FNCE 3030 - Midterm 2

real rate of return formula

(1 + nominal rate)/(1 + inflation rate) - 1

Treynor Ratio Formula

(return of portfolio - return of risk free asset)/Beta of portfolio

What is the retirement "nest egg" required to provide annual inflation-adjusted income? Annual retirement cash flow = $120,000 Retirement reinvestment rate = 6.5% Inflation rate = 2.3% Years in retirement = 27

-$2,016,055

Luke is the portfolio manager for the Front Range Value Fund. Last year his portfolio return was 9%, and the portfolio had a beta of 1.2. The S&P 500 Index had a 7.5% return. The T-bill rate was 2.3%. What is the alpha of the Fund?

0.46

What is the 5-year holding period return given the following Cost of investment $10,000 Annual cash flows Year 1 = $500 Year 2 = $800 Year 3 = $1,000 Year 4 = $1,200 Year 5 = $1,500 Sale proceeds (end year 5) $15,000

1

Which of the following individual client factors influence the appropriate asset allocation mix? (1) Risk tolerance (2) Financial need (3) Time horizon (4) Financial capacity (5) Investment knowledge and experience (6) Individual preferences and constraints

1, 2, 3, 4, 5, 6

Determinants of Portfolio Performance

1. Asset Allocation 2. Security Selection 3. Market Timing 4. Other Factors

Factors of Assessing risk Tolerance

1. Attitude - responses to the risk tolerance questionnaire 2. Financial Capacity - includes assets, cash flows and life-cycle considerations 3. Knowledge - investment knowledge 4. Propensity - past investing activity

Behavioral Finance Theory

1. Challenges the premises of EMH 2. Investors are not always rational 3. Use biases, shortcuts, and emotions to make investment decisions

Asset Allocation Methods

1. MPT 2. LifeCycle Investment Strategy 4. Practical approaches

assumptions of mean variance portfolio theory

1. Markets are efficient in respect to information and competition 2. Asset returns are normally distributed 3. Investors are rational and risk averse 4. Investment decisions based on expected mean-variance returns 5. Short selling is not restricted

Why do anomalies exist?

1. Risk Premiums 2. Investors might not be completely rational 3. Investor's emotion and faulty decision making

Prospect Theory Elements

1. Risk averse investors focus on loss or gain more than on terminal wealth 2. Change in wealth is reset to a reference point 3. More pain associated with losses than happiness with gains (loss aversion)

Efficient Market Hypothesis Assumptions

1. Security prices fully reflect all known information 2. Information is quickly obtained and prices adjust rapidly 3. Price changes are unpredictable and random 4. Investors are rational

3 types of market anomalies

1. Style - size and value vs. growth 2. Calendar - Related to Calendar 3. Fundamental - Having to do with the market mechanics

Individual factors of Asset allocation

1. Tolerance for risk (i.e., portfolio volatility) 2. Financial need and return objective 3. Time horizon (e.g., age, duration of need) 4. Financial capacity (to "weather the market storm") 5. Investment knowledge 6. Investing experience 7. Preferences and constraints

3 forms of market efficiency

1. Weak Form 2. Semi-Strong Form 3. Strong Form

What is the annualized holding period return given the following quarterly HPRs Quarter 1 HPR = .025 Quarter 2 HPR = .0125 Quarter 3 HPR = .0375 Quarter 4 HPR = .025

10.36%

Jake invested $10,000 in a mutual fund that returned 12% the first year. The second year he invested another $8,000 and the fund was up another 15%. Pleased with the growth of investments, he invested another $9,000 in year three and enjoyed another 9% increase. At the end of that year, the portfolio was valued at $37,460. What was Jake's average dollar-weighted return?

17%

Your client is considering a corporate bond with a 6.17% before-tax yield and a municipal bond with a 4.93% before-tax yield. At what marginal tax rate would the investor be indifferent between investing in the corporate and investing in the municipal bond?

20.1%

Based on the following data, what is the expected return of Stock A? Treynor ratio = .156 Standard deviation = .22 Beta = 1.2 Risk-free rate = 6%

24.7%

Over the past year you earned a nominal rate of interest of 6.4 percent on your money. The inflation rate was 2.8 percent over the same period. What is the exact real rate of return that was earned?

3.50%

What is the investor's 3-year holding period return given the following information? Initial investment $20,000 Year 1 cash distributions $1,200 Year 2 cash distributions $1,500 Year 3 cash distributions $800 End-of-year-3 sale proceeds $24,600

40.5%

Market volatility creates an on-going roller-coaster of emotion. Which of the following emotional or cognitive biases best describe the sabotaging behavior of hanging onto losers, rather than harvesting the tax loss and then re-positioning the portfolio? a. Regret avoidance b. Mental accounting c. Ambiguity aversion d. Herding e. Representativeness

A

Which form of efficient market hypothesis is supported by the January effect? a. None of these b. Weak form efficiency c. Strong form efficiency d. Semi-strong form efficiency

A In an efficient market, there should not be any anomalies.

Which of the following is NOT a fundamental premise of prospect theory. a. Risk-averse investors are more focused on gains than losses b. When experiencing a loss, risk-averse investors will become more risk seeking c. The highest portfolio value becomes a reference point for portfolio evaluation d.Investors focus on change in wealth rather than wealth maximization

A Key elements of prospect theory include 1) risk-averse investors focus on loss or gain more than on total terminal wealth, 2) investors focus on change in wealth, reset to a "reference point", 3) more pain is associated with losses than happiness associated with gains (loss aversion) and 4) investors tend to be risk-averse when experiencing gains but risk-seeking when experiencing a loss.

An investor recently profited from a series of trades. A new opportunity is considered, and the investor quickly decides on investing a large percentage of the portfolio. What heuristic probably impacted this aggressive investment decision. a. Sequential prospects b. Framing c. Endowment effect d. Mental accounting

A Sequential prospects suggest that risk perception changes based on prior experiences. Investors are more likely to take a gamble given a series of previous gains. In contrast, investors are more likely avoid the gamble if the previous prospects results in losses.

Which of the following cognitive biases help explain why individuals value current consumption more than deferred gratification? a. Hyperbolic discounting b. Status quo or endowment effect c. Ambiguity bias d. Over-conservatism bias e. Anchoring bias

A The tendency to discount the future value of something in the distant future more than reasonable. The more distant and more vague the item, then the greater the discount.

Your friend completed the Market Technician Association certification in technical analysis. Which form of market efficiency supports his efforts in applying the tenants of technical analysis to outperform? a. None of these b. Weak form efficiency c. Strong form efficiency d. Semi-strong form efficiency

A Weak form efficiency suggests that past information (i.e., technical analysis) cannot lead to consistent out-performance, but fundamental and insider information might. Semi-strong efficiency suggest that neither technical nor fundamental analysis can lead to consistent out-performance, but insider information might.

continuous compound interest formula

A=Pe^rt

Random Walk Theory

Any attempt to predict prices is futile because new information is random and unpredictable

Your client has a three-year investment horizon; therefore, you decide to use the last three years of historical market data in determining your expected return assumption. Based on the holding period returns, what is the arithmetic (time weighted) and geometric annual rate of return assumption you will use when entering data into your portfolio optimization analyzer? (Base your response on the following market data.) 3 years ago (begin price = $23.50; end price = $28.00) 2 years ago (begin price = $28.00; end price = $26.25) 1 year ago (begin price = $26.25; end price = $33.75)

Arithmetic: 13.82% Geo Mean: 12.82%

Mental Accounting

Assigning subjective value to money based on its source

Affect

Attitude about sometime impacts the decision.

"Stock prices adjust rapidly to the release of all new public information." This statement is an expression of which one of the following ideas?" a. technical analysis b. semi-strong form of efficient market theory c. random walk hypothesis d. arbitrage pricing theory

B

Your friend, Ben, is an active investor who practices sector rotation based on the chart patterns of different sector ETFs. Right now he is over-weighted in consumer non-durable goods. This trading approach is an example of which of the following? a. portfolio rebalancing b. tactical asset allocation c. strategic asset allocation d. trading optimization

B

Which of the following securities provides the client with the highest after-tax yield, given that the client is in the 24% marginal tax bracket? a. Corporate bond yielding 4.8% b. Municipal bond yielding 4.0% c. 5-year $10,000 corporate zero coupon bond priced at $7,650 d. Callable corporate bond with yield to call of 5.2%

B A - taxable yield 4.8% After-tax yield = 3.65% B - tax-equivalent yield = 5.26% After-tax yield = 4.0% C - taxable yield 5.50% After-tax yield = 4.18% D - taxable yield = 5.2% After-tax yield = 3.95%

The greater an investor's belief in market inefficiency, then the greater the argument for: a. Passive investing b. Active investing c. Buy and hold d. Investing in market indexes

B Market efficiency implies that active investing is not profitable, after transaction costs and taxation. If you believe that the markets are inefficient then it creates the case that active investing can outperform. Buy and hold strategy and investing in market indexes are examples of passive investment strategy.

Geometric Returns formula

Bottom right on formula sheet

According to the Brinson, Singer and Beebower study, which of the following is the most important decision that impacts long-term wealth accumulation? a. portfolio hedging b. market timing c. asset allocation d. security selection

C

Based on the life cycle investment strategy, at which stage of the economic life cycle would the investor be weighted in fixed income securities? a. never, the investment portfolio would always be weighted towards growth securities b. accumulation stage (age 20-45) c. distribution stage (in retirement) d. consolidation stage (age 45-67)

C

Which of the following is not a Style anomaly? a. Size of firm b. Neglected firm c. Stock Split d. Value vs Growth e. Low Market Multiple f. Dogs of Dow

C

Which of the following forms of analysis would add value given the belief that markets are weak-form efficient? a. Analyzing chart patterns b. Analyzing market cycles c. Analyzing financial statements d. Analyzing bullish versus bearish settlement

C because that one offers current information and semi-strong info

Framing

Choice is impacted by how the prospects are presented

Emotional Biases + Types

Decision Making based on Emotions 1. Fear and greed 2.Herding 3.Information cascades 4. Regret avoidance 5. Ambiguity aversion 6. Over-confidence 7. Illusion of control 8. Mood and sentiment

Availability

Decision-making based on information that comes to mind quickly

representativeness

Decision-making based on the commonality between the current situation and prior experience

Prospect Theory

Describes how decisions are actually made

Utility Theory

Describes how decisions under uncertainty should be made

Treynor Ratio

Describes the average excess return-to-risk trade-off and is typically used to assess alternative portfolios because beta replaces standard deviation. Want a higher Treynor

Which of the following is not a fundamental anomaly? a. Stock Split b. Buyback Announcement c. Dividend Increase d. Dividend Cut e. Low Market Multiple

E

Given: 8% annual return, with four compounding payment periods in the year. What is the EAR?

EAR = 1 + (.08/4)4 - 1 = 1.024 - 1 = 8.2432%

What is the effective annual rate given that the annual rate of return is 10% and there is continuous compounding?

EXP(.10) - 1 = 10.52%

Strategic Allocation

Establishing a long-term target strategic allocation* Portfolio monitoring and periodic rebalancing to maintain target mix

In a highly efficient market, there should be no exceptions. However, evidence shows some persistent patterns that offer out-performance relative to a buy and hold strategy. Which of the following is NOT recognized market anomalies? a. Small firm effect b. "Dogs of the Dow" c. Low market multiple stocks d. Turn-of-the-month effect e. January effect f. International stock effect

F

Feer and Greed

Following Market Cycle and corresponding Emotions

Herding Instinct

Following momentum of the crowd

Which of the following hedge funds offer the best return-to-risk profile based on William Sharpe's information ratio given the fact that the benchmark offered an 8.5% return? (1) Fund A - 17.0% return, tracking error 6.8%, beta 1.8 (2) Fund B - 24.0% return, tracking error 9.3%, beta 2.1 (3) Fund C - 28.0% return, tracking error 12.8%, beta 2.7 (4) Fund D - 10.0% return, tracking error 3.5%, beta 1.3

Fund B

Hyperbolic Discounting

Hyperbolic discounting refers to the tendency to overvalue immediate rewards at the expense of long-term goals

information cascades

Individual makes own assessment, observes actions of the group, follows group

Efficient Market Hypothesis Premise

Investors are unable to consistently outperform in a market with informed participants

regret avoidance

Investors may make decisions that allow them to avoid the pain of monetary loss and loss of self-esteem

Over-optimism

Investors tend to be excessively optimistic about forecasts

Empirical Evidence

Investors tend to be excessively optimistic about their forecasting ability, even though performance feedback suggests otherwise.

Sequential prospects

Investors will be risk-averse if prior opportunities resulted in a loss Investors will be more risk-seeking if prior opportunities resulted in a gain

Inflation-Adjusted Return Formula

Just use PV

Heuristics

Mental shortcuts or "rules of thumb" that often lead to a conclusion. 1. Anchoring 2. Representativeness 3. Availability 4. Affect

Given: 20 year, $10,000, 4% semi-annual coupon bond Callable in 10 years at 5% premium Cost of bond = $8,745 What is the nominal and current yield?

Nominal = 4% Current = 4.57%

Nominal yield vs Current Yield

Nominal Yield = coupon rate Current Yield = total annual coupon payments divided by the current price

Overestimating own Ability

Overconfidence in own judgment

Tactical Allocation

Overweighting of asset categories based on projected performance Minimum and maximum allocations might be established

Life Cycle Investment Strategy

Personal wealth is a function of financial wealth and present value of human capital 1. 100-age 2. 60/40 Adjustment

Total Holding Period Return Formula

Price end + Cash Distributions + Price begin/Price begin

semi-strong form efficiency

Prices reflect all past and current information 1. Technical and fundamental analysis cannot produce consistent returns 2. Insider information may produce superior returns

weak form efficiency

Prices reflect all past information 1. Technical analysis cannot produce consistent returns 2. Fundamental analysis might produce superior returns

strong form efficiency

Prices reflect all past, current, and insider information 1. Technical, fundamental, insider information will NOT produce consistent returns

Style anomalies

Size of firm, value versus growth, neglected firm, low market multiples, "dogs of Dow" Size of firm (small firm effect)= Small-cap stocks tend to outperform larger-cap firms over the long-term Neglected firm effect= Smaller-cap stocks not covered by institutional analysts tend to outperform those covered Value versus growth (beta)= Low beta stocks tend to out-perform high beta stocks over longer time periods Low market multiples= Stocks with low P/E and P/S ratios tend to outperform stocks with high P/E and P/S ratios "Dogs of the Dow"= 5 worst performing stocks in Dow over last year tend to outperform in the next year

Arithmetic Mean formula

Sum of returns/ # of observations

Behavior Biases

Systematic errors in human judgment 1. Cognitive 2. Emotional

Based on the following information... Market return = 12% Risk-free rate = 2.3% Beta = 1.2 Portfolio return = 13.5% What is the manager's alpha?

TBD

IRR (dollar-weighted) return formula

Take IRR of all cashflows First Cashflow is negative

Loss Aversion

Tendency for risk-averse investors to place greater value on avoiding losses than on acquiring gains

Anchoring

Tendency of decision-making from a reference point

Selective recall

Tendency to overweight recent information and successful trading experiences

Confirmation bias

Tendency to seek out data that supports your own beliefs or conclusions

Term Structure definition and theories

Term structure describes the yield to maturity of fixed income securities with similar credit ratings and tax characteristics 1. Liquidity Preference Theories 2. Expectations Theory 3. Segmentation Theory

Jensen's Alpha

The portfolio's excess return (alpha) over the expected market return as predicted by the capital asset pricing model

Information or Appraisal Ratio

The ratio appraises the portfolio manager's performance by comparing the portfolio return to the bench market return, adjusted for tracking error. Want the highest IR

Hindsight bias

This bias refers to the belief that past events were predictable

Ambiguity Aversion

This bias refers to the tendency of investors to make a decision that favors familiar over the unfamiliar.

Annualized holding period return formula

Way bottom left on formula sheet

Client Goal = Accumulate $1,000,000 Given: Current savings = $50,000 Time horizon = 20 years Annual savings assumption = $3,000 What is the required reinvestment rate to achieve goal?

What is the required reinvestment rate to achieve goal? N = 20 PV = -50,000 PMT = -3,000 FV = 1,000,000 solve for I = 14.26%

Pure Expectations Theory

Yield reflects market expectations of future rates

Market Segmentation Theory

Yields reflect supply and demand for credit across the different segments of the market

Liquidity Preference Theory

demand for liquidity determined by three motives 1. preference to hold cash for spending (level of income) 2. precaution 3. speculation regarding future interest rates

Fundamental Anomalies

dividends, buybacks, stock splits Buyback announcement= Stocks that announce share buybacks tend to outperform Dividend increase announcement= Stocks that increase dividends tend to outperform over the next few years Dividends cut or eliminated= Stocks that decrease dividend tend to underperform over time Stock splits= Stocks that announce stock splits outperform over time

Calendar anomalies

months, days, years January effect= Stocks (particularly small-cap stocks) tend to have their best trading month in January, particularly the first five days* Monday effect= Monday tends to be the worst day in respect to average stock returns (Friday tends to be the best day) Turn of the month = Large-cap stocks tend to perform well at the end of the month and first few trading days of next month "Sunny" days = Good weather days tend to produce better stock market returns than bad weather days

Tax Equivalent Yield

r/(1-t) r = Tax free yield t = marginal tax rate

Cognitive Biases + Types

systematic errors in thinking 1. Hyperbolic discounting 2. Continuation of trend 3. Anchoring 4. Confirmation bias 5. Hindsight bias 6. Framing 7. Mental accounting 8. Availability 9. Selective recall

Effective Annual Rate (EAR) Definition and Formula

the interest rate expressed as if it were compounded once per year (1 + period rate of interest) n where "n" = # of compounding periods