FIN 303-Concepts in Finance Unit 1

Risk

-Country risk, or political risk, is the variability in a security's returns resulting from the instability of a country's economy or government. -Market risk is the variability in a security's returns resulting from fluctuations in the overall market. -Business risk is the risk associated with the industry or environment in which a business operates.

The authority function of the self-regulatory organization FINRA includes

-Educating investors. -Examining firms for compliance with FINRA rules. -Writing and enforcing rules governing activities of all registered broker-dealers and broker-dealer firms within the U.S

Which of the following is an assumption of behavioral finance?

-Financial markets are not efficient. -Investors are emotional. -Investors make information processing errors. -Investors are easily influenced by their peers.

Characteristic of investing

-Sacrifice of money -Pursuit of a return -Sacrifice of time Investing requires sacrifice of both time and money. Generally an investors intends to earn a return commensurate with the risk level of their portfolio. There is a risk/return trade off and the more risk that is taken, the higher the potential return possibilities. Investors seek to minimize risk.

Which of the following is (are) correct regarding average returns?

-The arithmetic mean is the average return for a series of returns and will always be greater than or equal to the geometric mean. -The geometric mean is equivalent to IRR.

Securities and Exchange Commission's mission

-To maintain fair, orderly, and efficient markets. -To protect investors. -To facilitate capital formation.

Habits of successful investors

-Understand volatility of stock returns. -Contribute at least as much to a 401(k) as the employer will match. -Save early and be consistent. -Diversify your investments. -Understand that value is based on cash flow Successful investors generally have a long-term focus. They do not try to time the market. While it is good to buy low and sell high, how do you know when the market or a company stock is at a low or a high. It's smarter to start early and be consistent with your investing. Successful investors leave their emotions out of investing. They try to take an objective look at their investments and develop a long-term strategy that will be successful over time.

Which of the following choices are accurate descriptions of the differences between Modern Portfolio Theory (MPT) and Behavioral Finance (BF)? Check all that apply.

-With MPT securities are valued rationally and with BF securities are valued heuristically. -With MPT investors seek to maximize utility while with BF investors seek to minimize regret. -With MPT investors possess perfect information and with BF investors possess imperfect information. -With MPT new information is priced accordingly, and with BF new information is not immediately priced into the security. Modern Portfolio Theory states that investors are rational. They posses perfect information, act in their own self-interests, seek to maximize utility, price information accordingly, and are risk averse. Behavioral Finance believes investors will behave heuristically instead of rationally, act in their own self-interests with bias and errors, seek to minimize regret, not price in new information immediately, and are loss-averse instead of risk-averse.

You want to buy a new sports car 3 years from now, and you plan to save $4,200 per year, beginning one year from today (end of period payments = ordinary annuity). You will deposit your savings in an account that pays 5.2% interest. How much will you have just after you make the 3rd deposit, 3 years from now? Solve for FV with your $4,200 annual savings as the PMT.

$13,267 You started with nothing ($0 PV) and made three (N) payments of $4,200 (PMT), which was invested at 5.2% (I/YR), and calculated what that would be worth (FV).

You plan to buy a Certificate of Deposit in the amount of $1,500. What is the Future Value after 5 years if you are earning an annual interest rate of 6%, but interest is compounded semiannually?

$2,016

Sue now has $125. How much would she have after 8 years if she leaves it invested at 8.5% with annual compounding? Use TVM functions on your calculator or Excel to solve for Future Value (FV).

$240.08 The PMT function is used only for annuities. If a problem does not include a series of equal payments then the PMT function is not used and is entered as $0.00

Suppose you inherited $275,000 and invested it at 8.25% per year. How much could you withdraw at the end of each of the next 20 years? In other words, if you want to use this money to create an annuity payment that you receive at the end of each of the next 20 years until the money is gone, how much an this payment to yourself be? Solve for PMT.

$28,532

What is the present value of the following uneven cash flow stream discounted at a rate of 6.25%? Year 1 $75 Year 2 $225 Year 3 $0 Year 4 $300

$505.30

How much would $20,000 that is expected to be received in 50 years be worth today if the discount rate were 7.5%? Solve for PV.

$537.78

What should be considered when building a portfolio?

-A need for liquid assets (cash). -The length of time available for your assets to earn returns. -Ability and willingness to take risk. Time horizon, liquidity needs, and the ability and willingness to take risks are portfolio considerations along with return objectives and tax implications.Credit card debt is not a portfolio consideration but should be considered in the overall financial plan and may affect the ability to make greater portfolio contributions. Market timing is not a portfolio consideration and should not be considered as an investing strategy either. It is difficult to time the market, and this approach does not work out well for the average investor.

Portfolio D has a standard deviation of 17% and a correlation with the market of 1.00. If the standard deviation of the market is 15%, what is the beta for D?

1.13

Horace bought 10,000 shares of LaLa at $40 per share. Two years later he sold the stock for $80 per share. LaLa declared and paid a dividend of $4 per share during the period Horace held the stock. What was Horace's holding period return?

110%. HPR = [(sale price - purchase price) +/- cash flows] / purchase price; [(80-40) + 4] / 40 = 110%

Your bank quotes you a nominal (annual) rate of 12% for a personal loan. If the bank compounds interest quarterly, what is your effective annual return (EAR)?

12.55%. Effective Annual Return = (1 + .12/4)^4 -1 = 12.55%

The expected market return is 12% and the risk-free rate of return is 3%. Using the CAPM (SML), what is the expected (required) return for a portfolio that has a standard deviation of 18% and a beta of 1.3?

14.7% CAPM = Rf + B(Rm - Rf) CAPM = 3% + 1.3(12% - 3%) = 14.7%

Colin, a citizen of the USA, invested $1.5 million in Fish N Chips, a UK company, trading at a market value of £35 per share. The conversion rate for pounds to dollars was £1 to $1.70 at the time of the investment. Assume that after two years, he sells the stock for £40 per share when the conversion rate for pounds to dollars is £1 to $1.8. How much is his gain?

21.00%

Janice has $5,000 invested in a bank that pays 3.8% annually. How long will it take for her funds to triple? Solve for number of periods in years (N).

29.46

You want to invest in Apple, Inc. stock and would like to consider the risk of the company. You found that Apple's annual returns for the last five years were -6%, 55%, 38.71%, -8.3%, and 121.73%. Calculate the standard deviation using this sample of Apple's returns. (Hint: you first need to find the average return)

53.28% Average return = (-6% + 55% + 38.71% + -8.3% + 121.73%) = 40.23% Standard deviation = SQRT[((-6%-40.23%)2 + (55%-40.23%)2 + (38.71%-40.23%)2 + (-8.3%-40.23%)2 + (121.73%-40.23%)2)/4] = 53.28% High total risk based on a sample from the last five years!

Lisa invested $3,000 in CJD stock, $4,000 in JCD stock, and $5,000 in JFD stock. CJD, JCD, and JFD have expected returns of 6%, 7% and 10%, respectively. What is the weighted average expected return for Lisa's portfolio?

8% Total portfolio = 3000+4000+5000 = $12,000 Weights: CJD = 3000/12000 = 25%, JCD = 4000/12000 = 33.33%, and JFD = 5000/12000 = 41.67% Weighted average return = .25*6% + .3333*7% + .4167*10% = 1.5% + 2.33% + 4.17% = 8%

Jordan has a portfolio of mutual funds, A, B, and C. She has 50% in A, 40% in B, and 10% in C. What is theexpected return for the portfolio if the relative expected returns for A, B, and C are 10%, 8%, and 14%?

9.60%.

Aaron invested in the Not-so-Good mutual fund five years ago. His returns were -5%, -8%, -5%, -6% and-8%, respectively. What is the percentage difference between the arithmetic average and the geometric average return over the five years? (Hint: first calculate each type of average)

<0.01%. Arithmetic average = (-5% + -8% + -5% + -6% + -8%)/5 -6.400%. Geometric average = [(1+ -5%) x (1+ -8%) x (1 + -5%) x (1 + -6%) x (1 + -8%)] ^ 1/ 5 - 1= -6.4099%. The difference equals -6.400% - -6.4099% or 0.0099%.

Firms are least likely to use the primary equity market to raise capital for:

A desire to increase its financial leverage.

Regulation BI

A general obligation to act in the customer's best interest and avoid placing representative's interest above the customer's interest. Also requires the disclosure, care, and conflict of interest obligations.

Dodd Frank Act 0f 2010

A response to the Great Recession that establishes new government agencies to reduce volatility in financial markets.

Short-term goals should be funded with what type of investments to minimize the possibility of adverse price movements when cash is needed to fund investor goals?

All of the available investment choices should be included when developing a portfolio for short-term goals. All of the available investment choices should be included when developing a portfolio for short-term goals. Short-term investments include U.S Treasury Bills. Short-term investments tend to be lower risk investments.

Examples of anchoring most likely include:

An investor holding an underperforming equity security until its price rises by 25%. Holding on to losers is the classic example of anchoring as the investor waits until the stock rises so hewill not be labeled a loser stock picker.

Cognitive Dissonance

An investor holds on to the stock of a high-dividend paying firm even though the firm has significantly reduced cash flows, ignoring the ability of the firm to make future dividend payments.

Emma Jones shows signs of being averse to losses. Jones will most likely:

Avoid selling stocks that would generate capital loss.

Guinness is considering two portfolios: 1) Portfolio A with a return of 14% and a standard deviation of 14% and 2) Portfolio B with a return of 4% and a standard deviation of 7%. Assuming the correlation between A and B is 0.5 and he invests 70% in A and 30% in B, what range of returns should this portfolio produce 95% of the time? (Hint: first calculate the standard deviation of the combination of Portfolio A and Portfolio B using the two-asset standard deviation formula. Then calculate the weighted (expected) portfolio return. Use these to find the confidence interval of 95%; from chapter 3 standard deviation explanation).

Between -11% and 33%. Standard deviation: ST DEV = SQRT((.7)2(14%)2 + (.3)2(7%)2 +2(.7)(.3)(.5)(14%)(7%)) = 11% Expected return = 0.7(14%) + 0.3(4%) = 11% As noted in Chapter 3, the 95% confidence interval equals 2 standard deviations from the expected return. Therefore, the range -11 to 33% is the correct answer. Calculations: expected return - 2(standard deviation) and expected return + 2(standard deviation) = 11% - 2(11%) and 11% + 2(11%) = -11% and 33%.

Strategic Asset Allocation

Develop an appropriate diversification strategy across a broad set of asset classes. This is generally a long-term strategy where the goal is to minimize the probability of significant losses in one investment category. This generally includes a strict buy and hold strategy and passive re-balancing of a portfolio at preset intervals.

There is a strong correlation between earning potential and _____________________.

Education The average earnings of a college graduate are 65% higher than the earnings for a high school graduate.

Investment Company Act of 1940

Established and regulates mutual funds and hedge funds.

Securities Exchange Act of 1934

Established the SEC and governs the secondary trading market

Sarbanes Oxley Act of 2002

Expanded financial regulations in response to major accounting scandals.

What is the type of investing goal? A 40-year old investor that is comfortable with risk and market volatility with a focus on wealth accumulation.

Growth

What is the type of investing goal? A college graduate that is starting a new job and contributing 10% to their 401(k).

Growth

Dylan Hope uses commodity futures contracts as part of his search for low correlations and diversification for his equity portfolio. Which of the following decisions would most likely be described as behavioral in nature?

Hope avoids tobacco stocks because his grandmother died of lung cancer. Emotions can play a large role in security selection. Hope appears to be influenced by the death of his grandmother by avoiding tobacco stocks, which is classic behavioral decision making. Had Hope evaluated tobacco stocks using fundamental analysis and then rejected investing in them, this would not be a behavioral issue. Preferring growth stocks and using futures contracts based on fundamentals is not an indication of behavioral investing.

What is the type of investing goal? A retired couple that does not have enough social security and depends on their retirement funds to supplement their retirement budget.

Income Generation

Anyone who is engaged in the business of providing advice to others or issuing reports or analyses regarding securities for compensation is considered an _____________ ________________.

Investment Adviser

Representativeness

Investor's bid up the price of a firm's stock without doing any fundamental analysis and simply based on a name change.

Blue-chip stocks

Issued by reliable companies that have the potential to perform well in any market.

Assume Marleen adds Apple, Inc. stock to her portfolio, and Apple, Inc. stock is less than perfectly positively correlated with the portfolio (correlation coefficient < 1). Apple, Inc. has the same standard deviation as the portfolio. What will happen to the standard deviation of the portfolio after she adds Apple, Inc.? (Hint: consider the two-asset standard deviation formula and consider the portfolio as one asset and Apple, Inc. as the second asset).

It will decrease. The portfolio standard deviation should decrease as Apple, Inc. is not perfectly correlated with the portfolio. For example: Portfolio standard deviation = 20%, Apple, Inc. standard deviation = 20%. Correlation between the portfolio and Apple = 0.95. With a weight of 95% for the portfolio and 5% for Apple, the combined standard deviation equals 19.95%. St Dev = SQRT((.95)2(20%)2 + (.05)2(20%)2 + 2(.95)(.05)(.95)(20%)(*20%)) = 19.95% The last three variables in the formula are the Covariance = correlation coefficient*std dev of portfolio * std dev of Apple. Because the correlation coefficient is <1 the standard deviation of the portfolio and Apple combined is lower than the 20% standard deviation they each have separately.

Income stocks

Large dividend payments relative to other firms.

Value stock

Low prices given earnings and asset values leading to low price-to-earnings ratios.

Difference between a Mortgage-backed Security (MBS) and a Collateralized Mortgage Obligation (CMO)

MBS' are loans, similar to a bond, that are made up of a pool of mortgages that are then sold to the investors in a secondary market where the investors receive monthly payments from it. While, CMO's is a type of MBS', they are each individual private Firm's pass-through securities, which can be considered their own risks and maturity dates. The main difference between MBS' and CMO's is their tranches. Tranches are the revenue produced by those bundles of mortgages broken up into period of paying back the lender, in this case the investors.

Mental Accounting

Making decisions based on mental categories. Each category likely has its own investment strategy and ignores the effect on the overall portfolio.

Anchoring

Making investment decisions based on immaterial information like a round number.

Warren Buffet famously said, "You only find out who is swimming naked when the tide goes out." The quote, in part, means that when the equity market is increasing, it hides many weaknesses of businesses. What type of risk is this quote referring to?

Market risk. The increase or decrease in the market has an impact on most companies. This risk is referred to as market risk.

Covariance

Measures how much two assets move together.

R-squared

Measures how well diversified your portfolio is.

Beta

Measures only systematic risk; a stock's volatility relative to the market.

Coefficient of Variation

Measures risk per unit of return.

Standard deviation

Measures total return variability; includes systematic and unsystematic influences on asset returns.

A mortgage-backed security can be characterized as having:

Prepayment risk.

What is the type of investing goal? A couple nearing retirement that will need to start accessing their retirement funds soon.

Preservation of Capital

Cyclical stocks

Prosper in expanding economies and do poorly during downturns.

Correlation

Provides insight to the strength and direction two assets' returns move relative to each other.

One part of the concept of Prospect Theory states that people place undue emphasis on low probability events that have large potential losses. Which of the following is the best example of this behavior mistake?

Purchasing insurance with excessive coverage at high premium cost. Paying a high premium for excessive coverage shows the individual is overly focused on low probability worst case scenarios. Basing selections on risk and return is an example of modern portfolio theory. Holding on to an investment that has dropped 20% due to poor earnings is an example of anchoring. Making decisions based on rules of thumb (heuristics) is an example of bounded rationality.

Securities Act of 1933

Regulates offering and sale of securities (stocks and bonds).

Defensive stocks

Relatively unaffected by fluctuations in the economy

Form CRS

Requires advisers to deliver a two- to four-page relationship summary to retail investors at the beginning of their relationship, including services, fees and costs, and compensation among other things.

Investment Advisers Act of 1940

Requires registration with the SEC of firms or advisers managing over $110 million in assets.

Suitability Standard

Requires that an chosen investment is appropriate given an investor's risk tolerance and time horizon without regard to the overall impact to a client's investment portfolio and other investments. Allows an adviser to recommend products that provide greater compensation to the adviser when products paying less compensation would be more beneficial to the client.

Fiduciary Duty of Care

Requires the adviser to put the client's interest ahead of their own and to always act in the best interest of the client, and to consider the overall impact to a client's investment portfolio before recommending an investment. This generally applies on an ongoing basis.

Explain the concept of risk tolerance. Include in your discussion how risk tolerance affects asset allocation.

Risk tolerance is investors' willingness and ability to expose themselves to risk in order to seek higher investment returns. To obtain higher expected returns on a portfolio, investors must be willing to accept additional risk. Their ability to accept risk depends on their stage in their life cycle. They are less able to accept risk the closer they get to retirement. It is important to use risk tolerance questionnaires with investors to determine their appropriate risk level and asset allocation. The asset allocation will consider the client's age, stage of life cycle, and time horizon.

Which of the following statements is CORRECT? a. The cash flows for an annuity may vary from period to period, but they must occur at regular intervals, such as once a year or once a month b. If some cash flows occur at the beginning of the periods while others occur at the ends, then we have what the textbook defines as a variable annuity c. The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods d. The cash flows for an annuity due must all occur at the beginning of the periods e. If a series of unequal cash flows occurs at regular intervals, such as once a year, then the series is by definition an annuity

The cash flows for an annuity due must all occur at the beginning of the periods Cash flows for an annuity due occur at the beginning of the period, while cash flows for an ordinary annuity occur at the end of the period. All cash flows for an annuity must be equal and must occur at regular intervals.

Your bank account pays a 6% nominal rate of interest. The interest is compounded quarterly. Which of the following statements is CORRECT?

The periodic rate of interest is 1.5% and the effective rate of interest is greater than 6%. If a nominal (annual) rate is 6% then the periodic rate for quarterly compounding is 6%/4 = 1.5%. Divide by 4 because there are four quarters in a year. The effective annual rate will always be higher than the nominal rate if compounding is more frequent than annually. Therefore, a 6% nominal rate compounded quarterly will have an effective rate higher than 6%.

Tactical Asset Allocation

This strategy seeks to outperform the market in the short-term by picking asset classes that are expected to outperform market returns during the period. An investor attempts to time the market by moving into and out of asset classes based on short-term performance expectations.

Mean-Variance Optimization Asset Allocation

This strategy uses models that calculate an efficient frontier based on estimates of returns, standard deviations, and correlations among sets of investment assets. It seeks to maximize return based on a selected level of risk using an efficient frontier with efficient portfolio options.

Which of the following statements is CORRECT? a. Time lines cannot be constructed in situations where some of the cash flows occur annually but others occur quarterly b. Some of the cash flows shown on a time line can be in the form of annuity payments, but none can be uneven amounts c. Time lines cannot be constructed for annuities where the payments occur at the beginning of the periods d. A time line is not meaningful unless all cash flows occur annually e. Time lines are useful for visualizing complex problems prior to doing actual calculations

Time lines are useful for visualizing complex problems prior to doing actual calculations Time lines can be constructed for different time periods including days, months, quarters, etc., and can include multiple types of time periods in the same time line.They can also be used for annuities with cash flows at the beginning or the end of the period, and can be used with equal cash flows or for uneven cash flows. Time lines are a great tool to visualize complex problems before performing calculations.

Chris Cowlings, Chartered Financial Analyst®, uses fundamental analysis to evaluate equity securities in the country of Gooseburg. Cowling has been able to use inflation data, historical dividend information, and price to book ratios to consistently outperform Gooseburg's broad equity index. Cowling would most likely identify the markets in Gooseburg as being:

Weak form. The use of fundamental analysis to generate abnormal returns violates the semi-strong and strong form of the efficient markets hypothesis. Using publicly available information such as dividends and inflation would not result in outperformance in a semi-strong or strong form market. Therefore, the market can be only weak form level of efficiency.

The T-bill has a beta equal to ____, while the market portfolio's beta is equal to ____.

Zero; one. Within the CAPM, the T-bill should not be affected by changes in the market. Thus, its beta should be equal to zero. The market portfolio is defined as having a beta of 1.0.

Preferred Stock

both fixed-income investments and equity securities.

Common Stock

represents an ownership interest in a firm with owners that demand dividends and capital gains.