Chapter 12

Which of the following statements regarding futures contracts is(are) CORRECT? I. A futures contract is an agreement that provides for the future exchange of a particular asset or commodity between a buyer and a seller. II. Most participants in futures are either hedgers or speculators—hedgers seek to profit from the uncertainty of the future; speculators seek to reduce price uncertainty over some future period. A. I only B. II only C. Both I and II D. Neither I nor II

A. Statement II is incorrect because hedgers seek to reduce price uncertainty over some future period. Speculators seek to profit from the uncertainty of the future.

Which of the following statements regarding market efficiency is(are) CORRECT? I. The efficient market hypothesis (EMH) is the proposition that securities markets are efficient and that the prices of securities reflect their current economic value. II. Investors who believe the EMH usually adopt an active investment strategy. A. I only B. II only C. Both I and II D. Neither I nor II

A. Statement II is incorrect because investors who believe the EMH usually adopt a passive investment strategy; investors who do not accept the EMH pursue active investment strategies.

Which of the following statements regarding the use of a passive investment strategy in common stock valuation is(are) CORRECT? I. If the securities market is totally efficient, no active investment strategy should be able to beat the market on a risk-adjusted basis; therefore, a passive investment strategy may be superior. II. Passive investment strategies include stock selection, sector rotation, and market timing. A. I only B. II only C. Both I and II D. Neither I nor II

A. Statement II is incorrect because it describes active investment strategies. Passive investment strategies include buy-and-hold and the use of index funds.

Which of the following statements regarding the use of an active investment strategy in common stock valuation is(are) CORRECT? I. Pursuit of an active investment strategy assumes that investors possess some advantage relative to other market participants, such as superior analytical skills. II. Active investment strategies include buy-and-hold and using index funds. A. I only B. II only C. Both I and II D. Neither I nor II

A. Statement II is incorrect because it describes passive investment strategies. Active investment strategies include stock selection, sector rotation, and market timing.

Which of the following statements regarding capital market theory is(are) CORRECT? I. The capital market line (CML) is the graphical depiction of the capital asset pricing model (CAPM). II. The capital market line (CML) depicts the trade-off between risk and expected return for all assets, especially individual securities. A. I only B. II only C. Both I and II D. Neither I nor II

A. Statement II is incorrect because the CML is used with efficient portfolios and is not appropriate for individual securities.

All of the following are investments available through direct investing EXCEPT A. savings deposits, certificates of deposit, and U.S. savings bonds B. money market and hybrid mutual funds C. Treasury bills, commercial paper, and eurodollars D. option and futures contracts

B. Money market mutual funds and stock funds are examples of investment alternatives available through indirect investing.

Which of the following statements regarding the correlation coefficient as a measure of the relative movements between security returns is(are) CORRECT? I. The correlation coefficient is a relative measure of association that is bounded by +1.0 and −1.0. II. A correlation coefficient of +1.0 denotes perfect positive correlation; −1.0 denotes a perfect negative (inverse) correlation; 0.0 denotes zero correlation or no relationship. A. I only B. II only C. Both I and II D. Neither I nor II

C. Both I and II are correct.

Which of the following statements regarding the measuring of rate of return on investment is(are) CORRECT? I. Arithmetic mean is a better measure of average (typical) performance over single periods. II. Geometric mean is a better measure of the change in wealth over time (multiple periods). A. I only B. II only C. Both I and I ID. Neither I nor II

C. Both I and II are correct.

All of the following statements regarding risk and return on investments are correct EXCEPT A. market risk includes a wide range of factors originating outside of securities, including recessions, wars, structural changes in the economy, and changes in consumer preferences B. exchange rate risk is the variability in returns on securities caused by currency fluctuations C. a Treasury bill may have substantial liquidity risk, whereas a small over-the-counter (OTC) stock has little or no liquidity risk D. inflation risk, or purchasing power risk, is the variability in security returns caused by the changes in the purchasing power of invested dollars

C. C is incorrect because a Treasury bill has little or no liquidity risk, whereas a small OTC stock may have substantial liquidity risk.

All of the following statements regarding the mechanics of futures trading are correct EXCEPT A. Because a futures contract is a commitment to buy or sell a specific commodity at a specified future settlement date, no money is exchanged at the time the contract is negotiated. B. In futures trading, the seller and the buyer are agreeing to make and take delivery, respectively, at some future time for a price agreed upon today. C. Similar to an options contract, a futures contract involves the right to make or take delivery. D. When buyers sell their positions and sellers buy their positions sometime before delivery, an offsetting transaction has occurred and holders have liquidated their positions.

C. C is incorrect because an options contract involves the right to make or take delivery. A futures contract involves an obligation to make or take delivery.

All of the following statements regarding the use of the correlation coefficient in reducing portfolio risk are correct EXCEPT A. combining securities that have perfect positive correlation with each other provides no portfolio risk reduction B. combining two securities that have zero correlation with each other reduces portfolio risk C. combining two securities that have perfect negative correlation provides no portfolio risk reduction D. investors should seek out securities with the least correlation possible to reduce portfolio risk

C. C is incorrect because combining two securities with perfect negative correlation could totally eliminate risk. This is the principle behind hedging strategies.

Which of the following definitions best describes risk? A. The return expected by investors over some future holding period B. Actual return on an investment for a previous period C. The chance that the actual return on an investment will be different from the expected return D. The return on a riskless asset, often proxied by the rate of return on U.S. Treasury securities

C. A describes expected return; B describes realized return; D describes risk-free rate of return.

Which of the following statements regarding building an efficient portfolio is(are) CORRECT? I. An efficient portfolio is one with the highest level of expected return for a given level of risk or one with the lowest risk for a given level of expected return. II. The efficient frontier is the set of efficient portfolios generated by the Markowitz portfolio model. A. I only B. II only C. Both I and II D. Neither I nor II

C. Both I and II are correct.

Which of the following statements regarding derivatives is(are) CORRECT? I. Derivatives are securities that derive their value in whole or in part by having a claim on certain underlying securities. II. Gains or losses on the sale of derivatives will depend on the difference between the purchase price and the sales price. A. I only B. II only C. Both I and II D. Neither I nor II

C. Both I and II are correct.

Which of the following statements regarding market efficiency is(are) CORRECT? I. An efficient market is one in which security prices quickly and fully reflect all available information. II. The efficient market hypothesis states that securities markets are efficient and security prices reflect their true economic value. A. I only B. II only C. Both I and I ID. Neither I nor II

C. Both I and II are correct.

Which of the following statements regarding market efficiency is(are) CORRECT? I. To assess market efficiency, three cumulative forms of efficiency are discussed: the weak form, the semistrong form, and the strong form. II. The weak form of market efficiency involves market data, whereas the semistrong and strong forms involve the assimilation of all public and private information, respectively. A. I only B. II only C. Both I and II D. Neither I nor II

C. Both I and II are correct.

Which of the following statements regarding options is(are) CORRECT? I. Buyers of calls are betting that the price of the underlying common stock will rise, making the call option more valuable. II. Put buyers are betting that the price of the underlying common stock will decline, making the put option more valuable. A. I only B. II only C. Both I and II D. Neither I nor II

C. Both I and II are correct.

Which of the following statements regarding options is(are) CORRECT? I. The call option buyer expects the price of the stock to move up and relatively soon. II. The put option buyer expects the price of the stock to move down and relatively soon. A. I only B. II only C. Both I and II D. Neither I nor II

C. Both I and II are correct.

Which of the following statements regarding portfolio management (is)are CORRECT?I.Portfolio management consists of building a portfolio, revising the portfolio on a regular basis, and measuring the portfolio's performance. II. If an investor pursues an active investment strategy, the issue of market efficiency must be considered when revising a portfolio. A. I only B. II only C. Both I and II D. Neither nor II

C. Both I and II are correct.

Which of the following statements regarding risk is(are) CORRECT?I. Interest rate risk is the variability of a security's returns resulting from changes in interest rates. II. Inflation risk, or purchasing power risk, is the variability of security returns caused by the decline in the purchasing power of invested dollars. A. I only B. II only C. Both I and II D. Neither I nor II

C. Both I and II are correct.

Which of the following statements regarding systematic and unsystematic risk (is)are CORRECT? I. Systematic risk represents the portion in the variability of a stock's total return that is directly associated with overall movements in the general economy or stock market. II. Unsystematic risk represents the portion in the variability of a stock's total return that is not related to the variability in general economic activity. A. I only B. II only C. Both I and II D. Neither I nor II

C. Both I and II are correct.

Which of the following statements regarding the mechanics of futures trading is(are) CORRECT? I. Short position is an agreement to sell an asset at a specified future date at a specified price. II. Long position is an agreement to purchase an asset at a specified future date at a specified price. A. I only B. II only C. Both I and II D. Neither I nor II

C. Both I and II are correct.

Which of the following statements regarding the total risk of an asset is(are) CORRECT? I. Systematic risk is the risk attributable to broad macroeconomic factors affecting all securities, such as interest rate risk, market risk, and inflation risk. II. Unsystematic risk is the risk attributable to factors unique to an individual security, such as business risk, financial risk, and liquidity risk. A. I only B. II only C. Both I and II D. Neither I nor II

C. Both I and II are correct.

Which of the following statements regarding the use of passive investment strategies as a way to select and manage common stocks is(are) CORRECT? I. Passive investment strategies emphasize minimizing transaction costs and time spent in managing the stock portfolio because expected benefits from active trading or analysis are likely to be less than the costs. II. Passive investors act as if the market is efficient and accept the consensus estimates of return and risk, regarding current market price as the best estimate of a security's value. A. I only B. II only C. Both I and II D. Neither I nor II

C. Both I and II are correct.

All of the following statements regarding capital market theory are correct EXCEPT A. the capital asset pricing model (CAPM) allows an analyst to measure the relevant risk of an individual security as well as to assess the relationship between the risk and returns expected from investing B. the capital asset pricing model (CAPM) relates the required rate of return for any security to the risk for that security as measured by beta C. the market portfolio is the portfolio of all risky assets, with each asset weighted by the ratio of its market value to the market value of all risky assets D. the capital market line (CML), also known as the security market line, is the trade-off between expected return and risk only for efficient portfolios

D. Statement D is incorrect because the security market line specifies the equilibrium relationship between expected return and systematic risk and applies to individual securities as well as portfolios.

Which of the following statements regarding derivative securities is(are) CORRECT? I. A call option is an option to sell a specified number of shares of stock at a stated price within a specified period. II. A put option is an option to buy a specified number of shares of stock at a stated price within a specified period. A. I only B. II only C. Both I and II D. Neither I nor II

D. Statement I is incorrect because a call option is an option to buy a specified number of shares of stock at a specified price within a specified period. Statement II is incorrect because a putoption is an option to sell a specified number of shares of stock at a specified price within a specified period.

Only bonds issued by municipalities are subject to default risk.

False-- Bonds issued by corporations are also subject to default risk.

LEAPS are long-term options with expiration dates extending past 5 years.

False— LEAPS are long-term options with expiration dates extending beyond two years.

Semivariance only considers returns and volatility above the expected or average return.

False— Semivariance only considers returns and volatility below the expected or average return.

Passive investment management is an attempt to find undervalued or mispriced securities in order to earn higher returns than the overall market.

False—Active investment management is an attempt to find undervalued or mispriced securities to earn higher returns than the overall market.

Anomalies are occurrences in the stock market that are supported by the concept of an efficient market.

False—Anomalies are not supported by the EMH.

As with most financial securities, the value of a bond is equal to the future value of the expected cash flows.

False—As with most financial securities, the value of a bond is equal to the present value of the expected future cash flows.

Asset-backed securities, such as mortgage-backed securities and collateralized mortgage obligations, contain less uncertainty with regard to their cash flows than U.S. Treasury bonds.

False—Asset-backed securities have more uncertainty regarding cash flows.

Beta is a commonly used measure of total risk that is derived from regression analysis.

False—Beta measures only systematic risk.

Bonds provide investors with little security because they generally make irregular coupon payments.

False—Bonds make regular coupon payments.

Call options are derivatives that give the holder the right to sell the underlying security, whereas put options are derivatives that give the holder the right to purchase the underlying security.

False—Call options provide the right to purchase a specific security, and put options provide the right to sell a specific security.

Commercial paper consists of a private sector company's issue of long-term, secured promissory notes.

False—Commercial paper consists of a private sector company's issue of short-term, unsecured promissory notes.

Market risk, interest rate risk, purchasing power risk, country risk, and reinvestment rate risk are all examples of systematic risks.

False—Country risk is an unsystematic risk.

Debt obligations provide corporations with a method of raising needed capital funds while diluting the ownership of the entity.

False—Debt obligations provide corporations with a method of raising capital withoutdiluting the ownership of the entity.

Financial growth is the only element to consider in achieving financial goals.

False—Financial growth is one of many elements to consider in achieving financial goals.

From the investor's viewpoint, the best time for a company to redeem a bond issue is when interest rates have declined.

False—From the investor's viewpoint, the worsttime for a company to redeem a bond issue is when interest rates have declined.

Geometric mean is not as accurate as the arithmetic mean, and the difference becomes greater as returns become more volatile.

False—Geometric mean is considered more accurate.

The higher the correlation coefficient between asset classes, the lower the standard deviation of the total portfolio.

False—High correlation coefficients translate into higher portfolio standard deviations.

The internal rate of return (IRR) measures the discounted future cash flows to the future value of the asset.

False—IRR measures the discounted future cash flows to the present value of the asset.

If the reinvestment rate is greater than the yield to maturity, the actual yield earned on the bond will be less than the calculated yield to maturity.

False—If the reinvestment rate is greater than the yield to maturity, the actual yield earned on the bond will be greaterthan the calculated yield to maturity.

The systematic risk where changes in interest rates will affect the value of securities is known as default rate risk.

False—Interest rate risk is the risk that affects the value of securities when interest rates change

Changes in interest rates influence only the current market price of the bond and not the value of reinvested coupon payments.

False—Interest rates also affect the value of reinvested coupon payments.

An indirect relationship exists between risk and return.

False—Risk and return are directly related

Series HH savings bonds could only be acquired through an exchange of Series I savings bonds.

False—Series HH savings bonds could only be acquired through an exchange of Series E, EE, or H savings bonds.

Speculators and hedgers use futures contracts for the same reasons.

False—Speculators and hedgers use future contracts for different reasons.

Systematic risks are only affected by narrow economic factors that influence a few securities.

False—Systematic risks are those risks impacted by broad economic factors that influence all securities.

Tangible assets, such as collectibles, are usually characterized by an efficient market and liquidity.

False—Tangible assets are usually characterized by an inefficient market and an inherent lack of liquidity.

The United States is generally thought to have the lowest country risk because its political and economic systems are the most unstable.

False—The United States has one of the lowest levels of country risk because its political and economic systems are generally stable.

The money market consists of securities that have the following characteristics: short-term maturity, low credit risk, and low liquidity.

False—The money market is characterized by high liquidity rather than low liquidity.

The secondary market is the place where securities are first offered to the public.

False—The primary market is the place where securities are first

The range for covariance is from +10 to -10.

False—The range for covariance is positive infinity to negative infinity.

The use of debt magnifies return on equity (ROE) and makes gains and losses less volatile.

False—The use of debt makes gains and losses morevolatile.

Foreign power risk is the risk that a change in the relationship between the value of the dollar and the value of the foreign currency will occur during the period of investment.

False—This statement defines exchange raterisk.

Unsystematic risks are risks that are not unique to a single company, industry, or country.

False—Unsystematic risks are unique to a single company, industry, or country.

A call provision provides the issuer of the debt instrument the right to redeem the bond issue before maturity.

True

A tax benefit of Series EE savings bonds is that the interest earned on these securities can be completely excluded from taxable income if the proceeds are used for qualified higher education costs of the taxpayer, spouse, or dependents.

True

Although relatively safe, municipal bonds are often insured by third-party insurance companies to further reduce credit risk.

True

An asset allocation for a client's portfolio is derived through a mean-variance optimization model.

True

Asset allocation provides an investor with a guide to how much of the portfolio should be invested in each representative asset class.

True

Behavioral finance is a branch of personal finance that proposes psychology-based theories to explain investor behavior and stock market anomalies.

True

Bonds are used for the purpose of diversifying portfolios or providing income to individuals who are in need of a stream of cash flows.

True

Business risk can be thought of as the uncertainty of operating income.

True

Calculating the yield to maturity for a zero-coupon bond can be done using periodic payments of $0.

True

Convertible bonds are hybrid securities similar to option contracts that give the holder a right, not an obligation, to acquire shares of common stock from the issuing company by exchanging the currently held debt security.

True

Debenture holders are general creditors of the issuing corporation and will be paid in liquidation only after secured creditors have been repaid.

True

Federal agency securities are public debt instruments issued by agencies of the U.S. government as a means of raising funds for operations of the respective agency.

True

From the standpoint of volatility, the two common measures of risk are beta and standard deviation.

True

Holding period return measures the total return an investor receives over the life of the investment.

True

If the beta of ABC Company is 1.2 and the market return is expected to be 13% with a risk-free return of 3%, the expected return of ABC using the SML is 15%.

True

Investing is based on the concept that forgoing immediate consumption provides for greater future consumption.

True

Liquidity is the ability to sell an investment quickly and at a competitive price, with no loss of principal and little price concession.

True

Market timing is an investment strategy that investors use to be fully invested in periods of increasing stock prices and be out of the market during periods of declining stock prices

True

Modern portfolio theory is based on the diversification process.

True

Mortgage-backed securities (MBSs) are often referred to as pass-through securities because the monthly mortgage payments are passed along to the holders of the MBSs.

True

Municipal bonds, which include bonds issued by municipalities such as states, counties, and cities, are part of the tax-exempt bond market.

True

Preferred stocks are similar to bonds because their fixed income payments are also determined as a percentage of par value.

True

Pretax yields on taxable instruments are generally higher than the yields for tax-exempt securities with similar risk.

True

Reinvestment rate risk is the risk that earnings (cash flows) distributed from current investments will not be reinvested at a rate of return equal to the expected yield of the current investment.

True

Selecting the single best portfolio along the efficient frontier for a particular investor depends on being able to accurately assess the investor's personal preferences for expected return and risk.

True

Some common investment goals include purchasing a home, funding children's education, and saving for retirement.

True

Standard deviation measures the total volatility and total risk (systematic and unsystematic) of a portfolio.

True

The STRIPS (Separate Trading of Registered Interest and Principal of Securities) program permits investors to hold and trade the individual interest and principal components of eligible Treasury notes and bonds as separate securities.

True

The Series I savings bond earnings rate is a combination of two separate rates: a fixed rate of return and a semiannual inflation rate.

True

The bond indenture agreement is the legal document that sets forth the repayment schedules, restrictions, and promises between the issuer and the borrower.

True

The capital asset pricing model (CAPM) is an asset-pricing model that developed from the Markowitz efficient frontier and the introduction of a risk-free asset.

True

The coefficient of determination describes the percentage of variability of returns of an asset that can be explained by changes in the returns of another asset.

True

The correlation coefficient is a statistical measure generated from a regression analysis that provides insight into the relationship between two securities, two portfolios, or two indexes.

True

The purpose of budgeting is to manage the amount of income and expenses on a monthly basis.

True

The three ways to invest in natural resources are through direct investing in limited partnerships, investing in stocks of natural resource companies, and investing in natural resource mutual funds.

True

The yield an investor will earn from a bond is determined by evaluating yields on similar instruments offered in the market

True

Three advantages of real estate investments are cash flow, depreciation deductions, and low correlation with other asset classes.

True

Treasury inflation-protected securities (TIPS)provide protection both from devaluation of principal and from loss of purchasing power.

True

Yield to call (YTC) is the rate of return that equates the present value of the bond to the expected cash flows, adjusted for the timing of the call provision.

True

Yield to maturity (YTM) is the promised compound rate of return on a bond purchased at the current market price and held to maturity.

True

he efficient market hypothesis is a theory that suggests securities are priced fairly and efficiently by the market and investors are unable to consistently outperform the market on a risk-adjusted basis.

True