Part 2

If the Consumer Price Index (CPI) is down but consumer demand is up, the economy is likely in which stage of the business cycle? A) Recovery to expansion B) Contraction to trough C) Peak to contraction D) Recovery to trough

A. As prices trend downward and consumer demand increases, the economy is moving from recovery to expansion. As demand continues to increase, assuming supply remains constant, upward pressure will be put on prices through the expansion to the peak. U8LO2

Credit risk is commonly referred to as A) default risk B) unsystematic risk C) interest rate risk D) business risk

A. Credit risk, also known as default risk, is the risk that a company may have financial issues that lead to default on its debt obligations, bankruptcy, or both. U11LO2

Liquidity ratios measure the solvency of a firm or the firm's ability to meet short-term financial obligations. Which of the following is a liquidity ratio? A) Current assets divided by current liabilities B) Dividend divided by earnings per share C) Gross profit divided by net sales D) Net income divided by average total equity

A. Current assets divided by current liabilities is the current ratio, a ratio that measures the liquidity of a firm. Gross profit divided by net sales is a profitability ratio that measures the gross profitability of the firm's business operations, not its liquidity. Net income divided by average total equity is the return on stockholders' equity, which measures the efficiency of common shareholders' investment or equity in the firm. Dividend amount divided by earnings per share is the dividend payout ratio which measures how much of a company's earnings are distributed to common stockholders. U10LO7

The Conference Board releases information about the economy on a monthly basis. Included are a number of different indicators. Economic indicators can be leading, lagging, or coincidental, which indicates the timing of their changes relative to how the economy as a whole changes. Which of the following is a coincident economic indicator? A) Industrial production B) Agricultural employment C) Machine tool orders D) Stock market prices as measured by the S&P 500

A. Industrial production is a coincident indicator. The stock indices and manufacturing orders are leading indicators; economists do not use agricultural employment as an indicator. U8LO3

The risk to bondholders that bonds may lose value during periods of increasing inflation is known as A) interest rate risk B) reinvestment risk C) marketability risk D) credit risk

A. Interest rate risk is the risk that as interest rates rise, bond prices fall. Periods of inflation are accompanied by rising interest rates. Another risk in this scenario, but not an answer choice, is purchasing power risk; each semiannual interest payment has less purchasing power due to inflation, and, of course, the purchasing power of the principal at maturity will be far less as well. U11LO1

Which of the following is the risk that diminishes through portfolio diversification? A) Unsystematic risk B) Purchasing power risk C) Interest rate risk D) Systematic risk

A. Unsystematic risk (diversifiable risk) is the risk that is eliminated when the investor builds a well-diversified portfolio. Interest rate risk and purchasing power risk are examples of systematic (nondiversifiable risk). U11LO2

Mr. and Mrs. Rose, advisory clients of yours, request a meeting with you to discuss the options available if they wish to deposit a lump sum to save for college tuition for their child. All of these would be factors to consider EXCEPT A) the Roses' salaries B) the expected inflation rate C) current college costs D) the age of the child Explanation When making a lump sum investment, salary is not a factor. The funds will have to come out of savings or investments. This is basically a present value computation. In order to project how much will be needed, we need to know what the current tuition is, the rate at which it is expected to inflate, and the number of years we have until the child starts college. That will give us the three components of present value: total amount needed, earnings rate, and length of investment. U10LO1

A. When making a lump sum investment, salary is not a factor. The funds will have to come out of savings or investments. This is basically a present value computation. In order to project how much will be needed, we need to know what the current tuition is, the rate at which it is expected to inflate, and the number of years we have until the child starts college. That will give us the three components of present value: total amount needed, earnings rate, and length of investment. U10LO1

Use the following chart to answer this question: STOCK50%30%10%0%BONDS50%70%90%100%High return39.4%37.2%34.3%32.7%Low return1.4%6.5%7.2%8.5%Ave. return15.8%16.2%15.5%15.2%Std. Dev.11.2510.7510.1510.34 Which portfolio mix would you recommend to a client who is most concerned about projected near-term volatility? A) 10%/90% B) 30%/70% C) 100%/0% D) 50%/50%

Although this might look complicated, this is very simple if you realize that standard deviation is the measure of volatility. So, just pick the allocation with the lowest standard deviation and that is the 10%/90% at 10.15. U10LO5

Lagging Indicator

Average duration of unemployment and average prime rate U8LO3

Beta is most frequently measured against which of the following? A) Nasdaq Composite Index B) S&P 500 C) S&P 100 D) Dow Jones Industrial Average

B. The index most commonly used to analyze the beta of an individual security or portfolio is the S&P 500. Companies (portfolios) with a beta of 1.0 would be expected to move in tandem with the market, while companies with a beta greater than 1.0 would be more volatile than the market as a whole. Companies with a beta less than 1.0 should show a rate of change less than that of the market as a whole. U10LO4

A corporation calls in a portion of its long-term debt at 101. This will have the effect of decreasing working capital increasing working capital decreasing net worth increasing net worth A) II and III B) I and III C) II and IV D) I and IV

B. Working capital is computed by subtracting current liabilities from current assets. Using a current asset, like cash, to call in the bonds, reduces those assets with no corresponding reduction to current liabilities. Whenever a bond is called at a premium, net worth is reduced by that premium. U10LO7

A bond's yield to maturity reflects its A) nominal return B) internal rate of return C) taxable equivalent return D) return based on annual interest as a percentage of current price

B. Yield to maturity reflects the internal rate of return on a bond. Internal rate of return (IRR) equates the cost of an investment to the cash flows produced by that investment. U10LO1

T or F Real estate and equities tend to rise when things are good?

Both real estate and equities tend to rise when things are good, not during recessions. U8LO3

ALFA Enterprises pays a quarterly dividend of $0.15 and has earnings per share of $2.40. Assuming that payout rate is continued, what is the dividend payout ratio? A) 6.25% B) 14.4% C) 25% D) 30%

C. 25% Earnings per share are typically calculated for a year. If the quarterly dividend rate of $0.15 is continued, that will be an annual payout of $0.60 ($0.15 × 4). So the annual dividend of $0.60 is divided by $2.40 to calculate what percentage of earnings is paid as a dividend; or rather, the dividend payout ratio (0.60 ÷ 2.40 = 25%). U10LO7

If an economist were to describe defensive issues, he would probably not include companies that produce A) food products B) tobacco products C) building materials D) clothing

C. Defensive issues are issues that are defensive against a downturn in the economy. Building materials are usually susceptible to downturns when the economy is bad. U8LO2

An investment adviser is meeting with an elderly client whose portfolio consists largely of fixed-income investments. Over the past several years, she has been losing purchasing power. As a result, it would be important to inform her of A) market risk B) opportunity risk C) inflation risk D) liquidity risk

C. Fixed-income investments are subject to purchasing power risk, also called, inflation risk. U11LO1

A retired woman whose sole income comes from a portfolio of investments with a fixed rate of return is most affected by A) bearish market conditions B) volatile interest rates C) high inflation D) high income taxes

C. Portfolios of fixed-income securities are most affected by inflation or rising prices. Rising prices or inflation is known as purchasing power risk. Because the portfolio has a fixed rate of return, interest rate changes will not affect the income received, but that income will have lost some of its purchasing power as a result of rising prices. Tax rates and market conditions would be of lesser importance to this investor. U11LO1

Which of the following statements regarding the economics of fixed-income securities are TRUE? Short-term interest rates are more volatile than long-term rates. Long-term interest rates are more volatile than short-term rates. Short-term bond prices react more than long-term bond prices given a change in interest rates. Long-term bond prices react more than short-term bond prices given a change in interest rates. A) II and III B) II and IV C) I and IV D) I and III

C. There are two separate issues in this question: the volatility of rates and the volatility of bond prices. Short-term rates are more volatile than long-term rates and move more quickly than long-term rates. Often the most volatile interest rate is the federal funds rate, which is an overnight rate of interest. Given a change in rates, long-term bond prices move more than short-term bond prices because of the compounding effect over a much longer period. U8LO4

To determine the amount of change in the GDP from 1 year to another, both years' GDP should be converted into A) international depositary receipts B) the current dollar price of gold bullion C) constant dollars D) the exchange value of the dollar, as compared with major foreign currencies

C. To compare GDP from 1 year to another, and thus to compare the amount of actual economic activity, economists use constant dollars to eliminate distortions caused by inflation. U8LO2

During the past 2 quarters, the GDP declined by 3%, unemployment rose by 0.7%, and the Consumer Price Index fell off by 1.3%; this economic condition is called A) inflation B) stagflation C) recession D) depression

C. Two consecutive quarters of economic decline is termed a recession. U8LO2

The common stock of companies within which industry sector would be most adversely affected by an increase in the general level of interest rates? A) The electronics industry B) The clothing industry C) The utilities industry D) The food industry

C. Utilities are generally very heavily funded with debt. If interest rates go up, their new debt will be at higher interest rates, causing lower earnings available for common stocks. U11LO1

You recently took a trip to Warsaw, Poland, and when you received your credit card statement, you noticed that your vodka purchase for 100 Polish Zlotys resulted in a $30 charge on your statement. Based on this exchange rate, each dollar was worth approximately A) $3.33 B) 3 Zlotys C) 3.33 Zlotys D) $.33

C. When making an investment (or a transaction) in a foreign currency, it is important to be able to translate that into the exchange rate for your home currency. To do so, we divide the purchase in the foreign currency by the charge in U.S. dollars. In this case, 100 Zlotys only cost us $30, so that makes each dollar worth 3.3 Zlotys. U11LO2

Operating Activity

Cash receipts are included in cash flow from operating activities, even when it is generated through investments such as interest or dividends. U9LO2

All the pundits are predicting bad times ahead—not only a recession but a period where prices actually fall (deflation). If they are right, the best place for your client would probably be A) gold B) real estate C) common stock D) U.S. Treasury securities

D. It is times like this that the flight to safety has investors commit their funds to U.S. government securities. Gold (and other commodities) tends to increase in price during inflationary, not deflationary, periods. Both real estate and equities tend to rise when things are good, not during recessions. U8LO3

There are several measures of central tendency used by investment analysts. Included would be all of the following EXCEPT A) mode B) mean C) median D) moving averages

D. Moving averages are used to smooth out the fluctuations in a stock price over a period of time. The other 3 are the most popular measures of central tendency. U10LO2

Although there may be some slight differences in methodology, when S&P or Moody's evaluate a security in order to assign a rating, they would be least likely to consider the issuer's A) liquidity ratio B) profitability ratio C) cash flow to debt ratio D) asset turnover ratio

D. The rate at which assets are turned over is not nearly as important to determining a rating as the other three. U10LO7

Your client has $10,000 to invest and expects to earn an after-tax return of 8% to send his daughter to college in 12 years. Which of the following items will help determine whether the investment is likely to satisfy the client's goal? A) Present value B) Consumer Price Index C) Client's marginal federal income tax bracket D) Expected cost of college

D. To determine whether the investment will satisfy the goal, the investment adviser representative needs to know the amount needed to pay for college. While the investment will be worth $25,181.70, this may not be enough to pay for even one year of college 12 years from now. U10LO1

T or F Gold and commodities tends to increase in price during deflation?

False Gold (and other commodities) tends to increase in price during inflationary U8LO3

Financial Risk

Financial risk concerns itself with financing, particularly debt, so it is related to credit risk. U11LO1

Profitability Ratios

Gross profit divided by net sales is a profitability ratio that measures the gross profitability of the firm's business operations, not its liquidity. U10LO7

Increases in which of the following indicators are regarded as predictors of the level of business activity? A) Corporate profits B) Building permits C) Personal incomes D) Levels of inventories

Increases in building permits are indicative of increased future business activity and therefore are considered a leading economic indicator. Increases in personal income reflect current, not future, activity and is therefore considered a coincident indicator. Increases in inventories indicate that goods are not being sold in anticipated quantities and functions as a disincentive to manufacturing. Buildup in inventories is a lagging economic indicator. Corporate profits are not included in the Conference Board's list of economic indicators. U8LO3

Inflation Risk

Inflation risk is the uncertainty that an investment's purchasing power will decrease due to the shrinking value of the currency. U11LO1

Investing Activity

Investing activities include transactions and events involving the purchase and sale of securities, land, buildings, equipment, and other assets not generally held for resale as a product of the business. U9LO2

Coincidental Indicator

Manufacturing and trade sales U8LO3

Market Risk

Market risk is the uncertainty that the market price of a stock will drop even when earnings are strong. Most stocks follow the "market" and this would appear to be no exception. U11LO1

Monetarist

Monetarists believe that the economy and inflation are best controlled through the management of the money supply rather than through fiscal policy stimulation. U8LO1

Operating Income Formula

Net Sales - COGS U9LO1

Real Rate of Return

Nominal rate less the inflation rate.

Gross Profit or Gross Margin

Operating Income / Net Sales U9LO1

Financing Activity

The proceeds from issuing securities (stocks or bonds) is a financing activity as is using funds to retire bonds and/or pay dividends. U9LO2

Leading Indicator

The stock indices and manufacturing orders are leading indicators; U8LO3

Leading Indicator

average weekly initial claims for unemployment insurance U8LO3