Notes

Question 1

Cash and Money Market Securities

Answer 1

• Treasury Bills – Short term debt obligations of the U.S. government
  4, 13, 26, and 52-week Treasury bills (T-bills) in denominations of $100 are auctioned regularly.
  T-bills are sold at discounts with prices quoted as a percentage of the face value. Sold at a discount because they do not pay make any coupon payments
  Example: A bill sold at 99.125 translates into $99,125 for $100,000 in par value. At maturity, T-bills pay the face amount. Thus, the investor would make $875 from this investment.
• Commercial paper – Firms (corporations) often issue short-term, unsecured promissory notes. Usually used to finance working capital or to manage their short term cash flow issues
  
  • Typically issued in denominations of $100,000 or more.
  • Maturities are 270 days or less (avoids SEC registration) and are often backed by lines of credit from banks.
    
    • Maturities are often 45 to 90 days in length.
    • Commercial paper yields are higher than T-bills yields of similar terms (slightly higher default risk and less liquid).
• Certificates of Deposit (CDs)
• Negotiable CDs (Jumbo CDs) - deposits of $100,000 or more placed with banks at a specific stated rate of interest.
  
  • Can be bought and sold in the open market.
  • Usually have slightly higher yields than T-bills because they have more default risk and less marketability.
• Repo agreements - Securities dealers use repurchase agreements (repos) to finance large inventories of marketable securities from one to a few days. The issuer or seller agrees to repurchase the underlying security at a specific price and specific date. The repurchase price is higher than the selling price. The securities being sold are the collateral. The return the lender gets is interest (repo rate)
• Banker’s acceptance - acts as a line of credit issued from a bank
• Eurodollars - deposits in foreign banks that are denominated in U.S. dollars (not registered with SEC)
  
  • by contrast yankee bonds ARE registered with SEC

Question 2

True/False: Commercial Paper with a maturity more than 270 days are not permitted under SEC regulations.

Answer 2

Answer: False. You just must register the commercial paper with the SEC if longer than 270 DAYS

Question 3

Types of Fixed Income Securities

Answer 3

*U.S. Treasury Securities:

• Treasury notes are issued with maturities of two, three, five, and ten years.
• Treasury bonds are sold with maturities of thirty years.
• Treasury notes and bonds are coupon securities that pay interest on a semiannual basis.
• Treasury securities are default risk-free.

*Treasury inflation protected securities (TIPS) are inflation-indexed Notes and Bonds.

• Issued with terms of five, ten, and thirty years.
• Minimum purchase is $100 (through TreasuryDirect).
• The principal is adjusted for inflation, coupon rate is fixed.
• TIPS can provide protection from interest rate risk and purchasing power risk.

EXAMPLE

An institutional investor purchases $500,000 worth of five-year TIPS. The coupon rate on the note is 4.4%. The semi-annual coupon payment is $500,000 × (0.044 ÷ 2) = $11,000. Six months later the CPI increases by 2.1%. The principal is adjusted. The new principal can be computed as: $500,000 × 1.021 = $510,500The higher principal base causes the coupon payments to increase as well. The adjusted semi-annual coupon payment is now: $510,500 × (0.044 ÷ 2) = $11,231

Municipalities (states, counties, parishes, cities, and towns) issue bonds for operations or to finance public projects.

• The interest from municipal bonds is not subject to federal income tax (in some cases where a resident purchases an in-state bond issue, also not subject to state income tax).
• The yields on municipals are generally lower than that of U.S. Treasuries due to this tax treatment.
• The two common types of municipal bonds are general obligation bonds and revenue bonds

Corporate Bonds: Corporations raise funds by issuing both equity securities and debt obligations.

The benefits of using debt instead of equity include:

• No dilution of equity ownership
• Interest expense deduction
• Obtaining a lower cost of capital

Excessive amounts of debt increase the investor’s required return on equity.

Excessive debt can increase price volatility.

Fixed Income Securities - Mortgage Securities

Question 4

Munis - GO vs. Revenue Bonds

Answer 4

• General Obligation Bonds - backed by the full faith and credit of the issuing body and are repaid through taxes.
  
  • The proceeds of the bond are used for non-revenue generating projects, such as local roads, school systems, parks, etc.
• Revenue Bonds - issued to raise funds to finance specific revenue producing projects. They are not backed by the full faith and credit of the issuing body.
• Repaid from revenue generated from the project that was financed.
• Ex: toll roads with an existing toll revenues

Question 5

Housing Ratios (1 and 2)

Answer 5

HR 1. Shouldn’t exceed 28%

Housing Ratio 1 = housing costs / gross pay

• housing costs include principal (or rent), interest, homeowners insurance, property taxes, and association dues (PIITA)
• the benchmark for housing ratio 1 is less than or equal to 28%

HR 2. Shouldn’t exceed 36%

housing costs + other debt payments/gross pay

• Housing ratio 2 combines basic housing costs with all other monthly debt payments, including automobile loans, student loans, bank loans, revolving consumer loans, credit card payments, and any other debt payments made on a recurring basis.
• The housing ratio 2 benchmark should be less than or equal to 36 percent of gross pay.

Question 6

Housing Ratios (1 and 2)

Answer 6

HR 1. Shouldn’t exceed 28%

Housing Ratio 1 = housing costs / gross pay

• housing costs include principal (or rent), interest, homeowners insurance, property taxes, and association dues (PIITA)
• the benchmark for housing ratio 1 is less than or equal to 28%

HR 2. Shouldn’t exceed 36%

housing costs + other debt payments/gross pay

• Housing ratio 2 combines basic housing costs with all other monthly debt payments, including automobile loans, student loans, bank loans, revolving consumer loans, credit card payments, and any other debt payments made on a recurring basis.
• The housing ratio 2 benchmark should be less than or equal to 36 percent of gross pay.

Question 7

Debt to Total Assets Ratio

Answer 7

• The debt to total assets ratio is a leverage ratio reflecting what portion of assets a client has financed or is owned by creditors.
• Formula = total debt/total assets
• This ratio is commonly as high as 80 percent for young people and as low as 10 percent or less for those near retirement age

Question 8

Net Worth to Total Assets Ratio

Answer 8

• The net worth to total assets ratio provides the percentage of total assets owned or paid for by the client.
• Formula: net worth/total assets

Question 9

Current Ratio

Answer 9

measure of a client’s ability to meet short term obligations

Formula = current assets/current liabilites

Question 10

Emergency Fund

Answer 10

3-6 months non-discretionary living expenses (Ex: mortgage, food, car loan, property taxes, insurance premiums)

Emergenmcy Fund = current assets / monthly nondiscretionary expenses

Question 11

Debt Ratios (General)

Answer 11

• Consumer debt payments should not exceed 20% of NET income
• Housing debt should be less than or equal to 28% of gross income
• Housing plus all other recurring debt should be less than or equal to 36% of gross income

Question 12

Buying vs. Renting

Answer 12

Renting okay if client’s time in property will be short (1-3 yrs)

Buying okay if time frame will be longer, client wants to build equity, or they are in a high marginal tax bracket so makes sense for them to get the MI deduction

Question 13

Mortgages - ARM

Answer 13

Adjustable Rate Mortgage (ARM)

appropriate when client’s time in property will be short (1-3 yrs)

A 2/6 one arm means the int. rate cannot increase more than 2% per year or 6% during the term of the loan

Question 14

Reverse Mortgage

Answer 14

• homeowner receives a monthyly payment or lump sum from a bank while retaining the right to live in the house
• repayment of oustanding mortgage occurs at homeowner’s death

a reverse mortgage is appropriate to generate income for elderly homeowners

available if homeowner is 62 or older

Question 15

Savings Ratio

Answer 15

Formuila: (Employee + ER contributions)/annual gross income

• benchmark savings rate: 10-12% of gross income if client starts savings before Age 32
• if client waits until 45 or 50, rate may be 20-25% of gross income

Question 16

Forms of Underwriting

Answer 16

Best Efforts: underwrite agrees to sell as much of the offering as possible. Risk of issue not selling resides with the firm because shares not sold to public are returned to company

Firm Commitment - underwriter agrees to buy the entire issuance of stock from company. Ex: UW may buy the stock from company for $18 and then sell to public for $20 ($2 spread). Risk - resides with underrwiter.

Key Documents - Prospectus, Red Herring (preliminary prospectus - used to determine investor interest), 10K and 10Q, Annual Report

Question 17

liquidity vs. marketablity

Answer 17

Liquidity =- how quick something can be turned into cash

Marketability - exists when there is a ready made market for something. Ex: real estate is marketable but not v liquid.

Question 18

True/False: Dividends paid must be covered by a short seller

Answer 18

True,.

Question 19

Margin

Answer 19

Initial Margin - reflects amount of equity an investor must contribution to enter a margin transaction. Reg T - initial margin is 50%.

Maintenance Margin - minimum amount of equity required before a margin call.

Margin accounts - investors can borrow funds from the broker to purchase securities

• initial margin - The investor must pay for a certain percentage of the cost of an investment. The minimum initial margin is 50% (set by the Federal Reserve)
• maintenance margin - the percentage equity the investor must maintain. The minimum maintenance margin is 25% (set by Federal Reserve).

An investors margin (equity) position is determined as follows:

Margin Position = account value - debt

account value

If stock price falls, then the equity position falls. If the equity position falls below the required maintenance margin, then a margin call will occur. The formula to determine the lowest the price can fall before receiving a margin call is:

Margin Call Price = debt_______\_

1 - maintenance margin

EXAMPLE 1

Monica purchases one share of stock on margin for $104. The initial margin is 50%. If the maintenance margin equals 35%, then Monica will receive a margin call if the stock falls below $80.

Margin call price = $104 - $52 = $80

1 - 0.35

If the stock price drops below the margin call price, the account owner must deposit sufficient funds to restore the account equity to the maintenance margin.

To determine the amount of the margin call:

• Determine how much $ equity is required
• Determine how much equity the investor currently has

The difference is the amount of the margin call.

Example 2:

Monica purchases one share of stock on margin for $104. The initial margin is 50%. If the maintenance margin equals 35 percent, then Monica will receive a margin call if the stock falls below $80. Assume now that the stock drops to $70 per share.

The margin call amount owed is $6.50 per share:

Question 20

Margin Call Price Formula (not on CFP provided sheet)

Answer 20

Loan/(1- maintenance margin requirement)

Question 21

Valueline vs. Mornisntstart

Answer 21

VL rates stocks, Morningstar rates MFs

Question 22

**Dividend dates

Answer 22

• Typically paid quarterly
• Ex-dividend date - date stock trades without dividend. If you sell stock on the ex-div date, you will receive the div. If you buy on or after ex-div. you will not receive the div.
• record date - date on which you must be a registed shareholder to receive the div.
• date of record is one business day after the ex-date. Therefore, invsetor must purchase stock two businness day prior to date of record to receive div.

To receive dividend, an investor must purchase the stock prior to the ex-dividend date OR 2 business days before the date of record.*

Ex. MSFT Declares div payble to shareholder on record date of Wed. May 15th. What is last possible date an investor could purchase the stock and still receive the div?

Answer: May 13th. Ex-dividend date is May 14th.

Question 23

Cash Dividends vs. Stock Dividends taxation

Answer 23

Cash divs are taxed upon receipt.

Stock dividends are not taxable to shareholder until stock is sold.

Question 24

Securities Acts

Answer 24

Securities Act of 1933: regulated issuance of new securities (primary mkt)

requires prospectus to accompany new issues

Securities Act of 1934: (created SEC) regulates secondary market and trading of securiteis

Investment Company Act of 1940 - SEC regulation of investmetn companies (Open, Closed, UITs)

Investment Advisors Act of 1940: requires advisors to registeer with SEC of state

SIPC Act of 1970 - protects investors from loss due to BD failrue or fraud

Insider trading and Securites Act of 1988: insider = anyone with info that is not availibale to publich

Question 25

Euro dolars

Question 26

Investment Policy Statemetn

Answer 26

Establishes:

• client’s objective
• limitation on investment mgr

Used to measure investment mgr’s perf.

Investment policy statement does NOT include investment selection

IPS objectives: Return requirements (can be spcific to goal like retireeing at 55)

risk tolerance - important

IPS constraints - time horizon, liquidity, taxes, laws & Regs, uniqque circumstances

Remeber: IPS establishes RR TTLLU

Question 27

Dow Jones is Price Weighted Index

Answer 27

Ex: There are three stocks in our ABC avg. and their values at $44, $60 and $100. Price weighted average would be $68

Question 28

s&p 500

Answer 28

is a market cap weighted avg.

Question 29

Russell 2000

Answer 29

a value weighted index of the smallest market cap stocks in the russell 3000

Question 30

Wilshire 5000

Answer 30

broadest index that measures perf of over 3k stocks. Value weighted

Question 31

EAFE

Answer 31

value weighted - EUrope Austrailia asia and far east

Question 32

Behavioral Fiance makes the following assumptions:

Answer 32

• Ivnestors are Normal - they have needs and wants but may commit cogtnitive errors
• Markets are not efficient - there can be deviations in price from fundamental value. Markets are tough to beat, but they are not efficient
• Behavioral Portfolio Theory - investors seperate their money into different compartments
• Risk Lone does not determine returns - other factors like momentum and investors likes/dislikes about the stock or company

Question 33

Standard deviation

Answer 33

used to determine TOTAL RISK of an UNDIVERSIFED portfolio

SD is a measure of risk and variability of returns

measures how much something moves around an average

-be prepared to calculate SD and use SD to determine probability of returns

Memorize 68, 95, and 99 dpeending on if return is +/- 1, 2, or 3 SD away from avg.

Calculting using sigma and sx,sy button

“Which of the following assets is most risky” = calculate the SD

Question 34

Diversification (r-squared)

Answer 34

• In order to reduce risk (variability of returns) as measured by standard deviation (total risk that is undiversified) then combine assets with a correlation of less than 1

To determine how well-diversified a portfolio is, we also need to know what percentage of the fund’s return variation is associated with variation in the market’s return (R-squared/r=r²⁾

R-Squared: The Coefficient of Determination Indicates the reliability of the model or the reliability of Beta.

• R-squared indicates the percent of return is due to the market (when the portfolio is being compared to an index). How much of our risk is market risk?

R-squared is calculated by squaring the correlation coefficient.

Correlation = .8

R-squared = .64 or 64%

R-squared is a measure of how well diversified your portfolio is.

An S&P 500 Index Fund will have a r-squared = 100%

A Sector Mutual Fund will have an r-squared between 40-50%

In the process of adding new investments to a portfolio, the lowest correlation coefficient makes the best addition. Closest to negative one (-1) is always best.

Beta & R-Squared Implications (These have historically been tested by the CFP Board.)

• R-Squared will give us insight as to whether or not Beta is an appropriate measure of portfolio risk.
• If r-squared is greater than or equal to .70 then YES, Beta is an appropriate measure of risk.
• If r-squared is less than .70 then NO, Beta is not an appropriate measure of risk.
• As a general rule, .70 would be considered sufficient. But, the higher r-squared is, the more reliable Beta.
• • Correlation of +1 = perfectly correlated, 0 = no correlation, -1 = negative correlation

Question 35

• Coefficient of variation

Answer 35

• Coefficient of variation (CV) AKA covariance: A measure of relative risk when investments have different average returns. Useful when comparing assets with different returns and risk.
• The higher the CV, the greater the risk per unit of return.

CV = Standard Deviation

Avg. or Expected Return

An investor prefers the asset with the lower coefficient of variation because it’s less risk, for each unit of return (which also equates into more return per unit of risk).

Question 36

Leoptokurtic vs Platyskurrtic returns

Answer 36

Leoptoskurtic - high peak and fat tails (higher chance of extreme events

Platykurtic - low peak and thin tails (lower change of extreme events)

Question 37

Mean Variance Optimization

Answer 37

process of adding risky securities to a portfolio, but keeping the expected return the same. Balances of asset classes the provide lowest variance (as measured by SD)

Question 38

In the process of adding new investments to a portfolio, the lowest correlation coefficient makes the best addition. Closest to negative one (-1) is always best.

Question 39

Beta

Answer 39

The systematic risk of a portfolio is measured by its beta. A mutual fund beta is a weighted average of the betas of the assets in the portfolio.

• A fund that experiences price changes less dramatic than the benchmark portfolio has a beta that is less than one
• A fund that experiences price changes more dramatic than the benchmark portfolio has a beta that is greater than one

Beta measures systematic risk (cannot be diversified away - affects ALL stocks) only and is therefore only relevant when assessing the risk of a well-diversified portfolio (high r-squared).

*beta measures how did our portfolio change when the market changed?

Beta 1 = beta of the market

Beta less than 1 = less volatile than market

Beta greater than 1 = more volatile than market

bETA IS a measure of our systematic risk.

Best to use for a diversifed portfolio (high rsquared)

Question 40

Systematic risks

Answer 40

Systematic risks are those that affect all securities. As such, they cannot be diversified away. it is market risk.

• Market risk - the tendency for changes in the market to influence stock prices. When the market is increasing, most stocks increase in value. Stocks tend to fall with declines in the market.
• Interest rate risk - When interest rates decrease, stocks tend to increase in value. When rates rise, stock prices fall.
  
  • This is due to increased borrowing costs, attractiveness of alternative investments, and the valuation of securities.

Systematic Risks are ‘PRIME’ – Purchasing Power, Reinvestment Rate, Interest Rate, Market, and Exchange Rate. They are risks that affect all companies at the same time. (Ex: Inflation increasing,

Measured by a statistic known as beta.

Question 41

Unsystematic Risks:

Answer 41

Unsystematic Risks: Risks that are unique to individual firms, industries, or countries. These risks can be diversified away, unlike systematic risks.

• Business risk - relates to the variability of a firm’s operating income. It is the riskiness of a specific business, which may include the firm’s operations, management style, and philosophy.
• Financial Risk - related to the capital structure of the firm. If a firm uses debt to finance the purchase of assets, it increases the financial risk of the firm.
• Country Risk – Many U.S. firms have international ties. Country risk is related to uncertainties due to international political and economic risks.

Unsystematic risks can be diversified away

Remember “A, B, C, D, E, F G”

Accounting, Business, Country, Default, Executive, Financial, Government/Regulation

Question 42

Total Risk

Answer 42

• Total Risk = Systematic + Unsystematic RIsk
• Total risk is measured by standard deviation
• Systematic risk is measured by beta

Question 43

covariance and correlation coefficient are both ____ measures of risk

Answer 43

Relative

Question 44

Diversification benefits (risk is reduced) begin anytime correlation is

Answer 44

less than 1

Question 45

Beta can be calucclated by

Answer 45

dividing the security risk premium by the market risk premium

Ex: if a fund had a return of 20% and the market has a return of 10% the beta is 2

Question 46

Modern Portfolio Theory

Answer 46

Modern Portfolio Theory - the acceptance by an investor of a given level of risk while maximizing expected return objectives

Efficient Frontier - the cruve which illustrates the best possible returns that cuold be expected from all possible portfolios

Efficient Portfolio - occurs when an investor’s indifference ccurve is tangent ot eh efficient frontier

Optimal Portfolio - the one selected from all efficient portfolios

*Investors seek the highest return attainable at any level of risk

Question 47

Remember, negatively correlated assets aren’t necesary to reduce risk, just

Answer 47

assets with correlation of less than 1

Question 48

Capital Market Line

Answer 48

You may be asked what measure of risk the CML uses (which is standard deviation)

(Forumla is no longer on the provided sheet)

CML - is the macro aspect of the CAPM. It specifies the relationship between risk and return in all possible portfolios

A portfolio’s retur4ns should be on the CML (the CML becomes the new efficient frontier mixing in a risk free asset with a diversifed portoflio)

*Do not usse for individual securities - it is a measure of total portfolio rsk

Inefficient portfolios are below the CML.

Question 49

Capital Asset Pricing Model (CAPM)

Answer 49

-calculates the relationship of risk and return of an individual security using the beta (b) as its measure for risk.

Also called the Security Market Line

*formula provided on sheet. Remember that the market risk premium is (rm - rf)

May be asked “what is the expected return” Use CAPM formula Pg. 38 of pre-study book (investmetn planmnign)

Question 50

The SML uses as its measure of risk, while the CML uses __ as its measure

Answer 50

SML uses beta, CML uses SD.

Question 51

Portfolio Performance Measures Treynor vs Sharpe vs Jensen;s Alpha

.

Answer 51

• f r-squared is equal to .70 or greater, then use Treynor and Alpha.
• If r-squared is less .70, then use Sharpe.
• R-squared indicates how reliable Beta is as a measure of total risk. If Beta is unreliable, then Treynor and Alpha are not reliable.
• Remember sharpe ratio is the only one that uses SD, and the others (treynor and jensesn’s alpha) use beta

Treynor ratio is a measure of how much return was achieved for each unit of risk. The higher the treynor ratio the better. is a relative measure of performance

Sharpe - a measure of portfolio performance using a risk adjusted measure that standardizes returns for their variability. Its a relative measure. A measure of how much return was achieved for each unit of risk. The higher the sharpe ratio the better. Measures risk premiums of the portfolio relative to the total amount of risk in the portfolio

Jensens alpha (AKA alpha) - a measure of ABSOLUTE performance against a . Distinguishes a manager’s outperformance. postive alpha = manager provided more return than was expected for the risk undertaken. negative alpha = maanger provided less return than was expected for the risk undertaken. Alpha of zero expected return= actual return relative to risk taken.

Question 52

Remember that when measuring risk ___ is used for diversified portfolio, and ____ is for non-diversified portfolios

Answer 52

beta = diversified portfolios (treynor and jensens alpha), standard deviation = non-diversified portfolios (sharpe ratio)

Question 53

A portfolio is considered NOT well-diversified when r-ssquared is less then ____. then ____is not an appropriate measure of risk.

Answer 53

R squared less then 70 = not well diversified, so BETA is not an appropriate measure.

Question 54

Holding Period Return (HPR)

Answer 54

Holding Period Return (HPR)

• A measure of return that includes:
  
  • Capital appreciation or loss
  • Current income
• It is the return earned over a specific period of time
• HPR is most meaningful if holding period is one year

HPR = [Selling Price - Purchase Price +/- Cash Flows/Dividends]

Purchase Price

• Very simplistic measure, but entirely appropriate for one year investment.
• HPR does not directly address the time over which the investment is held.
• HPR ignores the riskiness of the investment and ignores time value of money
• memorize formula (not on sheet)
• hint: add dividend to numerator, subtract margin int. paid from numerator
• Look at pg. 50 in prestudy book (investment planning)

Question 55

Arithmetic Mean Return

Answer 55

• Arithmetic mean is a simple average return, but it does not account for compounding.
• Assume the following returns:
  
  • Year 1: 2%
  • Year 2: 4%
  • Year 3: 6%
  • Year 4: 8%

What is the Arithmetic Mean Return?

(2% + 4% + 6% + 8%) ÷ 4 = 5%

• The disadvantage to the Arithmetic Mean is that it doesn’t take compounding into account.

Answer 56

The geometric (mean) is a compounded rate of return.

ⁿ√[(1+r₁) x (1+r₂) x … (1+r_n)] - 1

GM = Geometric Mean | n = number of returns | r = actual return

What is the Geometric Mean?

Assume these returns over 3 years:

• Year 1: 12%
• Year 2: 5%
• Year 3: <2%>

So, the initial $1 investment would be worth $1.1525 in 3 years given the returns. Now use the TVM keys to solve for i (return).

N = 3

i = ? = 4.844%

PV = <1>

PMT = 0

FV = 1.1525

Look at Pg. 54 for cash flow keys

Question 57

Weighted Average

Answer 57

• can be used to calculate a weighted avg. share price, expected returns, beta or duration (process is same for everything)

Janis has a portfolio worth $30,000 consisting of three stocks. The expected return for each stock is given, along with its proportionate value of the portfolio. What is the expected return for the portfolio?

Stock Expected Return Value

A 10% $15,000

B 5% $5,000

C 12% $10,000

Step 1

Determine the total value of the investment portfolio:

$15,000 + $5,000 + $10,000 = $30,000

Step 2

Determine the weighting of each investment:

Stock A: $15,000 / $30,000 = .50

Stock B: $5,000 / $30,000 = .167

Stock C: $10,000 / $30,000 = .333

Step 3

Multiply the stock weighting by the expected return:

Stock A: .50 x .10 = .05

Stock B: .167 x .05 = .0084

Stock C: .33 x .12 = .040

Step 4

Sum the weighted expected return:

.05 + .0084 + .040 = .0984 or 9.84%

Question 58

IRR

Answer 58

Internal Rate of Return

• The internal rate of return (IRR) is the earnings rate of a series of cash inflows and outflows over a period of time assuming all earnings are reinvested. It equates discounted future cash flows to the present value of an asset.

Look at Pg.59

PV = the present value of the cash flows

• CF_n = the cash flow that occurs at period n
• i = the rate at which it makes the equation true (referred to as IRR)

Question 59

Arbitrage Pricing Theory

Answer 59

• asserts that pricing imbalances cannot exist for any significatn period of time, otherwise investorts will exploit the price imbalance until the market prices are back to equilibrium
• attempt to explain return based on factors
• attempts to take advantage of pricing imbalnces
• standard deviation and beta are NOT input variables into the APT formula

Question 60

Dividend Discount Model (Constant Growth Div. Discount Model)

Answer 60

Formula is provided on CFP formula sheet.

Make sure to use next year’s dividend when determining the value of stock using the constant growth dividend formula

Values a stock by discounting the future stream of cash flow

Formula = D1/(r-g)

where D1 = next expected dividne

r= required rate of return

g = dividend growth rate

D1 is calculated by D0(1+ g)

D1 is calculated using the current div. and dividing growth rate

P. 65 & Pg. 66 pre-study

Question 61

Expeccted Rate of Return

Answer 61

Formula is provided on CFP sheet

r = (D1/P) + g

p = market price

r = rate of return

Question 62

Bond Calc

Answer 62

Bond Int. = PMT

Par Value = FV

Length to maturiy = N

Int Rate = I

mkt int rate is the rate used to discount a bond to determine what it is currently selling for in the market-

Ex: a bond pay $100 per year with a par value of $1,000. Couon payment/par = Coupon Rate of 10%

Question 63

Bond Current Yield

Answer 63

Current Yield = Coupon Payment/Current Bond Price

Question 64

YTM

Answer 64

YIeld to Maturity - compounded rate of return if an investor buys a bond today and holds it until maturity

To calcutae YTM use the following ex: bond paying 10% int. rate (or $50 semi annually), market pricce is $876. 5 yr. period to maturity left, at which time th e$1,000 par value will be paid.

Calc: End Mode,

876+/-, PV

5x2=N

50, PMT

1000 FV

I/Yr = 6.744 x2 = 13.49% annually

Ex #2: Joe purchased a bond for $880 with a 9% coupon. He SOLD the bond after one year when it was paying him a current yield of 10%. What is the holding period return?

Answer: 12.5%. (Hint: find the sale price by using the current yield fomula (CY = coupon rate/current market price)

Question 65

YTC

Answer 65

Yield to call - compounded rate of return if an investor buy a bond today and the bond is called (retired) by the issue.

Ex: a bond paying 10% interest of $100/yr. ($50 semi annually) the market price is indicated $876. 5 yr. period to maturity at$1,000 par. Bond is callable in 3 yrs. at 1050. What is the YTC?

Answer: 16.7779

Question 66

Yield Ladder

Answer 66

Discount - Yields in order of highest yield (YTC, YTM, CY, NY)

Premium - Yields in order of highest yield (opposite of discount) (NY, CY, YTM, VTC)

Remember: if things are at a discount at the mall, CALL mom’s cell.

Question 67

Accrued Interst

Answer 67

-when purchasing a bond, the buyer pays the seller interest that has accrued since the last int. payment

new buyer receives full amount of interest due at the next int. payment

buyer receives a 1099 int that reflects the full periods int rec’d, however, buyer is entitled to a deduciotn equal to amt of accrued int. paid to seller

Ex: Pg. 99 investmeplent planning

Question 68

Zero coupon bonds are particuarly suited for which of following accounts? (IRA, Trust, Indiviual, Joint)(

Answer 68

Answer: IRA.

Zero coupon bonds generate phantom income

Question 69

Yield Curve THeoies

Answer 69

Liquidity Preference Theory - yield curve results in lower yields for shorter maturities bc some investors prefer liquidity and are willing to pay for liquidity in the form of lower yields

Longer term yields should be higher than ST yields because of added risks with LT maturities

Market Segmentation Theory - YC depends on a supply and demand at a given maturity and there are markets for given maturities’ with distinct buyers and sellers at each maturity

Expectations Theory - YC reflects investor’s inflation expectation. Since investors are uncertain or believe inflation will be higher in the future, LT yields are higher than ST yields. When inflation is expected to be lower in the future, LT yields will be lower than ST rates (AKA inverted YC)

Unbiased expectations Theory - related to the term structure of int. rates. Today’s LT int rates have imbedded in them expectations about future ST rates.

CFP provided formula (1RN = Pg. 101)

Question 70

Bond Duration

Answer 70

duration - the weighed avg. maturity of all cash flows.

• bigger duration = more price sensitivity to int. rate change
• modified duration is a bond’s price sensitivity to changes in in.t. rates

bond portfolio should have a duration equal tot he investor’s time horizon to be effectively immunized

Duration Calc is provided on CFP sheet

There is a direct relationship bw duration and term of the bond. As term increases or decrease, duraiton will increase or decrease.

There is an inverse relationship bw coupon rate/YTM and duration

*a zero coupon bond will always have a duration equal to its maturity

As coupon rate increases, the duration decreases. Ex Bond A 30 yr. zero coupon, duration = 3-. A 30 yr., 5% coupon, duration = 27, Bond C 30 yr., 10% coupon duration = 25

Duration understates the price appreciation when int. rates decrease and overstates the price deprecation when inr rates increase

Question 71

Estimating Bond Price

Answer 71

Formula is on your CFP sheet

Question 72

Preferred Stock

Answer 72

• has both debt and equity features
• dividend does not flucutate like a common stock dividend
• no maturity date like a bond
• price of preferred stock is more closely tied to int. rates than the common stock

Tax Advantage: Corps receive a 50 or 65% deduction of dividends (preferred and common) based on percentage of ownership of the company paying the dividends

Stated dividend rate as a percentage of par
Ex: XYZ preferred pays a 5% dividend with a par value of $20. Thereofre the preferred stock would pay $20 x 5% = $1/sh.

Which of the following types of investor benefits most from tax advantages of preferred stocks?

Answer: Corporate

Question 73

Convertible Bonds

Answer 73

conversion value is the value of the convertible bond in terms of the stock into which it can be converted

-primary benefits: even if stock doesn’t do well, investor has a floow built in. Floor = par value of bond the investor will receive if the convertible is held until maturity

CV = [PAR/CP]x Ps

Ps = price of the common stock

CP is the conversion price

(1,000 / CP is the conversion ratio or the number of shares the convertible can be converted into)

Question 74

Property Valuation

Answer 74

• to determine how much an investor is willing to pay for a piece of property, use the formula attached.
• Capitalized Value = NOI/Capitalization Rate AKA required rate of return
• • Capitalized Rate = NOI/Cost
• Important: NOI does not include depreciation or amort, which are NOT cash expenses. IT also excludes payments on debt services since this is a financing expense, NOT an operatin one

Lisa expects a potential rental property investment to have gross revenue of $1,000,000 annually. She anticipates $150,000 in maintenance expense, $300,000 in salaries, $100,000 in utilities, $200,000 in depreciation and a mortgage payment of $150,000. Her principal payment would be $50,000 and interest expense would be $100,000. How much should Lisa pay for the rental property if her required rate of return is 12%?

1. $4,166,667
2. $3,750,000
3. $3,333,333
4. $2,916,667

Solution

Solution: The correct answer is B.

Lisa’s expenses would be $150,000 in maintenance, $300,000 in salaries, $100,000 in utilities.

Formula item

Amount

Gross potential rental receipts

1,000,000

+ Other income

0

= Gross potential income

1,000,000

• Vacancy and collection losses

0

= Gross income before expenses

1,000,000

• Operating expenses (excluding interest & depreciation)

550,000

= Net Operating Income

450,000

Divide NOI by capitalization of 12% = 3,750,000

Mortgage and principal payment of a mortgage is a financing expense, not an operating expense and should not be used in calculating NOI.

NOTE: There is a second method of calculating NOI. If you back out ALL expenses instead of just operating expenses, you will need to add back in interest expense and depreciation expense.

Question 75

Three Types of Investment Companies (Closed End, Open End, UIT)

Answer 75

Closed End - shares trade in same manner that publicly traded stocks trade. Shares trade at premium or discount to NAV. Because cap is closed, manager has lots of flexibly for managing assets within the fund. Does not have to plan for cash redemptions. Supply and demand for shares drives price

Open end - have unlimited numbers of shares. Additional contributions = more shares issued. Shares are bought and redeemed directly from fund family. Shares trade at NAV. NAV = (assets - liab)/shares outstanding. Open-end funds determine the market value of their assets at the end of each trading day.

Unit Investment Trust - can be equity or fixed income unit investment trust. They are passively managed and self-liquidating. Managed by trustee ( no investment mgr). Issues “units” not shares.

Question 76

Types of Mutual Funds

Answer 76

Agg Growth = small caps and offers greatest potential for cap appreciation

Growth = equities with high p/e, low or no divs, growing ER and and revenue rapidly

Growth and Inc = invests in equities and income producing assets

value fund = invests in undervalued equities

Bond fund = liquid bond investment

Balanced = mix of bonds and stocks

MMF - highly liquid, good for emergency fund

index funds = tracks perf of various market indices. Passive investment strategy.

Sector funds = invests in sectors of the u.s. economy

Asset Allocation Funds = well diversified portfolios inlucidng stock, FI and international

Global funds - U.S. AND international

International = excludes U.S. securities

Question 77

Fund Expenes

Answer 77

• No Load Funds - do not charge a sales commission when purchased or redeemed
• Load Funds - sales commision when purchased of redeemed. Ex A shares and C shares
• A Shares - front end load. 12b-1 fee. No back end load. Ok for LT invsetors
• B SHares - back end load. high 12b1 fee. no Front end load.
• C shares - no front end load. Small back end load. Appropriate for ST investors

Question 78

ETF

Answer 78

represents Index.

low cost of ownership - typically passive investmetns

Can be passive or managed

Question 79

REIT

Answer 79

must pay out 90% of investment income to shareholders to maintain tax exempt status. Comapny passes tax burden to its sharehodlers

• low correlation with stock market (good for diversification)
• real estae is a hedge against inflation
• Because of this special tax treatment, most REITs pay out 100 percent of their taxable income to their shareholders and, therefore, owe no corporate tax. Because of their unique tax benefits, REITs have the ability to attract tax-exempt investors and foreign investors with favorable tax treatmen

Question 80

ADR

Answer 80

represents foreign stock held in domestic banks’ foregin branch.

dividends are paid in USD.

Do not eliminate exchange rate risk

Trade on U.S. exchanges and denominated in USD

Question 81

Alt INvestmetns

Answer 81

• Common ALt investmetns - real estate, REITS, CMOs, LPs, hedge funds, collectibles (LT gain = 28% tax), precious metals, crypto

Question 82

Fundamental Value of a Call

Answer 82

Stock Price - Strike Price (how much the option is in the money)

Premium = fundamental value + time value

Ex Strike Price = $75, Current STock Price = $76. Premium = 2.75 ( 1 fundamental value + 1.75 time value)

Question 83

One option contract controls how many shares of the underlying security?

Answer 83

100 shares

Ex: One option contract with a premium of $2 will cost $200

Question 84

Call option vs. Put Option

Answer 84

Call = right to buy a specific number of shares at a specific price (strike) within a period of time (american) or a specified future date (European)

put option = right to sell a specified number of shares at a specified price (strike) within a specified period of time (American) or specified future date (European).

Question 85

Option Premium consists of intrinsic value and a time premium

Answer 85

• Intrinsic Value

Call option: stock price - strike price

Put option = strike price stock price

Intrinsic value cannot be less than 0

Time Value

Premium - intrinsic value

Question 86

Gain or loss on option

Answer 86

Two compoentnes: premium paid or rec’d AND the instrinsic value of the option

STOPS - Stock gain or loss, options gain or loss (if you own underlying stock)_, premium paid or rec’d, shares controlled or ownerf

Question 87

Options”locking in gains” or “protecting profit”

Answer 87

Usually associated with buying a put

Question 88

Options Pricing Models

Answer 88

-Black/Scholes - used to determine the value of a CALL option. All variables have a direct relationship on the price of the option, except the strike price. As the strike price increases, the option decreases in value.

Variables include: current price of underlying asset, time until expiration, risk free rate of return, volatility of underlying asset

Put/Call Parity - attempts to value a PUT option based on the value of a corresponding call option

Binomial Pricing Model - attempts to value an option based on the assumption that a stock can only move in one of two directions

Question 89

Taxability of Options

Answer 89

• Call options = two potential tax consequences. If contract expires worthless, premium paid = ST loss and premium rec’d is ST gain.

Contract exercised, prem is added to SP to increase the basis in the underlying stock. If underlying stock is held for more than 12 months = LTG

Put option - (not likely to be tested)

Question 90

Long Term Equity Anticipation Securities (LEAPS)

Answer 90

options that have longer expiration periods than traditional options.

Expiration periods last for 2+ years (traditional optins are 9 months)

Premium paid is higher

Question 91

Warrants

Answer 91

-long term call options issued by the CORPORATION

Expiration period much longer than options (1-5 yrs)

Warrant terms are NOT standardized

Question 92

Futures

Answer 92

(2) types of Futures Contracts:

Commodities - oil, pork bellies, wheat

Financial futures - currency, int rate, stock indices

Option contracts= holder has RIGHt to ___, futures = holder has OBLIGation to make or take delivery of the underlying asset

Futures contracts are market to market (gain or loss in cash is credited/debited to your acct on a daily basis

• The spot price is the price of a commodity or asset to be delivered today. The spot price is also called the cash price.
• A futures price is the price of the commodity or asset at some time in the future.
• While prices may vary, there is a relationship between the spot price and the futures price. As the delivery date draws closer, the futures price converges with the spot price for that commodity.

EXAMPLE

Joe is a speculator in the futures market. He believes that coffee prices will increase in the future. Joe decides to buy a coffee futures contract, which has the following characteristics:

Contract Size: 37,500 pounds

Futures Price - 6 months: $1.2515 per pound

By entering into the contract, Joe has agreed to buy 37,500 pounds of coffee at a price of $1.2515 six months from now.

Assume that the price of coffee six months from now is $1.36. Since Joe has locked in a price of $1.2515, he has made a nice profit. He will pay $46,931.25 ($1.2515 x 37,500) and the coffee will be worth $51,000 ($1.36 x 37,500). Joe’s profit is $4,068.75.

If prices had decreased to $1.20 per pound, Joe would have a loss of $1,931.25 ($1.2515 - $1.20 = $.0515 per

pound).

Long & Short Positions

Investors can take long or short positions in futures contracts. Purchasing a contract is termed a long position (take delivery). Selling a contract is called a short position (make delivery).

• A long position increases in value if the underlying security or commodity increases in value
• A short position increases in value if the underlying security or commodity decreases in value. (sell a contract = short) Ex. Client bought an orangr grove. Wants to lock in future price of crop Since she is LONG the asset, you would want to take a short positions in the futures contract

Question 93

Which of the following statements about U.S. Treasury securities are correct?

1. The smallest denomination of Treasury bills is $5,000.
2. Treasury bills are issued at a discount.
3. Treasury bonds with 30-year maturities have default risk.
4. The maximum maturity on Treasury notes upon issue is 10 years.
5. I and II only.
6. II and III only.
7. II and IV only.
8. I, II and IV only.

Answer 93

Answer: II and IV only.

Question 94

An investor may use options on debt instruments to protect against:

1. Interest rate risk.
2. Reinvestment rate risk.
3. Default risk.
4. Call risk.

Answer 94

Solution: The correct answer is A.

Put options that lock in the price at which the security may be sold may be used to protect an investor from a drop in bond prices caused by rising interest rates.

Options are derivatives. They derive their value from an underlying investment. Reinvestment risk, default risk, and call risk have no associated value. Interest rates do have an associated value.

Question 95

Of the following investment, which is designed to provide growth and income?

1. Raw land.
2. Fixed premium annuity.
3. Non-participating mortgage Real Estate Investment Trust (REIT.)
4. Convertible bond.

Answer 95

Solution: The correct answer is D.

Raw land may appreciate, but provides no income. A fixed premium annuity provides income, but no growth. Mortgage REITs offer income but no growth. Convertible bonds offer income as a bond and growth potential when converted to a stock.

Question 96

Jennifer has asked you if you would advise her regarding several different types of investments. Her preference would be for an investment where she can simply put a fixed number of dollars into an investment and not worry about it. She wants the following: completely tax-advantaged investments, a moderately competitive interest rate, with relative safety, and very low fees. She would eventually like to be assured of getting her principal back, but does not require a great deal of liquidity. Which of the following would you recommend to her in order to best meet her goals?

1. Municipal Bond Mutual Fund.
2. Municipal Bond Unit Trust.
3. High Yield Money Market Fund.
4. Tax Free Money Market.

Answer 96

Solution: The correct answer is B.

UITs have no money manager, just a trustee, the fees will be lower. You can sell back to the fund or wait until maturity.

Due the tendency of Muni-Bond Fund managers to attempt to maximize profits by buying and selling various bonds, there are generally taxable gains to be dealt with in most of these funds. High Yield and Government Bond funds offer no tax advantage. Tax Free Money fund is highly liquid and the client stated they did not require much liquidity, nor does it have a moderately competitive interest rate.

Question 97

Which of the following statement(s) regarding bond swaps is/are true?

1. 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.
2. Rate anticipation swaps utilize forecasts of general interest rate changes.
3. The yield pickup swap is designed to alter the cash flow of the portfolio by exchanging similar bonds having different coupon rates.
4. The tax swap is made to substitute current yield in place of capital gains.
5. I, II and III only.
6. I and III only.
7. II and IV only.
8. IV only.

Answer 97

All are true except IV

Question 98

Which of the following best describes a long hedge position?

1. The investor is short the underlying commodity and short the futures contract.
2. The investor is long the underlying commodity and long the futures contract.
3. The investor is short the underlying commodity and long the futures contract.
4. The investor is long the underlying commodity and short the futures contract.

Answer 98

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 99

The primary reason for using a ladder bond strategy is to:

1. Lower overall interest rate risk.
2. Achieve greater capital gains as the yield curve changes shape.
3. Avoid the “wash sale” rule.
4. Immunize the bond portfolio.

Answer 99

Solution: The correct answer is A.

The ladder bond strategy staggers maturities and in doing so, reduces the exposure to interest rate risk. “B” is incorrect because longer term maturities experience the biggest percentage increase when interest rates decrease. Laddering bonds requires purchasing short and intermediate term bonds, along with long term bonds. “C” is incorrect because laddering bonds to avoid the wash sale rule is not the primary objective, reducing interest rate risk is the primary objective. “D” is incorrect because bond immunization suggests the portfolio has eliminated interest rate and reinvestment rate risk. Laddering bonds does not eliminate either interest rate or reinvestment rate risk, however it does reduce interest rate risk.

Question 100

Jocelyn Jane has come to you asking about investments that will produce steady income, provide relative safety of principal, and give her a tax advantage. What will you recommend that she consider adding to her portfolio?

1. MBIA-backed municipal bonds.
2. Zero-coupon U.S. Treasury bonds.
3. Collateralized Mortgage Obligations.
4. A mortgage REIT.

Answer 100

Solution: The correct answer is A.

The Municipal Bond Insurance Association provides protection against bond default (safe). Munis will provide steady income and they are tax advantaged. Treasury zeroes pay tax on accrued but unrealized income (phantom income.) CMOs, GNMAs, and Mortgage REITs all have volatility of payment and all run the risk of being paid off early if mortgagees decide to refinance their obligations.

Question 101

Physical assets might be suitable as an investment in the portfolio of an investor looking for:

1. Deflationary hedges.
2. Stability of periodic cash flows.
3. Short-term investments.
4. Long-term capital gains.

Answer 101

Solution: The correct answer is D.

Hard assets are generally considered a hedge against inflation, which will lead to price appreciation and potential capital gains.

Question 102

Lily Wassenbaum asks for your assistance in designing an educational investment program for her eight-year-old son, Max. She expects to need the funds in about 15 years when her AGI will be approximately $55,000. She wants to invest at least part of the funds in tax-exempt securities. Help her select which investment(s) would yield tax-exempt interest on her federal return if the proceeds were used to finance Max’s education.

1. Treasury bills.
2. EE bonds.
3. GNMA funds.
4. Zero coupon Treasury bonds.
5. III and IV only.
6. I, III and IV only.
7. II and III only.
8. II only.

Answer 102

Solution: The correct answer is D.

Options “I”, “III” and “IV” all generate taxable income during their inclusion in Lily’s portfolio: T-bills upon maturity, GNMA when income is paid, and Treasury zeros as the interest accrues within the bond, even though Lily will see no return paid to her. This is known as phantom income and it is fully taxable.

Question 103

Which of the following requires registration under disclosure rules with the Securities and Exchange Commission?

1. Sale of an entire issue of securities in an IPO.
2. Sale of securities in a single block to a public pension fund.
3. Sale of an entire issue of securities to a single investor.
4. Sale of securities in a single block to a publicly-traded mutual fund.

Answer 103

Solution: The correct answer is A.

All answers except “A” constitute private placement.

Question 104

Which of the following statements is correct with regard to the use of an arbitration clause in an investment advisory agreement?

1. The SEC and FINRA require arbitration if voluntary negotiation fails.
2. The SEC requires that such a clause be contained in any investment advisory agreement.
3. The FINRA requires that such a clause stipulate that arbitration must be conducted by non-industry organizations.
4. The clause must allow state regulations to take precedence over federal regulation.

Answer 104

Solution: The correct answer is A.

Both SEC and FINRA call for voluntary negotiations first. Barring success with this level of contact both SEC and FINRA require arbitration.

Question 105

A red herring is:

1. An IP that is considered a “hot” offering.
2. An underwriting that the SEC considers especially speculative.
3. A prospectus for a public offering of securities by the current shareholders of a private company.
4. A preliminary prospectus issued by the managing house of an offering.

Answer 105

Solution: The correct answer is D.

The red herring is so called because of the red lettering notifying prospective investors of its status as a prospectus without prices included.

Question 106

The Securities Act of 1933:

1. Requires the registration and provides for regulation of investment advisors.
2. Addresses the trading of previously issued securities.
3. Defines an investment advisor.
4. Regulates securities in the primary markets.

Answer 106

Solution: The correct answer is D.

The Securities Act of 1933 regulates securities in the primary markets.

Question 107

The Biomedics Corporation will have its initial public offering of securities this year. Which one of the following laws governs an IPO?

1. Securities Exchange Act of 1934.
2. Securities Investor Protection Act.
3. Investment Company Act of 1940.
4. Securities Act of 1933.

Answer 107

Solution: The correct answer is D.

The Securities Act of 1933 governs the registration requirements of all newly issued, publicly offered securities.

Question 108

The Securities Act of 1933 is best summarized by the following statement:

1. Requires the registration and provides for regulation of investment advisors.
2. The Act regulates securities in the secondary markets.
3. Regulates both initial public offerings and subsequent secondary offerings by a public company.
4. Established the organized securities exchanges.

Answer 108

Solution: The correct answer is C.

Option “A” - The Investment Advisors Act of 1940 regulates advisors. Option “B” is incorrect because the Act of 1934 regulates the secondary market. Option “C” - The Act of 1933 regulates both IPOs and secondary offerings. Option “D” - The organized exchanges and previously issued securities are governed by the Securities and Exchange Act of 1934.

Companies raise billions of dollars by issuing securities in what is known as the primary market. Contrasted with the Securities Act of 1933, which regulates these original issues, the Securities Exchange Act of 1934 regulates the secondary trading of those securities between persons often unrelated to the issuer, frequently through brokers or dealers

Question 109

Which of the following statements regarding federal law is correct?

1. The Securities Act of 1933 provides for protection from misrepresentation, deceit, and other fraud in previously issued securities.
2. The Securities Investor Protection Act of 1970 is designed to protect individual investors from losses as a result of brokerage house failures.
3. The Investment Advisers Act of 1940 requires that person or firms advising others about securities investment must register with the Securities and Exchange Commission.
4. The Investment Advisers Act of 1940 assures the investor’s safety of investment in companies engaged primarily in investing, reinvesting, and trading in securities.
5. I, II and III only.
6. I and III only.
7. II and IV only.
8. II and III only.

Answer 109

Solution: The correct answer is D.

Options “II” and “III” are correct statements. Option “I” is incorrect because the Security Act of 1933 pertains to new securities. Option “IV” is untrue because the Investment Advisers Act of 1940 addresses registration requirements and conduct of advisers, but does not deal with investment safety.

Question 110

An investor who rebalances her portfolio frequently to take advantage of perceived opportunities in other market sectors is using which one of the following types of asset allocation?

1. Tactical.
2. Strategic.
3. Passive.
4. Hybrid.

Answer 110

Solution: The correct answer is A.

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 111

An investor who rebalances her portfolio frequently to take advantage of perceived opportunities in other market sectors is using which one of the following types of asset allocation?

1. Tactical.
2. Strategic.
3. Passive.
4. Hybrid.

Answer 111

Solution: The correct answer is A.

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 112

If your client, Bertram Dell, has structured a well-diversified equity portfolio based on his belief that the market is not completely efficient, it is most likely that he will engage in what type of equity management?

1. Indexed.
2. Passive.
3. Active.
4. Buy and Hold.

Answer 112

Solution: The correct answer is C.

If one believes that markets are not efficient, a passive or indexed or buy and hold strategy would not address this inefficiency. An active management style would strive to take advantage of these inefficiencies.

Question 113

Match the investment characteristic(s) listed below which describe(s) an open-end investment company.

1. Only passive management of the portfolios.
2. Shares of the fund are normally traded in major secondary markets.
3. Both “A” and “B.”
4. Neither “A” nor “B.”

Answer 113

Solution: The correct answer is D.

Option “A” is incorrect because open-end funds are both passively and actively managed. Option “B” is incorrect because open-end fund shares are traded directly with the fund, not on the secondary market.

A closed-end fund has a fixed number of shares offered by an investment company through an initial public offering. Open-end funds (which most of us think of when we think mutual funds) are offered through a fund company that sells shares directly to investors.

A closed-end fund is launched through an initial public offering (IPO) in order to raise money for investment. The fund then trades in the open market just like a stock or an ETF.

Open-End Funds

Mutual funds are open-end funds. There is no limit to the number of shares that they can issue. (Some issuers do close their funds to new investors, as there are downsides to a fund that swells to a gigantic level of assets.)

When investors purchase shares in a mutual fund, more shares are created to accommodate them, When investors sell their shares back to the company, the shares are taken out of circulation. If a large number of shares are sold (called a redemption), the fund may have to sell some of its investments in order to pay the investor.

You can’t watch an open-end fund in the same way you watch your stocks because they don’t trade on the open market.

The funds do not trade on the open market. Their shares can only be sold back to the company that issued them.

Open-end funds are priced only once per day. At the end of each trading day, the funds are repriced based on the number of shares bought and sold. Their price is based on the net asset value of the shares.

Question 114

In the mutual fund industry, 12b-1 fees are charged as part of:

1. Fund management fees.
2. Distribution fees.
3. Commissions for sales.
4. Legal fees and expenses.
5. I only.
6. II only.
7. I and III only.
8. I, II and IV only.

Answer 114

Solution: The correct answer is B.

12b1 fees are used for marketing and distribution costs. All other costs, such as legal, accounting and analysis are paid through management fees. Commissions are paid using either a front load or a back load.

Question 115

Which of the following is/are characteristics of a municipal bond unit investment trust?

1. Additional securities are NOT added to the trust.
2. Shares may be sold at a premium or discount to net asset value.
3. Shares are normally traded on the open market (exchanges.)
4. The portfolio is self-liquidating.
5. I only.
6. I and IV only.
7. II and III only.
8. II and IV only.

Answer 115

Solution: The correct answer is B.

Unit investments do not make additions to investments once the trust has been structured. Shares are not bought or sold after structuring and the portfolio is self-liquidating.

Question 116

Which of the following are factors to consider when investing in a mutual fund?

1. The size of the fund.
2. The amount of time until a distribution is made.
3. The amount of time the current portfolio manager has managed the fund.
4. The availability of a third-party analysis of the fund.
5. I and III only.
6. II and IV only.
7. I, II and III only.
8. I, III and IV only.

Answer 116

Solution: The correct answer is C.

If an investor can find out I, II and III, he or she will not likely require IV. Though it may reinforce the investor’s findings, the third party analysis is unnecessary at that point.

Third party analysis looks at the exact same information you see from the fund. They cannot use inside information, only public information. Even if they attend due diligence meetings with the mutual fund managers, that is still public information. While you may find the format a third party puts the information in useful, or trust in their commentary or buy/hold/sell recommendations, it is based on information you have access to. As a planner, you should be doing that research on any company or investment you offer your client.

Question 117

A mutual fund investor who is looking for the opportunity to buy investments at a discount, so as to capture a greater portion of any capital gains, would probably decide to invest in a(n):

1. Open-end fund.
2. Closed-end fund.
3. Unit investment trust.
4. Exchange Traded Fund (ETF).

Answer 117

Solution: The correct answer is B.

Closed-end funds generally sell at either a premium or a discount to par value. When purchased at a discount, they afford investors an opportunity to realize up-side capital appreciation

Question 118

The theory of the Yield Curve that attempts to explain the yield curve based upon future rates of inflation is the:

1. Liquidity Preference Theory.
2. Market Segmentation Theory.
3. Short-Wave Theory
4. Expectations Theory.

Answer 118

Solution: The correct answer is D.

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 119

The bond investment strategy of “riding the yield curve” involves:

1. Investing equal amounts in short-term and long-term bonds.
2. Investing equal amounts in each of several maturity periods.
3. Investing either short-term or long-term to take advantage of anticipated interest rate changes.
4. Selling bonds with unrealized losses and replacing them with similar bonds.

Answer 119

Solution: The correct answer is C.

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.

Question 120

Which of the following is NOT a similarity between preferred stock and debt instruments?

1. Preferred stock represents the same level of risk as debt to the buyer.
2. Preferred stock pays a fixed income in its dividend.
3. Preferreds are purchased for their income stream.
4. Preferred stock is subject to interest rate and purchasing power risks.

Answer 120

Solution: The correct answer is A.

Preferred stocks are riskier than debt due to the lack of a maturity date on preferred issues.

Preferreds have fixed dividends and, although they are never guaranteed, the issuer has a greater obligation to pay them. Common stock dividends, if they exist at all, are paid after the company’s obligations to all preferred stockholders have been satisfied.

Question 121

The cumulative feature on a preferred stock is best described in the following:

1. The preferred stock gets to cast its entire total of votes in a grouping for one seat on the board of directors if the shareholders so desire.
2. The preferred shareholder has the option of accruing a certain number of shares and then converting them to common stock.
3. If there are additional or extra dividends declared, the preferred shareholders have the right to share in the profits.
4. If dividends are not paid in a given cycle, they cannot be paid to anyone else until they are paid to preferred shareholders.

Answer 121

Solution: The correct answer is D.

Preferred stocks are non-voting shares. The description of Option “A” is of common stocks’ cumulative voting rights. Option “B” refers to convertibility, while Option “C” addresses participating preferred stocks.

Question 122

Which one of the following types of investor benefits most from the tax advantage of preferred stocks?

1. Government.
2. Individual.
3. Corporate.
4. Mutual funds.

Answer 122

Solution: The correct answer is C.

The corporate dividend-received deductions are based on ownership. TCJA of 2017 updated the amounts. If a corporation owns 20% or less, the have a DRD of 50%. If 20% or more (and less than 80%) of the corporation paying the dividend is owned by the company receiving the dividends, then up to 65% of the dividend is tax free. If ownership is greater than 80% (affiliated corporations) the DRD is 100%.

DRD = dividend-received deductions

Question 123

Which of the following statements about preferred stock are true?

1. Its market fluctuations are greater than the long-term bond market fluctuations.
2. It is more risky than debt.
3. Its dividends are recomputed quarterly.
4. It has no interest rate risk because it is a stock and not a bond.
5. I and II only.
6. I and IV only.
7. II and III only.
8. II and IV only.

Answer 123

Solution: The correct answer is A.

The market prices of preferred stocks do tend to act more like bond prices than common stocks, especially if the preferred stock has a set maturity date. Preferred stocks rise in price when interest rates fall and fall in price when interest rates rise.

Question 124

Eddie Bauer bought a tax-exempt Original Issue Discount (OID) bond in November of 1998. Which of the following statements is/are true?

1. The bond basis increases at a set rate each year.
2. The difference between maturity value and the original issue discount price is known as the OID.
3. The bond’s earnings are treated as exempt interest income.
4. The bond was issued at a discount to its par value.
5. II and III only.
6. I and IV only.
7. I, II and IV only.
8. I, II, III and IV.

Answer 124

Solution: The correct answer is D.

All of the above statements are descriptions of the Original Issue Discount bond. Read this question carefully, a tax-exempt Original Issue Discount (OID) bond was purchased.

Question 125

The lowest bond rating that can still be considered investment grade debt is:

1. A
2. Baa
3. BB
4. Caa

Answer 125

Solution: The correct answer is B.

Baa is the lowest bond rating in Moody’s Rating System, while BBB is the lowest investment grade in the S&P bond rating system.

Question 126

Which of the following elements of risk in mortgage-backed securities can be difficult to determine?

1. Actual maturity is not known with certainty.
2. Mortgage rates vary between the different investment pools.
3. Actual cash flows are not known with certainty.
4. Government guarantees make the determination of an appropriate discount rate for calculating their present value difficult.

Answer 126

1. I and III only.

Question 127

An airline is considering issuing bonds to finance eight new airplanes that will be delivered in six months. Which type of bond will the airline issue?

1. Income bond.
2. Debenture.
3. High-yield bond.
4. Equipment trust certificate.

Answer 127

Solution: The correct answer is D.

Income bonds (Choice “A”) are high risk bonds, usually issued by financially troubled firms. Debentures (Choice “B”) are unsecured debt. High-yield bonds are lower quality than investment grade and cost the issuer more in interest payments. The airplanes would serve as collateral on the Equipment Trust Certificates.

Question 128

EMH

Answer 128

Question 129

Your client has purchased stock with a margin position that required 50% initial margin and a 35% maintenance margin. The stock was originally valued at $23 per share when the transaction was undertaken and your client bought 1,000 shares. What stock price will trigger a margin call?

1. $13.04
2. $17.69
3. $26.45
4. $32.86

Answer 129

Solution: The correct answer is B.

Price = Loan ÷ (1 - MM) = (23 × . 50) ÷ (1 - .35) = 17.69

Question 130

My margin requirements are 50% initial margin and 25% maintenance margin. I purchase a total of 200 shares at $100 per share using full margin amount for the 200 share purchase. Shortly thereafter, share prices fall to $50 per share. What will my margin call be?

1. $1,000
2. $1,500
3. $2,500
4. $5,000

Answer 130

Solution: The correct answer is C.

Required equity: $50 × .25 = 12.50 per share

Actual equity: $50 - $50 = 0 (current price- loan amount)

To meet required equity: $12.50 per share × 200 shares = $2,500

Question 131

Bristol-Buyers Company has a market price of $36.00 per share with earnings of $3.00 per share, a beta of 1.1 and a dividend of $1.20, which means a dividend payout ratio of 40%. Earnings for next year are projected to increase by 25%, and the retention ratio is projected to remain at 60%. Using the price/earnings multiplier, to what level might your client expect to see market prices move in a year?

1. $39.60
2. $45.00
3. $50.40
4. $57.60

Answer 131

vSolution: The correct answer is B.

The $36.00 per share price is divided by the $3.00 earnings per share resulting in a price/earnings multiplier of 12. The increase of earnings by 25% results in a projected earnings of $3.75 next year. This new earnings times the P/E multiplier of 12 (assuming the P/E ratio remains constant) results in a price of $45.00. The dividend information provided is unnecessary in answering the question.

Question 132

Donna sells stock in Martin Corporation to her brother David for $1,800. Donna purchased the stock four years ago for $3,000 and the current fair market value of the stock is $1,800. David paid Donna $1,800 for the stock. Which of the following statements is correct regarding the tax consequences of this transaction?

1. If David subsequently sells the stock to an unrelated party for $3,500, he will realize a gain of $1,700.
2. Donna has a recognized loss of $1,200.
3. If David subsequently sells the stock to an unrelated party for $2,200, he will have no gain or loss.
4. If David subsequently sells the stock to an unrelated party for $3,500, he will have no gain or loss.

Answer 132

Solution: The correct answer is C.

This is a related party sale of loss property. Dual basis rules will apply. David will have a double basis in the stock, determined as follows:

If the purchaser’s sale price isless than FMVbetween the original basis & FMVgreater than the original basisThen the purchaser’s basis used is$1,800 (Loss Basis)no gain or loss$3,000 (Gain Basis)

Question 133

XYZ company anticipates paying the following dividends, starting next year: Year 1: 2.25 Year 2: 2.75 Year 3: 3.01 After the third year, they anticipate dividends growing at 6%. If Diego’s required rate of return is 12%, how much would he be willing to pay for this stock?

1. $35.08
2. $40.07
3. $44.20
4. $47.38

Answer 133

Solution: The correct answer is C.

Step #1: Apply the constant growth dividend formula to value the stock as of year 3. V = 3.01(1.06) ÷ (.12 - .06) V = 53.18 Step #2: Use uneven cash flows to determine the NPV of the stock at time period zero (today). CF0 = 0 CF1 = 2.25 CF2 = 2.75 CF3 = 3.01 + 53.18 = 56.19 I = 12 NPV = ? Answer: $44.20

Question 134

XYZ company paid a dividend of $3.00 this year and anticipates the dividend to grow each year by: Year 1: 5% Year 2: 7% Year 3: 8% After the third year, they anticipate dividends growing at 6%. If Sydney’s required rate of return is 10%, how much would she be willing to pay for this stock?

1. $50.13
2. $60.57
3. $70.34
4. $80.86

Answer 134

Solution: The correct answer is D.

Step #1: Determine the dividend to be paid each year.

Year 1: 3.00 × (1.05) = 3.15

Year 2: 3.15 × (1.07) = 3.37

Year 3: 3.37 × (1.08) = 3.64

Step #2: Apply the constant growth dividend formula to value the stock as of year 3.

V = 3.64 (1.06) ÷ (.10 - .06)

V = 96.46

Step #3: Use uneven cash flows to determine the NPV of the stock at time period zero (today).

CF0 = 0

CF1 = 3.15

CF2 = 3.37

CF3 = 3.64 + 96.46 = 100.10

I = 10 NPV = ?

Answer: $80.86

Question 135

Company A has 60% debt and 40% equity; Company B has 20% debt and 80% equity. Assume both companies have the same dollar amount of assets and net income before interest and taxes. Which one of the following statements is true?

1. The unsystematic risk for the two companies is about equal.
2. Company A’s tax obligation will exceed Company B’s.
3. The company with the higher return on equity should be purchased by a risk-averse investor.
4. The return on equity for Company A can be expected to exceed the return on equity for Company B.

Answer 135

Solution: The correct answer is D.

Company A has a smaller amount of its assets financed by equity, therefore, with the same earnings in net income as Company B, the level of return on the equity of Company A would be greater.

Sample information (net income is provided, not calculated in this sample information):

A: Assets $10M; Liabilities $6M; Equity $4M; EBIDTA = $1M; I/Y = 5% Net Income = $700K; ROE = $700,000 ÷ $4M = 17.5%

B: Assets $10M; Liabilities $2M; Equity $8M; EBIDTA = $1M; I/Y = 5% Net Income = $900K; ROE = $900,000 ÷ $8M = 11.25%

EBIDTA = Earnings before interest, taxes, depreciation, and amortization

Question 136

A convertible bond has the following terms:

Maturity value = $1,000

Time to maturity = 20 years

Coupon rate = 8%

Call penalty = One year’s interest

Exercise price = $10 per share.

Given this information, you will inform your client as to how many shares of stock that the bond may be converted.

Answer 136

1. 100 shares
2. 80 shares
3. 50 shares
4. 20 shares

Solution: The correct answer is A.

The conversion ratio is used here (PAR/Conversion Price) to determine how many shares are available upon conversion. $1,000 / $10 = 100 shares.

Question 137

A convertible bond your client is interested in buying has a 8% coupon rate, a conversion ratio for 100 shares, while market rates on similar issues are currently 12%. It pays interest twice a year, has a par value of $1,000 with a maturity of 20 years. The current stock price is $8.50 per share. What price should your client expect to pay?

1. $1,125
2. $1,000
3. $850
4. $699

Answer 137

Solution: The correct answer is C.

The calculated value as a debt instrument here is $699.07, but when the conversion value puts the rate at $850, you can be certain that the bond is selling in the market place at its convertible value of $850, not its debt value of $699.

The conversion price is not given; however, (1,000 ÷ CP) is the conversion ratio, which is given (100 shares).

Therefore:

CV = 100 shares × P_s

CV = 100 × 8.50

CV = $850

Question 138

The value of the convertible bond as a debt instrument does not depend on which of the following?

1. The bond’s coupon.
2. Current interest rates.
3. The conversion price of the bond.
4. The term of the bond.

Answer 138

Solution: The correct answer is C.

The value of the bond as a debt instrument is considered separately from its convertibility and is calculated using the bond formula or the present value methodology on the calculator. However, should the conversion value be greater than the “debt value” of the bond, it will sell for the higher price.

Question 139

Your client owns a DGL Corporation convertible bond that has a coupon rate of 8% paid semiannually and matures in five years. Comparable debt yields 7% currently. The DGL bond is convertible into 22 shares of common stock. The current market price of the underlying stock is $52. What is the conversion value of this convertible bond?

1. $925
2. $1,000
3. $1,042
4. $1,144

Answer 139

Solution: The correct answer is D.

Use the formula for calculating conversion value of a bond. Keep in mind the conversion value may be different from the intrinsic value of the bond (which in equilibrium is the market price of the bond).

CV = (PAR ÷ Cp) x Ps 
CV = (1,000 ÷ 45.45) x Ps
CV = $22 x $52 
CV = 1,144​

Cp = conversion price: PAR / shares (1,000 / 22 = 45.45)
Ps = Price of the stock

Convertible Bonds

The conversion ratio can also be found by taking the bond’s par value, which is generally $1,000, and dividing it by the share price. A stock trading for $40 has a conversion ratio equal to $1,000 divided by $40, or 25.

Question 140

Anson Crowe has a 20% required rate of return. He is considering investing in XYZ, Inc., which pays an annual dividend of $.64 and is projected to increase its earnings and dividends by 17% annually. The current market price is $36.50. What is the expected rate of return from XYZ stock and is it undervalued or overvalued given Anson’s requirements?

15. 0%; overvalued.
16. 5%; undervalued.
17. 2%; overvalued.
18. 05%; overvalued.

Answer 140

Solution: The correct answer is D.

Use the expected rate of return and the intrinsic value formulas to calculate the correct answer to this problem.

Expected rate of return: E_r = (D1 ÷ P) + g

Intrinsic Value: V = (D1) ÷ (r - g)

D1 = .64 × 1.17 = .7488

Expected Return = (.7488 ÷ 36.50) + .17

= .1905 or 19.05%

Intrinsic Value = .7488 ÷ (.20 - .17)

= $24.96

Question 141

The current annual dividend of ABC Corporation is $2 per share. Five years ago, the dividend was $1.36 per share. The firm expects dividends to grow in the future at the same compound annual rate as they grew during the past five years. The required rate of return on the firm’s common stock is 12%. The expected return on the market portfolio is 14%. What is the value of a share of common stock of ABC Corporation using the constant dividend growth model? (Round to the nearest dollar.)

1. $11
2. $17
3. $25
4. $54

Answer 141

Solution: The correct answer is D.

Step 1:

N = 5

i = ? = .08

PV = <1.36>

PMT = 0 FV = 2

Step 2:

D1 = 2 × 1.08 (from Step 1) = 2.16

Step 3:

V = (D1) ÷ (r - g) = 2.16 ÷ (.12 - .08) = 54

Question 142

iso vs nqso

Answer 142

Because employees with ISOs don’t need to pay taxes immediately upon exercising their options, ISOs are generally more tax-advantaged than NSOs. Those exercising ISOs only pay taxes when they sell their shares. If an employee keeps the shares until at least one full year after vesting and at least two years after the grant date, the gains qualify as capital gains instead of ordinary income. The good news is that ordinary or capital gains taxes aren’t due on ISOs until you file your taxes for the calendar year in which they’re sold.

The AMT can take away some of the financial cushion of ISOs. If you hold onto your ISOs, you will need to report the difference between the grant price and exercise price as part of your alternative minimum taxable income. AMT is a critical component in working through an ISO exercise and hold strategy.

NSOs are different. Regardless of whether you hold your stock options or sell them, the spread (the difference between the exercise price and grant price) is counted as part of your earned income and taxed at your ordinary income rate. NSOs taxes are withheld at the time of exercise.

Non-qualified stock options are taxed on the “bargain element” (difference between the market price and the strike price) as ordinary income when exercised. (Market Price – strike price) × Number of Shares × Tax Rate = Tax

Question 143

Your clients, Nick and Betty Jo Byoloski, have come to you with some questions. She has been an employee of April Corporation for several years and received some stock options as compensation at times. He has worked with April Corporation as a consultant on several jobs over the last few years and was paid in part with stock options. Nick and Betty Jo want to know more about their situation regarding the options. What can you tell them?

1. Betty Jo’s options are qualified and Nick’s options are non-qualified.
2. Nick’s options are non-qualified and Betty Jo’s options are non-qualified.
3. Nick’s options are non-qualified and Betty Jo’s are either qualified or non-qualified.
4. Betty Jo’s options are non-qualified and Nick’s options are qualified.

Answer 143

Solution: The correct answer is C.

Because Nick is not an employee, we know that his options are non-qualified. We cannot be sure about Betty’s without more information.

Question 144

David is awarded an immediately vested, non-qualified stock option for 1,000 shares of company stock with an exercise price of $35 per share while the stock price is currently $33 per share. What are the tax ramifications, if any at the date of the grant?

1. $0
2. The gain between exercise and actual price of $2,000 is immediately taxable.
3. The awarded option price value of $33,000 will be immediately taxable.
4. Because these are unrealized gains, neither the option value nor the gain are taxable until the stock is finally sold.

Answer 144

Solution: The correct answer is A.

In the case of NQS Options, the option is not taxed at the grant if the exercise price is equal to or greater than the fair market value of the stock.

Question 145

Mary Grabowski owns an LMN, Inc. bond with a par value of $1,000. LMN is a AA-rated bond that matures in 7 years. Mary receives $55 of interest income from LMN semi-annually. Comparable debt, i.e., is AA-rated, 7-year maturity, yields 12%. The bond’s duration is 5 years. If the bond’s current price is $920, what is the yield to maturity of the bond?

1. 6.98%
2. 11.95%
3. 12.76%
4. 13.98%

Answer 145

Solution: The correct answer is C.

N = 7 × 2

i = ?

PV = <920>

PMT = 55

FV = 1,000

After solving for i, be sure to multiply your answer by 2 since it’s semi-annual compounding.

Question 146

Bob Conrad’s investment portfolio consists of several types of stocks, bonds, and money market instruments. The portfolio has an overall standard deviation of 12%, a beta of 1.06, and a total return for the year of 11%. Bob is considering adding one of two alternative investments to his portfolio. Stock A has a standard deviation of 13%, a beta of .87, and a correlation coefficient with the portfolio of .6. Stock B has a standard deviation of 11%, a beta of .97, and a correlation coefficient of .95. Which stock should Bob consider adding to his portfolio, and why?

1. Stock A, because it has a lower correlation coefficient.
2. Stock A, because it has a lower beta than that of the portfolio.
3. Stock B, because it has a lower standard deviation than that of the portfolio.
4. Stock B, because it has a higher correlation coefficient.

Answer 146

Solution: The correct answer is A.

In the process of adding new investments to a portfolio, the lowest correlation coefficient makes the best addition. Closest to negative one (-1) is always best.

Question 147

Sylvia has two assets in her portfolio, asset A and asset B. Asset A has a standard deviation of 40% and asset B has a standard deviation of 20%. 50% of her portfolio is invested in asset A and 50% is invested in asset B. The correlation for asset A and asset B is .90. What is the standard deviation of her portfolio?

1. Greater than 30%.
2. Less than 30%.
3. Equal to 30%.
4. Not enough information to determine.

Answer 147

Solution: The correct answer is B.

It’s not necessary to use the standard deviation of a two asset portfolio formula to answer this question. Since there’s a 50/50 weighting for each asset, simply take a simple average of the standard deviations (.40 + .20) / 2 = .30. Since the correlation is less than 1, the standard deviation for the portfolio will be less than the simple average. If correlation was equal to 1, then the standard deviation would be equal to 30%.

Question 148

After examining several funds and calculating the correlation coefficient relative to the client’s existing portfolio, which fund would provide the most diversification benefits?

1. Fund LMNO: with a correlation coefficient of +0.75.
2. Fund XYZ: with a correlation coefficient of +0.15.
3. Fund MYOB: with a correlation coefficient of 0.00.
4. Fund PDQ: with a correlation coefficient of -0.17.

Answer 148

Solution: The correct answer is D.

The most favorable correlation between two securities would always be -1 (negative one). That is they move against each other. Therefore, the most negative choice available here would be the best choice.

Question 149

remember LTCG you have to hold for a year and a day

Question 150

Distinguishing Characteristics of Insurance Contracts

Adhesion - insurance contract are take it or leave it (non-negotiable)

Aleatory - money exchanged may be unequal (small premiums vs large benefit)

Unilateral - only one promise made by the insurer which is to pay in the event of a loss (insured does not have to pay premiums)

Conditional - insured must pay the premium to receive the benefit/promise to pay

Answer 151

Agency Relationship and Types of Authority

Express authority - given via written documents

Implied authority - authority the public perceives, agent accepts premiums, signs on the door, business cards on the desk, letterhead, acceptance of premiums

Apparent authority - authority that the public perceives due to business cards, sign on the wall and letterhead but no authority actually exists because the agency agreement expired

Question 152

Waiver and Estoppel

Waiver - relinquishing a known legal right

If an insurer waives a legal right, they may not deny paying a claim based on the insured violating or breaching that right

Ex:David is applying for a health insurance policy. Before the policy can be issued, David must complete an application and take a physical exam. David completes the application but never takes the physical exam. The insurer still issues David a health insurance policy. The insurer cannot later deny paying claims on the policy because David did not take a physical exam.

Answer 152

Estoppel

• Estoppel is where through a legal process, you are denied a right you might otherwise be entitled to under the law.
• Estoppel applies when one party relies on information from another party and that information causes harm to the party that relied on the information.
• The party that made the statements can be estopped from denying the statements.

Ex: Walter and his wife walk into his insurance agent’s office and take out a $10 million life insurance policy on Walter’s life, with his wife as the beneficiary. Walter’s wife asks the insurance agent if the policy will pay a death benefit if he commits suicide and the agent responds “yes.” Two days later, Walter is found dead from an apparent suicide. Walter’s wife then tries to collect the $10M death benefit under the policy, however the policy has a “Suicide Clause” that stipulates that if the insured commits suicide within two years of the policy being issued, then the premiums will be returned and no death benefit is paid. Although the insurer will attempt to produce the policy and suicide provision, the insurer may be estopped from denying paying of the claim based on information the agent expressed to Walter’s wife.