Unit 21

The capital asset pricing model (CAPM) is used by many to assess the expected return of a security. If the current risk-free rate is 3%, the current return on the market is 10%, and a particular stock's beta is 1.4 with a standard deviation of 2.2, the expected return would be A) 12.8% B) 17.0% C) 14.0% D) 9.8%

A. 12.8% Expected Return = Risk Free Rate + Beta (Market Return - Risk Free Rate) __?__ = 3% + 1.4 x (10% - 3%) 3% + 1.4 x 7% 3% + 9.8% = 12.8% Explanation The formula for this computation is as follows: 10% (the return on the market is a beta of 1.0) minus the risk-free rate of 3%, or 7%. Then, multiply that by the beta of this stock (1.4) to arrive at 9.8%. That is, the stock should return 9.8% above the risk-free rate of 3%, or 12.8%. The standard deviation is not relevant to this computation. LO 21.h

The capital asset pricing model (CAPM) is used by many to assess the expected return of a security. If the current risk-free rate is 3%, the current return on the market is 10%, and a particular stock's beta is 1.4 with a standard deviation of 2.2, the expected return would be A) 12.8% B) 9.8% C) 17.0% D) 14.0%

A. 12.8% Risk Free Rate = 3% Market Return = 10% Beta = 1.4 Formula: Expected Return = RFR + Beta (Market Return - RFR) = 3% + 1.4 (10% - 3%) = 3% + 1.4 (7%) = 3% + 9.8 = 12.8%

The current market interest rate for a bond rated AA with 20 years to maturity is 5%. In an efficient market, a similar bond with a coupon of 4% could be expected to have an internal rate of return of A) 5%. B) 4%. C) 6%. D) 8%.

A. 5%. Explanation In an efficient market, bonds are priced so that their NPV is zero. That means the bond's yield to maturity is equal to the current market interest rates for similar bonds. When that rate is 5%, as is given in this question, all AA bonds with 20 years remaining to maturity should have a YTM of 5%. LO 21.i

An investment adviser representative is evaluating DEF stock to see if it is a good fit for a client's portfolio. Using the security market line (SML), what is the expected return for DEF when the return on the market is 8%, the 91-day Treasury bill is yielding 6%, DEF's beta is 1.50, and the inflation rate, as measured by the CPI, is 4%? A) 9% B) 12% C) 5% D) 8%

A. 9% Explanation: Market return = 8% Risk Free Rate = 6% Beta = 1.5 Formula: Expected Return = Risk Free Rate + Beta (Market Return - Risk Free Rate) __?__ = 6% + 1.5 (8% - 6%) = 6% + 1.5 x 2% = 6% + 3% = 9%

A fundamental analyst would be most interested in which of the following? A) A P/E analysis of the stocks included in the Dow Jones Industrial Average B) The outstanding short interest in the market C) A 200-day moving average D) Resistance and support levels

A. A P/E analysis of the stocks included in the Dow Jones Industrial Average Explanation Fundamentalists look at P/E ratios; the other tools mentioned are technical. LO 21.d

A new client's principal objective is income with a moderate degree of capital preservation. When reviewing his existing portfolio, you notice that the client's bond holdings are evenly split between those maturing in the next 1 to 2 years and those maturing in the next 10 to 11 years. This indicates that the client has been using which of the following strategies? A) Barbell B) Ladder C) Bullet D) Contrarian

A. Barbell Explanation The barbell strategy gets its name from the fact that the holdings are split into two maturity ranges. About half is near term and balance is at the long end of intermediate-term with nothing in between. The bullet strategy has all of the bonds maturing at the same time; some target date in the future. Laddering a bond portfolio has bonds maturing every year, just like the steps on a ladder. Contrarian is most often an equity strategy. LO 21.f

Which of the following is not correct regarding the capital asset pricing model (CAPM)? A) CAPM uses standard deviation as a measure of market risk. B) The stock risk premium is the inducement necessary to entice the individual to invest in a particular stock. C) The market risk premium is the incentive required for the individual to invest in the securities market. D) CAPM only considers the systematic risk.

A. CAPM uses standard deviation as a measure of market risk. Explanation Standard deviation is a measure of both systematic and unsystematic risk. CAPM accounts for the impact of systematic risk (as measured by beta) only and does not take into consideration unsystematic risk, which is assumed to have been diversified away. The stock or market risk premium is a key concept in finance that refers to the additional return that investors expect to receive as compensation for taking on the risk of investing in specific stocks or the overall market compared to investing in risk-free assets such as the 91-day Treasury bill. LO 21.g

Discounted cash flow is commonly thought of as applying solely to fixed-income securities. However, forms of DCF used for the valuation of common stock also include I. the price-to-earnings ratio II. the dividend discount model III. the discounted book value model IV. the dividend growth model A) II and IV B) II and III C) I and IV D) I and II

A. II and IV Explanation The 2 most common forms of DCF used in the valuation of common stock are the dividend discount and dividend growth models. LO 21.d

Which of the following would an investor who believes in MPT probably select for a client? A) JKL, with a return of 15% and a standard deviation of 15 B) ABC, with a return of 11% and a standard deviation of 15 C) GHI, with a return of 13% and a standard deviation of 20 D) DEF, with a return of 13% and a standard deviation of 18

A. JKL, with a return of 15% and a standard deviation of 15 Explanation Modern portfolio theory (MPT) proponents believe that the most appropriate investments are those that offer the greatest return with the lowest risk. JKL has delivered the highest return with a standard deviation (risk) equal to that of ABC (which has a much lower return). LO 21.g

When building an investment portfolio, it is generally recommended that an asset allocation process be used to increase the portfolio diversification and reduce risk. Which of the following is least likely to be considered an asset class? A) Mutual funds B) Stock C) Cash and cash equivalents D) Bonds

A. Mutual funds Explanation The 3 basic asset classes are equity (stock), debt (bonds), and cash/cash equivalents. Mutual funds are viewed as a tool for allocating to one or more specific asset classes; they, in themselves, are not an asset class. For example, a mutual fund investing in investment-grade bonds would be part of the portfolio's debt security allocation while a money market mutual fund would be part of the cash equivalents allocation. Many asset allocation models add tangibles, such as real estate or certain commodities. Unlike mutual funds, REITs are often used as a proxy for real estate so they might be considered an asset class on the exam. LO 21.a

Which of the following would not be of interest to a technical analyst? A) P/E ratio B) Moving averages C) Advance/decline line D) Volume

A. P/E ratio Explanation A technical analyst charts movement in market price and volume over a period of time. The price-to-earnings ratio is a tool used by fundamental analysts. LO 21.d

A portfolio manager who is engaging in rebalancing on a semiannual basis is most likely using which portfolio management style? A) Strategic asset allocation B) Buy and hold C) Active asset allocation D) Tactical asset allocation

A. Strategic asset allocation Explanation At least annually, and sometimes more frequently, a portfolio manager who follows strategic asset allocation will examine the relative proportion of the selected asset classes and, based on market performance, rebalance the portfolio to bring it back to its ideal. Active (also called tactical) asset allocation attempts to time the market and doesn't pay the same amount of attention to proportionate holdings as does strategic asset allocation. By its very nature, buy and hold can go years without a portfolio change. LO 21.c

Market timing is normally associated with which of the following portfolio management styles? A) Tactical asset allocation B) Passive management C) Strategic asset allocation D) Modern portfolio theory

A. Tactical asset allocation Explanation Tactical asset allocation, which attempts to capitalize on short-term market swings, is a market timing strategy. LO 21.c

A client wishing to hedge a long stock position would be most likely to: A) buy a put on that stock. B) buy a call on that stock. C) sell a call on that stock. D) sell a put on that stock.

A. buy a put on that stock. Explanation Hedging a long stock position would protect the investor from a market decline in the value of the stock. The best way to do this is to purchase a put option on that stock. This is why some refer to the purchase of puts as a form of portfolio insurance. LO 21.k

In the field of portfolio management, there are a number of different management styles. One of those styles involves committing additional capital to the market when others are reducing their exposure, or eliminating positions while others are increasing theirs. This style is generally referred to as A) contrarian B) active C) value D) growth

A. contrarian Explanation The contrarian style of portfolio management takes positions opposite those of the market as a whole. They are buying when others are selling and selling when others are buying. LO 21.e

An investment manager is looking at 10 possible stocks to include in a client's portfolio. In order to create the most efficient portfolio, the manager must A) find the combination of stocks that produces a portfolio with the maximum expected rate of return at a given level of risk. B) include only the stocks that have the lowest volatility at a given expected rate of return. C) include all 10 stocks in the portfolio in equal amounts. D) include only the stocks that have the highest volatility at a given expected rate of return.

A. find the combination of stocks that produces a portfolio with the maximum expected rate of return at a given level of risk. Explanation The most efficient portfolio will be the one that lies on the efficient frontier. It will offer the highest expected return at a given level of risk compared to all other possible portfolios. LO 21.g

An investment manager is looking at 10 possible stocks to include in a client's portfolio. In order to create the most efficient portfolio, the manager must A) find the combination of stocks that produces a portfolio with the maximum expected rate of return at a given level of risk. B) include only the stocks that have the lowest volatility at a given expected rate of return. C) include all 10 stocks in the portfolio in equal amounts. D) include only the stocks that have the highest volatility at a given expected rate of return.

A. find the combination of stocks that produces a portfolio with the maximum expected rate of return at a given level of risk. Explanation The most efficient portfolio will be the one that lies on the efficient frontier. It will offer the highest expected return at a given level of risk compared to all other possible portfolios. LO 21.g

It is agreed by most investment advisers that diversifying an investment portfolio can reduce the overall risk. Benefits of diversification would include all of the following except A) lowering trading costs. B) mitigating the effects of a bankruptcy of a security held in the portfolio. C) increasing risk-adjusted returns. D) lowering the volatility of the portfolio.

A. lowering trading costs. Explanation If anything, diversifying a portfolio will increase the trading costs. Those higher costs are outweighed by the benefits in risk reduction and potential higher returns. With a well-diversified portfolio, a single company going bankrupt will have a much smaller impact than if that security was the only asset held by the investor. It is the old theory of "don't put all of your eggs in one basket". Broad diversification, which includes different asset classes, has the effect of reducing the overall volatility of the portfolio and by holding assets that tend to rise while others decline, the risk-adjusted returns may well be increased. LO 21.b

While attending a seminar given by one of your firm's analysts, you hear the term, feasible set. That would mean the discussion was dealing with the topic of A) the efficient frontier B) opportunity cost C) a range of returns D) convexity

A. the efficient frontier Explanation The feasible set of portfolios represents all portfolios that can be constructed from a given set of stocks. An efficient portfolio is a feasible portfolio that provides the greatest expected return for a given amount of risk, or equivalently, the least risk for a given amount of expected return. This is also called an optimal portfolio. The efficient frontier is the set of all efficient portfolios. Obviously, an investor should choose a portfolio along the efficient frontier. LO 21.g

When attempting to construct the optimal portfolio, the investment adviser is looking to obtain A) the maximum return for the least risk. B) returns that fall within the efficient frontier curve. C) the maximum return in the shortest time period. D) the maximum return with the greatest risk.

A. the maximum return for the least risk. Explanation The optimal portfolio is the one which provides the greatest return for the least risk. It will fall on the efficient frontier. It is important not to get hung up on terminology when common sense works. As an investor, wouldn't you always want the highest return you could get for the least risk? LO 21.g

The capital asset pricing model (CAPM) is used by many to assess the expected return of a security. If the current risk-free rate is 2%, the current return on the market is 10%, and a particular stock's beta is 1.5 with a standard deviation of 3.2, the expected return would be A) 18.2% B) 14% C) 12% D) 15%

B. 14% Expected return = RFR + Beta (market return - RFR) 2% + 1.5 (10% - 2%) 2% + 1.5 (8%) 2% + 12% 14%

If the current risk-free rate is 4%, and the expected return from the market is 10%, what return should we expect from a security that has a beta of .9? A) 13% B) 9.4% C) 6.4% D) 9%

B. 9.4% Explanation Required return = 4% + ([10% - 4%] × .9) = 4% + (6% x .9) = 4% + 5.4% = 9.4%. LO 21.h

A fundamental analyst would be most interested in which of the following? A) Resistance and support levels B) A P/E analysis of the stocks included in the Dow Jones Industrial Average C) The outstanding short interest in the market D) A 200-day moving average

B. A P/E analysis of the stocks included in the Dow Jones Industrial Average Explanation Fundamentalists look at P/E ratios; the other tools mentioned are technical. LO 21.d

Your customer, age 29, is seeking a long-term growth investment, is concerned about the loss of purchasing power as a result of inflation, and often complains about high commissions that reduce his investment returns. When he was in college, he took a few economics courses and firmly believes that securities analysts cannot consistently outperform the overall market. Which of the following mutual funds is the most suitable for the customer? A) ATF Biotechnology Fund B) ARG Stock Index Fund C) ZB Asset Allocation Fund D) NC Growth & Income Fund

B. ARG Stock Index Fund Explanation The customer requires a mutual fund that offers potential for long-term capital growth. Because the client believes that money managers cannot outperform the market, an index fund, which simply mimics the market, is the appropriate investment. The client's complaint about high commission charges is a further argument for index funds, which have low expense ratios. LO 21.c

Investors wishing to employ a passive strategy for their bond portfolios would most likely elect which of the following? A) Laddering B) Buy and hold C) Bullet D) Barbell

B. Buy and hold Explanation Among investing strategies, it is hard to find one more passive than buy and hold—nothing is traded until maturity. Each of the other strategies involves some degree of activity. For example, with the barbell strategy of owning only short-term and long-term bonds (no intermediate-term ones), as those short-term bonds mature and the long-term become intermediate, they must be replaced. That is active management. With the bullet strategy, the only thing staying constant is the year of maturity. Each year bonds are purchased with that target maturity date. That is active management. With the laddering strategy, just as climbing a ladder is active, so is the reinvestment into new bonds as each step of the ladder matures. LO 21.f

Which of the following investment styles would be most suitable for a long-term investor who seeks capital growth but is concerned about execution costs? A) International B) Buy/hold C) Growth style D) Market timing

B. Buy/hold Explanation A buy-and-hold style would be appropriate for the long-term investor because long-term gains are taxed at a lower rate, and execution costs are reduced by not buying and selling frequently. LO 21.e

Which of the following statements are generally true of the buy-and-hold strategy? I. Equities would grow relative to fixed income II. Lower taxes and transactional costs III. Easy to manage IV. The portfolio would more accurately demonstrate the client's investment objectives and risk tolerance A) I and II B) I, II, and III C) III and IV D) II, III, and IV

B. I, II, and III Explanation Over the long run, using the buy-and-hold strategy with equity securities has outperformed the rate of return on fixed income investments. With few transactions, there are almost no commissions and capital gains taxes. Of all strategies, this is the easiest to follow. There is no way to determine the client's objectives or risk tolerance based on the decision to buy and hold. The portfolio might contain small-cap stocks or large-cap stocks. It might contain 90% equities or 75% debt securities. Investors with differing goals and risk tolerance can use this strategy. LO 21.e

Which of the following are methods of portfolio rebalancing? I. You can sell off investments from over-weighted asset categories and use the proceeds to purchase investments for under-weighted asset categories. II. You can purchase new investments for under-weighted asset categories. III. If you are making continuous contributions to the portfolio, you can alter your contributions so that more investments go to under-weighted asset categories until your portfolio is back into balance. IV. You can purchase new investments for better performing asset categories. A) I, III, and IV. B) I, II, and III. C) III and IV. D) I and III.

B. I, II, and III. Explanation When rebalancing, the goal is to get the portfolio back to a desired ratio between asset classes. Better performing assets are sold because they are now over-weighted. LO 21.c

Which of the following are disadvantages of index investing relative to active portfolio management? I. Indexed portfolios have higher transaction costs. II. Indexed portfolios have lower management fees. III. Indexed portfolios restrict the universe of potential investments. IV. Indexed portfolios may not represent optimal performance for a specific investor. A) II and IV B) III and IV C) I and III D) II, III, and IV

B. III and IV Explanation Indexing means that it is only possible to select securities that are within the index, meaning that the universe of investable securities is restricted. An index may not represent optimal performance if the index does not adequately match the investor's objectives. That is, a conservative investor should not be in a small-cap index and, conversely, the S&P 500 Index would be a poor choice for an aggressive one. There are lower, not higher, transaction costs, and lower management fees are certainly not a disadvantage. LO 21.e

Which investment style does not take into consideration whether a specific security is under or overvalued? A) Active B) Indexing C) Contrarian D) Growth

B. Indexing Explanation The style known as indexing merely attempts to mimic the underlying index. Therefore, security selection is not based upon any fundamental (or technical) parameters, but only changes made to that index. LO 21.e

Due to an inheritance, one of your clients now owns a large position in LMN stock. She is concerned that the stock may decline in the upcoming months while she is deciding what to do with the investment. What type of investment strategy could she employ to protect the stock from substantial downside risk? A) Diversify into an index fund B) Purchase put options on LMN stock C) Purchase call options on LMN stock D) Write call options on LMN stock

B. Purchase put options on LMN stock Explanation The best way to protect a long stock position against a potential substantial loss is to purchase put options on that stock. This is generally referred to as a protective put or portfolio insurance. Assuming the strike price is the same as the current market, the holding is fully protected and the investor's loss on the option is limited to the amount of the premium paid for the puts. Writing calls on LMN also offers protection against loss, but that protection is limited to the premium received on the calls. This question refers to substantial loss and the puts are the only way to protect against that. Once the client decides what she wants to do with the stock, she may decide to diversify into an index fund, but that does not answer the immediate need expressed in the question. LO 21.k

As a result of an inheritance, Danielle now owns a large position in XYZ stock. She is concerned that the stock may decline in the upcoming months while she is deciding what to do with the investment. What type of investment strategy could she employ to protect the stock from substantial downside risk? A) Write call options on XYZ B) Purchase put options on XYZ C) Purchase index put options D) Write put options on XYZ

B. Purchase put options on XYZ Explanation Danielle should purchase put options (referred to as protective puts or portfolio insurance) to protect herself from possible loss. Thereby, the portfolio is protected and the investor's loss on the option is limited to the amount of the premium paid for the puts. Purchasing an index put option is useful for protecting a portfolio, but would not necessarily offer any protection for the XYZ stock. Writing call options would provide partial protection (to the extent of the premium income received), but you have to buy protection if you want to avoid substantial risk. LO 21.k

A portfolio that maximizes an investor's preferences with respect to return and risk is called A) the efficient frontier B) an optimal portfolio C) a diversified portfolio D) an uncorrelated portfolio

B. an optimal portfolio Explanation An optimal portfolio will generally lie on the efficient frontier (which is a graph, not a portfolio). The special nature of an optimal portfolio is that it may not always be the most efficient portfolio (offering the greatest return for the least risk) because it takes into consideration the specific preferences of the individual investor, which might create a bias. LO 21.g

A portfolio manager who follows the growth style of investing would most likely purchase shares A) based on their market capitalization B) at the higher end of their price range for the past 52 weeks C) that are currently trading with a lower than average volume D) at the lower end of their price range for the past 52 weeks

B. at the higher end of their price range for the past 52 weeks Explanation The growth style of portfolio management looks for stocks that have earnings momentum and tend to be growing at a faster rate than the overall economy. Because of their potential, shares of these companies tend to sell at the higher end of their previous 52-week range and have a higher than average daily trading volume. LO 21.e

One of your customers asks you to interpret her observation that the short interest in a stock she owns has been rapidly increasing over the past 4 months. Aligning with the short interest theory, you would tell her that this is a A) indication of predictable volatility in the stock B) bullish indicator C) indication of predictable stability in the stock D) bearish indicator

B. bullish indicator Explanation While short interest in a stock represents the number of shares sold short, the short interest theory considers rising short interest a bullish indicator. Each share that has been sold short must be replaced (covered) at some point. To replace the stock shorted, an investor must go into the market to buy that stock. When all of those short sellers have to buy back stock they shorted, it puts upward pressure on the prices of those stocks. LO 21.d

Arthur M. Munger recently joined Piedmont Partners LLP as an analyst and is curious about modern portfolio theory (MPT). He approaches his senior, Sarah, to describe MPT. Sarah tells Arthur that MPT suggests that A) by combining securities into a diversified portfolio, the overall portfolio risk will be more than the weighted average risk of the individual stocks. B) by combining securities into a diversified portfolio, the overall portfolio risk will be less than the weighted average risk of the individual stocks. C) we cannot outperform the overall market. D) the total risk of a portfolio cannot be reduced at all.

B. by combining securities into a diversified portfolio, the overall portfolio risk will be less than the weighted average risk of the individual stocks. Explanation A diversified portfolio of stocks that are not perfectly positively correlated with each other will have portfolio risk (as measured by standard deviation of returns) less than the weighted average risk of the individual stocks. LO 21.g

An investor diversifying a corporate bond portfolio does not consider A) quality B) domicile of the investor C) maturity D) issuer

B. domicile of the investor Explanation Domicile, or geographic location of the investor, is not relevant in diversifying a corporate bond portfolio. For example, it is irrelevant if the client is located in Michigan or New Jersey or any other state; that will have no impact on the risks facing the issue. This could be a factor for municipal bond investors due to the possibility of avoiding state income tax. A corporate bond portfolio can be diversified by issuer, quality (rating), domicile of the issuer, and maturity. LO 21.b

Corpulent Asset Services of Hamburg (CASH), a covered investment adviser, has a philosophy of placing most of their clients' assets into broad market index funds and ETFs. This would indicate that CASH's portfolio management style is most likely A) active B) passive C) tactical D) conservative

B. passive Explanation Investing in broad market index funds and ETFs is generally considered to be a passive management style.

The capital asset pricing model (CAPM) is an investment theory that serves as a model for A) pricing securities based on their unsystematic risk B) pricing securities based on their systematic risk C) pricing securities based on their total risk D) measuring the correlation between a security and the overall market

B. pricing securities based on their systematic risk Explanation Under the CAPM, securities are priced based on their systematic risk only, because this risk cannot be eliminated through diversification. The expected return of a security or portfolio is calculated by adding the rate on a risk-free security to a risk premium multiplied by the asset's systematic risk. LO 21.g

A portfolio manager who routinely shifts portfolio assets to take advantage of the business cycle is said to be engaging in A) rebalancing B) sector rotation C) asset allocation D) correlation

B. sector rotation Explanation Sector rotation is the practice of moving out of those industries that are heading for a decline and into those whose fortunes are likely to rise as the economy follows the business cycle. LO 21.c

When an analyst discusses grouping companies by market capitalization, the 3 most commonly used categories are A) micro-cap, mini-cap, large-cap B) small-cap, mid-cap, large-cap C) small cap, mid-cap, jumbo-cap D) small cap, larger-cap, largest-cap

B. small-cap, mid-cap, large-cap Explanation Although the terms micro-cap and mega-cap are also used, the 3 most common are small-, mid-, and large-cap. LO 21.e

When reviewing potential securities to select for an investor's portfolio, a technical analyst would be most likely to evaluate A) the management tenure B) the daily trading volume C) the price-to-earnings ratio D) the price-to-book ratio

B. the daily trading volume Explanation A technical analyst charts price and volume over time. The other choices are of interest to a fundamental analyst. LO 21.d

Some risk is involved in almost all investments. In general, the greater the risk, A) the smaller the potential return B) the greater the potential return C) the more expensive the investment D) the longer the period until a return will be realized

B. the greater the potential return Explanation Risk and potential return tend to go together. Low-risk investments usually produce low returns. High-risk investments offer the hope of high returns. LO 21.g

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

B. the internal rate of return Explanation Internal rate of return (IRR) is not a component of modern portfolio theory as are the other 3 terms. LO 21.g

Investment advisers who preach the benefits of strategic asset allocation do so because they believe A) the market is basically inefficient and there is a strategy that can beat it B) the market is perfectly efficient because stock prices reflect all available information C) over the long run, strategic management will eventually outperform the market D) active management of a portfolio offers tactical benefits

B. the market is perfectly efficient because stock prices reflect all available information

Under modern portfolio theory (MPT), the optimal portfolio has A) no risk for a given amount of return B) the most return for a given amount of risk C) the least return for a given amount of risk D) the most return for the most amount of risk

B. the most return for a given amount of risk Explanation Under modern portfolio theory (MPT), the optimal portfolio is one that has the most return for a given amount of risk. LO 21.g

Which of the following statements is an accurate description of dollar cost averaging? A) An investor buys the same number of shares each interval, averaging out his purchase prices over time. B) An investor averages the costs of his shares purchased and then enters limit orders to purchase additional shares at the average price. C) An investor invests a set amount of money each interval to buy more shares when the prices are low and fewer shares when prices are high. D) An investor sells shares when the market rises and buys shares when the market declines in order to average his costs.

C. An investor invests a set amount of money each interval to buy more shares when the prices are low and fewer shares when prices are high. Explanation Dollar cost averaging involves investing a set amount of money each interval. If the market fluctuates, this will cause the client to buy more shares when the prices are low and fewer shares when prices are high. The result of this is a lower average cost per share than average price paid.

Jane and Malka are discussing the possible form of efficient markets. Jane states that, "A weak form price-efficient market is one in which security prices fully reflect past share price and trading volume data." Malka retorts that she is not sure of Jane's thoughts and says, "If markets are weak form efficient, we cannot consistently outperform the market based on technical analysis." A) Malka is correct, but Jane is incorrect. B) Jane is correct, but Malka is incorrect. C) Both Jane and Malka are correct. D) Both are incorrect.

C. Both Jane and Malka are correct. Explanation A weak form price-efficient market is one in which security prices fully reflect past share price and trading volume data. Therefore, successive future share prices should move independently of this past data in a random fashion, thereby nullifying any perceived informational advantage from adopting technical analysis to analyze trends. LO 21.i

Which of the following strategies would most effectively protect an investor with a short stock position? A) Buy a put B) Sell a call C) Buy a call D) Sell a put

C. Buy a call short stock = bearish Explanation Purchasing a call on the security protects the customer from a loss in excess of the strike price plus the cost of the call should the security rise in price. This is the most common way to hedge a short stock position. LO 21.k

If an investor purchases 500 shares of an aggressive growth stock, which strategy would limit his downside risk? A) Buying 5 calls on the stock B) Writing 5 straddles C) Buying 5 puts on the stock D) Writing 5 puts on the stock

C. Buying 5 puts on the stock Explanation A put gives the investor the right to sell stock at a set price (the strike price) for a period of time, and protects against losses below the strike price. Buying calls can protect a short stock position. If the customer is long stock, the purchase of calls on that security increases leverage and risk. Writing a put creates the obligation to buy more stock at the strike price, which increases downside risk. LO 21.k

A technical analyst is least likely to consider which of the following when selecting securities? A) Advance/decline line B) Short interest ratio C) Corporate earnings D) Trend lines

C. Corporate earnings Explanation Corporate earnings would be of least interest to a technical analyst, who is interested in market statistics indicative of future buying, market statistics that could reflect price or market trends, and trading volume. LO 21.d

In which of the following funds would a buy-and-hold style most likely be used by the manager? A) Options income fund B) Information technology fund C) Equity index fund D) Market timing fund

C. Equity index fund Explanation A manager of an equity index fund would use a buy-and-hold style. As the composition of the index changes through stock distributions or recapitalizations, the fund manager would buy or sell the issues to keep them in proportion to their position in the index prior to the distribution or recapitalization.

Which of the following is an example of a passive investment management style? A) Use of index funds in conjunction with selecting specific securities in the index to overweight certain sectors B) Investment in small capitalization technology securities C) Exclusive use of index funds D) Value investing

C. Exclusive use of index funds Explanation A passive investment style uses index funds because the manager does not believe that returns above the averages can be sustained for any length of time because the market is efficiently priced. Use of index funds in conjunction with specific securities in order to overweight sectors is an active style. Investment in small capitalization technology securities involves actively selecting securities that the manager believes will perform well or better than the market. Value investing involves the active search for securities that are undervalued by the market. LO 21.c

Which of the following is not associated with passive investment management approaches? A) Use of index investing B) Belief in efficient markets C) Goal of beating the market D) Belief in the random walk theory

C. Goal of beating the market Explanation Proponents of passive-management approaches believe in the random walk theory (market movements are unpredictable) and efficient markets (any information that could affect a stock's price is quickly reflected in its price). As a result, they feel that it is impossible to consistently beat the market. Index investing is a commonly used passive-management approach. LO 21.c

Which of the following is the form of portfolio management that rotates between sectors based on changes to the business cycle? A) Cyclical rotation B) Strategic portfolio management C) Segment rotation D) Tactical portfolio management

C. Segment rotation Explanation Segment rotation, more commonly known as sector rotation, involves altering portfolio composition based on which sectors are poised to outperform as the business cycle is changing phases. LO 21.c

Ian is a technical analyst who believes the market, as represented by the S&P 500 Index, is overbought. Over the next several months, there is a 12% correction. Which of the following strategies would have been successful for Ian? A) Buy call options on the S&P 500 Index B) Sell put options on the S&P 500 Index C) Sell futures contracts on the S&P 500 Index D) Buy futures contracts on the S&P 500 Index

C. Sell futures contracts on the S&P 500 Index Explanation Ian was obviously bearish on the market. When something is overbought, it means it is overvalued due to excessive buying at unreasonably high prices. In this case, it is likely the market is primed for a correction (a reversal). The 12% correction proves him to have been correct. Selling a futures contract is taking a short position. Just as with selling stock short, the investor profits when the price of the underlying asset declines. Ian could have also profited by going long (buying) put options on the index. Selling puts and buying calls generate profit in a bullish market, not a bearish one. LO 21.k

Although most investors are buying common stock issued by LMN corporation, Jack is selling it short. In this action, Jack appears to be A) a writer B) an institutional investor C) a contrarian D) a fundamentalist

C. a contrarian Explanation Investors who take positions opposite most other investors are generally regarded as contrarian investors. LO 21.e

An investment adviser representative may describe dollar cost averaging to a customer as A) a means of purchasing more shares when share prices are high B) a form of a mutual fund withdrawal plan C) a funding technique that will cause the average cost per share to be less than the average price per share D) a program for investing that will ensure profits even in a declining market

C. a funding technique that will cause the average cost per share to be less than the average price per share Explanation Dollar cost averaging is beneficial to the client because it achieves an average cost per share, which is less than the average price per share. Dollar cost averaging is not a program for investing that will ensure profits even in a declining market; it is just an economical method for acquiring shares. LO 21.j

One method used by some analysts to estimate the future value of a stock is the dividend growth model. This model would probably be most useful in the case of A) a preferred stock B) a AAA corporate bond C) a large-cap stock D) a small-cap stock

C. a large-cap stock Explanation The dividend growth model is a method to value the common stock of a company on the basis of assumed constant growth of dividends in the future. Therefore, it can only be applied to a corporation whose dividends might be expected to increase. It is far more likely that a large-cap stock will be paying dividends than a small-cap. Bonds don't pay any dividends, and in any event, their interest, just like the dividends on preferred stock, is fixed; there is no growth possible. LO 21.d

An analyst is reviewing a report on Company X. The report shows a P/E ratio of 10, compared with an industry average of 27. Based on the most current quarterly payment, X has a dividend yield of 3.65%. The analyst notices there is a footnote indicating the company has put $1.2 billion away for what it refers to as a rainy day fund. most likely, Company X would be considered A) a growth stock B) a utility stock C) a value stock D) a small-cap stock

C. a value stock Explanation Although there are no hard and fast rules, when a company's P/E ratio is substantially lower than its industry average and the dividend yield is fairly high, it will be considered to have great value. Solidifying this decision is the notation that there is the rather large rainy day fund. Yes, utility stocks do pay liberal dividends but what must be noticed here is the low P/E ratio compared with its peers. LO 21.e

In an efficient market: A) investors have a good chance of beating the market B) information is disseminated slowly C) any information that could affect a stock's value is quickly reflected in its price D) it is fairly easy to predict major market swings

C. any information that could affect a stock's value is quickly reflected in its price Explanation An efficient market is one in which every individual can quickly obtain and use information about new events in the marketplace. Because information is disseminated quickly, any new information that could affect a stock's value is quickly reflected in its price. LO 21.i

A technical analyst would be least concerned with A) advance/decline B) short interest C) book value per share D) S&P 500 index

C. book value per share Explanation A technical analyst is not concerned with any fundamental aspects of a company, including company financials. Open short interest theory, overall market movements, and advance/decline ratios are of concern to technical analysts. LO 21.d

As compared to value investors, growth investors tend to A) look for companies that are undervalued or overlooked by other investors B) be very price-conscious when purchasing stocks C) look for companies whose sales, earnings, or market share are increasing at an above-average rate D) take more of a long-term approach to their investments

C. look for companies whose sales, earnings, or market share are increasing at an above-average rate

It is agreed by most investment advisers that diversifying an investment portfolio can reduce the overall risk. Benefits of diversification would include all of the following except A) lowering the volatility of the portfolio. B) increasing risk-adjusted returns. C) lowering trading costs. D) mitigating the effects of a bankruptcy of a security held in the portfolio.

C. lowering trading costs. Explanation If anything, diversifying a portfolio will increase the trading costs. Those higher costs are outweighed by the benefits in risk reduction and potential higher returns. With a well-diversified portfolio, a single company going bankrupt will have a much smaller impact than if that security was the only asset held by the investor. It is the old theory of "don't put all of your eggs in one basket". Broad diversification, which includes different asset classes, has the effect of reducing the overall volatility of the portfolio and by holding assets that tend to rise while others decline, the risk-adjusted returns may well be increased. LO 21.b

Writing a call option provides all of the following except A) hedging. B) income. C) maximum protection against loss. D) limited downside protection when long the underlying asset.

C. maximum protection against loss. Explanation Writing a call option provides only limited protection for a long or short position. That protection is limited to the amount of the premium received and is why this is called a partial hedge. LO 21.k

Corpulent Asset Services of Hamburg (CASH), a covered investment adviser, has a philosophy of placing most of their clients' assets into broad market index funds and ETFs. This would indicate that CASH's portfolio management style is most likely A) tactical B) active C) passive D) conservative

C. passive Explanation Investing in broad market index funds and ETFs is generally considered to be a passive management style. The active style follows a tactical strategy and is based on the belief that value can be added by stock-picking rather than following the market. Although CASH may be acting in a conservative manner, "conservative" is not considered to be a portfolio management style. LO 21.c

Jim Cantore is a 45-year-old client with a $1.5 million portfolio that is heavily weighted toward equities. Cantore will continue working for the next 20 years and has a substantial retirement portfolio through his current employer. Cantore's three children are now nearing college age and will all attend premiere universities in the U.S. which each cost $50,000 per year to attend. All college expenses will be paid out of Cantore's portfolio. Cantore should A) not rebalance his portfolio because his children should all pay their own way through school. B) rebalance his portfolio towards aggressive small-cap stocks because he needs to increase the return of his portfolio to cover the upcoming college expenses. C) rebalance his portfolio toward high quality, intermediate-term debt instruments to service the expected liquidity needs of his portfolio.

C. rebalance his portfolio toward high quality, intermediate-term debt instruments to service the expected liquidity needs of his portfolio. Explanation The liquidity needs of sending his children to school should take precedence over his retirement needs, which are already well funded. Although the equities have liquidity, the potential market risk makes it wise to diversify such that the portfolio becomes less sensitive to market swings. LO 21.b

Value investors A) attempt to find value through diversification B) seek to find securities with high Sharpe ratios C) seek securities that are undervalued or selling for less than their intrinsic value D) seek undervalued stocks through careful chart analysis

C. seek securities that are undervalued or selling for less than their intrinsic value Explanation Value investors seek securities that are undervalued or selling for less than their intrinsic value. Value investors tend to use fundamental analysis and do not determine value from charting. LO 21.e

There are several popular investment styles and, in many cases, portfolio managers use a blended approach to security selection. If a portfolio manager adhered to a pure value style, he would put most of his focus on A) using technical analysis B) lagging indicators C) the company's financial statements D) projecting future earnings based on past earnings

C. the company's financial statements Explanation The value style of portfolio management looks for stocks that are undervalued. For example, the current market price is near or less than book value per share. The only way to find that out is by looking at the company's balance sheet. LO 21.e

All the following factors support fundamental analysis while assessing a wide range of qualitative factors except A) the company's management team's quality and experience. B) the company's competitive position. C) the company's stock price trend. D) the company's business model.

C. the company's stock price trend. Explanation The company's stock price trend is important to technical analysis. Remember that a technician "charts prices and volume over time". The others are factors to consider in fundamental analysis. LO 21.d

While attending a seminar given by one of your firm's analysts, you hear the term, feasible set. That would mean the discussion was dealing with the topic of A) a range of returns B) opportunity cost C) the efficient frontier D) convexity

C. the efficient frontier Explanation The feasible set of portfolios represents all portfolios that can be constructed from a given set of stocks. An efficient portfolio is a feasible portfolio that provides the greatest expected return for a given amount of risk, or equivalently, the least risk for a given amount of expected return. This is also called an optimal portfolio. The efficient frontier is the set of all efficient portfolios. Obviously, an investor should choose a portfolio along the efficient frontier. LO 21.g

All of the following are advantages of the buy-and-hold strategy except A) the investor will not be out of the market during an upturn in stock prices. B) the investor can minimize transaction costs. C) the investor is guaranteed a profit. D) the investor may effectively manage any investment tax obligations.

C. the investor is guaranteed a profit. Explanation The buy-and-hold strategy, among other investment strategies, does not guarantee a profit to the investor. LO 21.e

Under modern portfolio theory (MPT), the optimal portfolio has A) no risk for a given amount of return B) the least return for a given amount of risk C) the most return for a given amount of risk D) the most return for the most amount of risk

C. the most return for a given amount of risk Explanation Under modern portfolio theory (MPT), the optimal portfolio is one that has the most return for a given amount of risk. LO 21.g

Sortel Industries has preferred stock outstanding that pays annual dividends of $3.75 a share. If an investor wants to earn a rate of return of 8.5%, how much should she be willing to pay for a share of Sortel preferred stock? A) $31.88 B) $33.89 C) $42.10 D) $44.12

D. $44.12 Price = Required Rate of Return / Dividend per Share __?__ = 3.75 / 8.5% 44.12% Explanation This is a middle school math question. It is asking, 3.75 is 8.5% of what number? The computation is: 3.75 ÷ 0.085 = $44.12. LO 21.d

A technical analyst would be most interested in which of the following? A) Price-to-earnings ratios B) Working capital C) Capitalization ratios D) 200-day moving averages

D. 200-day moving averages Explanation Technical analysts try to predict the market by examining price and volume trends. They expect the market to act in the future as it has in the past. Technical analysts are not interested in the fundamental aspects of a company, such as its financial statement ratios. LO 21.d

Which of the following is the simplest portfolio management style for individual stocks? A) Indexing B) Moving averages C) Core D) Buy and hold

D. Buy and hold Explanation The key to answering this question correctly is recognizing that it is dealing with individual stocks. If the question dealt with managing a portfolio, then indexing would be the simplest style. LO 21.e

Which of the following is not an assumption of the capital asset pricing model (CAPM)? A) All market participants are well-diversified investors, and specific risk has been diversified away. B) All investors want to achieve a maximum return for minimum risk. C) All market participants borrow and lend at the same risk-free rate. D) Corporate and government taxes affect all transactions.

D. Corporate and government taxes affect all transactions. Explanation CAPM assumptions include: 1. There are no tax or transaction costs to consider. 2. All market participants borrow and lend at the same risk-free rate. 3. All market participants are well-diversified investors, and specific risk has been diversified away. 4. All investors want to achieve a maximum return for minimum risk. LO 21.g

"Stock prices adjust rapidly to the release of all new public information." This statement is an expression of which of the following ideas? A) Arbitrage pricing theory B) Odd-lot theory C) Tactical allocation D) Efficient market hypothesis

D. Efficient market hypothesis Explanation In an efficient market, all participants have equal access to information and, therefore, stock prices reflect that equality almost immediately. LO 21.i

Which of the following statements is correct in relation to the efficient frontier? A) It allows an investor to create a risk-free portfolio. B) It identifies the required rate of return on a particular stock. C) It implies an inefficiency in stock valuations. D) It represents the maximum return for a given level of risk.

D. It represents the maximum return for a given level of risk. Explanation The purpose of the efficient frontier is to plot the most efficient portfolios. An efficient portfolio is one that offers: the most return for a given amount of risk or the least risk for a given amount of return. LO 21.g

Ian is a technical analyst who believes the market, as represented by the S&P 500 Index, is overbought. Over the next several months, there is a 12% correction. Which of the following strategies would have been successful for Ian? A) Buy call options on the S&P 500 Index B) Sell put options on the S&P 500 Index C) Buy futures contracts on the S&P 500 Index D) Sell futures contracts on the S&P 500 Index

D. Sell futures contracts on the S&P 500 Index Explanation Ian was obviously bearish on the market. When something is overbought, it means it is overvalued due to excessive buying at unreasonably high prices. In this case, it is likely the market is primed for a correction (a reversal). The 12% correction proves him to have been correct. Selling a futures contract is taking a short position. Just as with selling stock short, the investor profits when the price of the underlying asset declines. Ian could have also profited by going long (buying) put options on the index. Selling puts and buying calls generate profit in a bullish market, not a bearish one. LO 21.k

Given the following information: Stock / Beta A / 2.16 B / 1.54 C / 0.96 D / 1.28 Assume the risk-free rate of return is 2.75% and the market rate of return is 6.75%. An investor has a required rate of return of 9.5%. Which of these stocks would offer the best investment opportunity? A) Stock B B) Stock C C) Stock D D) Stock A

D. Stock A Explanation Calculate the expected rate of return of each stock using CAPM and compare the result to the investor's required rate of return. Stock A: E(r) = 2.75 + (6.75 - 2.75)2.16 = 11.39%. Stock B: E(r) = 2.75 + (6.75 - 2.75)1.54 = 8.91%. Stock C: E(r) = 2.75 + (6.75 - 2.75).96 = 6.59%. Stock D: E(r) = 2.75 + (6.75 - 2.75)1.28 = 7.87%. Based on a required rate of return of 9.5%, Stock A with an expected return of 11.39% is the best available investment opportunity. LO 21.h

The statement, "Stock prices fully reflect all information from public and private sources," can be attributed to which form of the efficient market hypothesis (EMH)? A) Passive form EMH B) Semi-strong form EMH C) Weak form EMH D) Strong form EMH

D. Strong form EMH

Which of the following is not a type of diversification that is achieved by investing in international equities? A) Currency B) Asset class C) Geographic D) Style

D. Style Explanation Following a value or a growth style, or using a buy-and-hold strategy, is independent of the continent of domicile of the issuer. Investing in different countries diversifies investments among various currencies, other than the client's domestic currency. Different geographic areas have different types of industries whose performance may vary on the basis of regional resources. International equities are considered another asset class for purposes of asset allocation in one's portfolio. LO 21.e

Which of the following investment strategies reflects determining an appropriate portfolio allocation based on the short-term market movements and risk tolerance of the client? A) Top-down fundamental analysis B) Efficient market allocation C) Strategic asset allocation D) Tactical asset allocation

D. Tactical asset allocation Explanation Those following the tactical asset allocation strategy are generally attempting to time the market. That is, changing the allocation to benefit from the short-term swings in the market. In strategic asset allocation, once the allocation is determined, it remains relatively constant until some change to the investor's objectives occurs. Periodically, the portfolio is rebalanced to reflect any changes in market conditions. LO 21.c

Which of the following would be of least interest to a chartist? A) The advance/decline line B) The volume of shares traded during the past month C) The short interest D) The relationship between the current market price of an issuer's common stock and most recently reported earnings per share

D. The relationship between the current market price of an issuer's common stock and most recently reported earnings per share Explanation A chartist is interested in the volume of shares traded, and the short interest for that particular stock. The advance/decline line is another technical indicator. The price-to-earnings ratio is used in fundamental as opposed to technical (charting) analysis. LO 21.d

A popular funding technique that involves investing the same amount at regular intervals is known as dollar cost averaging. Participating in this funding approach tends to lessen which risk? A) Market B) Inflation C) Credit D) Timing

D. Timing Explanation Timing risk, sometimes called market timing risk, is the uncertainty that an investor will be buying at the market top or selling at the market bottom. In other words, at the wrong time. When one dollar cost averages, that risk is lessened because you automatically acquire more shares when the market is down and less when it is high. Is it foolproof? No, but it does take some of the timing risk away. LO 21.j

Which of the following statements is correct? A) As the correlation coefficient moves from +1 to zero, the potential for diversification diminishes. B) The efficient frontier represents individual securities. C) The efficient frontier represents portfolios that have the lowest expected return for each level of risk. D) When a risk-averse investor is confronted with two investment opportunities having the same expected return, the investor will take the opportunity with the lower risk.

D. When a risk-averse investor is confronted with two investment opportunities having the same expected return, the investor will take the opportunity with the lower risk. Explanation It is expected that investors will always choose the lower risk investment if both generate the same return. The other statements are incorrect. As the correlation coefficient declines, the potential for greater diversification increases. Efficient portfolios, not individual securities, lie on the efficient frontier. The efficient frontier contains portfolios with the highest expected return at each level of risk. LO 21.g

ABC Corporation, whose common stock is listed on the NYSE, declares a $3.00 per share cash dividend to its shareholders. ABC has paid dividends of only $.07 per share for each of the last 15 quarters, and market analysts had anticipated a similar dividend this quarter. In an efficient market, one would expect A) no price change before or after the announcement. B) a price increase before the announcement. C) a price decrease after the announcement. D) a price increase upon the announcement.

D. a price increase upon the announcement. Explanation In an efficient market, the price of the stock will represent all information that is public. Because the increase in the dividend was not public knowledge until it was declared, no price change would take place before the announcement. A price jump, representing the surprising increase in the dividend, would be expected immediately after the information became public. LO 21.i

High-tech Industries (HTI) went public 4 years ago by issuing 100 million shares of common stock at $1 per share. HTI's earnings have soared and the stock is now selling for $13 per share. HTI would be considered A) a micro-cap stock. B) a mid-cap stock. C) a large-cap stock. D) a small-cap stock.

D. a small-cap stock. Explanation: 100 mil shares x $13/share = $1.3b market cap Micro Cap: Less than $300 million Small Cap: $300 million to $2 billion Mid Cap: $2 billion - $10 billion Large Cap: More than $10 billion

Wrap fee accounts would tend to be most suitable for investors who follow A) a buy-and-hold philosophy B) a passive approach to investing C) a strategic approach to the market D) a tactical approach to investing

D. a tactical approach to investing Explanation Because one of the key benefits to the wrap fee program is the elimination of transaction fees (commissions), it is most suitable for those who are active traders, such as those who take a tactical approach to investing. The other 3 choices engage in far less trading activity, potentially not being able to take full advantage of all of the benefits of the wrap program. LO 21.c

A high-risk investment strategy is the short sale of stock. Each of the following is a method of offering some degree of protection except A) selling a put on the short stock. B) entering a buy stop order for the short stock. C) buying a call on the short stock. D) buying a put on the short stock.

D. buying a put on the short stock. Explanation The risk in selling a stock short is that the price of the stock will rise rather than fall. Those who purchase put options have the same market view as those who sell short—they will profit if the price of the security declines. Buying a put would be the equivalent of "doubling down" on your bet. The best way to hedge (protect) a short stock position is to purchase a call option on the security because that gives you a guaranteed "buy-back" price regardless of how high the stock's price rises. If you sell a put on the stock and the price rises, the put will expire and the seller will have the premium to partially offset any loss. If the short seller enters a buy stop order, once the price rises (or goes through) the stop price, a market order to buy the stock will be entered and the position will be closed out preventing any further loss. LO 21.k

An investor following the buy and hold model of investing would most likely be A) holding a stock until its ex-dividend date and then selling it to capture the dividend. B) buying a stock during the recovery cycle and selling at the peak. C) looking to shelter income from taxation. D) buying a stock as a long-term investment to reach a specific goal.

D. buying a stock as a long-term investment to reach a specific goal. Explanation Buy and hold is a perfect description of this strategy. Securities are purchased for the long run, generally with a specific objective in mind. Those would include things such as education, retirement, or future health needs.

A fundamental analyst would be interested in all of the following except A) statistics of the U.S. Department of Commerce on disposable income B) corporate annual reports C) innovations within the automotive industry D) daily trading volumes on the NYSE

D. daily trading volumes on the NYSE Explanation Trading volume interests the technical analyst, who looks at fluctuations in the market, not at fundamental economic values. LO 21.d

A support level is the price range at which a technical analyst would expect the A) demand for a stock to decrease substantially B) demand for a stock to remain constant C) supply of a stock to increase substantially D) demand for a stock to increase substantially

D. demand for a stock to increase substantially Explanation This question is about comparing support and resistance levels. Most stock prices remain relatively stable and fluctuate up and down within a narrow range. The lower limit to these fluctuations is called a support level - the price point where a stock appears cheap and attracts buyers. The upper limit is called a resistance level - the price point where a stock appears expensive and initiates selling. Generally, a support level will develop after a stock has experienced a steady decline from a higher price level. Technicians believe that, at some price below the recent peak, other investors will buy who did not buy prior to the first price increase and have been waiting for a small reversal to get into the stock. When the price reaches this support level, demand surges and price and volume begin to increase again. LO 21.d

An investor who uses dollar cost averaging to purchase a mutual fund would A) invest in a bond fund during a falling market and a stock fund during a rising market B) purchase the same number of shares each month C) allocate assets equally among cash, stocks, and bonds D) invest the same amount of money each month

D. invest the same amount of money each month Explanation In the dollar cost averaging investment strategy, the amount of dollars invested each month remains constant. Accordingly, the investor will automatically buy more shares when the price is low to reduce the average cost per share. LO 21.j

Amie Lear is a securities analyst employed by Empyreal Benefits, Inc., a registered broker-dealer. She is assigned to cover a number of different equity and debt investments. One of the investments is Taylor, Inc. (Taylor), a manufacturer of a wide range of children's toys. Based on her extensive analysis, she determines that her expected return on the stock, given Taylor's risks, is 10%. However, when applying the capital asset pricing model (CAPM), the result is a 12% rate of return. Based on Lear's analysis, Taylor's stock is A) correctly valued. B) undervalued. C) neither overvalued nor undervalued. D) overvalued.

D. overvalued. Explanation The CAPM gives us the expected rate of return on an investment. It is sometimes referred to as the required rate of return. That is, based on the risks, the CAPM reveals the return that should be earned. In this example, that return is 12%.Lear's computation expects the return to be only 10%. Therefore, Lear is showing that instead of providing the required return of 12%, she believes the stock will only return 10%. That makes the stock overpriced (a lower price will generate a higher rate of return). As a result, Lear would not recommend this stock because her calculations indicate it will not return as much as it should for the risk being taken. LO 21.g

During the analysis of XYZ stock, a technical analyst concludes that XYZ's support level has been broken. Being a technician, the most appropriate decision should be to A) rate the stock as a buy. B) purchase additional shares of the stock. C) rate the stock as a hold. D) rate the stock as a sell.

D. rate the stock as a sell. Explanation If a support level is broken, this provides a sell signal. Once the stock has lost its support, expectations are that it will continue to fall. The breaking of a resistance level, as the price of the asset gathers momentum to the upside, indicates a buying opportunity. LO 21.d

While attending a seminar given by one of your firm's analysts, you hear the term, feasible set. That would mean the discussion was dealing with the topic of A) a range of returns B) opportunity cost C) convexity D) the efficient frontier

D. the efficient frontier Explanation The feasible set of portfolios represents all portfolios that can be constructed from a given set of stocks. An efficient portfolio is a feasible portfolio that provides the greatest expected return for a given amount of risk, or equivalently, the least risk for a given amount of expected return. This is also called an optimal portfolio. The efficient frontier is the set of all efficient portfolios. Obviously, an investor should choose a portfolio along the efficient frontier. LO 21.g

That all market participants have equal access to information is a fundamental premise of A) asset allocation B) Monte Carlo simulation C) portfolio correlation D) the efficient market hypothesis

D. the efficient market hypothesis Explanation When all market participants have equal access, the theory is that stock prices will reflect that efficiently. LO 21.i

The pundits are predicting slowly-rising inflation over the next 5 years. An IAR recommends that one of her clients splits his bond portfolio into equal percentages with maturities ranging from 1 to 5 years. As each bond matures, the proceeds are used to purchase bonds with a 5-year maturity. The IAR is using A) the interest discount model. B) the bullet strategy. C) the barbell strategy. D) the laddering strategy.

D. the laddering strategy. Explanation The theory behind the laddering strategy is that with bonds maturing every year, the investor is reinvesting the principal at current market rates. In a period of rising inflation, interest rates follow along, so annually, the maturing bonds will be used to purchase new bonds with higher coupons.