Module 8 Quiz

Which of the following would cause the risk premium an investor expects to earn on a stock to increase when using the capital asset pricing model (CAPM)? A) An increase in beta B) An increase in the correlation coefficient C) An increase in standard deviation D) A decrease in covariance

The answer is an increase in beta. All other factors remaining equal, an increase in beta will cause the risk premium to increase. In addition, the resultant expected rate of return will increase. LO 8.2.1

All of the following affect an investor's risk tolerance except A) tax bracket. B) family situation. C) years of experience with investing in the markets. D) investment time horizon.

The answer is tax bracket. Tax concerns play an important role in investment planning; however, these constitute an investment constraint, not an investment objective (i.e., risk tolerance). LO 8.4.1

All of the following are primary factors in the arbitrage pricing theory (APT) except A) changes in GDP. B) unemployment rate. C) interest rates. D) inflation rate.

The answer is unemployment rate. These factors might include inflation, growth in GDP, major political upheavals, or changes in interest rates. LO 8.3.2

Mike, a stock analyst, has determined several factors affecting the expected return on a stock. In addition, he has estimated their sensitivity coefficients and associated risk premiums. Factor Sensitivity Coefficient Risk Premium Unemployment 0.7 6% Inflation 0.8 4% Demand 1.2 5% Assuming the current risk-free rate of return is 3%, calculate the expected return of the stock using the arbitrage pricing theory (APT). A) 13.40% B) 12.20% C) 18.00% D) 16.40%

The answer is 16.40%. The stock has an expected return of 16.40%, calculated as follows: using APT, ri = 0.03 + (0.7 × 0.06) + (0.8 × 0.04) + (1.2 × 0.05) = 0.1640, or 16.40%. LO 8.2.1

Calculate the expected rate of return for a stock with a beta of 2.0 when the risk-free rate is 6% and the return on the market is 12%. A) 12% B) 10% C) 18% D) 24%

The answer is 18%. Using the capital asset pricing model (CAPM), the expected rate of return is 18% [6% + (12% - 6%)2.0]. LO 8.2.1

Which of the following statements concerning the purpose of an investment policy statement is CORRECT? An investment policy statement is a written document that establishes client objectives and sets limitations on the investment manager. The investment policy statement can be used as the basis to measure the manager's performance against the stated objectives and constraints. Possible investment strategies that should be pursued by an investment adviser on behalf of the client begin with the formulation of a complete and thorough investment policy statement. An allocation among asset classes and their respective weights is a part of any investment policy statement. A) II and IV B) I, III, and IV C) I and III D) I, II, III, and IV

The answer is I, II, III, and IV. All of these statements are correct. In addition, the investment policy statement can be provided to the portfolio manager to use in establishing and managing the characteristics of the client's portfolio. LO 8.4.1

Indifference curves, which represent the risk-reward trade-off that the investor is willing to make, will cross the efficient frontier in two locations. lie tangent to the efficient frontier. will not intersect the efficient frontier. A) I and II B) I, II, and III C) II and III D) I only

The answer is I, II, and III. The portfolio that lies at the point of tangency of an indifference curve and the efficient frontier is the optimal portfolio for the investor. LO 8.1.1

Select the CORRECT statements concerning the analysis of portfolio risk. Investors estimate the risk of a portfolio on the basis of the variability of returns. Markowitz used risk and expected return as the basis for determining efficient combinations of assets. For a given level of risk, investors prefer lower returns to higher returns. Investors base decisions solely on expected return and risk. A) I only B) I, II, and IV C) II, III, and IV D) II and III

The answer is I, II, and IV. Only statement III is incorrect. For a given level of risk, investors prefer higher returns to lower returns. LO 8.1.1

Which of the following statements regarding the efficient market hypothesis (EMH) is CORRECT? The EMH suggests that active management should be used. Under the EMH, all publicly known information is incorporated into security A) I only B) II only C) Both I and II D) Neither I nor II

The answer is II only. The EMH suggests that passive, not active, management should be used. LO 8.3.2

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

The answer is 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. LO 8.3.1

The current risk-free rate of return is 4%, and the market risk premium is 5%. One stock under consideration for investment has a beta of 1.3. Calculate the expected rate of return for both the market portfolio and the individual stock. A) Market = 9.00%; Stock = 10.50% B) Market = 11.70%; Stock = 10.50% C) Market = 10.50%; Stock = 9.00% D) Market = 6.92%; Stock = 11.70%

The answer is Market = 9.00%; Stock = 10.50%. The expected rate of return for the market portfolio is 9%, calculated as follows: Using the capital asset pricing model (CAPM), rp = 4% + (5% × 1.0). The market has a beta of 1.0 and the market risk premium, rather than the market return, is given. The expected rate of return for the stock is 10.50%, calculated as follows: Using CAPM, ri = 4% + (5% × 1.3) = 10.50%. LO 8.2.1

Which statement regarding the concepts of modern portfolio theory (MPT) is NOT correct? A) An infinite number of portfolios exist on the efficient frontier. B) For any given level of risk, investors prefer higher returns to lower returns. C) Indifference curves represent the risk-reward trade-off that investors are willing to make. D) Markowitz used risk (as measured by beta) and expected return as the basis for determining appropriate assets or portfolios.

The answer is Markowitz used risk (as measured by beta) and expected return as the basis for determining appropriate assets or portfolios. Harry Markowitz's theory uses standard deviation as a measure of portfolio risk. LO 8.1.1

A firm declares a $3.00 cash dividend to its shareholders. The firm has issued dividends of only $0.07 per share for each of the last 15 quarters, and market analysts anticipate a similar dividend this quarter. In an efficient market, one would expect A) a price decrease after the announcement. B) no price change before or after the announcement. C) a price change upon the announcement. D) a price increase before the announcement.

The answer is a price change upon the announcement. In an efficient market, the price of the stock will represent all public information. Because the increase in the dividend was not public knowledge until it was declared, no price change would take place before the announcement. A price change, representing the increase in dividends, would be expected immediately after the information became public. LO 8.3.2

Which of the following statements regarding asset allocation is CORRECT? Asset allocation is the main determinant of a portfolio's total return. The purpose of strategic asset allocation is to determine an appropriate allocation based on the long-term financial goals of the client. A) I only B) II only C) Both I and II D) Neither I nor II

The answer is both I and II. Both of these statements are correct. LO 8.5.2

Identify which of the following statements regarding the risk premiums associated with the capital asset pricing model (CAPM) are CORRECT. The stock risk premium is the inducement necessary to entice the individual to invest in a given stock. The market risk premium is the incentive required for the individual to invest in the securities market. A) I only B) Both I and II C) Neither I nor II D) II only

The answer is both I and II. Statements I and II are both correct. The stock risk premium is the inducement necessary to entice the individual to invest in a particular stock, whereas the market risk premium is the incentive required for the individual to invest in the securities market in general. LO 8.2.1

The semistrong form of the efficient market hypothesis states that current market prices reflect all available information on the history of prices. all publicly available information concerning a company. A) I only B) II only C) Both I and II D) Neither I nor II

The answer is both I and II. The semistrong form states that all publicly available information, including past stock price history, is reflected in current stock prices. LO 8.3.1

After suffering an unexpected job loss and losing a $125,000 annual salary, your client, Joe, comes to you to review his asset allocation. In addition to possibly having a prolonged unemployment period, Joe, age 62, would like to retire within eight years. He is concerned about the allocation of the Section 401(k) plan at his prior employer which is 100% invested in an S&P 500 Index fund. The balance of the account is $2,500,000. Based on this information, what should you do next? A) Discuss Joe's risk tolerance and make appropriate changes to his plan's asset allocation. B) Recommend Joe apply for early Social Security benefits to provide him with income during his job search. C) Have Joe complete any necessary paperwork to transfer his 401(k) plan assets to an IRA. D) Tell Joe to focus on finding a job and not be concerned with his asset allocation.

The answer is discuss Joe's risk tolerance and make appropriate changes to his plan's asset allocation. With retirement looming on the horizon, Joe should consider reducing the risk exposure in his retirement plan. Moving the 401(k) to an IRA could be a consideration, but this should not be an immediate planning recommendation. Recommending he take early Social Security benefits may not be prudent due to tax issues and locking in a lower monthly benefit for life. LO 8.6.1

Which of the following statements about the importance of risk and return in the investment objective is least accurate? A) Expressing investment goals in terms of risk is more appropriate than expressing goals in terms of return. B) The return objective may be stated in dollar amounts even if the risk objective is stated in percentages. C) The investor's risk tolerance is likely to determine what level of return will be feasible. D) The return and risk objectives have to be consistent with reasonable capital market expectations, as well as the client constraints.

The answer is expressing investment goals in terms of risk is more appropriate than expressing goals in terms of return. Expressing investment goals in terms of risk is not more appropriate than expressing goals in terms of return. The investment objectives should be stated in terms of both risk and return. Risk tolerance will likely help determine what level of expected return is feasible. LO 8.5.1

All of the following statements concerning market efficiency are correct 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 securities 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 and private information.

The answer is investors usually react slowly to new and random information pertaining to securities markets. Another condition that guarantees an efficient market is investors reacting quickly to new information. LO 8.3.1

All of the following illustrate a characteristic of a Monte Carlo simulation except A) the user gets a best-case scenario and a worst-case scenario. B) the simulation provides insight into the range of outcomes. C) large changes in the projected rate of return will make small differences in the outcome. D) a clearer understanding of short-term and long-term risk can be gained.

The answer is large changes in the projected rate of return will make small differences in the outcome. Small changes in the projected rate of return will make large differences in the outcome. LO 8.4.1

Your client is concerned that the stock market is overvalued and may experience a large market correction within the next year. The client is 45 years old, has significant retirement savings, little debt, and no dependents. The current retirement portfolio mix is 80% stock/20% fixed-income. What is the best course of action for your client to take regarding this concern? A) Maintain a long-term perspective and consider keeping the current portfolio allocation. B) Reallocate the retirement plan proceeds into a conservative target asset allocation portfolio focused on U.S. Treasuries. C) Liquidate the retirement portfolio and reposition the proceeds into cash. D) Reposition all stock investments into fixed-income investments.

The answer is maintain a long-term perspective and consider keeping the current portfolio allocation. When confronted with financial or economic crisis events, the best course of action is for clients to keep a long-term perspective and focus on long time horizons rather than reacting negatively to market events. LO 8.6.1

Which of the following statements regarding the arbitrage pricing theory (APT) is CORRECT? A) Beta is a pricing factor. B) The risk-free rate of return does not affect the return. C) Inflation is not a pricing factor. D) Multiple factors affect the return of a security.

The answer is multiple factors affect the return of a security. The APT determines returns based on multiple factors. These factors might include inflation, growth in GDP, major political upheavals, or changes in interest rates. LO 8.2.1

Which of the following statements regarding the capital market line (CML) is CORRECT? A) Provides a direct relationship between the risk and return for a well-diversified portfolio B) Describes the required return of individual stocks C) Is not useful for diversified portfolios D) Uses beta as a risk measure

The answer is provides a direct relationship between the risk and return for a well-diversified portfolio. The capital market line (CML) graphically depicts the relationship of risk and return for efficient well-diversified portfolios. The CML uses standard deviation as a risk measure. LO 8.2.1

Which of the following is NOT likely to be an advantage of a valid investment policy statement? A) Provides for short-term strategy shifts in response to short-term dramatic value declines B) Allows for a continual dynamic process in meeting investor objectives C) Promotes long-term discipline in investment decisions D) Identifies and documents investment objectives and constraints

The answer is provides for short-term strategy shifts in response to short-term dramatic value declines. The investment policy statement does not provide for shifts in strategy due to short-term value declines. LO 8.4.1

Identify the efficient market hypothesis that suggests an investor can achieve above-market returns by only utilizing insider information. A) All of these forms B) Strong C) Weak D) Semistrong

The answer is semistrong. The semistrong form suggests that fundamental analysis is of no value and only through the use of insider information can an investor achieve above-market returns. LO 8.3.1

Your client has established a balanced portfolio with various amounts allocated to different asset classes, and periodically she rebalances the portfolio to keep the same approximate percentages in these asset classes. Her approach is A) tactical asset allocation. B) dynamic asset allocation. C) strategic asset allocation. D) core-satellite asset allocation.

The answer is strategic asset allocation. Strategic asset allocation involves re-balancing back to the original allocation and adjusting the allocation based on changing client circumstances. Tactical asset allocation involves choosing various sectors that you believe will do best, and changing as you believe is necessary. Dynamic asset allocation changes the allocation amounts as the market changes, typically used by institutional investors. Core-satellite asset allocation is a combination of strategic and tactical. LO 8.5.2

An investor who reallocates her portfolio frequently to take advantage of perceived opportunities in other market sectors is using which one of the following types of asset allocation? A) Tactical B) Strategic C) Dynamic D) Passive

The answer is tactical. Reallocating a portfolio frequently to take advantage of perceived under- or overvaluations in a particular market is tactical asset allocation, which is akin to market timing. Strategic asset allocation involves determining the best risk/return portfolio for an investor and then rebalancing to that optimum mix when percentages change due to market movements. The dynamic strategy is used by institutions, and involves increasing risky assets as the portfolio value rises, and decreasing risky assets as the portfolio value declines. LO 8.5.2

In a financial market A) that is efficient, new information will be slowly reflected in securities prices. B) investors who do not believe in the efficient market hypothesis (EMH) will stop seeking undervalued securities. C) investors will take an active investment strategy if they are strong believers in the efficient market hypothesis (EMH). D) that is efficient, the prices of securities will not differ from their justified economic values for any length of time.

The answer is that is efficient, the prices of securities will not differ from their justified economic values for any length of time. An efficient market is a market that quickly reflects all new information. Accordingly, security prices will not depart from their justified economic value for any extended period. Investors who are strong subscribers to the EMH will be passive investors. On the other hand, investors who do not believe in the EMH will become active investors and will seek to identify undervalued securities. LO 8.3.1

All of the following statements correctly explain the core and satellite approach to investing except A) the core portion of the portfolio uses an active investment philosophy to achieve above-market returns. B) core investments may include U.S. stocks, U.S. fixed-income, and developed international equities. C) one goal of this strategy is to reduce portfolio risk through diversification. D) the core and satellite investment strategy has the client invest in both broad market indexes (core) and higher-risk alternatives (satellite). Explanation

The answer is the core portion of the portfolio uses an active investment philosophy to achieve above-market returns. The core portion of the portfolio uses a passive investment philosophy to achieve market-based returns, while the satellite portion of the portfolio uses active investment management in an attempt to achieve above-market level returns. LO 8.5.2

Which of these best describes the concept of asset allocation? A) Dividends being automatically invested back into the investment from which they were earned B) The process of apportioning assets available for investment among various investment classes C) A written document that sets forth a client's investment objectives and limitations on the investment manager D) The process of purchasing securities over time by investing a predetermined amount at regular intervals

The answer is the process of apportioning assets available for investment among various investment classes. Asset allocation is the main determinant of a portfolio's total return. Historically, these investment classes have consisted of cash and cash equivalents, equities (stock), and debt (bonds). However, recently (and more properly), the potential investment classes have been broadened to also include real estate, international investments, collectibles, and precious metals. LO 8.5.2