Chapter 9
a bond investor buys a municipal bond with a face value of $100,000 and a 3% coupon. the bond matures in 1 year. the investor pays $99,500 for the bond which includes accrued interest. to the nearest 1/10th of 1%, what will be the total return on the bond at maturity?
a) 2.5% b) 3.0% c) 3.5% d) 4.0% C) the formula to calculate total return is profit/original cost. $100,000 x .03 = $3,000 interest. $3,000 interest + $100,000 principal = $103,000 cash flow. $103,000 - $99,500 = $3,500 gain. $3,500 gain/$99,500 cost = 0.351 or 3.5%
an investor has a broadly diversified portfolio of blue chip stocks. the use of index options to hedge the portfolio would reduce
a) systematic risk b) non-systematic risk c) interest rate risk d) timing risk A) systematic risk is known as market risk and the use of index put options on a portfolio of securities would reduce the systematic or market risk of a portfolio. buying put options on the stock or indexes that closely mirrors the portfolio of stocks is the best downside protection. if you invest in the same asset class, you cannot reduce or eliminate market risk. for example, if you only invest in stocks, then the market goes down, all your stocks will go down. you cannot reduce or eliminate your market risk with stocks if you invest in different asset classes, you can reduce market risk. for example, when you invest in stocks and you also have index options. if the stock market goes down, the stocks will decrease in value, but your option contracts could increase in value. you reduced market risk bc you have more than one asset investment
an investment's performance is best measured by:
a) the investment's yield b) the investment's total return c) the investment's benchmark return d) the investment's capital appreciation B) the best measure of an investor's performance is the sum of income and capital appreciation, known as total return
if the rates of inflation remains the same at 2% during the 5 year life of a TIPs bond with a coupon of 3%, what would be the nominal value of the bond at maturity to the nearest dollar
a) $1,000 b) $1,060 c) $1,104 d) $1,160 C) TIPs adjust the principal value of the bond yearly for inflation. the interest rate or coupon remains fixed and is not a factor in arriving to the correct answer. you use the future value formula using compounding. bc the principal amount will increase each year to adjust for inflation, you will get your principal amount plus the rate of inflation. FV = 1000 x (1+0.02)^5 years --> 1000 x 1.10408 = $1,104
if a client buys a car and has an interest rate of 7% with a monthly payment of $500 for 5 years, which of the following is the most probable original loan amount on the vehicle
a) $500 b) $6,000 c) $25,000 d) $30,000 C) the client is paying $500 per month, so $500 x 12 months = $6,000. total amount paid for loan = $6,000 x 5 years = $30,000. the $30k includes interest, so the amount borrowed (original loan amount) has to be less than $30k but more than $6,000 so it is probably $25,000
which of the following statements are true regarding dollar weighted return and time weighted return 1. dollar weighted return allows investors to compare the performance of one manager to the performance of another manager 2. time weighted return allows investors to compare the performance of one manager to the performance of another manager 3. dollar weighted return allows investors to see a snapshot of their investments in relation to their financial goals 4. time weighted return allows investors to see a snapshot of their investments in relation to their financial goals
a) 1 and 3 b) 1 and 4 c) 2 and 3 d) 2 and 4 C) time weighted return eliminates the effect of cash flows to give an idea of performance. it is an effective way to measure the performance of portfolio managers to one another as well as to a benchmark. dollar weighted return includes cash flows so that the investors can get an idea of the return and growth of their portfolio in relation to their financial goals. it is not an effective way to compare managers
an investor has a financial goal of saving for a down payment to purchase a house. she has $18,000 in a CD that pays 6.5% annually. she needs at least $36,000. currently, the inflation rate is 2% and long term treasuries are yielding 7%. given this info, about how many years will it take to reach her financial goal?
a) 11.07 b) 10.28 c) 14.40 d) 17.14 A) the rule of 72 is useful when attempting to give estimates of how long it will take for an investor to double her money given a specific rate of return on the investment - in this question, it is 6.5, the CD rate. the investor has $18,000 and wants to double it to $36,000. 72/6.5 = 11.07, so it would take the investor 11.07 years to get to $36,000
an IAR is analyzing a corporate bond using net present value to decide whether the bond is overvalued. the bond pays interest annually and matures in 3 years. when calculating the NPV how many cash flows should the IAR discount
a) 3 b) 5 c) 6 d) 4 D) in a net present value (NPV) calculation the investor must discount the expected cash flows of an investment - in this case, it is a bond. the expected cash flows for this bond are four: three annual interest payments and the maturity value of the bond, which is typically $1,000
jake, an IAR, is discussing with his client, suzie, her desire to invest conservatively in fixed income securities. she says she wants a minimum return of 3%. jake uses NPV to analyze several bonds for suzie. he finds bonds from ABC corp with 3 years until maturity and a par value of $1,000. the bonds have a coupon rate of 5% and are currently selling for $1,050. which of the following is true regarding the bonds from ABC corp
a) bc these bonds are selling for a premium at $1,050, they would not meet suzie's required rate of return and should not be recommended by jake b) the fact that the bonds have only 3 years until maturity means that NPV may not be an accurate means of assessing the bond's suitability for suzie c) these bonds would be considered suitable for suzie given her parameters and could be presented to her with other investment options that also meet her requirements d) bc these bonds have a 5% coupon rate and suzie's minimum required return is only 3%, these bonds greatly exceed suzie's required return, but may carry excessive risk C) using NPV to evaluate the bonds from ABC corp, we can find the following year 1: $50 in interest from 5% coupon/(1+3%)^1 = $48.54 year 2: $50/(1+3%)^2 = $47.13 year 3: $1000 principal returned + $50/(1+3%)^3 = $960.90 NPV = $48.54 + $47.13 + $960.90 = $1,056.57. the market price of $1,050 is less than the NPV so these bonds would slightly exceed her required rate of return and thus be suitable for her portfolio
ABC corp's common stock has been fluctuating dramatically over the past month due to unsubstantiated rumors about the popularity of the company's products in the marketplace. an IA does some investigation of the company and finds that the company's sales and earnings are above where they were expected to be. the IA decides to call all of his clients who hold positions in ABC to tell them that stock fluctuation is due to:
a) business risk b) interest rate risk c) market risk d) risk associated with lack of liquidity in the stock C) business risk is the risk associated with the unique situation of a company, such as bankruptcy. in this question it says the sales and earnings are above where they are expected to be -- they are doing well, they have strong financials, so little business risk and this would not be the reason for the wide swings in the stock price. market risk, however, is the correct answer bc it best explains why the company's stock price has been fluctuating due to rumors circulating in the market about its products. there is no indication in the question of liquidity risk and interest rate risk
an IAR is reviewing the statistical range of potential returns for a specific investment. the IAR is most likely reviewing an illustration of the security's
a) discounted cash flow b) internal rate of return c) historical price volatility d) dispersion D) dispersion illustrates a statistical range of potential returns for an investment or a portfolio's returns. it is a tool to help measure the risk of an investment. types of dispersion include range, variance, standard deviation, and mean. DCF and IRR are concepts used in the time value of money. historical price volatility is the plotting of past prices of the security
which of the following performance measurements attempts to remove distortions caused by inflows and outflows of capital to an investment over time
a) dollar weighted return b) current yield measurements c) time weighted return d) expected return C) time weighted return attempts to eliminate distortions in performance that can be caused by incoming and outgoing capital, thus giving a better idea of the performance of the investment. when calculating time weighted return, longer reporting periods are broken down into smaller reporting periods and the mean (mid-point) of performance results would be the time weighted return percentage
an analyst is reviewing the returns of 5 portfolios, all of which have the same risk profile as measured by the standard deviation. the portfolio among the 5 that is on the efficient frontier is one whose return is
a) equal to the standard deviation b) highest for the stated standard deviation c) below the standard deviation d) at least 1% above the standard deviation B) the efficient frontier in modern portfolio theory represents a set of a group of portfolios that will provide for the highest return at each level of risk incurred, often measured by the standard deviation. since they all have the same standard deviation, the one that has the highest return is on the efficient frontier
in reviewing a client's portfolio, shanna, an IAR, sees that a client has 30% of the portfolio in ABC common stock, 30% of the portfolio in DEF common stock, 30% of the portfolio in GHI common stock, and 10% of the portfolio held in cash. all of the securities are from large cap companies and the client has a good amount of risk tolerance and no need for income from her investments. shanna calls the client to discuss some concerns with the portfolio. on the call, shanna's greatest emphasis in terms of her concern should be on the fact that the client has
a) exposed herself to market risk by investing in these securities b) only 3 different companies in her portfolio, which subjects the client to unnecessary levels of business and credit risk c) only invested in common stocks, with no investment in bonds, options, mutual funds, or other securities and asset classes d) exposed herself to a high level of liquidity risk with investments in these securities B) in terms of the greatest area of concern, the business or credit risk of investing in only 3 companies would outweigh the other concerns that shanna may have in relation to the client's portfolio. even if only one of these companies were to go bankrupt, the reduction to value of the client's portfolio would be significant (up to 30%). the client is listed as having a high risk tolerance and no need for income, so there is not an immediate necessity to diversify across different types of securities and asset classes. market risk is inherent to investment in the stock market in general and would be a risk to discuss with the client, but is not the biggest issue facing this particular client. the companies are listed as "large cap", so liquidity of the securities should not be a problem
which of the following securities has the greatest credit risk
a) general obligation bond b) industrial development bond c) equipment trust certificates d) mortgage bonds B) industrial development bonds are bonds that are issued by municipalities on behalf of a public corporation and ultimate responsibility for the debt is placed on the corporation. therefore, these bonds would be considered a risky investment when compared to the other choices offered which all are backed by specific assets
an investor's portfolio consists of domestic equity securities, international equity securities, and securities from emerging markets. the most likely objective of this investor is:
a) growth via additional risk with focused investments in each respective category b) the reduction of risk via diversification across multiple different markets c) exploitation of decreasing domestic security values while foreign values increase d) exploitation of increasing domestic security values while foreign values decrease B) the question is written to indicate multiple securities from each respective category. rather than focusing only on one market, the investor has diversified across multiple markets, which leads to a reduction in overall risk on the portfolio. were this investor seeking growth, it would be likely that the mention would be made of the risk level being taken or the type of security being purchased. with long positions in each category, the investor is not seeking to exploit one market (domestic or foreign) against another market
the sharpe ratio measures the
a) level of investment return relative to the dollar amount invested b) level of portfolio volatility relative to a benchmark portfolio c) risk adjusted rate of return relative to the risk free rate of return d) risk adjusted rate of return relative to portfolio volatility D) the sharpe ratio measures whether the returns on a portfolio were due to smart investment decisions or excess risk which means that the risk adjusted rate of return on the portfolio is relative to the portfolio's volatility
the dividend discount model is used to determine which of the following items
a) preferred stock values b) common stock values c) a common stock's growth rate and cash flows d) a preferred stock's growth rate and cash flows B) the dividend discount model provides a tool for establishing the value of a common stock using the dividends paid as well as a given rate less the anticipated growth rate of dividends
all of the following statements about the efficient market theory are true except
a) price reflects the combined knowledge and expectations of all investors b) it is impossible to beat the market c) it is impossible to find undervalued or overvalued stock d) efficient fundamental and technical research can produce superior investment results D) efficient market hypothesis (EMH) is a theory that indicates that it is imposible to beat the market, bc all relevant info is factored into the pricing of a stock in real time. for this reason, it would be false to state that efficient fundamental and technical research can produce superior investment results when following EMH
an individual using which risk perspective would use modern portfolio theory to select an investment
a) risk neutral b) risk averse c) risk seeking d) risk indifferent B) modern portfolio theory attempts to optimize expected returns for a portfolio for a given level of risk. it can also work with opposite directions attempting to minimize risk for a given amount of return. an individual who seeks to minimize risk is generally risk averse
an investor has been unsuccessful in beating the market and concludes that stock prices reflect all publicly available info. the investor's conclusion reflects the principles of the
a) semi strong version of the efficient market hypothesis b) strong version of the efficient market hypothesis c) weak version of the efficient market hypothesis d) alpha investing theory A) efficient market hypothesis is an investment theory that states it is impossible to consistently beat the market bc in an informationally efficient stock market, current share prices always reflect all relevant info. the semi strong version of EMH says that publicly available info is reflected in the market prices. the strong version states that public and private info is reflected in market prices
an IA is researching a stock. she wants to estimate the fair price of the stock before investing. which of the following is commonly used to arrive at a fair market price
a) sharpe ratio b) dividend discount model c) r squared value d) convexity B) the dividend discount model is one method used to value equities. the DDM requires you to use the stock's expected dividend payments and discount them using a discount rate you select. the sharpe ratio is used to reflect the return on your portfolio adjusted by the risk of the portfolio. r squared values provide an indication of how the stock moves in comparison to a broader index. lastly, convexity is used to analyze bonds not stocks
sue recently won the lottery and took in over 10,000,000 in winnings after-tax. after purchasing a home, she doesn't intend to live a lavish lifestyle and wants to set up some investments to help provide $2,000 per month for herself and her 3 children for an indefinite period of time. after talking this through with an IA, the advisor claims he should be able to achieve an expected rate of return of 3% on an annual basis. what amount must sue invest per person in order to receive the $2,000 per month indefinitely
a) sue must invest approx $20,000 per person b) sue must invest approx $66,000 per person c) sue must invest approx $200,000 per person d) sue must invest approx $800,000 per person D) sue should invest approx $800,000 per person to ensure a perpetual payment of $2,000. you take the expected rate of return of 3% and divide by 12 months to get 0.0025. then, divide the monthly payment of $2,000 by 0.0025 to arrive at $800,000. you can also simply multiply the monthly figure by 12 months to find the annual payout of $24,000. then divide this by 0.03 to get the same $800,000
an IAR at your firm has a client in the 25% federal tax bracket who has a large portfolio of long term T-Bonds with an overall nominal yield on the portfolio of 4%. in reviewing the account, the IAR discovers that the transaction costs associated with the portfolio total roughly 1% and the anticipated rate of inflation for the foreseeable future is 2%. in a meeting with the client it would be most important for the IAR to discuss:
a) that the inflation adjusted return is only 2% after subtracting 2% rate of inflation and that it is likely to remain at that level for the foreseeable future b) a transition to municipal securities to avoid all taxation related to the bond portfolio c) the fact that the expected return on the portfolio would be higher than 4% as rates should only really increase from the 4% level d) the potential for a transition to an actively managed bond fund, where sales loads and annual expenses would be lower than 1% A) the IARs main concern should be the fact that the rate of inflation (2%) is going to have a significant impact on the inflation adjusted or real return, which is calculated by subtracting the rate of inflation from the nominal yield of the portfolio. there is no indication that the client is seeking to avoid taxation or seeking to transition to municipal securities from govt securities. expected return is a projected estimate of return based on various potential market conditions/outcomes. it would not dictate that the return on the portfolio should be exceeding 4%. though an actively managed bond fund may provide diversification for the client, there is no indication that the client is seeking higher returns. as well, an actively managed bond fund will have sales loads and annual expenses that are likely to exceed 1% which is what the question specifies as the rough transaction cost percentage
when using DCF to evaluate the impact of increasing interest rates in the market, what effects would it have on new bonds in the market
a) the DCF on new bond will increase b) the DCF on new bond will decrease c) the DCF on new bond will stay the same d) the DCF is not used to evaluate the interest rates on new bonds A) if interest rates are increasing, then it is expected that the return on new bonds will increase due to the increase in interest rates
a bond is purchased at issuance by an investor. the investor pays the face value of the bond which has a 5% coupon rate. which of the following would have a negative effect on this bond in terms of interest rate risk
a) the bond's market price goes up after the current interest rates on new bonds go to 4% b) the bond's market price remains constant after current interest rates on new bonds remain at 5% c) the bond's market price goes down after the current interest rates on new bonds go to 6% d) no determination can be made in relation to interest rate risk and the info provided C) if an investor has an existing bond with a coupon of 5% and interest rates go up on new bonds to 6%, then the 5% bonds will be less desirable. the lower demand will drive the market price of these bonds down, leaving them selling at a discount below face value. face value is $1,000 on bonds and a hypothetical discount would be $900 or $950 on this bond. the question asks for a negative effect, which is what occurs if rates increase on new bonds. a positive effect would be rates going to 4% and the 5% bond being more desirable
a client of an IA intends to purchase an RV in order to tour the country. the client is 55 years old and recently retired. he and his wife can afford a monthly payment of $750 per month. the going interest rate on RV is 7.5% for a 12 year loan. with a monthly payment of $750 on a 12 year loan with an interest rate of 7.5%, approx how much can this client afford to borrow when buying the RV?
a) the client can afford a loan amount of approx $9,000 b) the client can afford a loan amount of approx $9,675 c) the client can afford a loan amount of approx $71,000 d) the client can afford a loan amount of approx $108,000 C) with a monthly payment of $750 per month, the client would pay $9,000 per year, so answers A and B are too low for a loan that spans 12 years. as well, over a 12 year term, at $750 per month, the client would pay a total of $108,000, but remember that this includes paying back the loan PLUS interest. so the loan amount will be less. bc of this, we can reasonably assume that the loan value lies somewhere between the numbers that are far too low and the overall payout over the life of the loan.
