CFP Investment Planning Measures of Investment Returns

Anita bought ULA stock for $25,000 six years ago. Today, she sold the stock for $67,000. Calculate Anita's holding period return on ULA. A) 28.00% B) 8.40% C) 16.80% D) 168.00%

The answer is 168.00%. Anita's holding period rate of return was 168% {[(67,000 - 25,000) ÷ 25,000] × 100}. LO 7.1.1

Consider the following information for the CPM International Growth Fund: Average annual rate of return 7.45% Average market rate of return 8.50% Beta 1.25 Standard deviation 4.55% Risk-free rate of return 3.50% Select the statement that is NOT correct. A) Jensen's alpha for the fund is -2.30%. B) The fund manager underperformed the market over the given time frame. C) The Treynor ratio for the fund is 0.0400. D) The Sharpe ratio for the fund is 0.8681.

The answer is the Treynor ratio for the fund is 0.0400. Based on the information provided, the Treynor ratio for the fund is 0.0316, calculated as follows: Sharpe ratio = (0.0745 - 0.0350) ÷ 0.0455 = 0.8681 Treynor ratio = (0.0745 - 0.0350) ÷ 1.25 = 0.0316 Jensen's alpha = 7.45% - [3.50% + (8.50% - 3.50%) 1.25] = -2.30% When Jensen's alpha is positive, the fund manager outperformed the overall market. In this case, alpha indicates that the fund manager has underperformed. LO 7.2.1

Tripp is an investor in the 32% marginal tax bracket. If he invests in a 4.75% municipal bond, his taxable equivalent yield (TEY) would be A) 4.75%. B) 6.99%. C) 6.27%. D) 3.23%.

b Explanation taxable equivalent yield = tax-exempt yield ÷ (1 − marginal tax rate) = 4.75% ÷ (1 − 0.32) = 6.99% LO 7.4.1

Mark owns a corporate bond with a coupon rate of 6.78%. Assume the annual inflation rate is 2.5% and he is in the 35% federal marginal income tax bracket. Calculate his after-tax, inflation-adjusted rate of return on this bond. A) 2.04% B) 1.86% C) 1.50% D) 4.17%

Explanation The answer is 1.86%. First, calculate Mark's after-tax rate of return on the corporate bond [0.0678 × (1 - 0.35)] = 0.04407, or 4.41%. Next, calculate the after-tax, inflation-adjusted rate of return {[(1 + 0.0441) ÷ (1 + 0.025)] - 1} × 100 = 1.8634, or 1.86%. LO 7.1.1

An investor is researching a mutual fund. Last year this fund had a total return of 12% when the stock market had a 10% return. This fund has a beta of 1.2 and a standard deviation of 14%. The risk-free rate of return is 5%. What is the Sharpe ratio for this fund? A) 0.05 B) 0.62 C) 0.11 D) 0.50

The answer is 0.50. The Sharpe ratio is (the investment return - the risk-free return) divided by the investment's standard deviation. Therefore, (0.12 - 0.05) ÷ 14 = 0.07÷0.14 = 0.50. LO 7.2.1

Keegan is an analyst for Global Growth and Income Mutual Fund. For the past five years, the fund has returned -20%, 17%, 5%, 15%, and -7%, respectively. Calculate the geometric mean of these returns. A) 2.0000% B) 1.0221% C) 5.1105% D) 1.0018%

The answer is 1.0018%. The geometric mean return is calculated as follows: PV = -1 FV = (1 - 0.20)(1 + 0.17)(1 + 0.05)(1 + 0.15)(1 - 0.07) = 1.0511 N = 5 Solve for I/YR = 1.0018, or 1.0018% LO 7.1.1

Brenda is interested in calculating the inflation-adjusted rate of return of a recent investment. Assuming the after-tax return on her investment is 6.25% and the inflation rate is 5%, calculate the inflation-adjusted rate of return. A) 1.19% B) 11.25% C) 12.25% D) 1.25%

The answer is 1.19%. The inflation-adjusted rate of return is calculated as follows: [(1.0625 ÷ 1.05) − 1] × 100 = 1.19% LO 7.1.1

The yield to maturity on a zero-coupon bond ($1,000 par value) currently selling at $677 and maturing in four years is approximately A) 15.00% B) 10.00% C) 4.00% D) 37.48%

The answer is 10.00%. Solve for yield to maturity: END Mode, 2 P/YR PV = −677 FV = 1,000 PMT = 0 4, DOWNSHIFT, N = 8 Solve for I/YR = 10% (rounded). LO 7.4.1

What is the internal rate of return (IRR) on an investment that was purchased for $10,000, generated income at the end of Year 1 of $600, required an additional expenditure at the end of Year 2 of $300, and was sold at the end of Year 3 for $13,000? A) 9.50% B) 6.28% C) 12.11% D) 10.24%

The answer is 10.24%. Using the HP 10bII+: CF0 = (10,000) CF1 = 600 CF2 = (300) CF3 = 13,000 Solve for IRR/YR = 10.2432, or 10.24%. LO 7.1.1

Brantley recently purchased a new video game system on his credit card. Assuming the nominal annual percentage rate (APR) is 14.95% (compounded daily), calculate the effective annual rate (EAR). A) 15.02% B) 14.95% C) 16.12% D) 13.26%

The answer is 16.12%. The effective annual rate on his credit card is 16.12%, calculated as follows: EAR = [1 + (0.1495 ÷ 365)]365 - 1 = 0.1612, or 16.12%. LO 7.1.1

Jonathan purchased 500 shares of CPM stock for $12 per share. At the end of the first year, he made another purchase of 500 shares at a stock price of $12 per share. At the end of the third year, he sold all of the stock for $17 per share. In addition, the stock paid a dividend of 0.35 per share at the end of each year. Calculate the dollar-weighted return to Jonathan over the three-year period. A) 13.50% B) 11.63% C) 17.46% D) 15.60%

The answer is 17.46%. Jonathan earned a dollar-weighted rate of return of 17.46% on CPM stock over the three-year period, calculated as follows: CF0 = −12 × 500 = −6,000 CF1 = (−12 × 500) + (0.35 × 500) = −5,825 CF2 = (0.35 × 1,000) = 350 CF3 = (0.35 × 1,000) + (17 × 1,000) = 17,350 Solve for the internal rate of return (IRR/YR) = 17.4626, or 17.46% LO 7.1.1

Carolyn owns a corporate bond with a coupon rate of 3.60%. Currently, the inflation rate is 1.50%. Calculate the real rate of return on this bond. A) 5.10% B) 2.07% C) 2.10% D) 3.60%

The answer is 2.07%. The real rate of return on this bond is calculated as follows: [((1 + 0.036) ÷ (1 + 0.015)) - 1] × 100 = 0.0207 × 100 = 2.07% LO 7.1.1

Strahan Corporation's current annual common stock dividend is $3 and is expected to grow by 15% during the next year. The stock's current market price is $35 per share. If Strahan stock had a $30 market price one year ago, calculate the stock's total return. A) 26.67% B) 14.29% C) 8.57% D) 22.86%

The answer is 26.67%. A stock's total return (TR) = (the dividend received during a given period + the change in the stock's price during the same period) ÷ by the stock's current market value at the beginning of the period. Therefore, TR = ($3 + $5) ÷ $30 = 26.67%. LO 7.1.1

Leslie purchased a 10-year bond with a coupon rate of 4.75% paid semiannually. The bond has a current market price of $1,035. Calculate the yield to maturity (YTM) for Leslie's bond. A) 4.4520% B) 4.3118% C) 4.3154% D) 4.7500%

The answer is 4.3154%. The bond's YTM is calculated as follows: END Mode, 2 P/YR PV = −1035 FV = 1000 PMT = 4.75% × 1000 ÷ 2 = 23.75 10, DOWNSHIFT, N = 20 Solve for I/YR = 4.3154% The YTM for Leslie's bond is lower than its coupon rate because the bond is trading at a premium. LO 7.4.1

Eight years ago, ABC Company issued a 20-year bond with a 4% coupon rate. Due to a recent decline in market interest rates, the company decided to call the bonds for 103% of par value. Calculate the rate of return for an investor who purchased the bond at issue for par and surrendered it today for the call price. A) 4.32% B) 4.44% C) 4.10% D) 4.00%

The answer is 4.32%. The yield to call on this issue is calculated as follows: END Mode, 2 P/YR PV = -1000 FV = 1030 PMT = 4% x 1000 ÷ 2 = 20 8, DOWNSHIFT, N = 16 Solve for I/YR = 4.32% LO 7.4.1

Jefferson originally purchased 100 shares of XYZ stock for $45 per share. The stock is currently trading at $60 per share. The stock paid dividends of $2 per share in year 1 and $2.30 per share in year 2 (all paid at year end). If Jefferson has held the stock for two years, what is his holding period return? A) 19.0% B) 23.5% C) 42.9% D) 22.0%

The answer is 42.9%. This is calculated as: [($60 - $45) + $2 + $2.30] ÷ $45 = 42.9%. LO 7.1.1

Michael owns a municipal bond, trading at par, with a 4.25% coupon rate and is in the 32% federal marginal income tax bracket. Calculate the taxable equivalent yield (TEY) for this bond. A) 12.88% B) 6.25% C) 2.85% D) 5.65%

The answer is 6.25%. TEY = tax-exempt yield ÷ (1 − marginal tax rate) = 0.0425 ÷ (1 − 0.32) = 0.0625, or 6.25%. Therefore, the TEY for Michael's bond is 6.25%. Michael would require this rate of return or higher for an equivalent taxable bond. LO 7.4.1

Andy purchased a four-year bond with a coupon rate of 7.5% paid semiannually. The bond is trading for $1,025 in the secondary market. Calculate the bond's yield to maturity (YTM). A) 6.78% B) 3.39% C) 8.05% D) 4.34%

The answer is 6.78%. The bond's YTM is calculated as follows: END Mode, 2 P/YR PV = -1,025 FV = 1,000 PMT = 37.50 (1,000 × 7.5% ÷ 2) 4, DOWNSHIFT, N = 8 Solve for I/YR = 6.78%. LO 7.4.1

Al Jenkins owns a corporate bond that currently sells for $1,175. The coupon rate is 9%, interest is paid semiannually, and the bond matures in 20 years. The bond is callable in 11 years at $1,050. What is the yield to call on this bond? A) 6.72% B) 7.00% C) 7.42% D) 7.32%

The answer is 7.00%. The yield to call is calculated as follows: END Mode, 2 P/YR 11, DOWNSHIFT, N = 22 PV = -1175 FV= 1000 PMT = 9% x 1000 / 2 = 45 Solve for I/YR = 7.00% LO 7.4.1

A $1,000 U.S. Treasury note maturing in eight years is selling for $938.12. The semiannual coupon payment is $35. What is the yield to maturity (YTM) for the note? A) 8.06% B) 6.26% C) 4.03% D) 8.33%

The answer is 8.06%. The note's YTM is computed as follows: END Mode, 2 P/YR PV = −938.12 PMT = 35 FV = 1,000 8, DOWNSHIFT, N = 16 Solve for I/YR = 8.06% LO 7.4.1

The current yield of an 8% coupon bond, maturing in five years, and selling currently for $850 is A) 8.56%. B) 6.73%. C) 9.41%. D) 10.14%.

The answer is 9.41%. Current yield = annual interest payment ÷ current market price = $80 ÷ $850 = 0.09412, or 9.41%. LO 7.4.1

You are choosing between two investments: Mutual Fund A with a return of 12% and a standard deviation of 18%, and Mutual Fund B with a return of 8% with a standard deviation of 12%. If the risk-free rate is 3%, which fund should you choose based upon one of the risk-adjusted return measurements? A) Either Fund A or Fund B B) Fund A C) Fund B D) Not enough information is provided

The answer is Fund A. Enough information is given to calculate the Sharpe ratio for each investment. For Fund A (12 - 3) ÷ 18 = 0.50. For Fund B (8 - 3) ÷ 12 = 0.42. The higher the ratio, the better, so Fund A is the best choice. LO 7.2.1

Cindy has been an active investor for many years. She currently has a money market mutual fund and several equity mutual funds. She wants to maximize her return on an intermediate-term bond and plans to hold the bond to maturity. Which of the following two bonds would be more appropriate for Cindy, and why? Bond 1: callable at par value; BBB rated; coupon = 6%; matures in six years; selling for $863; duration = 5.16 Bond 2: callable at par value; A rated; coupon = 10%; matures in four years; selling for $1,103; duration = 3.5 Bond 1, because it is selling for a discount and is less likely to be called. Bond 1, because it has a higher yield to maturity than Bond 2. Bond 2, because its higher coupon gives it a better total return. Bond 2, because it has a higher yield to maturity than Bond 1.

The answer is I and II. YTM for Bond 1: END Mode, 2 P/YR -863 = PV 1000 = FV 30 = PMT 6, DOWNSHIFT, N = 12 Solve for I/YR = 9% And for Bond 2: PV = -1103 FV = 1000 PMT = 50 4, DOWNSHIFT, N = 8 Solve for I/YR =7% In addition, Bond 1 is selling at a discount—unlike Bond 2 selling at a premium—so it is not likely to be called. LO 7.4.1

A client of yours, George, wants to maximize his return on an intermediate-term bond that he plans to hold until maturity. You have gathered information on the following two bonds, both of which have a $1,000 par value. Bond 1: A rated; coupon rate of 6%; matures in 6 years and pays interest semiannually; currently selling for $850; duration is 5.16 years. Bond 2: A rated; coupon rate of 10%; matures in 8 years and pays interest semiannually; currently selling for $1,100; duration is 7.15 years. Which of these bonds would you recommend to George and why? Bond 1 because it has a higher yield to maturity than Bond 2 Bond 2 because its higher coupon rate gives it a superior total return to Bond 1 Bond 2 because it has a higher duration than Bond 1 A) II and III B) II only C) I only D) III only

The answer is I only. Bond 1's YTM (9.32%) is higher than Bond 2's YTM (8.26%) For both calculations, END Mode, 2 P/YR. Bond 1: PV = -850 FV = 1000 PMT = 30 (6% × $1,000 ÷ 2) 6, DOWNSHIFT, N = 12 Solve for I/YR = 9.32% Bond 2: PV = -1100 FV = 1000 PMT = 50 (10% × 1,000 ÷ 2) 8, DOWNSHIFT, N = 16 Solve for I/YR = 8.26%. LO 7.4.1

Which of the following are characteristics of the Sharpe ratio? The ratio adjusts the return for variability by using standard deviation as the measure of risk. The ratio assumes that the portfolio being evaluated is well diversified. Both alpha and beta appear in the formula for the ratio. The ratio indicates by how much the realized return differs from the return expected by the capital asset pricing model. A) II and III B) III and IV C) I and II D) I only

The answer is I only. Statements II, III, and IV are true of Jensen's alpha. Statement II is true of the Treynor ratio. LO 7.2.1

XYZ Company issued a series of bonds 20 years ago. The bonds originally sold at par, have a 6.25% coupon rate (paid semiannually), and mature in 30 years. Five years after issue, the prevailing market interest rate for similar type bonds was 5.15%. Based on this information, identify which of the following statements are CORRECT. The bond's yield to maturity at issue was 6.25%. The bond's price five years after issue was $1,153.68. The current yield of the bond five years after issue was 5.42%. The bond was selling at a discount in the secondary market five years after issue. A) I and II B) I, II, and III C) III and IV D) II, III, and IV

The answer is I, II, and III. Because the bond was selling for a price exceeding the par value, the bond was trading at a premium. A bond selling for par at issue will have a yield to maturity equal to the annual coupon rate. Statement II: END Mode, 2 P/YR FV =1,000 PMT = 62.50 ÷ 2 = 31.25 25, DOWNSHIFT, N = 50 I/YR = 5.15 Solve for PV = 1,153.68, or $1,153.68 Statement III: Current yield = $62.50 ÷ $1,153.68 (found in Statement II) Current yield = 0.0542, or 5.42% LO 7.4.1

An investor who would like to know how a portfolio manager performed relative to how the manager was expected to perform on a risk-adjusted basis would use which one of the following indicators? A) Treynor ratio B) Beta C) Sharpe ratio D) Jensen's alpha

The answer is Jensen's alpha. The indicator that measures performance in relation to what was expected on a risk-adjusted basis is Jensen's alpha. A positive number (alpha) indicates that the manager performed better than expected on a risk-adjusted basis. LO 7.2.1

During his next meeting with his financial advisor, Zachary would like to compare the performance of his international investments against a benchmark. Select the appropriate benchmark to use for this comparison. A) MSCI EAFE Index B) S&P 500 Index C) Dow Jones Industrial Average D) Wilshire 5000 Index

The answer is MSCI EAFE Index. The MSCI EAFE Index is used as a measure of the international securities markets. The other choices are not used to measure international investments, rather, they are used as benchmarks for domestic issues. LO 7.3.1

Which of the following would be an appropriate index to track an investment in an international developed markets mutual fund? A) IFC Investable B) MSCI EAFE C) Russell 2000 D) IFC Emerging Markets Free Global

The answer is MSCI EAFE. The MSCI EAFE Index tracks markets in Europe, Australasia, and the Far East (primarily Japan). LO 7.3.1

Your client owns a small-cap fund and wants to compare its performance to an appropriate benchmark. You would advise him to choose which benchmark? A) MSCI EAFE B) Russell 2000 C) Russell 3000 D) S&P 500

The answer is Russell 2000. The Russell 2000 is a small-cap index. LO 7.3.1

Adam is trying to evaluate the performance of his portfolio on a risk-adjusted basis. He has a nondiversified portfolio of large-cap stocks. He knows there are different measures of risk-adjusted performance and is not sure which one to use. Which of the following is the most appropriate measure to use? A) Jensen, because it compares a portfolio's return to that of a market index. B) Sharpe, because when a portfolio represents the entire investment fund, standard deviation is a better measure of risk. C) Treynor, because when a portfolio represents one subportfolio of a large diversified portfolio, beta is a better measure of risk. D) Sharpe, because it is used to compute alpha by comparing the Sharpe ratio for a portfolio with the Sharpe ratio for the S&P 500.

The answer is Sharpe, because when a portfolio represents the entire investment fund, standard deviation is a better measure of risk. The Sharpe ratio must be computed for a benchmark, which is then compared to the performance of a portfolio. The Treynor ratio is used when the performance of a subportfolio is measured. Alpha is computed using the Jensen performance measure. LO 7.2.1

The performance of two growth and income mutual funds is displayed below: ABC Fund XYZ Fund Average annual rate of return 8.65% 6.78% Standard deviation of returns 5.86% 9.98% Beta 0.75 1.00 Assuming a risk-free rate of return of 5%, which of these statements is CORRECT? A) All of these statements are correct. B) XYZ Fund has a higher level of systematic risk than ABC Fund. C) Based on the Treynor ratio, ABC Fund has a better risk-adjusted performance than XYZ Fund. D) The Sharpe ratio for XYZ Fund is 0.1784 and 0.6229 for ABC Fund.

The answer is all of the statements are correct. When compared with another investment, the higher the Treynor ratio, the better the risk-adjusted performance of the asset. Therefore, ABC Fund with a Treynor ratio of 0.0487 has a better risk-adjusted performance than XYZ Fund. XYZ Fund has a beta greater than ABC Fund, indicating a higher level of systematic risk. Calculations: Treynor ratio for ABC Fund is 0.0487 [(0.0865 - 0.05) ÷ 0.75] Treynor ratio for XYZ Fund is 0.0178 [(0.0678 - 0.05) ÷ 1.00] Sharpe ratio for ABC Fund is 0.6229 [(0.0865 - 0.05) ÷ 0.0586] Sharpe ratio for XYZ Fund is 0.1784 [(0.0678 - 0.05) ÷ 0.0998] LO 7.4.1

The Sharpe ratio A) uses the portfolio tracking error. B) does not assume the portfolio is well diversified. C) uses the portfolio's beta. D) assumes the portfolio is well diversified.

The answer is does not assume the portfolio is well diversified. The Sharpe ratio uses standard deviation in its denominator and, therefore, is a catchall formula that may be used to compare the performance of all portfolios whether they are diversified or not. LO 7.2.1

What type of index is the Dow Jones Industrial Average (DJIA)? A) Value-weighted B) Capitalization-weighted C) Price-weighted D) Equal-weighted

The answer is price-weighted. The DJIA is price-weighted, meaning that higher-priced stocks will have more impact on the average than lower-priced stocks. Cap-weighted, which is the same as value-weighted, means the prices of stocks with the largest capitalization relative to the market capitalization of the entire index will have the greatest impact on the index. Equally weighted means that the price movement of each stock in an index has the same impact as that of any other stock in the index. LO 7.3.1

The Allegro Mutual Fund has an alpha of +1.50, a Sharpe ratio of 0.44, and an R2 with the Russell 2000 of 0.45. The Moderato Mutual Fund has an alpha of +0.40, a Sharpe ratio of 0.48, and an R2 with the Russell 2000 of 0.52. Which fund should be chosen and why? A) The Moderato Fund because it has a higher Sharpe ratio. B) The Allegro Fund because it has a lower Sharpe ratio. C) The Moderato Fund because it has a lower alpha. D) The Allegro Fund because it has a higher alpha.

The answer is the Moderato Fund because has a higher Sharpe ratio. In order to use alpha (which uses beta in the formula), beta needs to be a reliable number. This can be determined by R2, which gives the level of systematic risk. The R2 for both funds is low (0.45 and 0.52), meaning beta, and formulas using beta, should not be used. You want an R2 of 0.70 or higher in order to use beta. This then leaves you with Sharpe, and the Moderato Fund has the highest Sharpe ratio of the two. LO 7.2.1

Shannon is evaluating the absolute performance of the Shining Star mutual fund. The return of the fund for the past year was 13%, beta is 1.10, and standard deviation is 23. The market return is 9.5%, and the risk-free rate is 4.5%. Which of the following statements is true? A) The fund's alpha is +3, meaning that the fund manager achieved a higher return than required for the risk taken. B) The fund's alpha cannot be determined; however, 13% is a good relative return. C) The fund's Treynor ratio is 7.73, meaning the fund manager achieved a 7.73% higher return than required for the amount of risk taken. D) The fund's Sharpe ratio is 0.37, meaning this fund should be chosen when compared with another fund with a Sharpe ratio of 0.48.

The answer is the fund's alpha is +3, meaning that the fund manager achieved a higher return than required for the amount of risk taken. Alpha is an absolute measure that is simply the difference between the return of the portfolio and the required return (CAPM). The formula is rp - [rf + (rm - rf)β. 13 - [4.5 + (9.5 - 4.5)1.1] = 3. Treynor and Sharpe are comparative or relative measures, and you would choose the investment with the highest number. Alpha is an absolute measure, giving you the actual return above the required return. LO 7.2.1

When using a security market index to represent a market's performance, the performance of that market over time is best represented by A) the percent change in the index value. B) the change in the index value. C) the index value. D) the change in the standard deviation of the index.

The answer is the percent change in the index value. Percentage changes in the value of a security market index over time represent the performance of the market, segment, or asset class from which the securities are chosen. LO 7.3.1

To evaluate the performance of a portfolio manager, you should calculate the portfolio's A) portfolio return. B) dollar-weighted return. C) holding period return. D) time-weighted return.

The answer is time-weighted return. Because portfolio managers have no control over the deposits and withdrawals made by clients, the time-weighted return is a more appropriate measure of performance. LO 7.1.1

Robin purchased a 20-year bond with a duration of 11 years for $1,323.18. Which of the following statements is CORRECT? A) The yield to maturity (YTM) is less than both the current yield and the coupon rate. B) The coupon rate is lower than the YTM, and the current yield should be higher than the coupon rate. C) The current yield is higher than both the coupon rate and the yield to maturity. D) The coupon rate is higher than the yield to maturity, and the YTM is higher than the current yield.

a CR = coupon rate CY = current yield YTM = yield to maturity Premium bonds: CR > CY > YTM Par bonds: CR = CY = YTM Discount bonds: CR < CY < YTM Because the bond was purchased at a premium, the yield to maturity is less than both the current yield and the coupon rate. LO 7.4.1

Quincy has narrowed his choice down to the following four mid-cap funds, which is a category he wants to add to his portfolio. Which fund should Quincy choose? A Fund J Fund Q Fund Z Fund Return 12% 9% 13% 11% Alpha 0.52 -1.04 0.66 1.10 Treynor 0.68 0.21 0.58 0.62 Sharpe 0.44 0.32 0.21 0.37 R-squared 0.88 0.78 0.82 0.84 A) J Fund B) Z Fund C) A Fund D) Q Fund

b The R-squared for all four funds is greater than 0.70, meaning beta is reliable. Alpha uses beta, and is a measure of absolute return, and the best measure to use if beta is reliable. The fund with the highest alpha is the Z fund. LO 7.2.1

Which of the following statements regarding the various performance measures are CORRECT? A positive alpha indicates that the manager consistently underperformed the market on a risk-adjusted basis. Jensen's alpha indicates how much the realized return differs from the expected return, as per the capital asset pricing model (CAPM). The Sharpe ratio is not useful for evaluating the performance of nondiversified portfolios. The Treynor ratio does not indicate whether a portfolio manager outperformed or underperformed the market portfolio. A) II, III, and IV B) II and IV C) I and II D) I and III

b The answer is II and IV. Statements I and III are incorrect. A positive alpha indicates that the manager outperformed the market on a risk-adjusted basis. The Sharpe ratio uses total risk, as measured by standard deviation, and is useful for evaluating the performance of both nondiversified and well-diversified portfolios. LO 7.2.1

If a mutual fund's beta and standard deviation are expected to decrease in the future, its average annual return and the market average annual return are expected to remain the same, and the risk-free rate is expected to remain constant, which of the following shows the real effect this would have on the following performance measures? Option Alpha Sharpe Ratio A increase decrease B decrease decrease C decrease increase D increase increase A) Option A B) Option D C) Option B D) Option C

b The answer is Option D. A decrease in the risk level decreases the denominator of the Sharpe ratio, while the numerator stays constant, thereby increasing the Sharpe ratio. The decreased risk level, as measured by beta, decreases the expected return for the fund, while the actual portfolio return remains constant, thereby increasing the alpha. LO 7.2.1

Brandon owns ABC mutual fund that has produced the following returns over the past three years: Year 1: 4.7% Year 2: −10.0% Year 3: 6.5% Based on this information, calculate both the arithmetic mean (AM) and geometric mean (GM) returns for this series. A) arithmetic mean: 7.07%; geometric mean: 7.04% B) arithmetic mean: 0.40%; geometric mean: 0.1182% C) arithmetic mean: −0.40%; geometric mean: −7.04% D) arithmetic mean: −3.93%; geometric mean: −0.1182%

b The answer is arithmetic mean: 0.40%; geometric mean: 0.1182%. The arithmetic mean is calculated as follows: (4.7% - 10.0% + 6.5%) ÷ 3. The geometric mean is calculated as follows: PV = -1, FV = (1.047)(0.90)(1.065), PMT = 0, N = 3, solve for I/YR = 0.1182. LO 7.1.1

A mutual fund with an investment objective of growth and income has an alpha of +4, a beta of 1.5, and a Sharpe ratio of 1.15. The fund A) should not be purchased even though the rate of return compensates for the level of risk. B) should be purchased, because the rate of return is high in relation to risk. C) should not be purchased, because it has a low level of return in relation to risk. D) should be purchased, because it has a relatively low level of risk in relation to return.

b The answer is should be purchased, because the rate of return is high in relation to risk. A positive alpha indicates the fund performed better than it should have on a risk-adjusted basis. Also, an alpha of +4, which is very high, means it performed 4% better than expected. LO 7.2.1

Capitalization-weighted indexes are A) characterized by higher-priced stocks having more influence on the overall movement of the index than lower-priced stocks. B) uncommon and not suitable for performance measurement. C) the preferred type of index to use in modern portfolio theory applications. D) constructed by giving each investment equal weighting.

c Explanation The answer is the preferred type of index to use in modern portfolio theory applications. Capitalization weighted indexes are the most prevalent type of index and are best suited for modern portfolio theory applications. In a price-weighted index, higher-priced stocks within this index have more influence on the overall movement of this index than lower-priced stocks. LO 7.3.1

A(n) ______________________ average allows small companies to have as much influence as large companies in the average; a(n)_________________ average gives greater influence to large companies than to small companies in the average; and a(n) ______________________ average gives greater influence to high-priced stocks than to low-priced stocks in the average. A) capitalization-weighted; price-weighted; equally weighted B) price-weighted; capitalization-weighted; equally weighted C) equally weighted; capitalization-weighted; price-weighted D) price-weighted; equally weighted; capitalization-weighted

c For a price-weighted index, higher priced stocks have more influence on the overall movement of this index than lower priced stocks. For a market capitalization weighted index, such as the S&P 500, a stock with a market capitalization value of $25 million will have 10 times the impact of a stock with a market capitalization value of a $2.5 million company. LO 7.3.1

Assume an investor purchased $10,000 of Fund ABC at the beginning of Year 1. Subsequently, he made investments at the beginning of Years 2, 3, and 4 of $1,000, $5,000, and $8,000, respectively. At the beginning of Year 5, the fund was worth $33,000. What was the internal rate of return (IRR) on this fund? A) 14.31% B) 10.08% C) 12.79% D) 20.55%

c The answer is 12.79%. This problem involves calculating the IRR/YR for uneven cash flows per the following inputs. Using the HP 10bII+: (10,000) CFj, (1,000) CFj (5,000) CFj (8,000) CFj 33,000 CFj SHIFT, IRR/YR = 12.79% LO 7.1.1

Five years ago, XYZ Company issued a 20-year bond with a 4.75% coupon paid semiannually. The bond may be called at 104% of par, 10 years after issue. Assuming the bond is currently selling for $990, calculate the bond's yield to call. A) 5.68% B) 4.95% C) 2.84% D) 5.18%

c The answer is 5.68%. The bond's yield to call is calculated as follows: Note: XYZ Company has the option to call the issue in five years. END Mode, 2 P/YR PV = -990 5, DOWNSHIFT, N = 10 PMT = 23.75 (4.75% x 1000 = 47.50 ÷ 2) FV = 1,040 (1,000 × 1.04) Solve for I/YR = 5.68% LO 7.4.1

Your client purchased a call of KLN Corp. for $800. The exercise price was $35, and the market price of KLN Corp. stock was $38. Six months later, the market price of KLN Corp. stock was $40 and the client sold the call for $1,250. What was the holding period return on this investment? A) 14.28% B) 8.57% C) 63.82% D) 56.25%

d Explanation HPR=sale price − purchase pricepurchase price=1,250−800800=56.25%HPR=sale price − purchase pricepurchase price=1,250−800800=56.25% LO 7.1.1

Which of the following statements regarding security market indexes is CORRECT? A) The Russell 2000 Index is a well-known index used to benchmark large capitalization companies. B) Market indexes reflect the average price behavior of a group of stocks at a given point in time. C) The Wilshire 100 Index is used as a measure of the financial stock sector. D) The S&P 500 Index automatically adjusts for stock splits and dividends by focusing on market value instead of price.

d The answer is the S&P 500 Index automatically adjusts for stock splits and dividends by focusing on market value instead of price. The Russell 2000 Index is a well-known index used to benchmark small capitalization companies. A market average, not a market index, reflects the average price behavior of a group of stocks at a given point in time. An index measures the current price behavior of a group of stocks in relation to a base value. The Wilshire 5000 index is used as a measure of the U.S. broad market. LO 7.3.1