Series 7: Analysis (Portfolio Analysis)
If 26-week T-bills are yielding 5%, all common stocks are yielding 10%, and growth stocks are yielding 15%, the risk premium for investing in growth stocks is:
10% The risk premium is the excess return achieved for investing in a specific class of assets as compared to the risk free return. The risk-free return is 5%, while growth stocks are yielding 15%. The excess return for investing in growth stocks is 10%.
A counter-cyclical stock would be described by which of the following?
A stock price that tends to move in the opposite direction of the market as a whole Counter-cyclical stocks are those whose performance runs counter to the economic cycle. In good economic times, these stocks don't do as well; in poor economic times, these stocks do very well. An example of a counter-cyclical stock is a basic food producer - in good times, people eat out more and do less cooking at home; in bad times, people eat out less and do more cooking at home. Thus, in bad times, the earnings of a basic food producer would improve, and its stock price would rise. In good times, the earnings of a basic food producer would deteriorate, and its stock price would fall.
Which of the following stocks would be considered cyclical?
Automobile manufacturer The performance of cyclical stocks follows the business cycle. In times of GDP expansion, they do well; in times of recession, they do poorly. The classic cyclical stocks are home building, automobile manufacturers and durable goods producers. All of these purchases are deferrable in hard times. Pharmaceutical companies are defensive and are not affected by the business cycle; in good times or bad, people must take prescribed drugs. Gold mining stocks are counter-cyclical. In bad economic times, people "flee to safety" and buy gold stocks. Computer software companies are growth companies.
Which statement is TRUE about a stock's Beta Coefficient?
Beta measures price movement of a stock relative to the market The "Beta" coefficient is a measure of price volatility of a stock (or a portfolio) relative to the market. A Beta of +1 indicates that a particular security moves as fast, and in the same direction, as the market. A Beta of +1/2 indicates that the stock's price moves half as fast, and in the same direction, as the overall market.
Which of the following best describes a stock that moves with the market?
Blue Chip stock Blue Chip stocks are large capitalization companies like General Electric that have a long track record (GE has been around for over 100 years) and P/E (Price/Earnings) multiples that are similar to the market as a whole. Their price movements tend to track the overall market. (For trivia freaks, the name "blue chip" comes from the most valuable poker chip.) In contrast, an income stock is one that pays a high dividend rate. These are often slow-growth companies that make up for their lack of growth in stock price by paying a higher dividend rate. Utilities are a "classic" income stock. A defensive stock is one whose price stays fairly stable, regardless of the price movements of the general market. Typical defensive stocks are food companies and health care companies. A special situations stock is a company that is the target of a merger or takeover or a company that is in bankruptcy and which stockholders hope will be able to turn itself around. These are companies in "special situations." If the turnaround or takeover is successful, the stock price could rise steeply.
An investor has a broadly diversified portfolio of blue chip stocks. To hedge the portfolio against market risk, which of the following strategies would you recommend?
Buy index puts Index options can be used to hedge a portfolio. If index puts are bought, then a drop in the market lowering the portfolio's value will be offset by a gain in the value of the index puts. This strategy hedges against market risk, also known as systematic risk. Non-systematic risk is the risk that any one security will perform poorly. The larger the portfolio, the lower the effect of non-systematic risk.
"CAPM" stands for:
Capital Asset Pricing Model "CAPM" stands for Capital Asset Pricing Model. This is a methodology for finding the most efficient investments - those that give the greatest return for the amount of risk assumed.
Equity securities of which issuer are the LEAST defensive?
Defense A defensive industry is one which is not greatly affected by economic downturns. Pharmaceuticals, grocers, and utilities are all defensive. If the economy sours, people still buy drugs, food, and use electricity. The defense industry is the least defensive of the choices offered. In periods of economic slowdowns, the government collects less taxes, and tends to reduce arms and expensive defense systems orders.
Which of the following securities is NOT directly interest rate sensitive?
Growth Stocks Utility stocks are directly interest rate sensitive since utilities have an extremely large portion of their capitalization as debt. If interest rates rise, as the utilities refund maturing debt, their interest costs increase, depressing earnings and therefore the stock price. Preferred stocks and bonds are directly interest rate sensitive because they pay a fixed dividend or interest rate. If interest rates rise, their prices must fall to provide comparable market yields; and vice-versa. Common stocks and growth stocks are priced primarily on future expectations of earnings for these companies. They are not directly interest rate sensitive.
Which of the following statements is TRUE about non-systematic risk? I It is the same as stock selection risk II It is the same as market risk III It can be diversified away IV It cannot be diversified away
I and III Market risk is the same as systematic risk. It is the risk of the market moving adversely, and one's securities positions moving with the market. This risk cannot be diversified away; but it can be hedged against. Non-systematic risk is the portion of risk in a portfolio that is "stock specific." Also known as selection risk, this can be diversified away by adding more and more stocks to the portfolio, until the portfolio becomes reflective of the "market" as a whole.
Pension funds seeking safety of principal and maximum income would use which investment strategies? I Purchase Government and Agency securities II Sell short Government and Agency securities III Sell covered Treasury Bond calls IV Sell naked Treasury Bond calls
I and III only Pension funds must be prudently managed. The purchase of government and agency securities is appropriate, as is the sale of covered calls against the securities in the portfolio to generate extra income. Short sales are not suitable because of unlimited loss potential, as is the sale of naked calls.
Growth companies typically have which of the following? I Low dividend payout ratios II High dividend payout ratios III Low Price / Earnings ratios IV High Price / Earnings ratios
I and IV Growth companies are characterized by high price-earnings ratios and low dividend payout ratios. Mature companies are characterized by low price-earnings ratios and high dividend payout ratios.
Rank the following investments from lowest to highest, for overall historical returns experienced by investors over long periods of time: I Treasury Bills II AAA Rated Corporate Bonds III Common Stocks
I, II, III Historically, common stocks have provided a superior return over time compared to that provided by Corporate Bonds and Treasury Bills. This has occurred because common stock investments have provided both capital gains over time, in addition to the dividend yield. Long term investments in Corporate Bonds and Treasury Bills do not provide capital gains; these securities mature at par value. The investment return consists solely of interest paid. Of the two, Corporate Bonds provide a higher return, since the interest rate reflects a premium for greater default risk, purchasing power risk and market risk, as compared to Treasury Bills. Please note that the risk/reward relationship holds true for these securities. Common stocks have given the highest return, but have the highest risk. Investment grade Corporate Bonds give a lower return, with lower risk. Treasury Bills give the lowest return with the lowest risk.
Which of the following are MOST susceptible to interest rate risk? I Common stock II Utility common stock III Preferred stock IV High tech common stock
II and III Interest rate risk is the risk that if market interest rates rise, securities prices will fall. Prices of bonds and preferred stocks that pay either a fixed interest rate or fixed dividend rate are directly interest rate sensitive. As market interest rates rise, their prices fall. Regarding common stocks, companies that use a lot of leverage (debt) in their capital base are also interest rate sensitive. If market interest rates go up, as these companies refund their maturing outstanding debt, their interest costs will rise and earnings per common share will drop. Utilities typically have 90% of their capital base as debt, so their common stock prices are interest rate sensitive. High tech companies typically have no debt in their capital base (since their earnings are so variable), so their common stock prices are not interest rate sensitive.
Common shares of which of the following issuers are likely to have a Beta coefficient much lower than +1?
Public utility The "Beta" coefficient is a measure of market volatility. A Beta of "+1" indicates that a particular security moves as fast as the market. A Beta higher than one means that the security moves faster than the market - for example a Beta of +2 means that the security moves twice as fast as the overall market. A Beta of less than 1, say 1/2, indicates that the stock's prices moves half as fast as the overall market. Thus, a stock with a low beta is one that is strongly defensive - that is one that is not affected by business cycles. Electric and gas utilities, and railroads have the lowest beta factors - around .5. These companies' betas are the lowest because their rates of return are regulated. Therefore, these firms' profits are generated independently of the business cycle and stay relatively constant - no matter how good or bad business conditions are. Airlines and high technology companies tend to have very high betas - their stocks' price movements are very volatile.
In a rising market, which of the following securities is MOST volatile?
Stock with a BETA coefficient of 1.5 "Beta" is a measure of a security's price volatility relative to the overall market. "Alpha" is a measure of a security's price volatility independent of the overall market. The relevant measure to assess volatility relative to the market is "beta." The higher the "beta," the more volatile that security's price movements relative to the market.
Which of the investments listed below offers the greatest protection against market risk?
Treasury Bills Market risk is the risk the securities prices, as a whole, will fall, dragging down both good and bad investments. To minimize market risk, common stocks should be avoided, as should long term fixed income securities, such as preferred stock and long bonds. To minimize this risk, investors "flee to safety" in the form of Treasury Bills. These are the safest type of credit - backed by the U.S. Government; and the price cannot drop that much because of their short term maturities. Since they will be redeemed shortly at par, the price cannot fall much below par, no matter what happens to the market as a whole.
All of the following securities are directly interest rate sensitive EXCEPT:
common stock issued by a manufacturer Utility stocks are directly interest rate sensitive since utilities have an extremely large portion of their capitalization as debt. If interest rates rise, as the utilities refund maturing debt, their interest costs increase, depressing earnings and therefore the stock price. Preferred stocks and bonds are directly interest rate sensitive because they pay a fixed dividend or interest rate. If interest rates rise, their prices must fall to provide comparable market yields; and vice-versa. Common stocks and growth stocks are priced primarily on future expectations of earnings for these companies. They are not directly interest rate sensitive.
A customer buys pharmaceutical and utility stocks in his portfolio. This portfolio would be best characterized as:
defensive Pharmaceutical stocks and utilities are defensive issues that are not affected much by the economic cycle. Cyclical stocks such as housing and autos, are greatly affected by the economic cycle. Aggressive portfolios consist of growth stocks such as high technology issues. Balanced portfolios buy a balance of stocks and bonds.
Mature companies are characterized by:
high dividend payout ratios and low price / earnings ratios Mature companies are characterized by low price-earnings ratios and high dividend payout ratios. Growth companies are characterized by high price-earnings ratios and low dividend payout ratios.
A company's common stock has a Beta of -1.5. The market has declined over the last 3 years. During this period, the price of the stock would have:
increased at a faster rate than the market Negative beta stocks move opposite to the general market - e.g., they are counter-cyclical stocks. If a stock has a negative "beta," the stock's price moves in the opposite direction to the market. If the beta is -1.5, the stock moves in the opposite direction of the market as a whole, at a rate that is 1.5 times as fast as the general market move.
A stock portfolio with a Beta of "+1" indicates coincidence with:
market risk as represented by the Standard and Poor's 500 Average A stock portfolio with a Beta of "+1" exactly matches the volatility of the market as a whole. The broadest stock market measure listed is the Standard and Poor's 500 Average. A Beta of +1 represents the "market risk" (also known as systematic risk) of the portfolio. This is the risk that cannot be diversified away. As more and more stocks are added to a portfolio, the "non-systematic risk" (also known as "stock specific risk") is reduced. Once a portfolio is fully diversified, non-systematic risk has been "diversified away," and the only risk left is the portfolio's systematic or market risk.
"Alpha" is a measure of:
non-systematic risk "Alpha" measures non-systematic risk - that is, stock specific risk.
The "Efficient Market Theory" states that securities markets are efficient if:
prices instantaneously and fully reflect all relevant available information Efficient market theory is an academic approach to securities pricing in the market that states that securities prices instantaneously and fully reflect all available information. There are 3 versions of this theory: Weak Form: States that historical patterns in stock prices are of no use in predicting future price movements. The use of technical analysis to create "trendlines" is therefore, useless. This version is not widely accepted. Semi-Strong Form: States that current securities prices reflect all publicly available information. Thus, the value of securities in the market reflects publicly distributed information, but does not reflect information known by "insiders." This is the most widely accepted version. Strong Form: States that current securities prices reflect all information, whether publicly available or not. Thus, information known by "insiders" that has not been publicly disseminated, is already reflected in a security's price. This version is also not widely accepted.
The risk inherent in a portfolio that cannot be diversified away is known as:
systematic risk Market risk is the same as systematic risk. It is the risk of the market moving adversely, and one's securities positions moving with the market. This risk cannot be diversified away; but it can be hedged against.
The Capital Asset Pricing Model (CAPM) is a methodology that values securities based upon:
the issue's risk-free rate of return plus a risk premium CAPM is a methodology for finding the most efficient investments - those that give the greatest return for the amount of risk assumed. The model identifies the most efficient investments as those that give a rate of return equal to the "risk-free" rate of return (the rate of return for investments only having systematic risk) plus a premium for any non-systematic risk inherent in the investment.
