Quiz #7

An investor who places the majority of assets in a single stock exposes the portfolio to: A. business risk B. liquidity risk C. inflation risk D. market risk

The best answer is A. Business risk is the risk that a specific issuer performs poorly due to business conditions - and its securities decline in price because of this. If a majority of a portfolio is in one stock, then the portfolio is highly exposed to this risk. As more and more stocks are added to the portfolio, this risk is diversified away. Once a portfolio is fully diversified, the only risk left is market risk - the risk that there is a general decline in the market; and all stocks fall as a result.

A portfolio of securities with a beta of 1.2 has produced an average annual return of 12%. Which investment should the portfolio manager consider adding? A. A stock with an 6% growth rate and a beta of .7 B. A stock with a 10% growth rate and a beta of .8 C. A stock with a 12% growth rate and a beta of 1.3 D. A stock with a 14% growth rate and a beta of 1.5

The best answer is B. The portfolio has generated a 12% return by taking on extra risk (beta of 1.2 is .2 above the market risk level of 1). If we divide the return by the beta, the market return for the portfolio would be 12% / 1.2 = 10%. Any investment that exceeds this amount (risk adjusted) is a good one for the portfolio. Choice A: 6% / .7 Beta = 8.57% risk adjusted return Choice B: 10% / .8 Beta = 12.50% risk adjusted return Choice C: 12% / 1.3 Beta = 9.23% risk adjusted return Choice D: 14% / 1.5 Beta = 9.33% risk adjusted return

The Current Ratio measures: A. debt service coverage B. liquidity C. leverage D. profitability

The best answer is B. The Current Ratio is: Current Assets / Current Liabilities. It is a measure of liquidity, because it looks at whether the company can pay its current bills as they come due.

2 years ago a woman leased a new car by putting $2,000 down and signing a 48 month lease at $500 per month. She has received a letter from the lease company saying that she can complete the lease right now by making a single $10,000 payment and keep the car for 2 more years; or she can finish the lease by making the remaining 24 monthly payments of $500. Assuming that this customer can earn 6% by investing in Treasury securities, and ignoring any tax consequences, to determine the best option, the method to be used is: A. Rule of 72 B. Internal Rate of Return C. Expected Return D. Future Value

The best answer is B. This customer can get out of the lease by making a $10,000 payment now; or can continue to make $500 per month payments for the next 24 months, paying a total of $12,000 to complete the lease. One method to compute the best option (lowest cost) would be to use net present value - but this is not given as a choice! The customer can pay off the lease now by paying $10,000 now - this is the present value of this payment. Using NPV and a 6% risk-free rate of return, the present value of continuing the lease payments is: $6,000 paid in 1 year ------------------------------ = $5,660 NPV for yr 1 payments 1.06 $6,000 paid in 2 years --------------------------------- = $5,340 NPV for yr 2 payments 1.06(2) Total NPV = $5,660 + $5,340 = $11,000 Paying off the lease in one payment costs $10,000; while the net present cost of continuing the lease is $11,000. The up-front $10,000 payment is the best alternative (assuming that the customer has the $10,000 on hand!). Since NPV is not given as a choice, we have to evaluate the cost of each option by another method. The customer can either pay $10,000 now; or can make 24 more monthly payments of $500. If we can find the interest rate that discounts these monthly payments to $10,000; then we know the true interest cost implicit in continuing to make the monthly payments (this is the Internal Rate of Return). This is done using a financial calculator or by interpolation. Just as an example, assume that we try a 12% interest rate to discount the payments: $6,000 paid in 1 year ------------------------------ = $5,357 NPV for year 1 payments 1.12 $6,000 paid in 2 years ------------------------------- = $4,783 NPV for year 2 payments 1.12(2) This gives us a Net Present Value of $5,357 + $4,783 = $10,140, which is darn close to the $10,000 we must pay now to terminate the lease. Thus, the interest cost of continuing to make the $500 payments is about 12%. If we can borrow money somewhere else at a cheaper interest rate than 12%; or if we are not earning at least 12% on our investments; then we should pay off this lease with the single $10,000 payment now!

A portfolio constructed by a manager has the following rate of return probabilities for the coming year: Rate of Return Probability 15% 40% 8% 30% -2% 30% What is the expected rate of return for this portfolio? A. 7.00% B. 7.80% C. 8.33% D. 9.00%

The best answer is B. To find the expected rate of return, each possible rate of return is multiplied by its probability; and then they are added up. Rate of Return Probability Expected Rate of Return 15% 40% 6.00% 8% 30% 2.40% -2% 30% -.60% ----------- 7.80%

CAPM is used to calculate the: A. risk-free rate of return B. expected rate of return C. geometric rate of return D. total rate of return

The best answer is B. CAPM (the Capital Asset Pricing Model) is used to identify the most "efficient" investments - meaning those that give the greatest return for the risk assumed. As long as the investment meets the minimum return dictated by the model, then it should be included in the portfolio. CAPM finds the "expected return of an investment" using the formula: Expected Return of An Investment = Risk-Free Rate of Return + Risk Premium* *Risk Premium is: Beta x (the excess of the Expected Market Return over the Risk-Free Rate of Return) In the formula, Beta is the measure of risk. Thus, high Beta stocks must give a higher rate of return to meet the formula's investment threshold.

What economic indicator shows, on a national basis, buying and investment? A. GNP B. GDP C. CPI D. BOP

The best answer is B. GDP - Gross Domestic Product, measures all output generated within the borders of a country, so it is a "national" measure. GNP - Gross National Product - measures economic output of U.S. owned entities, whether that production occurs within the country's borders or occurs overseas. CPI is the Consumer Price Index, while BOP is the Balance Of Payments. Both of these have nothing to do with economic output.

Supply Side Theory states that: A. increased government spending will stimulate the economy B. tax rate reductions and lower government spending will stimulate the economy C. the actions of the Federal Reserve are the driving force behind the economy D. tax rate increases will stimulate the economy

The best answer is B. Supply Side Theory states that economic growth is controlled by individual initiative. If individuals are given the incentive to produce, they will, and the economy will grow. To give this incentive, the theory holds that government spending, and the tax collections necessary to support that government spending, should be reduced. This leaves the individual with an economic incentive to produce, since less of his or her income is being taxed.

A customer buys a new issue inflation-adjusted government bond with a 4% coupon at par. After the first year, the inflation rate as measured by the CPI has increased by 5%. For the second year of holding the security, the customer will receive: A. interest of $40 B. interest of $42 C. interest of $50 D. interest of $40 and a principal adjustment of $50

The best answer is B. TIPS (Treasury Inflation Protection Securities) are issued with a fixed coupon that does not change. In the first year, this bond will pay 4% of $1,000 par = $40. At the end of year 1, because inflation was 5%, the principal amount of the bond is adjusted to $1,050 and in year 2, the investor will receive 4% of $1,050 = $42 of interest.

In 2015, a customer buys 1 GE 10%, $1,000 par debenture, M '30, at 115. The interest payment dates are Jan 1st and Jul 1st. The bond is first callable in 2025 at 102. The yield to call on the bond is: A. 6.96% B. 8.02% C. 8.37% D. 10.23%

The best answer is B. The formula for yield to call for a premium bond is: Ann Inc - Ann Cap Loss to Call Date Yield to Call Date = -------------------------------------------------- (Purchase Price + Call Price)/2 $100 - ($130 premium / 10 years to call) ---------------------------------------------------------- = ($1150 + $1020) / 2 $100 - $13 87 --------------- = --------- = 8.02% $1085 $1085 Note that because there is a 2 point ($20) call premium paid if the bond is called in 2025, $1020 is the redemption price at that date. Also note that because of the 2 point call premium paid at early redemption, the full 15 point premium is not lost; rather, only 13 points ($130) is lost when the bond is called at 102.

Given the set of the following numbers: 5, 4, 11, 6, 8, 5, 12, 13, what is the range? A. 8 B. 9 C. 10 D. 13

The best answer is B. The range is the difference between the highest and lowest numbers in the set. The highest number is 13 and the lowest number is 4, so the difference is 9. The numbers in the set "range" from a low of 4 to a high of 13.

During a period when the yield curve is inverted: A. short term bond prices are more volatile than long term bond prices B. long term bond prices are more volatile than short term bond prices C. short term and long term bond prices are equally volatile D. no relationship exists between short term and long term bond price changes

The best answer is B. Whether the yield curve is ascending (normal), flat or inverted, long term bond prices always move faster than short term bond prices, as interest rates change. This is due to the compounding effect on the bond's price that occurs, which increases with longer maturities.

An investor buys 1000 shares of ABCD stock at $50 per share. At the end of the 1st year, ABCD has increased to $60 per share. At the end of the 2nd year, ABCD has increased to $75 per share. At the end of the 3rd year, ABCD has decreased to $70 per share. Assuming that the customer is in the 15% tax bracket for dividends and long-term capital gains, if the customer liquidates the position at the end of year 3, the after-tax annualized rate of return is: A. 8.10% B. 9.53% C. 11.33% D. 13.33%

The best answer is C. This investment has increased from $50 in value to $70 in value over 3 years. The $20 gain will be taxed at 15%; so 85% of the gain is kept after tax. .85 x $20 = $17 after-tax gain / 3 year holding period = $5.66 annualized after-tax gain / $50 original investment = 11.33% annualized rate of return.

When the market is reaching an "overbought" condition, which of the following statements are TRUE? I Market price averages are decreasing daily II Market price averages are increasing daily III The number of advancing issues is declining relative to falling issues IV The number of declining issues is rising relative to advancing issues A. I and III B. I and IV C. II and III D. II and IV

The best answer is C. An overbought condition in the market occurs when the market price averages are increasing daily, but the strength of the market (the number of issues advancing versus the number of issues declining) is weakening. The market is reaching an "overbought" condition, and is approaching a peak. Thus, the next market move is likely to be a decline.

The definition of Net Present Value of an investment is: A. The sum of annual cash flows discounted by the cost of capital B. The sum of annual cash flows compounded by the cost of capital C. The sum of annual cash flows discounted by the cost of capital minus initial investment D. The sum of annual cash flows compounded by the cost of capital minus initial investment

The best answer is C. Net Present Value takes each annual cash flow projected to be received from an investment and discounts it back to today's present value, typically using the risk-free rate of return as the discount factor and adds them up. This computes the aggregate present value of those cash flows. Then, the initial cash outflow (the investment) is subtracted. If the net result (as in net present value) is positive, then the investment should be made. If it is negative, there would be a loss on the investment. Assume that an investor makes a $1,000 investment that will return $100 in the first year; $100 in the second year; and $1,100 in the third year. (Basically, this investment is returning 10% per year over 3 years.) A $100 cash flow to be received 1 year from now would have a present value of: $100 -------- = $95.24 1.05 A $100 cash flow to be received 2 years from now would have a present value of: $100 -------- = $90.70 (1.05)2 A $1,100 cash flow to be received 3 years from now would have a present value of: $1100 ----------- = $950.22 (1.05)3 The sum of the present values is: $95.24 + $90.70 + $950.22 = $1,136.16. If we subtract the initial investment of $1,000, we get a net present value of +$136.16. (Also note that, logically, since the rate of return on the investment of 10% is more than the discount factor of 5%, the net present value would have to be positive.)

Which investment offers the greatest protection against purchasing power risk? A. Long term U.S. government bonds B. Long term zero-coupon bonds C. Real estate investments D. Investment grade preferred stock

The best answer is C. Of the choices given, real estate offers the best protection against purchasing power risk (inflation risk). When there is inflation, the prices of real assets tend to inflate as well, hence they give inflation protection. In contrast, long term bonds and preferred stocks are lousy investments in times of inflation. These securities give a fixed income stream, that becomes worth less and less each year as prices inflate. Because of this, their prices drop as inflation rates rise. The actual cause of their price drop is simple - as inflation rates rise, market interest rates rise in tandem. As market interest rates rise, the prices of fixed income securities drop, with longer maturities and lower coupon rate issues being most susceptible to interest rate risk.

The formula for Return on Investment (ROI) is: A. (Total Beginning Return - Total Ending Return) / Average Cash Flow B. (Total Ending Return - Total Beginning Return) / Average Cash Flow C. Average Annual Cash Flow / Initial Investment Outlay D. Average Annual Cash Flow / Average Investment Value

The best answer is C. Return on Investment is a simple measure that takes an initial investment and shows how well it performs. The annual cash flows generated by the investment are averaged, and divided by the original investment amount. For example, assume that $1000 is invested, and that investment is expected to generate cash flow of $100 in the first year, $200 in the second year, and $300 in the third year, at which point the $1,000 original investment will be returned. The average annual cash flow is $100 + $200 + $300 = $600/3 years = $200 per year. Since $1,000 was invested, the ROI is $200 / $1,000 = 20%.

A customer wishes to make an investment that provides income along with high liquidity and high marketability. The BEST recommendation is: A. limited partnership units B. long term corporate bonds C. preferred stocks D. growth stocks

The best answer is C. This customer is looking for income, so growth stocks are inappropriate. This customer is looking for ready marketability, so limited partnership units are inappropriate, since they do not trade. We are left with either long term bonds or preferred stocks, both of which provide current income. Long term corporate bonds are not as actively traded as preferred stocks, so they have some marketability risk. Preferred stocks are traded like any other stock and are extremely marketable, so this is the best choice.

Which statements are TRUE about duration? I The lower a bond's coupon rate, the lower the bond's duration II The higher a bond's coupon rate, the lower the bond's duration III The longer a bond's maturity, the lower the bond's duration IV The shorter a bond's maturity, the lower the bond's duration A. I and III B. I and IV C. II and III D. II and IV

The best answer is D. Duration is a measure of bond price volatility. Bonds with low coupons have large duration numbers; as do bonds with long maturities. These bonds have the most volatile price movements in response to changes in market interest rates. Bonds with high coupons have small duration numbers; as do bonds with short maturities. These bonds do not move much in price as market interest rates move.

During periods when interest rates are rising, which of the following fixed income securities offers the greatest protection from "interest rate risk"? A. zero coupon bonds with long maturities B. low coupon bonds with long maturities C. current coupon bonds with long maturities D. high coupon bonds with long maturities

The best answer is D. The basic truths regarding bond price volatility and interest rate movements are: The longer the maturity, the greater the bond's price volatility in response to interest rate movements. The lower the coupon rate, the greater the bond's price volatility in response to interest rate movements. The farther away from par that the bond is priced, the greater the bond's price volatility in response to interest rate movements. This question only examines the second factor, since the maturities are equivalent for all choices, and no mention is made of whether the bonds are trading at a discount or a premium. The bond with the lowest price volatility will be the one with the highest coupon rate. Bonds with low coupon rates exhibit greater price volatility. Thus, to minimize price volatility due to interest rate movements ("interest rate risk"), high coupon bonds are appropriate.

The Sharpe ratio is: A. Risk Free Rate of Return / Standard Deviation B. Risk Adjusted Rate of Return / Standard Deviation C. Risk Free Rate of Return / Duration D. Risk Adjusted Rate of Return / Duration

The best answer is B. The Sharpe ratio measures the "extra return" achieved (Risk Adjusted Rate of Return) for "extra risk" assumed (Standard Deviation); and thus is a risk measurement. Rate of Return - Risk Free Rate of Return Sharpe Ratio = --------------------------------------------------------- Standard Deviation

If a company in the 50% tax bracket has sales of $2,000 and a gross margin of $400, what is the pre-tax gross margin percentage? A. 5% B. 10% C. 20% D. 50%

The best answer is C. Since this question asks for pre-tax gross margin, the tax bracket is irrelevant. Gross margin is sales minus cost of goods sold. This question gives the gross margin as $400. Taking this as a percentage of sales, $2,000, gives the gross margin percentage. $400 / $2,000 = 20% gross margin percentage.