7 - Quantitative Measures and Investment Risks

Assuming all of the following mature at about the same time, which of the following bonds should experience the greatest price decline if interest rates rise by 1%? A) Treasury bond issued at par and carrying a 4% coupon. B) Treasury bond issued at par carrying a 5% coupon. C) Treasury bond issued at par carrying a 7% coupon. D) Treasury bond issued at par carrying a 6% coupon.

Answer: A This is an example of duration. With approximately equal maturity dates, the bond with the lowest coupon will always have the longest duration. The longer the duration, the greater susceptibility to price changes due to fluctuations in interest rates.

The best known index is that of the Dow Jones 30 Industrials. It would be most accurate to characterize those 30 stocks as: A) mid cap. B) large cap. C) small cap. D) a blend of large, mid, and small cap.

Answer: B Each of the 30 stocks in the Dow Jones 30 Industrials meets the large-cap standard.

ABC Combination Fund has dual objectives of capital appreciation and current income. Last year, the fund paid quarterly dividends of $.25 per share and capital gains of $.10 per share. The annualized growth rate of the fund was 15%. The current net asset value (NAV) of the fund is $28.50 and the current public offering price (POP) is $30. Advertising and sales literature of the fund may report the fund's current yield to be: A) 0.83%. B) 3.85%. C) 3.33%. D) 27.20%.

Answer: C The current yield on mutual funds is calculated by dividing the annualized yield ($.25 × 4 = $1) by the POP. In this case, $1 ÷ $30 = .0333 × 100 = 3.33%. In calculating the current yield, the law prohibits the inclusion of capital gains and growth.

Managers of bond portfolios who anticipate an increase in interest rates should: A) assume higher risk in the secondary market. B) increase the portfolio duration. C) invest in high-yield or junk bonds. D) decrease the portfolio duration.

Answer: D A bond portfolio manager who anticipates periods of rising interest rates should decrease the duration of a bond portfolio to minimize the price decline. Duration is inversely related to changes in market and coupon interest rates.

If the required rate of return is less than anticipated in a present value calculation, the effect would be that the: A) present value would be lower. B) yield to maturity would decrease. C) future value would be lower. D) present value would be higher.

D) present value would be higher. *Try to follow me on this one. The present value computation is used to determine how much money must be deposited NOW (present) to reach a specified future goal when you know how many years to have to reach that goal. One critical component of the formula is the rate of return used in the formula. As a simple example, if you need $100,000 eighteen years from now for your newborn's college education and you expect to earn 8%, you'll have to deposit $25,000 now (present value) to reach the goal. However, if it turns out that the earnings rate is less than anticipated, say only 4%, then you would have to deposit twice as much presently. Therefore, we answer this question by indicating that a lower rate of return will require a higher present value.

If a stock has a beta of less than 1.0, the stock's price will: A) not increase as much as the market when the market is up. B) increase more than the market when the market is up. C) decrease more than the market when the market is down. D) decrease regardless of whether the market is up or down.

Answer: A Beta compares a stock's price history to the movement of a total market index for the same period. A beta of less than one means that the stock's price does not swing as widely, up or down, as the average for the entire market.

Which of the following is NOT a standard used to determine whether a particular mutual fund is suitable for an individual investor? A) The investor's estimated tolerance for risk and volatility. B) The amount of time elapsing between the deposit of the investment and the investor's anticipated use of the funds. C) Components of an investor's current portfolio. D) Whether the investment is made directly through the fund itself or through a broker/dealer.

Answer: D Whether a mutual fund is offered through the issuer or through broker/dealer channels is not a suitability determinant. However, time horizon, risk tolerance, and existing portfolio components help determine investment suitability.

From the following four portfolios, choose the one that would generally be considered to be the most diversified. A) STU common stock, beta .95, correlation to the S&P 500, +.84, VWX common stock, beta .90, correlation to the S&P 500, +.07; YZA common stock, beta .88, correlation to the S&P 500, -.45. B) ABC common stock, beta 1.20, correlation to the S&P 500, +.82; DEF common stock, beta .90, correlation to the S&P 500, +.91; GHI common stock; beta +.65, correlation to the S&P 500, .56. C) DCB common stock, beta 1.00, correlation to the S&P 500, +.75; HGF common stock, beta .10, correlation to the S&P 500, +.25; KJI common stock, beta -.50, correlation to the S&P 500 +.50. D) JKL common stock, beta 1.50, correlation to the S&P 500, +.77; MNO common stock, beta 1.00, correlation to the S&P 500, +.93, PQR common stock, beta .50, correlation to the S&P 500, +.34.

Answer: A Most analysts would agree that the greatest portfolio diversification occurs when there are some holdings with a negative correlation. Beta measures volatility, so varying those positions will offer some protection against volatility. However, including securities that move in opposite directions will provide protection against general market declines.

One element of the formula used to compute the Sharpe ratio is: A) standard deviation. B) alpha. C) beta. D) net present value.

Answer: A Standard deviation is used as the denominator in the formula used to compute the Sharpe ratio, a risk-adjusted rate of return. Standard deviation generally reflects the variability of portfolios that are not well diversified, while beta generally reflects the volatility of portfolios that are well diversified. Net present value measures the theoretical intrinsic value of an investment having uneven cash flows.

Which of the following correlations would represent 2 assets that tend to move in tandem with one another? A) 0.81. B) -0.68. C) 0.16. D) -0.11.

Answer: A The correlation coefficient ranges from -1.0 to +1.0 and measures the varying relationship of assets (or securities) to one another. A correlation close to +1.0 would indicate that the assets should move in tandem. A correlation close to 0 would indicate that the assets would have little relationship to one another, and a correlation of -1.0 would indicate that the assets should exhibit virtually opposite behavior.

Expected return is: A) an estimate of probable returns an investment may yield. B) the one discount rate that equates the future value of an investment with its net present value. C) the difference between an investment's present value and its cost. D) the worth of future income discounted to reflect what that income is worth today.

Answer: A The expected return is the estimate of probable returns that an investment may yield when taking the sum of all probabilities.

Given the following information, calculate the risk-adjusted return: 90-day T-bill rate: 4%. Actual return: 14%. Beta 1.40. CPI 3%. Standard Deviation 5.0. A) 2.0. B) 5.0. C) 10.0. D) 11.0.

Answer: A The risk-adjusted return is measured by the Sharpe ratio. This is calculated by subtracting the risk-free rate (90-day T-bill) from the actual return and dividing that remainder by the standard deviation. In this example, 14% − 4% = 10% divided by 5 = 2%.

A portfolio that is primarily invested in corporate bonds would be subject to: credit risk. interest rate risk. opportunity cost. purchasing power risk. A) I, II, III and IV. B) II and IV. C) I II, and IV. D) I and II.

Answer: A Unless the security is a US Government bond, all bonds have credit risk. Including government bonds, they all fluctuate with changes in the interest rates and lose value due to inflation. Opportunity cost is the risk taken by choosing to invest in a lower risk investment rather than attempt the higher returns that historically have been earned though investment in equities.

In an attempt to create diversification, which of the following securities would be the best candidate for inclusion in an investor's current portfolio? A) Security DEF with an expected return of 20% whose return's correlation with the portfolio is +2.0. B) Security ABC with an expected return of 10% whose return's correlation with the portfolio is -1.0. C) Security XYZ with an expected return of 10% whose return's correlation with the portfolio is +1.0. D) Security LMN with an expected return of 10% whose return's correlation with the portfolio is 0.

Answer: B Security ABC with an expected return of 10% whose return's correlation with the portfolio is -1.0 would provide the best fit because its returns are negatively correlated with the portfolio. Combining securities whose returns are negatively correlated with a portfolio provide the benefits of diversification. A security with a correlation of +1.0 would compound risk because of its perfect positive correlation and provide no benefits of diversification. A security with a correlation of 0 would provide no benefits of diversification. Correlation coefficients range from +1.0 to -1.0.

An analyst computing an issuer's book value per share would most likely not include the value of the company's: cash. wages payable. patents. preferred stock. A) I and II. B) III and IV. C) I and IV. D) II and III.

Answer: B The computation of book value per share is basically net tangible worth per share of common stock. Therefore, we remove the par value of the preferred stock and do not include the value of intangible assets such as patents.

An investment is made of $10,000. At the end of the year, $500 in dividends has been received and the value of the investment is $10,500. If the investor is in the 30% tax bracket, the after-tax yield is: A) 5.0% B) 3.5% C) 8.5% D) 6.5%

Answer: B The only return (as far as yield is concerned) is the $500 of dividends. Subtracting 30% for taxes leaves $350 which, when divided by the $10,000 initial cost, is an after-tax yield of 3.5%. If the question had asked about total return, then the $500 unrealized profit would have been included, although there would have been no tax on it.

What is the total return on a 1-year, newly issued (365 days to maturity) zero-coupon bond priced at 95? A) 5%. B) 5.26% C) 5.26% plus the implied coupon rate. D) The return cannot be determined without knowing current interest rates.

Answer: B To determine the total return on this zero-coupon bond, the $5 capital appreciation is divided by the cost of the bond (in this case, $5 divided by $95 equals a total return of 5.26%). Total return of a zero-coupon bond is made up entirely of the difference between the cost of the bond and the sale or maturity price of the bond.

When current interest rates are at 6%, you would expect a bond with a nominal yield of 4% to be: A) in danger of default. B) selling at a discount. C) selling at par. D) selling at a premium.

Answer: B With the market rate of return at 6%, a 4% bond just isn't as valuable so, the only way investors would be interested is if they could acquire it at a discount. That discount would work out to be a figure that would work out to a 6% return for the purchaser. Remember, as interest rates go up, bond prices go down and vice versa.

Which of the following has the greatest liquidity risk? A) Real estate investment trust (REIT). B) Municipal bond unit investment trust (UIT). C) Long-term bond mutual fund. D) Rental apartment building. View Answer and Explanation

Answer: D Real estate (such as an apartment building) is among the most difficult investments to convert into cash and the most illiquid of the choices given. REITS provide investors with liquidity through trading in the secondary markets. A bond mutual fund is a redeemable security; the issuer provides liquidity. Unit investment trusts are more liquid than real estate because they are redeemable securities.

****A method of assessing the value of a fixed income security by looking at the future expected free cash flow and discounting it to arrive at a present value is known as: A) Internal rate of return. B) Current yield. C) Future value. D) Discounted cash flow.

Answer: D The discounted cash flow, DCF, is used to asses the value of a fixed income security is by looking at the future expected free cash flow and discounting it to arrive at a present value. This is basically nothing more than taking the income payments you are scheduled to receive over a given future period and adjusting that for the time value of money.

Which of the following investments is the most liquid? A) Municipal revenue bond issued by a township. B) Oil drilling limited partnership interest. C) Common stock in a small oil drilling corporation that is quoted on the Pink Sheets. D) Long-term municipal bond fund.

Answer: D The long-term municipal bond fund is the most liquid because it is a mutual fund (a redeemable security), and the investor is assured of a buyer that will exchange money for the redeemed fund shares within seven days of the redemption request. Municipal bonds of a township, especially those that are from extremely small issuers, may have thin markets where sellers have difficulty finding willing buyers. There is not an active secondary market for reselling interests in limited partnerships. Stock of a small corporation that trades in the over-the-counter market may also have a thin market.