Series 6 Chapter 8

Capital Asset Pricing Model (CAPM)

is used in the Modern Portfolio Theory to determine the most efficient investments.

Net working capital

known as working capital, measures a company's liquidity, efficiency, and overall financial health.

Beta

measures market risk, which is systematic and cannot be eliminated through diversification. It is said to be a non-diversifiable risk

Net Sales

number by subtracting returns from gross sales

Active management

provides an investment adviser or professional money manager that makes buy and sell decisions for the portfolio or fund.

Straight-line depreciation

reduces the value of the asset by the same amount each year over its expected life

balance sheet

snapshot of the company's assets and liabilities at a specific point in time. It shows what the company has of value and what debt it has outstanding.

A stock/portfolio with a negative beta moves in

the opposite direction as the market.

Aggressive Growth

Higher risk with higher rewards and greater volatility Small-cap stocks/funds, aggressive growth funds, CMOs, sector and special situation funds, BDCs, DPPs, foreign securities/funds

oversold

If stock values are decreasing while volume is increasing, the fall will be expected to continue. If this is occurring while volume is decreasing, the market

Capital Appreciation

Long-term growth, long-term time horizon Common stocks, ADRs, growth funds, index funds, ETFs

Income

Low volatility, income producing securities Income funds, bonds, bond funds, utility stocks, preferred stocks

Timing Risk

Nonsystematic Buying or selling at the wrong time All securities

Taxation Risk

Nonsystematic Change in income tax laws affecting investments Municipals

Call Risk

Nonsystematic Company may call in security and offer new one at lower yield Callable bonds and callable preferred stock

Credit (Default) Risk

Nonsystematic Company may default or credit quality be lowered, unable to pay interest Bonds, preferred stock

Business (Selection) Risk

Nonsystematic Difficult to redeem or costly to redeem or redeem at a loss All investments in companies

Growth and Income

2 primary objectives: capital appreciation and income; causes reduced income with reduced growth Mixture of preferred stocks, bonds, common stocks, balanced funds, REITs

Returns

would be any purchased goods that have been returned for credit. These are deducted from gross sales.

Liquidity (Marketability) Risk

Nonsystematic Difficult to redeem or costly to redeem or redeem at a loss Small caps, out-of-favor stocks, some municipals, hedge funds, CMOs, market-linked CDs, annuities, ARS, VRDOs, interval funds, DPPs, penny stocks

Prepayment and Extension Risk

Nonsystematic Early payoff and longer time than expected to payoff Asset-backed, mortgage-backed securities

Social or Political Risk

Nonsystematic Foreign government changing laws Foreign issues

Legislative Risk

Nonsystematic Impact or law changes Specific security or industry issues

Regulatory Risk

Nonsystematic Regulations in specific industries could affect investment Specific industry issues

Capital Risk

Nonsystematic Risk of losing park of an investment due to changing prices All non-guaranteed securities

Capital Preservation

Risk averse, little or no loss, safety Treasurys, agency securities, high-credit-quality corporate and municipal debt

Speculation

Short-term aggressive investing Options, leveraged and inverse leveraged ETFs, short stock positions, futures and forwards, day-trading accounts

Liquidity

Short-term capital preservation Money market funds, T-bills, commercial paper, cash

The betas for 4 different stocks are .5, .8, 1 and 1.5. Which is considered the lowest risk? A .5 B 1 C .8 D 1.5

A .5 Beta measures the risk of a security or a portfolio in relation to the risk of the overall market. A stock index, like the S&P 500 is used as a measurement of the overall market. If the beta of a security is more than 1.00, it is expected to move more than the overall market and hence would be considered to have higher risk than the market. If the beta of a security is less than 1.0, it is expected to move less than the overall market and would be considered to have less risk than the market.

All the following statements are true regarding beta, except: A A negative beta means the investment will lose money B Beta measures volatility of a security or portfolio C The beta of the overall market is 1.00 D Beta measures market risk

A A negative beta means the investment will lose money Beta measures market risk, which is systematic and cannot be eliminated through diversification. It is said to be a non-diversifiable risk. The beta of the overall market is measure by 1.00. A beta less than 1 indicates the stock/portfolio is less volatile than the overall market. A beta greater than 1 indicates the security or portfolio is more volatile than the overall market. A positive beta means the stock/portfolio moves in the same direction as the market. A negative beta means the stock/portfolio moves in the opposite direction as the market.

Which of the following portfolios is not actively managed? A An S&P 500 index fund B An emerging market high yield bond mutual fund C A high dividend stock mutual fund D An international growth and income mutual fund

A An S&P 500 index fund Active management provides an investment adviser or professional money manager that makes buy and sell decisions for the portfolio or fund. The fee for active management is typically the largest expense of all expenses. Open-end and closed-end funds have professional investment managers. Passive management has no active money manager and therefore will have lower expenses. Turnover (trading securities) is either non-existent or minimal. Efficient market believers tend to prefer investments that provide passive management. Often this type of plan involves using index funds for each of the asset classes.

Which of the following is not used with technical analysis? A Balance sheets and income statements B Historical prices and price movement C Support and resistance prices of securities D Trading volume and trends

A Balance sheets and income statements Technical analysis is a method of analyzing the value of securities by studying historical prices, price movement, and the trading volume of a specific security. The tools used by technical analysts involve various charts where price data and volume are plotted on a graph over time. Historical price data that has been plotted, recorded, and charted begins to form patterns and trends including support and resistance prices of securities. These specific patterns and trends are used to predict short-term price levels for stocks usually no more than 6 weeks in the future. Financial statements such as balance sheets and income statements are used by fundamental analysts.

All the following are included in a corporation's assets on a balance sheet, except: A Bank loans B Intangible assets C Cash D Inventory

A Bank loans Assets include everything owned by the corporation, including cash, intangible assets and inventory. Bank loans are considered a liability.

The Capital Asset Pricing Model is used to determine the required rate of return of an asset or portfolio factoring in any risk taken above the risk-free rate. What is another component that is factored into this calculation? A Beta B Delta C Alpha D Sigma

A Beta CAPM calculations use a risk-free rate that represents the time value of money of an investment in a riskless security. In addition, CAPM includes the Beta of that security in the calculation. Remember, Beta measures the non-diversifiable or systematic risk of that security. From this calculation, an expected or required rate of return is derived for a security with the additional amount of risk

All the following are included in operating expenses, except: A Bond interest B Rent C Depreciation D Advertising

A Bond interest Operating expenses are the day-to-day expenses of running a business. They include rent, advertising, administrative salaries, and depreciation. The operating expense plus the cost of goods sold are sometimes represented as cost of sales. When the cost of sales is deducted from the net sales, the result is the operating profit of the business. Interest expenses are considered non-operating expenses. They are usually made up of the interest paid to bondholders and is sometimes called bond interest expense.

All the following are included in cost of goods sold, except: A Depreciation B Materials C Cost of manufacturing, excluding depreciation D Transportation costs

A Depreciation Cost of goods sold does not include depreciation or selling expense. It only includes the costs associated with producing the finished products.

Which of the following would not be used by a technical analyst? A Income statement B 200-day moving average C Advance/decline ratio D Trendlines

A Income statement Technical analysis examines the value of securities by studying historical prices, price movement, and the trading volume of a specific security. The tools used by a technical analyst include trendlines, the 200-day moving average, and the advance/decline ratio. The income statement is a financial statement used in fundamental analysis.

What is alpha? A It is a measure of return performance against a specific benchmark B It measures tax-efficiency C It measures opportunity costs D It measures risk-adjusted return

A It is a measure of return performance against a specific benchmark Alpha is a measure of return performance against a specific benchmark. It is often used to gauge the results of a mutual fund manager. For example, a large-cap mutual fund manager's year-end performance for the fund will be matched up against a large-cap index and how it performed. If the index had an 8% return and the manager had an 11% return, the manager has provided value with the positive alpha of 3 points over the index. A manager could provide negative alpha also. This would take place when the manager's return is below the relative index.

Which of the following statements about diversification is true? A It reduces nonsystematic risk B It guarantees portfolio profits C It prevents portfolio losses D It neutralizes the positive performance of other stocks

A It reduces nonsystematic risk Diversification can often smooth out nonsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others, but it cannot guarantee a profit or prevent a loss.

When considering an income statement, income earned on bank accounts and investment accounts is called: A Non-operating income B Gross margin C Operating income D Total income

A Non-operating income Non-operating income is the income earned on items like bank accounts and investment accounts. When non-operating income is added to operating income, the result is total income, or earnings before interest and taxes (EBIT). The operating income is gross margin minus the operating expenses. Gross margin is found by subtracting the cost of goods sold from the net sales number.

The percentage of stocks advancing to declining is known as: A The breadth of the market B The swing factor C The fundamental indicator D The breath of the wild

A The breadth of the market The breadth of the market represents the number of stocks that are increasing in prices compared to the number of stocks decreasing in prices.

What does the income statement show the analyst about the corporation? A The profitability of the corporation B The credit of the corporation C The net worth of the corporation D The debt to equity ratio

A The profitability of the corporation An income statement, also called a profit and loss statement, shows the incoming revenues and outgoing expenses over a specified period, such as the fiscal quarter or year. This is used to determine the profitability of a company.

What is the Capital Asset Pricing Model (CAPM) used for? A To find the required rate of return for a specific asset B To determine the optimal portfolio C To determine a portfolio's risk-adjusted return D To find out what asset classes would be best for diversification purposes

A To find the required rate of return for a specific asset The Capital Asset Pricing Model (CAPM) used in the Modern Portfolio Theory attempts to find the required rate of return for a specific asset. A CAPM calculation uses a risk-free rate that represents the time value of money of an investment in a riskless security. In addition, CAPM includes the beta of that security in the calculation. Remember, beta measures the nondiversifiable or systematic risk of that security. From this calculation, an expected or required rate of return is derived for a security with the additional amount of risk.

What does working capital measure? A A company's retained earnings B A company's liquidity C A company's ability to pay off long-term debts D A company's payroll

B A company's liquidity Net working capital, also known as working capital, measures a company's liquidity, efficiency, and overall financial health. It is the amount of money a company has for its operations after using current assets to pay current liabilities. The calculation for determining net working capital is: Net Working Capital = Current Assets - Current Liabilities

​​​​Assets are separated into all the following categories, except: A Intangible B Aged C Fixed D Current

B Aged Assets are defined as what is owned by the company and are listed in order of liquidity (how quickly they can be turned into cash). Assets are separated into 3 categories: current, fixed, and intangible assets. Fixed and intangible assets are considered noncurrent assets. Current and noncurrent assets comprise the total assets on the balance sheet.

Which of the following statements regarding beta is not true? A If a portfolio has a beta of 1.5 it is considered riskier than the market B If a portfolio has a beta of 0.5 it is considered twice as risky as the market C If a portfolio has a beta of 1 it is expected to move in tandem with the benchmark D A portfolio with a beta of 1 has systematic risk

B If a portfolio has a beta of 0.5 it is considered twice as risky as the market Beta measures the risk of a security or a portfolio in relation to the risk of the overall market. A stock index, like the S&P 500 is used as a measurement of the overall market. If the beta of a security is more than 1.00, it is expected to move more than the overall market and hence would be considered to have higher risk than the market. A beta of less than 1.00 would mean that the security is expected to move less than the overall market and would be considered to have less risk than the market. Systematic risk is market risk, which cannot be diversified away.

All the following are characteristics of active management, except: A The fee for active management is typically the largest of all portfolio expenses B Index funds are an example of active management C There could be a large amount of turnover in the portfolio D Professional money managers make buy and sell decisions

B Index funds are an example of active management Active management provides an investment adviser or professional money manager that makes buy and sell decisions for the portfolio or fund. The fee for active management is typically the largest expense of all expenses. Open-end and closed-end funds have professional investment managers. Passive management has no active money manager and therefore will have lower expenses. Turnover (trading securities) is either non-existent or minimal. Efficient market believers tend to prefer investments that provide passive management. Often this type of plan involves using index funds for each of the asset classes.

All the following are the components used in the Capital Asset Pricing Model (CAPM) calculation, except: A Beta B Opportunity cost C Risk-free rate D Expected price

B Opportunity cost The Capital Asset Pricing Model (CAPM) used in Modern Portfolio Theory attempts to find the required rate of return for a specific asset. A CAPM calculation uses a risk-free rate that represents the time value of money of an investment in a riskless security. In addition, CAPM includes the beta of that security in the calculation. Remember, beta measures the non-diversifiable or systematic risk of that security. From this calculation, an expected price or required rate of return is derived for a security with the additional amount of risk included.

All the following regarding advance/decline lines are true, except: A The percentage of stocks advancing to those declining is referred to as the breadth of the market, which attempts to gauge the direction of the overall market B The advance/decline ratio is # of declines ÷ # of advances C If more issues are increasing than decreasing in value, there is strength in the increase, and it should continue D If more issues are declining than increasing, it is thought that there is strength in the decline, and it should continue

B The advance/decline ratio is # of declines ÷ # of advances Technical analysts will also look at advance/decline lines to determine if there is any strength in the current market movements. If more issues are declining than increasing, it is thought that there is strength in the decline, and it should continue. If more issues are increasing than decreasing in value, there is strength in the increase, and it should continue. The technical analyst will look at the percentage of stocks advancing to those declining and vice versa. This is referred to as the breadth of the market, this technique attempts to gauge the direction of the overall market. The advance/decline ratio is used: Advance/Decline Ratio = # of Advances ÷ # of Declines.

Technical analysis is used to determine which of the following? A Proper portfolio diversification B When to invest/market timing C Market volatility D Which company to invest in

B When to invest/market timing Technical analysis uses historic numbers and charts to provide short term price trends. This is used primarily to determine market timing, when is the time to invest. On the other hand, fundamental analysis determines what companies to invest in.

If a large-cap mutual fund returned 8% and its benchmark returned 11% what is the alpha? A 11 B 3 C -3 D 8

C -3 Alpha is a measure of return performance against a specific benchmark. It is often used to gauge the results of a mutual fund manager. For example, a large-cap mutual fund manager's year-end performance for the fund will be matched up against a large-cap index and how it performed. If the index had an 11% return and the manager had an 8% return, the manager had a negative alpha of 3 points below the index. A manager could provide a positive alpha also. This would take place when the manager's return is above the relative index.

Which of the following is not used by a technical analyst when analyzing the value of a security? A Price movement B Trading volume C Credit rating D Historical prices

C Credit rating Technical analysis is a method of analyzing the value of securities by studying historical prices, price movement, and the trading volume of a specific security. The tools used by technical analysts involve various charts where price data and volume are plotted on a graph over time. Historical price data that has been plotted, recorded, and charted begins to form patterns and trends. These specific patterns and trends are used to predict short-term price levels for stocks, usually no more than 6 weeks in the future.

In measuring the volatility of a large-cap stock, what is beta likely being compared to? A The stock's past performance history B Other stocks in the same industry C The Standard and Poor's 500 Index D The Dow Jones Industrial Average

C The Standard and Poor's 500 Index The S&P 500 is a widely used measurement of the overall stock market, as it tracks the price and performance of 500 of the largest and most widely held publicly traded corporate stocks in the U.S. By definition, the S&P 500 has a beta of 1.0. Stocks with a beta greater than 1.0 are more volatile, and therefore have a higher risk, than the overall market as measured by the S&P 500. A stock with a beta less than 1.0 is less volatile and has less risk than the overall market. The Dow Jones Industrial Average (the Dow) is also widely used as a measure of the stock market but since it tracks only 30 stocks, it is not as effective as representing the whole market as the S&P 500. Beta does not compare a stock against its industry or its past history.

What does technical analysis measure? A The financial strength of a corporation B The business risks of investing in a particular security C The market risk involved when investing in a particular security D The income and cash flow statements of a company in comparison to other similar companies

C The market risk involved when investing in a particular security While fundamental analysis looks at the financial strength of a corporation and the business risks of investing in a particular security, technical analysis measures the market risk involved when investing in a particular security. Technical analysis is a method of analyzing the value of securities by studying historical prices, price movement, and the trading volume of a specific security.

What does beta measure? A The risk-adjusted return B The opportunity cost C The risk of a security or a portfolio in relation to the risk of the overall market D The systematic risk

C The risk of a security or a portfolio in relation to the risk of the overall market Beta measures the risk of a security or a portfolio in relation to the risk of the overall market. A stock index, like the S&P 500 is used as a measurement of the overall market. The underlying securities price movement is compared to the price movement of the S&P 500 index. Beta will determine if the underlying security moves more than the market, less than the market, or does it move in tandem with the market.

What is the amount an investor expects to receive above the risk-free rate? A The risk discount B Capital gains C The risk premium D The call rate

C The risk premium The risk-free rate of return is a return where it is assumed that there can be no losses and is extremely safe. Most analysts use Treasury bills for this measure. They are safe and have short maturities. Anything riskier than a Treasury bill, should provide a higher return. The amount the investor expects to receive above the risk-free rate is called the risk premium.

The Treasury bill rate is 3%. A small-cap stock has an average annual return of 15%. What is the risk premium? A 3% B 15% C 18% D 12%

D 12% The risk-free rate of return is a return where it is assumed that there can be no losses and is extremely safe. Most analysts use Treasury bills for this measure. They are safe and have short maturities. Anything riskier than a Treasury bill, should provide a higher return. The amount the investor expects to receive above the risk-free rate is called the risk premium.

Why is a statement of cash flow important? A It helps predict company profitability B Cash flow tends to be a good indication of a company's ability to pay bonuses C It helps in capital allocation decisions D Cash flow tends to be a good indication of a company's ability to pay its bills

D Cash flow tends to be a good indication of a company's ability to pay its bills The cash flow statement measures inflows and outflows of the company's cash and cash equivalents. Cash flow tends to be a good indication of a company's ability to pay its bills.

What does EBIT stand for? A Expenses before inventory and transportation B Earnings before investments and tariffs C A Nasdaq listed stock D Earnings before interest and taxes

D Earnings before interest and taxes The operating income is gross margin minus the operating expenses. Non-operating income is the income earned on items like bank accounts or investment accounts. When non-operating income is added to operating income, the result is total income, or earnings before interest and taxes (EBIT).

Which portfolio manager had the best portfolio for their client based on Modern Portfolio Theory, given the choices below? A Highest risk with the lowest return B Lowest return with the lowest risk C Highest return and the highest risk D Lowest risk with the highest return

D Lowest risk with the highest return If 2 portfolio managers have achieved an 8% return on their respective portfolios, but the second manager took on much more risk to achieve that return, then the first manager has achieved the better result. While both achieved the same return, the first manager did so with much less risk to the portfolio.

What is the relationship between securities, or asset classes, that have values moving in opposite directions? A Uncorrelated B Neutral correlation C Positive correlation D Negative correlation

D Negative correlation When a security or asset class is negatively correlated, it will move in the opposite direction of the other. If a security is unrelated or uncorrelated to another security the respective prices of each security will react differently to market movements and will tend to not move in the same direction. A positive correlation means the value of the securities/asset classes move in the same direction.

Which of the following about passive management is false? A There is no active money manager in a passively managed portfolio B Efficient market believers favor passive management investments C The goal is to match or beat the return of their benchmark index D Passive management involves tracking an index, so there will not be any losses

D Passive management involves tracking an index, so there will not be any losses Passive management has no active money manager and therefore will have lower expenses. Turnover (trading securities) is either non-existent or minimal. Efficient market believers tend to prefer investments that provide passive management. Often this type of plan involves using index funds for each of the asset classes. The goal of passive portfolio managers is to match or beat the return of their benchmark index, however there are no guarantees, and the portfolio is subject to losses.

Reinvestment Risk

Systematic A need to maintain a rate of return on reinvested dividends or interest All investments that pay interest or dividends

Inflation (Purchasing-Power) Risk

Systematic Cost of goods increases more than earnings Fixed-income investments, money market instruments, money market funds

Currency (Exchange-Rate) Risk

Systematic Currency rates vary as the dollar becomes weaker or stronger Foreign issues

market risk

Systematic Investments react with market changes All investments

Interest-rate risk

Systematic Prices vary as interest rates change All bonds, preferred stocks

Tax Efficiency

Tax-free, tax deferred, tax credits, tax deductions Municipal securities, municipal bond funds, annuities, retirement plans and accounts, DPPs allowing credits and/or deductions, ESAs, and 529 plans

risk premium

The difference between expected return of a portfolio or investment and the risk-free rate

Accelerated depreciation

allows the reduction in value to be more heavily weighted in the early years of the life of the asset.

Technical analysts

also known as technicians, or chartists, believe that trend is your friend. They believe that history will always repeat itself in the price trend of a stock.

Gross sales

are any sales that have been logged and billed.

Interest expenses

are considered non-operating expenses. They are usually made up of the interest paid to bond holders and is sometimes called bond

Intangible assets

are nonphysical assets, such as the company's brand name, trademark, and reputation.

Long-term liabilities

are obligations or debt that is due after the next 12 months. This includes mortgages and corporate bonds issued with maturities beyond the next 12 months

Current liabilities

are obligations or short-term debt due within the next 12 months

Operating expenses

are the day to day expenses of running a business. They include rent, advertising, administrative salaries, and depreciation

Passive management

has no active money manager and therefore will have lower expenses. Turnover (trading securities) is either non-existent or minimal.

overbought

his all works the same for increasing stock values, or a rising market. If the market is rising on increasing volume, it would be expected to continue. If it is occurring with decreasing volume the market is said

trendline

illustrates the price movement of a security by placing the price changes on a graph

A stock/portfolio with a positive beta moves

in the same direction as the market

Current assets

include cash and accounts receivable, marketable securities, and inventory that are expected to be converted into cash within the next 12 months

Fixed assets

including plant, property, and equipment, cannot readily be sold and may be depreciated over time

Modern Portfolio Theory (MPT)

is a capital market investment theory introduced by Harry Markowitz in the 1950

Alpha

is a measure of the return on an investment that cannot be attributed to the market in general

Market analysis

is a method of analyzing the value of securities by studying historical prices, price movement, and the trading volume of a specific security.

risk-free rate of return

is a return where it is assumed that there can be no losses, and the investment is extremely safe

Fundamental analysis

is an approach used in the industry to analyze the value of securities

Total income

is derived from adding the operating and non-operating income lines together.

Gross margin

is found by subtracting the cost of goods sold from the net sales number

operating income

is gross margin minus the operating expenses.

Pretax income

is the amount of income that is subject to taxation. Analysts will look at several income subtotals before taxes are taken out.

Cost of goods sold

is the cost of producing a finished product. This includes labor, materials purchased, freight, transportation, and any other costs of manufacturing of the goods that were sold. This does not include depreciation.

Non-operating income

is the income earned on items like bank accounts or investment accounts.

Net Income

is the income remaining after the taxes are paid. Preferred and common stock dividends are taken from net income, with the preferred being taken out first. The amount left is added to the retained earnings of the corporation on the balance sheet.

200-day moving average

is the one most well known in the industry. The analyst charts a daily average price over 200 days. Every day the chart has a new average based on the new day and the oldest one is removed.