Unit 23
Benchmark: S&P 500
-500 large-cap stocks -market value (cap) weighted -standard benchmark for large-cap equity
Benchmark: Dow Jones
-Price weighted (so it's an average of all 30 stock) -30 large cap stocks
Benchmark: Wilshire 5000
-broadest indicator of US equities market -approx 3500 securities
Benchmark: Russell 2000
-small cap stocks
Current Yield (stock)
Annual Dividend rate / Current Market Price
A bond of standard size has a nominal yield of 6%, paid in the customary fashion. The bond matures in 10 years, is callable at $105 in 5 years, and is currently priced at $110. An investor calculating the bond's yield to call would include A) the gain of $50 when called. B) the semiannual interest payments of $30. C) 20 payment periods. D) the loss of $100 at maturity.
B) the semiannual interest payments of $30. The yield to call computation involves knowing the amount of interest payments to be received, the length of time to the call, the current price, and the call price. A bond with a 6% coupon (nominal yield) will make $30 interest payments twice each year. Remember, unless otherwise stated, bonds have a par value of $1,000 and customarily pay interest semiannually. With a 5-year call, there are only 10 payment periods, not 20. The loss at call is $50 ($1,100 - $1,050); there is no gain and the loss at maturity of $100 is only relevant for YTM, not YTC. U23LO1
Returns when bonds are trading at premium
Whenever a bond is selling at a premium, the return, in descending order is: nominal yield, current yield, YTM, and YTC
One year ago, ABC Widgets, Inc., funded an expansion to its manufacturing facilities by issuing a 20-year first mortgage bond. The bond is secured by the new building and land and is callable at par 15 years after the issue date. The bond was issued with a 5.5% coupon and is currently rated Aa. If the current market price of the bond is 105, A) the yield to call is higher than the current yield. B) the nominal yield is lower than the current yield. C) the yield to call is lower than the yield to maturity. D) the yield to maturity is higher than the current yield.
C) the yield to call is lower than the yield to maturity.
After-Tax Return
is computed by taking the total return (appreciation plus income) and taking the investor's tax rate into consideration
Correlation
measures the movement of one security in relationship to the movement of another
real interest rate
the interest rate corrected for the effects of inflation (nominal rate - inflation rate)
YTM (yield to maturity)
the rate of return a bondholder will receive if the bond is held to maturity
Yield to Call (YTC)
the rate of return earned on a bond when it is called before its maturity date
Sharpe Ratio
used to measure risk-adjusted returns
Which of the indices or averages is based on the prices of only 65 stocks (30 industrial, 20 transportation, and 15 utility)?
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.
Standard deviation
measures the volatility of a security
The minimum rate of return that a reasonable investor will accept to acquire an investment (required rate of return) is generally determined by A) the investor's marginal federal income tax bracket B) the Federal Reserve Board (FRB) through its open-market operations C) the current risk-free rate of return plus the risk premium D) the investor's previous investment experience
C) the current risk-free rate of return plus the risk premium Reasonable investors relate return to the level of risk assumed; on Treasury bills, this is considered the risk-free rate. An investor in other than risk-free Treasury bills would require a premium to compensate for the additional risk taken. U23LO2
An investor owns a common stock that has been paying a dividend at an annual rate of $2.00. If the investor buys 100 shares of the stock at $50 and sells it 3 months later for $52, the approximate annualized rate of return is A) 4% B) 5% C) 12% D) 20%
D) 20% Annualized rate of return is computed by taking the investor's total return and annualizing it. In this case, the investor had $2 of appreciation and $0.50 (1 quarter) in dividends. Total return of $2.50 divided by the $50 cost is 5%. But, that is for 3 months − 1 quarter. Multiply that by 4 to get the annual rate.
Current Dividend Yield
The yield on a given investment based on its current price. You can calculate this by dividing the dividend paid for the year into the current price. Example: If the price of a stock decreases and the dividend remains the same, dividend yield will increase.
ABC's stock has paid a regular dividend every quarter for the past several years. If the price of the stock has remained the same over the past year, but the dividend amount per share has increased, it may be concluded that ABC's A) current yield per share has increased B) current yield per share has been unaffected C) yield to maturity has gone up D) current yield per share has decreased
A) current yield per share has increased The current yield would have increased because current yield is the income (dividend) divided by price. A higher dividend divided by the same price results in a higher yield. Stocks do not have a yield to maturity. U23LO1
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 coupons were reinvested at a rate exceeding the yield to maturity C) the investor purchased a put option on the bond D) the bond was called at a premium
B) 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. U23LO2
On June 20, 2016, an investor in the 30% marginal federal tax bracket acquired a growth stock paying no dividend for $10 per share. On June 22, 2017, the investor sold the stock for $20 per share. Presuming capital gains rates are 15%, the investor's after-tax rate of return is closest to A) 200% B) 70% C) 85% D) 100%
C) 85% Although the stock grew at a 100% rate of return (by doubling), the investor must pay capital gains tax on the investment at 15%, and the investor realizes an after-tax rate of return of approximately 85%. Because the investor held the stock for more than 1 year, the sale is taxed at a favorable capital gains rate rather than at the investor's ordinary income tax rate. U23LO2
Net Present Value (NPV)
the difference between an investment's market value and its cost
An agent making a sales presentation to a client about a mutual fund's historical returns is required to explain to the client the difference between the fund's A) current yield and total return. B) current yield and holding period return. C) total return and risk-adjusted return. D) current yield and real return.
A) current yield and total return. When comparing to a benchmark, it is common to show various return computations. In connection with the solicitation of investment company shares, it is considered an unfair business practice to discuss returns without fully explaining the difference between current yield and total return. U23LO1
A company with 20 million shares outstanding paid $36 million in dividends. If the current market value of the company's shares is $36, the current yield is A) 2% B) 5% C) 10% D) not determinable from the information given
B) 5% The current yield formula is annual dividends per share divided by current market price. The dividends per share are $36 million ÷ 20 million shares = $1.80 per share. Current yield is $1.80 ÷ $36.00 = 5%.
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) MSCI EAFE B) S&P 500 C) Russell 2000 D) Dow Jones 15 utilities
B) 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.
When a bond is selling at a premium, a bond callable at par will A) have a YTC that is more than the coupon B) have a YTC that is less than the YTM C) have a current yield that is less than the YTM D) have a YTM that is more than the coupon
B) have a YTC that is less than the YTM A bond selling at a premium will always have a yield that is lower than the coupon. Highest of the computed yields will be the current yield because, unlike the YTM or the YTC, the loss at payoff of the principal is not included. Comparing YTM and YTC, because in both cases the investor is getting back the same par value, the YTC is lower because the loss is occurring sooner (bonds are always called prior to maturity). U23LO1
An investor purchases a 6% callable senior lien mortgage bond at par. Exactly two years later, the bond is called at 102½. The investor's total return is A) 8.5%. B) 7.25%. C) 9.5%. D) 14.5%.
D) 14.5%. Total return consists of income plus gain. Buying this bond at par and having it called at 102½ ($1,025) results in a $25 gain. With a 6% coupon, there will be four semiannual interest payments of $30 in a two-year holding period. Adding the $25 + $120 = $145 total return on an investment of $1,000 which = 14.5%. Please note that the question didn't ask for the annualized rate of return. That would be approximately 7.25% per year. U23LO2
During the past year, the market price of Kapco common stock has increased from $47 to $50 per share. Over that period, Kapco's earnings per share (EPS) have increased from $2.00 to $2.50 per share, and their dividend payout ratio has decreased from 50% to 40%. Based on this information, the current yield on Kapco common stock is A) 2.13% B) 4.26% C) 6.34% D) 2%
D) 2% The current yield on a stock is computed by dividing the annual dividend rate by the current market price. With EPS of $2.50 and a 40% payout ratio, the annual dividend is $1.00. This dollar divided by the current market price of $50.00 results in a current return of 2%.
