Midterm 1
A company's gross operating profit is: A. gross sales - cost of goods sold B. gross profit - administrative and marketing costs C. operating profit - bond interest expense and taxes D. earnings for common - common dividend
The best answer is A. Gross profit margin is: Gross Sales - Cost of Goods Sold Net operating profit margin is: Gross Profit - Operating Expenses (Administrative, Marketing, Transportation) Net profit margin is: Operating Profit - Bond Interest Expense and Taxes When analyzing an income statement, net profit margin, because it deducts EVERY expense from sales, is the best measure of profitability.
Which of the following statements describes a universal life insurance policy? A. The policy owner can change the schedule of premium payments B. The cash value is invested in equities in separate accounts C. The death benefit is fixed and guaranteed for the insured's entire life D. Premium payments are low for a young insured and increase with age
The best answer is A. With a universal life insurance policy, the policy owner can change the schedule of premium payments. After the cash value increases, the owner can skip a premium payment or the policy owner can use the cash value to buy additional insurance. The cash value is not invested in equities, but is invested in the insurer's general account. Whole life offers a fixed death benefit that is guaranteed for the insured's entire life. Term life has low premiums for young insured individuals, but the premiums increase with each renewal as that person ages.
An investment adviser representative has been reviewing the likelihood that an equity investment will produce the desired return. He has determined that the mean return on the investment is 15%, with a 12% standard deviation, and a 95% probability of occurrence. This means that he would expect the range of returns to be approximately: A. 3.00% - 27.00% B. 13.20% - 16.80% C. 2.64% - 23.76% D. 10.20% - 13.80%
The best answer is A. A 12% standard deviation means that the investment return can vary plus or minus 12% from the mean (average) return over the course of a year. With a 15% average (mean) return, it might fall as low as 3% (15% - 12% deviation); or it might rise as high as 27% (15% + 12% deviation). The probability of the return falling in this range is 95%. This has nothing to do with the actual calculation of the range of returns. The "probability" of investment returns looks at historical investment return data to see how much investment returns have varied over the years. Historical investment returns follow a "normal distribution," which when plotted on a graph looks like a bell shaped curve. The mean return is the center of the "bell." Returns over time tend to center around the "mean" - the farther away one gets from the mean (either up or down), the less the likelihood of that return occurring. A 1 Standard Deviation move ( + or - ) encompasses 68% of the data history (the bulk of the bell curve); A move of 2 Standard Deviations ( + or - ) encompasses 95% of the data history; Historically, investment returns have not varied by more than 2 standard deviation moves in a given year For equities as measured by the Standard and Poor's 500 Index, this has been a maximum variance of: +/-15% that is equal to a 1 standard deviation move with a probability of occurrence of 68%. +/-30% that is equal to a 2 standard deviation move with a probability of occurrence of 95%. Based on this historical pattern, when stock prices dropped by 45% in 2008, the probability of this occurring was only 5%. Just because something has a very low probability does not mean that it cannot occur. By the way, the previous drop of a similar percentage occurred in 1973 to 1974 - so this is actually a pretty rare event!
Years ago, a bond was issued at par with a 7% coupon. This year, new issue bonds of similar credit quality are being issued at 10%. Which statement is TRUE? A. The new bonds will be issued at a premium to the current price of the 7% bonds B. The new bonds will be issued at a discount to the current price of the 7% bonds C. The new bonds will be issued at the same price as the current price of the 7% bonds D. There is no relationship between the prices of the 2 bond issues
The best answer is A. Because interest rates have risen from 7% to 10%, any new issue bonds will come out at par with a 10% coupon; while the prices of outstanding bonds with lower coupons will drop in the market. Thus, new bonds will be selling at a premium to the current price of existing bonds that have lower coupons.
Declines in all of the following would likely result in the FOMC making net purchases of government securities in the open market EXCEPT a decline in (the): A. unemployment levels B. Consumer Price Index C. Gross Domestic Product D. bond prices
The best answer is A. Falling unemployment levels means that economic activity is picking up. If this is true, the Fed would not want to stimulate the economy by loosening credit (the purchase of government securities by the Fed injects cash into the banks and loosens credit). A falling gross national product could cause the Fed to loosen credit to stimulate activity, as can falling bond prices (if bond prices are falling, yields are rising, which slows activity). A falling consumer price index means that the inflation rate is falling. The Fed will be more likely to loosen credit if inflation is low than if inflation is rising. To counteract rising inflation, the Fed will tighten credit.
China has announced that it will reduce its purchases of Treasury securities at the weekly auction and shift more of their investment to Euros. This action will: A. cause U.S. interest rates to rise B. cause U.S. interest rates to fall C. cause U.S. interest rates to be volatile D. have no effect on U.S. interest rates
The best answer is A. If there are fewer buyers of Treasury securities at the weekly auction, this will push prices down and yields up. As Treasury interest rates rise, other interest rates in the U.S. economy will rise as well.
Which of the following investments is LEAST defensive during deflationary periods? A. Common Stock B. Preferred Stock C. 10-Year Bonds D. 30-Year Bonds
The best answer is A. In a deflationary period, interest rates will fall, raising the prices of fixed income securities. Thus, fixed income securities are defensive securities in times of deflation. Equity securities' price movements will depend on the state of the economy at the time deflation occurs, and thus would not be defensive.
An investor believes that interest rates will be flat or falling into the future; and that prices may deflate. The MOST appropriate investment is: A. Long term U.S. Government bonds B. Real estate C. Gold D. Large Capitalization stocks
The best answer is A. In periods of deflation, interest rates fall. A fixed income security's price will go up as interest rates fall. Furthermore, since prices are deflating, the fixed interest payments received are able to buy more and more over time. This is the best investment choice. In times of deflation, real estate prices fall; as do gold prices. Stock prices tend to fall as well, since companies are forced to cut their prices to maintain sales volume.
What is a Yankee Bond? I A foreign bond traded in the U.S. market II A foreign bond traded in a foreign market III A foreign bond traded in U.S. dollars IV A foreign bond traded in foreign currency A. I and III B. I and IV C. II and III D. II and IV
The best answer is A. The Yankee Bond market is where foreign issuers sell bonds in the U.S. market, typically because interest rates are lower and the market is very deep and safe. The biggest issuers of Yankee bonds are Canadian companies and the government of Canada, since the U.S. debt market is so much larger than the Canadian debt market. The bonds pay in U.S. dollars, semi-annually, like conventional domestic bond issues.
Due to economic uncertainty in European markets, foreign investors are making large purchases of Treasury securities at the weekly auction. This action will: A. cause U.S. interest rates to rise B. cause U.S. interest rates to fall C. cause U.S. interest rates to be volatile D. have no effect on U.S. interest rates
The best answer is B. If there are large purchases of Treasury securities at the weekly auction, this will bid prices up and yields down. As Treasury interest rates fall, other interest rates in the U.S. economy will fall as well.
The Federal Intermediate Credit Banks make loans to, and buys the agricultural and livestock paper of all of the following EXCEPT: A. Commercial Banks B. Federal Reserve Banks C. Agricultural Credit Corporations D. Incorporated Livestock Loan Companies
The best answer is B. The Federal Reserve only deals with member banks - it does not issue loans, bonds, or notes to the public to support activities such as housing or farming. The Federal Intermediate Credit Bank is an "intermediary" providing short term loans to farmers. This is accomplished by purchasing the loans that have already been made to farmers by their "direct" lenders, which injects new monies into the direct lenders to make more loans. The FICB buys the "farm" paper of commercial banks, production credit associations, agricultural credit associations and incorporated livestock loan companies. The FICB gets the monies to buy the "direct" lender paper by selling notes through the Federal Farm Credit System. These notes are Federal Agency obligations.
Given the set of the following numbers: 5, 4, 11, 6, 8, 5, 12, 13, what is the range? A. 8 B. 9 C. 10 D. 13
The best answer is B. The range is the difference between the highest and lowest numbers in the set. The highest number is 13 and the lowest number is 4, so the difference is 9. The numbers in the set "range" from a low of 4 to a high of 13.
Life insurance companies developed variable life policies from the: A. term life policy B. whole life policy C. universal life policy D. fixed annuity
The best answer is B. Variable life policies are similar to whole life in that they: are permanent insurance policies; have fixed annual premiums: have an investment component that builds cash value against which owners may take policy loans. Unlike whole life, which guarantees a fixed rate of return, variable life does not. The rate of investment return depends on the performance of the securities in the separate account that funds the variable policy. Term life offers no cash buildup - it is a pure insurance product without any investment features. Universal life policies are also similar to whole life, but in a different way. Universal policies allow the holder to increase or decrease the premiums to buy a different death benefit amount. These policies build cash value from the interest income of the insurer's investments. Insurers fund universal policies from their general account - not from a separate account. As with whole life, they guarantee a fixed rate of return. A fixed annuity offers an unchanging annuity payment - there is a guaranteed rate of return. Variable products offer a rate of return that will vary, depending upon the performance of the separate account.
Which of the following corporate obligations are NOT secured? I Collateral trust certificate II Subordinated debenture III Commercial paper IV Debenture A. I only B. II and IV only C. II, III, IV D. I, II, III, IV
The best answer is C. A secured bondholder has a lien on a specific asset of the company - such as securities given as collateral in the form of a collateral trust certificate. A debenture and subordinated debenture (a second layer of debentures issued after the first debenture offering of a company, where the second layer of debentures will be paid after the first layer - thus, they are "subordinate" to the first layer of debentures) are promises to pay without any liens on corporate assets. Commercial paper is a short term IOU and is only backed by the issuer's promise to pay.
Which form of efficient market theory states that stock prices respond rapidly to publicly available information, so that no potential gains can be made by trading on that information? A. Weak Form B. Semi-Weak Form C. Semi-Strong Form D. Strong Form
The best answer is C. Efficient market theory basically states that markets are efficient at pricing stocks, and that over a long time frame, an investor cannot outperform the market. It is the economic argument used for index funds. There are 3 "forms" of efficient market theory: Weak Form: States that prices reflect all past publicly available information, but that this has no validity for predicting future price movements. It essentially states that price movements are random. This implies that technical analysis is basically useless to improve returns, but fundamental analysis still has potential value. Semi-Strong Form: States that prices respond rapidly to publicly available information, so that no potential gains can be made by trading on that information. This implies that anyone with inside information has an inherent advantage and can profit by trading on it. Strong Form: States that prices respond rapidly to both publicly available and private information, so that no one can profit by trading on this information. Most people subscribe to the "semi-strong" version of this theory.
The conversion price of a convertible debenture is set at issuance at $40 per share. The common stock is now trading at 42 while the bond is trading at par. If the bond rises 20% from its current market value, the new parity price of the common stock will be: A. $44 B. $46 C. $48 D. $50
The best answer is C. If the bond rises 20% from its current price of $1,000 (par), the new price will be 120% x $1,000 = $1,200 per bond. Since each bond is convertible based upon a conversion price of $40 per share, the conversion ratio is $1,000 par / $40 conversion price = 25:1. The new parity price is $1,200 / 25 = $48 per share.
The conversion price of a convertible debenture is set at issuance at $5 per share. The common stock is now trading at $3.50 while the bond is trading at par. If the bond rises 20% from its current market value, the new parity price of the common stock will be: A. $4 B. $5 C. $6 D. $8
The best answer is C. If the bond rises 20% from its current price of $1,000 (par), the new price will be 120% x $1,000 = $1,200 per bond. Since each bond is convertible based upon a conversion price of $5 per share, the conversion ratio is $1,000 par / $5 conversion price = 200:1. The new parity price is $1,200 / 200 = $6 per share.
In a deflationary period, which of the following statements are TRUE? I Equity securities are a defensive investment II Equity securities are not a defensive investment III Fixed income securities are a defensive investment IV Fixed income securities are not a defensive investment A. I and III B. I and IV C. II and III D. II and IV
The best answer is C. In a deflationary period, interest rates will fall, raising the prices of fixed income securities. Thus, fixed income securities are defensive securities in times of deflation. Equity securities' price movements will depend on the state of the economy at the time deflation occurs, and thus would not be defensive during deflationary periods.
Given the set of the following numbers: 5, 5, 7, 18, 12, 9, 23, what is the range, to the nearest 10th? A. 5.00 B. 11.30 C. 18.00 D. 23.00
The best answer is C. The range is the difference between the highest and lowest numbers in the set. The highest number is 23 and the lowest number is 5, so the difference is 18. The numbers in the set "range" from a low of 5 to a high of 23.
To counter rapidly rising inflation rates, the Federal Reserve would: A. decrease reserve requirements B. decrease the discount rate C. sell securities in open market operations D. sell bonds to the public
The best answer is C. To counter rising inflation, the Fed must decrease money supply levels and slow down economic activity. To do this, the Fed could tighten reserve requirements; increase the discount rate; or engage in "reverse repurchase" agreements with government dealers (mainly large commercial banks). In a reverse repurchase, the Fed sells Government securities to the dealers with an agreement to buy them back at a later date. This drains cash from the dealers and tightens credit. The Fed does not sell bonds directly to the public.
The Federal Intermediate Credit Banks make loans to, and buy the agricultural and livestock paper of: I Commercial Banks II Production Credit Associations III Agricultural Credit Corporations IV Incorporated Livestock Loan Companies A. I and II only B. III and IV only C. II and III only D. I, II, III, IV
The best answer is D. Consider this a learning question. The Federal Intermediate Credit Bank is an "intermediary" providing short term loans to farmers. This is accomplished by purchasing the loans that have already been made to farmers by their "direct" lenders, which injects new monies into the direct lenders to make more loans. The FICB buys the "farm" paper of commercial banks, production credit associations, agricultural credit associations and incorporated livestock loan companies. The FICB gets the monies to buy the "direct" lender paper by selling notes through the Federal Farm Credit System. These notes are Federal Agency obligations.
Which of the following risks is the primary concern when investing in a municipal bond? A. purchasing power risk B. market risk C. credit risk D. legislative risk
The best answer is D. Legislative (regulatory) risk is the risk of law changes; primarily the risk of tax law changes. Since the interest income from municipal bonds is exempt from Federal income tax, the main risk associated with these securities is that the Federal government may attempt to tax their interest income (this has already happened with certain types of municipal bonds). Also note that these securities are subject to purchasing power risk, market risk, and credit risk; but this is not the "primary" concern with these investments.
A married couple that is in the maximum tax bracket has 1 child, age 8. The couple is looking to start a 529 plan to fund the child's college education. The couple has $75,000 that they wish to invest. The child will enter college 10 years from now at age 18. The couple will need $200,000 for college to pay for a private 4 year college. To calculate whether the $75,000 investment is adequate, all of the following are required to find that investment's future value EXCEPT: A. present value of investment B. expected interest rate C. investment time horizon D. expected inflation rate
The best answer is D. To find the future value of a sum, simply take the sum's present value and multiply it by (1 + Growth (or Interest) Rate) for each year of the investment's time horizon. For example, a 3 year investment of $100 at a 5% growth rate will grow to $100 x 1.05 x 1.05 x 1.05 = $115.76 at the end of 3 years. The inflation rate is not part of the formula.
Which of the following statements are TRUE about Treasury Receipts? I Interest is paid semi-annually II Tax on interest earned is deferred until maturity III Interest and principal are paid at maturity IV Tax on interest earned is due annually A. I and II B. I and IV C. II and III D. III and IV
The best answer is D. Treasury Receipts are U.S. Government bonds which have been stripped of coupons. In essence, they are original issue discount Government obligations. As with any OID, the discount must be accreted annually, and the accretion amount is taxable as interest earned for that year. However, no monies are received from the issuer until maturity, when the security is redeemed at par. At this point, the owner receives the face amount but has no tax consequences (since the discount was taxed over the life of the bond).
Which of the following statements are TRUE about Treasury Receipts? I The investor "locks in" a rate of return that is free from reinvestment risk if the Receipt is held to maturity II The underlying bonds are held by a trustee for the beneficial owners III The interest income on the Receipts is subject to Federal income tax annually IV The Receipts are issued by broker-dealers, who maintain a secondary market in these securities A. III and IV only B. I, II, III C. I, II, IV D. I, II, III, IV
The best answer is D. Treasury Receipts represent an undivided interest in a portfolio of U.S. Government securities held by a trustee. The portfolio is assembled by a broker-dealer, who sells "receipts" representing ownership of the interest. Each receipt is, essentially, a zero-coupon obligation, that is purchased at a discount, and which is redeemable at par at a pre-set date. Thus, there is no reinvestment risk, since semi-annual interest payments are not received. The implicit rate of return is locked-in when the security is purchased, and the customer will earn that rate of return if the security is held to maturity. The annual accretion amount is taxable, since the underlying securities are U.S. Governments. At maturity, the receipt will have an adjusted cost basis of par, and will be redeemed at par, for no capital gain or loss. There are no new T-Receipt issues coming to market. Once the Treasury started issuing STRIPS in 1986, there was no need for the "middleman" anymore. However, T-Receipts still trade until they all mature (which happens in 2016).