Series 65: Unit 20 Exam

A securities analyst reviewing a corporation's financial statements notes that the enterprise has total current assets of $10 million, inventory of $4 million, cash on hand of $2 million, total current liabilities of $8 million, and net income of $15 million. The company's acid test ratio is closest to A. 0.75 to 1.00. B. 1.00 to 1.00. C. 1.25 to 1.00. D. 1.50 to 1.00.

.75 to 1

An investment of $5,000 made 10 years ago is now worth $20,000. Using the Rule of 72, the approximate compounded annual rate of return is A. 25% B. 14.4% C. 40% D. 7.2%

14.4% This investment has quadrupled in 10 years. Using the Rule of 72, we know how to compute the rate of return when an investment doubles. This one has doubled every 5 years. Dividing 72 by 5 years gives us an approximate rate of 14.4%.

Over the past five years, a stock has had returns of +16%, +5%, -4%, +12% and +8%. The median of the returns is A. 9.0%. B. 8.2%. C. 7.4%. D. 8.0%.

8%

If yields should change by 75 basis points, which of the following bonds would have the greatest price change? A. ABC 4s 2040 B. GHI 4s 2030 C. JKL 4s 2025 D. DEF 4s 2035

ABC 4s 2040 When all coupons are the same, the bond with the longest maturity will have the longest duration and, therefore, will be subject to the greatest price fluctuations. Conversely, those with the shortest time until maturity (the 4s of 2026) will have the shortest duration and will be subject to the least amount of price fluctuation.

The measurement of a portfolio's actual or realized return in excess of (or deficient to) the expected return calculated by the capital asset pricing model (CAPM) is known as A. alpha. B. net present value (NPV). C. beta. D. internal rate of return (IRR).

Alpha

The terms mean, median, and mode are all measures of A. correlation coefficient B. central tendency C. standard deviation D. beta coefficient

Central tendency Central tendency is usually defined as the center or middle of a distribution. The three most common tools used are mean, median, and mode.

An analyst wishes to assess the value of a fixed-income security by taking the income payments scheduled to be received over a given future period and adjusting that for the time value of money. This analytical tool is known as A. duration. B. future value. C. yield to maturity. D. discounted cash flow.

Discounted cash flow

In a group of returns, the central value of observations arranged in order from lowest to highest is known as the A. range. B. median. C. mode. D. mean.

Median

Adam has a portfolio of bonds worth approximately $125,000. He is concerned that interest rates will increase in the near term. Which of the following would be the least desirable strategy for Adam? A. Sell bonds with lower coupons and buy those with higher coupons B. Sell bonds with a short duration and buy those with a longer duration C. Sell Treasury bonds and buy Treasury bills D. Sell long-term bonds and buy short-term bonds

Sell bonds with a short duration and buy those with a longer duration Prices of bonds decline when interest rates rise. An investor expecting an increase in interest rates should sell more volatile bonds and purchase less volatile bonds. Bonds with higher coupons and shorter durations are less price volatile than low coupon, long-term, and long duration bonds.

The discount rate that makes the NPV of all cash flows from a security equal to zero is A. the internal rate of return. B. the median return. C. the present value return. D. the cash flow adjusted return.

The internal rate of return

An investment adviser representative is looking for a suitable investment for a client. The IAR wishes to find something that will offer an attractive return commensurate with its systematic risk. The choices have been narrowed to Security C and Security L, and the selection will be based on alpha. C has a beta of 1.0 and earned 13% which equalled its expected return, while L has a beta of 0.8 and earned 10.1%. The alpha of Security L is A. +0.3 B. −0.3 C. +2.9 D. −2.9

−0.3 Alpha is obtained by comparing how a security actually performed to the performance one would have expected based on its beta. A beta of 1.0 is used to indicate the expected volatility of the overall market. Because Security C has a beta of 1.0, its 13% return matches that of the market. Furthermore, Security C has an alpha of zero because its actual return was the same as the expected return. With a beta of 0.8, one would expect Security L to produce a lower return, but how much lower? Its return should be 80% of the market or, in this case, 80% of 13%, which computes to 10.4%. However, its actual return fell short of that by 0.3%, giving it a negative alpha of 0.3. Had its actual return been 10.7%, it would have had a 0.3 positive alpha. Although this question doesn't ask it, based on the criteria given, the IAR would have selected Security C.

Which of the following correlations would represent two assets that tend to move in tandem with one another? A. +0.81 B. −0.68 C. +0.16 D. −0.11

+.81

An investment adviser representative is researching a security and notices that its beta is zero. Which of the following securities is probably the subject of that research? A. A 91-day U.S. Treasury bill B. A public utility stock C. A 5-year U.S. Treasury note D. An ETF tracing the index of gold stocks

A 91-day U.S. Treasury bill A beta of zero means an investment whose price is not generally affected by fluctuations in the stock market. One could say that makes them free of market risk. The traditional example of that is the 91-day T-bill. All of the other choices would typically have a low beta, but none would have a beta of zero.

Use the following chart to answer this question: Portfolio: ABCD High return 39.4% 37.2% 34.3% 32.7% Low return 1.4% −6.5% 7.2% −1.4% Mean return 15.8% 16.2% 15.5% 15.2% Std. dev. 11.55 11.75 10.05 10.44 Which portfolio mix would you recommend to a client who is most concerned about projected near term volatility? A. C B. A C. B D. D

C 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 Portfolio C at 10.05.

If a corporation has a dividend payout ratio of 70%, the undistributed earnings will A. increase retained earnings B. increase earnings per share C. increase capital surplus D. decrease book value

Increase retained earnings Retained earnings represent income that has not been paid out to shareholders.

A portfolio manager who is successful at market timing will A. increase the beta of the portfolio in advance of a declining market. B. have a portfolio beta less than the beta required by the client. C. increase the beta of the portfolio in advance of a rising market. D. decrease the beta of the portfolio in advance of a rising market.

Increase the beta of the portfolio in advance of a rising market

An investor is considering the purchase of some bonds to diversify his portfolio. If he should decide to purchase Treasury STRIPS instead of Treasury Bonds, his major risk would be A. reinvestment risk B. credit risk C. interest rate risk D. purchasing power risk

Interest rate risk Treasury STRIPS are zero-coupon bonds and, as such, have a longer duration than those paying semiannual interest. The longer the duration, the greater the interest rate risk. Because both are guaranteed by the U.S. government, there is no credit risk. Both have the same purchasing power risk, and there is no reinvestment risk with a zero-coupon bond.

The statistical measurement of the total risk of a security or portfolio is known as A. duration. B. beta. C. Sharpe ratio. D. standard deviation.

Standard deviation Standard deviation is the statistic that measures both systematic and unsystematic risk (total risk). An investment with a high standard deviation tends to have a higher level of risk than an investment with a low standard deviation. Beta is a measure of systematic risk, and duration is an indication of interest rate risk. The Sharpe ratio measures the risk-adjusted return.

Twelve years ago, an investor placed $2,500 into an account. The account is now worth $10,000. Using the Rule of 72, you can determine that the approximate annual return was A. 12%. B. 400%. C. 6%. D. 36%.

12% Under the Rule of 72, we can determine an earnings rate by dividing 72 by the number of years it takes for money to double. In this case, the money had quadrupled. That means it has doubled twice in 12 years or, every 6 years. Dividing 72 by 6 years results in an annual return of 12%.

Plymouth Standard's common stock has an average return of 12%; its returns fall within a range of -2% to +26% approximately 68% of the time. Which one of the following numbers is closest to the standard deviation of returns of Plymouth Standard's stock? A. 14% B. 28% C. 8% D. 19%

14% A standard deviation of 14% means an investor can expect a return on an investment to vary ±14 from the average return approximately 68% of the time. A return of +26% minus the 12% average return equals 14%. Likewise, the difference between the -2% return and the average of 12% is also 14%.

ABD Corporation's income statement reports net sales of $100 million; cost of goods sold, $60 million; administrative costs, $20 million; and interest on debt, $5 million. Based on this information, ABD's gross margin is A. 40% B. 35% C. 20% D. 15%

40% Gross margin, sometimes referred to as gross profit on the exam, is computed by subtracting the cost of goods sold (COGS) from the net sales (or revenues) and dividing the remainder by the net sales. In this case, the computation is $100 million minus $60 million, which equals $40 million, and then dividing that by the $100 million resulting in a gross margin (or margin of profit) of 40%. Administrative costs and interest are not included in COGS.

The Wall Street pundits are predicting a substantial increase in interest rates. If they are correct, which of the following bonds would be most sensitive to that increase? A. 5s of 2040 B. 5s of 2035 C. 4s of 2025 D. 5s of 2045

5s of 2045 The bond with the longest duration will have the greatest sensitivity to change in interest rates. We examine two factors: the coupon rate and the length to maturity. When the coupon rates are the same, as they are for three of these bonds, the one with the maturity date farthest into the future will have the longest duration. Even though the 4% coupon is lower than the others, the maturity date is so much closer making it have the shortest duration (least sensitivity to change) of this group

Which of the following pairs of assets provides the greatest level of diversification? A. Assets 7 and 8, with a correlation coefficient of +0.37 B. Assets 1 and 2, with a correlation coefficient of -0.78 C. Assets 3 and 4, with a correlation coefficient of 0.0 D. Assets 5 and 6, with a correlation coefficient of -0.42

Assets 1 and 2, with a correlation coefficient of -0.78 The greatest level of diversification will occur when the correlation coefficient is closest to -1.0. Therefore, Assets 1 and 2 offer the greatest level of diversification.

The XYZ Corporation's income statement contains the following information: Total revenue $200,000 Cost of goods sold 60,000 Administrative expenses 30,000 Depreciation 10,000 Miscellaneous expenses 3,000 Taxes paid 5,000 Based on this information, XYZ's gross profit is A. $140,000 B. $100,000 C. $97,000 D. $110,000

$140,000 Gross profit, or gross margin, is sales (or revenues) minus the cost of goods sold (COGS). When the depreciation expense relates to the equipment used directly in the production of the sales, it is included in COGS. In this question, there is no choice of $130,000 (which would include depreciation in COGS). Clearly, by not including that choice, NASAA is taking the position that depreciation is excluded from COGS.

The Zxion Corporation has just distributed a 7½ to 1 split of its common stock. Prior to the split, Zxion had EPS of $15, the market price of Zxion common stock was $225 per share, and the price of its $75 par preferred stock was $82.50. As a result of the split, the price-to-earnings (P/E) ratio is now A. 7.5 x 1. B. 2 x 1. C. 15 x 1. D. 6 x 1.

15 x 1 A stock split does not change the P/E ratio because both the stock's price and its earnings decline by the same proportion. In this question, after the 7.5 to 1 split, the market price will drop to $30 per share ($225 ÷ 7.5) and the earnings per share are now $2 per share ($15 ÷ 7.5). That 30:2 is still a 15-to-1 P/E ratio. The information about the preferred stock is extraneous.

A stock traded on the Nasdaq Stock Market has a beta of 1.20. One could expect that the stock's volatility compared to the S&P 500 would be A. negatively correlated to the S&P B. 20% less volatile C. too variable to tell D. 20% more volatile

20% more volatile Beta is a measurement of a security's volatility when compared with the overall market, best measure by the S&P 500. The "market" is assigned a beta of 1.00, so when the beta is higher than 1.00, the stock has greater volatility and when lower than 1.00, the volatility is less.

A fundamental analyst reviewing the current ratios of four different companies would consider which of the following to be in the most liquid position? A. 1.5:1 B. 0.5:1 C. 2.7:1 D. 4.2:1

4.2:1 The current ratio is the current assets divided by the current liabilities. The higher the ratio, the more liquid the company. Therefore, a 4.2 to 1 ratio is the strongest and a 0.5 to 1 ratio is the weakest.

A company has two outstanding bond issues, both with a coupon rate of 10%. Bond A will mature in 3 years while Bond B will mature in 20 years. If interest rates were to decrease to 8%, which of the following statements is correct? A. Bond B will be selling at a greater premium than Bond A. B. The issuer will attempt to call in Bond A. C. Both bonds will be selling at a discount. D. Bond B will be selling at a greater discount than Bond A.

Bond B will be selling at a greater premium than Bond A. When interest rates go down, bond prices will go up. As far as which bond will sell at the higher premium using the discounted cash flow method, it is clear that the bond with the longer duration will be worth more.

According to most fundamental analysts, examining a company's price-to-earnings ratio gives an indication of A. how much investors value the stock as a function of the company's market price to its earnings. B. the historical support and resistance levels. C. the parity price of the issuer's convertible bonds. D. the degree to how liberal the company's dividend policies are.

How much investors value the stock as a function of the company's market price to its earnings

Which of the following measures the variability of an asset's returns over time? A. Time-weighted return B. Beta C. Standard deviation D. Alpha

Standard deviation

If you were using the discounted cash flow method to determine the appropriate value of a security, you would want to purchase that security when A. the current market price is below the PV B. the rating of the security has just been upgraded C. the current market price is above the PV D. the current market price equals the PV

The current market price is below the PV Those who use the DCF to value a security would recommend purchasing when the current market price is below the PV—that is, when the NPV is positive.

When constructing a portfolio, one of the goals is to increase diversification. Which of the following pairs offers the most diversification? A. Large-cap stock/blue-chip stock B. Municipal GO bonds and long-term U.S. Treasury bonds C. U.S. equity securities and foreign equity securities D. Corporate debentures/convertible bonds

U.S. equity securities and foreign equity securities Diversification is generally accomplished by adding securities that don't have a high degree of correlation. Large-cap and blue-chip are essentially the same thing. Most convertible bonds are debentures. Only in the case of domestic and international stocks will we find a low correlation.

Which of the following attributes of common stock best describes why internal rate of return (IRR) is not generally used to determine the return on common stock? A. Uneven cash flows and no maturity B. No net present value C. Uneven cash flows, no maturity date and price D. Uneven cash flows

Uneven cash flows, no maturity date and price Internal rate of return (IRR) best measures investments with a known price and maturity. The internal rate of return is the discount rate that makes the future value of an investment equal to its present value. The yield to maturity on a bond is actually its internal rate of return.

Which of the following bonds has the shortest duration? A bond with A. a 10-year maturity, 10% coupon rate. B. a 20-year maturity, 10% coupon rate. C. a 10-year maturity, 6% coupon rate. D. a 20-year maturity, 6% coupon rate.

a 10-year maturity, 10% coupon rate Two factors go into the computation of a bond's duration - the length to maturity and the coupon rate. When the maturities are the same, the bond with the highest coupon has the shortest duration. When the coupons are the same, the bond with the nearest maturity has the shortest duration. The 10% bond maturing in 10 years "wins" on both counts. It has the nearest maturity with the highest coupon. All else being equal, a bond with a longer duration will be more sensitive to changes in interest rates.

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

Expected cost of college To determine whether the investment will satisfy the goal, the investment adviser representative needs to know the amount needed to pay for college. The information we have here will allow us to compute the future value: $25,181.70. This may not be enough to pay for even 1 year of college 12 years from now.

An analyst compiled the following correlation coefficient matrix relating to Funds A, B, C, and D. Fund A Fund B Fund C Fund D Fund A 1.00 .56 −.34 .22 Fund B .56 1.00 −.12 −.78 Fund C−.34 −.12 1.00 .00 Fund D .22 −.78 .00 1.00 On the basis of these findings, combining which funds would provide the highest level of diversification? A. Funds B and C B. Funds A and B C. Funds B and D D. Funds A and C

Funds B and D Combining funds with the lowest correlation coefficient would create the greatest diversification. The quickest way to answer a question like this on the exam is to look for the largest negative number (in this question, -.78).

One of the critical components of making suitable recommendations is the ability to evaluate risk. Risk measurement tools would include all of the following except A. future value B. Sharpe ratio C. beta D. standard deviation

Future value Future value measures the time value of money and has no relationship to risk.

A securities analyst wishing to determine the cash flow for the Lucre Bread Manufacturing Company would find the necessary information on the company's A. income statement. B. bank statements. C. capitalization statement. D. property tax return.

Income statement The primary source for the information necessary to construct a cash flow statement is the company's income statement. In a similar fashion, if an investment adviser wants to determine a client's cash flow, you would help the client prepare an income statement and work from that. Although the bank statements have some of the required information, there are items adding to or subtracting from cash flow, such as depreciation, that cannot be determined from a bank statement.

Securities analysts would agree that it makes sense to purchase a fixed-income security when its net present value (NPV) is A. negative B. variable C. zero D. positive

Positive A positive NPV means the security is available for a price below its present value—it is a good buy. With a negative NPV, the price is too high. With a zero NPV, it is accurately priced.

Portfolio A has a beta of 1.0 and has returned 8% over the past year. Portfolio B has a beta of 1.5 and, over that same period, has returned 16%. Based on this information, an analyst would conclude that portfolio B has A. zero alpha. B. positive correlation. C. positive alpha. D. negative alpha.

Positive alpha

When analyzing a company's financial statements, gross profit is computed by subtracting from revenues A. all expenses, including income tax B. the cost of goods sold C. all expenses, including income tax plus preferred dividends D. the cost of goods sold plus interest expense

The cost of goods sold A company's gross profit, sometimes referred to as gross margin on the exam, is the profit from operations remaining after subtracting the cost of goods sold from the revenues (sales). It is frequently shown as a percentage derived from dividing the gross margin by the sales or revenues of the enterprise. Because interest is a fixed rather than operating expense, it is not included in the computation. You might also see this referred to as pre-tax margin.

Which of the following bonds would most likely be exposed to the greatest amount of interest rate risk? A. ABC 5s of 2045 B. DEF 6s of 2046 C. GHI 7s of 2047 D. JKL 4s of 2025

ABC 5s of 2045 The bond with the longest duration is generally going to have the greatest exposure to interest rate risk. Because there is very little difference between maturity dates of 2045 through 2047, the bond with the lowest coupon will have the longest duration. The 4s of 2025 have a relatively short duration, even though their coupon is low.

One popular method of determining the value of certain securities is discounted cash flow (DCF). Using the DCF with the current discount rate at 3%, which of the following would be expected to have the highest market value? A. XYZ Corporation mortgage bond maturing in 10 years with a coupon of 4.5% B. ABC Corporation debenture maturing in 25 years with a 5% coupon C. Bay Area Rapid Transit Authority 4% revenue bond maturing in 15 years D. U.S. Treasury bond maturing in 20 years with a 4% coupon

ABC debenture maturing in 25 yrs w/ a 5% coupon

Rank the following bonds in order of shortest to longest duration. 1. ABC 8s of 2035. 2. DEF 9s of 2034. 3. GHI 5s of 2036. 4. JKL zeros of 2033.

DEF 9s of 2034, ABC 8s of 2035, GHI 5s of 2036, & JKL zeros of 2033 There is an inverse relationship between a bond's coupon rate and its duration. A higher coupon will pay the investor back through cash flow at a faster rate. Therefore, a zero-coupon bond with no cash flow has a duration equal to its maturity.

Which ranking lists the following bonds in order from shortest to longest duration? 1. ABC 8s of 2050 2. DEF 9s of 2051 3. GHI 5s of 2049 4. JKL zeros of 2050

DEF 9s of 2051 to ABC 8s of 2050 to GHI 5s to 2049 to JKL zeros of 2050

Under the net present value (NPV) method of evaluating investments, an investment is attractive if the net present value of the expected returns is A. less than zero. B. greater than zero. C. greater than the risk-adjusted return. D. equal to zero.

Greater than zero

A portfolio manager with a growth style would probably diversify by A. concentrating in stocks in one or two industries. B. attempting to build a portfolio with a very high correlation. C. devoting a portion of the portfolio to securities with a negative correlation. D. placing a portion of the portfolio into high-yield bonds.

Devoting a portion of the portfolio to securities w/ a negative correlation

An investor reviewing the performance of a security reads that its returns for the past nine years are +9%, -4%, +13%, +6%, +2%, -8%, +11%, +2%, +5%. Using this information, which of the following is not a correct statement? A. The mode is 2%. B. The median is 5%. C. The range is 11%. D. The mean is 4%.

The range is 11%

Which of the following is not a component of the discounted cash flow method of determining the value of a fixed-income security? A. The security's rating B. The security's coupon C. The discount rate D. The security's maturity date

The security's rating The discounted cash flow method of valuing a fixed-income security discounts the investment's future cash flows to arrive at a present value. Those cash flows come from two sources. The first is the semiannual interest payments and the second is the final maturity payoff. Each of these is discounted using the required rate of return (usually the current market interest rate) and the result is the present value of those cash flows. The security's rating is not a factor in this computation although it may affect what investors are willing to pay for the security.

Which of the following purchases is most suitable for an investor pursuing an aggressive investment strategy? A. AMF stock with a beta coefficient of 1.0 B. DOH stock with a beta coefficient of 0.7 C. GHI stock with a beta coefficient of 1.3 D. LMN stock with a beta of -0.6

GHI stock with a beta coefficient of 1.3 Beta coefficients greater than 1.0 signify that the stock will fluctuate more than the market as a whole. In general, the higher the beta, the greater the risk. Such risk-taking is appropriate for investors who seek aggressive investment strategies.

The best time for an investor seeking returns to purchase long-term, fixed interest rate bonds is when A. long-term interest rates are high and beginning to decline. B. short-term interest rates are low and beginning to rise. C. short-term interest rates are high and beginning to decline. D. long-term interest rates are low and beginning to rise.

Long-term interest rates are high and beginning to decline

An investor's required rate of return is 6%. If the internal rate of return of the investment offered is 5.75%, then the NPV is A. zero B. positive C. between 5.75% and 6% D. negative

Negative Any time an investment's IRR is less than the required rate of return, the NPV is negative (and should probably be avoided). NPV is expressed as a dollar amount. It is the IRR that is expressed as a percentage.

The financial ratio that shows the relationship between the price of a company's stock and the company's net worth (stockholders' equity) is A. the dividend discount ratio B. the price-sales ratio C. the price-earnings (PE) ratio. D. the price-to-book-value ratio

The price-to-book-value ratio The price-to-book-value ratio is calculated by dividing the price per share by the stockholders' equity per share. This ratio shows the relationship between a company's stock price and the company's book value.

Bond investors use the discounted cash flow formula to A. determine the annual interest paid on a bond. B. translate future cash flows to be received from interest and principal repayment into their present value. C. compute their income tax liability. D. evaluate the risk of investing in a bond.

Translate future cash flows to be received from interest and principal repayment into their present value The discounted cash flow method of valuing a fixed-income security discounts the investment's future cash flows to arrive at a present value. Those cash flows come from two sources: The first is the semiannual interest payments and the second is the final maturity payoff. Each of these is discounted using the required rate of return (usually the current market interest rate) and the result is the present value of those cash flows. The security's rating is not a factor in this computation although it may affect what investors are willing to pay for the security.

A security that your client has been following has a historical average annual return of 11% and a standard deviation of 6%. Knowing this, it would be expected that 95% of the time, your client could expect a return within the range of A. +5% and +17%. B. −7% and +30%. C. −1% and +23%. D. −66% and +66%.

-1% and +23%

To make a quantitative evaluation using the future value computation, which of the following is NOT needed? A. Rate of return anticipated. B. Account value at the start of the period. C. Account value at the end of the period. D. Time period involved.

Account value at the end of the period. Future value is calculated to determine the value of a specific amount of money at some point in the future. The anticipated interest rate, the present amount to be invested, and a time period for the life of the investment are required to calculate the future value.

Cecil has a discretionarily-managed account with Pelf Reliable Advisors (PRA), an investment adviser registered in States C, D, and G. Over the past year, the portfolio produced a 12% return with a beta of 1.05. The risk-free rate is 3.5%, and the overall market returned 10.85%. Based on this information, calculate alpha and determine if PRA added any value to the portfolio. A. Alpha = 1.15%; the adviser outperformed the market by 1.15% B. Alpha = 0.78%; the adviser outperformed the market by 0.78% C. Alpha = -1.21%; the adviser underperformed the market by 1.21% D. Alpha = 0.78%; the adviser underperformed the market by 2.72%

Alpha = 0.78%; the adviser outperformed the market by 0.78% The alpha for this portfolio is +0.78% (rounded). A positive alpha indicates that Pelf outperformed the market on a risk-adjusted basis. As with most calculations, there are two ways to solve for the answer. Let's use the LEM's formula first. When the riskfree (RF) rate is given, the formula is (actual return - RF rate) - (beta x [market return - RF rate]). Plussing in the numbers, we have (12% minus 3.5%) minus (1.05 times [10.85% minus 3.5%]). That breaks down to 8.5% minus (1.05 times 7.35%) or 8.5% minus 7.72% = +0.78%. An alternative method is as follows: 12% - [3.5% + 1.05 (10.85% - 3.5%)] = 12% - [3.5% + 7.7175] = 12% - 11.2175 = +0.7825.

When analyzing a security's standard deviation, which of the following statements accurately describes observations according to a normal frequency distribution curve? A. Approximately 97.5% of all observations will be within two standard deviations on either side of the mean. B. Approximately two-thirds, or 68%, of observations will be within one standard deviation on either side of the mean. C. Approximately 97.5% of all observations will be within three standard deviations of the mean. D. Approximately 95.5% of all observations will be within three standard deviations of the mean.

Approximately two-thirds, or 68%, of observations will be within one standard deviation on either side of the mean Approximately two-thirds, or 68.26%, of observations will be within one standard deviation on either side of the mean. Approximately 95% will be within two standard deviations and approximately 99% will be within three.

A customer's portfolio has a beta coefficient of 1.1. If the overall market increases by 10%, the portfolio's value is likely to A. increase by 11% B. decrease by 10% C. increase by 10% D. decrease by 11%

Increase by 11% A beta of 1.1 means the portfolio is considered to be 1.1 times more volatile than the overall market. If the market is up 10%, the portfolio with a beta of 1.1 is likely to be up 11%.

If an investment can be expected to return 8%, using the rule of 72, what is the present value needed to have $50,000 for a child's education in 18 years? A. $2,777 B. $25,000 C. $6,250 D. $12,500

$12,500 Under the rule of 72, dividing 72 by the expected return shows the number of years it will take for a deposited sum to double. 72 divided by 8 equals 9 years. Over an 18-year period, there will be 2 doublings. So, dividing the future value ($50,000) by 4 solves for the present value required.

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

Internal rate of return 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.

One of your clients has $150,000 in his 401(k) plan at work. He is assuming the portfolio will increase in value at a rate of 7% compounded annually for the next 5 years. If that is the case, the portfolio value at the end of that 5-year period will be closest to A. $240,867. B. $210,383. C. $202,500. D. $160,500.

$210,383 This is a straightforward future value computation. The proper way to do this is to enter the beginning value ($150,000) into your calculator, and then multiply times 107% five consecutive times. We'll get you started: 150,000 x 107% = $160,500 x 107% = $171,735 x 107% = $183,756 (and do this 2 more times to get $210,383). If that is too challenging, then use the "shortcut" - it always works. Figure the answer using simple interest. The starting value is $150,000. Seven percent growth is $10,500. Do that for 5 years and it is $52,500. Add that to the initial value and you have $202,500. Then, select the next highest number because that takes into consideration the compounding effect.

A corporate bond with a 6% coupon is purchased for your customer's portfolio. If current bonds of the same quality and maturity are yielding 7.25% and the net present value (NPV) of the bond is zero, the bond's internal rate of return (IRR) is A. 6.00%. B. trading at a discount. C. more than 7.25%. D. 7.25%.

7.25% When a bond's NPV is zero, it means that it is priced to provide a yield to maturity equal to the current market interest rate. In this case, that rate is 7.25%. A bond's internal rate of return is its yield to maturity. Isn't the bond selling at a discount? Yes it is, but IRR is always expressed as a percentage, not a price.

The following numbers (in %) represent the returns from an investment fund over the past seven years: 2016: 13%, 2017: 11%, 2018: 2%, 2019: 6%, 2020: 5%, 2021: 8%, 2022: 6%. Using the range measure would indicate that the seven-year returns from the fund had a mid-range of A. 11%. B. 2%. C. 4%. D. 7.5%.

7.5% The midrange of any group of numbers occurs between the highest and lowest in the group. In this example, the highest number is 13% and the lowest is 2%. The number in the middle of those two is 7.5%. That is slightly higher than the mean (the average of the returns).

An investor's portfolio consists of a single stock. If a stock with a correlation of +.95 was added to the portfolio and the stock market turned bearish, what would be the likely effect of having added this additional security? A. The portfolio's value would remain the same. B. Not enough information to tell. C. The portfolio's value would increase. D. Almost no noticeable impact.

Almost no noticeable impact Adding additional securities to a portfolio usually increases the diversification, lowering the overall risk. However, that is more apparent when there is low or negative correlation. A +.95 correlation means that the "new" stock will perform close to exactly the same as the existing one so its addition should have little to no impact on performance. In a bearish market, values go down, not up or remain the same. If this additional stock had a negative correlation, that could have resulted in the portfolio going up or remaining the same, but not with a +.95 correlation. It is almost never that a question on the exam does not have enough information to arrive at the correct answer - steer away from that choice.

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. asset turnover ratio B. liquidity ratio C. cash flow to debt ratio D. profitability ratio

Asset turnover ratio What is the purpose of a security's rating? To inform investors of the financial risk of the investment. The higher the rating, the lower the risk. This is one of those questions that students answer correctly because all of the other choices are incorrect (they are important factors). Remember, this is a negative question: "least likely." Certainly profitability of the issuer is a key factor in assessing the safety of the issue. Liquidity and cash flow are important factors as well. The rate at which assets are turned over is not nearly as important to determining a rating as the other three.

The portfolio manager of a bond fund believes that interest rates are going to increase in the near future. As such, it would be wise for that manager to A. lengthen the average duration of the portfolio. B. increase the equity portion of the portfolio. C. shorten the average duration of the portfolio. D. shift into higher-rated bonds.

Shorten the average duration of the portfolio Increasing interest rates lead to declining bond prices, regardless of the ratings. This is interest rate risk. Those bonds with the longest duration have the most sensitivity to that risk, while short-term maturities are only slightly affected. Reducing the average duration of the portfolio means that the average maturities will be shortened, thus reducing the effects of an increase to interest rates.

Assuming all of the following mature at about the same time, which of the following bonds should experience the greatest price decline if interest rates rise by 1%? A. Treasury bond issued at par and carrying a 4% coupon B. Treasury bond issued at par carrying a 5% coupon C. Treasury bond issued at par carrying a 6% coupon D. Treasury bond issued at par carrying a 7% coupon

Treasury bond issued at par and carrying a 4% coupon This is an example of duration. With approximately equal maturity dates, the bond with the lowest coupon will always have the longest duration. The longer the duration, the greater the susceptibility to price changes due to fluctuations in interest rates.

RAP mutual fund had the following returns over the past 3 years: Year 1: 15%. Year 2: -5%. Year 3: 7%. What is the arithmetic mean of the returns for the RAP fund? A. 5.67% B. 9.00% C. 7.00% D. 20.00%

5.67% The arithmetic mean (the average) is 5.67%, calculated as follows: (15% - 5% + 7%) ÷ 3 = 17 ÷ 3 = 5.67%. The median is 7% and the range is 20% (the difference between -5 and +15). If you didn't notice the year 2 return was negative, then your computation would be 9%.

Current market interest rates are 6%. A bond with an 8% coupon would be most likely to have a net present value of zero when the bond's internal rate of return is A. 8%. B. 0%. C. 4%. D. 6%.

6% The internal rate of return of a bond is the interest rate that makes the NPV of the investment equal to zero. When a bond is selling at its present value, the NPV is zero. A bond's present value should be equal to a market price giving a yield to maturity equal to the current market interest rates. Therefore, when current market interest rates are 6%, a bond with an 8% coupon should be selling at a price producing a YTM, or IRR, of approximately 6%.

An investor's portfolio has a beta coefficient of 0.85. If the overall market declined by 10% over the course of a year, the portfolio's value has likely A. increased by 8.5% B. decreased by 11.76% C. decreased by 8.5% D. increased by 10.85%

Decreased by 8.5% A beta coefficient of 0.85 means that the portfolio is considered to be 0.85 times as volatile as the overall market. Therefore, if the market declines by 10%, the portfolio with a beta of 0.85 is likely to decline by only 8.5% (0.10 × 0.85).

When a company's debt-to-equity ratio is higher than typical for that industry, it might be said that the company is A. suitable for a conservative investor B. about to increase their dividends C. highly profitable D. highly leveraged

Highly leveraged The definition of a leverage is the use of borrowed money in the issuer's capital structure. This is seen through the debt-to-equity ratio. When that ratio is higher than industry standards, it is said that the company is highly leveraged.

Which of the following is a discounted cash flow computation? A. Holding period return B. Net present value C. Standard deviation D. Current yield

Net present value A key component of a DCF computation is using the time value of money. None of these, other than NPV, consider the time value of money.

An investor is considering a 10-year stripped U.S. Treasury and a 10-year U.S. Treasury note, both with a yield to maturity of 4.8%. Compared to the note, the strip has A. more liquidity risk and less interest rate risk. B. more reinvestment risk and less interest rate risk. C. less reinvestment risk and more interest rate risk. D. more interest rate risk and less liquidity risk.

Less reinvestment risk and more interest rate risk The strip is a zero-coupon security so it has no cash flows to reinvest and therefore no reinvestment risk. However, it has more interest rate risk (longer duration) than the Treasury note. Remember, the duration of a zero-coupon bond is its maturity date while any debt security paying periodic interest (Treasury notes pay semiannually) will always have a duration shorter than its length to maturity.

If the required rate of return is less than anticipated in a present value calculation, the effect would be that the A. present value would be lower. B. present value would be higher. C. future value would be lower. D. yield to maturity (YTM) would decrease.

Present value would be higher

Which of the following are likely to have a low beta? A. Public utility stocks B. Aerospace stocks C. Technology stocks D. Software stocks

Public utility stocks Public utility stocks tend to have low betas as do other defensive stocks. Technology, aerospace, and software stocks tend to have high betas.

A bond investor's portfolio consists of the following 3 bonds: ABC First Mortgage bond, current market value of $4 million with a duration of 5 years. DEF Debenture, current market value of $5 million with a duration of 8 years. U.S. Treasury bond, current market value of $1 million with a duration of 10 years. What is the average duration of the portfolio? A. 6.54 years B. 7 years C. 3.04 years D. 7.67 years

7 years It is unlikely that you will have a question this complicated on the exam, but, just in case, we wanted to show you the way to do it. Computing average duration of a bond portfolio involves taking each bond and figuring the proportion of the portfolio its duration represents. In this question, ABC is 40% of the portfolio so we take 40% of its 5-year duration (2). Then, we do the same with the other two bonds. DEF is 50% of 8 (4) and the Treasury bond is 10% of 10 (1). When we add the 3 numbers together, it results in an average duration of 7 years.

If the coupon rate on a bond increases, the duration of the bond will A. increase. B. decrease. C. change in an unpredictable fashion. D. remain unchanged.

Decrease

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

S&P 500 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.

A concern of some investors is the volatility of a security. Securities with a higher volatility exhibit a greater variability in their returns. A statistical measure used to predict the volatility of a security by examining the dispersion in a set of historical returns is A. beta. B. geometric mean. C. correlation. D. standard deviation.

Standard deviation The standard deviation measures how much variation there is in the returns from the average (the arithmetic mean). A low standard deviation indicates that the returns achieved by the security or portfolio tend to be very close to the average score; less volatile. The higher the standard deviation, the more dispersed the returns are for the security or portfolio; more volatile.

What happens to bond durations when coupon rates increase and maturities increase? As coupon rates As maturities increase, duration: increase, duration: A. decreases. decreases. B. increases. increases. C. increases. decreases. D. decreases. increases.

Decreases, increases As coupon rates increase, the duration on the bond will decrease because investors are receiving more cash flow sooner. As maturity increases, duration will increase because the payments are spread out over a longer time.

Some analysts use the discounted cash flow (DCF) to determine the theoretical value of a debt security. Under DCF, the bond price can be summarized as the sum of the A. present value of the par value repaid at maturity plus the present value of the coupon payments. B. present value of the par value repaid at maturity plus the future value of the coupon payments. C. future value of the par value repaid at maturity plus the future value of the coupon payments. D. future value of the par value repaid at maturity plus the present value of the coupon payments.

Present value of the par value repaid at maturity plus the present value of the coupon payments

Which of the following factors has a direct relationship to a bond's duration? A. Yield to maturity B. Rating C. Time to maturity D. Coupon rate

Time to maturity The longer the time to maturity, the higher (longer) the duration. Yield to maturity and coupon rate have an inverse relationship. That is, the higher the YTM and the coupon, the lower (shorter) the duration. The bond's rating is irrelevant.

Two securities with which of the following correlation coefficients could be combined to create a theoretically risk-free portfolio? A. 0.0 B. -1.0 C. -0.5 D. +1.0

-1

A sudden decrease in market interest rates will have the effect of increasing the trading price of an existing bond because A. a reduction in market interest rates generally signifies a stronger economy B. lower interest rates will result in a higher rating for the bond C. the present value of the bond's future cash flows increases D. the future value of the bond's present cash flows increases

The present value of the bond's future cash flows increases Bond valuations using discounted cash flow take into consideration the present value of the bond's future cash flows. That is, the greater the value of the interest payments to be received in the future, the higher the price of the bond. When market interest rates decline, because the coupon rate of the existing bond is fixed, the present value of those interest payments increases, creating a higher value for the bond. This is just the technical way for explaining why bond prices go up when interest rates go down.

Which of the following statements regarding the properties of duration is not true? A. Duration measures the holding period return on a bond. B. Duration measures the effect of an interest rate change on the price of a bond or bond portfolio. C. Duration measures a bond's price volatility by weighting the length of time it takes for a bond to pay for itself. D. Duration is a weighted-average term to maturity of a bond's cash flows.

Duration measures the holding period return on a bond Duration does not measure the holding period return on a bond; it measures the effect of an interest rate change on the price of a bond or bond portfolio. Duration measures a bond's price volatility by weighting the length of time it takes for a bond to pay for itself. Duration is also a weighted-average term to maturity of a bond's cash flows.

The portfolio manager of the Insatiate Bond Fund, an open-end investment company, believes that interest rates are going to increase in the near future. As such, it would be wise for that manager to A. lengthen the average duration of the portfolio. B. shorten the average duration of the portfolio. C. shift into higher-rated bonds. D. increase the equity portion of the portfolio.

Shorten the average duration of the portfolio Increasing interest rates lead to declining bond prices, regardless of the ratings. This is interest-rate risk. Those bonds with the longest duration have the most sensitivity to that risk while short-term maturities are only slightly affected. Reducing the average duration of the portfolio means that the average maturities will be shortened, thus reducing the effects of an increase to interest rates.

While searching for a suitable investment for your client, you narrow the choice to the following four companies: Company A with returns over the past four years of 12%, 4%, 8%, 6% Company B with returns over the past four years of 7%, 8%, 9%, 6% Company C with returns over the past four years of 10%, 12%, -2%, 10% Company D with returns over the past four years of 15%, 20%, -8%, 3% Which of these choices has the highest volatility? A. Company D B. Company C C. Company A D. Company B

Company D Although the exam will not ask you to compute standard deviation, you are required to know that it measures the deviation from the mean (average). In all four of these examples, the mean is 7.5% (30 divided by 4). In which of the choices do the returns occur furthest from that mean? In choice D, they range from 12.5% higher to 15.5% lower. In choice A, the range is from 4.5% higher to 3.5% lower; in choice B, the range is from 1.5% higher to 1.5% lower; in choice C, the range is from 4.5% higher to 9.5% lower. That should clearly point out that the greatest volatility, or dispersion from the mean, is choice D, while choice B would have the lowest standard deviation.

Which of the following statements is most accurate regarding the net present value (NPV) and internal rate of return (IRR) on a bond? A. IRR assumes the cash flows are reinvested annually. B. IRR assumes the cash flows are reinvested at market interest rates. C. NPV assumes the cash flows can be reinvested at market interest rates. D. NPV assumes that cash flows can be reinvested at the bond's IRR.

NPV assumes the cash flows can be reinvested at market interest rates The first step in finding the NPV is to compute the present value (PV). The PV is computed by taking the future cash flows and discounting them by a "discount" rate. That rate is the current market interest rate. So, if NPV is based on PV and PV assumes reinvestment at the discount rate, that assumption must hold true for figuring NPV. In the case of the IRR, that is the yield to maturity of a bond and assumes that the cash flows are reinvested at that IRR. For example, a bond with a YTM of 7% assumes that all reinvestments will be made at that 7% rate. The periodic cash flow on a bond comes from the semiannual interest payments making reinvestments semiannually, not annually.

An investment adviser representative has a client who prefers the safety of securities guaranteed by the U.S. Government, yet is concerned about volatility due to uncertainties in the future direction of interest rates. Which of the following recommendations would best address these concerns? A. 6% Treasury bond maturing in 2045 B. 8% Treasury bond maturing in 2046 C. Treasury STRIPS, maturing in 2046 D. 5% Treasury bond, maturing in 2047

8% Treasury bond maturing in 2046 Generally speaking, when the length of time to maturity is about the same, those bonds with the highest coupons have the shortest duration and are therefore the least subject to interest rate risk. STRIPS, which are zero-coupon bonds, are the most volatile because they have the longest duration. The 8s maturing in 2046 have approximately the same length to maturity as the other two interest-bearing bonds but have a significantly higher coupon, resulting in a much shorter duration (less volatility). The actual calculation of the duration of each of the other bonds given is beyond the scope of this exam.

The price-to-earnings ratio A. reflects how liberal the company's dividend policies are B. shows how much investors value the stock as a function of earnings to the company's market price C. is higher for value stocks than for growth stocks D. indicates current cash flows

Shows how much investors value the stock as a function of earnings to the company's market price The 2 components of the price-to-earnings ratio are the current market price and the earnings per common share. When a company has a high P/E ratio, it means that investors are placing greater value on expected growth in earnings. That is one of the reasons why growth stocks carry higher P/E ratios than do value stocks.

All of the following ratios are measures of the liquidity of a corporation except A. current ratio. B. quick ratio. C. debt-to-equity ratio. D. acid test ratio.

Debt-to-equity ratio

Fundamental analysts give significant credence to financial ratios. Which of the following tends to give an indication of the profitability of the enterprise? A. Current ratio B. Debt-to-equity ratio C. Price-to-earnings ratio D. Sales-to-earnings ratio

Sales-to-earnings ratio Of the four choices given, the sales-to-earnings ratio is the only one not discussed in the License Exam Manual. Why not? Because we know there will always be a question or two on the real exam that was not covered in our material. It is important that students use good test-taking skills to correctly answer those questions. It would seem logical that a question about profitability would relate to earnings. That would reduce the choices to two from four. The price-to-earnings (P/E) ratio reveals the relationship between the market price of the company's stock and its earnings, but it doesn't tell us anything about the degree of profitability of the enterprise. If we know that the P/E ratio compares the price to the earnings, then it makes sense that the sales-to-earnings ratio compares the net sales of the business with its earnings. Companies with a higher percentage of earnings from each dollar of sales are more profitable. For example, Company A and Company B both reported $100 million in net sales for the year. The net income (earnings) of Company A was $20 million and Company B was $8 million. We can see that each dollar of sales generated $0.20 of profit for Company A and only $0.08 of profit for Company B. Or, we could say that it takes $5 of Company A sales to generate $1 of profit ($100 ÷ 20) while it takes $12.50 of Company B sales ($100 ÷ 8) to earn that same $1 of profit.

In portfolio theory, the alpha of a security or a portfolio is A. a measure of the variance in returns of a portfolio divided by its average return B. the difference in the expected return of the portfolio, given the portfolio's beta, and the actual return the portfolio achieved C. the portfolio's average return in excess of the risk-free rate divided by the standard deviation in returns of the portfolio D. the risk of the portfolio associated with the macroeconomic factors that affect all risky assets

The difference in the expected return of the portfolio, given the portfolio's beta, and the actual return the portfolio achieved Alpha is the difference in the expected return of the portfolio, given the portfolio's beta and the actual return the portfolio achieved. The higher the alpha, the better the portfolio has done in achieving excess or abnormal returns. The risk of the portfolio associated with the macroeconomic factors that affect all risky assets is systematic risk. The portfolio's average return in excess of the risk-free rate divided by the standard deviation in returns of the portfolio is the Sharpe ratio or measure. The measure of the variance in returns of a portfolio around its average return is the standard deviation.

Patrice has an investment portfolio with the following characteristics: Portfolio actual return: 9% Market actual return: 12% Portfolio standard deviation: 4% Market standard deviation: 7% Portfolio beta: 0.65 Risk-free rate of return: 3% What is her portfolio's alpha? Did her portfolio outperform the market on a risk-adjusted basis? A. With an alpha of -5.10%, her portfolio underperformed the market. B. With an alpha of 5.10%, her portfolio outperformed the market. C. With an alpha of -0.15%, her portfolio underperformed the market. D. With an alpha of 0.15%, her portfolio outperformed the market.

With an alpha of 0.15%, her portfolio outperformed the market. As with most computation questions, there is more than one way to arrive at the answer. Using the steps in the LEM (U10LO4), Alpha - (total portfolio return minus risk-free rate) minus (portfolio beta times [market return minus risk-free rate]). Plugging in the numbers, we have (9% - 3%) - (.65 times [12% minus 3%]) = 6% - (.65 x 9%) = (6% - 5.85% = 0.15% An alternative method simply moves the parentheses a bit. If this is easier for you, use it. Alpha = 9% − [3% + 0.65 (12% − 3%)] = 9% - [3% + .65 (9)] = 9% - (3% + 5.85) = 9% - 8.85 = 0.15%. A positive alpha indicates that the portfolio outperformed the market on a risk-adjusted basis. Did you notice that the standard deviation was irrelevant to our computation? It is not unusual for the exam to include information that is extraneous to the question just to confuse you.