Unit 21

Which of the following describes an investment management style? A) Large capitalization B) Margin C) Current income D) Rebalancing

A) Large capitalization A large capitalization style distinguishes between investing in a small-cap company versus a large capitalization company. Current income is an investment objective and not an investment management style. Rebalancing is used to bring asset allocations back to their desired weightings. Margin can be used in a number of investment management styles.

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

B) Indexing 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.

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 small-cap stock B) a large-cap stock C) a AAA corporate bond D) a preferred stock

B) a large-cap stock

A portfolio manager who believes equity securities are overvalued in the short term reduces the weight of equities in her portfolio to 35% from its longer term target weight of 40%. This decision is best described as an example of A) tactical asset allocation. B) rebalancing. C) strategic asset allocation. D) contrarian investing.

A) tactical asset allocation

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) overvalued. B) correctly valued. C) neither overvalued nor undervalued. D) undervalued.

A) overvalued. 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.

An investor has $50,000 to invest in bonds. Currently, 10-year bonds are offering very attractive yields, but the client is concerned that in a few years, rates will be even higher. What would you suggest? A) Laddering B) Barbell strategy C) Bullet strategy D) Diversifying

B) Barbell strategy With the barbell strategy, the investor would place $25,000 into bonds maturing in 10 years and the other half into bonds maturing in two years. This makes $25,000 available for reinvestment in two years enabling the investor to take advantage of the higher rates (if they materialize).

When giving advice to a large pension plan invested heavily in large-cap stocks on how to reduce their systematic risk, you would probably recommend that they A) increase the standard deviation of the portfolio B) hedge by purchasing broad index puts C) raise the correlation coefficient of the securities in the portfolio D) increase their portfolio diversification

B) hedge by purchasing broad index puts Buying broad index put options, such as on the S&P 500, gives an effective hedge against the downside movement in the market. Another choice, although not necessarily as effective, would be to lower the standard deviation of the portfolio by switching into securities with a lower volatility. Diversification does not protect against systematic (market) risk and reducing the correlation would work, not increasing it.

Which of the following bond strategies is the least active? A) Yield curve B) Ladder C) Bullet D) Barbell

C) Bullet The least active strategy is the one requiring the lowest level of activity on the part of the investor. The bullet strategy involves investing in bonds at various intervals with all of the bonds maturing at or about the same time (such as when a child is entering college). As such, the only activity is buying bonds every couple of years. Barbell and ladder strategies have bonds maturing at regular intervals, requiring an active role in reinvesting the principal. All three of these require the investor to purchase bonds at different times, but the bullet strategy is the only one not concerned with the mechanics of collecting the matured principal and reinvesting it. Yield curve is not a specific strategy.

Which of the following is true of the weak form of the efficient market hypothesis? A) It implies that throwing darts is just as efficient as analyzing the market. B) It implies that insiders cannot make a profit from their trading. C) It implies that market information cannot be used to identify future price movements. D) It implies that stock prices react to information when it becomes publicly available.

C) It implies that market information cannot be used to identify future price movements. The weak form of the EMH states that all market information has already been incorporated into the current stock price. Therefore, having that information is of no help in predicting movements in the market. It is the strong form that says that inside information won't work, and from there the ultimate conclusion is that in an efficient market, throwing darts works as well as anything else.

If the current risk-free rate is 3% and the expected market risk premium is 6%, what return should we expect from a security that has a beta of 2? A) 18% B) 15% C) 9% D) 12%

B) 15% In most questions of this type, we are given the market return. Here, there is a trick. We are told there is a market risk premium of 6%. That means that the market return must be 6% above the risk-free rate, or 9%. Now, we can plug in the formula. Expected return = 3% + ([9% -3%] × 2) = 3% + (6% x 2) = 3% + 12% = 15%. In this question, because we're already given the risk premium, we can avoid the first step. That would be 3% + (6% x 2) = 3% + 12% = 15%.

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

ii & iv ii) the dividend discount model & iv) the dividend growth model The 2 most common forms of DCF used in the valuation of common stock are the dividend discount and dividend growth models.

Given below are the EPS for the previous four quarters for four different companies being analyzed by your research department. Which of these companies is exhibiting earnings momentum? A) GHI - Q1: $0.25; Q2: $0.27; Q3: $0.30; Q4: $0.36 B) ABC - Q1: $0.58; Q2: $0.61; Q3: $0.64; Q4: $0.67 C) DEF - Q1: $0.58; Q2: $0.52; Q3: $0.50; Q4: $0.49 D) JKL - Q1: $0.82; Q2: $0.90; Q3: $0.83; Q4: $0.92

A) GHI - Q1: $0.25; Q2: $0.27; Q3: $0.30; Q4: $0.36 Earnings momentum is a term used to describe accelerating growth in earnings per share (EPS). The first thing to note about GHI's earnings is that they are increasing. That is good, but, what is more important is that they are increasing at a faster rate. For instance, the rate of change between Q1 and Q2 was about 8%. The rate of change from Q2 and Q3 was higher—about 11%—and the rate of change from Q3 to Q4 was even higher—about 20%. This is earnings momentum. The company isn't just growing, it's growing faster. Although ABC's earnings are also growing, the rate of change is not increasing as each quarter's growth is the same amount. Company DEF's earnings are declining, and Company JKL's earnings are fluctuating up and down.