Unit 22
A client purchased a security for $60 and sold it 1 year later for $59. If the client received four quarterly dividends of $0.50 each during the period, stated as a percentage, the total return would be A) 1.67%. B) 0%. C) 3.30%. D) 2%.
A) 1.67%. The total return on an investment is the sum of the capital gains/losses plus any income distribution such as dividends or interest. In this case, the client had a capital loss of $1 ($60 − $59 = $1), which was offset by $2 (4 × $0.50 = $2) in dividend distributions for a total dollar return of $1. In percentage terms, the return is calculated by dividing the dollar return amount by the total invested or $1 divided by $60 = 1.67%.
In order to compute the real rate of return for a security, it would be necessary to know all the following except A) the beta of the security B) the purchase price C) the annual dividend D) the CPI
A) the beta of the security The real rate of return is the actual return less the inflation rate as measured by the CPI.
If you knew a given stock had a 40% chance of earning a 10% return, a 40% chance of earning 20%, and a 20% chance of earning −10%, the stock would have A) a total return of 10% B) a probable rate of return of 10% C) a real rate of return of 10% D) an annualized return of 10%
B) a probable rate of return of 10% The probable return is computed by taking the probability of each possible return outcome and multiplying it by the return outcome itself. In this example, if you knew a given stock had a 40% chance of earning a 10% return, a 40% chance of earning 20%, and a 20% chance of earning -10%, the expected return would be equal to 10%: = (0.4 × 0.1) + (0.4 × 0.2) + (0.2 × −0.1) = 0.04 + 0.08 = 0.12 − 0.02 = 10% You probably will not have to do this calculation on the exam, but you should know the concept.
In the formula for determining the real rate of return, A) the inflation rate is divided by the investment return B) the inflation rate is subtracted from the investment return C) the marginal tax bracket is subtracted from the investment return D) the investment return is divided by the inflation rate
B) the inflation rate is subtracted from the investment return In computing the real rate of return, which represents inflation-adjusted compounding (or discounting), a formula is applied in which the rate of inflation (usually as measured by the CPI) is subtracted from the investor's rate of return.
The real interest rate of a fixed income investment is A) the coupon interest payment B) the interest earned after inflation C) interest earned adjusted for the investment's premium or discount price D) interest earned after taxes
B) the interest earned after inflation The real interest rate is the interest received minus the inflation rate.
If the Consumer Price Index (CPI) rose 5% during the past year, during which time your client held a 6% bond, what would be the approximate annualized inflation-adjusted return? A) 5% B) 0% C) 1% D) 6%
C) 1% Because inflation, as measured by the CPI, rose by 5% during the year and the client's bonds returned 6% annually, inflation would have reduced the client's purchasing power by 5%, leaving an inflation-adjusted return of 1% for that year.
An investor buys 100 shares of KAPCO stock for $120 per share. During the year, he receives $260 in dividends and, at the end of the year, the stock is worth $13,000. The investor's holding period return is A) 8.33%. B) 9.69%. C) 10.50%. D) 2.17%.
C) 10.50%. Holding period return is computed by dividing the total return from income (dividends or interest) plus appreciation (or minus depreciation), by the original cost. In this example, the investor received $260 in income and has $1,000 of appreciation. That is a total return of $1,260 divided by $12,000 or 10.50%.
The total return on a bond that cost an investor $950, was sold for $1,000, and paid $50 in interest payments is nearest to A) The return cannot be determined from the information supplied B) 5.26% C) 10.53% D) 10.00%
C) 10.53% The total return on a bond is the sum of the interest payments plus any capital gain recognized on the sale (or minus any loss) divided by the purchase price. In our question, the interest payments total $50. A bond purchased for $950 and sold for $1,000 has realized a $50 capital gain. Therefore, the investor has received a total of $100 which, when divided by the cost of $950, equals a return of 0.10526 or 10.53%.
Using the following information, compute the inflation-adjusted rate of return for an investor holding the ABC Corporation's 20-year bond: Coupon rate 5%, paid semi-annually Rating Aa Maturity date December 1, 2046 CPI 2% Par value $1,000 Purchase price 90 Call date December 1, 2033 Call price 101 A) 2.50% B) 4.50% C) 3.56% D) 5.56%
C) 3.56% The inflation-adjusted rate of return is the actual return (income received divided by the purchase price) less the inflation rate as measured by the CPI. In this example, the bond pays $50 per year on an investment of $900. That is an actual return of 5.56%. Subtracting the CPI of 2% gives us an inflation-adjusted, or real, rate of return of 3.56%.
The Sharpe ratio measures a stock's A) excess return earned compared to its systematic risk. B) excess return earned compared to its unsystematic risk. C) excess return earned compared to its total risk. D) return earned compared to its total risk.
C) excess return earned compared to its total risk. The Sharpe ratio is defined as a fund's excess return (fund's return exceeding the risk-free rate) divided by the total risk (standard deviation). LO 22.a
One element of the formula used to compute the Sharpe ratio is A) beta B) alpha C) standard deviation D) net present value
C) standard deviation Standard deviation is used as the denominator in the formula used to compute the Sharpe ratio, a risk-adjusted rate of return. Standard deviation generally reflects the variability of portfolios that are not well diversified, while beta generally reflects the volatility of portfolios that are well diversified. Net present value measures the theoretical intrinsic value of an investment having uneven cash flows.
In order to compute a client's realized holding period return, it is not necessary to know A) the original investment B) the ending value C) the paper profits and losses D) the income received
C) the paper profits and losses An investor's realized holding period return is the total return received over the specified holding period. That return includes any income plus or minus any realized gain or loss. That is why paper gains or losses, which are not realized, are not part of the computation.
A stock is currently worth $75. If the stock was purchased one year ago for $60, and the stock paid a $1.50 dividend over the course of the year, what is the holding period return? A) 22.0% B) 25.0% C) 24.0% D) 27.5%
D) 27.5% (75 − 60 + 1.50) ÷ 60 = 0.2750, or 27.5%.
Which of the following indices or averages is based on the prices of only 65 stocks (30 industrial, 20 transportation, and 15 utility)? A) Value Line B) S&P Composite C) Wilshire 5,000 D) Dow Jones Composite Average
D) Dow Jones Composite Average The most widely quoted and oldest measures of changes in stock prices are the Dow Jones averages. They are also the smallest in terms of the number of stocks included in the averages with only 65 stocks. It is the only price-weighted index on the exam; all of the others are cap-weighted.
Your firm's market analyst believes the current bullish market in equities will continue. Your moderately conservative clients should consider investing in an ETF or index fund tracking the A) Russell 2000. B) Dow Jones 15 utilities. C) MSCI EAFE. D) S&P 500.
D) S&P 500. The S&P 500 represents the largest companies and, as a result, is most suitable for a growth-oriented investor with a moderate risk tolerance. The Russell 2000 is the small-cap benchmark and carries more than a moderate level of risk as does the MSCI EAFE index which is composed of foreign securities. Utilities are for those who are more than moderately conservative. Furthermore, utilities, being defensive issues, are likely to participate in a bullish market to a very small degree.
In order to compute an investor's real rate of return on a common stock holding, all of the following are necessary except A) appreciation B) dividends C) inflation rate D) marginal tax bracket
D) marginal tax bracket The real rate of return is another term for inflation-adjusted return. It is the total return, which is appreciation plus income (dividends), which is then adjusted for the inflation rate as expressed by the CPI. Tax bracket is necessary to compute after-tax return.
An investment advisory firm tracks its performance against the S&P 400. From this, you could determine that this firm concentrates on A) large-cap securities. B) small-cap securities. C) Nasdaq securities. D) mid-cap securities.
D) mid-cap securities. The S&P 400 is known as the mid-cap index.
One measure of an investor's total return is called holding period return. The computation includes both income and appreciation and is used for both debt and equity securities. An investor's holding period return would exceed the bond's yield to maturity if A) the bond was redeemed at a discount. B) the investor purchased a put option on the bond. C) the bond was called at a premium. D) the coupons were reinvested at a rate exceeding the yield to maturity.
D) the coupons were reinvested at a rate exceeding the yield to maturity. The calculation of yield to maturity assumes reinvestment of the bond's interest at the coupon rate. Therefore, if the investor were able to do better than that, the holding period return would be increased. This is part of the concept of internal rate of return (IRR) which takes into consideration the time value of money (compounding). It is tempting to answer a call at a premium and that might, in fact, increase the total return, but we have no idea when the call takes place, at what price and the original purchase price of the bond. Just keep it simple—if the question says you can earn more than the YTM, your return will be higher than the quoted YTM.
