Unit 21: Quizzing
Capital Market Theory Assumptions:
1) There are no taxes or transaction costs 2) All market participants borrow and lend at the same risk-free rate. 3) Market participants have the same expectations about the returns and standard deviations of all assets 4) All investors want to achieve maximum return for minimal risk.
In the field of securities analysis, there are many tools available. Which of the following would most likely be used by an analyst to approximate a reasonable price for a common stock? A) The dividend discount model B) Yield to maturity C) Book value per share D) Par value
Answer" A)
The semi-strong form of the efficient market hypothesis (EMH) asserts that stock prices A) fully reflect all publicly-available information. B) fully reflect all relevant information, including insider information. C) don't reflect any information. D) fully reflect all historical price information.
Answer: A) Explanation The semi-strong form of the EMH states that security prices fully reflect all publicly-available information. This would include all historical information. The weak form relates to historical information only. The strong form relates to public and private (inside) information. One could conclude from this that both fundamental and technical analysis don't "work" in an efficient market.
he bond strategy used most often by those with a target goal is A) the laddering strategy. B) the bullet strategy. C) the duration strategy. D) the barbell strategy.
B) When you think of a bullet, you think of it hitting a target. That is what the bullet strategy is all about. When an investor will be making periodic investments in bonds and there is a specific future goal, such as retirement, the bullet strategy seems most appropriate. Some investors might consider a barbell with the target date being in the middle of the short-term and the long-term group, but at least for exam purposes, select the bullet strategy when you are aiming for a target goal.
Define the Dividend Growth Model
"a stock valuation model that deals with divedends and their growth, discounted to today." Assumes the dividends will grow at a constant rate.
Which of the following is an example of dollar cost averaging? A) Investing $100 into the XYZ Fund each month on the 20th of the month B) Buying 20 shares of the XYZ Fund each month on the 20th of the month C) Rebalancing your portfolio each quarter on the 20th of the month D) Maintaining a constant ratio plan
Answer: A)
Formula methods of investing that involve selling equities in rising markets and buying them in falling markets would include constant dollar plan constant ratio plan dollar cost averaging DRIPs
Explanation In both a constant dollar plan and a constant ratio plan, the goal is to maintain a balance between equity and debt securities in the portfolio. This is done by selling equities as their price rises (the proportion has now changed) and buying equities when the prices fall to get back to the constant dollar or ratio. Both dollar cost averaging and dividend reinvestment programs (DRIPs) involve buying securities at regular intervals, not buying and selling based on the direction of the market.
If an analysts expected return is 10% with the inherent risks and the CAPM is showing 12%, then it is
OVERPRICED
MPT preaches that investors will always seek...
the highest return with the lowest risk.
Which of the following is not an assumption of the capital market theory? A) All market participants borrow and lend at different risk-free rates. B) There are no taxes or transaction costs. C) Market participants have the same expectations about the returns and standard deviations of all assets. D) All investors want to achieve a maximum return for minimum risk.
Answer: A) One of the assumptions of capital market theory is that all market participants borrow and lend at the same risk free rate. The other statements are all true:
Two of the major factors involved in the capital asset pricing model (CAPM) are interest rates stock risk premium tax rates market risk premium A) II and IV B) II and III C) I and III D) I and II
Answer: A) The model is made up of two separate components. One component is known as the stock risk premium and is the part of the model reflected by the following formula: (market return − the risk-free return) × beta of the stock. The other component is the market risk premium and is the part of the model reflected by the following formula: (market return − risk-free return). The stock risk premium is the inducement necessary to entice the individual to invest in a particular stock, whereas the market risk premium is the incentive required for the individual to invest in the securities market in general.
Amie Lear is a securities analyst employed by Empyreal Benefits, Inc., a registered broker-dealer. She is assigned to cover a number of different equity and debt investments. One of the investments is Taylor, Inc. (Taylor), a manufacturer of a wide range of children's toys. Based on her extensive analysis, she determines that her expected return on the stock, given Taylor's risks, is 10%. However, when applying the capital asset pricing model (CAPM), the result is a 12% rate of return. Based on Lear's analysis, Taylor's stock is A) overvalued. B) neither overvalued nor undervalued. C) undervalued. D) correctly valued.
Answer: A) Explanation The CAPM gives us the expected rate of return on an investment. It is sometimes referred to as the required rate of return. That is, based on the risks, the CAPM reveals the return that should be earned. In this example, that return is 12%.Lear's computation expects the return to be only 10%. Therefore, Lear is showing that instead of providing the required return of 12%, she believes the stock will only return 10%. That makes the stock overpriced (a lower price will generate a higher rate of return). As a result, Lear would not recommend this stock because her calculations indicate it will not return as much as it should for the risk being taken.
An investment adviser who believes that we are in the early recovery portion of the business cycle would most likely recommend A) defensive stocks. B) cyclical stocks. C) value stocks. D) long-term bonds.
Answer: B) Cyclical stocks have a high correlation to the swings in the economy as reflected in the business cycle. Purchase these in early recovery. Defensive stocks are good to hold when the economy is in early contraction.
It is agreed by most investment advisers that diversifying an investment portfolio can reduce the overall risk. Benefits of diversification would include all of the following except A) lowering the volatility of the portfolio. B) lowering trading costs. C) mitigating the effects of a bankruptcy of a security held in the portfolio. D) increasing risk-adjusted returns.
Answer: B) If anything this will increase the trading costs, but this is outweighed by the potential for higher returns and adjustment to risk.
Which of the following are disadvantages of index investing relative to active portfolio management? I. Indexed portfolios have higher transaction costs. II. Indexed portfolios have lower management fees. III. Indexed portfolios restrict the universe of potential investments. IV. Indexed portfolios may not represent optimal performance for a specific investor. A) I and III B) III and IV C) II and IV D) II, III, and IV
Answer: B) Indexing means that it is only possible to select securities that are within the index, meaning that the universe of investable securities is restricted. An index may not represent optimal performance if the index does not adequately match the investor's objectives. That is, a conservative investor should not be in a small-cap index and, conversely, the S&P 500 Index would be a poor choice for an aggressive one. There are lower, not higher, transaction costs, and lower management fees are certainly not a disadvantage.
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 A) laddering the portfolio B) buying bonds of highest quality C) holding bonds to maturity D) buying bonds with short-term maturities
Answer: B) Quality has no substantial impact on interest rate risk. When interest rates rise, all bond prices fall. However, those that are closer to their maturity date are impacted less. If one can hold until maturity, there is no interest rate risk because, regardless of mkt, you receive PAR VALUE. Laddering is effective. That means the portfolio is spread among a series of maturities, some near, some mid-term, and some long-term.
A portfolio manager using index options is trying to hedge which of the following types of risks? A) Purchasing power B) Systematic C) Financial D) Selection
Answer: B) Sh*t Systematic risk (sometimes called market risk) refers to the impact the overall market has on an equity portfolio's value. Index options help insure portfolios against systematic risk. The purchase of index puts to protect a portfolio by hedging is termed portfolio insurance.
The current market interest rate for a bond rated AA with 20 years to maturity is 5%. In an efficient market, a similar bond with a coupon of 4% could be expected to have an internal rate of return of A) 6%. B) 4%. C) 5%. D) 8%.
Answer: C) Explanation In an efficient market, bonds are priced so that their NPV is zero. That means the bond's yield to maturity is equal to the current market interest rates for similar bonds. When that rate is 5%, as is given in this question, all AA bonds with 20 years remaining to maturity should have a YTM of 5%.
Which investment strategy is consistent with a belief in the efficient market hypothesis? A) Searching for undervalued securities B) Waiting to purchase a stock until it increases above the 40-day moving average C) Selecting a random set of stocks for a portfolio D) Comparing the calculated value of a security, through fundamental analysis, to the market value of the stock
Answer: C) The efficient market hypothesis states that an investor cannot consistently outperform the market. Selecting a random set of stocks is consistent with this theory. The other strategies are aligned with technical and fundamental analysis.
The capital asset pricing model (CAPM) is an investment theory that serves as a model for A) pricing securities based on their total risk B) measuring the correlation between a security and the overall market C) pricing securities based on their systematic risk D) pricing securities based on their unsystematic risk
Answer: C) Under the CAPM, securities are priced based on their systematic risk only, because this risk cannot be eliminated through diversification.
If the efficient market hypothesis is true, portfolio managers should do all of the following except A) work more with clients to better quantify their risk preferences. B) minimize transaction costs. C) add some negatively correlated securities to the portfolio. D) spend more time working on security selection.
Answer: D)
The risk/return pyramid where the bottom is lowest risk and the "point" is the highest, generally places commodities A) in the middle. B) at the bottom. C) halfway between the middle and the top. D) at the top.
Answer: D)
Which of the following is a characteristic of the passive investment style? A) Income rather than growth objective B) High portfolio turnover C) Tactical management D) Rebalancing
Answer: D) Come on... Because the passive (strategic) style of investing does not involve frequent trading (as does the tactical or active style), periodically the portfolio will be rebalanced to insure that the asset mix is at the desired level. This style may be used for either income or growth objectives.
If the current risk-free rate is 3% and the expected market risk premium is 6%, what return should we expect from a security that has a beta of 2? A) 9% B) 18% C) 12% D) 15%
Answer: D) Explanation In most questions of this type, we are given the market return. Here, there is a trick. We are told there is a market risk premium of 6%. That means that the market return must be 6% above the risk-free rate, or 9%. Now, we can plug in the formula. Expected return = 3% + ([9% -3%] × 2) = 3% + (6% x 2) = 3% + 12% = 15%. In this question, because we're already given the risk premium, we can avoid the first step. That would be 3% + (6% x 2) = 3% + 12% = 15%.
An investor has arranged with her bank to have $1,000 sent to the KAPCO Balanced Fund on the same day each month. For the first 4 months of this arrangement, the prices of the fund have been: Month 1 - $10.00 per share Month 2 - $12.50 per share Month 3 - $15.00 per share Month 4 - $13.25 per share What is the difference between the investor's average cost per share and average cost per transaction? A) The average cost per share is approximately $0.19 less. B) There is no difference. C) The average price per transaction is approximately $0.27 less. D) The average cost per share is approximately $0.27 less.
Answer: D) Explanation When investing $1,000 per month, the investor acquired 100 shares the first month, 80 shares the second month, 66.667 shares the third month, and 75.472 shares the fourth month. That is a total of 322.139 shares purchased for a total cost of $4,000. That is an average cost per share of $12.42 per share. The average of the four transaction prices ($10, $12.50, $15, and $13.25) is $12.69. That is $0.27 higher than the cost per share. This demonstrates the advantage of dollar cost averaging.
Which of the following forms of the efficient market hypothesis claims that technical analysis works? A) Semi-strong B) Strong C) Weak D) None of these
Answer: D) The efficient market hypothesis is in direct contradiction to technical analysis because the efficient market hypothesis is founded on the notion that all historical price and volume data, which is used by technical analysts, is already accounted for in the current stock price. The weak form claims that fundamental analysis works and the semi-strong form claims that inside information works. True believers in EMH claim that none of these can outperform random selection.
All of the following statements concerning the EMH are correct except A) an efficient market is one in which the prices of securities quickly and fully reflect all currently-available security market information. B) the weak form of market efficiency involves market data, whereas the semi-strong and strong form involve the assimilation of all public and private information, respectively. C) the efficient market hypothesis states that securities markets are efficient, with the prices of securities reflecting their current economic value. D) investors usually react slowly to new and random information pertaining to all currently-available security market information.
Answer: D) The efficient market hypothesis posits that an eddient market is one in which the prices of securities quickly and fully reflect all currently-available security market information. Therefore, there is little chance than investor can "beat the market." The weak form uses historical market data, such as price and volume movements; semi-strong involves financial info publicly available; strong involves insider info. But, according to adherents, none of that helps. (random?)
There are several popular investment styles and, in many cases, portfolio managers use a blended approach to security selection. If a portfolio manager adhered to a pure value style, he would put most of his focus on A) lagging indicators B) projecting future earnings based on past earnings C) using technical analysis D) the company's financial statements
Answer: D) The value style looks for stocks that are undervalued. For example, the current market price is near or less than book value per share. Only way to determine if true is looking at balance sheet.
Writing a call option provides all of the following except A) limited downside protection when long the underlying asset. B) income. C) hedging. D) maximum protection against loss.
Answer: D) Writing a call option only provides limited protection for a long or short position.
An optimal portfolio is...
A portfolio that maximizes investor's preferences with respect to return and risk. An optimal portfolio will generally lie on the efficient frontier (which is a graph, not a portfolio). The special nature of an optimal portfolio is that it may not always be the most efficient portfolio (offering the greatest return for the least risk) because it takes into consideration the specific preferences of the individual investor, which might create a bias.
A portfolio manager with a growth style would probably diversify by A) concentrating in stocks in one or two industries B) devoting a portion of the portfolio to securities with a negative correlation C) attempting to build a portfolio with a very high correlation D) placing a portion of the portfolio into high-yield bonds
Answer: B) Securities with a negative correlation add diversification to a growth portfolio because they move in the opposite direction of the balance of the holdings. Therefore, losses are offset by gains.
Which of the following is the simplest portfolio management style for individual stocks? A) Moving averages B) Core C) Buy and hold D) Indexing
Answer: C) The key to answering this question directly is recognizing that it deals with individual stocks. If the question dealt with managing a portfolio, then indexing would be the simplest
Hexagon Portfolio Advisors (HPA) believes that the market is semi-strong efficient. The firm's portfolio managers most likely will use A) active portfolio management strategies. B) an enhanced indexing strategy that relies on trading patterns. C) technical analysis to create portfolio management strategies. D) passive portfolio management strategies.
Answer: D) If the market is semi-strong efficient, portfolio managers should use PASSIVE managmenet because they beleive neither tehcnical or fundamental analysis will generate positive abnormal returns on averge over time They believe that insider information can work, but because that info is generally prohibited, portfolio managers can't claim that as a strategy.
