Series 66: Chapter 7 Quantitative Measures and Investment Risk

How do you calculate a SML

Must use: - Expected Return for the asset - The risk free rate - The return of the market - The beta of the asset

Index are generally weighted for the capitalization (number of shares outstanding) of the companies, so obviously has most impact on the index performance

A large company's stock price change will have the greater effect on the index.

Describe the Sovereign Risk?

A sovereign risk ratings capture the RISK OF A COUNTRY DEFAULTING (ONLY) on its Commercial Debt Obligations. - The biggest indicator of Sovereign Risk is when there's a change to a country's credit rating

Barbell Style

- Barbell style uses the active management style technique of purchasing short term bonds (1-2 years) and long term bonds (10 years or longer) with no intermediate bond terms in between. The long term bonds provide the higher interest rates (higher income stream) and the short term bonds offer the liquidity and flexibility to reinvest at higher rates if the bonds market is going that way.

What are the different Asset Classes?

- Cash and Cash Equivalents - Equities - Fixed Income Investments - Hard Assets

What does the Cash/Cash Equivalent Categories consist of?

- Checking and Savings Accounts - Money Market Accounts - Money Market Funds - T-Bills - CDs = Capital Appreciation

What does the Hard Assets Categories consist of?

- Collectibles - Real Estate - Precious Metals and Stones

What does the Equities Categories consist of?

- Common Stock - Preferred Stock - Common Stock of all kinds of Growth, Income Appreciation stock mutual funds

What type of risk is more associated with lower rated bonds versus highly rated bonds?

- Default Risk - Business Risk

You must understand that an collection of efficient portfolios is called? and when plotted out is a ? 1) If you're below the efficient frontier curve?

- Efficient Frontier and Plotted as a CURVE. 1) You're taking too much risk for too little return

In order to calculate the Present (PV) or Future (FV) Value, what do you need to know?

- Either the Present Value or Future Value - Interest Rate = Present Value or Rate of Return = Future Value - Number of Years

How to hedge against deflation? Interest Rates going down?

- Fixed Income Investments

List the different types of Non-Systematic Risks?

- Legislative Risk - Liquidity Risk - Business Risk - Credit Risk (Financial Risk) - Regulatory Risk - Political Risk

What does the Fixed Income Categories consist of?

- Municipal Bonds - T-Bonds - Corporate Bonds - Bond Funds - Mortgage Backed Securities

1) List the types of Government Related Risks

- Regulatory Risk (US Govt, State and Local changes to "Regulations") - Legislative Risk (Laws passed by Legislature) - Political Risk - Sovereign Risk - Country Risk

Regulatory, Legislative and Political Risk are very similar to one another but you must know how they're different for the EXAM!

- Regulatory Risks come from a change to REGULATIONS enforced by US Government, State and Local Governments For example, Regulatory changes to Green Industries, Oil and Gas Explorations, Airlines and Pharmaceutical Manufacturers. - Legislative Risk comes from a change in the LAW. Law can only be change by Legislature (CONGRESS) For Ex. Change to the Tax Code is most obvious type of this risk. (Think about DPP, Municipal Bonds and REITS) - Political Risk comes from Political Instability and changes in the political control of a government such as a COUP.

What to know about the Efficient Market Hypothesis: 1) What to know about Semi-Strong Market Efficiency Method 2) What does a semi strong method about an investor achieving a positive risk-adjusted return on average??

- Security Prices RAPIDLY ADJUST without bias to the arrival of ALL NEW PUBLIC INFORMATION. (Emphasis on PUBLIC not including private info) - All new public information does include market information which makes them agree with weak form. - What makes it different from weak is believe the price rapidly adjusts to all new information including market and NON-MARKET INFORMATION. 2) An investor cannot achieve a positive risk-adjusted return on average by using FUNDAMENTAL ANALYSIS

To calculate the Alpha you must know:

- The expected rate of return - The actual rate of return - the Beta Alpha is the difference in the expected return of the portfolio, given the portfolio's beta and the actual return the portfolio achieved.

What to know about the Efficient Market Hypothesis: 1) What to know about Weak Form Efficiency Method

- Weak-Form Efficiency Method = States that current security prices fully reflect all current available SECURITY MARKET DATA. - Market Data is using past price and volume information to predicting the future directions of securities because price changes will be independent from one period to another. - Basically Must Know, An Active Manager cannot outperform market and generate positive risk adjust returns on average by using TECHNICAL DATA

Regulatory risk

- represents actions of government regulators that limit activities of businesses or add to their costs.

What you need to know about Beta measurements 1) What type of beta measurement is associated with a stock or portfolio appropriate for a aggressive stock? 2) What type of beta measurement is associated with a stock or portfolio appropriate for a conservative investor? 3) You must know how to calculate a rise or fall in the market and how it impacts the beta rating.

1) 1.50 Beta = Aggressive 2) .70 Beta = Conservative 3) If the S&P 500 rises by 10%, a stock with a beta 1 will rise by 10%. If a S&P 500 falls by 15%; a stock with a beta of 1.5 will fall by about 15%.

Dow Jones Industrial Average 1) List the type of securities. 2) What is the type of Weighted Index? 3) List the market(s) the securities are listed on? 4) Any unique pieces of information to know about this index?

1) 30 best known industrial stocks in the world. 2) Price-Weighted Index, The Dow Jones is truly an Average. 3) NYSE 30 best known corporations in the world. - In 1999, the DIJA added Microsoft and Intel both listed on the NASDAQ 4) The Dow Jones is best known of the indexes. Its well known for two things one being the type of securities listed and the fact the Dow Jones publishes the Wall Street Journal

What qualifies something as a Systematic Risk? List the different types of Systematic Risks?

1) Are risks that affect the ENTIRE MARKET and CANNOT be avoided by Diversification. - Market Risk . - Interest Rate Risk - Inflation Risk (Power Purchasing Risk) - Risk of War - Risk of Recession

1) How do you calculate the Rule of 72? 2) Use $2000 earning 6% in an example

1) You divide 72 by the Interest Rate the investment pays 72 / Interest Rate (r) $2k earning 6% will double in 72 / 6 = 18 years

1) You must be able to explain the difference between using a Beta measurement versus Standard Deviation measurement for volatility. 2) What type of risk(s) are they associated with?

1) Beta is a volatility measure of a security, compared with the OVERALL MARKET. - Standard Deviation is a volatility measure of a security, compared with its expected performance. 2) Beta = Systematic Risk and Standard Deviation = Systematic and Non-systematic risk

1) What does Beta (Beta Coefficient) measure? 2) Beta is most frequently measured against? 3) What's the beta measures what type of risk?

1) Beta measures the VOLATILITY of a stock or portfolio relative to the OVERALL STOCK MARKET. 2) S&P 500 composite index 3) Market Risk aka Systematic Risk. Non-systematic risk do not effect the Beta Rating.

What you must know: 1) What does CML and SML evaluate and how they use different type of measurement ratings

1) CML is used to evaluate DIVERSIFIED PORTFOLIO and uses Standard Deviation. 2) SML is used to evaluate individual securities for use in a diversified portfolio and uses BETA.

1) What's a better volatility measurement based on SIGNIFICANT change of bond's interest rate than Duration? 2) What are the two types of convexity? 3) What exactly does it measure?

1) Convexity - Watch out for this On EXAM! 2) Conclave (curving to the inside) and Convex (Bulging to the outside) 3) It is a measurement of the curve that results when plotting a bond's prices movement in response to changes of the interest rates.

Correlation and Coefficient: What you need to know: 1) You must know what Correlation means? 2) Know the Correlation range. 3) Be able to list the type of relationship two stocks have on a -1, 0, 1 correlation coefficient

1) Correlation means the securities move the same direction. 2) -1 to 1 3) -1 = Strongly Opposite 0 = they move in an unrelated directions 1 = Strongly or Perfect Correlation same direction

Net Present Value: 1) How does a corporation or investment adviser use NPV to evaluate a client's investment or to invest in a capital project? 2) Kaplan Take Note: What important to remember about NPV?

1) Does it have a positive net present value. A positive NPV indicates that the projected earnings generated by a project or investment (in present dollars) exceeds the anticipated costs (also in present dollars). 2) NPV is expressed in DOLLAR AMOUNTS and not as a Rate of Return.

1) What does Duration measure? 2) What are two key components to determine the duration?

1) Duration is used to measure the potential volatility of a debt security based on changes to the interest rate. 2) Coupon Rate and Maturity Date

EAFE Index 1) What does it stand for? 2) Who developed this index and what type of securities are listed on index? 3) What is the type of Weighted Index? 4) Any unique pieces of information to know about this index?

1) European, Asia and Far East 2) It was developed by Morgan Stanley Capital International and is an index for Foreign Stock. 3) Market Capitalization weighted. 4) Its the oldest foreign index and most common benchmark of foreign stock funds.

1) What type of security is most commonly known for reinvestment risk? What type of bond avoids reinvestment risks

1) Fixed Income Securities 2) Zero Coupon Bonds (No interest payments)

Lower or Higher Duration 1) The lower the coupon rate? 2) The shorter a bond's maturity? 3) How do measure the duration of a zero coupon bond? 4)

1) Higher the Duration. 2) Higher the Duration Remember: The Duration is always higher if: - On the Lower Coupon Rate - On the Longer Maturity 3) Its always equal to its maturity

Net Present Value versus Internal Rate of Return: 1) What does IRR represent? 2) Which one is generally more important 3) What is IRR commonly associated what type of yield

1) IRR expresses the rate of interest that matches the initial investment with the present value of future cash flows The interest rate that discounts the redemption price (par) to the discounted purchase price is the locked-in yield, which is the same as the internal rate of return, also referred to as the yield to maturity. 2) Net Present Value 3) Referred to as the yield to maturity. - So only good on determining Rate of Return for products only offer discounts not interest rates or debt securities and common stocks with stable dividends. That is why it is used primarily with debt securities and common stocks with stable dividends.

Correlation and Coefficient: 1) What type of funds and management style attempt to have a Perfect Correlation with an Index? 1) In relation to correlations, what's the strategy of passive management style?

1) Index Fund or Indexing management style 2) The goal of an index fund or indexing management style is to come as close as possible to MATCH the performance of the underlying index. Its NOT a goal to EXCEED the performance, ONLY to MATCH it.

Liquidity Risk: - You must know there's two types of liquidity risks

1) Is the risk that when an investor wishes to dispose of an investment and there's no one willing to buy it 2) OR that a very LARGE PURCHASE OR SALE would not be possible at the CURRENT PRICE.

1) What does the Total Return calculate? 2) Why do you people use Total Return calculation? 3) How long does the total return refer to the investment's return over?

1) It determines the INCOME plus GROWTH of PRINCIPAL from investment. 2) Total Return is considered to be the BEST MEASURE of how a security has performed for an investor. 3) OVER A ONE-YEAR PERIOD.

1) How can you utilize a Future Value calculation? 2) What's the formula for calculating?

1) It helps you determine what an AMOUNT invested today at a GIVEN RATE will be worth at some period in the future 2) FV = Current Value (1 x Rate of Return)number years invested

Which index serves as the benchmark for these Market Capitalizations? 1) Large Cap = 2) Mid Cap = 3) Small Cap = 4) Foreign Stock =

1) Large Cap = S&P 500 2) Mid Cap = S&P 400 3) Small Cap = Russell 2000 4) Foreign Stock = EAFE

1) Basis description of Net Present Value 2) What value represents the company or investor's rate of return when it

1) NPV is the difference between an investment's PRESENT VALUE and its COST - In these scenarios you compare the company's rate of return to the cost. Its an analytical concept used by CORPORATION to determine whether to invest in capital project.

1) What type of management styles believes in Efficient Market Hypothesis? 2) What does the Efficient Market Hypothesis believe? 3) What is EMH sometimes referred to or nicknamed?

1) Passive Management Style 2) The security prices adjust rapidly to new information with security prices fully reflecting all available information - Other words the markets are efficiently priced. 3) Random Walk Theory = This theory suggests that throwing a dart at the stock listings is as good a method as any for selecting stock for investment.

Currency or Exchange Rate Risk 1) Describe: 2) What type of question may be on the exam about currency risk associated with value changing on Dollar? 3) What type of investment can be subject to Exchange Rate Risk?

1) Purchasers of Foreign Securities and the risk associated with the devaluing of either the Foreign or Domestic Currency. 2) Be prepared for potential questions asking you how when visiting a foreign country you purchase the same object or dinner two days in a row for the same price, but noticed you were charged a different amount by the US Bank. Its due to change in relationship of the foreign currency and the dollar....aka currency or exchange rate risk 3) Direct Ownership of Foreign Currency or an ADRs

Internal Rate of Return: You must know what they're used for: 1) Even thought it possible it difficult to calculate IRR for investments with uneven cash flows, so what's IRR primarily used for:

1) That is why it is used primarily with debt securities and common stocks with stable dividends.

1) What's the main goal of a Modern Portfolio Theory? 2) What does an Efficient Portfolio offer?? 3) What is used to measure if a portfolio is considered efficient? 4) What is CML generally used for?

1) The goal is to construct the most efficient portfolio. 2) It offers the most return for a given amount of risk and the least amount of risk for the given amount of return. 3) The Capital Market Line CML provides the expected return for a PORTFOLIO based on the expected return of the market, risk-free rate of return and the standard deviation of the portfolio in relation to the standard deviation of the market. 4) Its used to evaluate DIVERSIFIED PORTFOLIO

NYSE INDEX COMPOSITE INDEX 1) List the type of securities. 2) What is the type of Weighted Index? 3) List the market(s) the securities are listed on? 4) Any unique pieces of information to know about this index?

1) The index includes all of the common stocks listed on the NYSE , more than 3,000 different companies. 2) Base-Weighted Index using the base is December 31, 1965. (Similar to S&P 500) and the index for the base is 50. - Cap-Weighted Index 3) Only NYSE 4) This index provides the most COMPREHENSIVE measure of market activity on the NYSE

What to know about the Efficient Market Hypothesis: 1) What to know about Strong Form Market Efficiency Method 2) What type of information does Strong Form believe the prices of stock already reflects?

1) They believe that security prices FULLY REFLECT ALL INFORMATION from PUBLIC and PRIVATE SOURCES (insider trading). 2) All information including: Market, Non-Market Public Information and Private Information (insider trading)

What you must know: 1) What's the approach of the Modern Portfolio Theory? 2) Must understand how they attempt to reduce risk compared to traditional security analyst.

1) They focus on the relationship among all the investments in the portfolio. This theory holds that specific risk can be diversified away by using selection of securities with negative correlation. 2)MPT emphasizes determining the relationship between RISK and REWARD in the total portfolio rather than analyzing specific securities

Weak Form vs Semi-Strong Form: 1) An investor cannot achieve a positive risk-adjusted return on average by using 2) What might a Fundamental Analysis believe they can beat to achieve a positive risk-adjusted return on average? 3) What does Strong Form Market Efficiency believe about analysis tools?

1) Weak Form = Technical Analysis - Semi-Strong form = Fundamental Analysis 2) According to the EMH, if a financial market is weakly efficient, Technical Analysis will be useless, but it is still possible to use Fundamental Analysis to seek out mispriced investments. 3) If a financial market is strongly efficient, then everything including information generally only available to insiders is KNOWN and without an edge, there is NO BENEFIT to be gained by using ANALYSIS TOOLS.

What to know about the Efficient Market Hypothesis: 1) You should know the three versions of the EMH method? What does all three versions of EMH believe in and consider the best way to manage a portfolio?

1) Weak Form Efficiency Method 2) Semi-Strong Form Market Efficiency 3) Strong Form Market Efficiency - All three versions believe that all information is already reflected in the security price and there's no way to accurately predict stock prices THUS a PASSIVE MANAGEMENT STYLE is most suitable for investment success.

Must Know! Weak Form knows what type of info Semi-Strong know what type of info Strong Form know what type of info

1) Weak Form is based on past security market information. (Market Information) 2) Semi-Strong Form is based on ALL PUBLIC Information including Market and Non-Market info 3) Strong form is based on All PUBLIC and NON-PUBLIC (PRIVATE) INFORMATION

1) Using the Rule 72 Formula, What is necessary to and How do you calculate what is the compound earnings rate? 2) Suppose an investment of $1,000.00 was worth $4,000 in 16 years. Under the rule of 72 what is the compounding earnings rate?

1) What's need: - Present Value - Future Value - Number of Years 2) You see the dollar amount quadrupled, so it took 16 years to double twice, it takes 8 years double one time. So 72 / 8 = 9%

1) A bond's yield to maturity reflects its: 2) What does IRR equate to?

1) Yield to maturity reflects the internal rate of return on a bond. 2) Internal rate of return (IRR) equates the cost of an investment to the cash flows produced by that investment.

1) What type of calculation can you do using the below information in the question? 2) 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?

1) You can calculate the Future Value based on the PV= $10k (1+.08)12 = $25,181.70 2) 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.

1) Liquidity risk 2) Legislative risk 3) Market risk 4) Reinvestment risk

1) is the measure of how quickly and easily a security can be converted to cash. 2) is a measure of how legal changes (e.g., taxes) affect an investment. 3) is a measure of the volatility of a stock or the risk of loss as a result of market changes. 4) is the risk that an investor will not be able to reinvest interest payments on a bond at the original rate during the life of the bond.

NASDAQ COMPOSITE INDEX 1) List the type of securities. 2) What is the type of Weighted Index? 3) List the market(s) the securities are listed on? 4) Any unique pieces of information to know about this index?

1) the OTC market is represented by the Nasdaq Index...It consists of more than 3000 OTC listed companies. - Similar amount to NYSE but instead listed on the NASDAQ. 2) Base-Weighted Index using the base of February 5, 1971 and an index number of 100. - Cap-Weighted Index

S&P 500 Composite Index: 1) List the type of securities. 2) What is the type of Weighted Index? 3) List the market(s) the securities are listed on?

1) there's FOUR main groups of securities: 400 industrial, 20 transportation companies, 40 public utilities and 40 financial institutions. 2) Base-Weighted Index using the base period of 1941-1943 - And a Cap-Weighted or sometime called Market Weighted Index 3) Most of the stocks are listed on the NYSE, but some are found on the AMEX and NASDAQ.

When dealing with a question on the exam regarding risks associated with Treasury Bills, Notes, Bonds...what are the potential

Although Treasury securities do not carry default risk (principal and interest are guaranteed by the federal government), they are subject to interest rate risk. The prices of Treasury securities will decline if interest rates rise, subjecting the client to loss of principal should he sell them prior to maturity.

If a customer is concerned about interest rate risk, which of the following securities is least appropriate? A) 5-year corporate bonds. B) 10-year corporate bonds. C) 25-year municipal bonds. D) Treasury bills.

Answer C: Interest rate risk is the danger that interest rates will rise and adversely affect a bond's price. This risk is greatest for long-term bonds; short-term debt securities are affected the least if interest rates change.

What type of portfolio makes the best trade off between risk and reward for a given's investors investment profile?

Optimal Portfolio - focused on returns the highest rate of return consistent with the amount of risk an investor is willing to take

A client approaches the IAR handling the advisory account with a request to find a preferred stock that will offer a 6% income return. The IAR suggests a stock paying a $.28 quarterly dividend. That stock will meet the income objective if it has a current market price of A) $18.67 B) $11.91 C) $4.67 D) $6.72

Answer: A The first thing to do is annualize the dividend by multiplying the $.28 by 4. Once we have the annual dividend of $1.12, divide by 6% and the result is $18.6666 or $18.67 properly rounded. If you left your math skills at home, all you have to do is multiply each of the 4 choices by 6% to see which one is closest to $1.12.

ABC Combination Fund has dual objectives of capital appreciation and current income. Last year, the fund paid quarterly dividends of $.25 per share and capital gains of $.10 per share. The annualized growth rate of the fund was 15%. The current net asset value (NAV) of the fund is $28.50 and the current public offering price (POP) is $30. Advertising and sales literature of the fund may report the fund's current yield to be: A) 3.33%. B) 0.83%. C) 3.85%. D) 27.20%.

Answer: A The current yield on mutual funds is calculated by dividing the annualized yield ($.25 × 4 = $1) by the POP. In this case, $1 ÷ $30 = .0333 × 100 = 3.33%. In calculating the current yield, the law prohibits the inclusion of capital gains and growth.

XYZ Corporation has a beta of 1 and ABC has a beta of 1.4. XYZ has returned 12% and ABC 18.8%. Based on this information ABC had alpha of A) 18.8% B) 2% C) 4.8% D) 6.8%

Answer: B Alpha is the extent to which a security's performance exceeds (or falls short of) what would be expected based on its beta. A stock with a beta of 1.4 would be expected to perform 40% better in an up market than one with a beta of 1.0. Because XYZ with a beta of 1.0 gained 12%, ABC should return 140% of that or 16.8% (12% x 1.4). With an actual return of 18.8%, ABC beat the expected by 2% and that is its alpha.

Your client with $100,000 to invest is looking for maximum current income. Which of the following would offer the highest current return? A) $100,000 of zero-coupon bonds with a yield to maturity of 6%. B) $100,000 market value of corporate bonds selling at a premium and yielding 6% to maturity. C) $100,000 AA rated corporate bonds trading at par with a 6% coupon rate. D) $200,000 of utility common stock paying a current dividend of 3.5%.

Answer: B Bonds selling at a premium have higher coupons than those selling at par. Therefore, the current yield on those bonds is higher than the ones at par, even though they would have the same yield to maturity. The zero-coupon bonds offer no current income and the investor only has $100,000 to invest so the utility stock is not a viable option.

Each of the following terms is commonly found in modern portfolio theory EXCEPT the A) feasible set B) internal rate of return C) capital asset pricing model D) efficient set

Answer: B Internal rate of return (IRR), is not a component of modern portfolio theory as are the other three terms.

What is the total return on a bond that cost an investor $950, was sold for $1,000, and paid $50 in interest payments? A) The return cannot be determined from the information supplied. B) 10.50%. C) 5%. D) 10%

Answer: B Total return is the sum of all payments ($50) plus the capital gains ($50) divided by the cost ($950). In this case, 50 + 50 ÷ 950 = .10526 or 10.5%.

XYZ Corporation has a beta of 1 and ABC has a beta of 1.4. XYZ has returned 12% and ABC 14.8%. Based on this information, ABC had alpha of A) 2.8% B) 14.8% C) -2% D) 2%

Answer: C Alpha is the extent to which a security's performance exceeds (or falls short of) what would be expected based on its beta. A stock with a beta of 1.4 would be expected to perform 40% better in an up market than one with a beta of 1.0. Because XYZ with a beta of 1.0 gained 12%, ABC should return 140% of that or 16.8% (12% x 1.4). With an actual return of 14.8%, ABC underperformed the expected by 2% and that is why it has a negative alpha.

ABC Industries common stock has a beta of .8 while DEF Technologies common stock has a beta of 1.2. The total return for ABC was 15% and that for DEF was 24.5%. Based on this information, you could say that DEF had alpha of: A) +6.5% B) +9.5% C) +2% D) -2%

Answer: C Alpha is the extent to which a security's performance exceeds (or falls short of) what would be expected. With a beta of 1.2, DEF should produce a total return that is 1.5 times greater than that of ABC (1.2/.8 = 1.5). Therefore, anything in excess of 22.5% (1.5 × 15%) would create a positive alpha and anything less would generate negative alpha. In this example, the actual return of 24.5% is 2% greater than what would be expected and that is our positive alpha.

If the Consumer Price Index (CPI) rose 5% during the last year, during which time your client held a 6% municipal bond, what would be the approximate annualized inflation- adjusted return? A) 0%. B) 5%. C) 6%. D) 1%

Answer: D Because inflation, as measured by the CPI, rose by 5% each year and the client's bonds returned 6% annually, inflation would have reduced the client's purchasing power by 5%, leaving an inflation-adjusted return of 1% each year. REMEMBER! Inflation reduces the client's purchasing power by the % of inflation.

Which of the following industries is most exposed to regulatory risk? A) Publishing companies. B) Entertainment companies. C) Consumer retailers. D) Public utilities.

Answer: D Most industries are subject to the regulation of their business through regulatory activity. Of the companies listed, public utilities are the most highly regulated. Their prices, production processes, and the economic returns are all subject to regulatory control such as from the state's Public Service Commission and the federal EPA. Publishing companies experience little regulatory interference because of the nature of the products and services they offer. They face legal issues such as copyright infringement and libel suits, but enjoy relatively little interference from regulatory bodies. Entertainment companies do not have the same level of exposure to regulatory risk as the others listed. Retailers are middlemen in the product production process and face less regulatory risk than other industries.

The primary risk in investment-grade bonds is: A) default. B) bankruptcy. C) liquidity. D) inflation.

Answer: D The primary risk of an investment in any high-quality bond is inflation. Default risk is lower with an investment-grade (high-quality) bond than with a low-quality bond. Bankruptcy risk is similar to default risk (i.e., very low in a high-quality bond). Liquidity risk, sometimes referred to as marketability risk on the exam, means difficulty in selling quickly without affecting the market price; high-quality bonds have fairly good liquidity.

Which of the following investments is the most liquid? A) Municipal revenue bond issued by a township B) Oil drilling limited partnership interest C) Common stock in a small oil drilling corporation that is quoted on the OTC Link D) Long-term municipal bond fund

Answer: D The long-term municipal bond fund is the most liquid because it is a mutual fund (a redeemable security), and the investor is assured of a buyer that will exchange money for the redeemed fund shares within seven days of the redemption request. Municipal bonds of a township, especially those that are from extremely small issuers, may have thin markets where sellers have difficulty finding willing buyers. There is not an active secondary market for reselling interests in limited partnerships. Stock of a small corporation that trades on the OTC Link (formerly known as the "Pink Sheets") may also have a thin market.

Why is it important to know the different categories and how to use them on the exam

Each of these asset classes as a whole, responds differently to different types of risk; therefore, diversifying or allocating investment resources among these classes is a proven way to reduce risk overall, dampen volatility and improve the performance of one's portfolio You must know importances these categories play in creating a diversified portfolio to reduce RISKS

How do you calculate the Current Yield for Common Stock and Debt Security?

Common Stock: Annual Dividend per Common Share Divided by Market Value per Common Share Bond: Annual Interest Divided by Market Price (Not Par Value) of Bond

Opportunity Cost What type of investments can be subject to opportunity cost

Is the forgone return, or the return given up, on an alternative investment (not AI product). Basically passing on a product for another product and you missed the opportunity for a better return. 1) US Government T-Bills have no opportunity risk, but Any Investment product that don't offer a risk free return is subject to opportunity cost.

What does high inflation do?

It reduces the dollar's buying power,

Bullet Technique

Its an active management style of buying bonds over a period time a particular target date in mind. This method of reducing interest rate risk is best for someone targeting particular date such as retirement or college. - Let's say you're saving money to send you child to college in 10 years, so you buys some bonds today that mature in 10 years, then some more in two years with 8 year term, then some more in two years with 6 year term and so. - Key to remember best used for targeting a date and Buying bonds at different times but all the same MATURITY DATE.

Laddering Technique

Its an active management style used by buying bonds all at the same time but with different terms. This method is truly staggering.

What's the single most important thing to remember about portfolio manager or IAR using bond strategy style such as barbell, laddering and bullet methods to reduce interest rate risk

Its considered an Active Management Style rather than Passive Management Style

What is Rule of 72 used for?

Its shortcut method used for determining the number of years it takes for an investment to DOUBLE in VALUE assuming compound interest.

Definition of Liquidity 1) Give an example of a Liquidity Product? Give an example of a product that faces liquidity risks

Liquidity measures the speed or ease to purchase or sell or converting an investment. 1) Government T- Bills 2) REITS or Real Estate Investments and DPPs

What has level of liquidity risk? Rental Real Estate Property or REITS?

Real estate (such as an apartment building) is among the most difficult investments to convert into cash - REITS provide investors with liquidity through trading in the secondary markets

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. or Capital Market Line

Technology companies are highly sensitive to what type of risk?

Technology companies are especially sensitive to business risk as a result of competing technologies.

A stock that is not readily convertible into cash has a high degree of

liquidity risk.

Two of the major factors involved in the Capital Asset Pricing Model (CAPM) are

time and risk CAPM is built on the theory that investors must receive a return commensurate with the amount of risk taken over a specified period of time.

The measure of the variance in returns of a portfolio around its average return is the

standard deviation.

The risk of the portfolio associated with the macroeconomic factors that affect all risky assets is

systematic risk.

The expected return estimates?

The estimate of probable returns that an investment may yield when taking the sum of all probabilities.

What does the founder of MPT believe is the most successful type of portfolio

The portfolio with the LEAST AMOUNT of VOLATILITY would do better than one with a greater amount of volatility.

What's the primary risk of any high rated bonds?

The primary risk of an investment in any high-quality bond is inflation

What's the Real Rate of Interest?

The real rate of interest is the nominal rate minus the inflation rate. Simple Subtraction Equation. Nominal Rate - Inflation Rate = Real Rate of Return aka Inflation-Adjusted Return.

You may be asked to determine which is higher (or lower), the Current Yield or the Yield to Maturity?

Think about it! If the bond is bought at Discount (below par value) so it earn more money by the time it matures, since whatever the discount is added profit to a bond. Discount Bond = YTM will always be HIGHER Than the bond's Current Yield (CY) Premium Bond = YTM will always be LOWER Than the bond's Current Yield (CY)

Reinvestment Risk

You must Know: - There's two types of reinvestment risk: reinvestment risk to the interest and reinvestment risk to the principal. - Reinvestment Risk to the Principal occurs at MATURITY, its the inability to reinvest the principal of the bond for the same interest rate or better. 10% Bond maturing an only able to reinvest for 5% bond. - Reinvestment Risk to the Interest (Similar) its when you're unable to reinvestment the income at the same rate as the security itself is paying.

How to minimize market risk in a portfolio?

You should diversify among all four asset classes and further diversify among the equities class

How to minimize business risk?

You should diversify among all four asset classes and mutual fund classes.

How do you hedge against interest rate risk?

You should diversify using fixed income investments using the different barbell, ladder and bullet strategies.

How do you determine the compound return calculation?

You take the initial value (PV) and multiply it that by (1 + interest rate) and continue to do that for how many years your looking for, so 10 would multiply PV w/ (1 + Interest Rate)

Under the CAPM, using the SML, we can determine the expected return of any given stock by

taking the risk-free rate and adding to that the product of that stock's beta coefficient and the difference between the expected return on the market and the risk-free rate. Standard deviation is not a factor in this computation. Risk Fee rate + Beta (Expected Rate - Risk Free Rate)

The client's investment (and indeed his employment) is entirely invested in his employer's stock, his portfolio is exposed to what type of risk

disproportionately exposed to business risk. Should the company experience a business or industry set back, the portfolio could suffer substantial losses. There are a large number of historical examples where this has happened (frequently wiping out retirement savings).

Some risk is involved in almost all investments. In general, the greater the risk, the:

greater the potential return

The real return formula measures?

inflation-adjusted performance.

A positive alpha means

you investment performance is better than what would have been anticipated (beta) give the risk in terms of volatility. Beta = 1.2 = 20% more volatile than the market. if the return is better than volatility of the portfolio you would have to a return of 3% or better.