Series 66 Chapter 9: Investment Recommendations - Risks and Returns
Mr. Smith, a client of yours, owns a large portfolio of many different common stocks. These holdings are spread amongst stocks of different industry sectors and capitalizations. His portfolio gives him protection from all of the following risks EXCEPT [A]Liquidity [B]Non-Systematic [C]Credit [D]Market
EXPLANATION A fully diversified portfolio of common stocks will still be subject to overall market risk (systematic risk). This is a risk that is inherent to all securities within a market and thus cannot be eliminated by diversification.
An efficient trading market is one with: [A]uniform trading procedures[B]centralized trading floor[C]small bid / ask spreads[D]publicly disseminated traded reporting
EXPLANATION An indication that the market for a security is operating efficiently is when the difference between the bid and the ask price is narrow or small.
An investor's concern regarding the corporation's profitability in the future is known as [A]Market risk. [B]Business risk**** [C]Inflationary risk [D]Liquidity risk
EXPLANATION Credit or Business risk is the risk that a company will declare bankruptcy.
If an investor is willing to bear market risk, what is the best investment strategy to exploit their acceptance of market risk? [A]The best risk management technique in this situation would be to eliminate the unsystematic risk from their portfolio.*** [B]The best risk management technique would be to only invest in stocks with a beta of 1.0 or less. [C]The best risk management technique would be to buy insurance policies that would cover all of the investor's losses. [D]The best risk management technique would be to invest in Treasury Bonds in an emergency fund as an aside to their normal portfolio.
EXPLANATION If an investor is willing to accept certain amounts of risk in their portfolio, the best investment strategies are those that take advantage of that acceptance of risk while minimizing all other types of manageable risk. If a person was not opposed to accepting systematic or market risk, then you would want to exploit that but at the same time, eliminate as much unsystematic risk as possible.
All of the following statements about the "efficient market" theory are TRUE EXCEPT: [A]Prices reflect the combined knowledge and expectations of all investors. [B]It is impossible to "beat the market." [C]It is impossible to find undervalued or overvalued stock.[D]Efficient fundamental and technical research can produce superior investment results.****
EXPLANATION The "efficient market" theory is also known as the "random walk" theory and believes that throwing darts will produce as good results as using a professional investment adviser. Therefore, using fundamental or technical research would unlikely produce results as the efficient market hypothesis states that all stocks are appropriately priced and fully reflect their value.
Which of the following are pieces of the formula which determine the real rate of return on an investment? The investment's risk level The investment's total return The current rate of inflation The investment's internal rate of return [A]I and III only[B]I and IV only[C]II and III only****[D]II and IV only
EXPLANATION The real rate of return is the total return of an investment minus the current rate of inflation. It attempts to give investors a picture of their return in relation to the current rate of inflation, showing the investor how inflation is affecting their overall returns.
An investor must decide if the current market price of a 20-year bond that pays semi-annual interest is fairly valued. To assess the value of the bond using discounted cash flow methodology, the investor must include which of the following in DCF calculations? [A]Coupon payments*** [B]Bond ratings [C]The relevant bond market index value [D]Common stock dividends
EXPLANATION DCF calculations on bonds include the discount rate, coupon payments, and the principal payment at maturity. All of the other choices are not included when calculating values of bonds using DCF. Note: common stock dividends are a consideration for equity valuations, but not for bonds.
A trader has a sizable position in a small capitalization stock with low trading volume. The trader is subject to which of the following types of risk? [A]Market [B]Liquidity**** [C]Business [D]Inflation
EXPLANATION Liquidity risk would be a major concern for anyone holding a small cap stock with low trading volume.
Why would a person who wins the lottery, take the full distribution today as opposed to taking distribution in periodic payments? [A]Time Value of Money**** [B]Opportunity cost [C]Business risk [D]Dollar Cost Averaging
EXPLANATION The Time Value of Money concept states that the value of a dollar today is worth more, than the future value of the same dollar. The person should take the money now and invest it, so it can grow with inflation.
The difference between an investment's rate of return and the inflation rate: [A]would be called the total return [B]is the real return**** [C]would be called the expected return [D]is the internal rate of return
EXPLANATION The real rate of return is the inflation rate adjusted rate of return (i.e. rate of return - inflation rate = the real rate of return).
Business risk of a company is directly associated with [A]Inflationary risk. [B]Market risk. [C]Call risk [D]None of the above***
EXPLANATION Business risk is the risk that a company will not be able to meet its expenses and subsequently fail. This risk does not directly apply to any of the choices listed leaving "D. None of the above" as the best answer. Inflationary risk relates to inflation, Market risk would be systematic risk which cannot be eliminated via diversification, and Call risk is directly related to callable bonds and whether they are called prior to maturity.
During the first years after the purchase of a long term investment grade bond, the bond would be most affected by which of the following types of risks? [A]Purchasing Power [B]Interest Rate**** [C]Market [D]Inflationary
EXPLANATION In the early years of owning a long term bond, the bond would be most sensitive to Interest Rate Risk. As the bond approaches maturity, the Interest Rate Risk diminishes.
Which of the following securities has the greatest credit risk? [A]General Obligation Bond [B]Industrial Development Bond**** [C]Equipment Trust Certificate [D]Mortgage Bond
EXPLANATION Industrial Development bonds are bonds that are issued by municipalities on behalf of a public corporation and ultimate responsibility for the debt is placed on the corporation. Therefore, these bonds would be considered a risky investment when compared to the other choices offered which all are backed by specific assets.
Joey recently came into some money via an inheritance. After all taxes, he received $2.5 million dollars from his grandparents. Joey has decided to spend part of the inheritance on a house that he will buy in cash, but he wants to invest a set amount to ensure that he receives $5,000 per month for his bills indefinitely. An adviser has recommended a fund which has an anticipated or expected annual rate of return of 4.8%. With these factors in mind, how much does Joey have to invest and how much remains for Joey to buy a house in cash? [A]Joey must invest $2,500,000 and will have $0 remaining for the house. [B]Joey must invest $1,250,000 and will have $1,250,000 remaining for the house.**** [C]Joey must invest $600,000 and will have $1,900,000 remaining for the house. [D]Joey must invest about $105,000 and will have about $2,395,000 remaining for the house.
EXPLANATION In this scenario, Joey is looking for a payment in perpetuity (indefinitely, forever, etc). So with the expected rate of return that is listed, we can calculate the amount necessary to arrive at that indefinite monthly payout. Our payment is given on a monthly basis while our expected rate of return is an annual figure. So we either need to calculate the annual payout or figure out our monthly rate of return to arrive at our answer.Monthly, Joey wants $5,000. So we can divide the 4.8% by 12 to arrive at a monthly expected return of 0.004 (0.048 / 12). We then divide $5,000 by 0.004 to arrive at the same figure of $1,250,000.So Joey must invest $1,250,000 to receive his monthly $5,000 and he will have $1,250,000 to spend on the house. Annually, Joey wants $60,000 ($5,000/mo). So we can divide $60,000 by 4.8% (60,000 / 0.048) to arrive at the amount that must be invested $1,250,000.
When you take the nominal return less the rate of inflation you have just determined the: [A]Inflation Adjusted Return*** [B]Expected Return [C]Realized Return [D]Standard Deviation
EXPLANATION The Inflation Adjust Return also called the Real Return or Real Interest Rate is determined by taking the total or nominal return less the rate of inflation.
Which of the following investments would have the highest degree of interest rate risk? [A]7% corporate bond maturing in 2010 [B]5% municipal bond maturing in 2010 [C]0 coupon bond maturing in 2010*** [D]6% government bond maturing in 2010
EXPLANATION The lower the coupon rate on a bond the more sensitive the price becomes (the duration is higher). Therefore, a zero coupon bond would have the greatest degree of risk or sensitivity.
Chad has an idea of how he thinks his portfolio will perform over the next 12 months. His current portfolio consists of 50% equities which he expects to appreciate 7%, 30% in bonds which he expects to appreciate 3%, and 20% money market funds which he expects to appreciate 1%. If this information is accurate, Chad would expect to see which of the following? [A]100% return on his portfolio [B]11% return on his portfolio [C]4.6% return on his portfolio*** [D]Cannot be determined with the information provided
EXPLANATION In order to determine Chad's return on his portfolio with the appropriate weighting to equities, bonds, and money market funds, we would figure the following :Equities 50% X .07 = .035 Bonds 30% X .03 = .009MMF 20% X .01 = .002 .046 = 4.6% return on his portfolio
An individual using which risk perspective would use modern portfolio theory to select an investment? [A]Risk Neutral [B]Risk Averse**** [C]Risk Seeking [D]Risk Indifferent
EXPLANATION Modern Portfolio Theory attempts to optimize expected returns for a portfolio for a given level of risk. Modern Portfolio Theory can also work with opposite directions attempting to minimize risk for a given amount of return. An individual who seeks to minimize risk is generally risk averse.
An investment's performance is best measured by: [A]The investment's yield [B]The investment's total Return*** [C]The investment's benchmark return [D]The investment's capital appreciation
EXPLANATION The best measure of an investment's performance is the sum of income and capital appreciation, known as total return.
Fixed annuity payouts are primarily subject to which of the following risks: [A]Inflation Risk*** [B]Market Risk [C]Regulatory Risk [D]Capital Risk
EXPLANATION The inflation risk is the purchasing power risk. Since fixed annuity payments are of a fixed amount, inflation will diminish the purchasing power of the payments. (Ex - $1000 today will be worth less than $1000 in 10 years)
Which of the following statements about discounted cash flow methods of evaluating investments is false? [A]Holding period return (HPR) is a discounted cash flow method.**** [B]Net Present Value (NPV) is a discounted cash flow method.[C]Internal Rate of Return (IRR) is a discounted cash flow method.[D]Discounted cash flow methods take into account the time value of money.
EXPLANATION Holding period return is another way of saying Total Return and Total Return does not discount cash flow. Total Return is the actual rate of return plus capital gains or minus capital losses over a given period of time and is considered to be the best measurement of an investments performance. Discounted cash flow represents the value of future expected cash receipts and expenditures as of a set date and is used when computing net present value and internal rate of return.
When using DCF to evaluate the impact of increasing interest rates in the market, what affect would it have on new bonds in the market? [A]The DCF on new bond will increase.**** [B]The DCF on new bond will decrease. [C]The DCF on new bond will stay the same. [D]The DCF is not used to evaluate the interest rates on new bonds.
EXPLANATION If interest rates are increasing, then it is expected that the returns on new bonds will increase due to the increase in interest rates.
What is the biggest risk to an investor with a portfolio that is over 90% invested in publicly traded common stocks with the remainder in the portfolio as cash? [A]Market Risk**** [B]Business Risk [C]Regulatory Risk [D]Interest Rate Risk
EXPLANATION Market risk is the potential for an investor to experience losses due to daily fluctuations in the price of securities. It is also known as systemic risk.
The Sharpe ratio measures the: [A]level of investment return relative to the dollar amount invested [B]level of portfolio volatility relative to a benchmark portfolio [C]risk-adjusted rate of return relative to the risk-free rate of return [D]risk-adjusted rate of return relative to portfolio volatility***
EXPLANATION The Sharpe Ratio measures whether the returns on a portfolio were due to smart investment decisions or excess risk which means that the risk-adjusted rate of return on the portfolio is relative to the portfolios volatility.
When using DCF to evaluate a bond, we would need all of the following information: I. Maturity Date II. Coupon Rate III. Par Value IV. Current market price [A]I and II[B]I and III[C]I, II, III, IV[D]I, II, III****
EXPLANATION The current market price of the bond would not be relevant when evaluating existing bondholdings.
When a portfolio is spread among U. S. Equity securities which two of the following types of risk are reduced? System Risk Financial Risk Market Risk Business Risk [A]I & III only[B]II & IV only****[C]I & IV only[D]II & III only
EXPLANATION Both Business and Financial risk would be reduced with diversification in domestic equity securities. System risk and Market risk are the same thing and would not be reduced with diversification within the SAME asset class (U.S. Equity stocks).
A fixed income security has as its greatest risk, which of the following? [A]Loss of liquidity [B]Credit risk [C]Market risk [D]Loss of purchasing power.****
EXPLANATION Inflationary risk is the risk of loss of buying power, especially on securities with long term maturities. Therefore, the greatest risk of fixed income securities would be buying power risk.
Which of the following statements are TRUE regarding Dollar-Weighted Return and Time-Weighted Return? I. Dollar-weighted return allows investors to compare the performance of one manager to the performance of another manager. II. Time-weighted return allows investors to compare the performance of one manager to the performance of another manager. III. Dollar-weighted return allows investors to see a snapshot of their overall investments in relation to their financial goals. IV. Time-weighted return allows investors to see a snapshot of their overall investments in relation to their financial goals. [A]I and III[B]I and IV[C]II and III***[D]II and IV
EXPLANATION Time-weighted return eliminates the effect of cash flows to give an idea of performance. It is an effective way to measure the performance of portfolio managers to one another as well as to a benchmark. Dollar-weighted return includes cash flows so that the investor can get an idea of the returns and growth of their portfolio in relation to their financial goals. It is not an effective way to compare managers.
An analyst is attempting to optimize a balanced portfolio for maximum returns with a specified level of risk. Which of the following is TRUE in this scenario? [A]The analyst cannot optimize a portfolio for a specified level of risk. [B]The analyst should only look at company fundamentals for specific stocks found within the portfolio. [C]The analyst should incorporate the expected or mean returns of securities in the portfolio into their optimization strategy.*** [D]The analyst should focus most of their attention on the maturities of bonds within the portfolio, the yield to maturity of these bonds, and the bonds total return to date.
EXPLANATION When optimizing a portfolio, the expected or mean returns of all securities within the portfolio should be considered. It would be irresponsible to only focus on stocks or bonds.
Business or Credit Risk is best defined as which of the following? [A]The risk that is unique to an individual companies current and future returns.**** [B]The risk that an investments returns will be affected by political changes. [C]The risk that an investment will not be able to be sold quickly.[D]The risk that the market as a whole will decline.
EXPLANATION Business or Credit Risk is the risk associated with the unique situation of an individual company's current and future returns as well as solvency of the company.
Suzanne is an IA who handles Bobby's account. Bobby is heavily invested in bonds and regularly reviews and calculates the current yield on his bonds. Which of the following would be of greatest concern to Suzanne in relation to Bobby's view of the bonds? [A]Bobby isn't getting an accurate idea of the market value of the bonds. [B]Bobby isn't getting an accurate idea of the nominal yield of the bonds. [C]Bobby isn't getting an accurate idea of the yield to maturity of the bonds.**** [D]Bobby isn't viewing a valid number when calculating current yield on any bond.
EXPLANATION Current yield is a great snapshot of a bond considering the bond's nominal yield (coupon rate) divided by the bond's current market price. It is a valid tool in analyzing bonds but does NOT give an accurate assessment of a bond's YTM - Yield to Maturity.
What is the main point of the Efficient Market Hypothesis (EMH)? [A]The market price of securities always reflects all relevant information, both public and private.**** [B]Investors select companies to invest in based on the efficiency of the companies that they evaluate. [C]Individuals invest in manufacturing companies that produce the most efficient products in their sector. [D]Investors always select the exchange at which order executions is most efficient.
EXPLANATION Efficient Market Hypothesis is an investment theory which states that the markets are efficient and that information that is relevant to the market prices of securities is always reflected in the current market price, making it impossible to "beat the market."
If Congress decides to change the long-term capital gains tax rate from 15% up to 20%, and the President signs the bill into law, which of the following types of risk best describes the negative impact this may have on those holding securities? [A]Credit Risk [B]Regulatory Risk [C]Liquidity Risk [D]Business Risk
EXPLANATION Regulatory Risk is the risk that changes in government activity, including changes in laws, rules, regulations, and tax rates on securities in the U.S. will have negative effect on investments, such as an increase in taxes on gains on securities investments.
Stella is considering retirement and while meeting with her investment adviser they determine that if she were to retire now based on her current assets and social security she would be able to live but would not have any extra income. Which of the following would be the most important type of risk for her investment adviser to explain to her before she makes the decision to retire? [A]Reinvestment Risk [B]Inflation or Purchasing Power Risk**** [C]Political Risk [D]Credit Risk
EXPLANATION Stella's investment adviser should explain the potential risk of reduction of purchasing power - will her money be able to continue to cover her living expenses based on the rate of inflation. It is expected that dollars received in the future will buy less than in the present.
The quantitative method of evaluating investments that determines the interest rate that discounts periodic cash inflows and outflows to a present value of "0" is: [A]inflation-adjusted return [B]net present value [C]total return [D]internal rate of return****
EXPLANATION The Internal Rate of Return measures the discount rate at which the present value of the future cash flows of the investment equal the cost of the investment. This is considered an outflow and inflow of cash in a portfolio.
If an IAR uses "discounting" in order to assist a client at arriving at a financial goal, which of the following would be a likely scenario? [A]The client has a specific amount of money today and would like to know how much they might have in 20 years, assuming a certain rate of return which fits their risk tolerance. [B]The client has a specific financial goal or need in 20 years and they'd like to know how much they would need to invest today in order to reach that goal, while investing within their risk tolerances.**** [C]The client has a mortgage, and asks the IAR to explain why the interest and principal amounts vary on each payment over the lifetime of the loan. [D]The client only has a certain amount that can be spent on their month-to-month financial planning, and asks the IAR to offer them a break off of the IAR's normal rate.
EXPLANATION If an IAR is using discounting, then it is likely that the IAR is figuring out a present value that would need to be invested today, assuming a certain rate of return, to arrive at a specific financial goal or need in 20 years. The rate of return anticipated would depend on the client's risk tolerance.The first answer discusses compounding. The third is likely a question related to amortization. The last answer discusses a possible discount or reduced charge, but this is not the same as "discounting".
A client has $100 dollars to invest and has the choice of investing in either gold or oil. The client chooses to invest in gold. After a year of being invested in gold, the investment is now worth $125. The oil would now have been worth $155. This $30 difference between the two investments one year later is best described as [A]Annualized Return [B]Risk-Adjusted Return [C]Expected Return [D]Opportunity Cost****
EXPLANATION Opportunity cost pertaining to securities is described in Barron's Dictionary of Financial Terms as being the "cost of forgoing a safe return on an investment in hopes of making a larger profit." In other words, the investor in this case could have invested in oil, which is more speculative and volatile, and would have made $30 more a year later. $30 dollars is the opportunity cost of having invested in gold, which is typically more stable.
Megan goes to her investment adviser for help with some questions regarding savings. She wants to be able to help her child out with college education expenses. She wishes to have $20,000 to contribute in 10 years from now. The IAR discusses Megan's risk tolerance with the funds, the amounts that she can contribute today, and possible investments. Knowing the variables, which two of the following are TRUE in this scenario? To arrive at an idea of how much would need to be invested today in order to have $20,000 in 10 years, the IAR will use compounding. To arrive at an idea of how much would need to be invested today in order to have $20,000 in 10 years, the IAR will use discounting. To arrive at an idea of how much would need to be invested today in order to have $20,000 in 10 years, the IAR will use straight-line amortization. The IAR will be attempting to find the present value today of the $20,000 future value. [A]I and III only[B]I and IV only[C]II and III only[D]II and IV only****
EXPLANATION Discounting uses a mathematical calculation to find the present value today of some desired future value. Here, that future value is $20,000, and the IAR would be discounting $20,000 by the expected rate of return on investments in order to find out how much would need to be invested today to arrive at that amount of money in 10 years. In other words, the present value is the unknown variable.Compounding is a method of using a present value and rate of return to find out what the future value will be with those assumptions. In other words, the future value is the unknown variable.Straight-line amortization is a term used to describe repayment of a loan and the manner in which principal and interest from the loan is repaid. It would not apply to this scenario.
Which of the following is TRUE of Holding Period Return (HPR)? [A]HPR can be annualized to give investors a means of comparing different investments.**** [B]HPR always assumes a specific benchmark, typically the S&P 500.[C]HPR normally excludes gains to an investment that may have occurred prior to the current year. [D]HPR always provides a realistic picture of what an investment would return for an investor, even if the length of time held was increased.
EXPLANATION Holding Period Returns can be annualized in order to give a client the ability to compare different investments which may have had holding periods of varying length. HPR factors in the purchase price, pay-out, and ending price of the investment, and thus would not require a benchmark or exclude gains received prior to the current year. By definition, HPR would include gains, start to finish. Though HPR can give an investor a realistic picture, it would not "always" give a realistic picture of what an investment would return. Sometimes short-term holdings of a security do not give an accurate representation of market performance over the long term.
When working with Internal Rate of Return (IRR) and Net Present Value (NPV), which of the following is TRUE? [A]When using IRR and NPV, the numbers that are found will always be 100% representative of what will occur in the future of the project or investment. [B]When using IRR and NPV, projections with relation to inflows and outflows are based on fact and there will be no actual fluctuation in these inflows and outflows. [C]If a net present value of $0 is found, it is accurate to say that you have found the IRR of a project or investment.**** [D]It is impossible to determine NPV when a project or investment has varying inflows over several years.
EXPLANATION If net present value (NPV) is equal to $0, then the rate used in the calculation in terms of discounting future values will be the project's internal rate of return (IRR). When working with IRR and NPV, the numbers that are used as input as well as the expectations/projections that are found are just that, projections. It is incorrect to say with 100% certainty that numbers found will represent what will occur in the future or that there will not be changes to inflows and outflows to a project over time. It is possible and often normally the case that NPV is found when varying inflows occur over several years. Annual inflows are discounted for the appropriate number of years at the appropriate rates and added together in these situations in order to find the NPV.
Which of the following would be LEAST susceptible to risks associated with inflation and interest rate movements? [A]Common stocks**** [B]Municipal bonds [C]Corporation bonds [D]Government bonds
EXPLANATION Investments in any bond type, especially Treasury Securities would carry risks associated with inflation and interest rate movements. Common stock is not exposed to the same level of those risks as fixed-income investments. The biggest risk when investing in common stock is Capital Risk, which is the risk of losing all the money you invested. Other risks that could impact both stocks and bonds would include liquidity risk, market risk, business risk, and opportunity risk.
Of the securities listed below, which would be considered the most vulnerable to interest rate risk? [A]Treasury bonds [B]T-Bills [C]Exchange listed common stocks [D]CD's
EXPLANATION Long term bonds are the most sensitive to changes in interest rates.
Which of the following statements reflects one of the four main considerations within Modern Portfolio Theory? [A]Historical performance tends to repeat itself over time. [B]Asset allocation helps diversify a portfolio.*** [C]Technical analysis is critical to security selection. [D]Expected returns cannot be calculated.
EXPLANATION Modern Portfolio Theory is an investment theory that attempts to optimize expected returns for a portfolio given a level of risk. It contains four main considerations: security valuation, asset allocation, portfolio optimization and performance measurement. Asset allocation is critical as an investor can achieve better returns for a given level of risk by diversifying across asset classes. All the other choices are false.
One of your clients has been looking to reduce some risk in his portfolio. One day, he calls you and tells you to sell 200 shares of XYZ, a Dow Jones Industrial Average company, and buy a Dow Jones Industrial Average Index fund with the proceeds. His decision to do so reduces most, what type of risk? [A]Market Risk [B]Liquidity Risk [C]Regulatory Risk [D]Business Risk***
EXPLANATION Owning only one stock, XYZ in this case, subjects the customer to the business risk of that particular stock. By buying an index fund, your customer has diversified his position and significantly reduced his business risk while increasing his market risk by spreading his money over the entire DJIA index. Liquidity and Regulatory risk would not be a factor based upon the information presented.
If the current rate of return on a 3-month Treasury Bill is subtracted from the total return of an investment, which of the following is likely the case? [A]The analysis is subtracting the current risk-free rate of return.****[B]The analysis is subtracting the current rate of inflation. [C]The analysis is subtracting the investment's internal rate of return.[D]The analysis is attempting to adjust for opportunity costs.
EXPLANATION The 3-month Treasury Bill is commonly used as the "Risk-Free" Rate of Return in financial equations. This will give the analysis a risk-adjusted perspective, which attempts to remove return that would be considered free of risk, and show returns related to the risks taken by investing with additional risk.
Of the following, which TWO examples BEST illustrate the time value of money? An investor with a fixed annuity currently has a cash surrender value of $100,000, but if annuitized, the contract would pay more than $175,000 over the next 15 years. An investor who is currently tied up in bonds yielding 5% hears about new bond issues with the same level of safety paying 8%. An investor has the option of investing in a stock which pays out 5% in annual dividends versus a growth stock which increases, on average, 7% per year. An investor goes to Vegas and wins at a slot machine, where the payout is $5,000 up-front, or 10 annual payments of $1,000, totaling $10,000. [A]I and III[B]I and IV****[C]II and III[D]II and IV
EXPLANATION The annuity example and winnings example are great demonstrations of the time value of money. The company offering the annuity will only pay out $100,000 right now, and the casino will only pay out $5,000 right now. However, if the investor or winner in Vegas allows the insurance company or casino, respectively, to hold onto that money and pay out over time, the amount received goes up. This is because those entities possess that money, invest it, and have the opportunity to profit off of it over that time period. Bond rates going up or down are a function of the Fed and the example is more one of opportunity cost. The difference in return on a stock paying dividends versus a growth stock is just a difference in investment and type of stock.
If a client buys a car and has an interest rate of 7% with a monthly payment of $500 for 5 years, which of the following is the MOST probable original loan amount on the vehicle? [A]The original loan amount is probably $500. [B]The original loan amount is probably $6,000. [C]The original loan amount is probably $25,000.**** [D]The original loan amount is probably $30,000.
EXPLANATION The client is paying $500 per month, so the original loan amount would not be $500. Over the course of a year, the client pays a total of $500 x 12 months, or $6,000, so that amount is also too low of an original loan amount, since the loan is for 5 years. The total amount paid related to the loan is $30,000 ($500/mo x 12 months x 5 years = $30,000). This $30,000 includes interest, so the amount borrowed (original loan amount) will be less than $30,000. With the information provided, the original loan amount is probably $25,000. When factored into an amortization schedule, a $25,000 loan with a 7% interest rate and a 5-year term would result in a monthly payment of $495.
Wayne is looking at buying a block of stock for his portfolio. He is evaluating one stock in particular, which has a beta of 1.15. Wayne is using the S&P 500 as his benchmark, and it has a beta of 1.0. If the S&P 500 returned 5% in the previous year and the stock that Wayne is evaluating returned 7.5%, what is the alpha of the stock that Wayne is evaluating? [A]The alpha of the stock is 8.625%. [B]The alpha of the stock is 6.35%. [C]The alpha of the stock is 2.5%. [D]The alpha of the stock is 1.75%.
EXPLANATION The formula for alpha is: Alpha = Realized Return - (Market Return x Beta)Alpha = 0.075 - (0.05 x 1.15)Alpha = 0.075 - 0.0575Alpha = 0.0175 or 1.75%
An investor decides to invest in both domestic equity securities, international equity securities, and some emerging markets. Why would an investor set-up their portfolio in this manner? [A]To lower risk and increase diversification**** [B]To increase risk and increase profit potential without diversification [C]To take advantage of decreasing domestic values and increasing foreign values. [D]To take advantage of increasing domestic values and decreasing foreign values.
EXPLANATION The investor has securities in both foreign and domestic securities and would want all securities to increase in value. Market diversification reduces risk therefore the best answer is A.
Ben is at a dinner party with several economics gurus. He is discussing the fact that the Fed is currently printing a lot of money to ensure a recession does not lead to a depression. One of the gurus begins to discuss how printing large volumes of paper money can lead to inflation. A wealthy bond investor begins to discuss the real rate of return that they are seeing on their investments. How does the real rate of return relate to the discussion that Ben is having with the economic gurus? [A]The real rate of return would be the actual rate at which the Fed is printing money. [B]The real rate of return would be the total rate of return on an investment. [C]The real rate of return would be the rate of return on an investment after total return has been adjusted for inflation.**** [D]The real rate of return would be the rate of return on an investment adjusted for the risk taken to achieve that return.
EXPLANATION The real rate of return is the total return of an investment minus the current rate of inflation. It attempts to give investors a picture of their return in relation to the current rate of inflation, showing the investor how inflation is affecting their overall returns.
Throughout a discussion with a client, an IAR mentions the "real rate of return" several times. After hearing the term more than once, the client interrupts the IAR and asks for an explanation as to what the "real rate of return" is on their investments/portfolio. Which is the BEST response from the IAR? [A]"The real rate of return is a figure that adjusts an investment or portfolio's return for taxes, risk, inflation, and the time value of money." [B]"The real rate of return is a figure that adjusts an investment or portfolio's return for inflation."**** [C]"The real rate of return is a figure that adjusts an investment or portfolio's return for risk." [D]"The real rate of return is a figure that adjusts an investment or portfolio's return in relation to a benchmark, such as an index."
EXPLANATION The real rate of return or real interest rate on an investment or portfolio is an inflation-adjusted figure. This figure attempts to give the investor an idea of the returns on their money after inflation is taken into account.
An investor is talking over some numbers that were provided to him while meeting with his IAR. The investor sees that a number was subtracted from total return to arrive at the "risk-adjusted" rate of return. What should the IAR tell the client? [A]The IAR should tell the client that the number that was subtracted was arbitrary and hypothetical. [B]The IAR should tell the client that the number that was subtracted was the rate of inflation. [C]The IAR should tell the client that the number that was subtracted is the risk-free rate of return.**** [D]The IAR should tell the client that the number that was subtracted is related to the losses in the client's account that were due to risk.
EXPLANATION The risk-adjusted rate of return attempts to measure how much of a client's returns were due to risks taken. To find this figure, the risk-free rate of return is subtracted in order to remove the amount of return that the client could expect without taking risk. The rate of return used is typically that of the 3-month Treasury Bill.
Which of the following statements are TRUE regarding Dollar-Weighted Return and Time-Weighted Return? I. Dollar-Weighted Return allows investors to compare the performance of one manager to the performance of another manager. II. Time-Weighted Return allows investors to compare the performance of one manager to the performance of another manager. III. Dollar-Weighted Return allows investors to see a snapshot of their investments in relation to their financial goals IV. Time-Weighted Return allows investors to see a snapshot of their investments in relation to their financial goals [A]I and III[B]I and IV[C]II and III***[D]II and IV
EXPLANATION Time-Weighted Return eliminates the effect of cash flows to give an idea of performance. It is an effective way to measure the performance of portfolio managers to one another as well as to a benchmark. Dollar-Weighted Return includes cash flows so that investors can get an idea of the returns and growth of their portfolio in relation to their financial goals. It is not an effective way to compare managers.
