Unit 21

Which of the following securities would most likely be included in the portfolio of a mid-cap manager? ABC, $12 per share, 100,000,000 shares outstanding DEF, $150 per share, 8,000,000 shares outstanding GHI, $40 per share, 75,000,000 shares outstanding JKL, $70 per share, 200,000,000 shares outstanding A) GHI B) ABC C) JKL D) DEF

A) GHI Mid-cap stocks are those with a market capitalization between $2 billion and $10 billion. GHI, with a market cap of $3 billion ($40 times 75 million), is the only company within that range. ABC's market cap is $1.2 billion ($12 times 100 million), DEF's is $1.2 billion ($150 times 8 million), and JKL's is $14 billion ($70 times 200 million). Two of these (ABC and DEF),are within the small-cap range, and JKL would be considered large-cap.

Over the past year, the market, with a beta of 1.0, has returned 15%. Under CAPM, which of the following stocks would be considered overvalued? A) RJP, beta 1.2, return 17.5% B) ACR, beta 0.9, return 13.6% C) LQR, beta 0.7, return 11% D) BED, beta 1.5, return 23.5%

A) RJP, beta 1.2, return 17.5% We compare the expected return to the actual return to determine if the security outperformed (making it undervalued) or underperformed (making it overvalued). RJP's beta of 1.2 would have led to an expected return of 120% of that of the market. That would be 15% x 120% = 18%. With an actual return of 17.5%, the stock did not perform relative to the additional risk taken. The actual return for all of the others exceeded the expected return. LQR was 11% compared to 10.5%; BED was 23.5% compared to 22.5%; and ACR was 13.6% compared to 13.5%.

During the analysis of XYZ stock, a technical analyst concludes that XYZ's support level has been broken. Being a technician, the most appropriate decision should be to A) rate the stock as a sell. B) purchase additional shares of the stock. C) rate the stock as a hold. D) rate the stock as a buy.

A) rate the stock as a sell. If a support level is broken, this provides a sell signal. Once the stock has lost its support, expectations are that it will continue to fall. The breaking of a resistance level, as the price of the asset gathers momentum to the upside, indicates a buying opportunity.

To a technical analyst, the resistance level signifies the price at which a stock's supply would be expected to A) cause the stock price to "break out". B) increase substantially. C) remain constant. D) decrease substantially.

B) increase substantially. This is about comparing support and resistance levels. Most stock prices remain relatively stable and fluctuate up and down. The lower limit to these fluctuations is called a support level - the price range where a stock appears cheap and attracts buyers. The upper limit is called a resistance level - the price range where a stock appears expensive and initiates increased selling. This selling represents an oversupply of the stock which results in downward pressure on the stock.

The capital asset pricing model (CAPM) is used by many to assess the expected return of a security. If the current risk-free rate is 2%, the current return on the market is 10%, and a particular stock's beta is 1.5 with a standard deviation of 3.2, the expected return would be A) 18.2% B) 12% C) 14% D) 15%

C) 14% The formula for this computation is as follows: 10% (the return on the market is a beta of 1.0) minus the risk-free rate of 2%, or 8%. Then, multiply that by the beta of this stock (1.5) to arrive at 12%. That is, the stock should return 12% above the risk-free rate of 2%, or 14%. The standard deviation is not relevant to this computation.

An investor has $50,000 to invest in bonds. Currently, 10-year bonds are offering very attractive yields, but the client is concerned that in a few years, rates will be even higher. What would you suggest? A) Diversifying B) Bullet strategy C) Barbell strategy D) Laddering

C) Barbell strategy With the barbell strategy, the investor would place $25,000 into bonds maturing in 10 years and the other half into bonds maturing in two years. This makes $25,000 available for reinvestment in two years enabling the investor to take advantage of the higher rates (if they materialize).

The tactical approach to the asset allocation review process A) is designed to maintain a minimum or floor for the value of the portfolio's assets B) requires no predictive abilities C) intentionally deviates from the normal asset mix to take advantage of market opportunities D) strives to maintain a constant asset mix over a long period of time

C) intentionally deviates from the normal asset mix to take advantage of market opportunities The approach to asset review that intentionally deviates from the normal asset mix to take advantage of market opportunities is the tactical approach. Investors using this approach try to use market timing to beat the market, so this approach requires a great deal of predictive ability.

An investor plans to fund the college education for her newborn child by purchasing $5,000 of investment-grade bonds on an annual basis. She is most likely using A) the laddering strategy. B) the barbell strategy. C) the bullet strategy. D) the 529 plan strategy.

C) the bullet strategy. The bullet strategy is used when aiming at a target. In this case, the target is having sufficient funds about 18 years from now. This strategy involves buying bonds at different intervals, but all with approximately the same maturity date. The barbell strategy has all bonds purchased at the same time with two different sets of maturities - half of the bonds mature near term and half mature intermediate term. Laddering requires purchasing bonds on a regular basis, but not with new funds as this investor is doing. As bonds mature, the proceeds are rolled-over into new bonds. She may be doing this in a 529 plan, but the plan is not a strategy, it is a type of account.

Sortel Industries has preferred stock outstanding that pays annual dividends of $3.75 a share. If an investor wants to earn a rate of return of 8.5%, how much should she be willing to pay for a share of Sortel preferred stock? A) $31.88 B) $33.89 C) $42.10 D) $44.12

D) $44.12 This is a middle school math question. It is asking, 3.75 is 8.5% of what number? The computation is: 3.75 ÷ 0.085 = $44.12.

In the technical analysis of the value of securities, which of the following items is not important? A) The breadth of market volume B) Resistance and support levels C) A prevailing market trend in response to shifts in supply and demand D) The amount of a company's past earnings

D) The amount of a company's past earnings The amount of a company's past earnings is a factor used in the fundamental analysis of securities, but not technical analysis. Technicians rely on market trends and supply and demand factors, as well as chart indications such as resistance and support levels.

In the field of securities analysis, there are many tools available. Which of the following would most likely be used by an analyst to approximate a reasonable price for a common stock? A) Yield to maturity B) Par value C) Book value per share D) The dividend discount model

D) The dividend discount model The simplest model for valuing equity is the dividend discount model—the value of a stock is the present value of expected dividends on it. Yield to maturity only applies to debt securities with a fixed maturity date. The par value of a common stock has nothing to do with its market price. Although fundamental analysts will examine a company's book value per share, it generally has little or no bearing on the current market price of the stock.

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

A) 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.

Formula methods of investing that involve selling equities in rising markets and buying them in falling markets would include 1. constant dollar plan 2. constant ratio plan 3. dollar cost averaging 4. DRIPs A) I and II B) III and IV C) II and III D) I and IV

A) I and II In both a constant dollar plan and a constant ratio plan, the goal is to maintain a balance between equity and debt securities in the portfolio. This is done by selling equities as their price rises (the proportion has now changed) and buying equities when the prices fall to get back to the constant dollar or ratio. Both dollar cost averaging and dividend reinvestment programs (DRIPs) involve buying securities at regular intervals, not buying and selling based on the direction of the market.

Which of the following is a characteristic of the passive investment style? A) Rebalancing B) Tactical management C) High portfolio turnover D) Income rather than growth objective

A) Rebalancing Because the passive (strategic) style of investing does not involve frequent trading (as does the tactical or active style), periodically the portfolio will be rebalanced to insure that the asset mix is at the desired level. This style may be used for either income or growth objectives.

If the risk and return profiles of all the possible risky portfolios were plotted on a graph, those portfolios that would be the most attractive to investors would lie on A) the efficient frontier B) the y-axis C) the security market line D) the capital market line

A) the efficient frontier An efficient portfolio is one that offers the most return for a given amount of risk, or the least risk for a given amount of return. The collection of efficient portfolios is called the efficient set or efficient frontier. This efficient frontier is plotted as a curve.

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

B) $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.

Which of the following statements are generally true of the buy-and-hold strategy? 1. Equities would grow relative to fixed income 2. Lower taxes and transactional costs 3. Easy to manage 4. The portfolio would more accurately demonstrate the client's investment objectives and risk tolerance A) III and IV B) I, II, and III C) I and II D) II, III, and IV

B) 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.

All of the major equity indexes have been making new highs. A portfolio manager employing which of the following management styles would be the most likely to have significant short positions? A) Growth B) Value C) Contrarian D) Passive

C) Contrarian The contrarian style of portfolio management is to do the opposite of the rest of the market. When prices are reaching new highs, it is an indication that the preponderance of investors are buying. Contrarians would be bearish and that would lead to shorting stocks.

Which of the following statements about technical analysis are true? 1. Technical analysis tries to identify trends and predict market changes. 2. Technical analysis is often accomplished by reviewing data in the form of charts. 3. Technical analysis looks primarily at past performance to predict future trends. A) I and III B) II and III C) I, II, and III D) I and II

C) 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.

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

C) 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.

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

An investor has arranged with her bank to have $1,000 sent to the KAPCO Balanced Fund on the same day each month. For the first 4 months of this arrangement, the prices of the fund have been: Month 1 - $10.00 per share Month 2 - $12.50 per share Month 3 - $15.00 per share Month 4 - $13.25 per share What is the difference between the investor's average cost per share and average cost per transaction? A) The average cost per share is approximately $0.27 less. B) The average price per transaction is approximately $0.27 less. C) There is no difference. D) The average cost per share is approximately $0.19 less.

A) The average cost per share is approximately $0.27 less. When investing $1,000 per month, the investor acquired 100 shares the first month, 80 shares the second month, 66.667 shares the third month, and 75.472 shares the fourth month. That is a total of 322.139 shares purchased for a total cost of $4,000. That is an average cost per share of $12.42 per share. The average of the four transaction prices ($10, $12.50, $15, and $13.25) is $12.69. That is $0.27 higher than the cost per share. This demonstrates the advantage of dollar cost averaging.

Which of the following is not a characteristic of a Monte Carlo simulation? A) The user gets a best-case scenario and a worst-case scenario. B) It provides insight into the range of outcomes. C) It is a technique used to model uncertainty in retirement planning. D) Large changes in the projected rate of return will make small differences in the outcome.

D) Large changes in the projected rate of return will make small differences in the outcome. Small changes in the projected rate of return will make large differences in the outcome.

Which of the following investment strategies reflects determining an appropriate portfolio allocation based on the short-term market movements and risk tolerance of the client? A) Top-down fundamental analysis B) Strategic asset allocation C) Tactical asset allocation D) Efficient market allocation

C) Tactical asset allocation Those following the tactical asset allocation strategy are generally attempting to time the market. That is, changing the allocation to benefit from the short-term swings in the market. In strategic asset allocation, once the allocation is determined, it remains relatively constant until some change to the investor's objectives occurs. Periodically, the portfolio is rebalanced to reflect any changes in market conditions.

The capital asset pricing model (CAPM) is based on several limiting assumptions. Which of the following statements is correct regarding the CAPM? A) The CAPM does not assume that the expected excess returns for the market are known. B) The CAPM does not assume that investors have access to the same information. C) The CAPM assumes that the optimal portfolio should be the one with the highest Sharpe ratio of all possible portfolios. D) The CAPM assumes that investors' expectations regarding risk and return are not identical but normally distributed.

C) The CAPM assumes that the optimal portfolio should be the one with the highest Sharpe ratio of all possible portfolios. The CAPM assumes that investors should construct a portfolio with the highest Sharpe ratio because that offers the highest risk-adjusted return. It also assumes that the expected excess returns for the market are assumed to be known in that investors have access to the same information. As well, it assumes that returns are normally distributed and investors' expectations for risk and return are identical.

Which of the following statements concerning market efficiency is least accurate? A) If semi-strong form market efficiency holds, technical and fundamental analysis cannot be used to earn abnormal returns over the long run. B) If weak form market efficiency holds, technical analysis cannot be used to earn abnormal returns over the long run. C) An efficient market assumes one can generate abnormal returns with active portfolio management. D) If strong form of market efficiency holds, even insider information cannot be used to earn abnormal returns.

C) An efficient market assumes one can generate abnormal returns with active portfolio management. Market efficiency assumes active portfolio management cannot help earn abnormal (excess) risk-adjusted returns. The weak form indicates that technical analysis doesn't work. The same is true for the use of inside information under the strong form. Semi-strong says that neither technical nor fundamental analysis will work.

Which of the following is not a type of diversification that is achieved by investing in international equities? A) Geographic B) Asset class C) Style D) Currency

C) Style Following a value or a growth style, or using a buy-and-hold strategy, is independent of the continent of domicile of the issuer. Investing in different countries diversifies investments among various currencies, other than the client's domestic currency. Different geographic areas have different types of industries whose performance may vary on the basis of regional resources. International equities are considered another asset class for purposes of asset allocation in one's portfolio.

When using the dividend discount model, A) ​​​the degree of accuracy in forecasting the price of preferred stock is less​ than​ that ​obtained by using the dividend growth model B) best results are obtained from stocks that pay irregular dividends C) future expected dividends are discounted to compute the present value of the stock D) the discount rate is generally lower than the expected rate of return

C) future expected dividends are discounted to compute the present value of the stock This method of common stock valuation takes the investor's expected future dividend returns and then discounts that amount by the expected rate of return to arrive at the supposed present value. Expected (or required) rate of return is a component of both the dividend discount model and the dividend growth model, and ​only the DDM is used for preferred stocks because the dividend can never increase. When using any dividend model, the greater the regularity of dividends, the more accurate the forecast.

The semi-strong form of efficient market hypothesis (EMH) asserts that A) both public and private information is already incorporated into security prices. B) only fundamental analysis and inside information can bring added value to a portfolio. C) all public information is already reflected in security prices making fundamental analysis valueless. D) all inside information is already reflected in current stock prices.

C) all public information is already reflected in security prices making fundamental analysis valueless. Semi-strong EMH states that publicly-available information (fundamental analysis) cannot be used to consistently beat the market performance. It is strong form EMH which states that all inside information is already reflected in current stock prices.

The portfolio of a client of an investment adviser began the year with a market value of $1.2 million. Sixty percent of the portfolio was in equities, thirty percent in bonds, and the remainder in cash. It was a good year for equities and, at the end of the year, the total value of the account was $1.5 million. This resulted in the portfolio manager liquidating approximately $100,000 of stock and placing the money into bonds. Given this information, it is most likely that this manager's investment style is A) contrarian. B) strategic asset management. C) rebalancing. D) tactical asset management.

B) strategic asset management. Strategic asset management, which is basically a passive strategy, views the market on a long-term basis. The manager does recognize that, over the period of one year, market and economic changes can result in managed portfolios becoming out of balance. Although we do not know the actual numbers, the fact that the manager is selling stock and buying bonds indicates that the portfolio mix no longer matches what was originally designed. Bringing the portfolio back into balance is the process of rebalancing. So, why isn't rebalancing a correct choice? It is not correct because rebalancing is not a management style; it is a feature of the strategic or passive style of portfolio management. Tactical asset management, a good example of which is market timing, looks at the short run changes and moves in and out of positions as necessary. That results in buying and selling far more frequently than once per year. The contrarian style is doing the opposite of what the majority does. That is, contrarians are selling when others are buying and vice versa.

Ian is a technical analyst who believes the market, as represented by the S&P 500 Index, is overbought. Over the next several months, there is a 12% correction. Which of the following strategies would have been successful for Ian? A) Buy call options on the S&P 500 Index B) Buy futures contracts on the S&P 500 Index C) Sell futures contracts on the S&P 500 Index D) Sell put options on the S&P 500 Index

C) Sell futures contracts on the S&P 500 Index Ian was obviously bearish on the market. When something is overbought, it means it is overvalued due to excessive buying at unreasonably high prices. In this case, it is likely the market is primed for a correction (a reversal). The 12% correction proves him to have been correct. Selling a futures contract is taking a short position. Just as with selling stock short, the investor profits when the price of the underlying asset declines. Ian could have also profited by going long (buying) put options on the index. Selling puts and buying calls generate profit in a bullish market, not a bearish one.

The pundits are predicting slowly-rising inflation over the next 5 years. An IAR recommends that one of her clients splits his bond portfolio into equal percentages with maturities ranging from 1 to 5 years. As each bond matures, the proceeds are used to purchase bonds with a 5-year maturity. The IAR is using A) the interest discount model. B) the barbell strategy. C) the laddering strategy. D) the bullet strategy.

C) the laddering strategy. The theory behind the laddering strategy is that with bonds maturing every year, the investor is reinvesting the principal at current market rates. In a period of rising inflation, interest rates follow along, so annually, the maturing bonds will be used to purchase new bonds with higher coupons. The barbell strategy has all bonds purchased at the same time with two different sets of maturities - half of the bonds mature near term and half mature intermediate term. The bullet strategy is used when aiming at a target. This strategy involves buying bonds at different intervals, but all with approximately the same maturity date. There is no such thing as the interest discount model - perhaps you confused it with the dividend discount model used with equity securities.