Portfolio Basics Series 65
A customer buys 100 shares of DEFF stock at $150 per share. During the first year of owning the stock, the customer receives $450 of dividends. At the end of the year the stock is trading at $161.25. Assuming that the customer does not sell the shares, what is the customer's Total return on investment for the holding period? A. 3.00% B. 7.50% C. 10.50% D. This cannot be determined from the information presented
The best answer is C. Return on Investment includes both income and asset appreciation. Over a 1-year holding period, this stock appreciated from $150 per share to $161.25 per share. This is a gain of $1,125 on 100 shares, plus $450 of dividends were received for a total return of $1,575 / $15,000 original investment = 10.50% return.
A portfolio with a beta of +1 has: A. systematic risk B. non-systematic risk C. both systematic and non-systematic risk D. no risk
The best answer is A. A portfolio with a beta of +1 is one that moves in the same direction and at the same rate as the market. Thus, this portfolio only has market risk - which is also known as systematic risk. This is the risk that cannot be diversified away.
An active portfolio manager generates a return of 17.50% on her equity portfolio that has a beta of 1.50. The expected return of the benchmark market index (beta of 1) is 10%. Assuming that the risk-free rate of return is zero, what is the alpha achieved by the manager? A. +2.50% B. -2.50% C. +7.50% D. -7.50%
The best answer is A. In its most simplistic form, alpha is the excess return of an investment as compared to the risk-adjusted return of the market. To find alpha, the following are compared: The excess actual rate of return given by this investment over the risk-free rate of return. Actual Return of Portfolio - Risk-Free-Return = 17.50% - 0% = 17.50%. The excess return of the benchmark index over the risk-free rate of return: Market Index Return - Risk-Free Return = 10% - 0% = 10%. To compute "alpha" we must compare the rate of return that the "benchmark index" would have given if it had the same "beta" as this portfolio. Since this portfolio has a beta of 1.50 x 10% excess benchmark return = 15% risk-adjusted excess benchmark return of the market index. Since the actual excess return of the portfolio was 17.50%, this portfolio has an "alpha" of "+2.50" - the actual excess return of the portfolio (17.50%) minus the expected risk-adjusted excess return of the benchmark index (15%). This means that, on a risk adjusted basis, an investment in the portfolio gave a 2.50% superior return to the benchmark index. An alpha of more than "0" indicates that the investment outperformed the market on a risk-adjusted basis. A negative alpha indicates that the investment underperformed the market on a risk adjusted basis.
A defensive stock is characterized by: I earnings variability due to changes in economic growth II no earnings variability due to changes in economic growth III a stock price that tends to move in the same direction of the market as a whole IV a stock price that tends to move independently of the market as a whole A. I and III B. I and IV C. II and III D. II and IVThe best answer is D.
The best answer is D. A defensive stock is one that is unaffected by the economic cycle. The classic defensive stocks are food, pharmaceuticals, tobacco, and beer.
Which of the following is NOT considered to be a defensive stock? A. Tobacco company B. Beverage manufacturer C. Pharmaceutical company D. Home builder
The best answer is D. Tobacco, beverage and pharmaceutical consumption is not tied to the economic cycle - people smoke, drink, and use their drugs without much variation in both good times and bad. Durable goods manufacturers and home builders are in notoriously cyclical industries - these are purchases that can be deferred when times are bad.
An investment adviser is assessing the performance of 3 separate investments. Investment A has increased by 6% over the past 6 months. Investment B has increased by 3% over the past 3 months. Investment C has increased by 9% over the past 9 months. Which statement is TRUE? A. Investment A gives the highest rate of return B. Investment B gives the highest rate of return C. Investment C gives the highest rate of return D. Investments A, B and C all give the same rate of return
The best answer is D. Each of these investments is giving an annual rate of return of 12% - since each is appreciating by 1% per month
A company's gross operating profit is: A. gross sales - cost of goods sold B. gross profit - administrative and marketing costs C. operating profit - bond interest expense and taxes D. earnings for common - common dividend
Gross profit margin is: Gross Sales - Cost of Goods Sold Net operating profit margin is: Gross Profit - Operating Expenses (Administrative, Marketing, Transportation) Net profit margin is: Operating Profit - Bond Interest Expense and Taxes When analyzing an income statement, net profit margin, because it deducts EVERY expense from sales, is the best measure of profitability.
A stock whose price moves down 5% when the market as a whole moves up by 10% has a beta coefficient of: A. -.50 B. +.50 C. -2.00 D. +2.00
The best answer is A. A stock with a positive "beta" moves in the same direction as the market; a stock with a negative "beta" moves in the opposite direction to the market. If a stock moves down 10% when the market moves up 10%, it has a beta of -1.00. If a stock moves down 5% when the market moves up 10%, it has a beta of -.50. If a stock moves down 20% when the market moves up 10%, it has a beta of -2.00. There are very few "negative" beta stocks - these are counter-cyclical stocks such as credit collection companies and pawnshops (when times are bad, these stocks do well; and vice-versa).
An active portfolio manager generates a return of 18.80% on her equity portfolio that has a beta of 1.40. The expected return of the benchmark market index (beta of 1) is 12%. Assuming that the risk-free rate of return is zero, what is the alpha achieved by the manager? A. +2% B. -2% C. +6% D. -6%
The best answer is A. In its most simplistic form, alpha is the excess return of an investment as compared to the risk-adjusted return of the market. To find alpha, the following are compared: The excess actual rate of return given by this investment over the risk-free rate of return. Actual Return of Portfolio - Risk-Free-Return = 18.80% - 0% = 18.80%. The excess return of the benchmark index over the risk-free rate of return: Market Index Return - Risk-Free Return = 12% - 0% = 12%. To compute "alpha" we must compare the rate of return that the "benchmark index" would have given if it had the same "beta" as this portfolio. Since this portfolio has a beta of 1.4 x 12% excess benchmark return = 16.80% risk-adjusted excess benchmark return of the market index. Since the actual excess return of the portfolio was 18.80%, this portfolio has an "alpha" of "+2" - the actual excess return of the portfolio (18.80%) minus the expected risk-adjusted excess return of the benchmark index (16.80%). This means that, on a risk adjusted basis, an investment in the portfolio gave a 2% superior return to the benchmark index. An alpha of more than "0" indicates that the investment outperformed the market on a risk-adjusted basis. A negative alpha indicates that the investment underperformed the market on a risk adjusted basis.
An investor has a broadly diversified portfolio of blue chip stocks. The use of index options to hedge the portfolio reduces: A. systematic risk B. non-systematic risk C. interest rate risk D. timing risk
The best answer is A. Index options can be used to hedge a portfolio. If index puts are bought, then a drop in the market lowering the portfolio's value will be offset by a gain in the value of the index puts. This strategy hedges against market risk, also known as systematic risk. Non-systematic risk is the risk that any one security will perform poorly. The larger the portfolio, the lower the effect of non-systematic risk. Timing risk is the risk that trades will be not be performed at the best market prices; interest rate risk is the risk that interest rates rise, forcing bond prices and stock prices down.
The real interest rate is the incremental interest earned by an investor above the: A. inflation rate B. prime rate C. investor's tax rate D. discount rate
The best answer is A. The "real" interest rate is the nominal rate minus the inflation rate. Thus, it is the incremental interest earned above the inflation rate. real rate of return = nominal rate - inflation rate
If the Required Rate of Return (RRR) on a security is less than the Internal Rate of Return (IRR) on that security, then the: A. security should be purchased for investment B. security should not be purchased for investment C. security has a positive risk premium D. security has a negative risk premium
The best answer is A. The RRR (Required Rate of Return) is the minimum return that an investment must offer in order for someone to decide to buy it. Assume that the RRR is 10%. If the security actually offers a return of 12% (the Internal Rate of Return, which is the same as the yield to maturity offered by the investment) then the purchase should be made because the IRR (actual return) exceeds the RRR (minimum required return).
It can be expected that the Sharpe Ratio will: A. increase as the composition of the underlying portfolio is broadened B. decrease as the composition of the underlying portfolio is broadened C. remain unaffected as the composition of the underlying portfolio is broadened D. become more volatile as the composition of the underlying portfolio is broadened
The best answer is A. The Sharpe Ratio measures incremental return achieved for each unit of incremental risk assumed, with the risk measure being determined by standard deviation of returns of the underlying investments. Standard deviation of returns goes down as a portfolio is broadened, due to the effect of diversification. Since this is the denominator (bottom number) in the formula, if it decreases, then the ratio will increase.
A customer purchases 100 shares of ABC stock valued at $100 per share. After 13 months, the customer sells the stock at $130 per share. During this period, the stock paid $2.00 in cash dividends. If the average long-term capital gains tax rate is 20% and the investor's marginal tax rate is 40%, what is the customer's approximate after-tax rate of return? A. 23% B. 25% C. 26% D. 32%
The best answer is A. This stock has a $30 long term capital gain, earned over 13 months. Since 20% of the gain is paid in tax, 80% is kept after tax. 80% of $30 = $24. Furthermore, since the gain was earned over 13 months, to annualize the gain, 12/13ths of $24 = $22.15. Regarding the cash dividend received, current law taxes cash dividends at the long term capital gains rate. Of the $2.00 in cash dividends received, 20% goes to tax and 80% is kept after tax. $2.00 x 80% = $1.60. The total after-tax return is $22.15 + $1.60 = $23.75 / $100 invested = 23.75%. Note that if this is a question using the "old" tax law, then the cash dividend would be taxed at 40% and 60% would be kept after tax ($2.00 x .6 = $1.20). In that case, the after-tax rate of return would be $22.15 + $1.20 = $23.35 / $100 invested = 23.35%. In both cases, the best answer is 23%.
A customer with $30,000 to invest places $10,000 in Investment A; $10,000 in Investment B; and $10,000 in Investment C. During the course of 1 year, Investment A pays $200 in dividends; Investment B pays $600 in dividends; and Investment C pays no dividends. At the end of the year, Investment A is down 20%; Investment B is up 5%; and Investment C is up 7%. The Total Return on Investment is: A. 0% B. 3% C. 5% D. 6%
The best answer is A. Total Return consists of both dividends and asset appreciation. Total dividends collected were +$800. Investment A depreciated by $2,000, Investment B appreciated by $500, and Investment C appreciated by $700, for a net loss of -$800 on the 3 investments of $10,000 each. The $800 of dividends received were exactly offset by $800 of capital losses. Thus, Total Return is "0" on $30,000 invested.
When the market price of a security has reached equilibrium, transaction costs will be: A. lower B. higher C. volatile D. stable
The best answer is A. When a stock has found its equilibrium price in the market, this means that the spread between bid and ask is non-existent and active trading is taking place between buyers and sellers at that price. In such a market, because there is very active trading, commission costs on a per-trade basis tend to become lower
An investment adviser that makes investment decisions by first selecting industries that are likely to outperform the market based on the current economic environment and then selecting specific companies within those industries based on product lines, market share, management strategy, etc., is using the: A. bottom up approach to investing B. top down approach to investing C. dynamic selection approach to investing D. efficient market approach to investing
The best answer is B. A "Top Down" investment approach means that the adviser looks at the "big picture" first, selecting those economic sectors that are likely to outperform the economy in general. After determining which sectors are most promising, the adviser looks for the best companies within those sectors for investment opportunities.
An individual is considering leasing a new automobile. Which quantitative method is used to calculate the monthly payment? A. Rule of 72 B. Time value of money C. Net present value D. Internal rate of return
The best answer is B. A monthly lease payment consists of 2 components - the monthly depreciation amount and the cost of the money borrowed to finance the lease. Since the borrowing charge is the interest rate on a loan, based on the number of years that the car will be leased, this computation uses the "time value of money" to compute the compound interest paid on the financed amount. The Rule of 72 is an oversimplified rule that states that if one takes the interest rate being earned on an investment and divides it into 72, then the result is the number of years that it will take for the investment to double in value. For example, if an investment earns 10%, then it will take 72 / 10 years = 7.2 years for the investment value to double. Net present value takes future cash flows and discounts them by today's interest rate to arrive at today's "net present value" (essentially, this is the opposite of compound interest). Internal rate of return is the interest rate needed to discount future cash flows to "0" - it is the true yield to maturity of an investment.
A mutual fund manager would use beta as part of the analysis of the fund's performance in order to: A. measure the fund's return on assets relative to the market as measured by the Standard and Poor's 500 index B. measure the volatility of the fund's share price relative to the Standard and Poor's 500 index C. select the specific securities that will be purchased by the fund; and those that will be sold by the fund D. determine the timing of purchases of securities and sales of securities by the fund
The best answer is B. Beta measures volatility of a stock (or in this case, a mutual fund share) to the volatility of the market as a whole, as measured by the Standard and Poor's 500 index. The greater the beta, the more volatile the stock. High beta stocks, since their price movements are so volatile, should also have high earnings potential to compensate for the additional risk assumed in investing in these securities.
CAPM is used to calculate the: A. risk-free rate of return B. expected rate of return C. geometric rate of return D. total rate of return
The best answer is B. CAPM (the Capital Asset Pricing Model) is used to identify the most "efficient" investments - meaning those that give the greatest return for the risk assumed. As long as the investment meets the minimum return dictated by the model, then it should be included in the portfolio. CAPM finds the "expected return of an investment" using the formula: Expected Return of An Investment = Risk-Free Rate of Return + Risk Premium* *Risk Premium is: Beta x (the excess of the Expected Market Return over the Risk-Free Rate of Return) In the formula, Beta is the measure of risk. Thus, high Beta stocks must give a higher rate of return to meet the formula's investment threshold.
A valuation model used to predict portfolio performance is: A. net present value B. expected return C. internal rate of return D. inflation adjusted rate of return
The best answer is B. Expected return assigns a probability percentage to each possible rate of return for that asset class; multiplies the probability by the possible rate of return; and then "sums these up" to get the "expected" rate of return - which may vary higher or lower, depending on market conditions. Thus, it is a predictor of portfolio performance. Net present value is a means of determining the value of an investment's cash flows. Internal rate of return is the implicit yield of an investment's cash flows. Inflation-adjusted rate of return is the "real rate of return" - the actual rate of return minus the inflation rate.
Investment "A" is purchased in May and sold at a gain in the July following. Investment "B" is purchased in June and sold at a gain in the October following. In order to compare the return of investment "A" to investment "B," which measure should be used? A. Dollar weighted return B. Annualized return C. Holding period return D. Total return
The best answer is B. Investment A has been held for 2 months and then sold at a gain; while Investment B has been held for 4 months and then sold at a gain. To compare them, their returns must be annualized. Dollar weighted return is another name for Internal Rate of Return. Holding period return is a non-annualized rate of return that is earned over the life of the investment. Total return includes the "total" of both dividends and capital gains as the components of investment return.
The risk inherent in a portfolio that can be diversified away is known as: A. systematic risk B. non-systematic risk C. credit risk D. marketability risk
The best answer is B. Non-systematic risk is stock-specific risk in a portfolio. As more and more stocks are added to a portfolio, that portfolio begins to resemble the market as a whole. Thus, non-systematic risk can be diversified away. Once a portfolio is fully diversified, it no longer has non-systematic risk. Now it is left with systematic risk only - that is market risk, which cannot be diversified away (but it can be hedged against).
A customer invests $1,000 in an investment that is expected to generate $100 in the first year, $200 in the second year, and $300 in the third year, at which time the original $1,000 investment will be returned. What is the Return on Investment (ROI)? A. 10% B. 20% C. 30% D. 60%
The best answer is B. Return on Investment is a simple measure that takes an initial investment and shows how well it performs. The annual cash flows generated by the investment are averaged, and divided by the original investment amount. In this example, $1000 is invested, and that investment is expected to generate cash flow of $100 in the first year, $200 in the second year, and $300 in the third year, at which point the $1,000 original investment will be returned. The average annual cash flow is $100 + $200 + $300 = $600/3 years = $200 per year. Since $1,000 was invested, the ROI is $200 / $1,000 = 20%.
When computing standard deviation of returns against the mean, the measure used for the mean is: A. geometric mean B. arithmetic mean C. weighted average mean D. moving average mean
The best answer is B. Standard deviation of investment returns is computed by comparing all of the investment returns against the "average" investment return. The more broadly dispersed the investment returns are as compared to the arithmetic mean (which is simply the average of all investment returns), then the greater the standard deviation. Standard deviation is a "risk" measure. Geometric mean considers compounding of annual returns, as compared to arithmetic mean, which is a simple average. The other 2 choices are not tested.
A corporation that has only issued common stock has income after tax. If this is divided by total assets - total liabilities, the result is: A. Earnings per common share B. Return on common equity C. Price to book value D. Return on assets
The best answer is B. The question is defining Return on Common Equity. It is Earnings for Common divided by Common Equity. Common equity is all assets - all liabilities, as long as the corporation has not issued preferred stock. If the corporation has issued preferred stock, this must be deducted as well to arrive at common equity.
The formula V = P (1 + r)n is used to compute an investment's: A. present value B. future value C. internal rate of return D. standard deviation
The best answer is B. This is the formula for compound interest - which determines the "future value" of an investment, compounded with interest over time. "P" is the "original" principal amount; "r" is the interest rate; "n" is the number of years. For example, $1,000 invested at 10% interest for 3 years has a future value of: $1,000 (1.10)3 = $1,000 x 1.331 = $1,331 at the end of the 3rd year.
A trader purchased 100 shares of XYZ stock at $20 per share. Subsequently, XYZ stock goes to $25 per share and then to $22 per share. During the year, XYZ stock paid a $1 dividend. If the trader is in the 30% tax bracket, what is the total return? A. 10.5% B. 15% C. 21% D. 30%
The best answer is B. Total return is presented before tax - since each customer is in a different tax bracket, the after-tax total return would be different for each person. income + capital gain ————————————— = total return cost of security $1 Dividend + $2 Capital Gain ———————————————— = 15% $20 per share Note that the relevant market price for the capital gain is the current market value of $22 per share versus the original cost of $20 per share - any interim price is irrelevant.
An investor buys 1,000 shares of XYZ stock at $34. It goes to $43 in the next year and pays a $3 dividend. At the end of the year following, the stock is trading at $40 and the stock pays another $3 dividend. What is the total return? A. 15.0% B. 17.7% C. 30.0% D. 35.3%
The best answer is B. Total return must be presented on an annualized basis. This stock paid a $3 dividend during each of the last 2 years. Over these 2 years, the stock's price went from $34 original cost to $40 at the end of the second year, for a total capital gain of $6 over 2 years = $3 capital gain per year. income + capital gain ————————————— = total return cost of security $3 Dividend + $3 Capital Gain ———————————————— = 17.7% $34 per share Note that the relevant market price for the capital gain is the current market value of $40 per share - any interim price is irrelevant.
"High Risk Investment = High Return Investment" "Low Risk Investment = Low Return Investment" This is an example of: A. Efficient Market Theory B. Correlation C. Duration D. Monte Carlo Simulation
The best answer is B. When looking at the world of investments, there is a correlation between risk and return. Low risk investments give lower returns, but have a low risk of loss. High risk investments give high returns, but have a high risk of loss. So the best answer to this question is that the question illustrates "correlation." Efficient market theory states that market pricing is "efficient" and that no one can do better than the market over a long-term investment time frame. Duration is a measure of bond price volatility. Monte Carlo simulation is a computer-based method to test thousands of probable outcomes to a set of investment variables.
Which of the following are components of the Capital Asset Pricing Model? I Risk-Free Rate of Return II Alpha III Beta IV Expected Market Rate of Return A. I and II only B. III and IV only C. I, III, IV D. I, II, III, IV
The best answer is C. CAPM (Capital Asset Pricing Model) attempts to find the Expected Return of an Investment by breaking the return down into 2 components. These are the Risk-Free Rate of Return and the Risk Premium. The Risk Premium increases with the risk of that investment. The risk premium is the "beta" of the investment times the excess of the expected market rate of return over the risk-free rate of return. The higher the "risk" as measured by "beta," the higher the expected return of that investment. Alpha has nothing to do with CAPM.
Which form of efficient market theory states that stock prices respond rapidly to publicly available information, so that no potential gains can be made by trading on that information? A. Weak Form B. Semi-Weak Form C. Semi-Strong Form D. Strong Form
The best answer is C. Efficient market theory basically states that markets are efficient at pricing stocks, and that over a long time frame, an investor cannot outperform the market. It is the economic argument used for index funds. There are 3 "forms" of efficient market theory: Weak Form: States that prices reflect all past publicly available information, but that this has no validity for predicting future price movements. It essentially states that price movements are random. This implies that technical analysis is basically useless to improve returns, but fundamental analysis still has potential value. Semi-Strong Form: States that prices respond rapidly to publicly available information, so that no potential gains can be made by trading on that information. This implies that anyone with inside information has an inherent advantage and can profit by trading on it. Strong Form: States that prices respond rapidly to both publicly available and private information, so that no one can profit by trading on this information. Most people subscribe to the "semi-strong" version of this theory.
Following is the balance sheet of a company: Cash $200,000 Accounts Receivable $200,000 Inventory $300,000 Long Term Assets $500,000 Trade Payables $200,000 Long Term Payables $400,000 Long Term Debt $500,000 What is the net working capital of the company? A. $100,000 B. $200,000 C. $500,000 D. $700,000
The best answer is C. Net working capital of a company is current assets - current liabilities. Current assets are those assets that are turned into cash within a year; current liabilities are those bills that must be paid within a year. The current assets in this example are cash, accounts receivable and inventory, totaling $700,000. The only current liability is trade payables, at $200,000. Thus, net working capital is $700,000 - $200,000 = $500,000.
A customer buys a new issue inflation-adjusted government bond with a 4% coupon at par. After the first year, the inflation rate as measured by the CPI has increased by 5%. After the second year, the inflation rate increases by 8%. For the third year of holding the security, the customer will receive: A. interest of $40.00 B. interest of $42.00 C. interest of $45.36 D. interest of $80.00
The best answer is C. TIPS (Treasury Inflation Protection Securities) are issued with a fixed coupon that does not change. In Year 1, this bond will pay 4% of $1,000 par = $40. At the end of year 1, because inflation was 5%, the principal amount of the bond is adjusted to 1.05 x $1,000 = $1,050. In Year 2, the bond will pay 4% of $1,050 = $42 of interest. At the end of year 2, because inflation was 8%, the principal amount is adjusted to 1.08 x $1,050 = $1,134. In Year 3, the bond will pay 4% of $1,134 = $45.36 of interest
Which interest rate would be used to calculate the risk free rate of return? A. Prime rate B. Call loan rate C. Fed Funds rate D. Eurodollar rate
The best answer is C. The risk free rate of return is the interest rate on risk free securities such as Treasuries. The Fed Funds rate (overnight loan rate on reserves lent from Fed member bank to Fed member bank) is the "base" lending rate in the economy and approximates the interest rate on very short term Treasury Bills. The Prime rate is the rate at which banks lend to their best commercial customers, and includes a "risk" component. It is typically 3 or 4 percentage points higher than Fed Funds. The Call Loan rate is the rate at which member banks will lend using securities as collateral. There is a "risk" component to this rate as well, and it typically is 2-3 percentage points higher than Fed Funds. The Eurodollar rate is irrelevant.
An investor buys 1000 shares of ABCD stock at $50 per share. At the end of the 1st year, ABCD has increased to $60 per share. At the end of the 2nd year, ABCD has increased to $75 per share. At the end of the 3rd year, ABCD has decreased to $70 per share. Assuming that the customer is in the 15% tax bracket for dividends and long-term capital gains, if the customer liquidates the position at the end of year 3, the after-tax annualized rate of return is: A. 8.10% B. 9.53% C. 11.33% D. 13.33%
The best answer is C. This investment has increased from $50 in value to $70 in value over 3 years. The $20 gain will be taxed at 15%; so 85% of the gain is kept after tax. .85 x $20 = $17 after-tax gain / 3 year holding period = $5.66 annualized after-tax gain / $50 original investment = 11.33% annualized rate of return.
The method for computing return as shown in a mutual fund performance chart is: A. Internal Rate of Return B. Dollar Weighted Average Return C. Time Weighted Average Return D. Expected Rate of Return
The best answer is C. Time weighted average return is the measure used for mutual fund performance charts (Total Return, which shows dividends and capital gains as continually reinvested). It reflects the growth that would be achieved from a 1-time investment into the fund and then holding that investment over time - this is a buy and hold strategy. This method is consistent when comparing one fund's performance to another fund's performance. In contrast, Dollar weighted average return accounts for all cash flows (deposits) into the fund and all cash redemptions from the fund made by that investor. It is the same as the Internal Rate of Return, and will vary with the timing of each investor's deposits and withdrawals. Because investors often "chase" past performance, they will buy a fund "too late" (after the fund has posted its best performance and now enters a period of lesser performance) and will sell "too soon." Thus, for the individual investor, Dollar weighted average return is often lower than Time weighted average return.
A customer buys a TIPS at par with a 3 1/2% coupon. Inflation stays at 4% over the life of the security. What is the total return on the investment? A. 3 1/2% B. 4% C. 7 1/2% D. This cannot be determined from the information presented
The best answer is C. Treasury Inflation Protection Securities (TIPS) give a fixed coupon rate (3 1/2% in this example), but they also adjust the principal value of the bond up each year for inflation (4% per year in this example). At maturity, the investor gets the inflated principal amount. The Total Return on this TIPS would be 3 1/2% annual income + 4% annual gain = 7 1/2%.
A customer buys a TIPS with a 3% coupon. The customer holds the investment for 5 years, during which the CPI increased by 3%, 4%, 4%, 4% and 5% respectively in years 1-5. What is the customer's Total Return over the 5 year holding period? A. 3% B. 4% C. 7% D. 38%
The best answer is D. A TIPS is a Treasury Inflation Protection Security - which grows principal at the rate of inflation each year and the interest paid each year is based on the inflated principal amount. In year 1, the investor will get $1,000 x 3% = $30 of interest. At the end of year 1, the principal is adjusted by the 3% inflation rate. $1,000 x 1.03 = $1,030 adjusted principal amount. In year 2, the investor will get $1,030 x 3% = $30.90 of interest. At the end of year 2, the principal is adjusted by the 4% inflation rate. $1,030 x 1.04 = $1,071.20 adjusted principal amount. In year 3, the investor will get $1,071.20 x 3% = $32.14 of interest. At the end of year 3, the principal is adjusted by the 4% inflation rate. $1,071.20 x 1.04 = $1,114.05 adjusted principal amount. In year 4, the investor will get $1,114.05 x 3% = $33.42 of interest. At the end of year 4, the principal is adjusted by the 4% inflation rate. $1,114.05 x 1.04 = $1,158.61 adjusted principal amount. In year 5, the investor will get $1,158.61 x 3% = $34.76 of interest. At the end of year 5, the principal is adjusted by the 5% inflation rate. $1,158.61 x 1.05 = $1,216.54 adjusted principal amount. This is the redemption price after year 5. Thus, the investor's Total Return is 5 years of interest plus 5 years of appreciation. The 5 years of interest totals $161.22. The 5 years of appreciation totals $216.54. The Total Return over 5 years is $161.22 + $216.54 = $377.76 / $1,000 invested = 38% (rounded). Note that this question asks for 5 year Total Return; not for annualized return. Also note that from the choices given, if you understand that the 5 years returns are added up to get the "Total", then doing all this math was not needed! Eyeballing the choices gives the answer!
An investment adviser that uses a "bottom up" approach to portfolio management will: A. select the key index that he or she believes will outperform other sectors B. analyze the entire economic outlook to sort out the areas for higher growth potential C. look for emerging markets that are likely to outperform mature markets D. select specific investments based on each investment's ability to generate exceptional growth, regardless of the economic outlook
The best answer is D. A portfolio manager that uses a "bottom up" approach looks for exceptional specific investments before considering overall economic conditions and their effect on investment returns. The philosophy here is that these exceptional companies, and their stock prices, will do well regardless of the economic climate.
A customer that is willing to assume market risk should: A. only invest in stocks that have a beta of at least 1.00 B. invest a portion of his funding in Treasury Bonds to diversify the portfolio C. allocate a portion of his portfolio to negative beta stocks D. diversify the portfolio sufficiently to eliminate non-systematic risk
The best answer is D. Another name for market risk is systematic risk. A fully diversified portfolio only has market risk. A portfolio that is not fully diversified is said to have both systematic and non-systematic risk. Once enough stocks are added to the portfolio, non-systematic risk is diversified away, leaving the portfolio with only market (aka systematic) risk.
What formula finds the "expected return" of an investment? A. Beta B. Duration C. Sharpe Ratio D. CAPM
The best answer is D. CAPM (Capital Asset Pricing Model) attempts to find the Expected Return of an Investment by breaking the return down into 2 components. These are the Risk-Free Rate of Return and the Risk Premium. The Risk Premium increases with the risk of that investment. The risk premium is the "beta" of the investment times the excess of the expected market rate of return over the risk-free rate of return. The higher the "risk" as measured by "beta," the higher the expected return of that investment. Duration measures bond price volatility as market interest rates move. The Sharpe Ratio measures the incremental investment return that is achieved for assuming incremental risk. Beta is a correlation coefficient that measures the correlation of a specific stock's price movement against the movement of a relevant stock index. It is used in the CAPM formula, but by itself, does not measure expected return.
An investment in common stock provides dividends equal to 4% per year and expected long term capital gains equal to 8% per year. For an investor in the 30% tax bracket, the after-tax rate of return is: A. 8.40% B. 9.00% C. 9.60% D. 10.20%
The best answer is D. Dividends and capital gains are taxed at a maximum rate of 15%. Thus, the after-tax rate of return on the dividends is 4% (100% - 15% Tax Bracket) = 3.4%; and capital gains is 8% (100% - 15% Tax Bracket) = 6.8%. Thus, the after-tax rate of return is 3.4% + 6.8% = 10.2%.
A customer wants an equity investment with a required rate of return of 5% and wants to receive a yearly dividend payment of $2.50. To meet the customer's requirements, the security must cost: A. $12.50 B. $25.00 C. $37.50 D. $50.00
The best answer is D. If the $2.50 dividend payment is divided by the required rate of return (5%), this give a per share price of $2.50/.05 = $50.00.
What is NOT a statistical measure? A. Arithmetic average B. Sharpe ratio C. Correlation coefficient D. Quick ratio
The best answer is D. The Quick Ratio is a measure of corporate solvency. It takes a corporation's current assets that can be quickly converted to cash (basically cash and accounts receivable) and divides them by that company's current liabilities. Arithmetic average (mean) is a statistic. The Sharpe ratio is the ratio of incremental return earned per unit of risk assumed (as measured by standard deviation). Standard deviation is a statistical measure, therefore, the Sharpe ratio is also a statistical measure. Beta is a correlation coefficient - it correlates a stock's price movements with the movement of the overall market. This is another statistical measure.
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
The best answer is D. The Sharpe ratio measures the incremental rate of return over the risk free rate achieved in a portfolio relative to the standard deviation (volatility) of the portfolio. If the ratio is positive, then there is a real benefit - extra investment return - for assuming the incremental risk. If the ratio is zero (or in exceptionally difficult economic times, such as a major recession or depression, it can even become negative), there is no benefit to assuming additional risk in the portfolio beyond what a risk free investment such as Treasury Bills will give.
A married couple that is in the maximum tax bracket has 1 child, age 8. The couple is looking to start a 529 plan to fund the child's college education. The couple has $75,000 that they wish to invest. The child will enter college 10 years from now at age 18. The couple will need $200,000 for college to pay for a private 4 year college. To calculate whether the $75,000 investment is adequate, all of the following are required to find that investment's future value EXCEPT: A. present value of investment B. expected interest rate C. investment time horizon D. expected inflation rate
The best answer is D. To find the future value of a sum, simply take the sum's present value and multiply it by (1 + Growth (or Interest) Rate) for each year of the investment's time horizon. For example, a 3 year investment of $100 at a 5% growth rate will grow to $100 x 1.05 x 1.05 x 1.05 = $115.76 at the end of 3 years. The inflation rate is not part of the formula.
When the securities markets have reached equilibrium, commission costs: A. are subject to high volatility B. are subject to low volatility C. have no volatility D. are subject to change
The best answer is D. When a stock has found its equilibrium price in the market, this means that the spread between bid and ask is non-existent and active trading is taking place between buyers and sellers at that price. In such a market, because there is very active trading, commission costs on a per-trade basis tend to become lower - so they change. We would like it if Choice D said that commission costs would tend to fall, rather than they are "subject to change" - but it is the best answer given. And yes, this point must be known for the exam!