513 - Module 8

An active approach to portfolio management is more likely to reward investors in which of the following asset classes? I. Emerging market equities II. U.S. large-cap stocks III. U.S. small-cap stocks IV. European large-cap stocks

A) I and III Investors who follow an active approach to portfolio management will benefit most from a portfolio containing emerging market equities and U.S. small-cap stocks, which tend to be more volatile investments.

Analyzing financial statements of a company and performing industry analysis would be beneficial under which of the following forms of the efficient market hypothesis (EMH)? I. Weak II. Semistrong III. Strong IV. Semiweak

A) I only The answer is I only. The weak form of the efficient market hypothesis (EMH) states that market prices incorporate all historical price information. However, fundamental analysis, such as analyzing financial statements, may be beneficial under the weak form of the EMH. Semiweak is not a form of the EMH.

In order to do an effective job of investment counseling, the investment adviser should examine and review the client's I. financial goals. II. risk tolerance and risk exposure. III. tax situation. IV. liquidity and marketability needs.

A) I, II, III, and IV The answer is I, II, III, and IV. In order to do an effective job of investment counseling, the adviser should examine and review the client's financial goals, risk tolerance and risk exposure, tax situation, liquidity and marketability needs, and financial statements.

Which of these statements regarding the capital asset pricing model (CAPM) are CORRECT? I. Standard deviation is used as the measure of risk on the security market line. II. The capital asset pricing model formula defines the security market line. III. Superior performance opportunity exists if a fund's position is above the security market line. IV. Both portfolio risk and return increase when investors substitute risky securities for risk-free assets.

A) II and III The answer is II and III. Beta is used as the measure of risk on the security market line. If risky securities are added to the portfolio, both risk and return will increase. The capital market line slopes upward indicating that as more risk is undertaken, more return should be achieved.

Which of the following is NOT considered a constraint when developing an investment policy statement? A) Market conditions B) Time horizon C) Liquidity needs D) Taxes

A) Market conditions The answer is market conditions. An investment policy statement is a written document that sets forth a client's objectives and establishes certain limitations on the investment manager. The following are constraints of the investment policy statement: time horizon, liquidity needs, taxes, laws and regulations, and unique circumstances/preferences. Market conditions are not a constraint when developing an investment policy statement.

What is the best choice for clients to use to finance an unanticipated financial crisis? A) Money market mutual fund B) Home equity C) Retirement plan loan D) Credit cards

A) Money market mutual fund The answer is money market mutual fund. Clients should establish an emergency fund, generally funded with highly liquid and marketable investments such as money market mutual funds, to finance any unanticipated financial emergencies. LO 8.6.1

Which of the following statements describes a limitation of Monte Carlo simulation? A) Outcomes of a simulation can only be as accurate as the inputs to the model. B) Variables are assumed to be normally distributed but may not be normally distributed. C) A clearer understanding of short-term and long-term risk can be gained. D) Simulations do not consider possible input values that lie outside of historical experience.

A) Outcomes of a simulation can only be as accurate as the inputs to the model. The answer is outcomes of a simulation can only be as accurate as the inputs to the model. Monte Carlo simulations can be set up with inputs that have any distribution and any desired range of possible values. However, a limitation of the technique is that its output can only be as accurate as the assumptions an analyst makes about the range and distribution of the inputs.

A client has a portfolio of blue-chip stocks that were purchased many years ago by her spouse. The spouse is now deceased and the client is considering her needs for income and feels the dividend yield on the stocks is not sufficient. You have decided she should be in 60% fixed-income. Which of the following sets of factors related to the recommended changes in the portfolio is the most important for the portfolio advisor to review? A) Tax issues, risk tolerance level, and client goals B) Tax issues, liquidity, and legal constraints C) Client goals, cash flows, and legal constraints D) Risk tolerance level, liquidity, and social investing

A) Tax issues, risk tolerance level, and client goals Investments purchased years ago will probably have a low tax basis, which could affect decisions to sell them, or they may have become worthless, in which case they can be used as a tax deduction. Likewise, the risk level of the investment is probably unknown and may not be compatible with the client's risk tolerance level and goals.

One implication of the efficient market hypothesis is that A) although security markets are efficient, they are not necessarily equally efficient. B) technical analysis, when combined with fundamental analysis, can lead to higher investment returns. C) using public information can provide superior investment results. D) nonfinancial markets are efficient.

A) although security markets are efficient, they are not necessarily equally efficient. Markets are efficient when many analysts follow a company, when information about a company is rapidly disseminated, and when no individual investor or analyst has information not readily available to any other investor or analyst. Some markets (e.g., foreign markets) may be less efficient, as may the markets for companies where few analysts follow a company, such as a small company that has few shares available for purchase by large institutional investors.

Assets with expected returns that lie above the security market line (SML) A) are undervalued. B) are valued correctly. C) are overvalued. D) should be sold.

A) are undervalued. The answer is are undervalued. Assets that lie above the security market line (SML) are undervalued because their expected returns are higher than the required return represented by the SML.

An investor selects an appropriate portfolio by choosing the portfolio A) at the point of tangency between the indifference curve and the efficient frontier. B) that lies below the efficient frontier. C) with the highest return. D) with the lowest risk.

A) at the point of tangency between the indifference curve and the efficient frontier. The answer is at the point of tangency between the indifference curve and the efficient frontier. The investor will choose a portfolio represented by the highest point attainable on the indifference curve. LO 8.1.1

Which of the following correctly describes a lifecycle fund? A) A fund that utilizes sector rotation to adjust the asset allocation based on where the economy is in its "life cycle" B) A fund that bases and adjusts its asset allocation on a specific target date at which the investor will retire C) A fund that bases and adjusts its asset allocation based on the current phase of life of the investor D) A fund that invests in other funds, usually offering three portfolios with different levels of risk, such as conservative, moderate, and growth

B) A fund that bases and adjusts its asset allocation on a specific target date at which the investor will retire The answer is a fund that bases and adjusts its asset allocation on a specific target date at which the investor will retire. This is also known as a target-date fund.

Which of the following are reasons why a client's preferences, understanding, and experience may influence the management of his or her portfolio? I. These factors affect investment strategies that might be used by the planner. II. Consideration of these factors relieves the planner of any fiduciary duty. III Consideration of these factors eliminates the need for due diligence of securities. IV Investment choices must be checked for suitability, with these factors kept in mind. A) II and III B) I and IV C) I and II D) I, II, and III PREV

B) I and IV The answer is I and IV. Investment strategies used by a planner should tie closely to the client's goals, risk tolerance, investment preferences, and other intangible factors. Clients with little understanding may not tolerate complicated investment strategies and products. Unsuitability lawsuits are very common in the investment universe. By matching as closely as possible a client's suitability factors with investment products, an advisor may be able to defeat claims of unsuitability.

Using the information on five portfolios and an indifference curve provided in the figure below, determine which of the following statements are CORRECT. I. Portfolio A is less efficient than Portfolio C. II. Portfolios A and E are not in the feasible set. III. Portfolio B is the optimal portfolio. IV. Portfolio E is less efficient than Portfolio D.

B) III and IV Portfolio A is not feasible; Portfolio E is feasible but less efficient. A portfolio above the efficient frontier is not feasible, but any portfolio below the efficient frontier is feasible, but not efficient. Portfolio B is optimal because it is at the point where the efficient frontier and the indifference curve are tangent.

Which of the following characteristics are associated with the market anomaly known as the neglected-firm effect? I. Low price-to-earnings (P/E) ratio stocks outperform high P/E stocks. II. Stocks of foreign companies outperform known domestic stocks. III. Neglected-firm stocks underperform large capitalization stocks. IV. Stocks not frequently followed by analysts outperform widely followed stocks. A) III and IV B) IV only C) II and III D) I only

B) IV only Neglected firms are those that are neglected (not followed) by many financial analysts. When such companies can be found, the market for those companies may not be efficient, and investors who can take the time to analyze these companies may be able to take advantage of undervalued situations.

Ophelia is considering the purchase of the Quest Mutual Fund, which has a beta of 1.2, a standard deviation of 15, and a return of 11%. The current risk-free rate is 4%, and the market risk premium is 7%. Should Ophelia purchase the fund? A) Yes, because of the fund's Treynor ratio. B) No, because the fund has a negative alpha. C) No, because of the fund's Sharpe ratio. D) Yes, because the fund has an 11% return.

B) No, because the fund has a negative alpha. This question can be answered with or without a calculation. We have nothing to compare Quest Mutual Fund to, and both Sharpe and Treynor are comparative measures, so neither can be used to evaluate the fund. The answer "Yes, because the fund has an 11% return" just restates the return of the fund without taking risk into account. The calculation would be as follows: a=¯¯¯rp−[¯¯¯rf+(¯¯¯¯rm−¯¯¯rf)βp]a=11−[4+7(1.2)]a=11−[12.40]a=−1.40a=rp¯−[rf¯+(rm¯−rf¯)�p]a=11−[4+7(1.2)]a=11−[12.40]a=−1.40 The fund has a negative alpha of 1.40, meaning the fund manager has not obtained the return she should for the amount of risk taken. LO 8.2.1

Which statement regarding indifference curves is CORRECT? A) Reflect happier investors when the curve is lower B) Represent all points where an investor is equally satisfied with the risk/return trade-off C) Represent the return patterns of two or more equally attractive stocks D) For risk-averse investors, show decreasing returns for increases in risk

B) Represent all points where an investor is equally satisfied with the risk/return trade-off The answer is represent all points where an investor is equally satisfied with the risk/return trade-off. Indifference curves express an individual's preference regarding two items: risk and return. The more risk averse an investor is, the steeper the slope is for that investor's indifference curve. Conversely, the less risk averse an investor is, the flatter the slope for that investor's indifference curve.

Which statement concerning an active portfolio management strategy is CORRECT? A) The key to success for an actively managed portfolio is to minimize trading activity. B) The goal of active portfolio management is to earn a return that exceeds the risk-adjusted return of a passive benchmark portfolio. C) An actively managed portfolio has low total transaction costs. D) An actively managed portfolio has lower risk than a passive benchmark portfolio in most cases.

B) The goal of active portfolio management is to earn a return that exceeds the risk-adjusted return of a passive benchmark portfolio. The answer is the goal of active portfolio management is to earn a return that exceeds the risk-adjusted return of a passive benchmark portfolio. This is net of transaction costs. Such a strategy also involves higher transaction costs and, usually, risk.

Roger is willing to invest in securities with above-average risk if he is rewarded for doing so. He has been following the stock of a company that he likes, but is concerned because the stock dropped 9% the last time the S&P 500 dropped 7%. Roger believes that an 11% return for the market next year would be good. The current market risk premium is 7.5% and the Treasury bill rate is 5.75%. The stock Roger has been following has the following characteristics: Standard deviation 18% Dividend yield 2.4% P/E ratio 17 P/E ratio relative to S&P 500 1.4 Beta 1.25 Using the CAPM formula, calculate the required rate of return for the stock and determine if the stock appears to meet Roger's criteria of investing in above-average-risk stocks only if he is rewarded for doing so. A) The required rate of return is 11.00%, and the stock does not meet Roger's criteria. B) The required rate of return is 15.13%, and the stock meets Roger's criteria. C) The required rate of return is 13.25%, and the stock meets Roger's criteria. D) The required rate of return is 12.31%, and the stock does not meet Roger's criteria.

B) The required rate of return is 15.13%, and the stock meets Roger's criteria. Required rate of return is 5.75% + (7.5%)1.25 = 15.13%. The fact that Roger believes 11% would be a good return is not relevant for computation of the required rate of return—only the computed market risk premium is relevant. The market return is computed as 7.5% + 5.75% = 13.25%. Roger will invest in an above-average risk stock (beta = 1.3) if he can be rewarded for taking the extra risk. The reward is the greater-than-market return of 15.13%.

The anticipation of inflation suggests that the investor should A) avoid real estate investments. B) anticipate higher interest rates. C) sell stocks of gold companies. D) buy bonds.

B) anticipate higher interest rates. Real assets, which includes gold and real estate, should do well in inflationary times. Bonds do poorly because interest rates will increase to fight inflation, and increases in interest rates cause bond prices to fall.

A well-crafted investment policy statement will take all of the following into account except A) investments the client is especially interested in considering for her portfolio. B) hobbies the client intends to pursue in retirement. C) anticipated liquidity needs. D) the client's time horizon.

B) hobbies the client intends to pursue in retirement. A properly crafted IPS will keep both the client and the advisor on track, and minimize any disagreements or confusion.

Jana believes that the allocation to emerging market equities in her portfolio has become overvalued, so she trims the holdings in that asset class and reinvests the proceeds in other asset classes that she believes are undervalued. Jana's approach to asset allocation can best be described as A) core-satellite asset allocation. B) tactical asset allocation. C) dynamic asset allocation. D) strategic asset allocation.

B) tactical asset allocation. Tactical asset allocation continuously adjusts the asset allocation and class mix in an attempt to take advantage of changing market conditions and overall investor sentiment.

All of the following statements regarding modern portfolio theory are correct except A) the optimal portfolio has the lowest risk for a given level of return. B) the optimal portfolio will always lie above the efficient frontier. C) the optimal portfolio for an investor depends upon the investor's ability to assume risk. D) the optimal portfolio offers the highest return for a given level of risk.

B) the optimal portfolio will always lie above the efficient frontier. The answer is the optimal portfolio will always lie above the efficient frontier. The optimal portfolio will always lie on the investor's efficient frontier. This portfolio is found at the point of tangency of the investor's indifference curve and the efficient frontier. LO 8.1.1

Which of the following should be agreed upon between the client and the investment professional when making recommendations based on an investment policy statement? A) Risk tolerance B) Permitted and excluded investments C) All of these D) Return requirement

C) All of these The answer is all of these. The client and the investment professional should agree on return requirement, risk tolerance, and permissible investments. Other factors to incorporate are liquidity needs, asset allocation, time horizons, tax considerations, and laws and regulations. LO 8.4.1

John, your client, received notice that he will be laid off from his job in one month due to his company downsizing as a result of a slowing economy. What would be the best course for your client after his job loss? A) Cash in a growth mutual fund with a large unrealized capital gain. B) Take a loan from his 401(k) plan to pay for current expenses. C) Apply for unemployment benefits. D) Cancel his health insurance.

C) Apply for unemployment benefits. The answer is apply for unemployment benefits. Cancelling his health insurance without reviewing any COBRA options would not be prudent. He will not be able to take a loan from his 401(k) plan after he terminates his employment. Cashing in his mutual fund may not be wise because any unrealized gain would become taxable.

During a period of increasing inflation, which one of the following investments might be appropriate? A) Common stock of financial firms B) Long-term bonds C) Common stock of energy firms D) None of these

C) Common stock of energy firms The answer is common stock of energy firms. Rising inflation causes interest rates to rise, which causes financial firms' cost of sales to rise, thereby restricting these firms' profits and depressing their stock prices. Rising inflation helps companies that hold and/or sell real assets, such as commodities and real estate, thereby causing these companies' stock prices to rise. Long-term bond prices fall as interest rates rise, which they generally do during periods of rising inflation.

Which of the following are implications of the weak form of the efficient market hypothesis (EMH)? I. Stock prices fully reflect all historical price behavior. II. Consistently superior performance is common. III. Fundamental analysis may produce superior investment performance. IV. Fundamental and technical analysis can produce superior investment performance. A) II and IV B) I and IV C) I and III D) I only

C) I and III Technical analysis is not considered valuable under any of the forms of the EMH; fundamental analysis is considered valuable under the weak form only.

The strong form of the efficient market hypothesis suggests which of the following? I. Inside information will not lead to superior investment results. II. Inside information will lead to superior investment results. III. Studying financial statements will not lead to superior investment results. IV. Studying financial statements will lead to superior investment results.

C) I and III The strong form says that all information, both public and private, is already reflected in the stock price, so nothing will produce superior results.

Assume that the economic forecast for the coming year is expected to be one of increasing inflation and interest rates. The GDP is expected to be strong. Which of the following types of investments would be advisable for the coming year and why? I. Liquid investments, such as money market funds and short-term securities, to allow the investor flexibility to reinvest as rates increase II. Long-term debt, such as 20-year government bonds, to lock in current interest rates III. Stock in public utilities and durable goods firms, becausethey benefit from a rising interest rate environment IV. Tangible assets, such as gold, to keep pace with the rate of inflation

C) I and IV Long-term bonds decrease in value in a rising interest rate environment. Stock in public utilities and durable goods firms does not benefit from a rising interest rate environment.

Which of the following statements correctly distinguishes an investor who practices indexing? I. The investor purchases index mutual funds. II. The investor is practicing an active form of portfolio management. III. The investor is attempting to beat the market (i.e., S&P 500). IV. Indexing and purchasing index funds tends to exhibit low administrative costs and a low turnover of existing assets.

C) I and IV The answer is I and IV. In actuality, the investor is following a passive portfolio management style. The purpose of indexing is not to beat the market, but merely match its long-term performance. LO 8.3.2

In order to do an effective job of investment counseling, which of the following should be analyzed and reviewed? I. Financial goals II Client tax situation III Client financial statements IV Client preferences, investment understanding, and experience A) I only B) I, II, and III C) I, II, III, and IV D) I and III

C) I, II, III, and IV The answer is I, II, III, and IV. All of these are parts of a comprehensive client analysis. In addition, the planner should discuss the risk tolerance and risk exposure of the client and the liquidity needs and the investment time horizon of the client.

The random walk hypothesis is supported when future price changes are not correlated with past price changes. stock price changes are random but predictable. stock prices respond rapidly to new information. past information is not useful in predicting future price changes. A) II, III, and IV B) III only C) I, III, and IV D) I, II, and IV

C) I, III, and IV The answer is I, III, and IV. The random walk hypothesis assumes that stock price changes are essentially random, and therefore unpredictable; or that successive stock returns are independent of past returns. Stock prices react quickly to new information. Past information is not relevant when predicting future price changes, hence, future price changes are not correlated with past price changes.

The weak form of the efficient market hypothesis: I. reinforces the value of technical analysis. II. implies that technical analysis is not worthwhile. III. implies that fundamental analysis is not worthwhile. IV. implies that inside traders cannot earn superior risk-adjusted returns. A) I and IV B) I, III, and IV C) II only D) II and III

C) II only The weak form implies that information contained in historical stock prices is fully incorporated into current stock prices; therefore, technical analysis (the study of historical prices and volume) is not worthwhile in predicting future prices. This form neither refutes fundamental analysis nor implies that traders using insider information cannot earn superior profits.

Under the efficient market hypothesis, which of the following terms best describes the movement of stock prices? A) Statistical B) Predictable C) Random D) Diverse

C) Random The answer is random. Random walk is the term used to describe the pattern of movement of stock prices. Because only new information, which is unpredictable and random, will affect the price of a security, the pattern of price movements for a stock will be random.

According to the arbitrage pricing theory (APT), the return on a stock represents which of the following? A) The APT is reduced through the construction of diversified portfolios. B) The APT equals the market return if the expected rate of inflation is realized. C) The APT depends on the stock's responsiveness to unexpected changes. D) The APT is not related to the expected return on the stock.

C) The APT depends on the stock's responsiveness to unexpected changes. The answer is the APT depends on the stock's responsiveness to unexpected changes. The APT is related to the expected return on the stock. The APT is not reduced by the construction of diversified portfolios. The APT does not take into consideration the market return if the expected rate of inflation is realized.

Richard has become very interested in the stock market and enjoys spending his spare time researching companies in the medical field. He believes studying and analyzing the industry, combined with his advanced exposure to trends and new innovations in medicine, will give him an advantage in achieving superior performance in medical stock investment opportunities. Choose the form of the efficient market hypothesis (EMH), if any, that Richard is considered subscribing to. A) Strong form B) Semistrong form C) Weak form D) None of these

C) Weak form Richard is subscribing to the weak form of the EMH because he believes fundamental analysis and insider information will yield superior performance.

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 position is ________ the CML, and equilibrium position exists if it is ________ the CML. A) below; above; on B) below; on; above C) above; below; on D) above; on; below

C) above; below; on According to modern portfolio theory, the CML defines performance of a portfolio. All portfolios should plot on the CML in proportion to the risk of the portfolio. The Y axis is return and the X axis is the risk level. If a fund has superior performance, its return will be above the return level for the given risk level; if inferior, its return will be below the return level for the given risk level; and if it is in equilibrium, then it will plot exactly on the CML.

ll of the following statements correctly evaluate market efficiency except A) an efficient market is one in which the prices of securities quickly and fully reflect all available information. B) the efficient market hypothesis states that securities markets are efficient, with the prices of securities reflecting their current economic value. C) investors usually react slowly to new and random information pertaining to security's markets. D) the weak form of market efficiency involves market data, whereas the semistrong involve the assimilation of all public information and the strong form involves both public and private information.

C) investors usually react slowly to new and random information pertaining to security's markets. The answer is investors usually react slowly to new and random information pertaining to security's markets. Another condition that guarantees an efficient market is investors reacting quickly to new information.

If information is generated randomly and information announcements are independent A) prices will not reflect all fully available information. B) price changes will be influenced by the information about past prices and volume. C) prices will change quickly in response to the new random information. D) price changes will be independent of each other and tend to move in a predictable fashion.

C) prices will change quickly in response to the new random information. The answer is prices will change quickly in response to the new random information. If information is generated randomly and information announcements are independent, prices will tend to fully reflect all available information. In addition, price changes will be independent of one another and tend to occur in random patterns. LO 8.1.1

The security market line (SML) A) indicates the market portfolio as the only optimal portfolio. B) plots diversifiable risk on the horizontal (X) axis. C) shows a security's expected return as a function of its systematic risk. D) presents the relationship between a security's return and the return of the market portfolio.

C) shows a security's expected return as a function of its systematic risk. The answer is shows a security's expected return as a function of its systematic risk. The security market line (SML) shows the relationship between the rate of return and systematic risk (beta). Thus, the SML depicts a security's expected return as a function of its systematic risk. The intersection between the efficient frontier and a line from the risk-free rate depicts all the optimal portfolios composed of a combination of the market portfolio and the risk-free asset. The market portfolio is the only optimal portfolio comprised solely of risky securities.

Henry is constructing an asset allocation portfolio for his financial planning client, Gretchen, based on information obtained from completing a risk-profile questionnaire. Which of the following are considerations for Henry to keep in mind when developing portfolio alternatives for Gretchen? A) Choose the appropriate benchmark(s) for investment performance comparison. B) Construct portfolios that match Gretchen's risk tolerance. C) Develop portfolios that take her tax situation into consideration. D) All of these are considerations.

D) All of these are considerations. The answer is all of these are considerations. A financial planner should be aware of all of these considerations when constructing and monitoring an investment portfolio for a client.

Phil has computed a required return for the Pepsi stock he is considering purchasing. He believes that interest rates and inflation will change over the expected holding period. Therefore, he adjusted the required return for his projected changes in these factors. Which of the following stock market theories did Phil use? A) Black-Scholes pricing theory B) Dividend growth theory C) Modern portfolio theory D) Arbitrage pricing theory

D) Arbitrage pricing theory An investor using the APT starts with a required return for a security, possibly computed using the CAPM. The investor then adjusts the required return for a multitude of factors that may affect that particular security, such as interest rates, industrial production, and inflation.

Which of the following statements regarding an efficient portfolio is CORRECT? Provides the highest return for a given level of risk Has the greatest risk for a given level of expected return Shows an investor's willingness to bear risk Can be created with minimum transaction costs A) II and III B) III and IV C) I, II, and III D) I only

D) I only The answer is I only. An investor should try to assemble an investment portfolio containing the optimum combination of risk and return. An efficient portfolio offers maximum return for a given level of risk. An investor's willingness to bear risk is reflected in indifference curves. LO 8.1.1

Which of the following statements about the efficient market hypothesis (EMH) and associated anomalies are CORRECT? I. An investor purchasing a high price-to-earnings (P/E) ratio is exploiting the P/E effect anomaly. II. An investor studying annual reports and analysts' reports in his stock selection process believes that markets are weak-form efficient. III. An investor who buys the securities of firms that are not followed by many analysts is trying to benefit from the neglected-firm effect. IV. An investor who befriends the chauffeur of a firm's CEO to solicit information about the firm's plans before making investment decisions believes the markets are strong-form efficient. A) I and II B) III and IV C) I and III D) II and III

D) II and III The answer is II and III. The P/E effect suggests that portfolios consisting of stocks with low price-to-earnings ratios have higher average returns than do portfolios consisting of stocks with high P/E ratios. Strong-form market efficiency suggests that all public and private information is included in market prices. A person who solicits private information believes that it is possible to profit by making trading decisions based on private information and does not believe that the markets are efficient in the strong form. Weak-form efficiency suggests that all historical price and volume information is included in stock prices but that gains may be made by analyzing other publicly available information. An investor studying annual reports and analysts' reports to make stock selections indicates that the person is conducting fundamental analysis, because the investor believes that the markets are weak-form efficient.

Which of the following steps are involved in the investment planning process? I. Establishment of a brokerage account II. Selection of assets for investment III. Implementation of investment plan IV. Determination of ability to invest

D) II, III, and IV The answer is II, III, and IV. Establishing a brokerage account is not a necessary step in the investment process; however, it may be included in the implementation phase.

JEM stock has a beta coefficient of 1.35 and the market has a rate of return of 8.50%. The 90-day U.S. Treasury bill rate of return is 1.75%. Based on the information provided, choose the CORRECT statements. The stock risk premium is 6.75%. The market risk premium is 9.11%. The expected rate of return is 10.86%. A) I, II, and III B) I and II C) I and III D) III only

D) III only The answer is III only. The expected rate of return based on the capital asset pricing model is 10.86%, calculated as follows: ri = 0.0175 + (0.085 - 0.0175)1.35 = 10.86, or 10.86% The stock risk premium is 9.11%, (0.085 - 0.0175)1.35. The market risk premium is 6.75%, (0.085 - 0.0175). LO 8.2.1

An individual who is a proponent of the efficient market hypothesis (EMH) will likely invest in which of the following? A) Sector mutual funds B) Growth mutual funds C) Balanced mutual funds D) Index funds

D) Index funds The answer is index funds. An individual who believes in the EMH will likely invest in index funds. Inherent in this strategy is a belief that an investor cannot outperform the market with active portfolio management techniques. The remaining choices all incorporate an active portfolio management philosophy.

StockBeta A 2.16 B 1.54 C 0.96 D 1.28 Risk-free rate of return is 2.75% Market rate of return = 6.75% The investor's required rate of return = 9.5% Based on the information provided, choose the stock that would offer the best investment opportunity.

D) Stock A The answer is Stock A. Calculate the expected rate of return of each stock using the capital asset pricing model (CAPM) and compare the result to the investor's required rate of return. Stock A: E(r) = 2.75 + (6.75 - 2.75)2.16 = 11.39% Stock B: E(r) = 2.75 + (6.75 - 2.75)1.54 = 8.91% Stock C: E(r) = 2.75 + (6.75 - 2.75)0.96 = 6.59% Stock D: E(r) = 2.75 + (6.75 - 2.75)1.28 = 7.87% Based on a required rate of return of 9.5%, Stock A with an expected return of 11.39% is the best available investment opportunity.

While managing his portfolio, James's investment adviser attempts to take advantage of perceived market inefficiencies. His investment adviser is not concerned with James's long-term goals; rather, the interest lies in continuously changing the investment mix to take advantage of overall investor sentiment. Based on this information, choose the type of portfolio management style that the investment adviser is using to manage James's money. A) Strategic asset allocation B) Buy and hold C) Portfolio ratio analysis D) Tactical asset allocation

D) Tactical asset allocation The answer is tactical asset allocation. Tactical asset allocation continuously adjusts the asset allocation in an attempt to take advantage of changing market conditions. LO 8.5.2

Which statement regarding portfolio theory is NOT correct? A) The optimal portfolio offers the highest return for a given level of risk. B) The optimal portfolio for an investor depends upon the investor's ability to assume risk. C) The optimal portfolio has the lowest risk for a given level of return. D) The optimal portfolio will always lie above the efficient frontier.

D) The optimal portfolio will always lie above the efficient frontier. The answer is the optimal portfolio will always lie above the efficient frontier. The optimal portfolio is found at the point of tangency of the investor's indifference curve and the efficient frontier. LO 8.1.1

An active portfolio strategy is based on which of the following premises? A) The portfolio manager's access to corporate management B) The stock market is efficient C) The investor's ability to obtain public information D) The stock market is inefficient

D) The stock market is inefficient If the market is efficient, then a buy-and-hold strategy would be best. Only if the market is inefficient is it worth the costs involved in active management to attempt to generate superior returns.

All of the following should be found in an investment policy statement (IPS) except A) the client's time frame. B) the client's liquidity needs. C) the client's risk tolerance. D) the actual investments.

D) the actual investments. The answer is the actual investments. Risk tolerance, time frame, and liquidity needs should all be found in the IPS; investments are not found in the IPS. The IPS is a roadmap and provides guidance for the adviser and client as to the type of investments that will be used (such as 15%-20% in large-cap U.S. stocks), but the actual investments are not specified in the IPS.

An investor who makes the assumptions that security prices reflect all available information, that organized exchanges can execute trades rapidly, that security prices change rapidly in response to new information, and that security prices follow random patterns is a believer in A) the arbitrage pricing theory. B) the constant growth hypothesis. C) the capital asset pricing model. D) the efficient market hypothesis.

D) the efficient market hypothesis. In its purest form, the efficient market hypothesis suggests that investors are unable to outperform the market on a consistent basis. The fundamental assumption of the theory is that current stock prices reflect all available information for a company and that prices rapidly (or immediately) adjust to reflect any new information.

In the Markowitz framework, an investor should most appropriately evaluate a potential investment based on its A) effect on portfolio risk and return. B) required return. C) intrinsic value compared to market value. D) expected return.

A) effect on portfolio risk and return. The answer is effect on portfolio risk and return. Modern portfolio theory concludes that an investor should evaluate potential investments from a portfolio perspective and consider how the investment will affect the risk and return characteristics of an investor's entire portfolio. LO 8.1.1

An investor analyzing a particular security is generally concerned with A) expected return. B) historical return. C) trailing P/E ratio of the stock. D) actual return.

A) expected return. The answer is expected return. Expected return is what determines an asset's value. The expected return must be greater than the investor's required return to induce the investor to make the investment. Historical return is only important to the extent that it may impact future return.

An investor considering investing in a particular security is more concerned with A) expected return. B) trailing P/E ratio of the stock. C) historical return. D) actual return.

A) expected return. The answer is expected return. Expected return is what determines an asset's value. The expected return must be greater than the investor's required return to induce the investor to make the investment. Historical return is only important to the extent that it may impact future return. LO 8.2.1

Which of these statements pertaining to the capital market line (CML) is CORRECT? 1. Lending portfolio—As the investor proceeds back along the CML toward the risk-free rate of return, he is becoming conservative in making investments and is investing more in risk-free government securities 2. Borrowing portfolio—As the investor proceeds along the CML, he is becoming more aggressive in making investments, including making use of margin and leverage A) I only B) Both I and II C) Neither I nor II D) II only

B. The answer is both I and II. The development of the capital market line allows investors to see that the risk and the potential return of various asset classes do increase along a relatively straight line.

Which of the following factors is NOT necessary for calculating the measure of risk that is used in Markowitz's efficient frontier? A) The percentage of the portfolio invested in each asset class B) Beta for each asset class C) Correlation between each asset class and every other asset class D) Standard deviation for each asset class

B) Beta for each asset class The efficient frontier consists of efficient portfolios. An efficient portfolio has the highest return for a given level of risk. The risk measure is standard deviation; specifically, the standard deviation of a multi-asset portfolio. The other choices represent inputs needed to determine the standard deviation of a multi-asset portfolio. Beta is not used in the calculation.

Which of the following statements regarding the efficient frontier is CORRECT? A) Combines all assets that can be held in a portfolio B) Shows all portfolios that offer the highest expected returns for each level of risk C) Represents the assets or asset combinations with the least return for the given level of risk D) Represents an inferior set of assets or asset combinations available to investors

B) Shows all portfolios that offer the highest expected returns for each level of risk The answer is shows all portfolios that offer the highest expected returns for each level of risk. Efficient frontiers take all of the possible combinations of assets that can be held in a portfolio into account in order to represent the set of portfolios that offer the highest expected return for a given amount of risk.

When working with anxious clients who are concerned about widely fluctuating stock market prices, what is the most important service you can provide to them? A) Discussing their risk tolerance B) Guaranteeing them a profit on their investments C) Managing their expectations D) Referring them to a financial counselor

C) Managing their expectations The answer is managing their expectations. Unrealistic expectations can be a function of a client's ignorance about financial markets and securities. By using your knowledge, you can educate clients about markets and securities so that expectations are realistic. Doing so also strengthens the client/planner relationship and allows you to demonstrate your expertise. LO 8.6.1

Which of the following is a written document that sets forth a client's objectives, sets limitations on the portfolio manager, provides guidance to the portfolio manager, and provides a means for evaluating performance? A) New account form B) Financial planning disclosure C) Risk-profile questionnaire D) Investment policy statement

D) Investment policy statement The answer is investment policy statement. The investment policy statement sets forth a client's objectives, sets limitations on the portfolio manager, provides guidance to the portfolio manager, and provides a means for evaluating performance.

Calculate the expected rate of return for Stock A based on the following information: Risk-free rate of return: 3.85%

D) 15.13% The answer is 15.13%. The expected rate of return for Stock A based on the arbitrage pricing model (APT) is calculated as follows: ri = 0.0385 + (1.2 × 0.04) + (0.9 × 0.0575) + (0.5 × 0.0260) = 0.0385 + 0.048 + 0.0518 + 0.013 = 0.1513, or 15.13%.

Which of the following correctly describes the efficient frontier in portfolio theory? A) It illustrates the optimal tradeoff between long- and short-term capital gains. B) It quantifies systematic and unsystematic risk. C) It identifies the optimal portfolio for the investor. D) It indicates the highest returns for given levels of risk.

D) It indicates the highest returns for given levels of risk. At any point along the efficient frontier the highest return for a given level of risk is present. The optimal portfolio is the point on the efficient frontier that intersects with the investor's indifference curve. LO 8.1.1

Using the information on five portfolios and the indifference curve provided below, which of the following statements are CORRECT? I. Portfolios D, B, and C all lie on the efficient frontier. II. Portfolio B is more efficient than Portfolio D. III. Portfolio C is not in the feasible set. IV. Portfolio C is more efficient than Portfolio E.

Option I is correct and II is incorrect because all portfolios on the efficient frontier are feasible and efficient; none are more efficient than another. Any portfolios on the efficient frontier are more efficient than those below the frontier. Those above the frontier are not feasible.

If information is generated randomly and information announcements are independent, A) prices will change very quickly in response to the new random information. B) price changes will be influenced by the information about past prices and volume. C) prices will not reflect all fully available information. D) price changes will be independent of each other and tend to move in a predictable fashion.

prices will change very quickly in response to the new random information. If information is generated randomly and information announcements are independent, prices will tend to fully reflect all available information. In addition, price changes will be independent of one another and tend to occur random patterns.