Unit 20 quizzes

Proponents of the efficient market hypothesis believe that A) markets operate efficiently and stock prices instantly reflect all available information. B) careful stock selection can produce positive alpha without increasing risk. C) time horizon is one of the most important investment constraints. D) active portfolio management will generally produce better results than passive management.

A

An individual is a participant in the 403(b) plan offered by his employer. If he were to invest $200 per month into one of the growth subaccounts offered under the plan, he would be A) following a constant ratio plan B) rebalancing C) dollar cost averaging D) maintaining a constant dollar plan

C

An individual who is a proponent of the efficient market hypothesis (EMH) will likely invest in which of the following? A) Growth mutual funds B) Balanced mutual funds C) Index funds D) Sector mutual funds

C An individual who believes in the EMH will likely invest in index funds. Inherent in this strategy is a belief that an investor cannot outperform the market with active portfolio management techniques. The remaining choices all incorporate an active portfolio management philosophy.

Several capital market theories exist, all with the goal of maximizing returns while minimizing risks. Capital Asset Pricing Model (CAPM): theory allowing the investor to determine an asset's expected rate of return, a form of risk-adjusted return encapsulating how much risk the investor should assume to obtain a particular return from an investment. - CAPM does so solely on the basis of the asset's systematic (non-diversifiable) risk. Modern portfolio theory (MPT): is an approach that attempts to quantify and control portfolio risk. - emphasizes determining the relationship between risk and reward in the total portfolio rather than analyzing specific securities. - Under the CAPM, the investor should be rewarded for the risks taken so it is proper to assume that the higher the risk, the higher the return. - *the portfolio with the least amount of volatility would do better than one with a greater amount of volatility.* The capital market theory: builds upon the Markowitz portfolio model. The main assumptions of the capital market theory are as follows. - Investors are rational - Investors can borrow or lend money at the risk-free rate of return - Investors have equal time horizons - No mis-pricing in markets - No inflation Capital Market Line (CML): Offshoot of CAPM - Provides an expected return based off the level of risk Using; -return on the market; - standard deviation of the market; - standard deviation of the portfolio : *As a measure of risk* - expected return of the portfolio; - risk-free rate; The security market line (SML), which is derived from the CML, allows us to *evaluate individual securities for use in a diversified portfolio.* - Calculated returns based off the securities beta, assumptions about market and risk free rate. - *determine how much over the risk-free rate we should earn for taking the investment risk.*

Calculate Security Market Line (SML): =(market return - risk free rate)x(Stock Beta)+risk free rate EX) if the beta of ABC Company is 1.2 and the market return is expected to be 13% with a risk-free return of 3%, then the expected return of ABC is 15%, as follows: (13-3)x(1.2)+3= 15%

Value investors A) seek securities that are undervalued or selling for less than their intrinsic value B) attempt to find value through diversification C) seek undervalued stocks through careful chart analysis D) seek to find securities with high Sharpe ratios

A Value investors seek securities that are undervalued or selling for less than their intrinsic value. Value investors tend to use fundamental analysis and do not determine value from charting.

An adviser that seeks to outperform a market index (such as the S&P 500) is said to be engaged in A) active management B) passive management C) technical management D) fundamental management

A Passive management is investing to mirror the returns of a market benchmark, such as the S&P 500 index; active management seeks to do better than a market benchmark.

When attempting to construct the optimal portfolio, the investment adviser is looking to obtain A) the maximum return for the least risk. B) returns that fall within the efficient frontier curve. C) the maximum return in the shortest time period. D) the maximum return with the greatest risk.

A The optimal portfolio is the one which provides the greatest return for the least risk. It will fall on the efficient frontier. It is important not to get hung up on terminology when common sense works. As an investor, wouldn't you always want the highest return you could get for the least risk?

growth style: portfolio management focus on stocks of companies whose earnings are growing faster than most other stocks and are expected to continue to do so. - rapid growth in earnings is often priced into the stocks, growth investment managers are likely to buy stocks that are at the high end of their 52-week price range. Therefore, in the eyes of some, they might be buying stocks that are overvalued. - High P/E ratios -does not pay dividends value style: of management concentrate on undervalued or out-of-favor securities whose price is low relative to the company's earnings or book value and whose earnings prospects are believed to be unattractive by investors and securities analysts. - sign of a value stock is a large cash surplus, sometimes referred to as a rainy day fund. - Low P/E ratios -Pay dividends

ABC Co. is a metal processor for parts used in the automotive industry. Earnings per share have grown by a compounded rate of 8% per year for the past 15 years but are somewhat susceptible to downturns in the economy. The stock has paid a quarterly dividend that has increased five times in the past 10 years and the current market price of the stock is six times earnings. Conservatively managed, *the company owns assets and cash that exceed the market value of its common stock*. *ABC would be attractive to value investors because its intrinsic value is higher than its market value, it appears to pay liberal dividends, and it is selling for a low earnings multiple.*

"Stock prices adjust rapidly to the release of all new public information." This statement is an expression of which of the following ideas? A) Arbitrage pricing theory B) Efficient market hypothesis C) Odd-lot theory D) Tactical allocation

B

The semi-strong form of efficient market hypothesis (EMH) asserts that A) all inside information is already reflected in current stock prices. B) all public information is already reflected in security prices making fundamental analysis valueless. C) both public and private information is already incorporated into security prices. D) only fundamental analysis and inside information can bring added value to a portfolio.

B Semi-strong EMH states that publicly-available information (fundamental analysis) cannot be used to consistently beat the market performance. It is strong form EMH which states that all inside information is already reflected in current stock prices.

Which of the following statements regarding modern portfolio theory is not correct? A) The optimal portfolio has the lowest risk for a given level of return. B) The optimal portfolio will always lie above the efficient frontier. C) The optimal portfolio for an investor depends upon the investor's ability to assume risk. D) The optimal portfolio offers the highest return for a given level of risk.

B The optimal portfolio for an investor will always lie on the efficient frontier. That is where, for any given level of risk, the return is the highest. Stated another way, for a given level of return, the risk is the lowest.

If the risk-free rate of return is 3.5%, the expected market return is 9.5%, and the beta of a stock is 1.3, what is the required return on the stock according to the capital asset pricing model? A) 7.80% B) 11.30% C) 8.85% D) 12.35%

B Calculate Security Market Line (SML): =(market return - risk free rate)x(Stock Beta)+risk free rate (9.5-3.5)x1.3+3.5

Some risk is involved in almost all investments. In general, the greater the risk, A) the more expensive the investment B) the greater the potential return C) the longer the period until a return will be realized D) the smaller the potential return

B Risk and potential return tend to go together. Low-risk investments usually produce low returns. High-risk investments offer the hope of high returns.

The pundits are predicting slowly-rising inflation over the next 5 years. An IAR recommends that one of her clients splits his bond portfolio into equal percentages with maturities ranging from 1 to 5 years. As each bond matures, the proceeds are used to purchase bonds with a 5-year maturity. The IAR is using A) the barbell strategy. B) the laddering strategy. C) the bullet strategy. D) the interest discount model.

B The theory behind the laddering strategy is that with bonds maturing every year, the investor is reinvesting the principal at current market rates. In a period of rising inflation, interest rates follow along, so annually, the maturing bonds will be used to purchase new bonds with higher coupons.

Which of the following is a characteristic of the passive investment style? A) Tactical management B) High portfolio turnover C) Income rather than growth objective D) Rebalancing

D Because the passive (strategic) style of investing does not involve frequent trading (as does the tactical or active style), periodically the portfolio will be rebalanced to insure that the asset mix is at the desired level. This style may be used for either income or growth objectives.

If a client who holds a convertible preferred stock believes the company may go bankrupt within the next 3 years, what would you advise the client to do with the stock? A) Buy puts on the common stock as a hedge. B) Immediately convert to common stock because the preferred dividends may no longer be paid. C) Sell calls on the preferred stock. D) Sell the security.

D In the event of bankruptcy, all debt holders have priority over equity holders in claims on the assets of the corporation in liquidation. The safest alternative is to sell the stock. Buying puts on the underlying common stock would be an effective hedge, but with a 3-year wait, the position would have to be renewed several times because the usual option only has a life of 9 months; this would lead to increased transaction costs.

***All of the following statements concerning capital market theory are correct EXCEPT A) the security market line (SML) is the graphical depiction of the capital asset pricing model (CAPM). B) the market risk premium is the difference between the expected return for the equities market and the risk-free rate of return. C) beta is a measure of volatility, or relative unsystematic risk, for stock or portfolio returns. D) the security market line (SML) depicts the tradeoff between risk and expected return for all assets, whether individual securities, inefficient portfolios, or efficient portfolios.

****C Beta is a measure of relative systematic risk for stock or portfolio returns. A stock or portfolio with a beta of 1.0 would have the same systematic risk as the overall market.

***Which of the following statements concerning market efficiency is not correct? A) The fundamental assumption of market efficiency is that current stock prices reflect all available information for a company and that prices rapidly adjust to reflect any new information. B) Any new information must be unexpected; therefore, any changes in the stock price resulting from this new information will be random. C) Investors who accept the efficient market hypothesis (EMH) usually adopt an active investment strategy. D) The efficient market hypothesis (EMH) is the proposition that the securities markets are efficient, with the prices of securities reflecting their current economic value.

***C Investors who accept the EMH usually adopt a passive investment strategy; investors who do not accept the EMH, pursue an active investment strategy. If the market is efficient, the best strategy is indexing rather than stock picking.

Hedging Long Stock and Long Puts: Portfolio insurance - If price of stock goes down exercise put and have the right to sell at the strike price Long Stock and Short Calls (Covered Call Writing) - reduces the risk of that long stock position and generates income - The covered call writer limits potential gain in exchange for the partial protection against a loss. - If the stock price falls below the purchase price minus the premium received, the investor incurs a loss. Should the stock price rise dramatically, the stock will likely be called. Short Stock and Long Calls: An investor who sells a stock short sells borrowed stock, expecting the price to decline. The short seller must buy stock to repay the stock loan and hopes to do so at a lower price. A short seller can buy calls to protect against a price rise.

An investor buys 100 shares of RST at 53 and writes 1 RST 55 call for 2. The premium offsets the stock price by the $2 per share premium received. The maximum gain equals $400: if the stock price rises above 55, the call will be exercised; thus, the investor will sell the stock for a gain of $200, in addition to the $200 premium received. The $200 premium initially received lowers the true cost of the stock to $51 per share so the investor is protected against loss for the first 2 points of market decline. The maximum loss is $5,100 (instead of $5,300) should the stock become worthless. An investor sells short 100 shares of RST at 58 and buys an RST 60 call for 3. The maximum loss is no longer unlimited as it would normally be for a short sale. Instead, it is $500: no matter how high the stock price rises above $60, the investor will exercise the call to buy the stock for 60, incurring a $200 loss on the short sale, in addition to the $300 paid for the call.