Unit 20

Writing an option provides all of the following EXCEPT

maximum protection against loss Writing an option provides only limited protection for a long or short position. That protection is limited to the amount of the premium received and is why this is called a partial hedge.

Investment advisers who preach the benefits of strategic asset allocation do so because they believe

the market is perfectly efficient because stock prices reflect all available information The primary difference between strategic and tactical asset allocation comes down to the belief by those following the strategic style that it is not possible, over a long period of time, to beat the market.

Under modern portfolio theory (MPT), the optimal portfolio has

the most return for a given amount of risk Under modern portfolio theory (MPT), the optimal portfolio is one that has the most return for a given amount of risk.

The statement, "Stock prices fully reflect all information from public and private sources," can be attributed to which form of the efficient market hypothesis (EMH)?

Strong form EMH This is the definition of the strong form EMH because it includes private information. Private sources include insider information, such as persons holding nonpublic access to information that may impact stock prices. There is no such term as passive form EMH.

The risk/return pyramid where the bottom is lowest risk and the "point" is the highest, generally places commodities

at the top. The risk/return pyramid shown in your LEM places commodities at the very top, the point of the pyramid.

In the field of portfolio management, there are a number of different management styles. One of those styles involves committing additional capital to the market when others are reducing their exposure, or eliminating positions while others are increasing theirs. This style is generally referred to as

contrarian The contrarian style of portfolio management takes positions opposite those of the market as a whole. They are buying when others are selling and selling when others are buying.

While reading the prospectus of a mutual fund, you notice that the management describes their style as contrarian. They further explain that they

generally buy when the majority of other investors are selling and sell when the majority of other investors are buying

All of the following are advantages of the buy-and-hold strategy except

the investor is guaranteed a profit. The buy-and-hold strategy, among other investment strategies, does not guarantee a profit to the investor.

The capital asset pricing model (CAPM) is used by many to assess the expected return of a security. If the current risk-free rate is 2%, the current return on the market is 10%, and a particular stock's beta is 1.5 with a standard deviation of 3.2, the expected return would be

14% The formula for this computation is as follows: 10% (the return on the market is a beta of 1.0) minus the risk-free rate of 2% or 8%. Then, multiply that by the beta of this stock (1.5) to arrive at 12%. That is, the stock should return 12% above the risk-free rate of 2%, or 14%. The standard deviation is not relevant to this computation.

An investor has $50,000 to invest in bonds. Currently, 10-year bonds are offering very attractive yields, but the client is concerned that in a few years, rates will be even higher. What would you suggest?

Barbell bonds With the barbell strategy, the investor would place $25,000 into bonds maturing in 10 years and the other half into bonds maturing in two years. This makes $25,000 available for reinvestment in two years enabling the investor to take advantage of the higher rates (if they materialize). U20LO7

When preparing an asset allocation program, all of these would be considered asset classes EXCEPT

Brady bonds When describing an asset class, we are not looking at a specific security. IBM common stock is considered as an equity security—it is not an asset class by itself. Brady bonds are considered a debt security, but not an asset class. Brady bonds are issued by a developing country as a result of a restructuring of its defaulted bank debt. They are government obligations issued after the debtor nation negotiates with the creditor banks' advisory committee to restructure loans that are no longer performing. The creditor banks exchange the nonperforming loans for various Brady bonds offered by the debtor government.

That all market participants have equal access to information is a fundamental premise of

the efficient market hypothesis When all market participants have equal access, the theory is that stock prices will reflect that efficiently.

Under modern portfolio theory (MPT), all portfolios that can be constructed from a given set of stocks is referred to as

the feasible set A feasible portfolio is defined as a portfolio that an investor can construct given the assets available. The feasible set is the collection of all feasible portfolios. Once we have the feasible set, we can select the efficient set (the most return for a given amount of risk, or the least risk for a given amount of return).

Which of the following is not an assumption of the capital market theory?

All market participants borrow and lend at different risk-free rates. One of the assumptions of the capital market theory is that all market participants borrow and lend at the same risk-free rate. The other choices are all true statements (and might be tested).

Which of the following is NOT a characteristic of the active management approach to investing?

Belief in random walk theory and efficient markets Proponents of the active management approach do not believe that markets are completely efficient or random. Instead, they feel that it is possible to predict market movements and to achieve returns that beat the market. Because an active approach to investment management involves more frequent trading and research than passive approaches, the active approach is generally more expensive to maintain.

"Stock prices adjust rapidly to the release of all new public information." This statement is an expression of which of the following ideas?

Efficient market hypothesis In an efficient market, all participants have equal access to information and, therefore, stock prices reflect that equality almost immediately.

If a portfolio manager wished to reduce inflation risk, which of the following would be most appropriate to add to the portfolio?

Tangible assets Tangible assets, such as real estate, precious metals, and other commodities, tend to keep pace with inflation. Fixed dollar investments do not.

The capital asset pricing model (CAPM) is an investment theory that serves as a model for

pricing securities based on their systematic risk Under the CAPM, securities are priced based on their systematic risk only, because this risk cannot be eliminated through diversification. The expected return of a security or portfolio is calculated by adding the rate on a risk-free security to a risk premium multiplied by the asset's systematic risk.

Which of the following stocks would probably be most appealing to a value investor?

A stock with a relatively low P/E ratio Value investors look for stocks in companies that have been overlooked or undervalued by other investors. They often focus on stocks with relatively low P/E ratios or price-to-book-value ratios or stocks with relatively high dividend yields compared with other stocks in the same industry.

Which of the following statements about diversification through asset class allocation are true? Diversification involves investing a portfolio in at least 20 different securities of the same asset class Diversification is a way to reduce unsystematic risk in a portfolio. Diversification is a defensive investment strategy.

II and III Diversification through asset class allocation is the popular investment strategy of investing in several different classes of investments. It is designed to lower the unsystematic risk in a portfolio. The opposite of diversification, through asset allocation is the aggressive strategy of concentrating the portfolio in a single asset class, even when spread out over a large number of issues. U20LO2

Which of the following is NOT associated with passive investment management approaches?

The belief that the market can be timed Proponents of passive-management approaches believe in the random walk theory (market movements are unpredictable) and efficient markets (any information that could affect a stock's value is quickly reflected in its price). As a result, they feel it is impossible to consistently beat the market.

Derivatives have a major role to play in the management of many large portfolios and can be used for all of the following except

highly risk-averse investors. Derivatives are generally not appropriate for highly risk-adverse investors due to the risk and sophistication involved. Some of the common uses of derivatives are for: Hedging to reduce the impact of adverse price movements (e.g., by buying put options or selling futures contracts). Anticipating future cash flows. Asset allocation changes. Income (selling options).

Which of the following strategies would most effectively protect an investor with a short stock position?

Buy a call Purchasing a call on the security protects the customer from a loss in excess of the strike price plus the cost of the call should the security rise in price. This is the most common way to hedge a short stock position.

Which form of the efficient market hypothesis (EMH) suggests that fundamental analysis and insider information may produce above-market returns?

Weak The weak form holds that current stock prices reflect all historical market data and that historical price trends are, therefore, of no value in predicting future prices. However, this form holds that credible fundamental analysis and insider information may produce above-market returns. Those who truly believe in the EMH are of the opinion that none of these will do any better than the market; random selection is as good as anything else. Random walk is not one of the 3 forms.

One of the most significant risks taken by bond investors is interest rate risk. All of these steps could be used to mitigate the effects of this risk EXCEPT

buying bonds of highest quality Quality has no substantial impact on interest rate risk. When interest rates rise, all bonds fall in price. However, those that are closer to their maturity date are impacted less (they have a shorter duration). If one can hold the bonds until maturity, there is no interest rate risk because, regardless of the prevailing market, you receive par value. One very effective way to lessen this risk is to ladder the maturities. That means that the portfolio is spread among a series of maturities, some near, some mid-term, and some long-term.

A customer who follows a strict dollar cost averaging program to acquire shares in a diversified common stock mutual fund should achieve

lower average cost to acquire fund shares relative to the fund's average price over the buying period By investing a constant amount of dollars at regular intervals, the investor buys fewer shares when the fund's price rises and more shares when the share price drops, thereby lowering the average cost.

Investment company portfolio managers are apt to classify common stocks into groups. One measurement is the product of multiplying the market price per share times the number of shares outstanding. The result is known as

market capitalization A stock's market capitalization is determined by multiplying the price per share times the number of outstanding common shares. For example, if a company had 1 billion shares outstanding and the market price was $20 per share, the company would be said to have a market cap of $20 billion. This would put it into the category of "large-cap" stocks.

An investor begins contributing $600 on the third day of each month to a purchase plan for the KAPCO Total Return Fund. For the first six months, the per share prices were: $10 $12 $15 $20 $12 $8 What is this investor's breakeven point?

$11.80 per share This is a dollar cost averaging question. This investor has purchased a total of 305 shares with a total cost of $3,600. Here's the math: Month 1- $600 divided by $10 = 60 shares Month 2 - $600 divided by $12 = 50 shares Month 3 - $600 divided by $15 = 40 shares Month 4 - $600 divided by $20 = 30 shares Month 5 - $600 divided by $12 = 50 shares Month 6 - $600 divided by $8 = 75 shares The total expenditure was $3,600 (6 months××$600) and the total number of shares purchased was 305. That makes the average cost per share $11.80 ($3,600 divided by 305). With the investor's average cost per share being $11.80, a sale of the shares at that price will cause the investor to break even.

Which of the following is a characteristic of index investing?

A portfolio that mirrors the performance of a specific market Index investing involves investing in a portfolio that has a high correlation to a specific market index, such as the S&P 500. The advantages of this approach are its low cost and the guarantee of achieving returns that tend to match the market's performance. In exchange for these advantages, index investors give up the opportunity to beat the market.

Which of the following would you most likely consider characteristics of a growth stock?

High P/E and low dividend yield Growth stocks generally have high P/E ratios and low (or no) dividends. Value stocks normally have low P/E ratios with higher dividend payouts.

An investor can choose between 4 portfolios with the following expected returns and standard deviations. Expected ReturnStandard Deviation I.8% 20% II.6%21%I II.8% 21% IV.7% 23% Based on modern portfolio theory (MPT), which portfolio should the investor choose?

I MPT preaches that investors will always seek the highest return commensurate with the lowest risk. The highest return is 8%. There are 2 portfolios with that rate, but 1 of them has a lower risk (20% versus 21%).

All of the following statements regarding asset allocation done by or on behalf of an investor are true EXCEPT

individual security selection is far more important than the asset allocation decision Studies have shown the asset allocation decision is the primary contributor to effective long-term portfolio management. Individual security selection is far less important in meeting investor objectives.

Customer A and Customer B each have an open account in a mutual fund that charges a front-end load. Customer A has decided to receive all distributions in cash, while Customer B automatically reinvests all distributions. How do their decisions affect their investments? Receiving cash distributions may reduce Customer A's proportional interest in the fund. Customer A may use the cash distributions to purchase shares later at NAV. Customer B's reinvestments purchase additional shares at NAV rather than at the offering price. Due to compounding, Customer B's principal will be at greater risk.

I and III If the customer elects to receive distributions in cash while other investors purchase shares through reinvestment, his proportional interest in the fund will decline. Automatic reinvestment is always at NAV.

Janice is investing in stocks that are temporarily neglected by the market and often have high-dividend yields. Which of the following investment styles might she be following?

Value Value is the oldest style and is based on the premise that deep and rigorous analysis can identify businesses whose value is greater than the price placed on them by the market. By buying and holding such shares for long periods, a higher return than the market average can be achieved. Managers of equity income or income and growth funds often adopt this style, since out-of-fashion stocks often have high-dividend yields. Why isn't this contrarian? A key is the high-dividend yield. Contrarians invest opposite the general market consensus without regard to dividends.

The tactical approach to the asset allocation review process

intentionally deviates from the normal asset mix to take advantage of market opportunities The approach to asset review that intentionally deviates from the normal asset mix to take advantage of market opportunities is the tactical approach. Investors using this approach try to use market timing to beat the market, so this approach requires a great deal of predictive ability.

An investor decides to make monthly investments into the KAPCO Growth Fund. Each month, the investor purchases 10 shares of the fund. Over a 4-month period, the investor accumulated 40 shares at the following prices: Month 1 - $10 Month 2 - $8 Month 3 - $12 Month 4 - $10 If, instead of purchasing 10 shares per month, the investor had invested $100 per month,

the investor would have acquired 40.833 shares instead of 40 shares. This shows the benefit of dollar cost averaging. This investor purchased 40 shares at a total cost of $400 or an average of $10 per share. If $100 per month had been invested instead, the total would have been the same $400, but the number of shares acquired would have been 40.833. In the first month, $100 divided by $10 = 10 shares. In the second month, $100 divided by $8 =12.5 shares. In the third month, $100 divided by $12 = 8.333 shares, and in the fourth month, $100 divided by $10 = 10 shares. That is a total of 40.833 shares instead of 40 shares; a better deal for the investor. With a total cost of $400 and 40.833 shares, the cost basis per share is slightly less than $9.80 per share instead of $10 per share.

Which of the following statements concerning market efficiency is not correct?

Investors who accept the efficient market hypothesis (EMH) usually adopt an active investment strategy. Investors who accept the EMH usually adopt a passive investment strategy; investors who do not accept the EMH, pursue an active investment strategy. If the market is efficient, the best strategy is indexing rather than stock picking.

The semi-strong form of efficient market hypothesis (EMH) asserts that

all public information is already reflected in security prices making fundamental analysis valueless. Semi-strong EMH states that publicly-available information (fundamental analysis) cannot be used to consistently beat the market performance. It is strong form EMH which states that all inside information is already reflected in current stock prices.

In general, the most passive investment style for a portfolio would be

indexing. This is a close call between indexing and buy and hold. We believe that the NASAA philosophy on this would be that buy and hold does require some management after the portfolio is set up. That is, some companies go out of business or are merged into other entities or go private and that requires making new decisions. The same can happen with the companies in an index, but the investor doesn't have to make the changes. When you invest in an index, it is sort of like (with credit to Ron Popeil) "set it and forget it". Clearly, the other two choices are not passive in the same way.

Which of the following statements are generally TRUE of the buy-and-hold strategy? Equities would grow relative to fixed income Lower taxes and transactional costs Easy to manage The portfolio would more accurately demonstrate the client's investment objectives and risk tolerance

I, II, and III Over the long run, using the buy-and-hold strategy with equity securities has outperformed the rate of return on fixed income investments. With few transactions, there are almost no commissions and capital gains taxes. Of all strategies, this is the easiest to follow. There is no way to determine the client's objectives or risk tolerance based on the decision to buy and hold. The portfolio might contain small-cap stocks or large-cap stocks. It might contain 90% equities or 75% debt securities. Investors with differing goals and risk tolerance can use this strategy.

A successful dollar cost averaging strategy requires stable market conditions volatile market conditions a fixed dollar amount invested monthly a fixed number of shares purchased monthly

II and III Dollar cost averaging requires a fixed dollar investment on a periodic or monthly basis. This strategy is most effective when prices in the market are volatile.

Emanuel owns 500 shares of IJKL common stock with a cost basis of $63 per share. IJKL is now priced at $82 and Emanuel is concerned that the stock may suffer a sharp decline in the near term. As his IAR, you would suggest his best move to protect his profit would be to

buy 5 IJKL 80 put options. When one is long a security, the best hedge is to buy a put. Should Emanuel's fears be realized, regardless of how low the stock declines, he will be able to exercise and deliver his 500 shares at the strike price of $80 per share. An alternative would be to sell call options, but that is generally not going to be the correct choice when the question asks about protecting a profit. Writing an option is more appropriate when the question deals with the investor generating income. U20LO12

Given the following information: StockBeta A 2.16 B 1.54 C. 96 D 1.28 Assume the risk-free rate of return is 2.75% and the market rate of return is 6.75%. An investor has a required rate of return of 9.5%. Which of these stocks would offer the best investment opportunity?

Stock A Calculate the expected rate of return of each stock using CAPM and compare the result to the investor's required rate of return. Stock A: E(r) = 2.75 + (6.75 - 2.75)2.16 = 11.39%. Stock B: E(r) = 2.75 + (6.75 - 2.75)1.54 = 8.91%. Stock C: E(r) = 2.75 + (6.75 - 2.75).96 = 6.59%. Stock D: E(r) = 2.75 + (6.75 - 2.75)1.28 = 7.87%. Based on a required rate of return of 9.5%, Stock A with an expected return of 11.39% is the best available investment opportunity.

Due to an escalating trade war, the portfolio manager of an equity mutual fund anticipates a negative impact on his fund's assets. To protect his investment portfolio, the fund manager would

buy S&P 500 index puts A portfolio manager who expects a decline in the market as a result of a trade war (or any factor that might hurt stock prices) would buy puts on a broad market index such as the S&P 500 to protect his position. Selling calls limits upside potential and only protects the portfolio to the extent of the income received from the sale of the calls

Which of the following is not a characteristic of a Monte Carlo simulation?

Large changes in the projected rate of return will make small differences in the outcome. Small changes in the projected rate of return will make large differences in the outcome

Which of the following statements is correct?

When a risk-averse investor is confronted with two investment opportunities having the same expected return, the investor will take the opportunity with the lower risk. It is expected that investors will always choose the lower risk investment if both generate the same return. The other statements are incorrect. As the correlation coefficient declines, the potential for greater diversification increases. Efficient portfolios, not individual securities, lie on the efficient frontier. The efficient frontier contains portfolios with the highest expected return at each level of risk.

Professor William Sharpe stipulated that certain assumptions must be present for the capital asset pricing model (CAPM) to be useful. Which of the following is not one of these assumptions?

Investment expenses, such as taxes and transaction costs, are relevant in investment decision making. The CAPM does not consider taxes or transaction costs; they are irrelevant. The main assumptions of the capital market theory are as follows: All investors can borrow or lend money at the risk-free rate of return. All investors are rational and evaluate investments in terms of expected return and variability (standard deviation). Therefore, given a set of security prices and a risk-free rate, all investors use the same information to generate an efficient frontier. The time horizon is equal for all investors: when choosing investments, investors have equal time horizons for the chosen investments. There are no transaction costs or personal income taxes; investors are indifferent between capital gains and dividends. There is no inflation. All assets are infinitely divisible: this means that fractional shares can be purchased. There is no mispricing within the capital markets: it is assumed that the markets are efficient and that no mispricings within the markets exist. Another way to state this is that capital markets are in equilibrium.

What investment style is employed by a portfolio manager whose list of eligible securities includes only those with a market capitalization in excess of $20 billion?

Large-cap When you see market cap, there are 4 levels tested on the exam: large-cap is those with a market cap in excess of $10 billion; mid-cap is the $2 billion to $10 billion range; small-cap is $300 million to $2 billion; and micro-cap is $50 million to $300 million. This manager may be focusing on "blue chip" stocks, but that is not an investment style. Are large-cap stocks conservative? In many cases, yes, but that is not a management style. It is critical on the exam that you choose the answer best fitting the question.

A portfolio manager who is engaging in rebalancing on a semiannual basis is most likely using which portfolio management style?

Strategic asset allocation At least annually, and sometimes more frequently, a portfolio manager who follows strategic asset allocation will examine the relative proportion of the selected asset classes and, based on market performance, rebalance the portfolio to bring it back to its ideal. Active (also called tactical) asset allocation attempts to time the market and doesn't pay the same amount of attention to proportionate holdings as does strategic asset allocation. By its very nature, buy and hold can go years without a portfolio change