CFP Exam Prep - Investment Planning (18%)
In an after-dinner conversation, your neighbor states that Hot-Flow, Inc. must certainly be a good investment now that the stock has fallen from its recent high of $80 per share. The company currently trades for $65 per share. You ask your neighbor if she has any other information on which to base her buy recommendation. "Not really," she replies, "but if the stock was $80 per share last month, surely it will return to that level in the near future. After all," she continues, "how much can things change in just a few months of time?" Your neighbor's attitude is best described as: A. anchoring. B. hindsight bias. C. regret avoidance. D. representativeness.
Answer: A. Anchoring results in buying securities that have fallen in value because it "must" get back up to that recent high. B is incorrect. Hindsight bias is a form of overconfidence related to an investor's belief that they had predicted an event that, in fact, they did not predict. C is incorrect. Regret avoidance, also known as the disposition effect, causes investors to take action (or inaction) in hopes of minimizing any regret. D is incorrect. Representativeness is thinking that a good company is a good investment without regard to an analysis of the investment.
Which of the following statement(s) regarding bond swaps is/are true? I. A substitution swap is designed to take advantage of anticipated and potential yield differentials between bonds that are similar with regard to coupons, rating, maturities, and industry. II. Rate anticipation swaps utilize forecasts of general interest rate changes. III. The yield pickup swap is designed to alter the cash flow of the portfolio by exchanging similar bonds having different coupon rates. IV. The tax swap is made to substitute current yield in place of capital gains. A. I, II and III only. B. I and III only. C. II and IV only. D. IV only.
Solution: The correct answer is A. All statements are correct except for IV. The tax swap replaces bonds with offsetting capital gains and losses.
What is one reason a company may call bonds that were previously issued? A. The bonds are currently selling at a premium. B. The bonds are currently selling at a discount. C. The company expects interest rates to decrease. D. The bonds are selling at par.
Solution: The correct answer is A. If the bonds are selling at a premium, then interest rates have decreased since the bonds were issued. The company would be motivated to retire the higher yield bonds and issue new bonds at lower market interest rates. A discount bond would indicate that interest rates of increased and the bond is paying a lower rate than current market interest rates. Companies do not make changes on expectations, but in actual rate changes.
Which of the following elements of risk in mortgage-backed securities can be difficult to determine? I. Actual maturity is not known with certainty. II. Mortgage rates vary between the different investment pools. III. Actual cash flows are not known with certainty. IV. Government guarantees make the determination of an appropriate discount rate for calculating their present value difficult. A. I and III only. B. I and IV only. C. II and III only. D. II and IV only.
Solution: The correct answer is A. Lack of a definite maturity date (you won't know if mortgages are paid off early ahead of time) and uncertain cash flows (due to possible early payoffs) are the elements of risk in mortgage-backed securities.
What is one implication of the efficient market hypothesis? A. Consistently superior performance is rare. B. The weak form suggests that security prices do NOT adjust to new information. C. The random walk hypothesis is invalidated. D. Anomalies are perceptions but do NOT actually exist.
Solution: The correct answer is A. One cannot consistently earn abnormal returns. Over time, these superior returns will be reversed and overall gain is consistent with the general market.
Which of the following statements about preferred stock are true? I. Its market fluctuations are greater than the long-term bond market fluctuations. II. It is more risky than debt. III. Its dividends are recomputed quarterly. IV. It has no interest rate risk because it is a stock and not a bond. A. I and II only. B. I and IV only. C. II and III only. D. II and IV only.
Solution: The correct answer is A. Option "III" - Dividends are set at issue by the Board as a percent of par value and do not change. Option "IV" - Changes in interest rates directly impact preferred stock, and there is no relief on preferred stock because most cannot be held to maturity (as most are issued without a maturity date). Preferred stock is more risky than bonds because bonds are a legal obligation and have a higher priority in bankruptcy proceedings.
If one of your clients has a profitable long position in an oranges futures contract and does nothing as the contract expires, what should she expect to occur? A. The oranges will be delivered to her. B. She will receive a substantial check as soon as the account is settled. C. Her contract will expire worthless unless she takes some action. D. Her broker will arrange for sale of the oranges in an appropriate market.
Solution: The correct answer is A. Positions in futures contracts are closed by taking an equal and opposite position. One who is long on a contract at the expiration should expect delivery of the commodities at the stated contract price. It is the buyers responsibility, but in this case, we could say the broker was remiss in his or her duties!
Robin purchased a mutual fund at NAV of $20.00 and sold it 8 months later at $21.00. During the time he owned the fund, he received a LTCG of $1.00/share and a qualified dividend distribution of $.75/share from the mutual fund. He has a marginal tax rate of 32%. The tax on LTCG is 15%. What is his after-tax holding period return? A. 10.84% B. 11.5% C. 11.8% D. 12.3%
Solution: The correct answer is A. Since this is a ST holding period, it's ordinary income at the marginal tax rate for the price increase. Since the dividend distribution is a qualified dividend, it receives capital gains tax treatment. HPR = (SP - PP +/- CF) × (1-TR) / PP [($21.00 - $20.00) × (1 - .32)] + [($1.00 + $.75) × (1 - .15)] / $20.00 Answer: 10.84% (remember to follow order of operations: Parenthesis, exponents, multiplication, division, addition, subtraction) Based on Subchapter M or pipeline theory, investment companies must payout at least 90% of their portfolio earnings. If a mutual fund sells a position they hold at a gain, it passes the gain, like-kind, to its investors.
A client invested in a stock recommended by a friend who worked in a bank. The stock provided the client with an 80% return within a year. When the client called his financial planner to discuss investments, the client wanted to add some new stocks to his portfolio. The client explained that he had been so successful in selecting the stock that appreciated by 80% that he wanted to make some additional selections. Which of the behavioral finance biases is most likely present in this client's situation? A. Overconfidence B. Anchoring C. Confirmation bias D. Recency
Solution: The correct answer is A. The client displays the bias of overconfidence. The client has been successful with one stock selection that was the recommendation of a friend. The client then thinks that he can select other stocks based on that one success. This overestimation of one's ability to perform a specific task is a bias that can lead to irrational risk taking. One could argue that other biases are also present but overconfidence seems to be the bigger concern. Anchoring - Attaching or anchoring one's thoughts to a reference point even thought here may be no logical relevance or is not pertinent to the issue in question. Confirmation bias - A commonly used and popular phrase is that "you do not get a second chance at a first impression". Recency - Giving too much weight to recent observations or stimuli.
Walt Drizzly stock is currently trading at $45 and pays a dividend of $3.50. Analysts project a dividend growth rate of 5%. Your client, Toby Benjamin, requires a rate of 12% to meet his stated goal. Toby wants to know if he should purchase stock in Walt Drizzly. A. Yes, the stock is undervalued. B. No, the stock is overvalued. C. No, the required rate of return is higher than the projected growth rate. D. Yes, the required rate is higher than the expected rate.
Solution: The correct answer is A. The intrinsic value is: V = (D1 / r - g), therefore V = (3.50 × 1.05) / (.12 - .05), V = $52.50 compared to the selling price of $45. Therefore the stock is undervalued. D is incorrect, use the rate of return formula on the top right of the formula sheet.r = (D1 / P) + Gr = ((3.50 x 1.05) / 45) + .05r = (3.675 / 45) + .05r = .08167 + .05f = .1317 or 13.17% Required rate of return was 12% is not higher than the expected rate of return.
Which of the following terms would be used to describe a municipal bond issued with a restricted revenue base? A. Limited general obligation bonds. B. Limited revenue bonds. C. Full faith and credit bonds. D. Revenue bonds.
Solution: The correct answer is A. The limited general obligation bond is a bond issued by an entity that has some ability to levy taxes to support itself (for example, a school district). However, this ability is limited when compared to that of the general taxing power of the state.
John Risotto has a cash need at the end of nine years. Which of the following investments best meets this need and serves to immunize the portfolio initially? I. An 11-year maturity coupon bond. II. A 9-year maturity coupon Treasury note. III. A series of Treasury bills. A. I only. B. II and III only. C. II only. D. I and II only.
Solution: The correct answer is A. The process of portfolio immunization entails not maturity of a security, but its duration. Duration is based on coupon rate. The larger the coupon payment, the shorter the duration. This being the case, a bond generally pays higher interest than a note, and a note pays higher than short-term Treasury bills. Given this information, one could reasonably expect a shorter duration (than time to maturity), while receiving better immunization from the bond.
David has $20,000 that is earmarked for a down payment on a house in two years. If David is in the 28% tax bracket, what should he invest the $20,000 in? A. A 4% tax free money market mutual fund. B. A 5.4% corporate bond. C. A well diversified growth mutual fund. D. An intermediate muni-bond fund paying 4.5%.
Solution: The correct answer is A. The taxable equivalent yield for the tax free money market fund is 5.56%. TEY = .04 / (1 - .28) TEY = .0556 The taxable equivalent yield is greater than the taxable corporate bond paying 5.4%. The mutual fund and intermediate muni-bond fund are not appropriate given the investor's time horizon.
Which of the following is NOT a premium factor that would be considered part of the nominal rate of interest? A. Economic premium. B. Default premium. C. Liquidity premium. D. Risk free rate of interest.
Solution: The correct answer is A. There is no such thing as an economic premium. All of the other premiums added to the risk free rate equal the nominal (or stated) rate. Keep in mind that return is made up of risk premium plus the risk-free rate. The risk premium is added to the risk free rate to compensate investors for additional risk. There is no true risk-free rate, so the treasury rate is used in it's place.
You are faced with several fixed income investment options. Which of these bonds has the greatest reinvestment rate risk? A. A U.S. Treasury bond with an 11.625% coupon, due in five years with a price of $1,225.39 and a yield to maturity of 6.3%. B. A U. S. Treasury strip bond (zero-coupon) due in five years with a price of $735.12 and a yield to maturity of 6.25%. C. A corporate B-rated bond with a 9.75% coupon, due in five years with a price of $1,038.18 and a yield to maturity of 8.79%. D. A corporate zero coupon bond due in 5 years with a price of $750 and a yield to maturity of 5.9%.
Solution: The correct answer is A. This is due to the high coupon and lack of similar rates currently. A good visual to use in the bond chart in Lesson 6 under Yield Summary. If the YTM is currently 6.3% on an 11.625% coupon bond, the bond is trading at a premium, meaning investors are willing to pay more to purchase that bond than new ones issued at par with the current coupon rate (much lower than 11.625%).
Jenny bought 250 shares of XYZ stock at $30 per share, with an initial margin of 60%. She paid 8% margin interest annually. One year later she sold all of the stock for $10,500. Jenny is in the 35% marginal tax bracket, 15% for capital gains, and itemizes her deductions. What is Jenny's holding period return? A. 61.33% B. 40% C. 51.47% D. 34%
Solution: The correct answer is A. To calculate the holding period return, use the following: HPR = [ (Sale price - purchase price) +/- cashflows* ] / purchase price or equity invested HPR = [ ((10,500 - (7,500 x .40)) - (7,500 x .60)) - (7,500 x .40 x .08) ] / (7,500 x .60) HPR = [ ((10,500 - (3,000)) - (4,500)) - (240) ] / (4,500) HPR = [ 2,760 ] / 4,500 HPR = .61333 or 61.33% *cashflow in this problem is the margin interest. Choice B is not correct because it does not factor in cashflows or the margin purchase. Choice C is not correct because that is the calculation for the after-tax holding period return. Choice D is not correct because that is the calculation for the after-tax holding period return without the margins.
Often, municipal bonds are insured. One group which insures them is the: A. Municipal Insurance Group. B. Municipal Bond Insurance Association. C. Federal Insurance Guarantee Corporation. D. Resolution Trust Corporation.
Solution: The correct answer is B. Another group which insures municipal bonds is the American Municipal Bond Assurance Corporation (AMBAC.)
An investor buys a share of stock for $50. At the end of the first year, he purchases a second share for $55. At the end of the second year, the stock is worth $62 per share and the investor sells both shares. (The investor received a cash dividend of $2 per share each year.) What is the time-weighted return on this investment? A. 13.6% B. 15.2% C. 16.5% D. 18.3%
Solution: The correct answer is B. CFo = <50>, CFj = 2, CFj = 64 (62 + 2) then solve for IRR. Remember, time-weighted return is only concerned about the security's cash flow, not the investors. The question is asking about time weighted return. TWR is looking at the performance from start to end, not the investors performance. In this case it is looking at one share from start to end. Two years of dividends are accounted for. The second purchase is the investors return, which would be dollar weighted return.
What is the portfolio deviation of a portfolio invested 60% in stock "A" with a 15% return and a deviation of 17.5%, and the balance in stock "B" with an 18% return and a 16.75% deviation. There is a .29 correlation between the two securities. A. 16.2% B. 14.0% C. 13.05% D. 4.69%
Solution: The correct answer is B. COV = .175 × .1675 × .29 = .0085 s p = √(.60)2(.175)2 + (.40)2(.1675)2 + 2(.60)(.40)(.0085) s p = √.011 + .0045 + .0041 s p = √.0196 s p = .1399
Sue Todd began purchasing BLT, Inc. mutual fund shares several years ago. She has followed a dollar-cost averaging approach by investing $1,000 each year for 5 years. The following describes Sue's purchases: Year 1 - $1,000 investment at $120 per share Year 2 - $1,000 investment at $100 per share Year 3 - $1,000 investment at $118 per share Year 4 - $1,000 investment at $97 share Year 5 - $1,000 investment at $130 per share What is Sue's average cost per share? A. $100 B. $111.58 C. $113 D. $118.23
Solution: The correct answer is B. Calculate the number of shares purchased over time (44.8 shares) and divide this figure into the total amount invested over that time ($5,000). The result is an average share price of $111.58 per share. Year 1 - $1,000 investment at $120 per share = 8.33 shares Year 2 - $1,000 investment at $100 per share = 10 shares Year 3 - $1,000 investment at $118 per share = 8.47 shares Year 4 - $1,000 investment at $97 share = 10.30 shares Year 5 - $1,000 investment at $130 per share = 7.69 shares $5,000/44.79 = 111.63 (give or take for rounding)
Developing cash flow projections and valuations for real estate can be difficult due to: A. A lack of comparable figures for other properties in the area. B. Changes in demographic and economic variables. C. Different financing methods amongst prospective purchasers. D. A lack of standardized methods for objectively evaluating an investment in a market that is considered inefficient.
Solution: The correct answer is B. Cash flow projections and comparable equity capitalization rates are easily obtained for a valid comparison. The difficulty is one of the unpredictability of changes in economics and demographics which directly impact values. Real estate valuation models such as one using net operating income, adjust for variations in real estate financing.
Match the investment characteristic(s) listed below which describe(s) closed-end investment companies. A. Passive management of the portfolios. B. Shares of the fund are normally traded in major secondary markets. C. Both "A" and "B." D. Neither "A" nor "B."
Solution: The correct answer is B. Close-end funds are traded on the secondary markets but are not passively managed.
A mutual fund investor who is looking for the opportunity to buy investments at a discount, so as to capture a greater portion of any capital gains, would probably decide to invest in a(n): A. Open-end fund. B. Closed-end fund. C. Unit investment trust. D. Exchange Traded Fund (ETF).
Solution: The correct answer is B. Closed-end funds generally sell at either a premium or a discount to par value. When purchased at a discount, they afford investors an opportunity to realize up-side capital appreciation.
Which of the following are results of security regulations on investments? I. The Federal Reserve Bank places a limit on the amount of credit that can be used to transact the acquisition of securities. II. Most new issues must be registered with the SEC. III. Investors are insured against investment losses by SIPC for any securities registered with the SEC. IV. Officers of an issuing firm may be held liable for material omissions or misstatements in the prospectus. A. I, II and III only. B. I, II and IV only. C. II, III, and IV only. D. I and III only.
Solution: The correct answer is B. Statement "III" - SIPC insures investors against losses due to bankruptcy or insolvency of brokerage firms. There is no protection against investment losses.
Margin accounts involve security transactions performed using some amount of capital borrowed from the brokerage firm as well as some of the investor's own capital. The entity that establishes the initial margin requirement is the: A. Securities and Exchange Commission. B. Federal Reserve. C. National Association of Securities Dealers. D. Brokerage firm with which an investor is dealing.
Solution: The correct answer is B. The Federal Reserve sets margin requirements for all security transactions.
A child is 8 years old and the parents want to invest today for the child's education. The parents have AGI of $210,000. Which investment vehicle would you recommend? A. Series EE savings bonds. B. S&P 500 index fund. C. Laddered CDs D. Money market mutual fund.
Solution: The correct answer is B. The S&P 500 index fund is the best answer because the time horizon is long term (10 years). The parents are currently phased-out of the interest income tax exclusion benefit on the series EE savings bonds. The CDs and money market mutual fund are too conservative.
How many days prior to the date of record must an investor purchase a stock to receive a dividend? A. One day. B. Two days. C. Three days. D. Four days.
Solution: The correct answer is B. The ex-dividend date is one day prior to the date of record. An investor must purchase the stock the day before the ex-dividend date to receive the dividend. Therefore, an investor would have to purchase the stock two days prior to the date of record to receive the dividend.
You are faced with several fixed income investment options. Which of these bonds has the greatest interest rate risk? A. A U.S. Treasury bond with an 11.625% coupon, due in five years with a price of $1,225.39 and a yield to maturity of 6.3%. B. A U.S. Treasury strip bond (zero-coupon) due in five years with a price of $735.12 and a yield to maturity of 6.25%. C. A corporate B-rated bond with a 9.75% coupon, due in five years with a price of $1,038.18 and a yield to maturity of 8.79%. D. A U.S. T-bill selling for $950 due in six months.
Solution: The correct answer is B. With the term being equal, the bond with the lowest coupon will have the biggest duration. The bigger the duration, the more price sensitive the bond is to interest rate changes. Bond B has the lowest coupon, zero.
Hannah Latham, a client of yours, recently bought an orange grove. She has asked you about locking in the future price of her crop to assure adequate funds to meet expenses for the coming year. You explain both forward contracts and futures contracts to her and advise that she take the following position: A. Structure a forward contract with the bank and the juice maker. B. Take a futures contract position short the commodity and long the contract. C. Take a futures contract position long the commodity and short the contract. D. Set aside enough money to cover expenses and hope for the best.
Solution: The correct answer is C. A forward contract (though very specific) requires a buyer and a seller, and the grower may not know yet to whom the oranges will finally go. The farming and produce business are far too risky to be left to chance. And since she has the oranges in the trees, she should be long the commodity and sell a contract (or "short" the contract.)
American Depository Receipts (ADRs): A. Eliminate currency exchange rate risk. B. Eliminate currency restrictions of foreign countries. C. Allow U.S. investors to buy foreign country stock denominated in dollars. D. Are generally exempt from capital gains taxes in the United States.
Solution: The correct answer is C. ADRs do not eliminate currency exchange rate risk (Choice "A") or currency restrictions of foreign countries (Choice "B") and tax will be paid on capital gains (Choice "D").
Match the investment characteristic(s) listed below which describe(s) a unit investment trust. A. Passive management of the portfolios. B. Self-liquidating investments usually holding bonds. C. Both "A" and "B." D. Neither "A" nor "B."
Solution: The correct answer is C. Both statements are correct because a UIT typically holds municipal bonds until maturity. UITs can also own equities.
Specific companies are researched and chosen as investments based on their outstanding investment possibilities by analysts who practice: A. The Dow theory analysis. B. Top-down analysis. C. Bottom-up analysis. D. Random Walk analysis.
Solution: The correct answer is C. Bottom up analysts are looking for the next big, but as yet, undiscovered stock that will break onto the scene. Bottom up analysts start with the company, then the industry and finally the economic climate. Top-down starts with the economic climate, moves to the industry and then the company.
The following investment return will result in what dollar weighted return? An initial outlay of $50,000, with three years of additional outflows of $10,000 each, and inflows as follows: $0 the first year, $20,000 in years 2 and 3, and sale of the property at the end of year 3 for $75,000. A. 27.64% B. 14.04% C. 18.32% D. 20.67%
Solution: The correct answer is C. CF0 = <50,000> CF1 = 0 - 10,000 = <10,000> CF2 = 20,000 - 10,000 = 10,000 CF3 = 20,000 - 10,000 + 75,000 = 85,000 IRR = ?
Which one of the following statements correctly matches a technical indicator to the information it provides to signal a bear market? A. Odd lot theory indicates that the ratio of odd lot purchases to odd lot sales has been falling. B. Dow theory confirmation after the fact not predictive indicates that there is a decline in both the Dow Jones Industrial Average and Dow Jones Utility Average. C. A moving average chart indicates that actual prices have dropped through the moving 200 day average line. D. Barron's Confidence Index indicates that the yield differential between municipal bonds and corporate bonds is increasing.
Solution: The correct answer is C. Choice "A" - Odd lot purchase levels indicate the number of small investors in the market. Odd lot theory says that small investors are always wrong. If odd lot purchases are falling relative to odd lot sales, it indicates the little guy thinks the market will fall. Since the little guy is always wrong, this would indicate a rally is coming, not a bear market. Choice "B" - The Dow Theory deals in three levels of market activity over time. Choice "D" - Barron's does not have a confidence index.
Which of the following are factors to consider when investing in a mutual fund? The size of the fund. The amount of time until a distribution is made. The amount of time the current portfolio manager has managed the fund. The availability of a third-party analysis of the fund. I and III only. II and IV only. I, II and III only. I, III and IV only.
Solution: The correct answer is C. If an investor can find out I, II and III, he or she will not likely require IV. Though it may reinforce the investor's findings, the third party analysis is unnecessary at that point. Third party analysis looks at the exact same information you see from the fund. They cannot use inside information, only public information. Even if they attend due diligence meetings with the mutual fund managers, that is still public information. While you may find the format a third party puts the information in useful, or trust in their commentary or buy/hold/sell recommendations, it is based on information you have access to. As a planner, you should be doing that research on any company or investment you offer your client.
Mark Wallens, CFP®, is reviewing a client's choices relating to refinancing the mortgage on the client's primary residence. Recent turmoil in the residential mortgage market has introduced significant uncertainty into the market. Rates over the past few weeks have varied significantly, even from one hour to the next. Mark's client was a subprime borrower when she took out an option adjustable rate mortgage (option ARM) and would have to pay a prepayment penalty of $6,000 to refinance. Mark's analysis suggests that there is a 40% chance the client could save $20,000 (in present value terms) with a new mortgage from First State Bank but there is a 60% chance she would be no better off with the new mortgage ($0 in present value terms). Mark also contacts the client's current lender and that bank is willing to renegotiate the client's current loan waiving the prepayment penalty. The renegotiated mortgage from the existing lender would save the client $1,000 (in present value terms). The client is having difficulty choosing which option to pursue. She tells Mr. Wallens that while she recognizes that the new mortgage from First State Bank has a higher expected value, the possibility of spending $6,000 and receiving no benefit is very unattractive. The client's dilemma is most consistent with: A. anchoring. B. cognitive dissonance. C. loss aversion. D. risk aversion.
Solution: The correct answer is C. Many individuals, indeed most individuals, exhibit loss aversion. Loss aversion notes that people more strongly prefer to avoid losses than to seek gains. Loss aversion was identified by Amos Tversky and Daniel Kahneman. Kahneman received the Nobel Prize in Economics in 2002 for his work on prospect theory and loss aversion. A is incorrect. Anchoring represents the investor's inability to objectively review and analyze new information. B is incorrect. Cognitive dissonance is a form of overconfidence because an investor's memory of past performance is better than the actual results. D is incorrect. Risk aversion is not considered to be a behavioral bias. Rather, risk aversion is an assumption of traditional financial analysis based on the precepts of rational, utility-maximizing economic theory.
Assuming the current market yield for similar risk bonds is 8%, determine the discounted present value of a $1,000 bond with a 7.5% coupon rate which pays interest semi-annually and matures in 17.5 years. A. $504.68 B. $539.78 C. $953.34 D. $968.96
Solution: The correct answer is C. N=17.5 × 2=35 i=8/2 = 4 PV=? PMT=(.075 × 1,000) / 2 = 37.50 FV= 1,000
The Securities Act of 1933 is best summarized by the following statement: A. Requires the registration and provides for regulation of investment advisors. B. The Act regulates securities in the secondary markets. C. Regulates both initial public offerings and subsequent secondary offerings by a public company. D. Established the organized securities exchanges.
Solution: The correct answer is C. Option "A" - The Investment Advisors Act of 1940 regulates advisors. Option "B" is incorrect because the Act of 1934 regulates the secondary market. Option "C" - The Act of 1933 regulates both IPOs and secondary offerings. Option "D" - The organized exchanges and previously issued securities are governed by the Securities and Exchange Act of 1934.
An old Wall Street saying is, "Cut your losses and let your profits run." However, investors often do the opposite. It seems that people are reluctant to admit they made a mistake in purchasing a stock that subsequently performs poorly. This behavior is most consistent with: A. anchoring. B. herd mentality. C. regret avoidance. D. representativeness.
Solution: The correct answer is C. Regret avoidance (also known as the disposition effect) leads investors to take action or to refuse to act in hopes of minimizing any regret over their actions or inactions. In investments, it leads people to sell winners too soon and to hold on to losers too long. A is incorrect. Anchoring represents the investor's inability to objectively review and analyze new information. B is incorrect. Herd mentality is the process of buying what and when others are buying and selling. D is incorrect. Representativeness is thinking that a good company is a good investment without regard to an analysis of the investment.
My margin requirements are 50% initial margin and 25% maintenance margin. I purchase a total of 200 shares at $100 per share using full margin amount for the 200 share purchase. Shortly thereafter, share prices fall to $50 per share. What will my margin call be? A. $1,000 B. $1,500 C. $2,500 D. $5,000
Solution: The correct answer is C. Required equity: $50 × .25 = 12.50 per share Actual equity: $50 - $50 = 0 (current price- loan amount) To meet required equity: $12.50 per share × 200 shares = $2,500
The bond investment strategy of "riding the yield curve" involves: A. Investing equal amounts in short-term and long-term bonds. B. Investing equal amounts in each of several maturity periods. C. Investing either short-term or long-term to take advantage of anticipated interest rate changes. D. Selling bonds with unrealized losses and replacing them with similar bonds.
Solution: The correct answer is C. Riding the yield curve refers to the purchase of debt instruments in anticipation of fluctuations in the rates of return on both long and short-term instruments. Rising rates of interest require repositioning a portfolio in advance of the rise in order to avoid significant price drops. These moves are based on anticipated changes in the yield curve.
Of the following indexes, which is the only one that uses the geometric average to compute its daily value? A. NASDAQ Index. B. Wilshire 5000 Index. C. Value Line Average. E. Dow Jones Industrial Average.
Solution: The correct answer is C. The NASDAQ, the NYSE Composite, and the Wilshire all use value weighted average, while the Dow Jones Industrial is a simple price weighted average. Only Value Line uses the geometric average.
A yield curve can be described as a curve that: A. Depicts the current yield on government debt. B. Slopes upward as the years to maturity increase. C. Shows the term structure of interest rates on government debt. C. Offers greater potential yield as the maturity approaches the present.
Solution: The correct answer is C. The yield curve demonstrates graphically the relationship between long-term and short-term government debt.
A rise in the price of the Japanese Yen in relation to the U.S. Dollar results in: A. A devaluation of the Yen. B. Excess reserves in the U.S. current account. C. A revaluation of the Yen. D. A negative balance of payments.
Solution: The correct answer is C. Were the Yen to fall in value against the dollar, this would constitute a devaluation, but when it costs more dollars to buy a Yen, this is considered an appreciation or revaluation of the Yen.
If the market risk premium were to increase, the value of common stock (everything else being equal) would: A. NOT change because this does NOT affect stock values. B. Increase in order to compensate the investor for increased risk. C. Increase due to higher risk-free rates. D. Decrease in order to compensate the investor for increased risk.
Solution: The correct answer is D. A need for higher return to meet the onset of higher risk would drive the price of a security down (all other things being equal). Using an example where rm is 14% and rf is 3%, and a beta of 1.1, the required return under the SML is: r = .03 + (.14-.03)1.1 = 15.10% Then let's assume the most recent dividend is $2 and the growth rate is 7%. The price of the stock using the constant growth model is V= (2 x 1.07)/(.1510 - .07) = $26.42 Now let's increase the rm to 15%. Using the SML: r = .03 + (.15-.03)1.1 = 16.20% The new price under the constant growth model is: V = (2x1.07)/(.1620 - .07) = $23.26
Which of the following are advantages of dividend reinvestment plans? I. Reinvested dividends currently are tax deferred. II. They help firms raise new capital. III. They give investors a systematic way to accumulate capital. IV. Companies build goodwill by offering these plans to shareholders. A. I and II only. B. II and IV only. C. III and IV only. D. II, III and IV only.
Solution: The correct answer is D. All are true with the exception of dividends paid on a mutual fund are taxable, even when reinvested. A dividend reinvestment plan (DRIP) is a program that allows investors to reinvest their cash dividends into additional shares or fractional shares of the underlying stock on the dividend payment date. DRIPs, which are also known as dividend reinvestment programs, gives shareholders the option of reinvesting the amount of a declared dividend into additional shares, which are bought directly from the company. Because shares purchased through a DRIP typically come from the company's own reserve, they are not marketable through stock exchanges. Shares must be redeemed directly through the company, also.
Eddie Bauer bought a tax-exempt Original Issue Discount (OID) bond in November of 1998. Which of the following statements is/are true? I. The bond basis increases at a set rate each year. II. The difference between maturity value and the original issue discount price is known as the OID. III. The bond's earnings are treated as exempt interest income. IV. The bond was issued at a discount to its par value. A. II and III only. B. I and IV only. C. I, II and IV only. D. I, II, III and IV.
Solution: The correct answer is D. All of the above statements are descriptions of the Original Issue Discount bond. Read this question carefully, a tax-exempt Original Issue Discount (OID) bond was purchased.
Whenever there is a cash dividend issued on an underlying stock, the price (or premium) for a call option available on that stock tend to be: A. Unaffected. B. Higher. C. Volatile. D. Lower.
Solution: The correct answer is D. Cash dividends will generally tend to drive the price of the underlying security lower and along with it, the call option prices.
The primary difference between open-end and closed-end investment companies would be: A. Closed-end funds always sell at par value. B. Open-end funds do not charge sales fees. C. Closed-end funds guarantee the Net Asset Value (NAV) at the time of sale or purchase. D. Closed-end funds sell only a limited number of shares.
Solution: The correct answer is D. Closed-end funds offer a limited number of shares, while open-end funds continually create new shares as new monies are obtained. Closed-end funds offer no price guarantees and do not always sell at net asset value.
Company A has 60% debt and 40% equity; Company B has 20% debt and 80% equity. Assume both companies have the same dollar amount of assets and net income before interest and taxes. Which one of the following statements is true? A. The unsystematic risk for the two companies is about equal. B. Company A's tax obligation will exceed Company B's. C. The company with the higher return on equity should be purchased by a risk-averse investor. D. The return on equity for Company A can be expected to exceed the return on equity for Company B.
Solution: The correct answer is D. Company A has a smaller amount of its assets financed by equity, therefore, with the same earnings in net income as Company B, the level of return on the equity of Company A would be greater. Sample information (net income is provided, not calculated in this sample information): A: Assets $10M; Liabilities $6M; Equity $4M; EBIDTA = $1M; I/Y = 5% Net Income = $700K; ROE = $700,000 ÷ $4M = 17.5% B: Assets $10M; Liabilities $2M; Equity $8M; EBIDTA = $1M; I/Y = 5% Net Income = $900K; ROE = $900,000 ÷ $8M = 11.25% EBIDTA = Earnings before interest, taxes, depreciation, and amortization
Using the following information, what is the duration of the bond being described? Maturity is 11 years. Par value is $1,000. The coupon rate is 8.25%. The bond is currently selling in the market at $1,094. The bond pays interest annually. A. 12.4 years. B. 11 years. C. 9.3 years. C. 7.8 years.
Solution: The correct answer is D. First the YTM must be calculated (7%). Once this is done, it can be plugged into the formula with the coupon rate and the number of periods, and reveals a Duration of 7.8 years. For duration, using annual amounts will not impact your answer significantly, so you can save yourself a few key strokes (not using semi-annual). Step 1: Calculate YTM N = 11 i = ? PV = <1094> PMT = 82.50 FV = 1000 i = 6.9967 i = 7% Step 2: D = (1+y)y−(1+y)+t(c−y)c[(1+y)t−1]+y D = (1.07).07−1.07+11(.0825−.07).0825[(1.07)11−1]+.07 D = 15.2857−1.2075.1612 D = 7.7950
Camping the US, Inc. is currently trading at $25 a share and will pay dividends of $1, $0, $2 respectively, at the end of this year and the following 2 years. They expect dividends to level out at a 3% growth rate after that. Your client is interested in purchasing some shares and would like to know the current value of the shares. Your client has a 7% required rate of return. What is the value per share of Camping the US, Inc. if you use the dividend growth model? A. $23.25 B. $25.75 C. $22.21 D. $44.61
Solution: The correct answer is D. For uneven dividend cash flow, you will need two steps. First use the dividend growth model for the 3% consistent growth.D1/r-g D1 is next year's dividend, which we don't have so we substitute with D0(1+g)2 (1+.03) / .07-.03 = 51.50Then do the cash flows to account for the uneven growthCFj 0 (the first entry in CF represents the starting amount. This valuation does not take into account the purchase)CFj 1 (the second entry represents the first cash flow)CFj 0CFj 2 + 51.50I = 7NPV = ?NPV = 44.6065 Since the stock is trading at $25 and is valued much higher at $44.61, based on the dividend growth valuation it would be considered undervalued and a buy recommendation (if the question had asked that). Instructor note: Dividend growth model does not take into account the cost of the stock to purchase. Dividend growth model is a valuation model, that calculates the fair value of stock, assuming that the dividends grow either at a stable rate in perpetuity or at a different rate during the period at hand. Once the valuation is determined, then the investor can make the decision to purchase or not. If you are struggling with Cash Flow, please visit the pre-study lecture on NPV.
Which of the following are characteristics of Government National Mortgage Association (GNMA) securities? I. Investors are guaranteed, by the U.S. government, against losses arising from investments in GNMA securities. II. The amount received by the investor each month may vary due to prepayment by homeowners. III. The realized yield on the certificates can be somewhat variable because of the principal prepayments. IV. If mortgage rates decrease, prepayments may increase. A. I and IV only. B. II and IV only. C. I, II, and III only. D. II, III, and IV only.
Solution: The correct answer is D. GNMA is "on budget" agency debt. This means the pools of mortgages are backed by the full faith, credit, and taxing power of the U.S. government itself. The government backs the issue against default, NOT against investor loss through poor timing or poor choices. It should also be noted no U.S. government agency debt has ever defaulted.
The Chesapeake Bay apartment complex contains 60 one-bedroom apartments renting for $650 per month. In addition, the complex generates $625 per month from laundry, parking, and vending machines. Vacancy and collection losses have averaged 8% of Potential Gross Income (PGI) and are expected to continue at about the same rate in the future. Annual expenses totaling $117,000 include: Property taxes = $2,000 Property management = $7,000 Interest expense = $72,000 Swimming pool = $5,000 Professional fees = $8,000 Other expenses = $23,000 There is a monthly mortgage payment of $10,000 per month. Out of the $10,000 mortgage, $6,000 is interest expense and $4,000 is repayment of principal. Assuming a capitalization rate of 9%, what is the market value of the Chesapeake Bay complex? A. $1,941,422 B. $2,884,140 C. $3,560,667 D. $4,360,667
Solution: The correct answer is D. Gross rental receipts ($650 × 60 × 12) = $468,000 plus non-rental income ($625 × 12) = $7,500 equals potential gross income (PGI) ($468,000 + $7,500) = $475,500. PGI minus vacancy and collection losses [$475,500 - (.08 × $475,500)] = $437,460 equals Effective Gross Income (EGI). EGI minus expenses equals net income $437,460 - $117,000 = $320,460. Next, determine net operating income by adding interest and depreciation expense back to net income. NOI = $320,460 + $72,000 interest + $0 depreciation = $392,460. Market value = $392,460 ÷ .09 = $4,360,667
Jack Rich has an investment portfolio equally divided among the following funds: Energy sector fund, Bond Unit Investment Trust (25-year average maturity), and a Money Market fund. He is a buy-and-hold investor. Which of the following risks is his portfolio exposed to? I. Business risk. II. Interest rate risk. III. Political risk IV. Purchasing power risk. A. I and III only. B. II and IV only. C. I, II and III only. D. III and IV only.
Solution: The correct answer is D. Interest rate risk does not affect a bond investor if he or she holds the securities to maturity. This is how unit investment trusts are structured. The energy sector will be directly impacted by regulatory influences of a political nature.
The theory of the Yield Curve that attempts to explain the yield curve based upon future rates of inflation is the: A. Liquidity Preference Theory. B. Market Segmentation Theory. C. Short-Wave Theory D. Expectations Theory.
Solution: The correct answer is D. Liquidity preference states that investors prefer liquidity, therefore, short-term money pays less. The market segmentation theory states that supply and demand explain at various maturities the shape of the yield curve.
Which of the following is not an appropriate match? A. Classification by time: Spot markets. B. Classification by type of claim: Equity markets. C. Classification by participants: Mortgage markets. D. Classification by products: Money markets.
Solution: The correct answer is D. Money market securities are short-term instruments categorized by time considerations, not product. Look at this from the product to determine the classification. For example, money markets and spot markets are classified as according timing because they are either short term maturities or current price. The common component when classifying these type of securities is timing. Equity and debt markets can be classified as to the order of claims in the event of liquidation. "Type of claims" simply refers to debt vs. equity and which is more senior. Bond markets, which include mortgage bonds, are divided into short, intermediate and long term markets. Each market has participants that prefer different segments of the yield curve. A participant in this case is an insurance company, bank, manufacturing company, etc. Different participants will prefer mortgage bonds over shorter term maturities.
Bob and Betty have approached you looking for the right hedge against possible, expected future inflation. You suggest to them that they: A. Invest in technology stocks. B. Invest in commodity futures. C. Invest in long-term U.S. Treasury issues. D. Invest in precious metals.
Solution: The correct answer is D. None of the choices are necessarily stellar, but in contrast to the other choices, Option "D" makes far more sense, as metals have generally performed well as inflation hedges over time.
Match the investment characteristic(s) listed below which describe(s) an open-end investment company. A. Only passive management of the portfolios. B. Shares of the fund are normally traded in major secondary markets. C. Both "A" and "B." D. Neither "A" nor "B."
Solution: The correct answer is D. Option "A" is incorrect because open-end funds are both passively and actively managed. Option "B" is incorrect because open-end fund shares are traded directly with the fund, not on the secondary market.
Bottom-up equity managers include: I. Group rotation managers. II. Value managers. III. Market timers. IV. Technicians. A. I only. B. II only. C. I and III only. D. II and IV only.
Solution: The correct answer is D. Options "I" and "III" are both "top down" style managers.
Mark is the 100% owner of Widget Manufacturing, Inc. (WMI). The WMI 401(k) plan covers 35 employees with 70% of the employees under age 40. Employee turnover is high. Mark wants to retire in 20 years at age 65. Mark has a medium tolerance for volatility within his investments. The market value of the 401(k) is $4,000,000 and Mark is the trustee and manages the investments. The portfolio consists of the following assets: - 10% short-term CDs with staggered maturity date. - 20% limited partnership interest in a private commercial real estate project which generates a high income yield. - 40% in a brokerage account invested in four stocks. - 30% in long-term government bonds with staggered maturity dates. You have been retained to evaluate the appropriateness of the portfolio. Which of the following statements best describes the portfolio? I. Short-term certificates of deposit have a fixed maturity date and therefore are not appropriate for liquidity purposes. II. The brokerage account investments are not adequately diversified. III. The investment in the limited partnership may be subject to unrelated business taxable income and therefore is inappropriate. IV. Overall, the asset classes selected by the plan are sufficiently diversified and therefore minimize overall portfolio volatility. A. I and II only. B. II and III only. C. I, II and III only. D. II, III and IV only.
Solution: The correct answer is D. Statement "I" - Short-term CDs are an appropriate choice for liquidity needs due to fixed value of the vehicle and short maturity periods. Statement "IV" - Even though the current investments within the asset classes are not properly positioned, the asset class allocation would, under Modern Portfolio Theory, reduce overall volatility to the plan.
XYZ company paid a dividend of $3.00 this year and anticipates the dividend to grow each year by: Year 1: 5% Year 2: 7% Year 3: 8% After the third year, they anticipate dividends growing at 6%. If Sydney's required rate of return is 10%, how much would she be willing to pay for this stock? A. $50.13 B. $60.57 C. $70.34 D. $80.86
Solution: The correct answer is D. Step #1: Determine the dividend to be paid each year. Year 1: 3.00 × (1.05) = 3.15 Year 2: 3.15 × (1.07) = 3.37 Year 3: 3.37 × (1.08) = 3.64 Step #2: Apply the constant growth dividend formula to value the stock as of year 3. V = 3.64 (1.06) ÷ (.10 - .06) V = 96.46 Step #3: Use uneven cash flows to determine the NPV of the stock at time period zero (today). CF0 = 0 CF1 = 3.15 CF2 = 3.37 CF3 = 3.64 + 96.46 = 100.10 I = 10 NPV = ? Answer: $80.86
Your client has asked you to assist her in examining possible additions to her bond portfolio. She has expressed a desire to minimize risk at this stage in her planning process, and to assure income beginning at the point of her retirement, and lasting throughout. She has a tentative retirement date in seven years at age 65. She will then have an eighteen year life expectancy. Which of the following is an appropriate addition to her current portfolio? I. 25-year AAA-rated corporate bonds with a seven-year maturity. II. 20 year AAA-rated municipal bonds with a seven-year duration. III. 25-year AAA-rated corporate zeroes with a seven-year duration. IV. 20-year US Treasury zeroes with a seven-year maturity. V, 25-year AAA-rated corporate bonds with a seven-year duration. A. I, III and V only. B. II, III and V only. C. III and IV only. D. V only.
Solution: The correct answer is D. The client is looking for income to begin in 7 years. Therefore anything maturing in 7 years will not provide that income. Zeroes provide no income. She wants something out 25 years, not 20 years. Thus, option "V" is the only appropriate answer.
The market where exchange and broker dealer services are eliminated entirely is: The primary market. The secondary market. The third market. The fourth market.
Solution: The correct answer is D. The fourth market is the market where corporation and institutional investors deal directly with one another. Primary market is where investment bankers and corporations meet to arrange offerings to the public. Secondary markets are where previously issued securities are sold (exchanges, etc.).
What is the geometric rate of return for a stock that has experienced the following prices over a four-year period? Year 1 = $20 Year 2 = $32 Year 3 = $24 Year 4 = $28 A. 17.23% B. 15.78% C. 13.82% D. 11.88%
Solution: The correct answer is D. There are many ways to solve this, but here is the quickest: N=3 i=? PV=<20> PMT=0 FV=28 Assume you paid $20 for the stock today and three years later, it is trading at $28. Answer is 11.8689 If you choose to use the formula for geometric mean, you will need to calculate the return for each year. Year 1 to year 2 = 60% return Year 2 to year 3 = -25% return Year 3 to year 4 = 17% return 3√(1+.6) x (1+ -.25) x (1+.1667) - 1 3√ 1.6 x .75 x 1.1667 - 1 3√1.400 - 1 1.1187 - 1 .1187 or 11.87%
Your client is considering the two stocks described below. Assume for this question that the risk-free rate is 6%, the expected return on the market is 14%, and the market's standard deviation is 18%. Stock A price per share = $18 Stock A annual dividend = $2 Stock A dividend growth rate = 3% Stock A Beta = 1.1 Stock A standard deviation = 21% Stock A realized return over past 12 months = 15% Stock B price per share = $12 Stock B annual dividend = $1.50 Stock B dividend growth rate = 4% Stock B beta = 0.88 Stock B standard deviation = 14% Stock B realized return over past 12 months = 12.5% Which stock would you recommend your client purchase, and why? Stock A, because its intrinsic value is greater than Stock B's. Stock A, because its required return is greater than Stock B's. Stock A, because its risk-adjusted return is greater than Stock B's. Stock B, because it is selling for less than its intrinsic value.
Solution: The correct answer is D. Though there is a great deal of information here, one should be looking at the intrinsic values of the stocks and comparing them to the market prices of the stocks for over valuation or under valuation. A market selling price above intrinsic value is overvalued. A market price below the intrinsic value means the stock is undervalued and may be considered for purchase. (remember order of operations: Parenthesis, exponents, multiplication, division, Addition, subtraction) The first step in this problem is to compute the required rate of return using the CAPM formula: R = Rf + B(Rm - Rf) Stock A =14.8% = 6 + 1.1 x (14 - 6) Stock B = 13.04% = 6 + .88 x (14 - 6) Now that we have the required rate of return on the securities based on their volatility, I would utilize the Gordon Growth Model (or dividend model) to determine the price that the security should be at to be "fairly valued." V = D * (1 + g) / (R - g) Stock A =17.45 = [2 x (1+.03)] / (0.148-.03) Stock B = 17.25 = [1.5 x (1+.04)] / (0.1304-.04) So the "fair value" for our investor is $17.45 for stock A and it is trading at $18. Therefore the stock is overvalued (trading higher than its value). Stock B is valued at $17.25 for our investor and is trading at $12. Therefore the stock is undervalued (trading lower than its value).
Your client's federal marginal tax rate is 24%, and the state marginal rate is 7%. The client does not itemize deductions on his federal return and is considering investing in a municipal bond which yields 5% issued in his state of residence. What is the taxable equivalent yield? A. 4.65% B. 5.38% C. 6.58% D. 7.25%
Solution: The correct answer is D. Use the tax equivalent yield formula of the taxable security return divided by one minus the client's tax rate to arrive at the correct answer to this problem. TEY= (Tax Exempt Security) ÷ (1 - the investor's marginal tax rate). This should include the state rate in the calculation of marginal rates as the municipal security is state tax-free in the state of issue if one is a resident of that state. Use the taxes you save in the formula. = .05 ÷ (1 - .24 - .07) = .07246
Jim and Anne Taylor are baby boomers who would like to add an equity investment to their portfolio. They require a 12% rate of return and are considering the purchase of one of the following two common stocks: Stock 1: Dividends currently are $1.50 annually and are expected to increase 8% annually; market price = $35Stock 2: Dividends currently are $2.25 annually and are expected to increase 7% annually; market price = $50 Using the dividend growth model, determine which stock would be more appropriate for the Taylors' to purchase at this time: A. Stock 2, because the stock is undervalued. B. Stock 2, because the return on investment is greater than the Taylor required rate of return. C. Stock 1, because its dividend growth rate is greater than Stock 2's growth rate. D. Stock 1, because the expected return on investment is greater than the Taylor required rate of return.
Use the intrinsic value formula to determine whether the stock is over valued or under valued. Then use the expected rate of return formula to determine whether the stock meets the investor's required rate of return. r = D0(1 + g) + g (P) Stock 1 = $1.50 (1.08) + .08 = 12.63% $35 Stock 2 = $2.25 (1.07) + .07 = 11.82% $50
