Unit 21
An investor has $50,000 to invest in bonds. Currently, 10-year bonds are offering very attractive yields, but the client is concerned that in a few years, rates will be even higher. What would you suggest? A) Barbell strategy B) Bullet strategy C) Laddering D) Diversifying
A) Barbell strategy With the barbell strategy, the investor would place $25,000 into bonds maturing in 10 years and the other half into bonds maturing in two years. This makes $25,000 available for reinvestment in two years enabling the investor to take advantage of the higher rates (if they materialize).
Which of the following is a characteristic of the passive investment style? A) High portfolio turnover B) Rebalancing C) Tactical management D) Income rather than growth objective
B) Rebalancing 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.
Which of the following statements is true? A) A growth company would be more likely to pay a cash dividend than a stock dividend. B) A corporation is required to pay a cash dividend to stockholders if the earnings are sufficient, especially if it is of preferred stock. C) Dividends have a significant influence on the value of the corporation's stock. D) A stock split increases the owner's proportionate share of the company.
C) Dividends have a significant influence on the value of the corporation's stock. Dividends play a large role in what someone is willing to pay for the stock. For example, the dividend discount model (DDM) values a stock as the discounted present value of future dividends. A company is not required to pay dividends. A growth company will tend to pay no cash dividends but rather use the money for expansion.
While attending a seminar given by one of your firm's analysts, you hear the term, feasible set. That would mean the discussion was dealing with the topic of A) opportunity cost B) a range of returns C) the efficient frontier D) convexity
C) the efficient frontier The feasible set of portfolios represents all portfolios that can be constructed from a given set of stocks. An efficient portfolio is a feasible portfolio that provides the greatest expected return for a given amount of risk, or equivalently, the least risk for a given amount of expected return. This is also called an optimal portfolio. The efficient frontier is the set of all efficient portfolios. Obviously, an investor should choose a portfolio along the efficient frontier.
Although there is no universal agreement on numbers, the minimum threshold for a stock to be considered large-cap is A) $25 billion B) $10 million C) $100 billion D) $10 billion
D) $10 billion Explanation At least for testing purposes, consider any company with a market cap of at least $10 billion to be large-cap. In recent years, the term mega-cap has come into use for those companies with a market cap of $200 billion or more.
If the current risk-free rate is 5%, and the expected return on the market is 10%, what return can be expected from a security that has a beta of 1.5? A) 20% B) 15.5% C) 15% D) 12.5%
D) 12.5% Explanation The formula for this is: risk-free rate plus the (difference between the market return and the RF) times the beta. In this question, those numbers are: 5% + [(10% - 5%) × 1.5] = 5% + (5% x 1.5) = 5% + 7.5% = 12.5%.
Which of the following is not a characteristic of the active management approach to investing? A) Focus on beating the market B) Attempt to predict market changes C) Higher expenses as compared to passive approaches D) Belief in random walk theory and efficient markets
D) Belief in random walk theory and efficient markets Explanation Proponents of the active management approach do not believe that markets are completely efficient or random. Instead, they feel that it is possible to predict market movements and to achieve returns that beat the market. Because an active approach to investment management involves more frequent trading and research than passive approaches, the active approach is generally more expensive to maintain.
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) 11.30% B) 7.80% C) 8.85% D) 12.35%
A) 11.30% The formula for the required return is: E(R) = Rf + (E (RM) - Rf) × Beta or 0.035 + (1.3 × [0.095 - 0.035]) = 0.035 + 0.078 = 0.113, or 11.3%.
The current market interest rate for a bond rated AA with 20 years to maturity is 5%. In an efficient market, a similar bond with a coupon of 4% could be expected to have an internal rate of return of A) 5%. B) 8%. C) 4%. D) 6%.
A) 5%. In an efficient market, bonds are priced so that their NPV is zero. That means the bond's yield to maturity is equal to the current market interest rates for similar bonds. When that rate is 5%, as is given in this question, all AA bonds with 20 years remaining to maturity should have a YTM of 5%.
All the following factors support fundamental analysis while assessing a wide range of qualitative factors except A) the company's stock price trend. B) the company's management team's quality and experience. C) the company's competitive position. D) the company's business model.
A) the company's stock price trend. The company's stock price trend is important to technical analysis. Remember that a technician "charts prices and volume over time". The others are factors to consider in fundamental analysis.
Each of the following terms is commonly found in modern portfolio theory except A) the internal rate of return B) the feasible set C) the efficient set D) the capital asset pricing model
A) the internal rate of return Internal rate of return (IRR) is not a component of modern portfolio theory as are the other 3 terms.
An investor begins contributing $600 on the third day of each month to a purchase plan for the KAPCO Total Return Fund. For the first six months, the per share prices were: $10 $12 $15 $20 $12 $8 What is this investor's breakeven point? A) $8.00 per share B) $11.80 per share C) $12.83 per share D) $12.50 per share
B) $11.80 per share This is a dollar cost averaging question. This investor has purchased a total of 305 shares with a total cost of $3,600. Here's the math: Month 1- $600 divided by $10 = 60 shares Month 2 - $600 divided by $12 = 50 shares Month 3 - $600 divided by $15 = 40 shares Month 4 - $600 divided by $20 = 30 shares Month 5 - $600 divided by $12 = 50 shares Month 6 - $600 divided by $8 = 75 shares The total expenditure was $3,600 (6 months××$600) and the total number of shares purchased was 305. That makes the average cost per share $11.80 ($3,600 divided by 305). With the investor's average cost per share being $11.80, a sale of the shares at that price will cause the investor to break even.
An investor has $50,000 to invest in bonds. Currently, 10-year bonds are offering very attractive yields, but the client is concerned that in a few years, rates will be even higher. What would you suggest? A) Bullet strategy B) Barbell strategy C) Diversifying D) Laddering
B) Barbell strategy With the barbell strategy, the investor would place $25,000 into bonds maturing in 10 years and the other half into bonds maturing in two years. This makes $25,000 available for reinvestment in two years enabling the investor to take advantage of the higher rates (if they materialize).
Which of the following is the simplest portfolio management style for individual stocks? A) Moving averages B) Buy and hold C) Indexing D) Core
B) Buy and hold The key to answering this question correctly is recognizing that it is dealing with individual stocks. If the question dealt with managing a portfolio, then indexing would be the simplest style.
A fundamental analyst would be most interested in which of the following? A) A 200-day moving average B) Resistance and support levels C) A P/E analysis of the stocks included in the Dow Jones Industrial Average D) The outstanding short interest in the market
C) A P/E analysis of the stocks included in the Dow Jones Industrial Average Fundamentalists look at P/E ratios; the other tools mentioned are technical.
Which efficient market hypothesis suggests that an investor can achieve above-market returns only by utilizing insider information? A) Super-strong B) Strong C) Semi-strong D) Weak
C) Semi-strong The semi-strong form suggests that fundamental analysis is of no value, and only through the use of insider information can an investor achieve above-market returns. The weak form suggests that technical analysis is of no value, and the strong form suggests that nothing has any value, that efficient markets are totally random.
An investor wants to moderate overall portfolio risk and return profile with assets that have a low correlation to traditional asset classes. Which of the following is an appropriate asset class for the investor? A) Small-cap shares B) Treasury bills C) Corporate bonds D) Private equity
D) Private equity Explanation Alternative asset classes like hedge funds, private equity, and commodities help moderate overall portfolio risk and different return profiles from traditional asset classes like stocks and bonds.
There are several financial models that refer to the "risk-free" rate of return. Which of the following instruments is used to measure that rate? A) 91-day Treasury bill B) 30-year Treasury bond C) Federal funds D) 1-year CD
A) 91-day Treasury bill The standard benchmark used to measure the "risk-free" rate of return is the 91-day (13 week) Treasury bill.
Based on the following information, which stock is most likely to appeal to a growth investor? A) Dividend yield of 0.3% B) Book value of $22 per share, current market value of $17 per share C) P/E ratio of 8:1 D) Dividend payout ratio of 65%
A) Dividend yield of 0.3% Growth investors usually seek stocks with high-growth expectations, reflected by a higher-than-normal P/E ratio, typically 20:1 or higher, and a low dividend yield, usually caused by a low dividend payout ratio. It would be unlikely to find a growth stock selling for close to its book value and certainly not below it.
Wrap fee accounts would tend to be most suitable for investors who follow A) a tactical approach to investing B) a buy-and-hold philosophy C) a strategic approach to the market D) a passive approach to investing
A) a tactical approach to investing Because one of the key benefits to the wrap fee program is the elimination of transaction fees (commissions), it is most suitable for those who are active traders, such as those who take a tactical approach to investing. The other 3 choices engage in far less trading activity, potentially not being able to take full advantage of all of the benefits of the wrap program.
The weak form of the efficient market hypothesis A) implies that technical analysis is not worthwhile. B) implies that inside traders cannot earn superior risk-adjusted returns. C) reinforces the value of technical analysis. D) implies that fundamental analysis is not worthwhile.
A) implies that technical analysis is not worthwhile. The weak form implies that information contained in historical stock prices is fully incorporated into current stock prices; therefore, technical analysis (the study of historical prices and volume) is not worthwhile in predicting future prices. This form neither refutes fundamental analysis nor implies that traders using insider information cannot earn superior profits.
During the analysis of XYZ stock, a technical analyst concludes that XYZ's support level has been broken. Being a technician, the most appropriate decision should be to A) rate the stock as a sell. B) rate the stock as a buy. C) purchase additional shares of the stock. D) rate the stock as a hold.
A) rate the stock as a sell. If a support level is broken, this provides a sell signal. Once the stock has lost its support, expectations are that it will continue to fall. The breaking of a resistance level, as the price of the asset gathers momentum to the upside, indicates a buying opportunity.
Which of the following is not associated with passive investment management approaches? A) Belief in efficient markets B) Goal of beating the market C) Belief in the random walk theory D) Use of index investing
B) Goal of beating the market Proponents of passive-management approaches believe in the random walk theory (market movements are unpredictable) and efficient markets (any information that could affect a stock's price is quickly reflected in its price). As a result, they feel that it is impossible to consistently beat the market. Index investing is a commonly used passive-management approach.
A successful dollar cost averaging strategy requires I. stable market conditions II. volatile market conditions III. a fixed dollar amount invested monthly IV. a fixed number of shares purchased monthly A) I and III B) II and III C) II and IV D) I and IV
B) II and III Dollar cost averaging requires a fixed dollar investment on a periodic or monthly basis. This strategy is most effective when prices in the market are volatile.
What is the risk measure associated with the capital market line (CML)? A) Systematic risk B) Alpha C) Standard deviation D) Beta
C) Standard deviation In the context of the CML, the measure of risk is total risk, or standard deviation. Beta (systematic risk) is used to measure risk for the security market line (SML).
An analyst is reviewing a report on Company X. The report shows a P/E ratio of 10, compared with an industry average of 27. Based on the most current quarterly payment, X has a dividend yield of 3.65%. The analyst notices there is a footnote indicating the company has put $1.2 billion away for what it refers to as a rainy day fund. most likely, Company X would be considered A) a utility stock B) a growth stock C) a value stock D) a small-cap stock
C) a value stock Although there are no hard and fast rules, when a company's P/E ratio is substantially lower than its industry average and the dividend yield is fairly high, it will be considered to have great value. Solidifying this decision is the notation that there is the rather large rainy day fund. Yes, utility stocks do pay liberal dividends but what must be noticed here is the low P/E ratio compared with its peers.
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) maintaining a constant dollar plan B) following a constant ratio plan C) dollar cost averaging D) rebalancing
C) dollar cost averaging Dollar cost averaging is the investment formula where an investor invests the same amount at regular intervals.
A securities market investment theory that attempts to derive the expected return on an assetbased upon the asset's systematic risk is A) the Monte Carlo simulation. B) the random walk theory. C) the capital asset pricing model (CAPM). D) the efficient market hypothesis (EMH).
C) the capital asset pricing model (CAPM). The capital asset pricing model (CAPM) attempts to describe the relationship between the systematic risk and the expected return of the asset in an effort to determine the asset's appropriate price.
Which of the following attributes best describes a tactical asset allocation portfolio style? A) Has an aggressive growth objective B) Employs a strategic management style C) Employs an active management style D) Employs a passive management style
C) Employs an active management style Tactical asset allocation managers actively manage their portfolios, switching the percentage of holding in each asset category according to the performance of the asset class. An aggressive growth manager would actively pursue specific growth securities such as stocks and not allocate funds between bonds, real estate, or other asset categories. A passive or strategic style is, as the name implies, relatively inactive rather than active.
The statement, "Stock prices fully reflect all information from public and private sources," can be attributed to which form of the efficient market hypothesis (EMH)? A) Weak form B) Semi-strong form C) Strong form D) Semi-weak form
C) Strong form This statement is the definition of the strong form EMH. Private sources include insider information, such as persons holding non-public access to information relevant to the company. Weak includes historical pricing and volume information. Semi-strong includes all publicly-available information, such as earnings reports. There is no such thing as semi-weak.
An investment manager is looking at 10 possible stocks to include in a client's portfolio. In order to create the most efficient portfolio, the manager must A) include only the stocks that have the highest volatility at a given expected rate of return. B) include only the stocks that have the lowest volatility at a given expected rate of return. C) include all 10 stocks in the portfolio in equal amounts. D) find the combination of stocks that produces a portfolio with the maximum expected rate of return at a given level of risk.
D) find the combination of stocks that produces a portfolio with the maximum expected rate of return at a given level of risk. Explanation The most efficient portfolio will be the one that lies on the efficient frontier. It will offer the highest expected return at a given level of risk compared to all other possible portfolios.
Which investment strategy is consistent with a belief in the efficient market hypothesis? A) Waiting to purchase a stock until it increases above the 40-day moving average B) Selecting a random set of stocks for a portfolio C) Comparing the calculated value of a security, through fundamental analysis, to the market value of the stock D) Searching for undervalued securities
B) Selecting a random set of stocks for a portfolio The efficient market hypothesis states that an investor cannot consistently outperform the market. Selecting a random set of stocks is consistent with this theory. The other strategies are aligned with technical and fundamental analysis.
A stock has been in a downtrend for several days. When its price decreases to near $30, many investors enter orders to buy the stock and the price increases to $31. This is most likely an example of A) a reversal. B) a support level. C) a resistance level. D) a change in polarity.
B) a support level. The downtrend reached a support level where buying demand sustained the price. A resistance level is a price at which selling pressure emerges that stops an uptrend.
An advantage of dollar cost averaging is that it results in an average cost per share that is less than the stock's average price, assuming which of the following? I. The price of the underlying shares fluctuates. II. A set number of shares is purchased regularly. III. A set dollar amount is invested regularly. IV. A set dollar amount of investments is maintained. A) I and II B) II and IV C) III and IV D) I and III
D) I and III Explanation Dollar cost averaging results in a lower average cost per share, provided the share price fluctuates and the same number of dollars is invested at each interval (e.g., monthly).
The strong-form efficient market hypothesis (EMH) asserts that stock prices fully reflect which of the following types of information? A) Public, private, and future B) Inside only C) Market D) Public and private
D) Public and private Explanation The strong form EMH assumes that stock prices fully reflect all information from public and private (inside) sources. That is why proponents of EMH engage in passive strategies, such as using index funds and ETFs.
High-tech Industries (HTI) went public 4 years ago by issuing 100 million shares of common stock at $1 per share. HTI's earnings have soared and the stock is now selling for $13 per share. HTI would be considered A) a mid-cap stock. B) a micro-cap stock. C) a large-cap stock. D) a small-cap stock.
D) a small-cap stock. Explanation It is only today's market price multiplied by the number of shares outstanding that determines a stock's market capitalization. With 100 million shares at $13 per share, HTI has a market cap of $1.3 billion. That puts it in the small-cap range. When the stock was first issued, its market cap was only $100 million. At that time, it was a micro-cap stock.
Which of the following statements regarding the growth style of investing is correct? A) Growth managers believe that, although a firm's earnings are depressed now, the earnings will rise in the future as they revert to the historical range. B) Growth managers focus on the denominator in the P/E ratio, searching for firms and industries where high expected earnings growth will drive the stock price up even higher. C) Growth managers look for a high-dividend yield and often take a contrarian approach. D) Growth managers focus on the numerator in the P/E ratio, desiring a low stock price relative to earnings or book value of assets.
B) Growth managers focus on the denominator in the P/E ratio, searching for firms and industries where high expected earnings growth will drive the stock price up even higher. High P/E ratios are one of the keynotes of growth investing. The other choices here all relate to the value style.
Which of the following statements are generally true of the buy-and-hold strategy? I. Equities would grow relative to fixed income II. Lower taxes and transactional costs III. Easy to manage IV. The portfolio would more accurately demonstrate the client's investment objectives and risk tolerance A) I and II B) I, II, and III C) III and IV D) II, III, and IV
B) I, II, and III Over the long run, using the buy-and-hold strategy with equity securities has outperformed the rate of return on fixed income investments. With few transactions, there are almost no commissions and capital gains taxes. Of all strategies, this is the easiest to follow. There is no way to determine the client's objectives or risk tolerance based on the decision to buy and hold. The portfolio might contain small-cap stocks or large-cap stocks. It might contain 90% equities or 75% debt securities. Investors with differing goals and risk tolerance can use this strategy.
Which of the following are methods of portfolio rebalancing? I. You can sell off investments from over-weighted asset categories and use the proceeds to purchase investments for under-weighted asset categories. II. You can purchase new investments for under-weighted asset categories. III. If you are making continuous contributions to the portfolio, you can alter your contributions so that more investments go to under-weighted asset categories until your portfolio is back into balance. IV. You can purchase new investments for better performing asset categories. A) I, III, and IV. B) I, II, and III. C) III and IV. D) I and III.
B) I, II, and III. When rebalancing, the goal is to get the portfolio back to a desired ratio between asset classes. Better performing assets are sold because they are now over-weighted.
To a technical analyst, the resistance level signifies the price at which a stock's supply would be expected to A) remain constant. B) increase substantially. C) cause the stock price to "break out". D) decrease substantially.
B) increase substantially. This is about comparing support and resistance levels. Most stock prices remain relatively stable and fluctuate up and down. The lower limit to these fluctuations is called a support level - the price range where a stock appears cheap and attracts buyers. The upper limit is called a resistance level - the price range where a stock appears expensive and initiates increased selling. This selling represents an oversupply of the stock which results in downward pressure on the stock.
Which of the following is an example of dollar cost averaging? A) Rebalancing your portfolio each quarter on the 20th of the month B) Maintaining a constant ratio plan C) Buying 20 shares of the XYZ Fund each month on the 20th of the month D) Investing $100 into the XYZ Fund each month on the 20th of the month
D) Investing $100 into the XYZ Fund each month on the 20th of the month Explanation Dollar cost averaging is that formula method of investing that contemplates investing a fixed amount of money, in this case $100 at regular intervals, in this case on the 20th of each month, regardless of price swings in the market. By doing so, more shares are bought when the price is low and fewer when the price is high.
Derivatives have a major role to play in the management of many large portfolios and can be used for all of the following except A) asset allocation. B) income. C) hedging. D) highly risk-averse investors.
D) highly risk-averse investors. Explanation Derivatives are generally not appropriate for highly risk-adverse investors due to the risk and sophistication involved. Some of the common uses of derivatives are for: Hedging to reduce the impact of adverse price movements (e.g., by buying put options or selling futures contracts). Anticipating future cash flows. Asset allocation changes. Income (selling options).
Which of the following would an investor who believes in MPT probably select for a client? A) JKL, with a return of 15% and a standard deviation of 15 B) GHI, with a return of 13% and a standard deviation of 20 C) DEF, with a return of 13% and a standard deviation of 18 D) ABC, with a return of 11% and a standard deviation of 15
A) JKL, with a return of 15% and a standard deviation of 15 Modern portfolio theory (MPT) proponents believe that the most appropriate investments are those that offer the greatest return with the lowest risk. JKL has delivered the highest return with a standard deviation (risk) equal to that of ABC (which has a much lower return).
One of the goals of modern portfolio theory (MPT) is to construct a portfolio that provides the highest return with the lowest risk. This would be known as A) the Sharpe's portfolio B) the efficient portfolio C) the risk-free portfolio D) the managed portfolio
B) the efficient portfolio According to Harry Markowitz, the founder of MPT, the goal is to craft an "efficient" portfolio. An efficient portfolio is a portfolio that offers the highest expected return for a given level of risk. The line that connects all these efficient portfolios is the efficient frontier. The efficient frontier represents that set of portfolios that has the maximum rate of return for every given level of risk.
An investor who uses dollar cost averaging to purchase a mutual fund would A) invest the same amount of money each month B) invest in a bond fund during a falling market and a stock fund during a rising market C) allocate assets equally among cash, stocks, and bonds D) purchase the same number of shares each month
A) invest the same amount of money each month In the dollar cost averaging investment strategy, the amount of dollars invested each month remains constant. Accordingly, the investor will automatically buy more shares when the price is low to reduce the average cost per share.
Formula methods of investing that involve selling equities in rising markets and buying them in falling markets would include I. constant dollar plan II. constant ratio plan III. dollar cost averaging IV. DRIPs A) I and II B) II and III C) I and IV D) III and IV
A) I and II In both a constant dollar plan and a constant ratio plan, the goal is to maintain a balance between equity and debt securities in the portfolio. This is done by selling equities as their price rises (the proportion has now changed) and buying equities when the prices fall to get back to the constant dollar or ratio. Both dollar cost averaging and dividend reinvestment programs (DRIPs) involve buying securities at regular intervals, not buying and selling based on the direction of the market.
An investor plans to fund the college education for her newborn child by purchasing $5,000 of investment-grade bonds on an annual basis. She is most likely using A) the bullet strategy. B) the barbell strategy. C) the 529 plan strategy. D) the laddering strategy.
A) the bullet strategy. The bullet strategy is used when aiming at a target. In this case, the target is having sufficient funds about 18 years from now. This strategy involves buying bonds at different intervals, but all with approximately the same maturity date. The barbell strategy has all bonds purchased at the same time with two different sets of maturities - half of the bonds mature near term and half mature intermediate term. Laddering requires purchasing bonds on a regular basis, but not with new funds as this investor is doing. As bonds mature, the proceeds are rolled-over into new bonds. She may be doing this in a 529 plan, but the plan is not a strategy, it is a type of account.
Which form of the efficient market hypothesis (EMH) suggests that fundamental analysis and insider information may produce above-market returns? A) Strong B) Weak C) Semi-strong D) Semi-weak
B) Weak The weak form holds that current stock prices reflect all historical market data and that historical price trends are therefore of no value in predicting future prices. However, this form holds that credible fundamental analysis and insider information may produce above-market returns. Those who truly believe in the EMH are of the opinion that none of these will do any better than the market; random selection is as good as anything else.
A fundamental analyst researching a stock is concerned with all of the following except A) management efficiency B) volume of shares traded C) capitalization ratio D) the stock's market price as a multiple of the company's earnings
B) volume of shares traded A fundamental analyst is concerned with the economic climate, the inflation rate, how an industry is performing, a company's historical earnings trends, how it is capitalized, and its product lines, management, and financial statement ratios, such as the P/E ratio. A technical analyst is concerned with trading volumes or market trends and prices.
You have a client who wishes to manage his own portfolio of individual stocks. The simplest style for him to follow would be A) tactical B) indexing C) buy and hold D) core
C) buy and hold When it comes to individual stocks, nothing is simpler than buy and hold. If the client wished to have the simplest overall portfolio and didn't want to manage things, then indexing would be the answer.
Two contrasting styles of portfolio management are growth and value. Which of the following pairs best describes the contrast? A) Capital structure/earnings per share B) High P/E ratio/low current ratio C) Dividend yield/dividend payout ratio D) Earnings momentum/book value
D) Earnings momentum/book value Explanation One of the important metrics to growth managers is the rate at which the company is growing. Earnings momentum is an excellent indicator of that. On the other hand, the primary tool of the value manager is the company's financial statements. Value managers frequently look for companies whose market price is less than their book value. Perhaps you misread "low current ratio" as "low P/E ratio" (which would have been a correct contrast). This is why you have to read each word carefully.
Which of the following actions would you most likely expect from a contrarian investor? A) Buy when most other investors are buying B) Sell when most other investors are selling C) Buy stocks trading near or below to their book values D) Sell when most other investors are buying
D) Sell when most other investors are buying Explanation Contrarian investors trade in the opposite direction from most other investors.
When using the dividend discount model, A) the discount rate is generally lower than the expected rate of return B) best results are obtained from stocks that pay irregular dividends C) the degree of accuracy in forecasting the price of preferred stock is less than that obtained by using the dividend growth model D) future expected dividends are discounted to compute the present value of the stock
D) future expected dividends are discounted to compute the present value of the stock Explanation This method of common stock valuation takes the investor's expected future dividend returns and then discounts that amount by the expected rate of return to arrive at the supposed present value. Expected (or required) rate of return is a component of both the dividend discount model and the dividend growth model, and only the DDM is used for preferred stocks because the dividend can never increase. When using any dividend model, the greater the regularity of dividends, the more accurate the forecast.
Which of the following is not correct regarding the capital asset pricing model (CAPM)? A) CAPM only considers the systematic risk. B) The market risk premium is the incentive required for the individual to invest in the securities market. C) CAPM uses standard deviation as a measure of market risk. D) The stock risk premium is the inducement necessary to entice the individual to invest in a particular stock.
C) CAPM uses standard deviation as a measure of market risk. CAPM accounts for the impact of systematic risk (as measured by beta) only and does not take into consideration unsystematic risk, which is assumed to have been diversified away.
An investor with a bearish outlook on the future market price of the common stock of Amalgamated Metals Processing Corporation (AMPC) sells 600 shares of the stock short. The investor's account is credited with the proceeds of $30,000. As the investor's representative, you might suggest which of the following actions to hedge this position? A) Sell 6 AMPC 55 puts B) Buy 6 AMPC 55 puts C) Sell 6 AMPC 55 calls D) Buy 6 AMPC 55 calls
D) Buy 6 AMPC 55 calls Explanation When using options to hedge, we recommend purchasing options with the opposite view. That is, when one shorts stock (bearish), the hedge is to buy options that are bullish (calls). Because the proceeds from the short sale of 600 shares was $30,000, the price per share was $50. The risk with a short sale is unlimited because the short stock will have to be replaced, and there is potentially no limit on how high the price of the stock can go. By purchasing AMPC 55 calls, the short seller has capped the maximum cost of covering the short at the strike price of $55 regardless of how high the market price rises. Selling the puts is a hedge to the extent of the premium, but given the choice, we always buy our hedges.
Which of the following would you most likely consider characteristics of a growth stock? A) Low P/E and low dividend yield B) Low P/E and high dividend yield C) High P/E and high dividend yield D) High P/E and low dividend yield
D) High P/E and low dividend yield Explanation Growth stocks generally have high P/E ratios and low (or no) dividends. Value stocks normally have low P/E ratios with higher dividend payouts.
All of the following statements concerning capital market theory are correct except A) the market risk premium is the difference between the expected return for the equities market and the risk-free rate of return. B) beta is a measure of volatility, or relative unsystematic risk, for stock or portfolio returns. C) the security market line (SML) is the graphical depiction of the capital asset pricing model (CAPM). 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.
B) beta is a measure of volatility, or relative unsystematic risk, for stock or portfolio returns. 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.
An investment adviser has the practice of rebalancing client portfolios on an annual basis. This would be an example of which management style? A) Churning B) Market timing. C) Strategic asset management D) Tactical asset management
C) Strategic asset management Strategic asset management, which is basically a passive strategy, views the market on a long-term basis. The manager does recognize that, over the period of one year, market and economic changes can result in managed portfolios becoming out of balance. That is, the portfolio mix no longer matches what was originally designed. Bringing the portfolio back into balance is the process of rebalancing. Tactical asset management, a good example of which is market timing, looks at the short run changes and moves in and out of positions as necessary. Churning is the practice of excessive trading in a brokerage account for the purpose of generating commissions and is not considered a management style.
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 bullet strategy. B) the interest discount model. C) the laddering strategy. D) the barbell strategy.
C) the laddering strategy. 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. The barbell strategy has all bonds purchased at the same time with two different sets of maturities - half of the bonds mature near term and half mature intermediate term. The bullet strategy is used when aiming at a target. This strategy involves buying bonds at different intervals, but all with approximately the same maturity date. There is no such thing as the interest discount model - perhaps you confused it with the dividend discount model used with equity securities.
Which of the following is not correct regarding the capital asset pricing model (CAPM)? A) The stock risk premium is the inducement necessary to entice the individual to invest in a particular stock. B) CAPM only considers the systematic risk. C) The market risk premium is the incentive required for the individual to invest in the securities market. D) CAPM uses standard deviation as a measure of market risk.
D) CAPM uses standard deviation as a measure of market risk. Explanation CAPM accounts for the impact of systematic risk (as measured by beta) only and does not take into consideration unsystematic risk, which is assumed to have been diversified away.
Which of the following factors would be considered by an investor who uses fundamental analysis to value a company's stock? I. The company's financial condition, as revealed by its income statement and balance sheet II. General economic conditions, such as employment levels and changes in interest rates III. Charts showing past movements in stock prices and trading volumes A) I, II, and III B) I and III C) II and III D) I and II
D) I and II Explanation Fundamental analysis attempts to value stock by examining general economic conditions and the company's financial condition and growth prospects. Technical analysis, on the other hand, tries to identify trends and predict changes in the market. Charts showing past price movements and trading volumes would be used in technical analysis but not in fundamental analysis.
An increase in the earnings per share growth rate from one reporting period to the next is called A) price-to-earnings ratio. B) profitability. C) finding alpha. D) earnings momentum.
D) earnings momentum. Explanation When a company's rate of earnings per share growth is increasing, that is, not only is the company becoming more profitable, but it is doing so at an accelerating rate, analysts call that earnings momentum. The company may or may not be generating positive alpha. We would have to know its beta, the risk-free rate, the market return, and the stock's return to compute that. It is likely that earnings momentum would cause the P/E ratio to increase, but that doesn't answer the question. Earnings momentum is one of the goals of the growth style of investing.
There are several popular investment styles and, in many cases, portfolio managers use a blended approach to security selection. If a portfolio manager adhered to a pure value style, he would put most of his focus on A) projecting future earnings based on past earnings B) lagging indicators C) using technical analysis D) the company's financial statements
D) the company's financial statements Explanation The value style of portfolio management looks for stocks that are undervalued. For example, the current market price is near or less than book value per share. The only way to find that out is by looking at the company's balance sheet.
A customer who follows a strict dollar cost averaging program to acquire shares in a diversified common stock mutual fund should achieve A) lower average cost to acquire fund shares relative to the fund's average price over the buying period B) reasonable assurance against loss of principal, presuming the customer dollar cost averages over an extended period C) allocation among various funds within a single investment company's family of funds D) significant reduction of market risk due to enhanced diversification
A) lower average cost to acquire fund shares relative to the fund's average price over the buying period By investing a constant amount of dollars at regular intervals, the investor buys fewer shares when the fund's price rises and more shares when the share price drops, thereby lowering the average cost. There is no assurance against loss of principal.
A support level is the price range at which a technical analyst would expect A) the demand for a stock to increase substantially. B) the demand for a stock to decrease substantially. C) the supply of a stock to decrease substantially. D) the supply of a stock to increase substantially.
A) the demand for a stock to increase substantially. Most stock prices remain relatively stable and fluctuate up and down from their true value. The lower limit to these fluctuations is called a support level, the price range where a stock appears cheap and attracts buyers. The upper limit is called a resistance level. Generally, a support level will develop after a stock has experienced a steady decline from a higher price level. Technicians believe that at some price during the decline, those investors who have been waiting for a reversal to get into the stock will now buy. When the price reaches this support price, demand surges, and price and volume begin to increase again. Other terms that may be used in this context are overbought and oversold. Overbought generally refers to the resistance level. Interest in buying the stock has begun to dry up and the price of the stock plateaus. Oversold is when the opposite occurs: there are few sellers to be found and the price of the stock bottoms. In either case, the next move is a reversal: down when the stock is overbought and up when oversold.
An investor decides to make monthly investments into the KAPCO Growth Fund. Each month, the investor purchases 10 shares of the fund. Over a 4-month period, the investor accumulated 40 shares at the following prices: Month 1 - $10 Month 2 - $8 Month 3 - $12 Month 4 - $10 If, instead of purchasing 10 shares per month, the investor had invested $100 per month, A) the investor's cost basis would be the same. B) the investor would have acquired 40.833 shares instead of 40 shares. C) the investor would have acquired 40 shares in either case. D) the investor would have paid slightly more in the second case.
B) the investor would have acquired 40.833 shares instead of 40 shares. This shows the benefit of dollar cost averaging. This investor purchased 40 shares at a total cost of $400 or an average of $10 per share. If $100 per month had been invested instead, the total would have been the same $400, but the number of shares acquired would have been 40.833. In the first month, $100 divided by $10 = 10 shares. In the second month, $100 divided by $8 =12.5 shares. In the third month, $100 divided by $12 = 8.333 shares, and in the fourth month, $100 divided by $10 = 10 shares. That is a total of 40.833 shares instead of 40 shares; a better deal for the investor. With a total cost of $400 and 40.833 shares, the cost basis per share is slightly less than $9.80 per share instead of $10 per share.
