CFP II - Investment Planning (Midterm)

Zarathustra Industries has assets of $300 million, and liabilities of $100 million. Zarathustra earned $25 million last year, and paid out $5 million in dividends. What is Zarathustra's dividend growth rate? What happens if the retention rate falls to 50%

$300M (assets) - $100M (liabilities) = $200M of equity$25M/$200M = .125 = 12.5% ROE $25M (earnings) - $5M (dividends) = $20M in retained earnings $20M/$25M = .80 Retention Rate (RR) g = ROE x RR12.5 x .80 = 10% If retention rate falls to 50%? 12.5 x .50 = 6.25%. So as the retention rate falls, so does the growth rate. And as the retention rate increases, the growth rate will increase. Also, remember to be aware of how leverage affects ROE (discussed in the ratio section of this module). For example, contrast Zarathustra with another company (Zeus Inc.) that also has $300 million of assets, but $200 million of liabilities, and assume everything else is the same. This would give Zeus Inc. equity of only $100 million, so earnings of $25 million would give Zeus Inc. a ROE of 25% (twice that of Zarathustra).

Coefficient of Determination

(R-Squared): How much of a securities movement can be explained by the movement in the index. Just square the R R-squared of .70 or greater for Beta to be reliable.

Describe top-down analysis

1) Economic analysis GDP growth Monetary (fed) & fiscal policy (congress/President) Political analysis Inflation analysis 2) Industry analysis: The industry life cycle refers to a regular pattern of growth, maturity, and decay." 3) Company analysis

What are the different weighting methods for stock indices?

1) Equally weighted: Gives small-cap stocks as much influence as large-cap stocks (Value Line) 2) Price weighted: Gives high-priced stocks more influence than low-priced stocks (Dow Jones Industrials) Only 30 stocks Not a straight average 3) Capitalization weighted (most common) Gives large-cap stocks more influence than small-cap stocks (most indexes―capitalization weighted indexes are the ones used in MPT)

Describe bottom-up analysis

1) Ratio analysis Liquidity (current and quick ratios) Activity (inventory turnover) Profitability (EBITDA) Return on capital Leverage 2) Cash flow analysis 3) Business analysis Industry competitors New products Regulation trends Acquisitions management

Victor purchases 1,000 shares at $50 per share using a 50% margin. The stock pays a $1.00 dividend and Victor pays $450 in margin interest. He sells the shares for $60 per share. What is his holding period return?

= [60,000 + 1,000 - 450 - 50,000] / 25,000 = 10,550 / 25,000 = .422 = 42.2% The key here is that Victor only puts up 50% of the $50,000 purchase price; he has to pay back the $25,000 margin loan when he sells. So, his profit on the stock is the difference between the sale value and the value of the stock when he purchased it ($60,000 - $50,000 = $10,000). The other $550 is the difference between the $1,000 received in dividends, and the $450 paid in margin interest. Note the impact of use of margin in the instance. If Victor had used cash, the calculation would be $11,000 / $50,000 for a 22% HPR. (if has margin, the numerator includes the margin and the denominator excludes)

How are indices calculated when used for modern portfolio theory analysis? a. value weighted b. price weighted c. equal weighted d. geometrically weighted

A. Is the correct answer. MPT IS ALWAYS VALUE WEIUGHTED. S&P 500, ETC Price weighted is Dow Equal weighted is Value Line Geometrically weighted is n/a

What would be the approximate price movement of the Acme Fund if it has a beta of .85, and the benchmark it is being compared to has a return of 15%? What if Acme's beta were 1.25?

Answer: 15% x .85 = 12.75% Answer: 15% x 1.25 = 18.75% what is the approximate beta for and S&P 500 Index Fund? Should be 1.0. High beta = more volatile

Define Arithmetic return vs Geometric return

Arithmetic return Assumes no compounding Each year is independent Always higher than geometric return Geometric return (compounded or time average/time weighted) Assumes compounding Always lower than arithmetic return

Annual returns of 8%, 15%, -7%, and 12% Calculate the arithmetic and geometric returns

Arithmetic return: 8 + 15 - 7 + 12 = 28 28/4 = 7% (or solve for mean return on calculator) ALWAYS HIGHER THAN GEOMETRIC. ONLY THE SAME IF THE RETURNS ARE IDENITCAL Geometric (time-weighted) return: (don't need the first $1) $1.00 x 1.08 x 1.15 x 0.93 x 1.12 = $1.2937 This means $1 would have grown to $1.2937 Then just do a simple TVM calculation for i 1 (+/-) = PV 1.2937 = FV 4 = n i = 6.65%

Calculation of Beta

B = (Std Dev of individual asset / Std Dev of market) x Correlation Coefficent of the security and the market. Beta of 1.0 will have exact same expected volatility as the benchmark. Beta of 1.25 will have 25% greater expected volatility than the benchmark.

How to determine which method of portfolio performance?

B...is beta reliable? A...if beta is reliable you can use Alpha. T...if beta is reliable you can use Treynor. S...if beta is not reliable, you must use Sharpe (a catchall) Also, when using Sharpe or Treynor, the higher result is the investment you go with, as it indicates more return per unit of risk.

Behavioral finance

Behavioral finance challenges one of the major assumptions of the EMH, namely that investors are rational! Recognizing common mistakes can help both the adviser and the investor make better decisions.

What does Beta of 1 mean?

Beta of 1 means the asset has the same volatility as the benchmark.

ON MIDTERM Theo has been offered a parcel of vacant land for $50,000. Taxes and upkeep (at the end of each year) are anticipated to be $2,000 per year for the next five years. At the end of five years, Theo hopes to sell the land for $100,000.  If Theo's required rate of return is 9%, should he purchase the property? A. yes, because the NPV is positive B. yes, because the NPV is negative C. no, because the NPV is positive D. no, because the NPV is negative

CAN ELIMINATE B&C BC THEY ARE IMPOSSIBLE. WANT A POSTIIVE NPV Calculate the NPV for this scenario. Cash flows are: (50,000), CFj (2,000), CFj (2,000), CFj (2,000), CFj (2,000), CFj 98,000, CFj 9, i/yr SHIFT, NPV = 7,213.84. If the NPV is 0 or positive, then one would purchase the property. SHIFT IRR (FOR THE IRR)

John Baker purchased a plot of land for $100,000. He had the following inflows and outflows associated with the investment. At the end of Year 5 John sold the land for $127,000. What was the internal rate of return on his investment ? End of Year Inflow Outflow 1 2,000 21,000 2 9,000 4,100 3 10,000 2,100 4 10,500 2,500 5 9,000 7,200

Calculate and draw the net annual flows (subtract them or net them) in the space to the right of the outflow column, then label the timeline on the next page and follow the keystrokes. Pg. 24 in the book. Uneven cash flows Today (100,000) (19,000) + 4,900 +7,900 +8,000 +128,800 Set calculator for 1 P/YR, end mode 100,000 (+/-) = CFj (CFo in the HP 12C) 19,000 (+/-) = CFj 4,900 = CFj 7,900 = CFj 8,000 = CFj 128,800 = CFj ($1,800 + $127,000) SHIFT, IRR = 5.13%

Use of leverage

Can increase return on equity but also increases financial risk ROE = Net Income / Equity

What are moving averages (as part of technical analysis)?

Compare the stock's current price to a moving average of the stock's price. Use of moving average eliminates impact of short-term fluctuations. Moving averages may be varying amounts, such as 50, 100, or 200 days The moving average follows the current price If more than 80% of the market's stocks are selling above their 200-day moving average, the market is considered to be overvalued, which is a bearish sign. If less than 20% of the market's stocks are selling above their 200-day moving average, the market is considered to be undervalued, which is a bullish sign.

A real estate property is being offered for $250,000 and is expected to have cash flows of $26,000, $31,000, $34,000, and $38,000 at the end of each of the next four years. At the end of Year 4 the property is expected to be worth $320,000. If an investor has a required rate of return of 12%, what are the PV and NPV of the property?

Complete the timeline. Calculate PV first, then NPV. PV (disregards entry price) NPV (considers entry price) and all you need is a positive number PV NPV 0 Today (250,000) 26,000 1 26,000 31,000 2 31,000 34,000 3 34,000 358,000 4 358,000 (38,000+320,000) DON'T FORGET TO ENTER THE INTEREST RATE First we will calculate the PV of the cash flows (disregard the purchase price for this calculation): 12 = i (this is our discount rate) 0 = CFj 26,000 = CFj 31,000 = CFj 34,000 = CFj 358,000 = CFj SHIFT, NPV - $299,643 Next we will calculate the NPV of the investment (enter the purchase price): 12 = i 250,000 (+/-) = CFj 26,000 = CFj 31,000 = CFj 34,000 = CFj 358,000 = CFj SHIFT, NPV = $49,643 IF POSTIIVE NPV, IRR SHOULD BE HIGHER THAN REQUIRED RETURN $299,643 present value Less $250,000 purchase price Equals $49,643 net present value

what are the liquidity ratios?

Current ratio = current assets / current liabilities Quick ratio = [current assets - inventory] / current liabilities must be undertaken relative to industry competitors. Current = one year or less. Balance sheets will go in order of liquidity.

Dollar weighted returns vs Time weighted returns

Dollar weighted (IRR) Client returns are dollar weighted This reflects the actual return to the client Identical in concept to internal rate of return Time weighted (Geometric return) Investment manager returns are time weighted This reflects the actual performance of a manager over a specified time period CFA Institute required

What is the Information Ratio

Extension of the Sharpe ratio: - The numerator is the return of the portfolio minus the return of the benchmark (instead of risk-free rate). - The denominator is the standard deviation of the difference between the returns on the portfolio and the returns on the benchmark (also known as tracking error). This is also a relative measure. Inf Ratio = [Return of Portfolio - Return of Benchmark ] / Std Dev of return on Portfolio & returns on benchmark Higher result is better

Describe technical analysis

Focus on the stock price, not on the company Interprets supply and demand for the stock Uses graphs of stock's price movements and volume

You have to choose between the following two funds; the current risk-free rate is 5%. Use Treynor. Fund A: 18% return, beta of 1.3 Fund B: 14% return, beta of 0.85

Fund A [18-5] / 1.3 = 10 Fund B [14-5] / 0.85 = 10.59 Answer: Fund B with the higher Treynor ratio, show can also use decimal rather than whole numbers for returns, as long as you are consistent. Fund A had the higher absolute return, but at much greater risk (a higher beta).

Behavioral finance biases

LOSS AVERSION: Investors hate to take losses, and people generally prefer to avoid losses than to achieve gains. Kahneman & Taversky study found a loss has about 2.5 times the impact of a gain of the same magnitude. Get-even-itis. FEAR OF REGRET: Regret is more than experiencing the pain of a loss. Regret involves the pain of feeling responsible for the loss. POSTPONING WISE MOVES OVERCONFIDENCE: overconfidence can lead to illusions of control that can lead to biased judgments. Often results in excessive trading. REPRESENTATIVENESS: Stereotyping, appears when investors become overly negative about investments that have done poorly in the past and overly positive about investments that have done well in the past. FRAMING: The notion that it matters how a concept is presented to an individual. Examples of meal discounts and coin flipping. RATIONALIZATION: . The tendency to give too much importance to information that confirms one's impressions or preferences is called confirmation bias. HINDSIGHT BIAS: Looking back, seeing events that took place in the past as having been more predictable than they seemed before they happened. SELF-ATTRIBUTION BIAS: Self-enhancing bias (claim irrational degree of credit) and self-protecting bias (irrational denial of responsibility for failure). ANCHORING: Hold to certain beliefs even when faced with new info that should alter those beliefs. RECENCY: Too much weight on current events and conditions and too little weight on historical trends. MENTAL ACCOUNTING: Treating each dollar of wealth differently base upon the source. Examples of inherited money and "house money". MONEY ILLUSION: Misunderstanding nominal and real rates of return. Example of 7% gain with 8% inflation versus 4% gain with 2% inflation. People will choose 7% nominal gain. AVAILABILITY: More weight to data that is easily obtained, such as P/E ratio. STATUS QUO: Choose options that continue the existing situation. ILLUSTION OF CONTROL: Tendency to believe they can control or influence outcomes. ENDOWMENT: An asset already owned is more valuable than those that are not owned, ownership endows the asset with added value.

What does it mean if IF R = 0.9 and R2 = 0.81?

It tells us that 81% of the price change in a given security can be explained by the change in price of the appropriate benchmark. 81% is systematic risk and 19% is unsystematic (diversifiable) risk.

Standard Deviation: Single Asset Calculation Assume Acme Industries has the following annual returns: 15%, 22%, -7%, 10% What is the standard deviation and mean return?

Keystrokes are: 1, SHIFT, P/YR 15, ∑+ 22, ∑+ 7, +/-, ∑+ 10, ∑+ SHIFT, 8 (g, "." on 12C) Answer = 12.36 For the mean return the keystrokes would be: SHIFT, 7 (g, "0" on 12C) Answer = 10%

What is Covariance?

Measure how assets move alike or apart over time. No boundaries, hard to interpret and meaningless as a stand alone measurement. It is used in the calculation of Std Dev of a 2 Asset Portfolio calculation and in Correlation Coefficient calc. Cov = R (std dev of 1 security)(std dev of other security)

ON MIDTERM Kaleidoscope Inc. has assets of $600 million and liabilities of $350 million. Earnings for the current year were $50 million, and the dividend payout ratio is 25%. What is the dividend growth for Kaleidoscope Inc.? A. 10% B. 15% C. 20% D. 25%

ON MIDTERM b. The equity for Kaleidoscope is $250 million (600 million - $350 million). Earnings were $50 million, so the return on equity is 20% (50/250 = .20). The earnings retention rate is 75% (1 - .25 payout ratio), so g = roe x rr g = 20 x .75 = 15%

Libra Inc. has a mean return of 11%, and a standard deviation of 9. Assuming the returns are normally distributed, what is the probability that the stock will have a return greater than 20%?

ON MIDTERM (ANSWER IS 16%) Sketch out a normally distributed bell curve and label the standard deviation zones.

What do you use when you don't have dividends to work with?

P/E Ratio & PEG Ratio Price/Earnings ratio:  Current stock price / current/projected EPS PEG ratio: Current P/E ratio / Current year earnings growth rate

Efficient Market Anomalies

Possible exceptions to the efficient market hypothesis, called anomalies, appear to exist. 1) January effect = Buy stocks in December and sell in January of each year (especially small stocks) 2) Dividend-yield anomaly = Buy stocks with high dividend rates 3) Weekend effect= Buy stocks on Mondays 4) Low P/E = Low P/E stocks outperform high P/E stocks 5) Size (small firm) effect = Small-cap stocks outperform large-cap stocks 6) BV/MV effect = Stocks with high book to market prices outperform stocks with low book to market prices 7) Neglected-firm effect = Buy stocks followed by few analysts 8) Value Line effect = Stocks rated 1 in Value Line outperform stocks rated 5

If Co has no dividends AND no earnings, what can you use?

Price to Sales Ratio: PSR = Current stock price / sales per share Price to Book ratio: Current stock price / BV per share

What is risk?

Risk is broken into Systematic and Unsystematic risk. Total risk can be measured by standard deviation and used on a standalone basis. Unsystematic risk is diversifiable and unique. Systematic risk is undiversifiable and is measured by BETA. PRIME

George and Thelma Blake purchased a stock six months ago for $4,600. At the end of the third month, the Blakes received $104 in dividends. Today, they sold the stock for $4,900. What is the annual internal rate of return on this investment?

Set calculator for 12 P/YR, end mode First complete the timeline with the -$4,600 at left end, $0 at Month 1, $0 at Month 2, +$104 at Month 3, $0 at Month 4, $0 at Month 5 and +$4,900 at right end (Month 6). Set calculator for 12 P/YR, end mode 4600 (+/-) = CFj 0 = CFj, 2, SHIFT, Nj (2 zero periods in a row) or just put each 0 in Cfj 104 = CFj 0 = CFj, 2 SHIFT, Nj (2 zero periods in a row) 4900 = CFj SHIFT, IRR = 17.14%

Travis is interested in buying a stock that currently pays a dividend of $0.60 cents per share annually. His required return on investments is 9%. The dividend is expected to grow 15% annually for the next two years, followed by an expected growth rate of 6% thereafter. What is the most that Travis should pay for the stock? (or calculate the intrinsic value of the stock)

Step 1: Find the amount of the dividend at the end of each of the two years of the non-constant growth: 0.60 x 1.15 = 0.69 0.69 x 1.15 = 0.7935 Step 2: Find the value of the stock at the end of Year 2 based on the dividend to be paid at the end of Year 3 (constant growth): 0.7935 (1.06) = $28.04 0.09 - 0.06 Step 3: Using the calculator, solve for the PV of unequal cash flows using the timeline. OR High growth (15%) Stable growth (6%) D0 $0.60 D1 0.69 D2 0.7935 D0 $0.7935 D1 0.8411 Insert the cash flows on the timeline and then run the following calculation: 9i; 0CFj (CFo on the 12C); 0.69CFj; (0.7935 + 28.04) = 28.83 CFj SHIFT, NPV, Answer = $24.90 (See extra handout slide 4-28) CF0 = 0 CF1 = 0.69 CF2 = 0.7935 + 28.04 (calculate the intrinsic value of D1)

Expected return

Stock Overvalued: Expected return less than required return Stock Undervalued: Expected return more than required return

Kerry owns the following two mutual funds: Weighting Std Dev Octopus 50% 22 Squid 50% 28 The covariance between the two funds is -44. What is the standard deviation of Kerry's portfolio? a) 17.2 b) 19.6 c) 21.3 d) 25.0

The correct answer is a. (0.52 x 222)+ (0.52 x .282) + 2(0.5)(0.5)(-44)

Belinda follows and charts the price and volume for various securities. You can interpret that she a. does not believe in the EMH. b. believes in the weak form of the EMH. c. believes in the semi-strong from of the EMH. d. believes in the strong form of the EMH.

The correct answer is a. Technical analysis is not a part of any of the three EMH forms. Belinda is using technical analysis, so she does not believe in the EMH.

Which of the following illustrate the important factors in the construction of a portfolio under the principles of modern portfolio theory? I. investors want to maximize utility II. correlation between pairs of securities III. beta as a measure of total portfolio risk IV. investors indifferent to efficient portfolios a. I and II only b. II and III only I, II, and III only I, II, and IV only

The correct answer is a. Beta is a measure of systematic risk, not total risk. Investors are not indifferent to efficient portfolios, they want efficient portfolios in order to be compensated for the amount of risk they are taking.

Simon inherited some bank stock from his mother, and will not sell any of it even though it now represents a substantial percentage of his portfolio, nearly 30%. He tells his adviser that he is not concerned about the shares since it is "found money anyway." In order to help Simon, you would explain the behavioral finance concept of a. recency. b. hindsight. c. self-attribution. d. mental accounting.

The correct answer is d. This is a classic case of mental accounting, where some money (in this case inherited stock) is treated differently than other money (such as earned income). Recency is giving too much weight and consideration to recent events when making investment decisions. Hindsight is the illusion that something that has happened was predictable - even if it was not. Self-attribution describes the tendency of individuals to take credit for their successes, and to blame others for their failures.

Arbitrage pricing theory (APT) takes into account unexpected changes in all of the following except a. interest rates. b. GDP. c. inflation. d. market risk premium. e. standard deviation.

The correct answer is e.

Valuation

The determination of what a stock is worth; the stock's intrinsic value - If the valuation exceeds the current price, you should buy the stock. - If the valuation is less than the current price, do not buy the stock, or go ahead and short the stock.

What is Holding Period Return?

The percentage earned on an investment during a period of time Simply the profit divided by the amount invested HPR = [S + I - Pc] / Pc S = sale price, I = income (subtract costs, such as margin interest), Pc = purchase cost **This HPR formula is not on the Board's formula sheet*** Any transaction costs (i.e. sales charges or commissions) must be included if they are given in the fact set. If haven't sold, just use the ending value instead of sales price Not an annualized number

Define NPV. What does positive or neg NPV mean?

The present value of future cash flows using an appropriate discount rate (investor's required return), and then subtracting the investment's cost. A positive NPV means: the investor will earn a return higher than the discount rate used, and the investment should be purchased. A zero NPV means: the investor will earn the same return as the discount rate used, and the investment should be purchased. A negative NPV means: the investor will earn a return lower than the discount rate used, and the investment should be rejected.

How do you define diversified unsystematic risk?

There are diminishing effects of diversification when the number of securities reaches a certain threshold. For EXAM, to be considered diversified, you need: 10-15 for large cap stocks 25-30 for small cap stocks 4-7 Mutual funds in diff asset classes. There are mutual funds that hold concentrated portfolios, such as Fairholme (FAIRX) with 22 holdings at last report, Yacktman Focused Fund (YAFFX) with 22 stocks, 3 bonds and 1 other, and Janus Twenty (JAVLX) with 30 holdings at December 31, 2015. The flip side of that is Growth Fund of America (AGTHX) with 285 equity holdings at December 31, 2015.

How is risk measured?

Total risk is measured by standard deviation (variability) and can be used as a standalone measure. Systematic risk is measured by beta.

Describe Treynor ratio

Treynor is a relative measure (use for comparison). Ti = [Rp - Rf] / B Meaningless if used in isolation - the higher the better (more return for a given level of risk) - Once again, beta needs to be reliable. Reliability = .70 or greater R-squared. Treynor is not reported on Morningstar fund reports.

Stock VIP sells for $50 and pays an annual dividend of $3.00; its dividends are expected to increase by 3% annually. The stock has a beta of .85. The required rate of return on the market is 10%, and the risk-free rate is 5.5%. What is the investor's required rate of return? What is the intrinsic value of Stock VIP? What is the expected rate of return on Stock VIP? Stock VIP is trading at $50 and its intrinsic value is $48.82. Would you buy the stock?

Use CAPM to arrive at required rate of return to be used in DDM calc. = 5.5 + (10 - 5.5) .85 = 5.5 + 3.83 = 9.33% V = D1 / (R-G) = $3(1.03)/(0.0933-0.03) = $48.82 Intrinsic value above is less than stock price so it's overvalued And the expected return will definitely be less than required return E(R) = (D1/P) + G = $3.09/$50 + .03 = 9.18% No, it is overvalued. When a stock is overvalued the expected return (9.18% for VIP) will be less than the required return (9.33% for the VIP investor).

Constant Growth DDM

V = D1 / [r-g] r = required rate of return from CAPM

A stock has a current price of $66, earnings of $1.70, and pays out a dividend of $0.75. The stock's historical P/E range is 18 to 26. Which of the following are correct statements about the stock's P/E ratio, valuation, and possible future action?  I. P/E = 39 II. P/E = 88 III. stock is overvalued, downward pressure expected IV. stock is undervalued, upward pressure expected a. I and III only b. I and IV only c. II and III only d. II and IV only

a is the correct answer. $66/$1.70 = 39 P/E. Stock is trading at a higher P/E multiple than its historical range, so this may mean the stock is overvalued.

ON MIDTERM You are considering an investment in Moose Industries, and want to know the geometric return over the past five years. Total returns for the past five years have been +22%, -8%, +13%, +4%, and -7%.  What is the annual compound rate of return (geometric average) for Moose Industries? A. 4.17% B. 4.80% C. 5.58% D. 7.57%

a is the correct answer. 1 x 1.22 x .92 x 1.13 x 1.04 x .93 = 1.2267, so (1) pv, 1.2267 fv, 5 n. i = 4.1712

If the risk premium in the CAPM equation for a stock decreases, what is the likely consequence of the valuation of the stock when the dividend growth model is used to compute its value? A. The stock's value will increase. B. The stock's value will not change. C. The stock's value will decrease. D. The risk premium is not relevant to the CAPM.

a. If the risk premium decreases, then the required return will also decrease, based on CAPM. If the required return is less, then the denominator of the DDM will decrease, resulting in a higher valuation of the stock (see formulas).

Jake is considering two mutual funds for purchase. The Circus Fund has a beta of 1.2 and 3-year return of 8.5%. The Hindsight Fund has a beta of 0.9, and 3-year return of 8%. The current market risk premium is 5%, and the risk-free rate is 3%. Which fund should Jake purchase, and why? a.the Circus Fund, because it has a higher alpha b. the Hindsight Fund, because it has a higher alpha c. either fund, since each has the same alpha d. neither fund, since both have negative alphas

b. Alpha is calculated as follows for each of the funds: Circus Fund: 8.5 - [3 + (5)1.2] = -0.50 Hindsight Fund: 8 - [3 + (5)0.9] = +0.50

Alice is considering the purchase of some antiques. She anticipates spending the following amounts at the end of each of the following three years on restoration: $9,000, $7,000, and $6,500. At the end of the third year, she anticipates selling the antiques for $45,000.  If her required rate of return is 18%, what is the most she should pay for the antiques? A. $6,600 B. $10,778 C. $22,500 D. $27,665

b. Cash flows are: 0, CFj (9,000), CFj (7,000), CFj 38,500, CFj 18, i/yr SHIFT, NPV = 10,777.88.

Echo Echo Inc. sells for $79 per share and pays an annual dividend of $2.48. The price and dividend is expected to increase by 5% annually. Using the constant growth dividend discount model for valuation, and assuming an investor has a required rate of return of 8%, which of the following are true statements? I. The expected rate of return is greater than the required rate of return. II. The expected rate of return is less than the required rate of return. III. The stock is undervalued. IV. The stock is overvalued. a. I and II only b. I and III only c. I and IV only d. II and III only

b. If you know a stock is over- or undervalued, you then know if the expected return is going to be less or more than your required return, and vice versa. Calculate the expected return: The 8.3% expected return is greater than the 8% required return. D0 = 2.48 D1 = 2.604 Expected return = D1/p + g (2) Use DDM to get the intrinsic value: The stock is trading at $79 per share, which is less than its $86.80 intrinsic value; so it is undervalued. Expected Return = (($2.48 * 1.05) / $79.00) +.05 = .08296 or 8.3% Intrinsic Value = ($2.48 * 1.05) / .08 - .05 = $86.80

In designing and implementing an investment plan for a client, a planner who believes in the strong form of the efficient market hypothesis will use which one of the following combinations of analytical techniques? a. moving average analysis, industry analysis, and weighted average returns b. efficient frontier, correlation coefficients, and weighted average returns c. efficient frontier, industry analysis, and company analysis d. technical analysis, fundamental analysis, and correlation coefficients

b. Options a and d include aspects of technical analysis, which is not valid under the EMH. Option c would be the weak form of the EMH, which allows for fundamental analysis. TECHNICAL ANALYSIS DOESN'T WORK IN ANY OF THEM.

You are researching a company that retains all of its earnings, and has no immediate plans to pay a dividend. It has a positive cash flow, but negative earnings per share for the past two years. Which one of the valuation approaches would you consider when analyzing the company? a. constant growth dividend discount model b. PSR c. PEG ratio d. P/E ratio

b. Price to sales ratio: There are no dividends, so the constant growth DDM is not possible. Also, there are no earnings with which to calculate a P/E or PEG ratio.

You are choosing among the following funds. Which fund should you purchase?

b. R-squared has been given so you can determine beta reliability. R-squareds are too low (below 70), so use Sharpe. Following the BATS methodology works very well for this type of analysis.

Your client has narrowed her choices down to three different mutual funds, and you have compiled the following data on the funds shown. Beta R-squared Treynor Sharpe GG .8 44 3.36 5.52 RR .5 19 2.22 7.66 ZZ .6 35 1.95 4.34 Which fund should you select? a. Fund GG b. Fund RR c. Fund ZZ

b. The R-squared is too low (below 70) in order for beta to be considered reliable, so Treynor cannot be used. This leaves Sharpe, which uses standard deviation, a measure of total risk. Fund RR has the highest Sharpe ratio. Use the BATS methodology!

When computing the interest rate that equates the present value of an investment's cash flows with the cost of investment, which one of the following methods of computing interest is used? a. arithmetic average return b. internal rate of return c. geometric average return d. time-weighted return

b. The internal rate of return (also called the dollar-weighted return) takes into account cash flows.

Laura is considering buying some foreclosed real estate property for $150,000. She expects to receive, at year end, net cash benefits of $6,000 the first year, $6,500 the second year, and $7,000 the third year. At the end of the third year she anticipates a better housing market, and hopes to sell the property for $200,000.  If her projections are correct, what would be the internal rate of return on this investment? A. 12% B. 13% C. 14% D. 15%

c. Cash flow keystrokes are: (150,000), CFj 6,000, CFj 6,500, CFj 207,000, CFj SHIFT, IRR = 13.9957.

NOT ON MIDTERM OR FINAL If a company payout ratio over the past five years has gradually declined from 50% to 25%, which one of the following statements summarizes the impact on the dividend growth model? a. The payout ratio has no impact on the dividend growth model. b. The required return ("r") in the dividend growth equation will rise. c. The "g" in the dividend growth model may be difficult to determine. d. The current dollar dividend amount will be affected, but neither "r" nor "g" will be affected.

c. If the payout ratio changes, then so will 'g' (g = roe x rr). It does not impact 'r,' which is the required return derived from CAPM. The only possible answer is option c. The key here is that this dividend payout change is not one-time, but is a trend that makes future dividend growth predictions that much harder to model. A. CAN ELIMINATE A B. NO IMPACT D. NOT TRUE

Fundamental analysis includes which of the following? I. computation of the current ratio II. comparison of a company's PEG ratio to its industry's PEG ratio III. computation of the company's debt-to-equity ratio IV. comparison of a company's daily trading volume to its historical volume A. I and II only B. I and III only C. I, II, and III only D. I, III, and IV only E. I, II, III, and IV

c. Option IV describes technical analysis.

Your client has a mutual fund that had a 15% return last year, with a beta of .90. The risk-adjusted return of the fund is a. 13.50%. b. 15.00%. c. 16.67%. d. 17.25%.

c. The risk-adjusted return is the mean return divided by beta; so 15/.90 = 16.6667.

Fiona, age 35, needs income and is considering the purchase of a preferred stock that pays $1.75 in annual dividends. The preferred stock is currently trading at $29 per share. Your research shows that other preferred shares with comparable ratings are currently yielding 7%.  You would advise Fiona to: A. purchase the shares; they appear to be fairly priced at $29 per share. B. purchase the shares; they are undervalued since they have an intrinsic value of $32 per share. C. not purchase the shares, they are overvalued since they have an intrinsic value of $25 per share. D. not purchase the shares; she is too young to be purchasing preferred stock.

c. Zero Growth Model (D/r) is the valuation formula for preferred stock since it has a perpetual dividend. $1.75/.07 = $25 intrinsic value.

ON MIDTERM - CARMELO ANTHONY Robert purchased a fireworks business for $85,000. He expects the following cash flows from the business over the next three years: End of Year 1: $45,000 inflow $20,000 outflow End of Year 2: $55,000 inflow $25,000 outflow End of Year 3: $65,000 inflow $35,000 outflow Robert plans to sell the business at the end of the third year for $100,000. If these projections are correct, what will be Robert's internal rate of return on this investment? A. 22.4% B. 26.2% C. 32.7% D. 36.9%

d. Cash flow keystrokes are: (85,000), CFj 25,000, CFj 30,000, CFj 130,000, CFj SHIFT, IRR = 36.8571. TODAY (85,000) 1 25,000 2 30,000 3 130,000

Which of the following are correct interpretations of the meaning of each of the portfolio performance measurements? I. The higher the Treynor ratio is, the better the relative portfolio performance. II. Jensen measures absolute return relative to the amount of risk taken, as measured by standard deviation. III. Jensen is an absolute, not relative, measure of return. IV. If a portfolio is not well diversified, the Sharpe ratio is more representative of the risk-adjusted performance. a. I and II only b. I and III only c. III and IV only d. I, III, and IV only e. II, III, and IV only

d. Jensen (alpha) is the difference between the return of the portfolio and CAPM, which uses beta, not standard deviation. Jensen is an absolute measure of return.

Which one of the following methods of computing investment returns should be used to evaluate the performance of investment managers? a. internal rate of return b. arithmetic weighted average return c. dollar-weighted return d. time-weighted return

d. The time-weighted return (also called geometric average return) is used to compare investment managers. Dollar-weighted return (also called internal rate of return) is used for calculating an individual investor's return based on cash flows. The arithmetic return does not take into account compounding, which the time-weighted (geometric) return does.

The return of a market index has been 11% with a standard deviation of 18. A managed fund, Fund America, has a return of 14% with a standard deviation of 25. If the risk-free rate is 2%, which of the following actions would you take? a. Purchase Fund America since its Sharpe ratio is higher. b. Purchase Fund America since it has a higher return. c. Purchase the market index because its risk is lower. d. Purchase the market index because its risk/return relationship is better.

d. is the correct answer. The Sharpe ratio is 0.50 for the market index and 0.48 for Fund America. Risk and return must always be considered together. Hve to use Sharpe bc of the info given. 14 - 2/25 = 0.48 11-2

You have been given the following information on the following two funds and the market. The risk-free rate is 4%. Fund A Fund B Market Realized return 16% 11% 12% Beta 1.1 0.8 1.0 Std Dev 20 12 15 R-squared w market .87 .81 Which of the following statements are correct? I. Fund B outperformed the market as measured by the Sharpe ratio. II. Fund A has a better Treynor ratio than Fund B. III. Fund B has a better return than the market with 87% of the risk. IV. Fund A has an alpha of +3.20. a. I only b. I and II only c. II and III only d. II and IV only e. I, II, and IV only

e. Sharpe ratio is .5833 for Fund B and .5333 for the Market. Treynor ratio is 10.9091 for Fund A and 8.75 for Fund B. Alpha for Fund A is +3.20. Equation is 16 - [4 + (12 - 4)1.1] First look at R-squareds.

Dividend growth rate (g)

g = ROE x RR Here is the way to arrive at "g" in the DDM. RR = retention rate, which is 1-payout rate. Percentage of earnings that is retained (100% - dividend payout rate) ROE = Net Income/Shareholders equity

Dividend growth rate

g = ROE x RR Where: g = dividend growth rate ROE = return on equity RR = earnings retention rate

The risk-free rate is 3.5%, and the market's expected return is 8%. Your stock has a beta of 1.1. What is the required return? What is the market risk premium?

r = 3.5 + (8.0 - 3.5)1.1 r = 3.5 + 4.95 required return = r = 8.45 Market risk premium = (8 - 3.5) = 4.5%

What is Correlation Coefficient?

(R): Standardizes the Covariance. Adds boundaries (-1 to +1) to Covariance, denoted by either R or Greek letter Rho, Anything less than +1 correlation will help diversify a portfolio Illustrate perfect positive and perfect negative correlation, when given a choice of a security to add to a portfolio you should choose the one that is lowest R (i.e. farthest to the left). R = Cov / (std dev of 1 security)(std dev of other security)

Facts about Correlations

- Correlations change over time. - Correlations increase in down markets. - Some correlations can be harder to measure than others, such as hedge funds and alternative investments. - A low correlation with a portfolio does not necessarily mean that it is a good investment.

Efficient Market Hypothesis

- Hard to beat the market on a risk-adjusted basis consistently - Outperforming the market is not just earning a higher return - Considering risk is also important - Large number of competing participants - Information readily available - Small transaction costs - Investors behave rationally - A security cannot be overvalued or undervalued. - An investor cannot outperform or underperform the market. - An investor can, however, earn a return that is commensurate with the amount of risk assumed—no more, no less.

Random walk

- It does not mean prices are random. - Successive price changes are independent. - Today's price does not forecast tomorrow's price (so technical analysis does not work). - Current price embodies all known information.

What is the Efficient Frontier?

-The universe of possible investment opportunities lies within the efficient frontier. -Only those portfolios that are on the efficient frontier are considered efficient. - Portfolios north of the efficient frontier are unattainable -Whether B, C or D is considered optimal for an investor is dependent upon their preferences (i.e. utility curves). -How would you characterize A (inefficient)? Why is it inefficient? (could achieve same return with much lower risk (B) or much higher return with same amount of risk (D). -ON MIDTERM. Draw in portfolio E somewhere above the efficient frontier line and between C and D. How would E be characterized (unattainable)?.

Risk Tolerance Measurement

. There is no one perfect measure of risk tolerance. LOSS AVERSION: will gamble on a gain rather than accept a loss...studies indicate the pain from a loss is greater than the joy from a gain. RISK AVERSION: prefer lower returns with known risks over higher returns with unknown risks. LIQUIDITY AVAILABLE: investors with higher liquidity and job stability can afford to take greater risks than those with little liquidity and job fragility. LIFE CYCLE PHASE: risk tolerance is linked to the phase of life; accumulation, consolidation, spending or gifting. VAR/MONTE CARLO: simulates random trials using historical data to arrive at a probability of success, ignores sequential risk via the randomization of returns.

You have invested in two funds: 50% in Fund A, with a standard deviation of 20 50% in Fund B, with a standard deviation of 10 If the correlation coefficient is +1, what is the risk? What happens when they are no longer perfectly correlated, and the correlation coefficient is 0?

15, you can use a weighted average of the two standard deviations [(.50 x 20) + (.50 x 10)] = 15 This is a perfectly positively correlated asset pair, so using weighted standard deviation approach will give you the same answer as the formula. Even when the correlation is not +1, the weighted average approach can be used for a quick reality check before you run a lengthy calculation. Finally, work the problem using the two asset std dev formula to prove the concept that a +1 correlation coefficient will result in the same answer as taking a weighted average approach. The lower the correlation, the lower the risk. The weighted average SD is 15% when the correlation coefficient is +1, and risk is going to go down as the funds become less correlated, so the standard deviation is going to be less than 15.

Describe Alpha

A = Rp - [Rf + (Rm-Rf)B] Alpha is widely used to measure the value added by an active portfolio manager. Since beta is used in the formula, make sure beta is reliable (R-squared of 70 or higher). Alpha measures whether the actual return exceeds the return that should have been earned based on the CAPM. Alpha is an absolute measure of return and can be used in isolation to determine the risk adjusted performance of a portfolio manager.

ABC Fund has a return of 15% and a beta of 0.90. The risk-free rate is 5%, and the return of the market is 16%. Has ABC provided the level of return required for the amount of risk taken?

A = Rp - [Rf + (Rm-Rf)B] = 15 - [5 + (16 - 5).90] 15 - [5 + 9.90] 15 - [14.90] = +0.10 There is a positive alpha, so the answer is yes. The portfolio manager has obtained 0.10% return greater than the return required for the amount of risk taken.

What is Markowitz Portfolio Theory (MPT)?

Assumes: - Investors are risk-averse. - Decisions are made based on expected risk and return only. - Investors have homogeneous expectations regarding return and risk for opportunities in the market. - Investors have a common one-period time horizon. - Investors have free access to all information. - There are no transaction costs. - The capital market is perfectly competitive.

Asset A Asset B St Dev 6% St Dev 9% Mean 10% Mean 12% Which is less risky?

CV(A) = 6%/10% = 0.60 CV(B) = 9%/12% = 0.75 B has a higher mean return, but also has a higher CV, which means you take higher risk per unit of return. Remember that you can easily calculate both standard deviation and mean return for a single asset with your financial calculator, as we did previously. A more risk averse investor may be better suited to investment A than to Investment B. - LOWER is better

Unsystematic risk

Diversifiable. Unique to Co that is diversifiable Business risk: Associated with the nature of the business Financial risk: Associated with the use of debt in the financing of a firm or property. Even US Treasuries have risk/debt Political risk: Associated with investing in foreign countries (also called country risk) Liquidity Risk

Valuation Approaches

Dividend Discount Model Price/Earnings Ratio Price/Book Ratio (use if no earnings) Price/Sales Ratio (use if no earnings) PE/Growth (PEG) Ratio (Earnings growth rate) DDM can be used with dividend paying stocks, otherwise you have to use the forms of ratio analysis. Compare the above to peer group and historical trends Dividend Yield = Dividend / stock price

If the formula for required return is the CAPM, what is the formula for expected return?

Er = D1/P + g D0 = Dividend now D1 = Dividend next year P = stock price G = dividend growth rate

Forms of Efficient Market Hypothesis (EMH)

For all 3: technical analysis doesn't work AND current prices reflect all historical info Weak Form: historical performance doesn't help returns. Fundamental analysis may lead to superior returns. Technical analysis will not help (remember that technical analysis will not work for any of the forms of EMH). Semi-Strong form: Inside information may lead to superior returns. Studying economic and accounting data will not lead to superior investment returns. Strong Form: can't outperform the market AT ALL. Public and Private information are reflected in the stock price. Investor cannot outperform the market under any circumstances. Not even inside information enables an investor to outperform the market. How do you think that believers in EMH are inclined to invest? (indexing) Fundamental analysis: financial analysis, industry analysis Technical: Empirical results generally support the weak form, and the semi-strong form

SML and equilibrium

Here are the results from the preceding slide after they are plotted on the graph. Higher and to the left of the SML = returning greater than required. Y is in equilibrium. X is overvalued and should be sold or shorted. W and Z are undervalued and should be purchased. (W IS HIGHER RETURN AT SAME BETA) Z IS UNDERVALUED TOO WITH A NEGATIVE BETA (BETTER DIVERSIFICATION) When the RFR changes, the SML will shift. An upward shift will put pressure on stocks, as the required return will increase. The opposite is true if the RFR falls. When an investors risk tolerance changes, the slope of the SML will change. The new slope being illustrated is when an investor becomes more conservative, as the investor will require more return for each incremental unit of risk. The opposite would be true for an investor that becomes more aggressive, and the new line would be flatter and beneath the original line.

What are the 3 most common performance measures? 1) What separates Alpha from Treynor and Sharpe? 2) What differentiates Treynor from Sharpe? 3) Since Treynor uses beta, what type of portfolio is it useful in analyzing?

Here are the three most common performance measurement: Measure Uses Jensen/Alpha Beta Absolute measure of performance or standalone Treynor Beta Comparative Sharpe Stand Dev Comparative 1) (Alpha is absolute (i.e. a stand alone measure) while Treynor and Sharpe are use for relative comparisons) 2) (Treynor's risk measure is beta, while Sharpe's risk measure is std dev) 3) (must be a diversified portfolio to use beta, and r-squared must be at least .70) If it uses Beta, then you have to be able to rely on it

Standard Deviation

Know the curve Standard Dev: how far are returns from mean/norm. Usually, exam asks questions about 1 standard dev 1σ 68% of the time, returns will be within 1σ. Leaving 16% on each side For normally distributed returns, calculate the standard deviation range, add and subtract the standard deviation amount from the mean return. Example: Mean return of 10%, Std deviation of 15%. One standard deviation: 10 + 15 = +25, and 10 - 15 = - 5 Two standard deviations: 25 + 15 = +40, and - 5 - 15 = - 20 Three standard deviations: +55 to -35 1 std dev 68% of the time returns fell within the range of +25 to - 5; (show on line) 2 std dev 95% of the time returns fell within the range of +40 to -20; 3 std dev 99% of the time returns fell within the range of +55 to -35

Beta Coefficients

Measures the volatility of a stock (or portfolio) relative to the market (a benchmark); so, the greater the correlation, the more accurate beta becomes. Since R-squared (aka coefficient of determination) measures systematic risk, it can be used to determine beta reliability; generally you are looking for an R-squared of 70 or higher in order for beta to be considered reliable. High correlation is low correlation coefficient

Arbitrage Pricing Theory (APT)

Multi-factor model. Four factors used are unexpected changes in: Inflation GDP changes Risk premiums Interest rates (yield curves)

Coefficient of Variation

Need to memorize, not on CFP Board formula sheet -Lower result is better...less risk per unit of return (differs from Sharpe and Treynor, which measure return per unit of risk) CV = Stand Dev / Mean

Thor Industries pays an annual dividend of $2.00 per share, and its dividends are expected to grow at 6% annually. If your required return is 10%, what is the intrinsic value of Thor?

Next period's dividend (D1) divided by required return less dividend growth rate. V = [2(1.06)]/(.1-.06) = $53

Systematic risk

Nondiversifiable within the asset class (measured by BETA). P urchasing Power Risk: Caused by inflation in the economy. Bonds do terribly in high inflation R einvestment Rate Risk: Caused by variability in interest rates and the need to reinvest income or principal as rates fall I nterest Rate Risk: Caused by fluctuations in the general level of interest rates M arket Risk: Resulting from investor reaction to tangible and intangible events E xchange Rate Risk: Caused by changes in the relative value of foreign currency compared to the value of home-country currency Endogenous Risk: Risk within the financial system

Standard Deviation Concepts

Normal distribution Skewness (security returns are positively skewed) Kurtosis Leptokurtic Platykurtic All of the above (except for normal distribution) are not associated with normal distribution

Your client is considering a purchase of Titan Industries, and you are helping the client evaluate the stock. This past year the company earned $3.00 a share, and paid out 25% of its earnings as dividends. Titan expects both dividends and earnings to grow at 5% for the foreseeable future, and it expects the payout ratio to remain at 25%. Your required rate of return is the current 10-year Treasury note rate of 6%, plus a risk premium of 6%. What is the intrinsic value of Titan Industries? a. $11.25 b. $28.55 c. $45.00 d. $78.75

ON MIDTERM a. 25% of $3.00 = $0.75 dividend. Then solve using the DDM [D1 / (r-g)] $0.75 * 1.05 = $0.7875 (D1). $0.7875 / .12 - .05 = $11.25.

You are evaluating Retro Holdings, Inc., for a possible purchase. Last year it paid $1.00 in dividends, and you expect the dividend to grow at a rate of 12% for the next three years, and then grow at 6% thereafter. Your required return is 9%.  What is the maximum amount you should pay for the stock? A. $35.33 B. $41.50 C. $45.22 D. $47.86

ON MIDTERM b. First inflate the $1.00 by 12% over the next three years: 1.00 x 1.12 = 1.12; 1.12 x 1.12 = 1.2544; 1.2544 x 1.12 = 1.4049 We now know the dividend three years out, and can now use the constant growth DDM going forward since the dividend growth is now going to be a constant 6%: On a timeline: 0-------1.12-------1.2544---------1.4049+49.64=51.0449; enter 9 as "I" for required return. Answer a. is calculated using $1.00 as the dividend and calculating using the constant growth DDM. Answer c leaves out the first cash flow (the zero). High growth (12%) Stable growth (6%) D0 $1.00 D1 1.12 D2 1.2544 D3 1.4049 D0 $1.4049 D1 1.48922 Cfo = 0 CF2 = 1.12 Cf3 = 1.2544 Cf4 = 1.4049 + 49.64

CAPM

R = RF + (RM - RF) Beta also has a micro component that looks at individual stock returns - the Security Market Line - SML This micro component is also used to help value stocks MACRO component (known as CML - CAPITAL MARKET LINE); explains risk and return in a portfolio context and uses standard deviation MICRO component (known as SML - SECURITY MARKET LINE); explains individual stock returns and uses beta The micro component is the one used to value stocks: The CAPM formula is the SML version and this is what we will focus on in order to evaluate individual assets and diversified portfolios.

Scenario: 40% in Security A with a 10% SD 60% in Security B with a 20% SD Correlation between the two is 0.95

R is less than +1.0, so we have to run the full calculation. However, for illustration purposes, first run a quick weighted average std dev to indicate the maximum SD. IF PERFECTLY CORRELATED, THE STD DEV WOULD BE = [(.40 * 10) + (.60 * 20)] = 16 as the maximum possible std dev. Work problem in three sections. Point out that the last section uses the inputs for covariance, rather than a number for covariance. Answer should come out to 15.8493. (0.16) (100) + 0.36 Covariance = Coorelation (decimals) = xσi x σj As covariance (correlation) falls, so does risk as measured by standard deviation.

Sample Correlation Coefficients Asset Large Cap Index Small Cap Index Large-Cap 1.0 Small Cap 0.72 1.0 Intl Stocks 0.66 0.55 LT Corp Bonds 0.29 0.15 TBills 0.11 0.05

Sample correlation table. Each asset class adds some measure of diversification from Large Cap, but which asset class adds the most diversification from Large Cap. Plot samples on the correlation coefficient range (following slide) to visually illustrate. _________________________________________________________ -1 0 +1 +1: A+/B+. perfectly correlated -1: PERFECTLY negatively correlated. A+/B- 0: no idea These are very low correlations above

Describe Sharpe ratio

Sharpe is your default when you can't rely on the Beta. Sharpe standardizes the return in excess of the risk-free rate by the portfolio's standard deviation. Sp = [Rp - Rf] / Std Dev of Portfolio - Can be used when beta is not reliable - Calculation is similar to Treynor—Sharpe uses standard deviation in the denominator, Treynor uses beta - Relative measure used for comparison, the higher the better

What is the weighted beta of the following portfolio? $40,000 in AAA, beta of 1.2 $20,000 in TTT, beta of 0.9 $15,000 in ZZZ, beta of 0.8

Shortcut on 10BII+ calculator: 1.2, INPUT (ENTER on 12C) 40,000, ∑+ .9, INPUT 20,000, ∑+ .8, INPUT 15,000, ∑+ SHIFT, 6 (g, 6 on 12C) Answer = 1.04 p.80 in book 2 (don't need all the zeroes)

Scorpio Inc. has a mean return of 19%, and a standard deviation of 25. What is the probability that the stock will have a return greater than 19% if the returns are normally distributed?

Sketch out a normally distributed bell curve and label the standard deviation zones. 50% probability

Asset Allocation strategies

Strategic allocation: high level asset class decision is made for long term horizon and then routinely rebalanced. BUY THE ASSET CLASS THAT IS DOING WORST Tactical allocation: focused more on security selection, along with sector rotation and market timing. Based on your view of the market Dynamic allocation: limited to institutional investors, shift between risky and riskless assets as market values change. AKA PORTFOLIO INSURANCE Core/Satellite allocation: combines strategic and tactical (AKA CORE AND EXPLORE) Public allocation recommendations by investment firms: seeing fewer firms make public statements about allocation, as there is no one size fits all allocation.

A mutual fund you are considering has a beta of 0.75, a standard deviation of 11, a correlation coefficient of .90 with the Russell 2000, an R-squared of .65 with the S&P 500, and an expected return of 12%.  Which one of the following is the fund's coefficient of variation? a. .92 b. 1.09 c. 1.15 d. 1.25

The correct answer is a. More information is given than is needed—all that is needed is the standard deviation and the mean return, so 11/12 = .9167.

Stock ABC has a standard deviation of 16 and beta of 1.1. Stock XYZ has a standard deviation of 9, and a beta of 0.7. The covariance between the two stocks is +88. What is the correlation coefficient between the two stocks? a) .61 b) .77 c) .88 d) .94

The correct answer is a. Refer to the formula sheet. The correlation coefficient equals .6111 (88/144). Beta is a red herring and does not apply to this question.

Jake wants to know the beta coefficient for his portfolio of stocks, shown below: Stock CMV Beta Alto 33k 1.1 Bolero 12.5k 1.0 Cactus 45k 0.9 Dire 29k 1.6 What is the beta coefficient for Jake's portfolio? A. 1.14 B. 1.19 C. 1.23 D. 1.28

The correct answer is a. This is a straight forward weighted average calculation. This can be calculated manually or by using the calculator.

Nicholas owns the Cosmic Fund, and wants to invest in another mutual fund. The Cosmic Fund has a standard deviation of 12, and a beta of .80. He has narrowed his choices down to three funds. Since he will only own two funds, he wants to choose the fund that offers him the greatest ability to reduce the risk of his portfolio. To help Nicholas with his decision you have gathered the following information: Fund Std Dev Beta R w Cosmic Fund 5-yr retur Jupiter 28 1.3 0.4 14% Pluto 19 0.9 .92 9% Mars 24 1.1 .74 16% Which fund should you recommend to Nicholas, and why? a) Jupiter Fund, because its correlation coefficient with the Cosmic Fund is the lowest b) Pluto Fund, because it has the lowest beta c) Mars Fund, because it has the highest 5-year annualized return d) Pluto Fund, because the correlation coefficient with the Cosmic Fund is the highest e) Jupiter Fund, because it matches a low volatility fund (Cosmic) with a high volatility fund (Jupiter)

The correct answer is a. You are looking for the fund that "offers the greatest ability to reduce the risk of his portfolio." This would be the fund that is the least correlated to the fund he already owns. REDUCE RISK BY CHOOSING THE LOWEST CORRELATION COEFFICIENT

The capital asset pricing model (CAPM) accounts for which one of the following risks associated with a stock? a. financial risk b. systematic risk c. total risk d. unsystematic risk

The correct answer is b. Note that beta is used in CAPM, so systematic risk is the relevant risk.

The current return of the market is 11%. The current market risk premium is 7%, and the risk-free rate is 4%.  If the beta of your stock is 1.1, what is your required return? a. 7.30 b. 11.70 c. 12.10 d. 16.10

The correct answer is b. r = 4 + (11-4)1.1 (note that the market risk premium, which is Rm - Rf, is given to you: 7%) r = 4 + (7)1.1 r = 4 + 7.7 r = 11.7

Your client, Glenda, is a conservative investor and has found a stock that she is considering purchasing. She informs you that even though the stock has a standard deviation of 32, the beta is just .35. She tells you that she likes the fact that the stock has approximately one-third the volatility of the overall market.  You would advise Glenda that she: a) is correct that the low beta would be a good match for her conservative risk tolerance. b) needs to check further; the low beta is misleading and may be the result of a low correlation between the stock and the market. c) needs to take into account the high standard deviation, which would result in an adjusted beta of over 1. d) is a conservative investor, so any stock with a beta of less than 1 would be appropriate for purchase.

The correct answer is b. A low beta for a stock with such a high standard deviation is a signal that further research needs to be done. Correlation coefficient is used in the formula for beta (see previous question), and the lower the correlation, the lower (and less reliable) beta becomes. S&P 500 STAND DEV = 20% AVERAGE RETURN = 10% (GOLD STOCKS ARE VOLaTILE BUT LOW BETA)

Angela follows the stock market on a daily basis and often trades based upon her "gut" feeling as to what is the right move to make. She does not consider herself to be a day trader, but since she follows current news and events closely, she often trades based upon this information. The market has been trending down for the past year, and she believes that this will continue. Which behavioral biases is Angela displaying the most?  I. framing II. overconfidence III. Recency IV. endowment  a. I and II only b. II and III only c. II and IV only d. III and IV only

The correct answer is b. Angela is displaying both overconfidence and recency biases. She is overconfident, which is leading to her active trading and relying on her "gut" feeling as to when to trade. She is also exhibiting recency bias, since she focuses more on what has happened recently than what has happened in the past in order to make decisions. Angela's outlook is short-term, not long-term. Framing is the tendency to respond to various situations differently based on the context in which it is presented. Endowment is valuing something that one owns more than assets that are not owned.

Jake just had his 6%, five-year note mature. The bank is currently offering five-year notes with a similar credit rating at 4.2%. Which of the following terms best explains what Jake is experiencing? a. interest rate risk b. reinvestment risk c. exchange rate risk d. credit risk

The correct answer is b. Jake's note has matured, and he now has to reinvest it; rates are currently lower. Interest rate risk impacts bond prices while the bond (note) is being held. Once it matures, interest rate risk is not relevant since the owner receives back the principal amount at maturity.

Your client has been told the following information. Which statement would you advise him is false? a. Most analysts believe that some markets are more efficient than others (such as U.S. stocks compared with emerging market stocks). b. The efficient market hypothesis is consistent with behavioral finance. c. The less efficient a market is, the more potential there may be for discovering undervalued securities. d. Overconfidence in one's ability to "read" the market can lead to overtrading.

The correct answer is b. The efficient market hypothesis assumes that all investors are rational. Behavioral finance attempts to explain behavior that is often irrational.

Your client has narrowed his choice down to the following three mutual funds, and wants your opinion concerning which one to choose based on the fund that will provide the lowest amount of risk per unit of return. Fund Mean Return St. Dev ABC 8% 12 DDD 10% 14 EFG 7% 10 Which fund should your client choose? a. Fund ABC b. Fund DDD c. Fund EFG

The correct answer is b. This requires calculating the coefficient of variation for the three funds and choosing the lowest number. Fund ABC: 12/8 = 1.50; Fund DDD 14/10 = 1.40; Fund EFG 10/7 = 1.4286.

Seth is considering the purchase of the Delta Fund, which has a correlation coefficient of .92 with the S&P 500. He asks you how much unsystematic risk he is taking by investing in this fund.  You would tell him that the percentage of unsystematic risk is a. 8%. b. 15%. c. 85%. d. 92%.

The correct answer is b. You have been given the correlation coefficient, so it needs to be squared in order to come up with the coefficient of determination. .92 squared = .8464. This is the amount of systematic risk, so 1 - .8464 = .1536% unsystematic risk.

Which of the following statements is correct? a. Reinvestment, exchange rate, and liquidity risk are examples of systematic risk. b. Default, purchasing power, and political risk are examples of non-diversifiable risk. c. A company without debt will have no financial risk, but will have business risk, which is a type of unsystematic risk. d. Default, call, and liquidity risk are unique to bonds and not applicable to stocks.

The correct answer is c. Financial risk refers to the use of debt (leverage). If a company does not have any debt, then it does not have any financial risk. All individual companies will have business risk, which is a type of unsystematic risk. In choice a., "liquidity" risk is an unsystematic risk. In choice b. "default" and "political" risk are diversifiable (unsystematic). In choice d., "liquidity" risk is also applicable to stocks. Think P.R.I.M.E. for systematic risk.

Fred has been an investor for over 30 years and strongly believes that the market "will always come back," and dismisses any possibility that "this time things may be different." He invests in both bull and bear markets, taking a long-term perspective. Which one of the behavioral biases is Fred closest to exhibiting? a. regret aversion b. recency c. status quo d. strategic

The correct answer is c. Fred is closest to exhibiting a "status quo" bias, namely that his outlook is based upon the way things have been in the past, and he expects the same pattern to continue into the future. Fred is not exhibiting regret aversion, which is the fear that decisive action would be less than optimal - if that were the case, Fred would not invest at all. Recency is different in that it describes how people place more emphasis on recent events than those that occurred in the past. An example of recency would be believing that the market will continue to go down in the future just because it has gone down for the past two years. Strategic is a type of asset allocation strategy, not a behavioral bias.

Triad Industries has a mean return for the past five years of 12%, with a standard deviation of 9%.  Assuming the returns are evenly distributed, what is the probability that Triad will have a return greater than 21%? a. 3% b. 12% c. 16% d. 24%

The correct answer is c. Graph it out! One standard deviation, which is 68% of the returns, is between 3% and 21%. This leaves 32% of the returns greater than 21%, and less than 3%. Since the returns are evenly distributed, this would mean half of the remaining returns (16%) would be greater than 21% (and the other 16% of returns would be less than 3%).

The efficient market hypothesis (EMH) makes all of the following assumptions, except a. an investor cannot underperform or outperform the market. b. securities cannot be undervalued or overvalued. c. historical information provides guidance on future prices. d. an investor can earn a return commensurate with the amount of risk being taken; no more, no less.

The correct answer is c. Historical information does not provide guidance on future prices according to the efficient market hypothesis. Future prices are a "random walk" determined by whatever happens in the future.

The market has an expected return of 14% and a standard deviation of 19. The fund you are considering has an expected return of 10% with a standard deviation of 14. The coefficient of determination between the market and the fund is .81. Which one of the following is closest to the fund's beta? a) .53 b) .60 c) .66 d) 1.00

The correct answer is c. Square root of .81 is .90, (14/19) x .90 = .6632

Your client has 50% in each fund. Fund A has an average return of 8.5% and standard deviation of 16. Fund B has an average return of 5.5% and a standard deviation of 8. The correlation between the two funds is 0.78. Which of the following answers is correct, regarding the average return of both funds and the portfolio standard deviation? a. 7% mean return, 12% std dev b. 6.5% mean return, 12% std dev c. 7% mean return, 11.4% std dev d. 6.5% mean return, 11.4% std dev

The correct answer is c. Step #1: Calculate the weighted mean return first, which comes to 7% [(.50 * 8.5) + (.50 * 5.5)]. This leaves us with just answers a. or c. as possibilities. Step #2: Do a weighted average of the standard deviations, which comes to 12%. Since the correlation is less than 1, we know that the portfolio standard deviation would be less than 12%.

Which one of the following is not a stock market anomaly? a. BV/MV b. neglected firm c. Value Line d. Morningstar

The correct answer is d. Morningstar provides a mutual fund analysis service, among other things.

John does not believe he can outperform the market, so he invests exclusively in index funds. He believes the only way one could "beat the market" would be by knowing and using nonpublic inside information. John believes in the: a. weak form of the efficient market hypothesis. b. semi-weak form of the efficient market hypothesis. c. strong form of the efficient market hypothesis. d. semi-strong form of the efficient market hypothesis.

The correct answer is d. Weak form allows for fundamental analysis. Strong form does not allow for fundamental analysis or insider information. Semi-weak is not a valid form.

The construction of an investment portfolio according to the principles of modern portfolio theory includes which of the following risk/return concepts? I. The intercept of the capital market line is the risk-free rate of return. II. The intercept of the security market line is the risk-free rate of return. III. Low correlations between securities lowers the portfolio standard deviation. IV. The beta coefficients for a portfolio are more stable over time than those for an individual security. a. I and II only b. I, II, and III only c. II, III, and IV only d. I, II, III, and IV

The correct answer is d. All choices are correct. Both the capital market line (CML) and the security market line (SML) start with the risk-free rate (intercept).

Beta is a measure of a stock's: a. range of returns. b. total risk. c. variability. d. volatility.

The correct answer is d. Beta measures volatility (systematic risk), and standard deviation measures variability (both systematic and unsystematic risk; i.e., total risk).

Hector has been investing for years, and has approximately three-quarters of his portfolio invested in stock index and bond index funds, which he rebalances periodically. He has the remainder of his portfolio invested in oil and health care stocks, which he believes provide above-average price appreciation potential over the next few years.  His style of asset allocation would be best described as a) strategic. b) tactical. c) dynamic. d) core/satellite.

The correct answer is d. Hector is using a combination of strategic and tactical asset allocation, which is core/satellite.

Jessica owns four stocks in various industries. She has come to you to assess the risk she is taking.  You inform her that her portfolio is subject to which one of the following types of risk, and why? a. purchasing power risk, because stocks fluctuate with inflation b. systematic risk, because the stocks she owns are in various industries c. political risk, since companies are subject to the laws of the countries in which they operate d. unsystematic risk, because she only owns four stocks

The correct answer is d. It takes 10 to 15 stocks in various industries in order to eliminate a large amount of the unsystematic risk. Jessica only owns four stocks, so even though this provides more diversification than just one or two stocks, there is still a good amount of unsystematic risk.

Using the same fact pattern as in the previous question, what would the standard deviation of the portfolio be if the correlation coefficient between the two funds were +1.0? a) 17.1 b) 19.6 c) 21.3 d) 25.0

The correct answer is d. Since this is a perfect positive correlation of +1, you can use a weighted average of the two standard deviations. [(.50 * 22) + (.50 * 28)] = 25. If you calculate using the formula, you will come up with the same answer of 25.

Using CAPM, what is the required return for the following securities? The risk-free rate is 4%, and the market return is 8%. Fund Beta Triad 0.9 Triangle 1.1 Trapeze 2.0 Tango 1.4 Tangent 1.0

Triad: 7.6% Triangle: 8.4% Trapeze: 12.0% Tango: 9.6% Tangent: 8.0%

Zero Growth Model Example: Lightning Enterprises Preferred pays a $1.50 dividend and yields are currently 6%.

Used when you have dividends into perpetuity, in which the dividend is fixed Use for preferred stocks V = Do/r 1.50/.06 = $25.00 **Not on the formula sheet** Likely will give you r by saying how similar stocks are currently yielding (current market yields) You can rearrange to determine the return for a given price. Paid $20? 1.5/20 = 7.5% return. Paid $30? 1.5/30 = 5.0% return

Non- constant growth DDM

Uses more than one growth rate, with a higher growth rate initially, and then a lower rate as the company matures Calculation requires the use of the cash flow key (CFj) on the financial calculator Get in the habit of creating a timeline of cash flows diagram (Assumes dividend payout ratio remains constant)

Constant growth DDM

V = D1 / (r - g) Constant Growth DDM (Dividend Discount Model): calculates the intrinsic value of a stock AKA "infinite period DDM". More on this formula later. Cannot be used with a company experiencing temporarily high or low growth rates. D1 = dividend next year R = required return G = dividend growth rate

BETA

VOLATILITY. indicates the relationship of the security's price movement to that of the movement in the appropriate benchmark

Formula for Stand Dev of a Portfolio

W = weights (decimal) σ = Standard Deviation: whole numbers Cov = Covariance: whole #'s

Assume the risk-free rate is 5%, and the market return is 13%. Asset Beta R (required return) W 0.8 11.4% X 1.5 17% Y 1.0 13% Z -0.5 1% Write the CAPM formula in on the slide and quickly show how each R was arrived at.

Write the CAPM formula in on the slide and quickly show how each R was arrived at. R= RFR + (RM - RFR) (β) R = 5 + (8)(β) What is the R-squared (coefficient of determination) threshold for beta to be considered reliable? (.70 or greater)