Ch. 15 Portfolio Management and Investment Risk
_______________ return allows an investor to measure the amount of money she has earned on her investments.
Dollar-weighted return allows an investor to measure the amount of money she has earned on her investments.
True or False: Securities with a correlation coefficient of zero are considered uncorrelated.
True
True or False: Systematic rebalancing involves buying and selling on a periodic basis.
True
If a security's beta is more than 1, is it considered more or less volatile than the market as a whole?
The higher the beta, the greater the volatility.
Describe inflation or purchasing power risk.
The risk that today's investment will not be worth as much when the money is received in the future.
True or False: Tactical asset allocation is changing a portfolio's asset mix due to impending market and economic factors.
True
How much principal, compounding at 3% annually, is needed to make annual payments of $3,000 in perpetuity?
$100,000 principal = $3,000 annual payment /.03 rate of return
What is the present value of a perpetual monthly payment of $1,000 earning 5% per year?
$240,000 = ($1,000 x 12 mo)/.05
What is the present value of an annuity that pays $2,000 per year and earns 5% per year?
$40,000 = $2,000/.05
What is the formula for determining an asset's total return?
(Ending Value - Beginning Value + Dividends/Interest) ÷ Beginning Value
What is the formula for determining holding period return?
(Ending Value - Beginning Value + Dividends/Interest) ÷ Beginning Value
What is the formula for the Sharpe Ratio?
(Return on Investment - Risk-Free Return) ÷ Standard Deviation
What method of investing is characterized by regularly investing a set amount of money, regardless of share prices?
Dollar Cost Averaging
What is the beta of the market (S&P 500)?
1
Identify the range from the following set of numbers: 10, 12, 5, 1, 7, 7, 8, 4
11. Range is calcuated by starting with the largest value (12) and then subtracting the smallest value (1).
A security has appreciated from $10 to $15 over three months and has paid no dividend. What is the annualized return?
200%, which is calculated by multiplying the holding period return (50%) by four quarters
Identify the range from the following set of numbers: 7, 3, 5, 4, 4, 6
4. Range is calcuated by starting with the largest value (7) and then subtracting the smallest value (3).
What is the likelihood of an investment's return falling within 1, 2, and 3 standard deviation units?
67% within 1 standard deviation, 95% within 2 standard deviations, and 99% within 3 standard deviations
A bond is yielding 8% and the rate of inflation is 3%. What is the bond's real interest rate?
8% - 3% = 5%. Real interest rate measures the true yield once inflation is factored out.
What type of trading strategy would be used if you believe markets are inefficient?
Active strategies, such as tactical asset allocation or sector rotation
What is the risk that certain circumstances or factors may have a negative impact on the profitability of a company?
Business risk
A 20-year U.S. Treasury zero-coupon bond is most susceptible to _________ risk.
A 20-year U.S. Treasury zero-coupon bond is most susceptible to inflation risk.
An investor needs an IRR of 5%. His investment has a NPV of $0. Is its IRR greater than, less than, or equal to 5%?
A NPV of $0 would indicate that an investment has an IRR that is equal to the required rate.
If a bond is trading at a discount to its value based on DCF, will an investor earn more or less than a comparable bond?
A bond trading at a discount to its DCF value will earn more than comparably priced bonds.
If a bond is trading at a premium to its value based on DCF, will an investor earn more or less than a comparable bond?
A bond trading at a premium to its DCF value will earn less than comparably priced bonds.
A bond's inflation-adjusted rate of return may also be referred to as the _______ interest rate.
A bond's inflation-adjusted rate of return may also be referred to as the real interest rate.
A capital needs analysis is done to determine a client's _________ needs in order to fund future financial goals.
A capital needs analysis is done to determine a client's insurance needs in order to fund future financial goals.
What is a dollar-weighted return?
A dollar-weighted return is a geometric mean (average) used to measure how a portfolio performed over time.
A fund whose portfolio is created to mirror the composition of a particular index is referred to as an ________ fund.
A fund whose portfolio is created to mirror the composition of a particular index is referred to as an Index fund.
What is an efficient market?
A market in which prices reflect all known information; therefore, nothing will be overvalued or undervalued.
What is the Capital Asset Pricing Model (CAPM)?
A model of the relationship between expected risk and expected return
An investor needs an IRR of 5%. His investment has a negative NPV. Is its IRR greater than, less than, or equal to 5%?
A negative NPV would indicate that an investment has an IRR that is less than the required rate.
A __________ is a stream of cash flows that continues forever.
A perpetuity is a stream of cash flows that continues forever.
A ____________ is an annuity that never stops paying money.
A perpetuity is an annuity that never stops paying money.
An investor needs an IRR of 5%. Her investment has a positive NPV. Is its IRR greater than, less than, or equal to 5%?
A positive NPV would indicate than an investment has an IRR that is greater than the required rate.
What measures risk-adjusted return?
Alpha and the Sharpe Ratio
What type of risk is avoided through indexing?
Business risk, since indexing involves purchasing stocks of many companies
A stock with a positive alpha is generally considered a _______ opportunity by an analyst.
A stock with a positive alpha is generally considered a buying opportunity by an analyst.
Define sector rotation.
A strategy that anticipates the next turn in the business cycle and shifts assets into the sectors that will benefit.
What is a time-weighted return?
A time-weighted return is a geometric mean (average) that eliminates the effect of varying cash inflows (dividends).
What is a Perpetuity?
An annuity that pays out forever.
If an investment has increased in value, when would its annualized return be greater than its holding period return?
An investment's annualized return would be greater than its holding period return if it was held for less than one year.
An investor buys stock that returns 2% for the year rather than a T-Bond yielding 6%. The ____________ cost is 4%.
An investor buys stock that returns 2% for the year rather than a T-Bond yielding 6%. The opportunity cost is 4%.
An investor who follows the __________ style of investing bets against market trends.
An investor who follows the contrarian style of investing bets against market trends.
An investor's net return is the gross return minus ________ paid.
An investor's net return is the gross return minus taxes paid.
What is the formula for determining a stock's current yield?
Annual dividend ÷ current market value of the stock
Another name for a security's risk-adjusted return is its ________.
Another name for a security's risk-adjusted return is its alpha.
What is a major disadvantage when using an arithmetic mean to measure investment performance?
Arithmetic means (averages) can misrepresent compounding effects on an investment's return.
___________________ is the balancing of investment classes according to an investor's investment objectives.
Asset allocation is the balancing of investment classes according to an investor's investment objectives.
Business, regulatory, political, and liquidity risk are all types of ____________ risk.
Business, regulatory, political, and liquidity risk are all types of unsystematic risk.
Which return measures investment performance by including all cash inflows and outflows?
Dollar-weighted return
______ is the measure of an asset's volatility compared to the market as a whole.
Beta is the measure of an asset's volatility compared to the market as a whole.
Bond A yields 7.5% when inflation is 3%. Bond B yields 8% when inflation is 4%. Which has a higher real interest rate?
Bond A. Bond A's real interest rate is 4.5% (7.5% - 3%) and Bond B's real interest rate is 4% (8% - 4%).
Identify the risk: A particular enterprise may not perform well due to poor management or increased competition.
Business risk
Buying gold or gold futures may protect an investor against _________ risk.
Buying gold or gold futures may protect an investor against inflation risk.
What is the risk of having an excessive portion of a portfolio invested in one particular security or asset class?
Concentration risk
Identify the acronym: CAPM
Capital Asset Pricing Model
If an investor is attempting to maximize her portfolio growth over a long period, what is her strategy called?
Capital appreciation
___________ is the term that BEST describes the process used to calculate an investment's future value.
Compounding is the term that BEST describes the process used to calculate an investment's future value.
______________ measures the degree to which the movements of two variables are related.
Correlation measures the degree to which the movements of two variables are related.
Is business risk considered a form of diversifiable or non-diversifiable risk?
Diversifiable risk
Which asset class is most susceptible to interest-rate risk?
Debt (i.e., bonds)
What types of securities tend to have a low beta?
Defensive stocks
What theory states that all known relevant information is reflected in a security's price?
Efficient Market Theory (also called the Random Walk Theory)
Do investors who favor passive strategies believe markets are efficient or inefficient?
Efficient. Rather than trying to time the market, they may rebalance their portfolios periodically (e.g., quarterly).
What are the three main concepts underlying the Modern Portfolio Theory?
Expected return, standard deviation, and correlation
True or False: Systematic rebalancing assumes markets are inefficient.
False
True or False: The Efficient Market Theory indicates that, through analysis, undervalued situations can be discovered.
False
True or False: A buy-and-hold strategy is considered an active/tactical investment strategy.
False. A buy-and-hold strategy is considered a passive/strategic investment strategy.
True or False: There are no suitability requirements for institutional investors.
False. Although they differ from retail requirements, suitability requirements do apply to institutional investors.
True or False: A low beta security would be expected to rise more than a high beta security in a bull market.
False. An asset with a low beta would be less volatile and would, therefore, be expected rise less in a rising market.
True or False: A bottom up approach to investing uses the economy as a main factor in determining which stocks to buy.
False. Bottom up investing uses company specific items (e.g., earnings and dividend payments) to pick stocks.
True or False: With a buy and hold strategy, investors are consistently rebalancing their portfolios.
False. Buy and hold involves no rebalancing.
True or False: In a weak-form efficient market, technical analysis will be useful.
False. In a weak-form efficient market, only fundamental analysis will be useful.
True or False: Investors who are planning to hold bonds until maturity have no risk.
False. Opportunity risk (the risk of missing out on a superior investment) is a risk these types of investors face.
True or False: The S&P 500 is an asset class.
False. Stocks, bonds, real estate, and cash are asset classes.
True or False: Strategic asset allocation is considered an active asset allocation approach.
False. Strategic asset allocation is considered a passive approach.
True or False: Strong-form market efficiency advocates believe they can beat the market.
False. Strong-form market efficiency states that no person can beat the market.
True or False: Systematic risk may be avoided through diversification.
False. Systematic (non-diversifiable) risk may not be avoided through diversification.
True or False: Tactical asset allocation is considered a passive asset allocation approach.
False. Tactical asset allocation is considered an active approach.
True or False: The longer an investor's time horizon, the more concerned he is with market fluctuations.
False. The longer the time horizon, the less concerned he is with market fluctuations.
__________ value determines how much a dollar amount invested today will be worth at a set point in the future.
Future value determines how much a dollar amount invested today will be worth at a set point in the future.
_________ value projects what an investment will be worth at some point in the future.
Future value projects what an investment will be worth at some point in the future.
What types of securities tend to have a high beta?
Growth stocks
Do long-term bonds have higher or lower interest-rate risk?
Higher
Highly regulated companies, such as utilities, are subject to __________ risk.
Highly regulated companies, such as utilities, are subject to regulatory risk.
Which is a better hedge against inflation, investing in stocks or bonds?
Historically, stocks have outperformed inflation. Since bonds are fixed income instruments, they are hurt by inflation.
If a client eliminates unsystematic or diversifiable risk in his portfolio, he is willing to accept ______ risk.
If a client eliminates unsystematic or diversifiable risk in his portfolio, he is willing to accept market risk.
If an adviser attempts to exceed the performance of the market, it is using ______ portfolio management.
If an adviser attempts to exceed the performance of the market, it is using active portfolio management.
If there is no relationship between the movement of two investments, they are considered to be _______________.
If there is no relationship between the movement of two investments, they are considered to be uncorrelated.
If two investments closely track one another, this is referred to as ___________ correlation.
If two investments closely track one another, this is referred to as positive correlation.
If two investments go in opposite directions from one another, this is referred to as ___________ correlation.
If two investments go in opposite directions from one another, this is referred to as negative correlation.
12 years ago, Tina invested $25,000 which has now grown to $100,000. What is the annual growth rate of her investment?
In 12 years, the money doubled twice (every six years). Using the Rule of 72, 72 divided six years = 12%.
Do those who favor market timing (active strategies) believe markets are efficient or inefficient?
Inefficient. They may alter their portfolio to take advantage of anticipated economic events.
Gold coins, gold certificates, or gold futures may be purchased in an effort to avoid what type of risk?
Inflation risk
List the risks associated with investing in 30-year U.S. Treasury bonds.
Inflation risk and interest-rate risk
Define real interest rate (real rate of return).
Interest rate minus the inflation rate (e.g., Bond yielding 8% when inflation is 3% has a real interest rate of 5%).
Identify the risk of existing bond prices declining while interest rates are rising.
Interest rate risk
Two investments have the same price, but the net present value (NPV) of choice A is $50 while B's is $40. Which is best?
Investment A is better. NPV measures net cash flows above a discount rate. A greater NPV indicates more value.
Is a person who invests in a variable annuity more susceptible to legislative risk or investment risk?
Investment risk, since the separate account of a variable annuity fluctuates with the overall performance of the market
What are two assumptions of MPT?
Investors want to minimize risk and maximize returns
What type of risk is liquidity risk?
It is non-systematic risk, since liquidity risk may be diversified against by buying actively traded assets.
If an asset outperforms the market when prices are up, but underperforms when prices are down, what is its beta?
Its beta must be greater than 1.00.
Is indexing considered an active or passive portfolio management strategy?
Passive, since the composition of the benchmark index generally remains the same.
What is the risk that Congress may enact tax law changes that negatively impact the value of an investment?
Legislative risk
What is the risk that changes in tax law could impact securities prices?
Legislative risk
What risk is based on the possibility that new laws may have a negative impact on an investment's value?
Legislative risk
A client notices that a thinly traded stock has had few daily trades effected. To what risk is it most susceptible?
Liquidity risk
What is the risk that investors may be unable to dispose of a securities position quickly and at a fair price?
Liquidity risk
____________ risk is the inability to sell an investment easily.
Liquidity risk is the inability to sell an investment easily.
MPT has found that having asset classes with a slight ___________ correlation provides the best long-term performance.
MPT has found that having asset classes with a slight negative correlation provides the best long-term performance.
Which type of risk is non-diversifiable?
Market risk
Market, interest rate, and inflation risk are all types of ___________ risk.
Market, interest rate, and inflation risk are all types of systematic risk.
Identify the acronym: MPT
Modern Portfolio Theory
Modern Portfolio Theory (MPT) focuses on differing __________ of assets rather than on _____________ securities.
Modern Portfolio Theory (MPT) focuses on differing classes of assets rather than on individual securities.
What is another name for non-diversifiable risk?
Systematic risk
If a client's goal is preservation of principal, what fund would be most appropriate?
Money-market fund
What uses computer simulations to present random outcomes of an investment strategy?
Monte Carlo Simulation
What type of risk does beta measure?
Non-diversifiable
Is market risk considered a form of diversifiable or non-diversifiable risk?
Non-diversifiable risk
What is another name for diversifiable risk?
Non-systematic risk
Describe a growth investor.
One seeking stocks of companies with an above-average growth rate, high P/E ratios, and low dividend payout ratios
What is considered an optimal portfolio?
One that has the highest expected return given the client's tolerance for risk
Identify the risk: Investors miss out on receiving a better return by placing their funds elsewhere.
Opportunity risk
What type of trading strategy would be used if you believe markets are efficient?
Passive strategies, such as indexing or systematic rebalancing
What is the risk of foreign investors losing money due to changes with a country's government or regulatory environment?
Political risk
List some forms of business risk that apply when investing in individual equity securities.
Poor management, obsolete products, changing market conditions
__________ value is the amount of money that must be invested today to result in a certain sum at a future time.
Present value is the amount of money that must be invested today to result in a certain sum at a future time.
__________ value is the dollar amount to be invested today to meet a specific dollar objective at a set future point.
Present value is the dollar amount to be invested today to meet a specific dollar objective at a set future point.
Define range.
Range is the difference between the largest value and smallest value of a given set of numbers.
What is the risk that environmental regulations could impact the prices of securities?
Regulatory risk
What risk is based on the possibility that new regulations may have a negative impact on an investment's value?
Regulatory risk
What is required to make the dollar weighted return and the time weighted return equal?
Remove or subtract any deposits into and/or withdrawals out of the portfolio
What is the formula for calculating the risk premium?
Risk premium = total return - risk-free rate
What strategy involves moving a client's funds from one industry to another during defined periods?
Sector rotation
Which form of market efficiency declares that only insiders can regularly beat the market?
Semi-strong
Assuming a 12% rate of return, how long will it take $50,000 to double?
Six years. Using the Rule of 72, 72 divided by the rate of return determines the number of years (72 ÷ 12 = 6 years).
What is used as the basic measure of risk for an investment?
Standard deviation
Standard deviation is a measure of the dispersion of ____________ returns.
Standard deviation is a measure of the dispersion of expected returns.
Name four asset classes.
Stocks, Bonds, Real Estate, Cash
What form of asset allocation attempts to keep the asset percentages balanced over a long period?
Strategic asset allocation
Strategic asset allocation assumes that the markets are ____________.
Strategic asset allocation assumes that the markets are efficient.
Name the three forms of market efficiency.
Strong-, Semi-Strong and Weak-Form
Sue bought a 6% bond at par. One year later, her bond's value has fallen to $970. What is her annual return?
Sue received the 6% rate of interest, but her bond lost 3% of its value. (-$30 + 60) ÷ $1,000 = 3%.
For a person with a diversified portfolio of large-cap stocks, what type of risk may be reduced by using index options?
Systematic risk
Tactical asset allocation assumes that markets are ______________.
Tactical asset allocation assumes that markets are inefficient.
What rule can be used to determine how long it takes for an amount of money to double at a given rate of return?
The Rule of 72
What rule can be used to determine the annual rate of return needed for funds to double if given a number of years?
The Rule of 72
What is the Sharpe Ratio used to determine?
The Sharpe Ratio is used to determine if returns are from wise investments or the result of excess risk.
What is an advantage to buy and hold portfolio management?
Transaction costs and tax consequences are minimized.
True or False: A country with high interest rates will generally have a stronger currency.
True
True or False: According to CAPM, a security's return equals a risk-free return (T-Bill return) plus a risk premium.
True
True or False: Alpha represents an investment's actual return in excess of its expected return.
True
True or False: Diversification is one method by which an investor may avoid non-systematic risk.
True
Mack, in the 35% tax bracket, is earning 5.4% on a tax-free municipal bond. What is his taxable equivalent yield?
The formula is: Tax-Free Yield ÷ (100% - Tax Bracket %). 5.4% ÷ 65% = 8.3%
What is the net yield for an investor in the 28% tax bracket who owns an 8.5% corporate bond?
The formula is: Taxable Yield x (100% - Tax Bracket %). 8.5 x 72% = 6.12%.
The greater the dispersion of historical returns of a security, the _________ its standard deviation.
The greater the dispersion of historical returns of a security, the higher its standard deviation.
The difference between an investment's total return and the risk-free rate is the risk _______.
The difference between an investment's total return and the risk-free rate is the risk premium.
Define net present value (NPV).
The difference between the value of an investment's cash inflows and outflows above a discount rate
What is the fair value of a bond?
The discounted present value of the sum of the future payments
What is the name for the graph of optimal portfolios?
The efficient frontier
The ________ rate of return is used to calculate the anticipated return for a portfolio of securities.
The expected rate of return is used to calculate the anticipated return for a portfolio of securities.
Describe a typical index fund's expenses and management style.
The expenses are generally low and it is passively managed.
The formula for net (after-tax) yield is: __________ x (________- ________)
The formula for net (after-tax) yield is: Taxable Yield x (100% - Tax Bracket %)
The formula for taxable equivalent yield is: __________ ÷ (________ - ________)
The formula for taxable equivalent yield is: Tax-Free Yield ÷ (100% - Tax Bracket %)
What is commonly used to measure an asset's risk-free rate of return?
The interest rate on a U.S. T-bill
The interest rate on a U.S. T-bill is commonly used to measure an asset's _________ rate of return.
The interest rate on a U.S. T-bill is commonly used to measure an asset's risk-free rate of return.
What is used to determine how a given present value will become a needed future value.
The internal rate of return (IRR)
What return will an investment have if its net present value is less than zero?
The investment will generate a negative return.
What return will an investment have if its net present value is greater than zero?
The investment will generate a positive return.
What is the efficient frontier?
The line representing portfolios (excluding risk-free alternatives) showing the lowest risk for a given level of return
$10,000 has become $80,000 in 36 years. What is the internal rate of return?
The money doubled every 12 years. The 10 grew to 20, the 20 to 40, and the 40 to 80. Using the Rule of 72, 72 ÷ 12 = 6%.
Define expected return.
The possible return of an asset multiplied by the likelihood of occurrence
Define capital risk.
The risk that an investor may lose a part or her entire investment (principal). Capital risk is a form of diversifiable risk.
Define reinvestment risk.
The risk that an investor will not be able to reinvest her principal at the same interest rate.
Define currency risk.
The risk that foreign investments will be worth less in the future due to changes in exchange rates.
True or False: Perfect negative correlation is -1.00, while a perfect positive correlation is 1.00.
True
Over the last three months, a stock rose from $50 to $51 and paid a $.25 dividend. What is its annualized return?
The three-month return is 2.5% ($1.25 ÷ $50). A quarterly return is annualized by multiplying by four (2.5% x 4 = 10%).
"A dollar received today is worth more than a dollar received tomorrow" describes what concept?
The time value of money
Define holding period return.
The total return received from holding an asset or portfolio of assets
What happens to the U.S. trade deficit if the dollar is weakening?
The trade deficit will shrink as U.S. goods become cheaper for foreign consumers.
What type of mean is used to calculate the expected return?
The weighted arithmetic mean
_____________ return allows an investor to compare the performance of two investment advisers.
Time-weighted return allows an investor to compare the performance of two investment advisers.
To determine a bond's real interest rate, the bond's yield is subtracted by the rate of ___________.
To determine a bond's real interest rate, the bond's yield is subtracted by the rate of inflation.
To find a stock's current yield, the formula is: ____________ ÷ ____________
To find a stock's current yield, the formula is: Annual Dividend ÷ Current Market Price
What is the use of the Capital Asset Pricing Model (CAPM)?
To find an investor's optimal portfolio by comparing expected risk with expected rates of return
True or False: Dollar weighted return (DWR) takes into account the deposits into or withdrawals out of the portfolio.
True. DWR includes the weighted value of cash flows into and out of the portfolio when calculating return.
True or False: When the market suffers a large, general decline, most stocks are affected.
True. Stocks are subject to the risks of the market as a whole.
In a declining market, is a high beta security expected to outperform or underperform the market as a whole?
Underperform
In a rising market, is a low beta security expected to outperform or underperform the market as a whole?
Underperform
Jim invested $25,000 in an annuity with a 6% return. How long will it take for the money to double?
Using the Rule of 72, divide 72 by the rate of return (72 ÷ 6 = 12 years).
An investment earns 10%, 50%, and 30% in three years. How would the annualized average rate of return be calculated?
When calculating an annualized rate of return over time, the geometric mean is used.