Kaplan 5 and 6 (Part 2)

An investor takes a long position in a commodity forward contract at a forward price of 105 when the spot price is 102. One month later the spot price has increased to 110. At that time, the forward price of the contract is:

105. The price of a forward contract is fixed at initiation. Its value may change during its life.

Using historical returns data, Joe Perkins estimates a beta of 1.3 for Wellness Company. Perkins should estimate the adjusted beta for Wellness as:

2/3 (1.3) + 1/3 = 1.2

Which of the following is least likely a short-term source of funds for a bank?

A banker's acceptance is a guarantee of payment, not a source of funds.

Analysts often use an adjusted beta for a stock, rather than its beta estimated from a regression of the stock's returns against market returns, because:

Adjusting a stock's historical beta is recommended because studies have shown that betas tend to move toward one over time.

A hedge fund investor is analyzing several funds' returns relative to risk, and believes the appropriate risk measure is a fund's largest decrease in value. This investor should compare the funds based on their:

Calmar ratios. The Calmar ratio uses maximum drawdown, the decline in a fund's value from peak to trough, as its risk measure. The Sortino ratio uses downside deviation and the Treynor ratio uses beta.

Which of the following statements about derivatives is most accurate about default swaps and the type of claims they are?

Credit default swaps are contingent claims because payment by the protection seller is dependent on a future credit event.

Which of the following industries most likely exhibits a low threat of entry and strong power of buyers?

Defense. The defense industry often exhibits economies of scale so that the large required capital investment is a barrier to entry that limits the threat of new entry. However, industry sales are limited to a small number of large buyers (i.e., national governments) that have significant bargaining power.

The creation and redemption of shares by authorized participants, which keeps the price of fund shares close to their net asset value, is a feature unique to which of the following types of pooled investments?

Exchange-traded funds. A unique feature of ETFs is that they will create shares when institutional investors deposit securities that are included in the ETF basket and will redeem ETF shares for institutional investors. This is done to ensure an efficient and orderly market in the shares and to prevent the fund shares from trading at (much of) a premium or discount, thereby avoiding one of the pitfalls of closed-end funds.

Which of the following behavioral biases is a financial advisor most likely to be able to mitigate by educating the client?

Illusion of control. Cognitive errors can often be mitigated by educating clients, while emotional biases are more difficult to mitigate and may have to be accommodated. Illusion of control bias is considered a cognitive error, while loss aversion bias and status quo bias are considered emotional biases.

A company is considering whether to allocate capital to a new product line. They estimate the project will require an initial cash outflow of $3 million. If the new product succeeds, they foresee a profitable opportunity to expand the project in three years, which would require a $3 million cash outflow. In evaluating the opportunity to introduce the new product line, how should the company most appropriately consider the opportunity to expand the project in the future?

Include it and assign it a positive value. The company should give a positive value to the expansion option when estimating the NPV of the project. Just as with financial options, real options cannot have negative values because the company can choose not to exercise them.

For three otherwise identical bonds, which feature would result in the largest increase in value during a period of rising interest rate volatility?

Put feature. The price of a putable bond equals the price of an otherwise identical, yet non-putable, bond plus the price of the bond put option. The price of the bond put option increases when interest rate volatility increases. Therefore, the price of the putable bond will rise. The price of a callable bond equals the price of an otherwise identical, yet non-callable, bond minus the price of the bond call option. The price of the bond call option increases when interest rate volatility increases. Therefore, the price of the callable bond will fall.

A private equity firm considering a public company as a leveraged buyout candidate would be least likely to find which of the following target-firm characteristics attractive?

Strong profit growth. private equity investors want to come in and create the value and growth, not pay more for it if its already there

The price of an interest rate swap is equal to:

The par swap rate, or fixed rate specified in the contract, is the price of an interest rate swap.

A par bond yield curve is constructed from the yields of:

The par yield curve is constructed from the yields of hypothetical bonds at different maturities that would be trading at par given current spot rates.

For which of the following types of investment companies are shares least likely to trade at their net asset value?

Venture capital fund.

A 30-day forward rate agreement on 90-day LIBOR is most likely to be used by:

a borrower to lock in an interest rate on a loan it will take out in 30 days' time.

A bond for which the holder has a legal claim on specific financial assets as well as the overall assets of the issuing corporation is most appropriately termed:

a covered bond. "Covered bond" refers to a bond for which specific balance sheet assets are legally segregated as collateral for the bond and for which the bondholder also has a claim against the firm's overall assets in the event the segregated assets prove insufficient. "Asset-backed security" is backed by financial assets sold by a company to a special purpose entity (the issuer of the bond) for which the bondholder does not have a claim against the company that has sold the underlying financial assets to the SPE. "Secured bond" refers to any bond that has a priority claim to specific firm assets.

A structured financial security that combines a risk-free bond with a short position in a credit default swap is termed:

a credit-linked note.

A financial intermediary that offers to buy an asset at a bid price and to sell the same asset at an ask price is best described as:

a dealer. Dealers maintain an inventory of securities and profit from a bid-ask spread. Brokers locate counterparties for buyers and sellers.

Under hedge accounting rules for derivatives, an interest rate swap may be classified as:

a fair value hedge or a cash flow hedge. An issuer may account for a pay-fixed interest rate swap as a cash flow hedge if it converts a fixed-rate liability to a floating-rate liability. An issuer may account for a pay-floating interest rate swap as a fair value hedge if its purpose is to decrease the volatility in balance sheet values of a fixed-rate liability recognized at market value.

James Franklin, CFA, has high risk tolerance and seeks high returns. Based on capital market theory, Franklin would most appropriately hold:

a leveraged position in the market portfolio. According to capital market theory, all investors will choose a combination of the market portfolio and borrowing or lending at the risk-free rate; that is, a portfolio on the CML. An investor with high risk tolerance will choose a position in the market portfolio, partially funded by borrowing at the risk-free rate.

The covariance of monthly returns for two stocks is 0.91. Based on the covariance, it is most accurate to conclude that the monthly returns on these two stocks have:

a positive linear relationship. Covariance indicates the direction of the linear relationship (i.e., positive or negative) between two variables, but its magnitude does not directly indicate the strength of that relationship. If 0.91 was the correlation, rather than the covariance, it would indicate the monthly returns on these two stocks have a strong linear relationship.

Shares of Mitchell Company trade on an exchange. Mitchell wants to raise equity capital by issuing additional shares. An investment bank buys the new shares from Mitchell and sells them to interested buyers. This transaction is most accurately described as:

a secondary issue of shares. Underwritten offering: IB guarantees security sale Bet Efforts: IB acts as broker

Taking a private company public in the United States and at the same time raising capital for company growth would be best achieved through:

an IPO. In an IPO (initial public offering), typically shares are sold to raise equity for the company. With a SPAC (special acquisition company), a company is purchase by the SPAC. With a direct listing, existing shares are traded on an exchange but no additional shares are issued to raise capital.

For a corporate bond, it is most likely that a decrease in its bond rating will:

be preceded by a decrease in price.

The price of an existing fixed-for-floating interest rate swap will:

be unaffected by changes in the market reference rate after the swap is initiated. The price of a swap is the fixed rate which is set at initiation and will not change over the life of the swap. The value will change as the market reference rate changes.

Compared to long-only equity and fixed income investments, alternative investments typically have:

biased historical returns data.

Assuming that asset prices are semistrong-form efficient, the portfolio manager:

can add value by recommending an appropriate asset allocation. Even if asset prices are semistrong-form efficient so that neither fundamental nor technical analysis can add value, the portfolio manager can add value by matching the portfolio asset allocation to the client's needs and risk tolerance, based on capital market expectations.

For a profitable and rapidly growing firm, holders of preference shares are least likely to benefit from the firm's growth if the preference shares are:

cumulative. Preference shares are cumulative if any dividends in arrears must be paid before the firm pays any common dividends. A profitable and rapidly growing firm is unlikely to be in arrears on its preferred dividends. Participating preference shares may receive additional dividends if the firm's profits exceed a stated level. Convertible preference shares can benefit from the firm's growth because they may be converted to common shares.

The repo margin in a repurchase agreement refers to the:

difference between the purchase price and market price of the underlying bond.

When pricing European options with a binomial model, the expected payoff at expiration is discounted at an interest rate that:

does not include a risk premium. discounted at the risk free rate

Based on a questionnaire about investment risk, an advisor concludes that an investor's risk tolerance is high, but based on an analysis of the client's income needs and time horizon, he concludes the investor's risk tolerance is low. The most appropriate action for the advisor is to:

emphasize bonds over stocks. When determining an investor's risk tolerance, an advisor must consider both the investor's ability and willingness to bear risk. Even though the investor has a high willingness to bear risk, his ability to take risk (based on his financial situation) is low, and this should take precedence. A portfolio that emphasizes bonds over stocks has less investment risk and is the most appropriate choice.

One disadvantage of using NPV for capital allocation decisions is that it:

fails to consider the size of a project.

A similarity between interest rate swaps and credit default swaps is that both:

have payments based on a notional principal. The fixed payments in a credit default swap, and both the fixed and floating payments in an interest rate swap, are based on a notional principal amount. Credit default swaps are contingent claims because their payoffs depend on an event occurring. Credit default swaps typically do not have floating-rate payments and therefore do not require a market reference rate.

An annual-pay bond with a modified duration of 7.61 is priced with a yield-to-maturity of 7.5%. If an investor has an expected holding period for the bond of 8 years, an investment in this bond will have reinvestment risk that:

is less than its price risk. (Mac D > Horizon -> price risk more important because not getting everything paid back in horizon)

Over a recent period, an investment portfolio had a positive M-squared alpha but its Jensen's alpha was negative. A portfolio manager should conclude that the portfolio:

lies on a capital allocation line that has a slope greater than that of the capital market line. If a portfolio's M-squared alpha is positive, its Sharpe ratio, which equals the slope of the portfolio's capital allocation line, is greater than that of the market portfolio. Negative alpha means the portfolio returned less than its expected equilibrium return based on its systematic risk.

A portfolio manager and a client are developing an investment policy statement (IPS). The client works as an auditor for a public accounting firm that has a policy prohibiting its employees from investing in companies the firm audits. This restriction is most appropriately:

listed in the IPS as a constraint. (because legal constraint)

An investor who sells a stock short is most likely required to:

make dividend payments.

In conducting an industry analysis for a firm, an analyst would most likely put a higher valuation on a company, all other things equal, if the industry's:

market shares have been stable.

The covariance of rates of return on two securities is most accurately described as the correlation of the asset returns:

multiplied by the product of the assets' standard deviations of returns.

An analyst is most likely to use a free cash flow model to value an equity security of a firm that is:

not expected to pay a dividend in the near future. Free cash flow models may be used as an alternative to dividend discount models if a firm is not expected to pay dividends in the foreseeable future.

A risk averse investor is best described as an individual who:

prefers investments with less risk to those with more risk if they have the same expected return.

The least amount of detailed analysis of capital allocation projects is required for:

replacement projects that maintain the existing business.

A floating rate note with three years to maturity is valued at 101.34 percent of par. For this bond it is most likely that the:

required margin is less than the quoted margin. -The required margin is the percentage discount rate that would make the bond price equal to its par value. -The quoted margin is the percentage (of par) that the bond will pay. -Because this bond is trading at a premium, the required margin must be less than the quoted margin.

An analyst refers to a company that has high-yield debt on its balance sheet as being "top heavy." This company most likely has a high proportion of:

secured bank debt in its capital structure. (top heavy = secured debt)

Holders of a firm's senior debentures have priority of claims over holders of the same firm's:

senior subordinated debt. Senior debentures are senior unsecured debt. Unsecured debt has a lower priority of claims than secured debt, including debt secured by mortgages or liens. Subordinated debt classes, including senior subordinated debt, have a lower priority of claims and lower recovery rates than senior debentures.

A company is considering an acquisition of significant size in a new line of business. The acquisition is expected to increase the value of the firm's shares, but will require issuing debt that will increase the company's financial leverage. It is most likely that the acquisition will be opposed by:

suppliers of a key component of the company's existing products. (higher leverage higher operating risk which means supplier may lose business with company if things go bad)

Carlson, Inc., has two coupon bonds outstanding, one with two years remaining to maturity and one with eight years remaining to maturity. The price volatility of the two-year bond is greater than the price volatility of the eight-year bond. The most likely reason is that the:

term structure of yield volatility is downward sloping.

If put-call parity holds, a long asset position, combined with a long put option and short call option on the same asset with the same exercise price and expiration date, will have a payoff at the expiration date of the options equal to:

the exercise price of the options.

In securitization, the party that purchases the loans is least likely:

the servicer. Servicer -> Issuer, then Issuer sells to SPE

In capital market theory, the efficient frontier is:

the set of portfolios with the highest expected return for each possible level of portfolio risk.

The category of alternative investments most likely to produce current income as well as the potential for appreciation in value is:

timberland.

An analyst estimates the prices that would result from changes in yield to maturity for an option-free, 10-year coupon bond using the bond's modified duration. His price estimates will be:

too low for both an increase and decrease in YTM. Duration is a linear measure, but the relationship between bond price and yield is actually convex, causing the estimated price change to always be low if duration alone was used.

The primary difference between a fixed-for-floating interest rate swap and a series of forward rate agreements (FRAs) that is otherwise equivalent to the swap is that each FRA may have a different:

value at initiation. An interest rate swap is equivalent to a series of FRAs with the same fixed rate, reference rate, and notional principal. The series of FRAs would have values at initiation that sum to zero but their individual values at initiation may be positive or negative.

Capital market theory implies that all investors:

who hold risky assets will invest in the market portfolio.