Unit 21 - Portfolio Management Styles, Strategies, and Techniques

One of your retired clients aims to maintain a 70%/30% relationship between bonds and equities in her portfolio. At the beginning of the year, the mix was $1.4 million in bonds and $600,000 in equity. At the end of the year, her bonds were worth $1.54 million. Rebalancing the portfolio would not be required if the equities were worth A) $462,000 B) $660,000 C) $666,000 D) $513,333

B) $660,000 If the bonds are now worth $1.54 million and the desired percentage is 70%, dividing that value by 70% results in a portfolio value of $2.2 million. That would mean that the 30% in equity would have to be the other $660,000. At the test center, you would plug in $1.54 million; divide by 70% to get the total of $2.2 million. When you subtract the bonds of $1.54 million the remainder is the equity of $660,000. LO 21.c

If the current risk-free rate is 5%, and the expected return from the market is 10%, what return should we expect from a security that has a beta of 1.5? A) 15% B) 12.5% C) 10% D) 11.5%

B) 12.5% The expected return = 5% + (10% - 5%) × 1.5 = 5% + (5% x 1.5) = 5% + 7.5% = 12.5%. LO 21.h

A portfolio manager with a growth style would probably diversify by A) placing a portion of the portfolio into high-yield bonds B) devoting a portion of the portfolio to securities with a negative correlation C) concentrating in stocks in one or two industries D) attempting to build a portfolio with a very high correlation

B) devoting a portion of the portfolio to securities with a negative correlation Securities with a negative correlation add diversification to a growth portfolio because they move in the opposite direction of the balance of the holdings. Therefore, losses are offset by gains. LO 21.e

Proponents of which of the following technical theories assume that small investors are usually wrong? A) Breadth of market B) Short interest C) Advance/decline D) Odd lot

D) Odd lot Odd lots are usually traded by small investors; some analysts believe small investors are generally wrong. LO 21.d

A firm declares a $3.00 cash dividend to its shareholders. The firm has issued dividends of only $.07 per share for each of the last 15 quarters, and market analysts had anticipated a similar dividend this quarter. In an efficient market, one would expect A) a price increase before the announcement. B) no price change before or after the announcement. C) a price decrease after the announcement. D) a price change upon the announcement.

D) a price change upon the announcement. In an efficient market, the price of the stock will represent all information that is public. Because the increase in the dividend was not public knowledge until it was declared, no price change would take place before the announcement. A price change, representing the increase in dividends, would be expected immediately after the information became public. LO 21.i

As a technique in portfolio management, portfolio diversification reduces A) market risk. B) interest rate risk. C) systematic risk. D) unsystematic risk.

D) unsystematic risk. Unsystematic risk, such as business risk, can be almost eliminated with a well-diversified portfolio. Systematic risks, such as interest rate risk and market risk, are not helped by diversification. For example, no matter how many bonds you hold in your portfolio, if interest rates go up, they'll all drop in price. On the other hand, holding many bonds limits the overall loss should one or two issuers default. LO 21.b

An investor does not wish to attempt to time the market, so she invests $300 each month into the GEMCO Growth Fund. Over the past five months, her purchase prices have been $10, $12, $15, $20, and $25. On the basis of this information, if she were to stop investing at this point and sell her shares two months from now when the net asset value (NAV) is $15 per share and the public offering price is $15.79, it would be correct to state that her A) average cost per share was $16.40. B) cost basis for tax purposes was $14.71. C) realized loss was $1.40 per share. D) proceeds were $15.79 per share.

B) cost basis for tax purposes was $14.71. This client is taking advantage of dollar cost averaging. Each month, the $300 investment acquires a different number of shares. Take a look at the math below: Month 1: $300 @ $10 per share = 30 shares Month 2: $300 @ $12 per share = 25 shares Month 3: $300 @ $15 per share = 20 shares Month 4: $300 @ $20 per share = 15 shares Month 5: $300 @ $25 per share = 12 shares Total cost is $1,500. Total number of shares is 102. She spent $1,500 and bought a total of 102 shares. Dividing her cost ($1,500) by the number of shares (102) results in a cost per share of $14.71, and that is her cost basis for tax purposes. When redeeming, she would receive the NAV of $15 per share, not the public offering price. There is no loss here because the proceeds of $15 per share exceed the cost of $14.71. LO 21.j

A strategy used by bond investors to mitigate interest rate risk that involves buying bonds with short-term, intermediate-term, and long-term maturities is called A) bulleting B) laddering C) barbelling D) diversifying

B) laddering One builds a laddered portfolio by investing in bonds with maturities ranging from near- to long-term. In this fashion, there will always be some of the portfolio approaching maturity, thus reducing the interest rate risk on that portion. LO 21.f

Some risk is involved in almost all investments. In general, the greater the risk, A) the more expensive the investment B) the greater the potential return C) the longer the period until a return will be realized D) the smaller the potential return

B) the greater the potential return Risk and potential return tend to go together. Low-risk investments usually produce low returns. High-risk investments offer the hope of high returns. LO 21.g

If the risk-free rate of return is 3.5%, the expected market return is 9.5%, and the beta of a stock is 1.3, what is the required return on the stock according to the capital asset pricing model? A) 11.30% B) 7.80% C) 12.35% D) 8.85%

A) 11.30% The formula for the required return is: E(R) = Rf + (E (RM) - Rf) × Beta or 0.035 + (1.3 × [0.095 - 0.035]) = 0.035 + 0.078 = 0.113, or 11.3%. LO 21.h

Which of the following bond strategies is the least active? A) Bullet B) Barbell C) Ladder D) Yield curve

A) Bullet The least active strategy is the one requiring the lowest level of activity on the part of the investor. The bullet strategy involves investing in bonds at various intervals with all of the bonds maturing at or about the same time (such as when a child is entering college). As such, the only activity is buying bonds every couple of years. Barbell and ladder strategies have bonds maturing at regular intervals, requiring an active role in reinvesting the principal. All three of these require the investor to purchase bonds at different times, but the bullet strategy is the only one not concerned with the mechanics of collecting the matured principal and reinvesting it. Yield curve is not a specific strategy. LO 21.f

A corporation sponsors a defined benefit pension plan. The assets of the plan are invested in a diversified portfolio of large-cap stocks. Which of the following options positions would be most appropriate if the corporation wished to protect their ability to meet their obligations to employees? A) Buy S&P 500 index puts B) Buy S&P 500 index calls C) Sell S&P 500 index puts D) Sell S&P 500 index calls

A) Buy S&P 500 index puts In a defined benefit plan, the corporation is assuming the investment risk. Regardless of the security, the best way to protect a long position is to buy a put, either on that security or on an index with a close correlation. In this case, with a portfolio of large-cap stocks, the S&P 500 index would seem to be the appropriate option to use. LO 21.k

Which of the following describes an investment management style? A) Large capitalization B) Current income C) Rebalancing D) Margin

A) Large capitalization A large capitalization style distinguishes between investing in a small-cap company versus a large capitalization company. Current income is an investment objective and not an investment management style. Rebalancing is used to bring asset allocations back to their desired weightings. Margin can be used in a number of investment management styles. LO 21.e

An adviser who does not believe he can time the market, or pick those securities that will outperform their benchmarks, would have which of the following as the most important portfolio consideration? A) Minimizing investment expense and proper asset allocation B) Selecting stocks that are expected to outperform their benchmarks C) Maximizing current income to provide a solid base for total return D) Looking for asset classes that will outperform their benchmarks

A) Minimizing investment expense and proper asset allocation This adviser is following a passive management style. As such, the goal is to match the specified benchmarks as closely as possible. In order to do that, expenses must be kept to a minimum (the benchmark has no expense) and the index that is chosen must have a very high correlation to the benchmark. LO 21.c

The dividend discount model is A) an analytical tool used to value a common stock using the present value of future dividends. B) based on the dividend payout ratio. C) primarily used by technical analysts. D) the inverse of the price-to-earnings ratio.

A) an analytical tool used to value a common stock using the present value of future dividends. There are two widely accepted forms of common stock price valuation using dividends: the dividend discount model and the dividend growth model. Neither would be used by technicians because they rely on fundamentals. LO 21.d

An investment adviser representative is discussing various investment strategies with a prospective client. When discussing the "buy and hold" strategy, it would be correct to state that a characteristic of this strategy is it A) has low expenses. B) is favored by market timers. C) better aligns with the risk tolerance of the investor. D) outperforms most equity indexes.

A) has low expenses. Because there is a minimum of trading activity in a buy and hold account, expenses, such as commissions and taxes, tend to be minimized. Performance cannot be predicted and this strategy may or may not outperform an index. Likewise, without knowing more about the client, we don't know if this matches the client's risk tolerance. For example, buy and hold is inappropriate for the aggressive investor. Market timers are in and out of the market constantly - the opposite of buy and hold. LO 21.e

Investment company portfolio managers are apt to classify common stocks into groups. One measurement is the product of multiplying the market price per share times the number of shares outstanding. The result is known as A) market capitalization B) debt-to-equity ratio C) market value D) total value

A) market capitalization A stock's market capitalization is determined by multiplying the price per share times the number of outstanding common shares. For example, if a company had 1 billion shares outstanding and the market price was $20 per share, the company would be said to have a market cap of $20 billion. This would put it into the category of "large-cap" stocks. LO 21.e

The bond strategy used most often by those with a target goal is A) the bullet strategy. B) the barbell strategy. C) the laddering strategy. D) the duration strategy.

A) the bullet strategy. When you think of a bullet, you think of it hitting a target. That is what the bullet strategy is all about. When an investor will be making periodic investments in bonds and there is a specific future goal, such as retirement, the bullet strategy seems most appropriate. Some investors might consider a barbell with the target date being in the middle of the short-term and the long-term group, but at least for exam purposes, select the bullet strategy when you are aiming for a target goal. LO 21.f

According to the efficient market hypothesis, information found when reading The Wall Street Journal would be considered A) weak form market efficiency. B) random walk. C) strong form market efficiency. D) semistrong form market efficiency.

A) weak form market efficiency. The closer to inside information, the stronger the information is. Anything published in widely read media would be considered very weak. LO 21.i

A portfolio that maximizes an investor's preferences with respect to return and risk is called A) a diversified portfolio B) an optimal portfolio C) the efficient frontier D) an uncorrelated portfolio

B) an optimal portfolio An optimal portfolio will generally lie on the efficient frontier (which is a graph, not a portfolio). The special nature of an optimal portfolio is that it may not always be the most efficient portfolio (offering the greatest return for the least risk) because it takes into consideration the specific preferences of the individual investor, which might create a bias. LO 21.g

Although there is no universal agreement on numbers, the minimum threshold for a stock to be considered large-cap is A) $25 billion B) $100 billion C) $10 billion D) $10 million

C) $10 billion At least for testing purposes, consider any company with a market cap of at least $10 billion to be large-cap. In recent years, the term mega-cap has come into use for those companies with a market cap of $200 billion or more. LO 21.e

What is the risk measure associated with the capital market line (CML)? A) Systematic risk B) Alpha C) Beta D) Standard deviation

D) Standard deviation In the context of the CML, the measure of risk is total risk, or standard deviation. Beta (systematic risk) is used to measure risk for the security market line (SML). LO 21.g

Under which of the following asset allocation programs is it most likely that commission expense will have a significant impact on portfolio performance? A) Rebalancing B) Strategic C) Buy and hold D) Tactical

D) Tactical Tactical asset allocation, also known as active asset allocation, attempts to time the market. As such, there is a relatively high amount of in and out trading, causing commission expense to be a significant factor. LO 21.c

A securities analyst does not believe that markets are highly efficient. This analyst most likely follows which of the following investing strategies? A) Passive B) Indexing C) Strategic D) Tactical

D) Tactical Those who believe that stock markets are not efficient believe that they can beat the market. That is the style followed by active or tactical managers. Those who believe in efficient markets would be passive or strategic investors, such as those who buy index funds. LO 21.i

Two contrasting styles of portfolio management are growth and value. Which of the following pairs best describes the contrast? A) Earnings momentum/book value B) Dividend yield/dividend payout ratio C) Capital structure/earnings per share D) High P/E ratio/low current ratio

A) Earnings momentum/book value One of the important metrics to growth managers is the rate at which the company is growing. Earnings momentum is an excellent indicator of that. On the other hand, the primary tool of the value manager is the company's financial statements. Value managers frequently look for companies whose market price is less than their book value. Perhaps you misread "low current ratio" as "low P/E ratio" (which would have been a correct contrast). This is why you have to read each word carefully. LO 21.e

Customer A and Customer B each have an open account in a mutual fund that charges a front-end load. Customer A has decided to receive all distributions in cash, while Customer B automatically reinvests all distributions. How do their decisions affect their investments? I Receiving cash distributions may reduce Customer A's proportional interest in the fund. II Customer A may use the cash distributions to purchase shares later at NAV. III Customer B's reinvestments purchase additional shares at NAV rather than at the offering price. IV Due to compounding, Customer B's principal will be at greater risk. A) I and III B) I and IV C) II and IV D) II and III

A) I and III If the customer elects to receive distributions in cash while other investors purchase shares through reinvestment, his proportional interest in the fund will decline. Automatic reinvestment is always at net asset value (NAV). LO 21.j

Which of the following statements about technical analysis are true? I Technical analysis tries to identify trends and predict market changes. II Technical analysis is often accomplished by reviewing data in the form of charts. III Technical analysis looks primarily at past performance to predict future trends. A) I, II, and III B) I and II C) II and III D) I and III

A) I, II, and III Technical analysts attempt to identify trends so they can predict market changes. They do this by reviewing past performance as depicted in charts and graphs. The type of analysis that attempts to value stock by examining a company's financial condition and growth potential is fundamental analysis. LO 21.d

A computerized mathematical technique that is often used by investment advisers to project future financial outcomes, such as the probability of a client's funds lasting through retirement, is called A) Monte Carlo simulation (MCS). B) asset allocation modeling (AAM). C) efficient market hypothesis (EMH). D) capital asset pricing model (CAPM).

A) Monte Carlo simulation (MCS). A popular form of mathematical modeling that uses computer-generated distributions is the Monte Carlo simulation (MCS). For those approaching (or in) retirement, it can be very useful to answer questions such as: "Do savings need to be increased?", "Can I retire earlier?", "Must I retire later?", "Do I need to reduce my withdrawal rate?", "Can I increase my withdrawal rate?". LO 21.e

An investor believes that he can study the history of security trades and security markets in order to identify buying opportunities. Furthermore, he prepares and studies charts on the past prices of the securities he is most interested in purchasing for his portfolio. He uses these charts to try to predict the future activity of a particular stock. What type of strategy is this investor using to make his investment decisions? A) Technical analysis B) Tactical asset allocation C) Ratio analysis D) Fundamental analysis

A) Technical analysis Technical analysis is an attempt by an analyst to predict the direction of a security's future market price. Such terms as moving average, trendline, and support and resistance level are then used by an analyst to determine when the time is right to purchase (or sell) the security. LO 21.d

A popular funding technique that involves investing the same amount at regular intervals is known as dollar cost averaging. Participating in this funding approach tends to lessen which risk? A) Timing B) Credit C) Inflation D) Market

A) Timing Timing risk, sometimes called market timing risk, is the uncertainty that an investor will be buying at the market top or selling at the market bottom. In other words, at the wrong time. When one dollar cost averages, that risk is lessened because you automatically acquire more shares when the market is down and less when it is high. Is it foolproof? No, but it does take some of the timing risk away. LO 21.j

An investment adviser who believes that we are in the early recovery portion of the business cycle would most likely recommend A) cyclical stocks. B) value stocks. C) long-term bonds. D) defensive stocks.

A) cyclical stocks. Cyclical stocks have a high correlation to the swings in the economy as reflected in the business cycle. The ideal time to purchase stocks that are affected by economic cycles is right as the recovery begins from a trough (or recession). Defensive stocks are good to hold when the economy is in the early contraction period of the cycle. During a recovery, interest rates usually rise and that is not good for holders of long-term bonds because as interest rates go up, bond prices fall. Value stocks might also perform well, but many studies have shown that they offer better relative performance in periods of contraction rather than expansion. LO 21.c

The chief analyst at your firm suggests that some of the IARs add emerging market equity securities to some client's portfolios. Among the benefits of doing so would be A) diversification. B) steady income. C) positive correlation. D) tax efficiency.

A) diversification. Adding foreign equity to a portfolio is adding another equity class. This generally has the effect of adding diversification because emerging market securities are not positively correlated with domestic securities. Dividend payments from emerging economy stocks tend to be less stable than those paid by domestic corporations. LO 21.b

An optimal portfolio is one that A) lies on the efficient frontier. B) works well in bull markets but suffers when there is a market reversal. C) offers the greatest reward for the highest risk. D) is diversified in such a manner as to nearly eliminate systematic risk.

A) lies on the efficient frontier. In portfolio design, the collection of efficient portfolios is called the efficient set or the efficient frontier. This efficient frontier is plotted as a curve. The objective is for the portfolio to lie on the curve. Then, by being on the efficient frontier, the optimal portfolio has been created—one in which there is the highest return for the least risk. Remember, systematic risks are considered nondiversifiable ones. It is the unsystematic risks that can be reduced through diversification. LO 21.g

The capital asset pricing model (CAPM) is an investment theory that serves as a model for A) pricing securities based on their systematic risk B) measuring the correlation between a security and the overall market C) pricing securities based on their unsystematic risk D) pricing securities based on their total risk

A) pricing securities based on their systematic risk Under the CAPM, securities are priced based on their systematic risk only, because this risk cannot be eliminated through diversification. The expected return of a security or portfolio is calculated by adding the rate on a risk-free security to a risk premium multiplied by the asset's systematic risk. LO 21.g

The process of making changes to an asset allocation model over time, in an effort to adapt for any allocation percentages that are no longer in tandem with the original portfolio allocation model, is called A) rebalancing B) allocation adjustment theory C) portfolio modification D) corrective adaptation

A) rebalancing Adjusting a portfolio to keep it in alignment with the original portfolio allocation percentages is called rebalancing. Rebalancing is necessary in the event that the performance of the different assets causes some classes to represent a larger percentage than originally intended, and others to represent a smaller percentage than intended. By rebalancing the portfolio, the client will be back at their original risk/reward level on the efficient frontier. It should be noted that some fluctuation from the original model might be advisable so that the client may capitalize to some degree on a higher-performing asset category. LO 21.c

Diversifying a portfolio could be expected to provide all of the following benefits except A) reducing transaction costs. B) reducing overall risk. C) dampening volatility. D) improving returns.

A) reducing transaction costs. If there is one negative about portfolio diversification it is that assembling a group of 15 to 20 securities (generally considered to be the minimum for beneficial diversification) will generate higher transaction costs than concentrating on a smaller group. LO 21.b

One popular method used to predict the expected return of a stock is the capital asset pricing model (CAPM). Analysts using CAPM rely on all of these except A) the standard deviation of the stock. B) the beta coefficient of the stock. C) the risk-free rate available in the market. D) the expected return on the market.

A) the standard deviation of the stock. Under the CAPM, by using the security market line, we can determine the expected return of any given stock by taking the risk-free rate and adding to that the product of that stock's beta coefficient and the difference between the expected return on the market and the risk-free rate. Standard deviation is not a factor in this computation. LO 21.h

If the expected return on the market is 20% and the risk-free rate is 4%, a stock with a beta coefficient of 0.8 would have an expected rate of return under CAPM of A) 16.0%. B) 16.8%. C) 19.2%. D) 12.8%.

B) 16.8%. The formula for the capital asset pricing model (CAPM) is the risk-free rate (0.04) plus the product of the stock's beta (0.8) and the difference between the expected return on the market and the risk-free rate (0.20 - 0.04). In this case, it would be 0.04 + (0.8)(0.16) or 0.04 + 0.128 = 0.168 = 16.8%. LO 21.h

The current market interest rate for a bond rated AA with 20 years to maturity is 5%. In an efficient market, a similar bond with a coupon of 4% could be expected to have an internal rate of return of A) 6%. B) 5%. C) 4%. D) 8%.

B) 5%. In an efficient market, bonds are priced so that their NPV is zero. That means the bond's yield to maturity is equal to the current market interest rates for similar bonds. When that rate is 5%, as is given in this question, all AA bonds with 20 years remaining to maturity should have a YTM of 5%. LO 21.i

Your client's child is entering college next year. Which of the following would be the most appropriate recommendation? A) A U.S. Treasury note mutual fund B) A five-year laddered portfolio of U.S. Treasury notes C) A large-cap growth fund D) A zero-coupon bond maturing in five years

B) A five-year laddered portfolio of U.S. Treasury notes Most would agree that with a regularly scheduled commitment for tuition and other expenses associated with a college education, there is a need for not only income but also (and perhaps more importantly) for the assurance that when the bills are due, the principal will not have fluctuated. That would be best accomplished through a laddered portfolio where each year there are T-notes maturing. The growth fund would be attractive if the time horizon was long (this one is very short). The zero-coupon bond will not provide any money until five years from now, and this client needs cash flow starting in one year. The mutual fund does not offer the guaranteed repayment of principal that the ladder does. LO 21.f

Your customer, age 29, is seeking a long-term growth investment, is concerned about the loss of purchasing power as a result of inflation, and often complains about high commissions that reduce his investment returns. When he was in college, he took a few economics courses and firmly believes that securities analysts cannot consistently outperform the overall market. Which of the following mutual funds is the most suitable for the customer? A) NC Growth & Income Fund B) ARG Stock Index Fund C) ATF Biotechnology Fund D) ZB Asset Allocation Fund

B) ARG Stock Index Fund The customer requires a mutual fund that offers potential for long-term capital growth. Because the client believes that money managers cannot outperform the market, an index fund, which simply mimics the market, is the appropriate investment. The client's complaint about high commission charges is a further argument for index funds, which have low expense ratios. LO 21.c

Which of the following bond diversification strategies involves purchasing only short-term and long-term bonds? A) Laddering strategy B) Barbell strategy C) Bullet strategy D) Immunization

B) Barbell strategy A barbell strategy involves splitting the portfolio between bonds with short-term maturities and those on the longer end of intermediate maturities. With the "weight" on either end of the maturities, it resembles a barbell. Laddering involves staggered maturity across fixed-income investments. A bullet is several bonds of the same maturity. LO 21.f

Jasper Quartermaine is interested in using the options market to create "insurance" against a severe drop in the value of a stock portfolio that he owns. How could he best accomplish this goal and what is this type of strategy called? Type of option | Strategy A) Write call options | Covered call B) Buy put options | Protective put C) Buy call options | Protective call D) Write call options | Protective call

B) Buy put options | Protective put An investor who is long securities can obtain portfolio insurance by purchasing put options. Losses in the underlying portfolio are offset by gains in the put position. This is known as a protective put strategy. Buying calls would be "insurance" when having a short position and would be considered protective calls. Writing covered calls provides downside protection to the extent of the premium received, but if you want real insurance, you have to buy it. LO 21.k

Given below are the EPS for the previous four quarters for four different companies being analyzed by your research department. Which of these companies is exhibiting earnings momentum? A) ABC - Q1: $0.58; Q2: $0.61; Q3: $0.64; Q4: $0.67 B) GHI - Q1: $0.25; Q2: $0.27; Q3: $0.30; Q4: $0.36 C) DEF - Q1: $0.58; Q2: $0.52; Q3: $0.50; Q4: $0.49 D) JKL - Q1: $0.82; Q2: $0.90; Q3: $0.83; Q4: $0.92

B) GHI - Q1: $0.25; Q2: $0.27; Q3: $0.30; Q4: $0.36 Earnings momentum is a term used to describe accelerating growth in earnings per share (EPS). The first thing to note about GHI's earnings is that they are increasing. That is good, but, what is more important is that they are increasing at a faster rate. For instance, the rate of change between Q1 and Q2 was about 8%. The rate of change from Q2 and Q3 was higher—about 11%—and the rate of change from Q3 to Q4 was even higher—about 20%. This is earnings momentum. The company isn't just growing, it's growing faster. Although ABC's earnings are also growing, the rate of change is not increasing as each quarter's growth is the same amount. Company DEF's earnings are declining, and Company JKL's earnings are fluctuating up and down. LO 21.e

Which of the following factors would be considered by an investor who uses fundamental analysis to value a company's stock? I The company's financial condition, as revealed by its income statement and balance sheet II General economic conditions, such as employment levels and changes in interest rates III Charts showing past movements in stock prices and trading volumes A) I, II, and III B) I and II C) II and III D) I and III

B) I and II Fundamental analysis attempts to value stock by examining general economic conditions and the company's financial condition and growth prospects. Technical analysis, on the other hand, tries to identify trends and predict changes in the market. Charts showing past price movements and trading volumes would be used in technical analysis but not in fundamental analysis. LO 21.d

Which of the following statements about diversification are true? I Diversification involves investing a portfolio in 1, or very few, classes of investments. II Diversification is a way to reduce unsystematic risk in a portfolio. III Diversification is a defensive investment strategy. A) I and III B) II and III C) I, II, and III D) I and II

B) II and III Diversification is a defensive investment strategy of investing in several different classes of investments. It is designed to lower the unsystematic or business risk in a portfolio. The opposite of diversification, concentration, is an aggressive strategy of concentrating the portfolio in one, or very few, classes of investments. LO 21.b

A successful dollar cost averaging strategy requires I stable market conditions II volatile market conditions III a fixed dollar amount invested monthly IV a fixed number of shares purchased monthly A) I and III B) II and III C) I and IV D) II and IV

B) II and III Dollar cost averaging requires a fixed dollar investment on a periodic or monthly basis. This strategy is most effective when prices in the market are volatile. LO 21.j

Which of the following risks most likely would be reduced as a result of the addition of tangible assets to an investor's portfolio? A) Liquidity B) Inflation C) Nonsystematic D) Market

B) Inflation An asset allocation model that includes tangible assets, such as real estate and commodities, tends to provide inflation protection. These assets may have limited liquidity. LO 21.a

One of the asset allocation classes is fixed income securities. When an investment adviser representative is determining which securities should fill that portion of the client's portfolio, which of the following would not be included? A) Treasury bonds B) Preferred stock C) Municipal bonds D) Mortgage-backed securities

B) Preferred stock Although generally referred to as a fixed-income security due to its fixed dividend, for asset allocation purposes, preferred stock is included in the equity class. Historically, Treasury bonds have a negative correlation to preferred stock (about ‒0.20), while the S&P 500 has a correlation of about +0.60. LO 21.a

Which of the following are asset classes? A) Large-cap stock funds B) REITs C) Forward contracts D) Options

B) REITs The general consensus is that the major classes, for purposes of an asset allocation program, are equity, debt, cash (or cash equivalents), real estate, and commodities. Large-cap stock funds are not a separate asset class; they are a way to invest in the asset class known as equity. Derivatives, such as options, are not generally considered an asset class; it is the actual commodity (precious metals, oil, and so forth), not a forward or futures contract, that is the asset class. Most agree that real estate investment trusts (REITs) can serve as a proxy for real estate itself. LO 21.a

Given the following information: Stock | Beta A | 2.16 B | 1.54 C | 0.96 D | 1.28 Assume the risk-free rate of return is 2.75% and the market rate of return is 6.75%. An investor has a required rate of return of 9.5%. Which of these stocks would offer the best investment opportunity? A) Stock D B) Stock A C) Stock C D) Stock B

B) Stock A Calculate the expected rate of return of each stock using CAPM and compare the result to the investor's required rate of return. Stock A: E(r) = 2.75 + (6.75 - 2.75)2.16 = 11.39%. Stock B: E(r) = 2.75 + (6.75 - 2.75)1.54 = 8.91%. Stock C: E(r) = 2.75 + (6.75 - 2.75).96 = 6.59%. Stock D: E(r) = 2.75 + (6.75 - 2.75)1.28 = 7.87%. Based on a required rate of return of 9.5%, Stock A with an expected return of 11.39% is the best available investment opportunity. LO 21.h

Sector rotation would most likely be employed by an investment adviser using which of the following investment styles? A) Strategic B) Tactical C) Contrarian D) Buy and hold

B) Tactical Sector rotation is the practice of moving portfolio assets from those industries that have reached their peak in the current economic cycle to those that are now on the upswing. Buy and hold, as the name implies, does not involve constant trading, and strategic is a passive technique as well. Contrarian investors go opposite the trend, which is not the case here. LO 21.c

Lower maintenance costs would be least likely to be found when using which of the following management styles? A) Buy and hold. B) Tactical. C) Strategic. D) Rebalancing.

B) Tactical. Tactical asset allocation, also known as active asset allocation, attempts to time the market. As such, there is a relatively high amount of in and out trading causing commission expense to be a significant factor. LO 21.e

In the field of portfolio management, there are a number of different management styles. One of those styles involves committing additional capital to the market when others are reducing their exposure, or eliminating positions while others are increasing theirs. This style is generally referred to as: A) active. B) contrarian. C) growth. D) value.

B) contrarian. The contrarian style of portfolio management takes positions opposite those of the market as a whole. They are buying when others are selling and selling when others are buying. LO 21.e

As compared to value investors, growth investors tend to A) be very price-conscious when purchasing stocks B) look for companies whose sales, earnings, or market share are increasing at an above-average rate C) take more of a long-term approach to their investments D) look for companies that are undervalued or overlooked by other investors

B) look for companies whose sales, earnings, or market share are increasing at an above-average rate Growth investors look for stocks in companies that are growing very quickly. Because they focus on growth rates, they do not look so closely at price when they make their investments; they don't mind paying a high price for a stock they believe will continue to grow. Growth stocks tend to be somewhat volatile, so growth investors must actively manage their portfolios in response to fluctuating growth rates. Because growth stocks are volatile, growth investors take more of a short-term approach to investing than do value investors. LO 21.e

Growth companies tend to have all of the following characteristics except A) low dividend payout ratios B) low P/E ratios C) potential investment return from capital gains rather than income D) high earnings retention ratio

B) low P/E ratios Growth companies have high P/E ratios and a low dividend payout ratio because they retain most if not all their earnings. Investors anticipating fast growth bid up prices so P/E ratios tend to be high. Growth companies retain most of their earnings to fund future growth. Investors select growth companies for capital gain potential, not for investment income. LO 21.e

It is agreed by most investment advisers that diversifying an investment portfolio can reduce the overall risk. Benefits of diversification would include all of the following except A) increasing risk-adjusted returns. B) lowering trading costs. C) lowering the volatility of the portfolio. D) mitigating the effects of a bankruptcy of a security held in the portfolio.

B) lowering trading costs. If anything, diversifying a portfolio will increase the trading costs. Those higher costs are outweighed by the benefits in risk reduction and potential higher returns. With a well-diversified portfolio, a single company going bankrupt will have a much smaller impact than if that security was the only asset held by the investor. It is the old theory of "don't put all of your eggs in one basket". Broad diversification, which includes different asset classes, has the effect of reducing the overall volatility of the portfolio and by holding assets that tend to rise while others decline, the risk-adjusted returns may well be increased. LO 21.b

The management style that is most similar to buy and hold is: A) active management. B) strategic management. C) tactical management. D) contrarian.

B) strategic management. A strategic management style, sometimes referred to as passive, is less apt to have a high degree of portfolio turnover than active or tactical management. Contrarian style generally involves taking positions that are currently out of favor in the market place, but would incur somewhat frequent activity. LO 21.e

A technical analyst (chartist) with a long position in a particular stock would most likely enter a sell stop order below that stock's A) 200-day moving average B) support level C) resistance level D) previous high

B) support level Sell stops are entered below the market. They are used to turn an order into a market order if the current market value falls below the stop level. In technical analysis, support levels are theoretical levels where the market supports the stock price (keeps it from falling below the stated level). A technical analyst who makes investment decisions by watching the technical graphs and numbers would enter a sell stop below a support level in order to sell out if the support level is breached. A breakthrough of a support level is believed to forecast a major market price decline. LO 21.d

If an investor practices value investing, which of the following stock types is the investor least likely to purchase? A) A stock with negative earnings in the most recent quarter B) A stock that is presently selling for ⅔ of net tangible assets C) A stock with an above-average price-to-earnings ratio D) A stock that has exhibited a high dividend yield in the past

C) A stock with an above-average price-to-earnings ratio A growth investor looks for stocks with above-average price-to-earnings (P/E) ratios. Conversely, a value investor focuses on stocks with low P/E ratios, a low price-to-book value, and historically high dividend yields. It is not unusual for value investors to hunt for companies that have been beaten down because of a bad earnings report (a loss) for a quarter. LO 21.e

Given below are the EPS for the previous four quarters for four different companies being analyzed by your research department. Which of these companies is exhibiting earnings momentum? A) JKL - Q1: $0.82; Q2: $0.90; Q3: $0.83; Q4: $0.92 B) ABC - Q1: $0.58; Q2: $0.61; Q3: $0.64; Q4: $0.67 C) GHI - Q1: $0.25; Q2: $0.27; Q3: $0.30; Q4: $0.36 D) DEF - Q1: $0.58; Q2: $0.52; Q3: $0.50; Q4: $0.49

C) GHI - Q1: $0.25; Q2: $0.27; Q3: $0.30; Q4: $0.36 Earnings momentum is a term used to describe accelerating growth in earnings per share (EPS). The first thing to note about GHI's earnings is that they are increasing. That is good, but, what is more important is that they are increasing at a faster rate. For instance, the rate of change between Q1 and Q2 was about 8%. The rate of change from Q2 and Q3 was higher—about 11%—and the rate of change from Q3 to Q4 was even higher—about 20%. This is earnings momentum. The company isn't just growing, it's growing faster. Although ABC's earnings are also growing, the rate of change is not increasing as each quarter's growth is the same amount. Company DEF's earnings are declining, and Company JKL's earnings are fluctuating up and down. LO 21.e

Which of the following statements are generally true of the buy-and-hold strategy? I Equities would grow relative to fixed income II Lower taxes and transactional costs III Easy to manage IV The portfolio would more accurately demonstrate the client's investment objectives and risk tolerance A) II, III, and IV B) III and IV C) I, II, and III D) I and II

C) I, II, and III Over the long run, using the buy-and-hold strategy with equity securities has outperformed the rate of return on fixed income investments. With few transactions, there are almost no commissions and capital gains taxes. Of all strategies, this is the easiest to follow. There is no way to determine the client's objectives or risk tolerance based on the decision to buy and hold. The portfolio might contain small-cap stocks or large-cap stocks. It might contain 90% equities or 75% debt securities. Investors with differing goals and risk tolerance can use this strategy. LO 21.e

Discounted cash flow is commonly thought of as applying solely to fixed-income securities. However, forms of DCF used for the valuation of common stock also include I the price-to-earnings ratio II the dividend discount model III the discounted book value model IV the dividend growth model A) I and IV B) I and II C) II and IV D) II and III

C) II and IV The 2 most common forms of DCF used in the valuation of common stock are the dividend discount and dividend growth models. LO 21.d

Which of the following is true of the weak form of the efficient market hypothesis? A) It implies that insiders cannot make a profit from their trading. B) It implies that throwing darts is just as efficient as analyzing the market. C) It implies that market information cannot be used to identify future price movements. D) It implies that stock prices react to information when it becomes publicly available.

C) It implies that market information cannot be used to identify future price movements. The weak form of the EMH states that all market information has already been incorporated into the current stock price. Therefore, having that information is of no help in predicting movements in the market. It is the strong form that says that inside information won't work, and from there the ultimate conclusion is that in an efficient market, throwing darts works as well as anything else. LO 21.i

One of the offshoots of the capital asset pricing model (CAPM) is the capital market line (CML). The equation for the CML uses which of the following? A) Correlation coefficient B) Beta C) Standard deviation D) Alpha

C) Standard deviation The CML provides an expected return for a portfolio based on the expected return of the market, the risk-free rate of return, and the standard deviation of the portfolio in relation to the standard deviation of the market. The equation for the CML uses the -expected return of the portfolio, -risk-free rate, -return on the market, -standard deviation of the market, and -standard deviation of the portfolio. LO 21.g

If a portfolio manager wished to reduce inflation risk, which of the following would be most appropriate to add to the portfolio? A) Preferred stock B) Fixed annuities issued by an insurance company with Best's highest rating C) Tangible assets D) AAA bonds

C) Tangible assets Tangible assets, such as real estate, precious metals, and other commodities, tend to keep pace with inflation. Fixed dollar investments do not. LO 21.a

Which of the following would be of least interest to a chartist? A) The advance/decline line B) The volume of shares traded during the past month C) The relationship between the current market price of an issuer's common stock and most recently reported earnings per share D) The short interest

C) The relationship between the current market price of an issuer's common stock and most recently reported earnings per share A chartist is interested in the volume of shares traded, and the short interest for that particular stock. The advance/decline line is another technical indicator. The price-to-earnings ratio is used in fundamental as opposed to technical (charting) analysis. LO 21.d

One of your customers notices that the short interest on KAPCO common stock is high. When she asks you for an interpretation, you should tell her that this signals A) that a change in interest rates is coming B) a shortage of enough stock to go around C) a bullish outlook D) a bearish outlook

C) a bullish outlook Even though short interest represents the number of share sold short (typically by bearish investors), technical analysts believe that when it gets high, it is a bullish indicator. Each share that has been sold short must be replaced (covered) at some point. To replace the stock, an investor must go into the market to buy that stock. When all of those short sellers have to buy back the stock they shorted, it puts upward pressure on the price of that stock. LO 21.d

An investor who buys a stock and wishes to limit the potential downside risk should A) enter a sell limit order B) buy a call C) buy a put D) enter a buy stop order

C) buy a put This is the classic example of a protective put. It can be thought of as insurance that limits the downside risk to the difference between the stock price and the put's strike price. For example, if the investor bought stock at 93 and then purchased a 90 put, no matter how low the price of the stock fell (even to zero), the investor can exercise the put and sell the stock for 90. The loss is limited to that $3 per share difference (plus the premium paid for this insurance). This is the most common way to hedge a long stock position. LO 21.k

You have a client who wishes to manage his own portfolio of individual stocks. The simplest style for him to follow would be A) core B) indexing C) buy and hold D) tactical

C) buy and hold When it comes to individual stocks, nothing is simpler than buy and hold. If the client wished to have the simplest overall portfolio and didn't want to manage things, then indexing would be the answer. LO 21.e

In contrast to the strategic approach, tactical asset allocation A) offers significant commission savings by generally qualifying for a lower commission schedule than a strategic manager. B) is used to determine an appropriate allocation based on the long-term financial goals of the client. C) continuously adjusts the asset allocation and class mix in an attempt to take advantage of changing market conditions. D) consistently provides higher net returns whether the market is performing well or is in decline.

C) continuously adjusts the asset allocation and class mix in an attempt to take advantage of changing market conditions. This is what tactical or active management is all about: timing the market and changing the portfolio to try to beat it. Although the manager may qualify for a lower commission per trade, the volume of trading causes the overall commission expense to be much higher than with the strategic approach. There is no evidence that tactical managers consistently outperform strategic ones. LO 21.c

The semi-strong form of the efficient market hypothesis (EMH) asserts that stock prices A) fully reflect all relevant information, including insider information. B) don't reflect any information. C) fully reflect all publicly-available information. D) fully reflect all historical price information.

C) fully reflect all publicly-available information. The semi-strong form of the EMH states that security prices fully reflect all publicly-available information. This would include all historical information. The weak form relates to historical information only. The strong form relates to public and private (inside) information. One could conclude from this that both fundamental and technical analysis don't "work" in an efficient market. LO 21.i

An investor is long 100 shares of XUZ common stock. If the investor wishes to generate some additional income while also creating a partial hedge, the recommended strategy would be to A) go long an XUZ call. B) buy additional XUZ stock. C) go short an XUZ call. D) go short an XUZ put.

C) go short an XUZ call. The only way to generate income with options is to sell them (take a short position). Selling the call brings in a premium that creates a partial hedge to the extent of the premium received. A full hedge would be accomplished by purchasing an XUZ put, but that would not generate income and the question is looking for a partial hedge. LO 21.k

All of the following statements regarding asset allocation done by or on behalf of an investor are true except A) it is the process of dividing investable assets into different asset classes B) the process is concerned with the risk associated with different assets C) individual security selection is far more important than the asset allocation decision D) the process is concerned with the relationship among the returns of different assets

C) individual security selection is far more important than the asset allocation decision Studies have shown the asset allocation decision is the primary contributor to effective long-term portfolio management. Individual security selection is far less important in meeting investor objectives. LO 21.b

A customer who follows a strict dollar cost averaging program to acquire shares in a diversified common stock mutual fund should achieve A) reasonable assurance against loss of principal, presuming the customer dollar cost averages over an extended period B) allocation among various funds within a single investment company's family of funds C) lower average cost to acquire fund shares relative to the fund's average price over the buying period D) significant reduction of market risk due to enhanced diversification

C) lower average cost to acquire fund shares relative to the fund's average price over the buying period By investing a constant amount of dollars at regular intervals, the investor buys fewer shares when the fund's price rises and more shares when the share price drops, thereby lowering the average cost. There is no assurance against loss of principal. LO 21.j

Proponents of the efficient market hypothesis believe that A) active portfolio management will generally produce better results than passive management. B) time horizon is one of the most important investment constraints. C) markets operate efficiently and stock prices instantly reflect all available information. D) careful stock selection can produce positive alpha without increasing risk.

C) markets operate efficiently and stock prices instantly reflect all available information. Because, in an efficient market, all participants are privy to the same information, price fluctuations are unpredictable and respond immediately to genuinely new information. As a result, efficient markets do not allow investors to earn above average returns (positive alpha) without accepting additional risks. Therefore, active management will not produce better results than simply indexing. Although time horizon is an investment constraint, that statement has nothing to do with this question. LO 21.i

When reviewing potential securities to select for an investor's portfolio, a technical analyst would be most likely to evaluate A) the price-to-book ratio B) the price-to-earnings ratio C) the daily trading volume D) the management tenure

C) the daily trading volume A technical analyst charts price and volume over time. The other choices are of interest to a fundamental analyst. LO 21.d

A fundamental analyst researching a stock is concerned with all of the following except A) capitalization ratio B) the stock's market price as a multiple of the company's earnings C) volume of shares traded D) management efficiency

C) volume of shares traded A fundamental analyst is concerned with the economic climate, the inflation rate, how an industry is performing, a company's historical earnings trends, how it is capitalized, and its product lines, management, and financial statement ratios, such as the P/E ratio. A technical analyst is concerned with trading volumes or market trends and prices. LO 21.d

An investor begins contributing $600 on the third day of each month to a purchase plan for the KAPCO Total Return Fund. For the first six months, the per share prices were: $10 $12 $15 $20 $12 $8 What is this investor's breakeven point? A) $8.00 per share B) $12.50 per share C) $12.83 per share D) $11.80 per share

D) $11.80 per share This is a dollar cost averaging question. This investor has purchased a total of 305 shares with a total cost of $3,600. Here's the math: Month 1- $600 divided by $10 = 60 shares Month 2 - $600 divided by $12 = 50 shares Month 3 - $600 divided by $15 = 40 shares Month 4 - $600 divided by $20 = 30 shares Month 5 - $600 divided by $12 = 50 shares Month 6 - $600 divided by $8 = 75 shares The total expenditure was $3,600 (6 months××$600) and the total number of shares purchased was 305. That makes the average cost per share $11.80 ($3,600 divided by 305). With the investor's average cost per share being $11.80, a sale of the shares at that price will cause the investor to break even. LO 21.j

Which of the following statements regarding a bond ladder strategy is correct? A) A bond ladder strategy involves the purchase of very long-term and very short-term bonds. B) A bond ladder strategy is generally more aggressive than a bond barbell strategy. C) A laddered portfolio of bonds will provide lower yields than a portfolio consisting entirely of short-term bonds. D) A bond ladder strategy is a relatively easy way to immunize a portfolio against interest rate risk.

D) A bond ladder strategy is a relatively easy way to immunize a portfolio against interest rate risk. A bond ladder strategy is a relatively easy way to immunize (protect) a portfolio against interest rate risk. By holding many positions across the yield curve, the individual is diversified in the event that yields behave differently in one part of the curve than in another. The laddered portfolio will generally provide higher (not lower) yields than a portfolio consisting entirely of short-term bonds. Purchasing very long-term and very short-term bonds describes the bond barbell strategy, not the bond ladder strategy. LO 21.f

Published studies have shown that much of the performance of a portfolio can be attributed to which of the following factors? A) Security selection B) Other factors C) Market timing D) Asset allocation

D) Asset allocation A study conducted by Sharpe and Markowitz revealed that 91.5% of the returns achieved by the average investor were based upon the allocation of assets among various investment classifications. Market timing and security selection did account for some of the remaining percentages, but asset allocation proved to be the most important factor. LO 21.a

All of the following are examples of a portfolio diversified through asset allocation except A) Daniella's portfolio, which consists of shares of common stock, municipal bonds, and money market funds. B) Dakota's portfolio, which consists of shares of common stock, corporate bonds, and jumbo CDs. C) Dawson's portfolio, which consists of shares of preferred stock, Treasury bonds, and Treasury bills. D) Daniel's portfolio, which consists of shares of common stock in 52 different corporations.

D) Daniel's portfolio, which consists of shares of common stock in 52 different corporations. Although Daniel's portfolio is diversified, it is diversified within a single asset class: equity. Asset allocation means diversifying the portfolio using at least the three primary asset classes: equity, debt, and cash or cash equivalents. Remember that even though preferred stock is generally considered a fixed-income security, for the purpose of asset allocation, it is part of the equity class, not debt. Each of the other three portfolios contain equity, debt, and cash equivalents (money market securities). LO 21.b

"Stock prices adjust rapidly to the release of all new public information." This statement is an expression of which of the following ideas? A) Tactical allocation B) Arbitrage pricing theory C) Odd-lot theory D) Efficient market hypothesis

D) Efficient market hypothesis In an efficient market, all participants have equal access to information and, therefore, stock prices reflect that equality almost immediately. LO 21.i

Which of the following statements regarding the growth style of investing is correct? A) Growth managers focus on the numerator in the P/E ratio, desiring a low stock price relative to earnings or book value of assets. B) Growth managers look for a high-dividend yield and often take a contrarian approach. C) Growth managers believe that, although a firm's earnings are depressed now, the earnings will rise in the future as they revert to the historical range. D) Growth managers focus on the denominator in the P/E ratio, searching for firms and industries where high expected earnings growth will drive the stock price up even higher.

D) Growth managers focus on the denominator in the P/E ratio, searching for firms and industries where high expected earnings growth will drive the stock price up even higher. High P/E ratios are one of the keynotes of growth investing. The other choices here all relate to the value style. LO 21.e

A mutual fund investor is using a dollar cost averaging strategy. For the average price per share to exceed the investor's average cost, which of the following conditions must be present? I The market price per share fluctuates with each purchase. II A fixed dollar amount is invested at regular intervals. III A fixed number of shares is purchased monthly. IV A constant dollar value is maintained in the account. A) II and IV B) I and III C) II and III D) I and II

D) I and II Dollar cost averaging requires investing of a fixed amount of money at regular intervals. This procedure results in a lower average cost per share than the average price paid if the mutual fund price fluctuates. The constant dollar plan involves buying and selling to maintain a constant dollar amount of either equity or debt securities in the account. LO 21.j

An individual who is a proponent of the efficient market hypothesis (EMH) will likely invest in which of the following? A) Sector mutual funds B) Growth mutual funds C) Balanced mutual fund D) Index funds

D) Index funds An individual who believes in the EMH will likely invest in index funds. Inherent in this strategy is a belief that an investor cannot outperform the market with active portfolio management techniques. The remaining choices all incorporate an active portfolio management philosophy. For example, the sector fund manager is regularly shifting assets from one sector to another depending on the business cycle. A balanced fund manager is buying and selling securities to keep the balance (the proper percentage mix) between the equity and the debt securities in the portfolio. LO 21.i

Which of the following is an example of dollar cost averaging? A) Buying 20 shares of the XYZ Fund each month on the 20th of the month B) Rebalancing your portfolio each quarter on the 20th of the month C) Maintaining a constant ratio plan D) Investing $100 into the XYZ Fund each month on the 20th of the month

D) Investing $100 into the XYZ Fund each month on the 20th of the month Dollar cost averaging is that formula method of investing that contemplates investing a fixed amount of money, in this case $100 at regular intervals, in this case on the 20th of each month, regardless of price swings in the market. By doing so, more shares are bought when the price is low and fewer when the price is high. LO 21.j

Kellie is a senior equity analyst for a large brokerage firm. She primarily uses fundamental analysis techniques to assist her in picking stocks for her firm's clients. Today, she is reviewing the XYZ Corporation. The company is a manufacturer of computer keyboards and is currently going through an expansion phase. Which of the following techniques would Kellie be least likely to use to determine whether to buy, sell, or hold this company's stock? A) She may examine the overall state of the economy, the computer industry, and then XYZ Corporation. B) She may calculate the intrinsic value of the stock using one or more of the stock valuation models. C) She may consider trends towards tablets and smart phones. D) She may review the company's stock 200-day moving average.

D) She may review the company's stock 200-day moving average. Reviewing the company's stock 200-day moving average is a technique used by technical analysts (chartists). All of the other techniques are used by fundamental analysts. The process of examining the economy, the specific industry, and the specific company is a reflection of top-down fundamental analysis. LO 21.d

Which of the following statements regarding modern portfolio theory is not correct? A) The optimal portfolio offers the highest return for a given level of risk. B) The optimal portfolio has the lowest risk for a given level of return. C) The optimal portfolio for an investor depends upon the investor's ability to assume risk. D) The optimal portfolio will always lie above the efficient frontier.

D) The optimal portfolio will always lie above the efficient frontier. The optimal portfolio for an investor will always lie on the efficient frontier. That is where, for any given level of risk, the return is the highest. Stated another way, for a given level of return, the risk is the lowest. LO 21.g

The use of futures to hedge against a price increase is best referred to as A) a short hedge. B) a neutral hedge. C) a trimmed hedge. D) a long hedge.

D) a long hedge. Just as with stock options, the strongest hedge is always accomplished by buying (going long) on the opposite side. When the investor is afraid the price will rise, going long (benefits if the price does rise) fixes the purchase price regardless of how high the price might rise. LO 21.k

Emanuel owns 500 shares of IJKL common stock with a cost basis of $63 per share. IJKL is now priced at $82 and Emanuel is concerned that the stock may suffer a sharp decline in the near term. As his IAR, you would suggest his best move to protect his profit would be to A) sell 500 shares of IJKL short. B) buy 5 IJKL 80 call options. C) sell 5 IJKL 80 put options. D) buy 5 IJKL 80 put options.

D) buy 5 IJKL 80 put options. When one is long a security, the best hedge is to buy a put. Should Emanuel's fears be realized, regardless of how low the stock declines, he will be able to exercise and deliver his 500 shares at the strike price of $80 per share. An alternative would be to sell call options, but that is generally not going to be the correct choice when the question asks about protecting a profit. Writing an option is more appropriate when the question deals with the investor generating income. LO 21.k

A client wishing to hedge a long stock position would be most likely to: A) sell a put on that stock. B) sell a call on that stock. C) buy a call on that stock. D) buy a put on that stock.

D) buy a put on that stock. Hedging a long stock position would protect the investor from a market decline in the value of the stock. The best way to do this is to purchase a put option on that stock. This is why some refer to the purchase of puts as a form of portfolio insurance. LO 21.k

Your client owns 500 shares of RMBN purchased at $11.94 per share. The stock is now selling for $12.70 per share, and the client is concerned that the market may turn downward. You could suggest protecting the profit by A) buying five RMBN 12.50 calls. B) buy one RMBN 12.50 put. C) selling five RMBN 12.50 puts. D) buying five RMBN 12.50 puts.

D) buying five RMBN 12.50 puts. The best way to hedge (protect) a profit on a long position is the purchase of puts with a contract value equal to the number of shares held. Because the client owns 500 shares, that would mean buying five puts. If the stock should fall, the investor knows that $12.50 per share can be realized by exercising the put. If the stock continues to rise, the investor can allow the puts to expire and continue to participate in the growth. LO 21.k

When giving advice to a large pension plan invested heavily in large-cap stocks on how to reduce their systematic risk, you would probably recommend that they A) increase the standard deviation of the portfolio B) raise the correlation coefficient of the securities in the portfolio C) increase their portfolio diversification D) hedge by purchasing broad index puts

D) hedge by purchasing broad index puts Buying broad index put options, such as on the S&P 500, gives an effective hedge against the downside movement in the market. Another choice, although not necessarily as effective, would be to lower the standard deviation of the portfolio by switching into securities with a lower volatility. Diversification does not protect against systematic (market) risk and reducing the correlation would work, not increasing it. LO 21.k

An investment adviser (IA) explaining modern portfolio theory (MPT) to a client might make all of the following statements except A) if two securities offer the same risk, choose the one with the higher return. B) if one security has a higher return than another and at the same time has a lower risk, choose it. C) if two securities offer the same rate of return, choose the one with the lower risk. D) if one security has a higher return than another and at the same time has a higher risk, choose it.

D) if one security has a higher return than another and at the same time has a higher risk, choose it. The goal of MPT is to maximize the return for any given amount of risk. Therefore, always look for a choice giving the highest return for the least risk. Although it is true that the security with the higher risk should have the higher return, a follower of MPT is most likely to recommend securities only when the security offers the highest return with the lowest risk. LO 21.g

An analyst using the dividend growth model would take into account all of the following factors except A) the current dividend. B) the growth of the dividend. C) the investor's required rate of return. D) the current earnings per share.

D) the current earnings per share. The dividend growth model is a stock valuation model that deals with dividends and their growth, discounted to today. The value of the stock equals next year's dividends divided by the difference between the required rate of return and the assumed constant growth rate in dividends. The earnings per share figure is irrelevant because the company may be retaining most or all of its earnings and paying a small dividend or no dividend. LO 21.d

An investment adviser is doing some research on a company and notices that the current market price is $21 per share. The most recently reported earnings per share is $3, and the company is paying a $0.26 quarterly dividend. On the balance sheet, the company is carrying a significant amount of cash. This company would probably be attractive to this adviser if his investment style was A) passive. B) contrarian. C) growth. D) value.

D) value. This is an example of the kind of company appealing to those who follow a value style of portfolio management. The company is selling at a low price-to-earnings (P/E) ratio of 7 to 1 ($21/$3) with a liberal dividend yield of 4.95% ($1.04/$21). The high cash balance only adds to the value. LO 21.e