Equity 1

For portfolio managers of passive funds, market indexes are least useful as: proxies to measure systematic risk. benchmarks for portfolio performance attribution. tools to develop exchange-traded funds for non-accessible markets.

B is correct. Market indexes are used as benchmarks for actively managed portfolios, which is not relevant to passively managed funds. A is incorrect because market indexes are used as proxies to measure systematic risk. The use is relevant to passively managed funds. C is incorrect because market indexes are used as model portfolios to develop new ETFs. The use is relevant to these portfolio managers as some emerging markets are not easily accessible for direct investments.

Technical analysts assume that markets are: weak-form efficient. weak-form inefficient. semi-strong-form efficient.

B is correct. Technical analysts use past prices and volume to predict future prices, which is inconsistent with the weakest form of market efficiency (i.e., weak-form market efficiency). Weak-form market efficiency states that investors cannot earn abnormal returns by trading on the basis of past trends in price and volume.

Which of the following is least likely to explain the January effect anomaly? Tax-loss selling. Release of new information in January. Window dressing of portfolio holdings.

B is correct. The excess returns in January are not attributed to any new information or news; however, research has found that part of the seasonal pattern can be explained by tax-loss selling and portfolio window dressing.

Which of the following statements concerning financial regulatory bodies is least accurate? Financial regulatory bodies: act to level the playing field for market participants. define minimum standards of competence for agents. require that regulated firms maintain optimum levels of capital.

C is correct. Financial regulators impose minimum levels of capital that apply across the board to all regulated firms—not the optimum level, which is firm specific. A is incorrect because financial regulators act to level the playing field for market participants as in the case of regulation concerning insider trading. B is incorrect because financial regulators help define minimum standards of competence for agents (e.g., the GIPS standards from CFA Institute).

Like traditional finance models, the behavioral theory of loss aversion assumes that investors dislike risk; however, the dislike of risk in behavioral theory is assumed to be: leptokurtic. symmetrical. asymmetrical.

C is correct. Behavioral theories of loss aversion allow for the possibility that the dislike for risk is not symmetrical, which allows for loss aversion to explain observed overreaction in markets such that investors dislike losses more than they like comparable gains.

Fixed-income indexes are least likely constructed on the basis of: maturity. type of issuer. coupon frequency.

C is correct. Coupon frequency is not a dimension on which fixed-income indexes are based.

The Standard & Poor's Depositary Receipts (SPDRs) is an investment that tracks the S&P 500 stock market index. Purchases and sales of SPDRs during an average trading day are best described as: primary market transactions in a pooled investment. secondary market transactions in a pooled investment. secondary market transactions in an actively managed investment.

secondary market transactions in a pooled investment.

Researchers have found that value stocks have consistently outperformed growth stocks. An investor wishing to exploit the value effect should purchase the stock of companies with above-average: dividend yields. market-to-book ratios. price-to-earnings ratios.

A is correct. Higher than average dividend yield is a characteristic of a value stock, along with low price-to-earnings and low market-to-book ratios. Growth stocks are characterized by low dividend yields and high price-to-earnings and high market-to-book ratios.

An aggregate fixed-income index: comprises corporate and asset-backed securities. represents the market of government-issued securities. can be subdivided by market or economic sector to create more narrowly defined indexes.

C is correct. An aggregate fixed-income index can be subdivided by market sector (government, government agency, collateralized, corporate), style (maturity, credit quality), economic sector, or some other characteristic to create more narrowly defined indexes.

A stop-buy order is most likely placed when a trader: wants to limit the loss on a short position. thinks that the stock is overvalued. wants to limit the loss on a long position.

A is correct. A trader who has entered into a short sale will incur losses if the stock price begins to increase. A stop-buy order helps limit the loss on a short position because it becomes valid for execution when the stock price rises above the specified stop price. B is incorrect because a stop-buy order is beneficial when the stock is undervalued (not overvalued) but the trader is unwilling to trade without market confirmation. C is incorrect because a stop-sell order is appropriate when the trader holds a long position, not short position. A stop-sell order becomes valid when the stock price falls.

The values of a price return index and a total return index consisting of identical equal-weighted dividend-paying equities will be equal: only at inception. at inception and on rebalancing dates. at inception and on reconstitution dates.

A is correct. At inception, the values of the price return and total return versions of an index are equal.

A closed-end fund is trading at a premium to its net asset value. This scenario most likely reflects: a belief that the portfolio securities are undervalued. concerns about the quality of management. excess demand for redemption of the shares.

A is correct. Closed-end funds may trade at a premium (discount) to net asset value when investors believe that the portfolio securities are undervalued (overvalued). B is incorrect because concerns about the quality of management could suggest discounts from net asset value. C is incorrect because excess redemption demand suggests selling pressure, which could indicate a discount to net asset value.

An overreaction in the financial markets causes a security's price to experience a significant loss during a short period. If this overreaction is caused by investors that sell because other investors are selling, the behavior is bestdescribed as: herding. overconfidence. loss aversion.

A is correct. Herding occurs when investors trade on the same side of the market in the same securities, or when investors ignore their own private information and/or analysis and act as other investors do. Herding behavior has been advanced as a possible explanation of under-reaction and over-reaction in financial markets. B is incorrect because if investors are overconfident, they overestimate their own ability to process and interpret information about a security. C is incorrect because loss aversion refers to the tendency of people to dislike losses more than they like comparable gains. This results in a strong preference for avoiding losses as opposed to achieving gains.

An investor analyzes the stock market of a specific country and discovers that the stock prices are very slow to reflect new information. The investor can best profit from this situation using a(n): active fund. passive fund. low cost approach.

A is correct. In an efficient market, asset prices reflect new information quickly. Conversely, an inefficient market reflects new information slowly. In a very inefficient market, as implied in this situation, opportunities may exist for active investment strategies (such as those used by active funds) to achieve superior risk-adjusted returns as compared with passive investment strategies (such as those used by equity index funds or passive funds). B is incorrect because an efficient market is a market in which asset prices reflect new information quickly. Conversely, an inefficient market reflects new information slowly. In a very inefficient market, as implied in this situation, opportunities may exist for active investment strategies (such as those employed by active funds) to achieve superior risk-adjusted returns as compared with passive investment strategies (such as those employed by equity index funds or passive funds). C is incorrect because an efficient market is a market in which asset prices reflect new information quickly. Conversely, an inefficient market reflects new information slowly. In a very inefficient market, as implied in this situation, opportunities may exist for active investment strategies (such as those employed by active funds) to achieve superior risk-adjusted returns despite higher costs as compared with passive investment strategies (such as those employed by equity index funds or passive funds).

Regulation that restricts some investors from participating in a market will most likely: impede market efficiency. not affect market efficiency. contribute to market efficiency.

A is correct. Reducing the number of market participants can accentuate market imperfections and impede market efficiency (e.g., restrictions on foreign investor trading).

Which of the following is not a function of the financial system? To regulate arbitrageurs' profits (excess returns). To help the economy achieve allocational efficiency. To facilitate borrowing by businesses to fund current operations.

A is correct. Regulation of arbitrageurs' profits is not a function of the financial system. The financial system facilitates the allocation of capital to the best uses and the purposes for which people use the financial system, including borrowing money.

Pierre-Louis Robert just purchased a call option on shares of the Michelin Group. A few days ago he wrote a put option on Michelin shares. The call and put options have the same exercise price, expiration date, and number of shares underlying. Considering both positions, Robert's exposure to the risk of the stock of the Michelin Group is: long. short. neutral.

A is correct. Robert's exposure to the risk of the stock of the Michelin Group is long. The exposure as a result of the long call position is long. The exposure as a result of the short put position is also long. Therefore, the combined exposure is long.

Uses of market indexes do not include serving as a: measure of systematic risk. basis for new investment products. benchmark for evaluating portfolio performance.

A is correct. Security market indexes are used as proxies for measuring market or systematic risk, not as measures of systematic risk.

With respect to rational and irrational investment decisions, the efficient market hypothesis requires: only that the market is rational. that all investors make rational decisions. that some investors make irrational decisions.

A is correct. The efficient market hypothesis and asset-pricing models only require that the market is rational. Behavioral finance is used to explain some of the market anomalies as irrational decisions.

Compared with its market-value-weighted counterpart, a fundamental-weighted index is least likely to have a: momentum effect. contrarian effect. value tilt.

A is correct. The momentum effect is a characteristic of a market-capitalization-weighted index, not a fundamental index. B is incorrect because the fundamental indexes generally have a contrarian effect in that the portfolio weights will shift away from securities that have increased in relative value whenever the portfolio is rebalanced. C is incorrect because fundamental weighting leads to a value tilt because the ratios of book value, earnings, dividends, etc., to market value of the firms in a fundamental index tend to be larger than those of the firms in its market-capitalization-weighted counterpart.

James Beach is young and has substantial wealth. A significant proportion of his stock portfolio consists of emerging market stocks that offer relatively high expected returns at the cost of relatively high risk. Beach believes that investment in emerging market stocks is appropriate for him given his ability and willingness to take risk. Which of the following labels most appropriately describes Beach? Hedger. Investor. Information-motivated trader.

B is correct. Beach is an investor. He is simply investing in risky assets consistent with his level of risk aversion. Beach is not hedging any existing risk or using information to identify and trade mispriced securities. Therefore, he is not a hedger or an information-motivated trader.

A German company that exports machinery is expecting to receive $10 million in three months. The firm converts all its foreign currency receipts into euros. The chief financial officer of the company wishes to lock in a minimum fixed rate for converting the $10 million to euro but also wants to keep the flexibility to use the future spot rate if it is favorable. What hedging transaction is most likely to achieve this objective? Selling dollars forward. Buying put options on the dollar. Selling futures contracts on dollars.

B is correct. Buying a put option on the dollar will ensure a minimum exchange rate but does not have to be exercised if the exchange rate moves in a favorable direction. Forward and futures contracts would lock in a fixed rate but would not allow for the possibility to profit in case the value of the dollar three months later in the spot market turns out to be greater than the value in the forward or futures contract.

A unique feature of hedge fund indexes is that they: are frequently equal weighted. are determined by the constituents of the index. reflect the value of private rather than public investments.

B is correct. Hedge funds are not required to report their performance to any party other than their investors. Therefore, each hedge fund decides to which database(s) it will report its performance. Thus, for a hedge fund index, constituents determine the index rather than index providers determining the constituents.

If markets are semi-strong efficient, standard fundamental analysis will yield abnormal trading profits that are: negative. equal to zero. positive.

B is correct. If all public information should already be reflected in the market price, then the abnormal trading profit will be equal to zero when fundamental analysis is used.

If securities markets are semi-strong-form efficient, the most appropriate role of a portfolio manager is to: invest by analyzing publicly available information to consistently generate abnormal returns. manage portfolios with appropriate diversification and asset allocation, taking into consideration investor preferences. exploit appropriate trading rules and serial correlations for achieving excess returns.

B is correct. If markets are semi-strong-form efficient (which also encompasses weak-form efficiency), the role of a portfolio manager is not necessarily to beat the market, but rather to establish and manage a portfolio consistent with the portfolio's objectives, with appropriate diversification and asset allocation, while taking into consideration the risk preferences and tax situation of the investor. A is incorrect because the semi-strong-form efficiency assumes that prices reflect all publicly known and available information, and therefore efforts to analyze publicly available information is futile. C is incorrect because exploiting trading rules and serial correlations would not be feasible if markets are weak-form efficient, leave alone semi-strong-form efficiency.

An investor writes a put option on FTSE 100 Index futures. Which of the following best describes the investor's position with respect to the put contract and her exposure to the underlying index future, respectively? Long, short Short, long Short, short

B is correct. The investor has written a put contract, which means she is short the option. She, therefore, must satisfy the obligation to purchase the asset if requested to do so by the put owner. The investor has a long exposure to the risk of the underlying index future because she benefits when its quoted price increases—that is, when the put declines in value (or suffers a loss when its quoted price decreases as the put increases in value). A is incorrect because the investor has a short position in the put contract, not a long position, because she suffers a loss when the quoted price of the contract increases. The investor has a long exposure to the underlying index future, not a short position, because she benefits when its quoted price increases (or suffers a loss when its quoted price decreases). C is incorrect because the investor has a long exposure to the underlying index future, not a short position, because she benefits when its quoted price increases (or suffers a loss when its quoted price decreases).

An informed trader buys a company's stock. His close friends, who lack information or expertise, imitate his action and buy the stock. Which of the following statements concerning this behavioral bias is most accurate? It: is identical to representativeness. improves market efficiency. is inconsistent with rational behavior.

B is correct. This behavioral bias is an example of an information cascade wherein the transmission of information is from those participants who act first and whose decisions influence the decisions of others. The behavior of informed traders acting first and uninformed traders imitating the informed traders is consistent with rationality. The imitation trading by the uninformed traders helps the market incorporate relevant information and improves market efficiency. A is incorrect because representativeness is a behavioral bias wherein investors assess probabilities of outcomes depending on how similar they are to the current state. C is incorrect because the behavior of informed traders acting first and uninformed traders imitating the informed traders is consistent with rationality.

Which of the following market anomalies is inconsistent with weak-form market efficiency? Earnings surprise. Momentum pattern. Closed-end fund discount.

B is correct. Trading based on historical momentum indicates that price patterns exist and can be exploited by using historical price information. A momentum trading strategy that produces abnormal returns contradicts the weak form of the efficient market hypothesis, which states that investors cannot earn abnormal returns on the basis of past trends in prices.

In the semi-strong-form of market efficiency, fundamental analysis most likely requires the analyst to: extrapolate historical data to estimate future values and make investment decisions. use trading rules for detecting the price movements that lead to new equilibrium prices. do a superior job of estimating the relevant variables and predicting earnings surprises.

C is correct. Fundamental analysis facilitates a semi-strong-form efficient market by disseminating value-relevant information. Fundamental analysis can be profitable in terms of generating abnormal returns if the analyst creates a comparative advantage with respect to this information. Such an advantage can be achieved by doing a superior job of estimating the relevant variables and predicting earnings surprises. A is incorrect because simply extrapolating historical data may not produce superior returns in an efficient market. B is incorrect because the use of technical rules for detecting the price movements and gradual price adjustments comprises technical analysis, not fundamental analysis.

Fundamental analysts assume that markets are: weak-form inefficient. semi-strong-form efficient. semi-strong-form inefficient.

C is correct. Fundamental analysts use publicly available information to estimate a security's intrinsic value to determine if the security is mispriced, which is inconsistent with the semi-strong form of market efficiency. Semi-strong-form market efficiency states that investors cannot earn abnormal returns by trading based on publicly available information.

With respect to efficient markets, a company whose share price reacts gradually to the public release of its annual report most likely indicates that the market where the company trades is: semi-strong-form efficient. subject to behavioral biases. receiving additional information about the company.

C is correct. If markets are efficient, the information from the annual report is reflected in the stock prices; therefore, the gradual changes must be from the release of additional information.

If a market is weak-form efficient but semi-strong-form inefficient, then which of the following types of portfolio management is most likely to produce abnormal returns? Passive portfolio management. Active portfolio management based on technical analysis. Active portfolio management based on fundamental analysis.

C is correct. If markets are not semi-strong-form efficient, then fundamental analysts are able to use publicly available information to estimate a security's intrinsic value and identify misvalued securities. Technical analysis is not able to earn abnormal returns if markets are weak-form efficient. Passive portfolio managers outperform fundamental analysis if markets are semi-strong-form efficient.

Rebalancing an index is the process of periodically adjusting the constituent: securities' weights to optimize investment performance. securities to maintain consistency with the target market. securities' weights to maintain consistency with the index's weighting method.

C is correct. Rebalancing refers to adjusting the weights of constituent securities in an index to maintain consistency with the index's weighting method.

Reconstitution of a security market index reduces: portfolio turnover. the need for rebalancing. the likelihood that the index includes securities that are not representative of the target market.

C is correct. Reconstitution is the process by which index providers review the constituent securities, re-apply the initial criteria for inclusion in the index, and select which securities to retain, remove, or add. Constituent securities that no longer meet the criteria are replaced with securities that do. Thus, reconstitution reduces the likelihood that the index includes securities that are not representative of the target market.