Quiz2 Flashcards
You are building a portfolio and want to make sure it is properly diversified. Based on correlation, if you are adding one new investment, which one provides the greater diversification benefit?
A. ABC, which has a correlation of .50 to your current portfolio B. EFG, which has a correlation of .10 to your current portfolio C. RST, which has a correlation of -.27 to your current portfolio D. XYZ, which has a correlation of -.50 to your current portfolio
D. XYZ, which has a correlation of -.50 to your current portfolio
XYZ provides the greatest negative correlation therefore it provides the best diversification.
Jerry has 40% of his portfolio invested in an ETF that tracks the S&P 500 and 40% in a mutual fund that tracks the Dow Jones Industrial Average (DJIA) and 20% in government bonds. In order to evaluate the performance of his portfolio, what is Jerry’s best benchmark to use?
A. The S&P Index B. The Dow Jones Industrial Average Index C. A government bond index D. An index consisting of half of answer option A and half of answer option B E. A combination of answer options A, B, and C
E. A combination of answer options A, B, and C
The weights allocated to each benchmark should be in accordance to the weights in Jerry’s portfolio (weighted average).
A financial adviser that recommends non-actively managed exchange traded funds (ETF’s) is most likely a proponent of which form of the efficient market theory?
A. Semi-strong form B. Weak form C. Semi-weak form D. Strong form
D. Strong form
The strong form holds that all public and insider information is reflected in market prices. Therefore, there is no active strategy that will outperform the market on a consistent basis. Passive investing via ETFs will provide equivalent returns over time. There is no semi-weak form in the efficient market theory.
An investment policy statement (IPS):
A. Should include specific bonds to be included in the investment portfolio. B. Should not include any parameters on client risk tolerance, as this is determined by the planner. C. Should include broad guidelines for investor preferences for asset allocation. D. All of the above.
C. Should include broad guidelines for investor preferences for asset allocation.
The IPS should establish the framework for a client’s investment goals and objectives, risk-tolerance and time horizon. Specific security selection should not be part of the statement. An investment policy statement should include language dealing with client risk-tolerance, whether it is determined by the client or planner.
Which of the following would result in the largest increase in the price of a diversified common stock mutual fund?
A. Unexpected inflation B. Expected dividend increases C. Unexpected corporate earnings growth D. Expected increase in the prime interest rate
C. Unexpected corporate earnings growth
In an efficient market, expected market developments, such as those in B and D, would have little or no impact on securities prices. Unexpected inflation, as in A, might cause some increase or decrease in the price of a diversified common stock mutual fund, but a large increase would be produced by C since the price of a common stock mutual fund will be closely related to the earnings of companies whose common stocks are held by the fund.
Maria prefers using index funds in her portfolio. She most likely subscribes to which form of the efficient market theory?
A. Semi-strong form B. Weak form C. Strong form D. None of the above
C. Strong form
The strong form of the efficient market theory says that all public and insider information is reflected in market prices. Therefore, no active strategy will outperform on a consistent basis. Therefore passive investing via index funds will provide equivalent returns at a lower cost than active management.
Which of the following statements concerning market efficiency is (are) correct?
I. Investors who believe in the efficient market theory (EMT) usually utilizes an active management strategy.
II. EMT is the proposition that the securities markets are efficient, with the prices of securities reflecting their current economic value.
A. I only B. II only C. Both I and II only D. Neither I nor II only
B. II only
I is incorrect as those who believe in EMT usually adopt a passive strategy, not an active strategy. Statement II is correct.
All of the following statements concerning capital market theory are correct, EXCEPT:
A. The Capital Asset Pricing Model (CAPM) relates to the required rate of return for any security with the risk for that security as measured by beta. B. The capital market line (CML), also known as the security market line, is the trade-off between the expected return and risk for efficient portfolios. C. The Capital Asset Pricing Model (CAPM) allows us to measure the relevant risk of an individual security as well as to assess the relationship between risk and the returns expected from investing. D. The market portfolio is the portfolio of all risky assets, with each asset weighted by the ratio of its market value to the market value of all risky assets.
B. The capital market line (CML), also known as the security market line, is the trade-off between the expected return and risk for efficient portfolios.
The security market line is different from the capital market line and specifies the equilibrium relationship between expected return and systematic risk. The security market line applies to individual securities as well as portfolios.
If T-bills are yielding 3%, T-bonds are yielding 4.5%, and the stock market on the whole is yielding 8%, then one should be willing to buy a stock with a beta of 1.5 only if that stock can be expected to yield at least:
A. 7% B. 9.50% C. 10.50% D. 12.30%
C. 10.50%
To find the required return of the stock using the Capital Asset Pricing Model (CAPM), the equation is: risk free rate + (market return- risk-free rate)beta of stock= required return: 3%+ (8%- 3%)1.5= 10.5%
Which combination of the following statements about investment risk is correct?
(1) Beta is a measure of systematic, non-diversifiable risk.
(2) Rational investors will form portfolios and eliminate systematic risk.
(3) Rational investors will form portfolios and eliminate unsystematic risk.
(4) Systematic risk is the relevant risk for a well-diversified portfolio.
(5) Beta captures all the risk inherent in an individual security.
A. (1), (2) and (5) only B. (1), (3) and (4) only C. (2) and (5) only D. (2), (3) and (4) only E. (1) and (5) only
B. (1), (3) and (4) only
Beta is a measure of systematic, or undiversifiable risk. Systematic risk refers to factors that affect the returns on all similar investments. Therefore, (1) is correct. Since systematic risk cannot be diversified away, by definition, (2) is incorrect. Since systematic risk cannot be diversified away, rational investors will form portfolios to do so. Therefore, (3) is correct. In a well-diversified portfolio, then, unsystematic risk has been eliminated, so that systematic risk is the only relevant risk. (4) is, therefore, correct. (5) is incorrect because beta captures only systematic, nondiversifiable risk.
In analyzing the position of a portfolio in terms of risk/return on the capital market line (CML), superior performance exists if the fund’s position is _____________ the CML, inferior performance exists if the fund’s performance is ____________ the CML, and equilibrium position exists if it is ____________ the CML.
A. Above; on; below B. Above; below; on C. Below; on; above D. Below; above; on E. On; above; below
B. Above; below; on
Superior position exists if the fund’s position is above the CML. Inferior performance exists if the fund’s position is below the CML since less than an optimal return is being earned for the risk being taken. Equilibrium exists if the performance is on the CML, which shows the best possible combinations of risk and return.
The following set of newly issued debt instruments was purchased for a portfolio:
Treasury bond
Zero-coupon bond
Corporate bond
Municipal bond
The respective maturities of these investments are approximately equivalent.
Which one of the investments in the preceding set would be subject to the greatest relative amount of price volatility if interest rates were to change quickly?
A. Treasury bond
B. Zero coupon bond
C. Corporate bond
D. Municipal bond
B. Zero coupon bond
The zero-coupon bond has the longest duration (equal to its maturity), so is would have the greatest price volatility.
Company ABC is currently trading at $35 and pays a dividend of $2.30. Analysts project a dividend growth rate of 4%. Your client Tom requires a rate of 9% to meet his stated goal. Tom wants to know if he should purchase stock in Company ABC.
A. Yes, the stock is undervalued. B. No, the stock is overvalued. C. No, the required rate is higher than the projected growth rate. D. Yes, the required rate is higher than the expected rate. E. No, the required rate is lower than the expected rate.
A. Yes, the stock is undervalued.
Using the constant dividend growth model, this stock has an intrinsic value of $47.80. This is found by dividing next year’s dividend, $2.30(1.04), or $2.39, by the difference between the 9% required rate of return and the 4% growth rate. $2.39/0.05= $47.80. Since the stock is selling at $35.00, the stock is undervalued.
Eight years ago, Justin invested $11,000 in the Gusto Growth Mutual Fund, with all dividends and distributions to be reinvested. Eight years later, Justin liquidated the entire account and received proceeds of $21,000. What was the internal rate of return on this investment?
A. 6.50% B. 7.15% C. 8.42% D. 9.85%
C. 8.42%
The following key strokes are utilized to find the IRR on the HP 12C calculator:
8, n
11,000, CHS, PV
21,000, FV
i
The calculator gives an internal rate of return of 8.42%.
You are faced with the following alternative fixed income investments.
A. a U.S. Treasury bond with an 11.625% coupon, due in 2004 with a price of $142.50 and a yield to maturity of 6.3%
B. a U.S. Treasury strip bond (zero coupon) due in 2004 with a price of $46.75 and a yield to maturity of 6.25%
C. a corporate B-rated bond with a 9.75% coupon, due in 2004 with a price of $104.75 and a yield to maturity of 8.79%
Which of these bonds has the greatest interest rate risk?; Which of these bonds has the longest duration?
A. Bond B; Bond B
B. Bond A; Bond C
C. Bond A; Bond B
D. Bond C; Bond C
E. Bond B; Bond C
A. Bond B; Bond B
The interest rate risk is greatest for the security that has the lowest coupon rate. The longest duration is found in the bond that pays no interest except at the time of its maturity.
The duration of a bond is a function of its:
(1) current price.
(2) market interest rate.
(3) number of compounding periods until maturity.
(4) coupon rate.
A. (1) and (3) only B. (2) and (3) only C. (2) and (4) only D. (1), (2) and (3) only E. (2), (3) and (4) only
E. (2), (3) and (4) only
“Price” is not a determinant in calculating duration. Price is a function of the market rate of interest.
A long strangle is created on a $40 stock with a call with an exercise price of $50 and premium of $3 and a put with an exercise price of $30 and a premium of $1. If the stock price is $20 at maturity, what is the net before-tax per share dollar return on this position?
A. negative B. $6 C. $8 D. $11 E. $17
B. $6
A long strangle is the purchase of out-of-the-money call and put options. The cost of the position is $(4) (-3 -1). At a stock price of $20, only the put is exercised. The stock is purchased for $20 in the market to be sold for $30 by exercising the put. The total dollar return is -20 + 30 – 4 = $6
