FIN 4504 Exam 1
What is the real return on an investment that earns a nominal 10% return during a period of 5% inflation?
0.048 or 4.8% Explanation: 1+r=(1+R)/(1+i) r= real interest rate R= Nominal Interest Rate i=inflation rate 1+r=(1+0.10)/(1+0.05)=0.048
Types of Investment Companies
1. Face Amount Certificate Companies 2. Unit Investment Trusts (UIT's) 3. Management Investment Companies A. Closed End B. Open End 4. Hedge Fund 5. Commingled Funds 6. REITs
Instrument Yields
360 days for money market instruments. 365 days for bond equivalent.
Suppose your combined tax bracket is 30%. Would you prefer to earn a 6% taxable return or a 4% tax-free yield? What is the equivalent taxable yield of the 4% tax-free yield?
A 6% taxable return is equivalent to an after-tax return of 6%(1 − .30) = 4.3%. Therefore, you would be better off in the taxable bond. The equivalent taxable yield of the tax-free bond is 4%/(1 − .3) = 5.71%. So a taxable bond would have to pay a 5.71% yield to provide the same after-tax return as a tax-free bond offering a 4% yield.
Derivative Asset
A security with a payoff that depends on the prices of other securities.
You short-sell 200 shares of Tuckerton Trading Co., now selling for $50 per share. What is your maximum possible gain, ignoring transactions cost? A. $10,000 B. $150 C. $50 D. unlimited
A. $10,000 Explanation: 200*50=10,000
You sold short 300 shares of common stock at $30 per share. The initial margin is 50%. You must put up ________. A. $4,500 B. $9,000 C. $6,000 D. $10,000
A. $4,500 Explanation: (300(30)-x)/(300(30))=0.50 (9000-x)/9000=0.50 x=4500
Active trading in markets and competition among securities analysts helps ensure that: I. Security prices approach informational efficiency. II. Riskier securities are priced to offer higher potential returns. III. Investors are unlikely to be able to consistently find under- or overvalued securities. A. I, II, and III B. I and II only C. II and III only D. I only
A. I, II, and III
Ownership of a call option entitles the owner to the ________ to ________ a specific stock, on or before a specific date, at a specific price. A. right; buy B. obligation; sell C. right; sell D. obligation; buy
A. right; buy
Net Asset Value
Amount that one share of a mutual fund is worth. NAV=(Market Value of Assets-Liabilities)/Shares Outstanding
The most marketable money market security is ________. A. bankers' acceptances B. Treasury bills C. certificates of deposit D. common stock
B. Treasury bills
If you thought prices of stock would be rising over the next few months, you might want to ________ on the stock. A. place a short-sale order B. purchase a call option C. sell a futures contract D. purchase a put option
B. purchase a call option
Assume that you have recently purchased 100 shares in an investment company. Upon examining the balance sheet, you note that the firm is reporting $225 million in assets, $30 million in liabilities, and 10 million shares outstanding. What is the net asset value (NAV) of these shares? A. $25.50 B. $1.95 C. $19.50 D. $22.50
C. $19.50 Explanation: Net Asset Value =Assets-liabilities/# of shares outstanding NAV =(225,000,000-30,000,000)/10,000,000 NAV =19.50
You purchased 200 shares of ABC common stock on margin at $50 per share. Assume the initial margin is 50% and the maintenance margin is 30%. You will get a margin call if the stock drops below ________. (Assume the stock pays no dividends, and ignore interest on the margin loan.) A. $26.55 B. $30.77 C. $35.71 D. $28.95
C. $35.71 Explanation: $50*200*50%=5000 Equity=200P-5000 margin=equity/share=maintenance margin 200P-5000/200P=0.30 P=35.71
A T-bill quote sheet has 90-day T-bill quotes with a 4.92 ask and a 4.86 bid. If the bill has a $10,000 face value, an investor could sell this bill for ________. A. $9,880.16 B. $9,877 C. $9,878.50 D. $10,000
C. $9,878.50 Explanation: = Face value * ( 1 - Ask * (days / 360)) = 10,000 * ( 1 - 4.86% * (90/360)) = $9,878.50
A tax free municipal bond provides a yield of 3.2%. What is the equivalent taxable yield on the bond given a 35% tax bracket? A. 5% B. 3.2% C. 4.92% D. 3.68%
C. 4.92% Explanation: Yield=0.032/(1-0.35)=0.0492
________ is not a money market instrument. A. Commercial paper B. A Treasury bill C. A Treasury bond D. A certificate of deposit
C. A Treasury bond
________ are examples of financial intermediaries. A. Insurance companies B. Commercial banks C. All of the options D. Investment companies
C. All of the options
Firm-specific or residual risk
Component of return variance that is independent of the market factor
An investor purchases one municipal bond and one corporate bond that pay rates of return of 5% and 6.4%, respectively. If the investor is in the 15% tax bracket, his after-tax rates of return on the municipal and corporate bonds would be, respectively, ________. A. 5% and 6.4% B. 5.75% and 5.44% C. 4.25% and 6.4% D. 5% and 5.44%
D. 5% and 5.44%
The interest rate charged by large banks in London to lend money among themselves is called ________. A. the federal funds rate B. the discount rate C. the prime rate D. LIBOR
D. LIBOR
The difference between the price at which a dealer is willing to buy and the price at which a dealer is willing to sell is called the ________. A. bid-ask gap B. market spread C. market variation D. bid-ask spread
D. bid-ask spread
Margin
Describes securities purchased with money borrowed in part from broker.
Buy a share of stock for $50, hold for 1 year, collect $1 dividend, and sell stock for $54 What were dividend yield, capital gain yield, and total return?
Dividend Yield: (Sell-Buy+Div)/Buy=($54-$50+$1)/$50=10% Capital Gain: Div/Buy=$1/$50=2% Total Return: (Sell-Buy)/Buy=(54-50)/50=8%
Efficient Frontier of Risky Assets
Graph representing set of portfolios that maximizes expected return at each level of portfolio risk Three methods •Maximize risk premium for any level standard deviation •Minimize standard deviation for any level risk premium •Maximize Sharpe ratio for any standard deviation or risk premium
Security Market Line (SML)
Graphical representation of the expected return-beta relationship of the CAPM. Graphs individual asset risk premiums as function of asset risk.
Maintenance Margin Requirement
Minimum amount equity can be before additional funds must be put into account. Exchanges mandate minimum 25%
Initial Margin Requirement (IMR)
Minimum set by Federal Reserve under Regulation T, currently 50% for stocks Minimum % initial investor equity 1 − IMR = Maximum % amount investor can borrow
Index Model
Model that relates stock returns to returns on both a broad market index and firm-specific factors
Futures Contract
Obliges traders to purchase or sell an asset at an agreed-upon price at a specified future date
Excess Return
Rate of return in excess of the risk-free rate
Real vs. Financial Assets
Real assets are assets used to produce goods and services. Financial Assets are claims on real assets or the income generated by them.
Beta
Sensitivity of security's returns to market factor.
Alpha
Stock's expected return beyond that induced by market index.
Market Participants
The legal entities that are involved in the process of buying and selling assets or liabilities in the respective markets. Brokers, custodians, hedgers, portfolio managers, investment advisers etc. are all market participants.
Ask Price
The price you would have to pay to buy a T-bill from a securities dealer.
Call Option
The right to buy an asset at a specified price on or before a specified expiration date.
Put Option
The right to sell an asset at a specified exercise price on or before a specified expiration date
Bid Price
The slightly lower price you would receive if you wanted to sell a bill to a dealer.
A T-bill with face value $10,000 and 87 days to maturity is selling at a bank discount ask yield of 3.4%. a. What is the price of the bill? b. What is its bond equivalent yield?
a. $9,917.83 b. 4.23% Explanation: a. (10,000-P)/10,000*(360/87) P=9,917.83 b. 10,000/9,917.83=1.0083*(365/87)=4.23%
A respected analyst forecasts that the return of the market index over the coming year will be 10%. The one-year T-bill rate is 5%. Examination of recent returns of the S&P 500 Index suggests that the standard deviation of returns will be 18%. a. What does this information suggest about the degree of risk aversion of the average investor, assuming that the average portfolio resembles the market index? b. What is the Sharpe ratio of the index portfolio
a. 1.54 b. 0.28 Explanation: a. A=(0.10-0.05)/(0.18^2)=1.54 b. S=(10-5)/18=0.28
Short Sale
the sale of shares not owned by the investor but borrowed through a broker and later purchased to replace the loan