IFM Qualitative Study

Which of the following anomalies is an example of underreaction to an event or information? I. New-issue puzzle II. Earnings announcement puzzle III. Momentum effect IV. Reversal effect

II. and III.

Which of the following would not support the weak form of the efficient market hypothesis? A Stock prices behave more like a random walk. B Stock returns exhibit positive serial correlation. C Prior to the takeover announcement, there was a gradual increase in the target's stock price. At the time of the announcement, there was a one-time instantaneous price increase. After the announcement, there was no significant further price drift. D The top performing fund managers in one year only have a 50% chance to beat their reference index the following year. E (A), (B), (C), and (D) support the weak form of the efficient market hypothesis.

B Stock returns exhibit positive serial correlation.

Determine which of the following statements regarding private debt is FALSE: A Private debt is cheaper to issue than public debt. B The private debt market is larger than the public debt market. C The private debt market is more liquid than the public debt market. D A private placement is a bond issue that is sold privately to a small group of investors. E A revolving line of credit is a credit commitment for a specific time period up to some limit.

C The private debt market is more liquid than the public debt market.

Which of the following statements about the Fama-French-Carhart factor specification is FALSE? A Trading strategies based on market capitalization, book-to-market ratios, and momentum appear to have positive alphas. B A trading strategy that each year buys a portfolio of small stocks and finances this position by short selling a portfolio of big stocks has produced positive risk-adjusted returns historically. C A trading strategy that each year buys a portfolio of low book-to-market stocks and finances this position by short selling a portfolio of high book-to-market stocks has produced positive risk-adjusted returns historically. D A momentum strategy is constructed by longing the top 30% of stocks and shorting the bottom 30% and then holding the portfolio for a year. E All factor portfolios in the FFC model are self-financing.

C.

Investors actively try to follow each other's behavior and imitate each other's actions. Determine which of the following are explanations for this behavior: I. Investors desire intense risk-taking experiences. II. Investors believe others have superior information that they can take advantage of. III. Investors want to avoid the risk of underperforming their peers. IV. Professional fund managers may face reputational risk if their actions are far different from those of their peers.

II. III. and IV.

Determine which of following is an example of a behavioral bias that might cause the market portfolio not to be efficient. A Investors are attracted to large growth stocks that receive greater news coverage. B Investors are attracted to investments with skewed distributions that have a small probability of an extremely high payoff. C The true market portfolio may be efficient, but the proxy an investor uses to mimic the market portfolio may be inaccurate. D Investors are exposed to significant non-tradeable risks outside their portfolio, such as human capital. E Investors systematically ignore positive-NPV investment opportunities.

A Investors are attracted to large growth stocks that receive greater news coverage.

Determine which of the following statements about the option to delay is FALSE. A Regardless of whether we have the option of when to invest, it is optimal to invest as long as NPV is positive. B Given the option to wait, an investment that currently has a negative NPV can have a positive value. C The option to wait is most valuable when there is a great deal of uncertainty regarding what the value of the investment will be in the future. D It is always better to wait unless cost of waiting is greater than the value of waiting. E An option to delay adds value to an investment.

A Regardless of whether we have the option of when to invest, it is optimal to invest as long as NPV is positive.

Determine which of the following statements regarding the disposition effect impacting investor tax obligations is TRUE. A The disposition effect causes investor tax obligations to increase. B The disposition effect causes investor tax obligations to decrease. C The disposition has no effect on investor tax obligations. D The disposition effect increases tax obligations for losing stocks only. E The disposition effect decreases tax obligations for winning stocks only.

A The disposition effect causes investor tax obligations to increase.

Determine which of the following statements regarding multi-factor models is NOT true. A Trading strategies based on market capitalization, book-to-market ratios, and momentum appear to have zero alphas. B It is much easier to identify a collection of portfolios that captures systematic risk than just a single portfolio. C All factor portfolios in the Fama-French-Carhart factor specification are self-financing. D The first portfolio in the Fama-French-Carhart factor specification is a self-financing portfolio that consists of a long position in the market portfolio​ that is financed by a short position in the risk-free security. E A high-minus-low (HML) portfolio is constructed​ by taking a long position in firms with high book-to-market and taking a short position in firms with low book-to-market.

A Trading strategies based on market capitalization, book-to-market ratios, and momentum appear to have zero alphas.

Shareholders can gain by making negative-NPV investments or decisions that sufficiently increase the firm's risk. Which of the following best describes the agency cost above? A Asset substitution B Debt overhang C Cashing out D Managerial entrenchment E Asymmetric information

A Asset Substitution

Determine which of the following statements is TRUE. A Beta measures market risk whereas volatility measures firm-specific risk. B In a well-diversified portfolio, market risk accounts for a considerably greater proportion of total risk than firm-specific risk. C A portfolio's beta is the arithmetic average of all the betas for the individual stocks in the portfolio. D A stock's beta is the ratio of the covariance between the stock returns and the market returns to the standard deviation of market returns. E The average beta of a stock in the market is greater than 1.

B In a well-diversified portfolio, market risk accounts for a considerably greater proportion of total risk than firm-specific risk.

Determine which of the following scenarios does NOT cause the market portfolio to be inefficient. A A significant number of investors do not have rational expectations. B Sensation-seeking investors hold inefficient portfolios. C Investors keep the losers and sell the winners in their portfolio. D Investors do not seek to maximize the Sharpe ratio of their portfolio. E All of the above would cause the market portfolio to become inefficient.

B. Sensation-seeking investors hold inefficient portfolios.

Which of the following options is/are path-dependent? I. Asian option II. Barrier option III. Gap option IV. Compound option A I only B II only C I and II only D I, II, and III only

C I and II only

Assume the Black-Scholes framework applies. Determine which of the following statements about gap call options is FALSE. A If the strike price is equal to the trigger price, then increasing the trigger price reduces the option premium. B If the trigger price is fixed, then increasing the strike price reduces the option premium. C If the trigger price exceeds the strike price, it is possible to have negative payoffs. D If the trigger price is equal to the strike price, then the price of the gap option is the same as the price of an ordinary European call option. E Assuming the strike price is positive, there is a trigger price that will make the premium for a gap call equal to zero.

C If the trigger price exceeds the strike price, it is possible to have negative payoffs.

A binomial tree is used to model stock prices. As the number of periods in the tree increases, which distribution of stock price will the binomial tree approximate? A Uniform B Normal C Lognormal D Exponential E None of (A), (B), (C), and (D) are correct.

C Lognormal

Determine which of the following statements about Modigliani and Miller propositions in a perfect capital market is FALSE. A If investors would prefer an alternative capital structure to the one the firm has chosen, investors can borrow or lend on their own and achieve the same result. B As long as investors can borrow or lend at the same interest rate as the firm, homemade leverage is a perfect substitute for the use of leverage by the firm. C With perfect capital markets, because different choices of capital structure offer no benefit to investors, they do not affect the value of the firm. D A firm's WACC increases with the firm's market value debt-equity ratio. E With perfect capital markets, a firm's WACC is independent of its capital structure and is equal to its equity cost of capital if it is unlevered, which matches the cost of capital of its assets.

D A firm's WACC increases with the firm's market value debt-equity ratio.

Determine which of the following statements regarding multi-factor models is NOT true. A If we use multiple portfolios as factors, then together these factors will capture all systematic risk, with each factor captures different components of the systematic risk. B The model is also referred to as the Arbitrage Pricing Theory (APT). C A self-financing portfolio is any portfolio with portfolio weights that sum to zero. D A self-financing portfolio is constructed​ by going long some stocks, and going short other stocks with equal book value. E Multifactor models rely on the weaker condition that we can construct an efficient portfolio from a collection of well-diversified portfolios or factors.

D A self-financing portfolio is constructed​ by going long some stocks, and going short other stocks with equal book value.

Which of the following best describes the credibility principle? A A seller with private information is likely to sell you worse-than-average goods. B Managers will prefer to use retained earnings first, and will issue new equity only as a last resort. C Wasteful spending is more likely to happen when firms have high levels of cash flow in excess of what is needed. D Claims in one's self-interest are credible only if they are supported by actions that would be too costly to take if the claims were untrue. E When a seller has private information about the value of a good, buyers will discount the price they are willing to pay due to adverse selection.

D Claims in one's self-interest are credible only if they are supported by actions that would be too costly to take if the claims were untrue.

An insurance company is concerned about a catastrophe that may result in large losses for the company. The company decides to hedge the risk by selling a catastrophe bond. Which of the following strategy should the company use? A The company should sell a catastrophe bond with interest rate that is higher than the market interest rate. If large losses occur, the company will repay the principal. B The company should sell a catastrophe bond with interest rate that is lower than the market interest rate. If large losses occur, the company will repay the principal. C The company should sell a catastrophe bond with interest rate that is equal to the market interest rate. If large losses occur, the company will repay the principal. D The company should sell a catastrophe bond with interest rate that is higher than the market interest rate. If large losses occur, the company will not repay the principal. E The company should sell a catastrophe bond with interest rate that is lower than the market interest rate. If large losses occur, the company will not repay the principal.

D The company should sell a catastrophe bond with interest rate that is higher than the market interest rate. If large losses occur, the company will not repay the principal.

Determine which one of the following statements about raising capital is TRUE: A A private equity firm invests in publicly traded corporations. B A venture capital firm is a corporation. C Convertible notes held by angel investors are converted into equity at the price paid by new investors. D A major disadvantage of an initial public offering is that the equity holders of the corporation become more widely dispersed. E The lead underwriter of an initial public offering is generally the venture capital firm that has already provided funding to the firm. Solution

D.

The Fama-French-Carhart (FFC) factor specification is the most commonly used multi-factor model. Determine which of the following portfolios is NOT self-financing. A A portfolio consists of a long position in the market portfolio and a short position in the risk-free asset. B High-minus-low portfolio C Small-minus-big portfolio D Prior one-year momentum portfolio E All of the portfolios above are self-financing.

E All of the portfolios above are self-financing.

Determine which of the following strategies creates a ratio spread, assuming all options are European. A Buy a one-year call, and sell a three-year call with the same strike price. B Buy a one-year call, and sell a three-year call with a different strike price. C Buy a one-year call, and buy three one-year calls with a different strike price. D Buy a one-year call, and sell three one-year puts with a different strike price. E Buy a one-year call, and sell three one-year calls with a different strike price.

E Buy a one-year call, and sell three one-year calls with a different strike price.

A certain benefit is an optional benefit available with some variably annuity products that pays the beneficiary an additional amount when the policyholder/annuitant dies based on the increase in the account value over the original amount invested. Which of the following best describes such benefit? A Guaranteed minimum death benefit B Guaranteed minimum accumulation benefit C Guaranteed minimum withdrawal benefit D Guaranteed minimum income benefit E Earnings-enhanced death benefit

E Earnings-enhanced death benefit

Since the development of the CAPM model, it is not uncommon that practitioners use market capitalization, book-to-market ratio and past returns to form portfolios that have a positive alpha. Thus, the market portfolio may not be efficient, and therefore a stock's beta is not an adequate measure of systematic risk. Determine which of the following is NOT a reason why a market portfolio may not be efficient. A Alternative Risk Preferences B Non-Tradable Wealth C Proxy Error D Behavioral Biases E No portfolios are efficient

E No portfolios are efficient

Determine which of the following is NOT a reason why the market portfolio might not be efficient. A We cannot include most of the traded investment wealth in the economy in the market proxy because competitive price data is not available. B Some investors may be subject to systematic behavioral biases. C Some investors may be attracted to investments with skewed distributions that have a small probability of an extremely high payoff. D Some investors are exposed to other significant risks outside their portfolio that are not tradable, the most important of which is due to their human capital. E Some investors fail to diversify their portfolios adequately.

E Some investors fail to diversify their portfolios adequately.

Determine which of the following statements about catastrophe bonds is TRUE. A Bondholders receive repayment of principal and interest when a catastrophe occurs. B Holders of catastrophe bonds receive lower rates than market interest rates due to the risk of default. C If a catastrophe occurs, a special purpose vehicle will make a payment to bondholders. D Bondholders have a legal recourse to a company's assets when a catastrophe occurs. E The correct answer choice is not given by (A), (B), (C), or (D).v

E The correct answer choice is not given by (A), (B), (C), or (D).

An investor has long positions in a two-asset portfolio. During a market decline, the correlation between the two assets increases. If there is no change in the proportion of each asset held in the portfolio or the expected return and standard deviation of the individual assets, determine which of the following statements is true. A Both the expected return of the portfolio and the volatility of the portfolio increase. B The expected return of the portfolio decreases but the volatility of the portfolio increases. C The expected return of the portfolio increases but the volatility of the portfolio decreases. D The expected return of the portfolio remains the same but the volatility of the portfolio decreases. E The expected return of the portfolio remains the same but the volatility of the portfolio increases.

E The expected return of the portfolio remains the same but the volatility of the portfolio increases.

Determine which of the following statements regarding diversification in stock portfolios is FALSE. A The risk premium for a diversifiable risk is zero. B Investors are not compensated for holding diversifiable risk. C The risk premium of a security is not affected by its diversifiable risk. D Investors will not require a risk premium for holding diversifiable risk. E The risk premium of a security is determined by its total risk.

E The risk premium of a security is determined by its total risk.

A company uses derivatives to manage its financial risk. Determine in which of the following scenarios the company is MOST LIKELY to use a derivative security. A To comply with generally accepted accounting principles. B To minimize its tax deductions. C To hedge against the increase of an asset the company already owns. D To guarantee that an asset it will be purchasing can be bought at higher price. E To adequately fund a guarantee it has sold to its customers.

E To adequately fund a guarantee it has sold to its customers.

Determine which of the following is TRUE regarding semi-variance. A It satisfies translation invariance. B It satisfies positive homogeneity. C It satisfies subadditivity. D It satisfies monotonicity. E It does not satisfy all four characteristics of a coherent risk measure.

E.

Determine which of the following statements regarding coherent risk measure is FALSE. A Variance does not satisfy monotonicity. B Semi-variance does not satisfy translational invariance. C Value-at-Risk does not generally satisfy subadditivity. D Value-at-Risk is generally not coherent. E The conditional​ tail expectation is not coherent.

E.

Assume the Black-Scholes framework. Which of the following statements is/are true? I. The Sharpe ratio for an asset is the ratio of its risk premium to its volatility. II. The Sharpe ratio of a call option is equal to the Sharpe ratio of its underlying stock. III. The Sharpe ratio of a call option is equal to the Sharpe ratio of an otherwise equivalent put option.

I and II

Which of the following statements regarding Asian options is/are true? I. The value of a geometric average price Asian call option is always less than or equal to the value of an otherwise equivalent arithmetic average price Asian call option. II. As the number of averaging periods increases, the price of an average strike Asian call option increases. III.As the number of averaging periods increases, the price of an average price Asian call option increases.

I and II

Which of the following statements regarding market efficiency is/are TRUE? I. If an investor believes in all three forms of market efficiency, the investor is likely to prefer passive investment strategies over active investment strategies. II. If an investor does not believe in any of the three forms of market efficiency, the investor is likely to use more information to make decisions. III. If the stronger form of market efficiency is violated, then the weaker forms are also violated.

I and II

Which of the following behaviors may cause the market portfolio to be inefficient? I. Investors invest in stocks of companies that are in the same industry or are geographically close. II. Investors tend to hold on to investments that have lost value and sell investments that have increased in value III. Investors tend to buy stocks that have recently been in the news.

II. and III.

Which of the following should NOT be possible in a strong-form efficient market? I. An investor invests in stocks with high systematic risk and earns high returns from the investment. II. An investor selects four stocks and all four stocks earn abnormal profits over the next year. III. An investor consistently beats the market by using difficult to acquire or expensive information.

III.

Which of the following statement(s) is/are FALSE? I. The higher the firm's leverage, the more the firm can exploit the tax advantage of debt. II. The higher the firm's leverage, the lower the firm's net income. III. The higher the firm's leverage, the higher the firm's weighted average cost of capital.

III.

Momentum effect

asserts that there is a positive serial correlation in stock prices, meaning rising stock prices continue to rise and falling prices continue to fall, as investors underreact to new information.

New-Issue/IPO puzzle

is an example of overreaction to information. Overreaction to new issues pushes up stock prices initially. There is often a frenzy to buy stocks when a private company goes public because investors try to take advantage of an opportunity to earn big returns. However, within a few years, the returns fall below those of a comparable portfolio.

Earnings announcement puzzle

is an example of underreaction to information. A study was performed using data from 1972 to 2001 to analyze stock performance after unexpectedly good earnings and unexpectedly bad earnings were announced. The study showed that the 10% of stocks of companies with the best earnings earned approximately 1% more each month in the next six-month period than the 10% of the stocks of companies with the worst earnings. Evidently, the investors underreacted to the earnings announcement.

reversal effect

suggests a negative correlation in stock prices and that a mean reversion in stock prices is in effect as investors overreact to new information.