 = $30
N = 12 (6 x 2 periods per year)
Solve for I/YR = 9%
YTM for Bond 2:
PV = -$1,103
FV = $1,000
PMT = $1,000 x 10% = $100 / 2 = $50
N = 8 (4 x 2 periods per year)
Solve for I/YR =7%
In addition, Bond 1 is selling at a discount—unlike Bond 2 selling at a premium—so it is not likely to be called.
LO 7.4.1
Myles purchased 1,000 shares of XYZ growth fund for $15 per share. At the end of the two years, he sold all of the shares for $22 per share. At the end of each year, the fund paid a dividend of $0.50 per share. Calculate the fund’s time-weighted return over the two-year period.
A)
24.15%
B)
18.07%
C)
13.62%
D)
20.82%
a Explanation
The answer is 24.15%. The fund produced a 24.15% time-weighted rate of return over the two-year period, calculated as follows:
CF0 = -15 × 1,000 = −15,000
CF1 = 0.50 × 1,000 = 500
CF2 = (0.50 × 1,000) + (22 × 1,000) = 22,500
Solve for the internal rate of return (IRR/YR) = 24.1525% (rounded to 24.15%)
LO 7.1.1
Janice, who is in the 35% marginal income tax bracket, would like to purchase a bond for her investment portfolio. Assuming all of the bonds are of similar investment quality, which would produce the highest after-tax yield?
A)
2.75% U.S. Treasury bond
B)
2.25% U.S. Treasury note
C)
3.55% municipal bond
D)
5.25% corporate bond
c Janice should purchase the municipal bond based on the following after-tax yield calculations:
U.S. Treasury bond [2.75% × (1 − 0.35)]
1.79%
Corporate bond [5.25% × (1 − 0.35)]
3.41%
Municipal bond (tax-free)
3.55%
U.S Treasury note [2.25% × (1 − 0.35)]
1.46%
LO 7.4.1
You own a small-cap fund and are trying to compare its performance to an appropriate benchmark. Which of the following benchmarks would be the best to use?
A)
The S&P 500 Index
B)
Russell 2000
C)
CS First Boston High Yield
D)
Treasury bills
nb The Russell 2000 is generally considered the benchmark for small-cap funds.
LO 7.3.1
Michael purchased 800 shares of ABC stock for $75 per share. The stock paid a $1.20 dividend per share at the end of the year, and there was a 2-for-1 stock split during the year. Assuming the value of his investment at the end of the year was $66,000, calculate the holding period return for the investment.
A)
14.0%
B)
12.0%
C)
8.3%
D)
13.2%
d The answer is 13.2%. The investment’s holding period return is calculated as [($66,000 − $60,000) + ($1.20 × 800 × 2)] ÷ $60,000 = 13.2%. The dividend is based on 1,600 shares because of the 2-for-1 stock split.
LO 7.1.1
To measure the performance of an investment manager, which of the following methods of computing returns should be used?
A)
Time-weighted return
B)
Dollar-weighted return
C)
Arithmetic average
D)
Holding period return
a The answer is time-weighted return. The time-weighted return should be used to measure the performance of an investment manager.
LO 7.1.1
Your client purchased a call of KLN Corp. for $800. The exercise price was $35, and the market price of KLN Corp. stock was $38. Six months later, the market price of KLN Corp. stock was $40 and the client sold the call for $1,250.
What was the holding period return on this investment?
A)
14.28%
B)
56.25%
C)
8.57%
D)
63.82%
b
HPR = (Sale price-purchase price)/purchase price
(1250-800)/800
56.25%
A mutual fund with an investment objective of growth and income has an alpha of +4, a beta of 1.5, and a Sharpe ratio of 1.15. The fund
A)
should be purchased, because it has a relatively low level of risk in relation to return.
B)
should not be purchased, because it has a low level of return in relation to risk.
C)
should be purchased, because the rate of return is high in relation to risk.
D)
should not be purchased even though the rate of return compensates for the level of risk.
c The answer is should be purchased, because the rate of return is high in relation to risk. A positive alpha indicates the fund performed better than it should have on a risk-adjusted basis. Also, an alpha of +4, which is very high, means it performed 4% better than expected.
LO 7.2.1
If the market interest rate is 7.27%, the current yield of a bond with a 9% coupon, $1,000 par, selling for $1,120, and maturing in 10 years is
A)
6.49%.
B)
7.27%.
C)
9.00%.
D)
8.04%.
d The answer is 8.04%. The current yield is the coupon payment divided by the market price of the bond:
($90 ÷ $1,120) x 100 = 8.04%.
LO 7.4.1
Crowder made an investment that paid him an 8% nominal rate of return for the year in which he held the investment. During that year, the inflation rate was 3%. Based on this information, calculate Crowder’s inflation-adjusted return (real return).
A)
4.85%
B)
3.08%
C)
2.67%
D)
5.10%
a The answer is 4.85%. The inflation-adjusted return (IAR) is computed as:
IAR = [((1 + nominal rate of return) ÷ (1 + inflation rate)) − 1] × 100
= ((1.08 ÷ 1.03) − 1) × 100 = 4.8544, or 4.85%
LO 7.1.1
Sammy owns a 7% corporate bond that is currently trading at $1,040. The bond matures in 22 years; however, it is callable in nine years at a 3% premium over par. What is the yield-to-call on Sammy’s bond?
A)
6.82%
B)
6.97%
C)
6.65%
D)
6.57%
c The call premium is 3%, which would be a price of $1,030. The inputs can be used on the financial calculator:
TVM Inputs
-$1,040 PV
$1,030 FV
$35 = $1,000 x 7% = $70 / 2 PMT
N = 18 (9 x 2 periods per year) N
Solve for I/YR = 6.65%
LO 7.4.1
CDE Inc. bonds have these characteristics:
10% coupon
$1,000 par value
Current price of $1,136.92
Eight years to maturity
Callable in five years at $1,100
Calculate the bond’s yield to maturity (YTM) and yield to call (YTC).
A)
YTM: 7.65%; YTC: 8.24%
B)
YTM: 3.84%; YTC: 4.13%
C)
YTM: 7.97%; YTC: 8.54%
D)
YTM: 7.68%; YTC: 8.26%
d Explanation
The answer is YTM: 7.68%; YTC: 8.26%
Yield to maturity is calculated using the following TVM inputs on the financial calculator:
PMT = $1,000 x 10% = $100 / 2 = $50
FV = $1,000
PV = -$1,136.92
N = 16 (8 x 2 periods per year)
Solve for I/YR (YTM) = 7.68, or 7.68%
Yield to call is calculated using the following TVM inputs on the financial calculator:
PMT = $1,000 x 10% = $100 / 2 = $50
FV = $1,100
PV = -$1,136.92
N =10 (5 x 2 periods per year)
Solve for I/YR (YTC) = 8.26, or 8.26%
LO 7.4.1
Zenith Mutual Fund has had the following annual returns: +12%, +18%, +22%, and –13%. What is the Zenith Fund’s geometric mean return?
A)
10.17%
B)
8.83%
C)
9.75%
D)
11.66%
b The simplest way to do this problem is to see how much $1 would have grown to over the four years, and then do a simple time value of money calculation. $1.00 × 1.12 × 1.18 × 1.22 × 0.87 = $1.4027. (1) PV, 1.4027 FV, 4 N, I/YR = 8.8281%.
LO 7.1.1
Rose purchased TRM stock for $40. A year later the stock paid a dividend of $4. At the end of the second year, Rose sold her TRM stock for $60 per share. What is the time-weighted return for TRM stock for the two-year period?
A)
27.58%
B)
23.26%
C)
20.81%
D)
18.56%
a The answer is 27.58%. Time-weighted return is calculated as follows:
CF0 = (40)
CF1 = 4
CF2 = 60
IRR/YR = 27.58%
LO 7.1.1
Jane considers herself to be a conservative investor. To generate additional income, she wants to add an investment-grade bond to her portfolio. She lives in a state that does not have an income tax and she is in the 35% federal income tax bracket. Select the best choice for her portfolio.
A)
Bond B, A rated corporate debenture with a 4.75% coupon rate
B)
Bond D, AAA rated Treasury bond with a 1.5% coupon rate
C)
Bond C, D rated corporate debenture with a 6% coupon rate
D)
Bond A, AA rated municipal bond with a 3.5% coupon rate
d The answer is Bond A, AA rated municipal bond with a 3.5% coupon rate. Even though Bond C has the highest after-tax rate of return, this bond would not be appropriate for Jane based on her desire for an investment-grade bond. Therefore, Bond A would be the best choice.
Calculations:
Bond A: 3.5%
Bond B: 4.75% × (1 – 0.35) = 3.0875%
Bond C: 6% × (1 – 0.35) = 3.90%
Bond D: 1.5% × (1 – 0.35) = 0.9750%
LO 7.4.1
Mark owns a corporate bond with a coupon rate of 6.78%. Assume the annual inflation rate is 2.5% and he is in the 35% federal marginal income tax bracket. Calculate his after-tax, inflation-adjusted rate of return on this bond.
A)
1.86%
B)
2.04%
C)
1.50%
D)
4.17%
a The answer is 1.86%. First, calculate Mark’s after-tax rate of return on the corporate bond [0.0678 × (1 – 0.35)] = 0.04407, or 4.41%.
Next, calculate the after-tax, inflation-adjusted rate of return {[(1 + 0.0441) ÷ (1 + 0.025)] – 1} × 100 = 1.8634, or 1.86%.
LO 7.1.1
Harry has an investment that has produced the following returns: Year 1: 10%, Year 2: 5%, Year 3: –7%, Year 4: –3%, Year 5: 12%. Calculate the arithmetic mean return on this investment.
A)
6.75%
B)
3.40%
C)
8.50%
D)
17.00%
b The answer is 3.40%. The arithmetic mean is calculated by dividing the sum of the periodic returns by the total number of periods being evaluated. Therefore, Harry earned an average of 3.40% [(10% + 5% – 7% – 3% + 12%) ÷ 5] per year on his investment.
LO 7.1.1
Al Jenkins owns a corporate bond that currently sells for $1,175. The coupon rate is 9%, interest is paid semiannually, and the bond matures in 20 years. The bond is callable in 11 years at $1,050.
What is the yield to call on this bond?
A)
7.32%
B)
7.00%
C)
6.72%
D)
7.42%
b The answer is 7.00%. The yield to call is calculated using the following TVM inputs in the financial calculator:
N = 22 (11 x 2 periods per year)
PV = -$1,175
FV= $1,000
PMT = 9% x $1,000 = $90 / 2 = $45
Solve for I/YR = 7.00%
LO 7.4.1
Your client purchased the Zenith Fund three years ago at $13.16. Here are the year-end prices of the fund up until today:
20X7
$14.21
20X8
$15.86
20X9
$14.78
What is the geometric return of Zenith Fund for this three-year period?
A)
5.88%
B)
4.61%
C)
3.95%
D)
5.26%
c The $13.16 has grown to $14.78 over a three-year period, so ($13.16) is the PV: $14.78 FV, 3 N, and solve for I/YR, which equals 3.95%.
LO 7.1.1
Lauren invested $15,000 in a growth and income fund four years ago. She received a dividend of $800 the first year and $900 each in the second, third, and fourth years. Today, her investment has a total value of $27,234.56. Calculate the approximate internal rate of return (IRR) on Lauren’s investment. (Round to the nearest percent.)
A)
13%
B)
12%
C)
21%
D)
18%
c The answer is 21%. IRR is the discount rate that equates the present value of all the cash inflows with the present value of the cash outflows. The cash flow inputs for the financial calculator are as follows:
- 15,000 CF0,
800 CF1,
900 CF2,
900 CF3,
27,234.56 + 900 = 28,134.56 CF4,
Solve for IRR/YR = 20.80 (rounded to 21%).
Note the final cash flow consists of both the dividend ($900) and the ending value ($27,234.56).
LO 7.1.1
Bond ABC is selling at par, offers an 8% coupon, and matures in 20 years. The bond has a call feature that allows the issuer to call the bond after 10 years at a price of $1,050. Which of these statements explains the relationship between the bond’s yield to call (YTC) and yield to maturity (YTM)?
A)
The YTC for Bond ABC is 8.33%, which is more than Bond ABC’s YTM.
B)
The YTC for Bond ABC is 8.00%, which is more than Bond ABC’s YTM.
C)
The YTC for Bond ABC is 8.33%, which is less than Bond ABC’s YTM.
D)
The YTC for Bond ABC is 8.00%, which is equal to Bond ABC’s YTM.
a The answer is the YTC for Bond ABC is 8.33%, which is more than Bond ABC’s YTM.
Because Bond ABC is selling at par, the YTM is equal to the coupon rate of 8%. Use the following TVM inputs in the financial calculator:
PV = –$1,000
FV = $1,050
N = 20 (10 x 2 periods per year)
PMT = 8% × $1,000 = $80 ÷ 2 = $40
Solve for I/YR = 8.33%
LO 7.4.1
Ellen is an aggressive investor who is willing to take above-average risk to maximize capital appreciation. She is not interested in current income. The two mutual funds that she has under consideration are the following:
Small-Cap Value Fund
Small-Cap Growth Fund
Current yield
1.1%v
0.6%g
Five-year total return
14.2%v
16.7%g
Beta
0.89v
1.14g
Sharpe ratio
1.12v
0.93g
Standard deviation
8.20v
12.60g
Alpha
+2.70v
+0.40g
Which mutual fund is more appropriate for Ellen and why?
A)
Small-cap value fund, because its risk-adjusted performance statistics are superior
B)
Small-cap value fund, because its coefficient of variation is higher
C)
Small-cap growth fund, because its total return is higher
D)
Small-cap growth fund, because growth stocks fit her goal of maximum capital appreciation
a Perhaps a fund other than one with a lower-than-market beta fund should have been considered since she is an aggressive investor. However, no such alternative is shown. Total return alone is insufficient reason to select one fund over another. Risk-adjusted return is the appropriate measure. The value fund has a higher alpha, a higher Sharpe ratio, and a higher risk-adjusted performance when the total return is divided by beta. The current yield is relatively low for both funds.
LO 7.2.1
The answer is 10.00%. Solve for yield to maturity using the following TVM inputs in the financial calculator:
PV = −$677
FV = $1,000
PMT = 0
N = 8 (4 x 2 periods per year)
Solve for I/YR = 10% (rounded)
LO 7.4.1
a This is a false statement. A bond is selling at par when the current yield equals the YTM.
LO 7.4.1
The yield to maturity on a zero-coupon bond ($1,000 par value) currently selling at $677 and maturing in four years is approximately
A)
15.00%.
B)
37.48%.
C)
10.00%.
D)
4.00%.
c The answer is 10.00%. Solve for yield to maturity using the following TVM inputs in the financial calculator:
PV = −$677
FV = $1,000
PMT = 0
N = 8 (4 x 2 periods per year)
Solve for I/YR = 10% (rounded)
LO 7.4.1
Capitalization-weighted indexes are
A)
constructed by giving each investment equal weighting.
B)
the preferred type of index to use in modern portfolio theory applications.
C)
uncommon and not suitable for performance measurement.
D)
characterized by higher-priced stocks having more influence on the overall movement of the index than lower-priced stocks.
b Explanation
The answer is the preferred type of index to use in modern portfolio theory applications. Capitalization weighted indexes are the most prevalent type of index and are best suited for modern portfolio theory applications. In a price-weighted index, higher-priced stocks within this index have more influence on the overall movement of this index than lower-priced stocks.
LO 7.3.1