QBank Quiz - Module 6

A stock fund had these yearly returns: 20X5 14% 20X6 7% 20X7 -3% 20X8 18% 20X9 9% What is the standard deviation of the returns? A) 8.43 B) 7.97 C) 7.13 D) 6.04

Calculation as follows for the TI BA II+: Step 1: press "2nd" then "7". This activates the data screen. Step 2: press "2nd" then "CE/C" to clear all your existing work. Step 3: enter the first return "14" into the first "X01" screen and press enter. Step 4: hit the down arrow button "↓" and scroll past "Y01" and hit "↓" one more time until you get to "X02". Step 5: input the next return value which would be "7" and hit enter. Follow this process until you input all 5 values. Step 6: press "2nd" then "8" which is the "STAT" screen. Step 7: press "2nd" then "enter" which is the "SET" screen. Keep hitting the "2nd" and "enter" button until you see "1-V". Step 8: press "↓" to scroll through the calculated statistics. You will hit the "↓" button 3 times before you reach the standard deviation screen which will start with "Sx" and should equal "7.97". LO 6.2.2

Taylor, a personal friend of yours, has been a practicing veterinarian for eight years. She is 35 years old and has a 3-year-old daughter. Taylor has a moderate risk tolerance, wants to save for retirement, and is considering increasing her investment in the following mutual fund. Taylor has asked you for your recommendation. Risk-free return 7.0% Return of market 12.5% Growth and Income Fund NAV (beginning of year)$53.00 NAV (end of year)$52.75 Dividend$3.25 Capital gains distributed$2.75 Beta0.70 Realized return10.85% Which of the following is CORRECT regarding the risk and return of the fund? A) The fund has greater risk and less return than the market. B) The fund has less risk and less return than the market. C) The fund has equal risk and greater return than the market. D) The fund has less risk and greater return than the market.

Explanation A beta of 1 represents the risk of the market. A beta of less than 1 represents risk less than the market's risk, and a beta of greater than 1 represents risk greater than that of the market. LO 6.2.1

Which of the following is the most appropriate and accurate indicator for determining a client's risk tolerance level? A) There is no single appropriate method for determining risk tolerance. B) Beta C) Standard deviation D) Questionnaire

Explanation A client's risk tolerance level is an intangible and subjective factor. No single method accurately determines that risk level. LO 6.2.5

You want to recommend two mutual funds to a new client and have narrowed your selections to the following three funds. The expected returns and standard deviations of each fund are approximately equal. The correlations between the funds are as shown in the following table. Correlation of Returns Large-cap Fund Mid-cap Fund Small-cap Fund Large-cap fund +1.00 Mid-cap fund +0.67 +1.00 Small-cap fund +0.41 +0.23 +1.00 Which two funds should you recommend, assuming that your goal is to recommend the two funds that will provide the lowest total portfolio risk and that the portfolio will be equally weighted in the two funds you select? A) The large-cap fund and the mid-cap fund B) The mid-cap fund and the small-cap fund C) None, since no fund is negatively correlated with another fund D) The small-cap fund and the large-cap fund

Explanation A negative correlation is not necessary; low positive correlations are adequate to lower the standard deviation of a portfolio. The fund combination that should be selected, given the objective and the fact that all other factors are equal, is the combination with the lowest correlation—the mid-cap fund and the small-cap fund. LO 6.2.4

You are considering buying a stock that has a mean return of 14% and a standard deviation of 20. You can expect the return to fall within what range 95% of the time? A) -0.46 to 0.74 B) Cannot be determined from the information given C) -0.06 to 0.34 D) -0.26 to 0.54

Explanation A stock with a standard deviation of 20 will deviate from the mean by one standard deviation 68% of the time, two standard deviations 95% of the time, and three standard deviations 99% of the time. So for this stock, plus or minus 40 from the mean of 14% would be -26% and +54%. LO 6.2.2

Stock XYZ has an average return of 18% with a standard deviation of 21. Within what range could an investor expect a return to fall 68% of the time? A) 3% to 39% B) -3% to 39% C) 0% to 21% D) -3% to 18%

Explanation By definition, an investment's return will be within one standard deviation of the mean return 68% of the time. The mean return of 18% plus or minus one standard deviation is 18% - 21% (-3%) and 18% + 21% (39%). LO 6.2.2

Gordon, age 40, wants to invest in a mutual fund that will provide capital appreciation. He wants a fund that will do as well as the overall market and has a low expense ratio, but he does not want to assume a high risk to achieve his objective. He is considering purchasing one of the following mutual funds: Fund A: a growth mutual fund that has a beta of 1.10 and invests in medium- to high-grade common stock Fund B: an index mutual fund that has a beta of 1.00 and invests in common stock that mirrors the S&P 500 Index Which of these funds would best meet Gordon's objective? A) neither alternative is appropriate for his objective B) Fund A, because it invests in lower-risk stocks than Fund B C) Fund A, because it can be expected to outperform the market and has an acceptable level of risk D) Fund B, because it has a beta of 1.00, has low expenses, and is less risky

Explanation Fund B can be expected to do as well as the overall market, will have a low expense ratio, and is less risk, as measured by beta, than Fund A. LO 6.2.1

Mutual fund I has a standard deviation of 4% and an expected return of 10%. Mutual fund J has a standard deviation of 8% and an expected return of 13%. If I and J have a correlation coefficient of -1.0, which of the following statements is CORRECT? A) I and J are perfectly negatively correlated. B) J is less risky than I on a risk-adjusted basis. C) A portfolio combining funds I and J may have an expected return less than 10%. D) There is no combination of I and J such that the portfolio's standard deviation is zero.

Explanation J's coefficient of variation is 8% ÷ 13% = 0.615. I's coefficient of variation = 4% ÷ 10% = 0.40. I is less risky, on a risk-adjusted basis, than J. Because I and J are perfectly negatively correlated (correlation coefficient of -1.0), there exists a combination of I and J such that the standard deviation is zero. The expected return of a portfolio is the weighted average, which cannot be less than the lowest expected return of the portfolio components. LO 6.2.4

The Finite Mutual Fund has a correlation coefficient of 0.90 with the S&P 500 Index. How much of the price movement of the Finite Mutual Fund is explained by the S&P 500 Index? A) 81% B) 75% C) 90% D) 100%

Explanation R-squared gives us the amount of systematic risk, and we have been given R (correlation coefficient). So, we square 0.90 to come up with an R-squared of 0.81, or 81%. LO 6.2.5

Assume your client's portfolio contains these: $20,000 of Stock A with a beta of 0.90 $50,000 of Stock B with a beta of 1.20 $30,000 of stock C with a beta of 1.10 What is the beta coefficient for this portfolio? A) 1.00 B) 1.16 C) 1.05 D) 1.11

Explanation The answer is 1.11. Calculated as follows: 0.20 × 0.90 = 0.18 0.50 × 1.20 = 0.60 0.30 × 1.10 = 0.33 0.18 + 0.60 + 0.33 = 1.11 Using the HP 10bII+: 0.9, INPUT, 20,000, Σ+ 1.2, INPUT, 50,000, Σ+ 1.1, INPUT, 30,000, Σ+ SHIFT, 6 key (x̅w,b) = 1.11 LO 6.2.1

ABC Mutual Fund has a correlation coefficient of 0.93 with the S&P 500 Index. How much of the price movement of the fund can be explained by the S&P 500 Index? A) 93% B) 7% C) 86% D) 14%

Explanation The answer is 86%. The correlation coefficient (R) has been given, so it needs to be squared (R2) in order to come up with the coefficient of determination. (0.932 = 0.8649, or 86%) LO 6.2.5

ABC Corporation is a manufacturer of electronic devices used in the manufacturing of airplanes. Five years ago, the corporation floated a $100 million bond issue that would be used to finance improvements at its main manufacturing and distribution center. However, orders for its products have dropped dramatically due to much lower than anticipated demand. The company believes it may miss paying the coupon payment on the bond issue in the upcoming fiscal year. Which of these risks may the owners of ABC Corporation bonds be subject to by holding the bonds? A) Default risk B) Regulation risk C) Market risk D) Reinvestment rate risk

Explanation The answer is default risk. Default risk is the risk that a business will be unable to service its debt obligations. LO 6.1.2

Bobby has these securities in his portfolio: ABC common stock, XYZ common stock, PQR mutual fund (domestic small cap), DEZ mutual fund (foreign small cap), 30-year Treasury bond, and 5-year Treasury note. Point out the risk that should NOT concern Bobby. A) Reinvestment rate risk B) Systematic risk C) Financial risk D) Default risk

Explanation The answer is default risk. Treasuries are considered default risk-free. Financial risk is the uncertainty introduced from the method by which a firm finances its assets (i.e., debt versus equity financing). Reinvestment rate risk is the risk that as cash flows are received they will be reinvested at lower rates of return than the investment that generated the cash flows. Systematic risk is the risk that all securities are subject to and typically cannot be eliminated through diversification. LO 6.1.2

Andy owns a yen-denominated bond that matures in 15 years. Andy's bond is subject to which one of these combinations of systematic risk? A) Financial risk and purchasing power risk B) Exchange rate risk and reinvestment rate risk C) Interest rate risk and default risk D) Market risk and business risk

Explanation The answer is exchange rate risk and reinvestment rate risk. Because Andy owns a foreign investment, he would be subject to exchange rate risk. Also, coupon-paying bonds are subject to reinvestment rate risk. LO 6.1.2

Bill and Jane are considering adding additional assets to their investment portfolio. They consider themselves moderate-to-high-risk investors. Based on safety of principal, point out the investment that would offer the couple the least amount of protection from risk. A) Real estate B) Futures C) High-grade common stock D) Balanced mutual funds

Explanation The answer is futures. Based on the risk-return pyramid, futures will offer the couple the least amount of protection. However, due to their high risk, futures may offer the greatest amount of return. LO 6.1.1

Investors who want to bear the least amount of risk should acquire stocks with beta coefficients A) less than 1.0. B) greater than 1.0. C) greater than 1.5. D) less than 0.5.

Explanation The answer is less than 0.5. When seeking investments having the least amount of risk, the lowest beta should be selected. LO 6.2.1

Which of these is NOT an unsystematic risk? A) Liquidity risk B) Default risk C) Market risk D) Business risk

Explanation The answer is market risk. Unsystematic risk is the risk that affects only one company, country, or sector and its securities. Market risk is an example of a systematic risk. LO 6.1.2

A general risk component representing the variability of a stock's total return as it directly relates to overall movements in the general economy is known as A) financial risk. B) business risk. C) systematic risk. D) reinvestment rate risk.

Explanation The answer is systematic risk. Systematic risk, also referred to as market risk, is the variability in a stock's total return that is directly associated with overall movements in the general economy and cannot be eliminated through diversification. LO 6.1.2

Exchange rate risk refers to fluctuations in A) the values of bonds and other debt instruments. B) the value of an investor's portfolio. C) the prices of stocks on the New York Stock Exchange. D) the price of one currency relative to other currencies.

Explanation The answer is the price of one currency relative to other currencies. Relative currency prices and changes to them are the basis of exchange rate risk. LO 6.1.2

If two stocks have positive covariance, which of these statements is CORRECT? A) The rates of return tend to move in the same direction relative to their individual means. B) If one stock doubles in price, the other will also double in price. C) The rates of return tend to move in the opposite direction relative to their individual means. D) The two stocks must be in the same industry.

Explanation The answer is the rates of return tend to move in the same direction relative to their individual means. If one stock doubles in price, the other will also double in price is true if the correlation coefficient = 1. The two stocks need not be in the same industry. LO 6.2.4