Series 66: Economic Factors and Business Information (5% of Exam)

If your client's entire investment portfolio consists of his company's employee stock ownership plan and stock in the company acquired under the executive stock option program, the client's portfolio is most exposed to A) business risk B) interest rate risk C) market risk D) inflation risk

A) business risk Because the client's investment (and indeed his employment) is entirely invested in his employer's stock, his portfolio is disproportionately exposed to business risk. Should the company experience a business or industry setback, the portfolio could suffer substantial losses. There are a large number of historical examples where this has happened (frequently wiping out retirement savings).

Angela, a wealthy client of yours, has constructed her portfolio with individual common stocks that closely match the weighting of the S&P 500 index. In so doing, Angela has significantly reduced her A) default risk B) business risk C) systematic risk D) market risk

B) business risk By matching the composition of the S&P 500 index, the client has broadly diversified her portfolio. One of the primary benefits of diversification is the reduction of business risk, an unsystematic risk. Market risk, one of the systematic risks, is not reduced through diversification. Default (or credit) risk, would apply when the portfolio contains debt securities.

One way in which internal rate of return (IRR) differs from most return computations is that A) it takes into consideration the rate of inflation B) it takes into consideration the time value of money C) its application to debt securities is limited D) it is always an annualized rate of return

B) it takes into consideration the time value of money The internal rate of return compounds returns and takes into consideration the time value of money. Real rate of return considers the inflation rate.

One of your clients has $150,000 in his 401(k) plan at work. He is assuming the portfolio will increase in value at a rate of 7% compounded annually for the next 5 years. If that is the case, the portfolio value at the end of that 5-year period will be closest to A) $202,500. B) $240,867. C) $210,383. D) $160,500.

C) $210,383 This is a straightforward future value computation. The proper way to do this is to enter the beginning value ($150,000) into your calculator, and then multiply times 107% five consecutive times. We'll get you started: 150,000 x 107% = $160,500 x 107% = $171,735 x 107% = $183,756 (and do this 2 more times to get $210,383). If that is too challenging, then use the "shortcut" - it always works. Figure the answer using simple interest. The starting value is $150,000. Seven percent growth is $10,500. Do that for 5 years and it is $52,500. Add that to the initial value and you have $202,500. Then, select the next highest number because that takes into consideration the compounding effect.

Twelve years ago, an investor placed $2,500 into an account. The account is now worth $10,000. Using the Rule of 72, you can determine that the approximate annual return was A) 400% B) 6% C) 36% D) 12%

D) 12% Under the Rule of 72, we can determine an earnings rate by dividing 72 by the number of years it takes for money to double. In this case, the money had quadrupled. That means it has doubled twice in 12 years or, every 6 years. Dividing 72 by 6 years results in an annual return of 12%.

XYZ Corporation has a beta of 1.0, and ABC has a beta of 1.4. XYZ has returned 12% and ABC 14.8%. Based on this information, ABC had alpha of A) 2.8% B) 14.8% C) 2% D) −2%

D) −2% Alpha is the extent to which a security's performance exceeds (or falls short of) that of the market compared to what would be expected based on its beta. A key to this question is that XYZ's beta of 1.0 equals the beta of the market. A stock with a beta of 1.4 would be expected to perform 40% better in an up market than the market itself. Because XYZ with a beta of 1.0 gained 12%, ABC should return 140% of that or 16.8% (12% × 1.4). With an actual return of 14.8%, ABC underperformed the expected by 2% and that is why it has a negative alpha.

Which of the following rates of return is used by investment professionals as the risk-free rate? A) 91-day Treasury bill rate B) Prime rate C) Discount rate D) Federal funds rate

A) 91-day Treasury bill rate The interest rate used as the basis for a risk-free rate of return is the 91-day Treasury bill rate. T-bills are U.S.-government guaranteed, the rate is short-term, and the market risk is minimal.

The statistical measurement that indicates how much an investment's returns have fluctuated compared with its average return over a period of time is known as A) standard deviation B) duration C) beta D) Sharpe ratio

A) standard deviation Standard deviation is the statistic that indicates how much an investment's returns have fluctuated compared with its average returns over a given period of time. An investment with a high standard deviation tends to have a higher level of risk than an investment with a low standard deviation.

A financial analyst computing the current ratio of a company whose stock trades on the Nasdaq Stock Market would use which of the following components? A) Accounts receivable B) Current liabilities C) Operating income D) Rent

B) Current liabilities There are two components to the current ratio formula: current assets and current liabilities. Although accounts receivable are a current asset, the component in the formula is current assets.

A securities analyst wishing to determine the cash flow for the Lucre Bread Manufacturing Company would find the necessary information on the company's A) capitalization statement. B) income statement. C) property tax return. D) balance sheet.

B) income statement. The primary source for the information necessary to construct a cash flow statement is the company's income statement. In a similar fashion, if an investment adviser wants to determine a client's cash flow, you would help the client prepare an income statement and work from that. Although the balance sheet shows cash on hand, that is only at that moment in time and doesn't indicate the "flow" in and out.

Which of the following are examples of systematic risk? I. Business risk II. Market risk III. Interest rate risk IV. Credit (default) risk A) II, III, and IV B) I and III C) II and III D) I, II, III, and IV

C) II and III Systematic risk affects entire groups of investments. Market risk and interest rate risk affect stock and bond markets overall, respectively, and are therefore systematic.

A retired woman whose sole income comes from a portfolio of investments with a fixed rate of return is most affected by A) volatile interest rates B) bearish market conditions C) high inflation D) high income taxes

C) high inflation Portfolios of fixed-income securities are most affected by inflation or rising prices. Rising prices or inflation is known as purchasing power risk. Because the portfolio has a fixed rate of return, interest rate changes will not affect the income received, but that income will have lost some of its purchasing power as a result of rising prices. Tax rates and market conditions would be of lesser importance to this investor.

The uncertainty resulting from the possibility that the value of an investment will be affected by a change in the law is known as A) credit risk B) legislative risk C) business risk D) market risk

B) legislative risk Legislative risk measures the possibility that a change in the law will affect the value of an investment. Market risk involves the possibility that an investment will be affected by changes in the market for that investment. Business risk, or credit risk, is the uncertainty about the prospects of the company that issued a security.

If your customer is pursuing an aggressive stock buying strategy, which of the following is most suitable for him? A) Convertible bonds of a mid-cap company B) ABC stock with a beta coefficient of 1.0 C) GHI stock with a beta coefficient of 1.20 D) DEF stock with a beta coefficient of 0.93

C) GHI stock with a beta coefficient of 1.20 Beta coefficients greater than 1.0 signify that the stock will fluctuate more than the market as a whole. In general, the higher the beta, the greater the risk. Such risk-taking is appropriate for investors who seek aggressive stock-buying strategies and have both the financial ability and the temperament to withstand downturns in the market.

Whippet Bus Lines, Inc., serving most of the country, has just been informed by the Surface Transportation Board of the United States that all of its buses must be retrofitted with expensive safety equipment. The effect of this will be a significant drop in Whippet's net income. To an investor in Whippet Bus Lines, Inc., this would be an example of A) business risk. B) country risk. C) regulatory risk. D) market risk.

C) regulatory risk. When an action by a regulatory agency, such as the STB, leads to increased costs and lower income, that is regulatory risk.

XYZ Corporation has a beta of 1, and ABC has a beta of 1.4. XYZ has returned 12% and ABC 18.8%. Based on this information ABC had alpha of A) 18.8% B) 4.8% C) 6.8% D) 2%

D) 2% Alpha is the extent to which a security's performance exceeds (or falls short of) what would be expected based on its beta. A stock with a beta of 1.4 would be expected to perform 40% better in an up market than one with a beta of 1.0. Because XYZ with a beta of 1.0 gained 12%, ABC should return 140% of that or 16.8% (12% × 1.4). With an actual return of 18.8%, ABC beat the expected by 2% and that is its alpha. More accurately, this question should also include the risk-free rate, but if, as in this case, it doesn't, the computation is easier. If the RF rate was shown, then that would have to be subtracted from "both sides." If the RF was 2%, then the computation would be (12% − 2%) × 1.4 = 14%. Then, we subtract the 2% RF rate from the 18.8 to get 16.8%. The difference between 16.8% and 14% would be alpha of 2.8%.

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

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

The STU Corporation has issued common stock, preferred stock, promissory notes, and mortgage bonds. Should STU enter bankruptcy proceedings, the order of payment against claims would be A) the mortgage bonds, the promissory notes, the preferred stock, and the common stock. B) the mortgage bonds, the preferred stock the common stock, and the promissory notes. C) the preferred stock, the common stock, the mortgage bonds, and the promissory notes. D) the promissory notes, the mortgage bonds, the preferred stock, and the common stock.

A) the mortgage bonds, the promissory notes, the preferred stock, and the common stock. In a bankruptcy, secured creditors, such as those with a mortgage against real property, have the first priority. They are followed by unsecured creditors, such as holders of promissory notes, with stockholders coming last. Preferred stock is "preferred" over common in both liquidation priority and payment of dividends.

If an investor wanted to verify a company's working capital, she would do so by reviewing their A) income statement B) footnotes C) balance sheet D) cash flow statement

C) balance sheet Working capital, current assets minus current liabilities, is determined from numbers found on the balance sheet.

One of the risks found in equity investing is known as unsystematic risk. The most common way to reduce this risk is? A) Diversification B) Specialization C) Increasing the positive correlation D) Reducing the beta coefficient

A) Diversification Unlike systematic (market) risk, unsystematic or nonsystematic risk can be reduced through diversification.

A portfolio that has a negative correlation coefficient relative to the market will I. decrease in value as the market declines II. increase in value as the market declines III. decrease in value as the market goes up IV. increase in value as the market goes up A) II and III B) II and IV C) I and III D) I and IV

A) II and III A negative correlation coefficient indicates that the portfolio's value will move in the opposite direction of the market. A positive correlation indicates the portfolio's value will change with the market.

Your client has $10,000 to invest and expects to earn an after-tax return of 8% to send his daughter to college in 12 years. Which of the following items will help determine whether the investment is likely to satisfy the client's goal? A) Present value B) Expected cost of college C) Consumer Price Index D) Client's marginal federal income tax bracket

B) Expected cost of college

One of your firm's portfolio managers is discussing risk that can be reduced during the portfolio construction process. Which of the following options might she be referring to? A) Market risk B) Unsystematic risk C) Credit risk D) Systematic risk

B) Unsystematic risk Unsystematic risk (diversifiable risk) is the risk that is eliminated when the investor builds a well-diversified portfolio. Credit risk is a form of unsystematic risk.

Which of the following statements regarding investment risk is not correct? A) The beta coefficient measures an individual stock's relative volatility to the market. B) A stock's level of risk is a combination of market risk and diversifiable risk. C) Systematic risk may be reduced or eliminated by effective portfolio diversification. D) Investors expect to earn a higher rate of return for assuming a higher level of risk.

C) Systematic risk may be reduced or eliminated by effective portfolio diversification. Unsystematic (diversifiable) risk may be effectively managed through portfolio diversification. It is systematic risk where diversification has little effectiveness.

A company's current ratio is 0.5:1. This could be an indication A) the company is highly leveraged. B) the company's current assets are twice its current liabilities. C) the company's working capital is sufficient to meet daily needs. D) the company may have trouble paying its bills.

D) the company may have trouble paying its bills. The formula for current ratio is the current assets divided by the current liabilities. A 0.5:1 ratio means that the company has current liabilities that are twice its current assets. This would also mean a negative working capital (current assets minus current liabilities) and would probably mean that the company is going to have a difficult time paying its bills.

If you were using the discounted cash flow method to determine the appropriate value of a security, you would want to purchase that security when A) the rating of the security has just been upgraded B) the current market price equals the PV C) the current market price is above the PV D) the current market price is below the PV

D) the current market price is below the PV Those who use the DCF to value a security would recommend purchasing when the current market price is below the PV—that is, when the NPV is positive.

Use the following chart to answer this question Equity. 100% - 35% - 20% - 0% Fixed income. 0% - 65% - 80% - 100% High return. 45.4% - 34.2% - 31.3% - 28.7% Low return. -7.4% - 5.5% - 8.2% - 6.5% Avg. return. 18.8% - 19.2% - 16.5% - 14.2% Std. dev. 12.25 - 10.95 - 10.02 - 10.46 Which of these portfolio allocations would you expect to show the least volatility over the next year? A) 20%/80% B) 0%/100% C) 35%/65% D) 100%/0%

A) 20%/80% This imposing-looking question should take 10 seconds to do. When the question is dealing with volatility, look for the standard deviation. The portfolio with the lowest (the 20/80 at 10.02) is the least volatile, the one with the highest (100/0 at 12.25) is the most volatile.

Beverly has two stocks with a correlation coefficient of zero. Which of the following is correct? A) These stocks will move independently of each other. B) These stocks are well diversified because they will move in unison. C) These stocks are well diversified because as one stock appreciates in value, the other decreases in value. D) These stocks are not well diversified because they move in unison.

A) These stocks will move independently of each other. A correlation coefficient of zero means that the two stocks will move independently. They may move in the same direction, or they may not. The zero correlation coefficient indicates that there is no pattern to the relationship between their price movements.

If an analyst wished to determine the degree to which leverage was being employed by a subject company, she would most likely examine that issuer's A) debt-to-equity ratio B) price-to-book ratio C) sales-to-debt ratio D) current ratio

A) debt-to-equity ratio The debt-to-equity ratio is computed by dividing the issuer's long-term debt by their total capitalization. The higher the ratio, the more leverage is being used by the company.

Which of the following is the risk that diminishes through portfolio diversification? A) Purchasing power risk B) Unsystematic risk C) Systematic risk D) Interest rate risk

B) Unsystematic risk Unsystematic risk (diversifiable risk) is the risk that can be reduced or even eliminated when the investor builds a well-diversified portfolio. Interest rate risk and purchasing power risk are examples of systematic (nondiversifiable risk).

One of your clients owns shares of the NERP Corporation's senior preferred stock. He is concerned about NERP's financial solvency and wonders where he would fall in the event of NERP declaring bankruptcy. The proper response is, the client's claim is A) after the secured creditors, but ahead of the unsecured creditors because of the senior claim. B) after the creditors, but ahead of the common stockholders. C) after the creditors and the common stockholders. D) ahead of all claims because his stock has a senior claim.

B) after the creditors, but ahead of the common stockholders. In a corporate bankruptcy, the first claim is that of secured creditors. They are followed by the unsecured creditors. After all creditors have been satisfied, any remaining funds are used to pay off the preferred stock up to its par value, and finally, if there is anything left, it goes to the common stockholders. When a preferred stock is named as a senior preferred, it generally means that there is more than one class of preferred stock outstanding and this one has priority over the others.

All of the following statements concerning the types of risk are correct except A) default risk is the potential inability of a debt issuer to make timely interest and principal repayments. B) financial risk is the risk that a firm's financial structure will negatively affect the value of an equity investment. C) reinvestment rate risk is the risk that proceeds available for reinvestment must be reinvested at a higher rate than that of the investment vehicle that generated the proceeds. D) business risk is the uncertainty regarding operating income.

C) reinvestment rate risk is the risk that proceeds available for reinvestment must be reinvested at a higher rate than that of the investment vehicle that generated the proceeds. Reinvestment rate risk is the risk that proceeds available for reinvestment might be reinvested at a lower rate than that of the investment vehicle that generated the proceeds. The computation of a bond's yield to maturity assumes that the coupon interest will be reinvested at the coupon rate. Reinvestment risk is the uncertainty of that happening.

The present value of a dollar A) is equal to its future value if the level of interest rates stays the same B) indicates how much must be invested today at a given interest rate, to equal a specific cash value in the future C) cannot be calculated without knowing the level of inflation D) is the amount of goods and services it will buy in the future at today's rate price level

B) indicates how much must be invested today at a given interest rate, to equal a specific cash value in the future The present value of a dollar will indicate how much must be invested today at a given interest rate, to equal a cash amount required in the future.

Which of the following statements about systematic and unsystematic risk is most accurate? A) Systematic risk can be eliminated through diversification. B) As an investor increases the number of stocks in a portfolio, the unsystematic risk will remain constant. C) Total risk equals market risk plus company-specific risk. D) The unsystematic risk for a specific firm is similar to the unsystematic risk for other firms in the same industry.

C) Total risk equals market risk plus company-specific risk. Total risk equals systematic (market) plus unsystematic (company-specific) risk. The unsystematic risk for a specific company is not similar to the unsystematic risk for other firms in the same industry. Unsystematic risk is firm-specific or unique risk, such as business risk, financial risk, or credit risk. Generally, systematic risk cannot be eliminated and remains relatively constant regardless of the number of securities within a portfolio; however, unsystematic risk can be reduced by adding securities to a portfolio.

Cecil has a discretionarily-managed account with Pelf Reliable Advisors (PRA), an investment adviser registered in States C, D, and G. Over the past year, the portfolio produced a 12% return with a beta of 1.05. The risk-free rate is 3.5%, and the overall market returned 10.85%. Based on this information, calculate alpha and determine if PRA added any value to the portfolio. A) Alpha = -1.21%; the adviser underperformed the market by 1.21% B) Alpha = 0.78%; the adviser underperformed the market by 2.72% C) Alpha = 1.15%; the adviser outperformed the market by 1.15% D) Alpha = 0.78%; the adviser outperformed the market by 0.78%

D) Alpha = 0.78%; the adviser outperformed the market by 0.78% The alpha for this portfolio is +0.78% (rounded). A positive alpha indicates that Pelf outperformed the market on a risk-adjusted basis. As with most calculations, there are two ways to solve for the answer. Let's use the LEM's formula first. When the riskfree (RF) rate is given, the formula is (actual return - RF rate) - (beta x [market return - RF rate]). Plussing in the numbers, we have (12% minus 3.5%) minus (1.05 times [10.85% minus 3.5%]). That breaks down to 8.5% minus (1.05 times 7.35%) or 8.5% minus 7.72% = +0.78%. An alternative method is as follows: 12% - [3.5% + 1.05 (10.85% - 3.5%)] = 12% - [3.5% + 7.7175] = 12% - 11.2175 = +0.7825.