S65 PROGRESS EXAM 04A
Regarding risk tolerance and suitability, Modern Portfolio Theory contends that:
An investment that is risky on its own might be less risky in a portfolio if it behaves independently from the other investments in that portfolio An investment that might not be suitable on its own, such as a hedge fund, might be appropriate as part of a larger portfolio. According to Modern Portfolio Theory, an investment that is risky but relatively uncorrelated with other investments in the portfolio, could reduce the risk of the portfolio while maintaining or even increasing the portfolio's expected return.
An investor initially deposited $10,000 and it has grown to $10,800 over four months. The approximate annualized rate of growth on the funds is:
24% One method of approximating the annualized rate of growth on the funds is to consider the performance over the last four months, which is 8%. Since four months is 1/3 of one year, the annualized performance is approximately triple that amount, or 24%.
Which of the following is a demand deposit?
A checking account Demand deposits represent money that can be freely withdrawn (i.e., on demand). Securities (e.g., stocks and bonds) are not considered demand deposits. Also, real estate is typically less liquid than securities and is not considered a demand deposit. A certificate of deposit is typically classified as a term deposit, since the funds cannot be withdrawn until the maturity (i.e., until the term is up).
Which of the following is the likely result of persistent deflation?
A decrease in interest rates Deflation is considered a reduction in the general level of prices. Deflation leads to lower interest rates, which results in higher bond prices. Equities tend to perform well during periods of inflation, not deflation.
Which of the following is the BEST description of inflation?
A general increase in prices. Inflation is when the prices of goods and services rise. Inflation often leads to higher interest rates, which causes bond prices to fall.
An investor wants to invest in a fixed-income security for her portfolio. She understands there is a tradeoff between risk and return; however, she prefers to avoid speculative-grade investments. Which of the following bonds is MOST suitable for her portfolio?
BBB collateral trust certificate, present value = $1,251, market price = $1,148 In order to answer this question, each bond's current market value must be compared to its present value. The present value of each bond has been calculated by discounting the cash flows from each coupon payment and determining the present value of the principal repayment, using the investor's desired rate of return. When comparing the present value of a bond to its current market value, an investor can determine if the bond is fairly valued, undervalued, or overvalued. The bonds in the choices where the current market value is greater than the present value are trading at a premium to their present value, which means the investor would receive a lower return than desired. The bonds in the choices where the current market value is less than their present value are trading at a discount to their present value and the investor would receive a higher return than desired. Since the investor also wants to avoid speculative-grade investments (BB and below), the best choice is the BBB-rated collateral trust certificate.
All of the following statements about Benchmark Portfolio Management are TRUE, EXCEPT:
Benchmarks should be reweighted at least quarterly to improve the relative performance of the portfolio When portfolio managers construct a portfolio, they usually start with the securities in the benchmark as a beginning point. Then the decision as to what additional positions to take is made in an effort to add value. The benchmark indicates not only the kinds of securities that should be included in the portfolio, but also the types that should not be. For example, choosing a government bond index as the benchmark makes it clear that the portfolio should not include a large percentage of securities with a high degree of risk. Reweighting a benchmark on a quarterly basis would not have any effect on the actual performance of the portfolio. If it were done to make the portfolio appear to perform better, that would be considered, at best, unethical and, more likely, fraudulent.
All of the following are needed to perform a discounted cash flow analysis, EXCEPT:
Credit rating of the bond's issuer Discounted cash flow analysis can be used to estimate the current market price of a bond. Discounted cash flow analysis involves taking a bond's interest payments (i.e., cash flows) and discounting them back to their present value using the present value formula. In order to do this, the calculation requires the interest payments (i.e., future cash flows), the par or principal value of the bond, and a discount rate (i.e., expected rate of return). Discounted cash flow analysis doesn't consider the credit rating of the bond's issuer.
If an analyst wants to determine a company's ability to pay its liabilities that will be maturing in one year with its liquid assets, he will be most interested in the:
Current ratio The current ratio is a comparison of current assets to current liabilities for a one-year period and is used as an indicator of a company's ability to pay those liabilities. On the other hand, the acid-test (quick asset) ratio excludes the company's inventories and is usually for a one- to three-month period.
When an individual invests a constant dollar amount over a fixed period, which of the following activities is he engaging in?
Dollar cost averaging Dollar cost averaging calls for a client to invest a fixed dollar amount in a particular investment over a regularly scheduled period. This approach results in purchasing more shares when prices are low and fewer shares when prices are high. Dollar cost averaging is a long-term investment strategy that many investors find beneficial but does not guarantee profitability, due to the fact that the security purchased could still drop in value by the time the investor liquidates the position.
If the NPV (net present value) of an investment is greater than zero, the investment will provide a return:
Greater than the discount rate used If the net present value of an investment is greater than zero, the investment will generate a positive return. Net present value is used in discounted cash flow (DCF) analysis. It is a standard method for using the time value of money to evaluate investments. For example, if an adviser wants to purchase a portfolio of bonds, she would discount the cash flows of those bonds into one present value amount, for example, $1,300,000. If the adviser can purchase the bonds for less than that amount, then the investment has a positive net present value. This would mean that the return on the portfolio would be greater than the discount rate used to arrive at the net present value. If the adviser could not locate the bonds for a total price of less than $1,300,000, then the purchase would not be completed.
Which of the following statements are TRUE regarding a comparison of strategic versus tactical asset allocation? I. Strategic asset allocation focuses on the client's investment objectives and risk tolerance, while tactical asset allocation focuses on economic and market conditions. II. Strategic asset allocation has a long-term outlook, while tactical asset allocation encompasses short-term decisions. III. Unlike strategic asset allocators, tactical asset allocators believe that investors can time the market.
I, II, and III Asset allocation based on a client's risk tolerance and investment objectives is called strategic asset allocation. In theory, it is the best mix of assets given the client's goals and level of risk aversion, giving it a long-term outlook. Strategic asset allocators tend to view the market as efficient and market timing as ineffective. By contrast, those who believe securities markets are not perfectly efficient may try to use an active strategy to alter the portfolio's asset mix, to take advantage of anticipated economic events. This market timing approach is sometimes called tactical asset allocation.
Which of the following statements about net present value is TRUE?
Investors should buy securities that have a net present value that's greater than 0. Net present value is the difference between the present value of an investment's cash flows (e.g., interest payments), MINUS the market value of the investment (i.e., NPV = PV Cash Flows - Market Price). Investments with a positive NPV (i.e., the present value of the cash flows is greater than the current market price) represent a buying opportunity because the investment is undervalued. The present value of an investment is always based on the future cash flows, rather than on cash flows that have already occurred.
Which of the following choices is considered a leading economic indicator?
Manufacturing new orders Manufacturing new orders is considered a leading economic indicator. Industrial production is considered a coincident indicator, while average duration of employment and commercial and industrial loans outstanding are lagging indicators.
Interest-rate risk is BEST described as the possibility that:
Rising interest rates will cause bond prices to fall Interest-rate risk is the risk that rising interest rates will decrease the market value of a bond investment.
An advisory client is concerned that the economy is close to reaching its peak. He instructs his adviser to sell his holdings in automobile stocks, and invest the proceeds in consumer staples. This strategy is known as:
Sector rotation Sector rotation is a strategy often used in anticipation of changes in the business cycle. If it is believed the economy is about to slow, profitable sectors to invest in would be consumer staples, or defensive stocks.
A portfolio manager has recently taken his client's equity holdings out of technology stocks and moved them into manufacturing stocks. The manager has historically moved client funds from one industry to another during defined periods. What is this type of strategy called?
Sector rotation Sector rotation is the switching from one industry (sector) into another as the economy changes. Dollar cost averaging is investing the same dollar amount over a fixed period, regardless of the price changes. Rebalancing strategies involve buying and selling to keep the portfolio's asset mix consistent over the long term.
During periods of easy money when interest rates are declining, yield curves tend to:
Slope upward from the shorter to the longer maturities During periods of easy money when interest rates are declining, yields on shorter maturities will be less than yields on longer maturities. Yield curves tend to slope upward from the shorter to the longer maturities.
If a portfolio manager is focused on keeping a client's assigned asset allocation properly balanced over the long term, she is using a:
Strategic asset allocation strategy Strategic asset allocation attempts to maintain the assigned allocation over a long period and is more passive in nature than a tactical asset allocation strategy. Portfolio rebalancing does not describe a strategy; instead, it is the adjustment of a portfolio in preparation for an investment strategy. Laddering is considered diversifying a bond portfolio by staggering the maturity dates of the bonds in an attempt to manage interest-rate risk.
What does the Wilshire 5000-to-GDP ratio measure?
The market value of all U.S. stocks relative to the U.S. economy The Wilshire 5000 is a stock index that's made up of all U.S. stocks, not just large or small-cap stocks. The Wilshire 5000-to-GDP ratio measures how over- or under-valued U.S. stocks are relative to the U.S. economy. A ratio above 1.0 indicates that U.S. stocks are over-valued, while a ratio below 1.0 indicates that U.S. stocks are under-valued.
