Ch. 15 - Portfolio Management and Investment Risk

An investment advisory firm is analyzing the market and building a portfolio for a client. The firm starts by identifying companies with strong financial performance and then creates forecasts for the entire sector based on its analysis. This is an example of: a. A top-down approach b. A bottom-up approach c. A form of technical analysis d. A form of top-down analysis for the entire sector

b. A bottom-up approach Explanation: When an investment adviser analyzes the market by first evaluating individual companies, it is considered a bottom-up approach. Conversely, when an adviser begins by analyzing the performance of a sector as a whole, it is considered a top-down approach.

A widow has a mix of small-cap growth stocks, large-cap stocks from mature industries, investment-grade bonds, speculative bonds, preferred stock, and foreign securities. She is attempting to reduce: a. Credit risk b. Market risk c. Money-rate risk d. Liquidity risk

b. Market risk Explanation: Market risk is reduced by investing in different asset classes. The more random the correlation between the different asset classes, the greater the overall reduction in market risk. A high positive correlation between the asset classes equates to high market risk.

An investor buys a two-year U.S. Treasury note. If the note is purchased at par and held to maturity, what is the real rate of return over the holding period, assuming the CPI is 3% and the yield-to-maturity is 6.0%? a. 3% b. 6.3% c. 3.3% d. 0.3%

a. 3% Explanation: The formula for calculating an investment's real rate of return is to subtract the rate of inflation (CPI) from the coupon rate. When a note is purchased at par the coupon rate and the yield-to-maturity (YTM) are the same. In this question, since the YTM is 6.0% the note's coupon rate is 6.0%. Therefore, the answer to this question is 3% (6% coupon - 3% CPI).

Currency risk would be the LEAST of a concern for which of the following investors? a. A 28-year-old saving for retirement b. A 55-year-old couple seeking to invest their annual IRA contributions c. A 28-year-old couple saving to buy a house in two years d. The parents of a thirteen-year-old saving for college expenses

a. A 28-year-old saving for retirement Explanation: Currency risk is particularly acute for short-term investors. A twenty-eight-year-old saving for retirement probably has thirty years before she plans to access the funds. All the other choices describe investors who have much shorter time horizons (two-to-ten years).

Investor Jones begins the year with a portfolio of high-grade bonds and blue-chip stocks valued at $300,000. During the year he receives dividends and interest amounting to $11,345, all of which is reinvested. At year-end, the portfolio is valued at $325,435. The percentage return for the year for this portfolio is: a. 7.8% b. 8.5% c. 12.3% d. 3.7%

b. 8.5% Explanation: The portfolio increased in value by $25,435, of which $11,345 represents interest and dividends. If the portfolio was valued at $300,000 at the beginning of the year, the return is 8.5% ($25,435 / $300,000).

When managing a portfolio of bonds, which of the following would be considered a passive investment strategy? a. An interest-rate anticipation strategy b. Buy and hold c. An immunization strategy d. A bond barbell strategy

b. Buy and hold Explanation: A buy-and-hold strategy is a passive one in which the portfolio generally remains fixed with very little turnover. Barbell, immunization, and interest-rate anticipation strategies all require a portfolio manager to actively rebalance the portfolio at various points in time or due to changing market conditions.

Buy and hold and systematic rebalancing are examples of passive approaches to asset allocation, and based on the theory known as: a. Modern Portfolio Theory b. CAPM c. Efficient Market Hypothesis d. Sector Rotation

c. Efficient Market Hypothesis Explanation: Efficient Market Hypothesis (Theory) states that financial markets are efficient and that the prices of securities reflect all known information; therefore, it is impossible to outperform or time the market. Sector rotation is the moving of investments from one industry sector into another in anticipation of a change in the economy. CAPM, Capital Asset Pricing Model, describes the relationship between risk and expected return. Modern Portfolio Theory focuses on diversifying across various asset classes to enhance returns without significantly increasing risk.

Which of the following approaches to portfolio management is most closely associated with market timing? a. Passive management b. Strategic asset allocation c. Tactical asset allocation d. Value investing

c. Tactical asset allocation Explanation: Managers who believe securities markets are not perfectly efficient may try to use an active strategy to alter the portfolio's asset mix to take advantage of anticipated economic or market events. This market timing approach is sometimes called tactical asset allocation.

At the beginning of the year, an investor's portfolio was valued at $265,000. At year-end, it was worth $243,000. What is the approximate return on this portfolio at year-end? a. -8.30% b. -5.80% c. 5.80% d. 8.30%

a. -8.30% Explanation: This investor has seen his portfolio lose $22,000 during the year. Based on an opening year figure of $265,000, the account has experienced a loss of 8.30% ($22,000 divided by $265,000).

An investment has a 25% chance of earning an 8% return, a 50% chance of earning a 4% return, and a 25% chance of earning a 4% loss. What is this investment's expected return? a. 1% b. 4% c. 8% d. 3%

d. 3% Explanation: The expected return of an investment is the possible returns on the investment weighted by the likelihood that return will occur. The expected return of this investment is calculated as follows: (.25 x 8%) + (.50 x 4%) + (.25 x -4%) = 2% + 2% + (-1%) = 3%

If a money market fund pays 1% per year for four years, what's its total return? a. 0.04 b. 0.01 c. 0.1 d. 0.14

a. 0.04 Explanation: The formula for calculating Total Return = (Ending Value - Beginning Value) + Investment Income/Beginning Value. Since money market funds attempt to keep their value stable, investors will not have any gains or losses. Investors in money market funds will only receive the interest payments every year. In this question, investors will receive 1% of their investment each year for four years, which is approximately 4%. For example, a $10 investment will pay $0.10 per year and $0.40 over four years; therefore, the total return is 4% ($.40/$10).

Drawbacks to the bottom-up approach to investing generally would NOT include the idea that: a. The management team of a company is usually not a reliable gauge as to how the company might perform in the global economy b. Investors are more concerned about possible losses than they are motivated by possible gains, thus preventing them from rallying around a stock and causing its price to rise c. The price of a stock is based on other, external factors, such as the economy, not just facts about the company itself d. When negative news about a small company is disseminated, it can significantly affect investor perception about what the price of the undervalued company should be

a. The management team of a company is usually not a reliable gauge as to how the company might perform in the global economy Explanation: One of the factors involved in the evaluation of stocks in the bottom-up approach is the management team of the company. This should not be dismissed while considering whether to include a stock in an investment portfolio under this approach.

A state pension fund is evaluating three separate investment advisers to manage the equity portion of its portfolio. Two of the advisers have had significant client growth in the past three years. The pension fund is worried that the positive in-flows of cash may distort the returns of the advisers. Which of the following measures would give the fund the BEST comparison of the three advisers' returns over that three-year period? a. Dollar-weighted return b. Annualized return c. Time-weighted return d. Holding period return

c. Time-weighted return Explanation: Time-weighted return (TWR) is a more accurate measure of a portfolio manager's performance since it eliminates the effects of cash flowing into the portfolio over a given period. It is assumed that all cash distributions are reinvested in the portfolio and the same periods are used for comparisons. The effect of varying cash inflows is eliminated by assuming a single investment at the beginning of a period and measuring the growth or loss of value to the end of that period.

Jonah has recently retired at age 65. He is receiving a large lump-sum retirement payout from his former employer. Although he has only a small investment portfolio, he has accumulated savings that would cover six months of expenses. Which of the following combinations would be an appropriate allocation of Jonah's lump sum in an investment portfolio if his primary interest is income and his secondary interest is growth for inflation protection? a. 85% bonds, 15% equities b. 25% cash, 75% equities c. 50% cash, 45% bonds, 5% equities d. 100% cash

a. 85% bonds, 15% equities Explanation: While a portfolio that consists of 75% equities (25% cash and 75% equities) might be too volatile for a 65-year-old retiree, increased life expectancies have made some exposure to equities justifiable for such investors. Since equities provide much more inflation protection than bonds or cash (money-market investments), a small portion in stocks would generally be suitable. Based on the fact that this investor already has a six-month liquidity cushion in the form of savings, a large additional allocation to cash (either 100%, 50%, or 25%) may not provide enough income or inflation protection in the long run.

Eight years ago, Catherine purchased $10,000 of shares in the Big Blue Marble Global Fund. After reinvestment of dividends and capital gains, her investment is currently valued at $20,000. What is Catherine's annual growth rate for her investment? a. 9% b. 12.5% c. 8% d. 10%

a. 9% Explanation: Using the Rule of 72 to approximate the compounded growth rate, 72 divided by the number of years it will take a sum of money to double will yield the growth rate. 72 divided by 8 years equals a 9% annual growth rate.

While examining a client's investment profile, an IAR determines that the client is able to tolerate a high degree of risk and does not anticipate the need to access invested funds for the next 25 years. What would be the best investment allocation for the client's portfolio? a. 95% equities and 5% money-market instruments b. 40% debt, 50% equities, and 10% money-market instruments c. 25% bonds, 25% equities, 25% money-market instruments, and 25% real estate d. 65% bonds and 35% equities

a. 95% equities and 5% money-market instruments Explanation: An investor who has a long time horizon and is willing to tolerate high levels of risk may allocate a large percentage of her portfolio in stocks. 95% equities and 5% money-market instruments is the only one that allocates more than 50% of the portfolio in equities.

In general, emerging markets differ from developed markets in which of the following ways? a. Developed markets are more stable b. Emerging markets are more predictable c. Emerging markets are more profitable d. Developed markets are less stable

a. Developed markets are more stable Explanation: Emerging markets are markets that are just beginning to develop. They are typically characterized by primitive capital markets, underdeveloped industry, relatively low personal income levels and low profitability levels. There is strong growth potential in such markets, but also above-average risk and significant instability factors.

An advisory client is discussing the purchase of AA-rated, 15-year municipal bonds with his adviser. The bonds offer a coupon rate of 3.2% and can be purchased at a small premium to par. The adviser is not certain if the bonds are trading at an advantageous price. Which calculation would provide the BEST method of determining whether the bonds should be purchased? a. Discounted cash flow b. Duration c. Current yield d. Yield to maturity

a. Discounted cash flow Explanation: Discounted cash flow evaluates each coupon payment and the repayment of a bond's principal at a present value, based on a rate of return. This makes it possible to evaluate a bond's value against the investor's desired rate of return. The sum of each of the discounted cash flows, plus the present value of the bond's principal, determine the total value of the bond. By comparing this value to the current price of the bond, the adviser will be able to determine if the bond is an attractive investment for her client.

When considering investments in various mutual funds, an IA may recommend an emerging markets fund as a means of: a. Diversifying investments in various funds b. Reducing the risk of various fund holdings c. Achieving a higher return than with other funds d. Reducing taxes, since earnings are not subject to U.S. taxes

a. Diversifying investments in various funds Explanation: An emerging markets fund invests in companies of countries that are moving out of their economic development phase and into a more growth-oriented stage in their development. Such funds do have risk and, typically, a high degree of volatility. Investing in such a fund together with other funds may provide greater diversification and the opportunity for a greater return.

A married couple is about to retire and would like to roll over their employer-sponsored 401(k) plans into an IRA and invest all of their assets in U.S. Treasury bonds. Based on this strategy, which risks are the most significant? a. Interest-rate risk and inflation risk b. Market risk and business risk c. Regulatory risk and opportunity risk d. Credit risk and business risk

a. Interest-rate risk and inflation risk Explanation: Treasury bonds are long-term debt instruments that are guaranteed by the U.S. government. Because they are backed by the U.S. government, regulatory risk and business risk do not really apply to these investments. However, investing in bonds will expose investors to interest-rate risk and inflation. Interest-rate risk is based on the concept that if interest rates rise, bond prices will decline. Inflation risk is the chance that the cash flows from an investment will not be worth as much in the future because of changes in purchasing power due to inflation.

A portfolio manager purchased a CMO at par. One hour later, she decided to change her portfolio mix and sold the CMO. Despite stable interest rates, the CMO was sold at 98. This is an example of: a. Liquidity risk b. Prepayment risk c. Reinvestment risk d. Call risk

a. Liquidity risk Explanation: This example illustrates liquidity risk. Despite the fact that the market was stable, the security was resold at a loss shortly after it was purchased. Lack of liquidity is often reflected in the spread between the bid and asked price for a security. If this CMO was quoted at 98-100, an investor could buy the CMO at par, but would have to accept 98 (a two-point loss) in an immediate resale. The less liquid the security, the greater the bid/asked spread will be.

What's the best indicator of a successful mutual fund? a. Tenure of the manager b. The turnover rate in the portfolio c. The fund's expense ratio d. The returns of the portfolio over the previous year

a. Tenure of the manager Explanation: Tenure refers to the length of time that a manager has been running a mutual fund portfolio. Investment advisers with a longer tenure have most likely been successful over a long period. Previous year results are probably not a reliable indicator of success, since most mutual fund investors have a longer term outlook.

In order for a $25,000 investment to increase in value to $100,000 in 20 years, it would have to earn an annual return of: a. 25% b. 7.2% c. 50% d. 14.4%

b. 7.2% Explanation: To determine the rate of return at which an investment would double in value, use the rule of 72. Since the investment doubled every 10 years, 72 / 10 years = 7.2%, which is the annual rate of return for the investment to increase to $100,000 after 20 years.

The annual percentage returns on ABC over the last 10 years have been: 7, 8, -9, 8, -4, 5, 6, 8, 10, and 12. Which of the following choices represents the mode? a. -9 to 12 b. 8 c. 7.5 d. 5.1

b. 8 Explanation: The mode of a set of data (in this case, annual returns) is the value in the set that occurs most often. In this question, 8% occurs most often and therefore is the mode.

What formula is used to find the present value of an investment by using a future value that is decreased at a compound rate over time? a. Beta b. A discounting formula c. Accretion d. An adjusting formula

b. A discounting formula Explanation: Present value is found by discounting the future value of an investment by an internal rate of return. The formula used to determine the present value is called the discounting formula.

Which of the following is a measure of non-systematic risk? a. Theta b. Alpha c. Beta d. Gamma

b. Alpha Explanation: Alpha is a way to measure risk that's association with a single investment, which is better known as non-systematic risk. On the other hand, systematic risk is associated with all investments and is measured by beta. Gamma and theta are both risk measurements, but they're specific to option contracts.

A client sells shares of an S&P 500 company's common stock. The proceeds are reinvested in an S&P 500 Index fund. The client has reduced which of the following risks? a. Economic b. Business c. Market d. Political

b. Business Explanation: By selling the shares, the client is no longer subject to the risks that may affect a single company. By investing in the S&P 500 Index, the client has greater diversification.

According to dividend discount model, if a stock's current market value is less than the net present value an investor should: a. Not buy the investment b. Consider buying the investment c. Consider selling the investment d. Sell the investment short

b. Consider buying the investment Explanation: The Dividend Discount Model is a way to calculate the present value of a stock using expected (i.e., future) dividend payments. If a stock's current market price is less than the value found using the Dividend Model, the stock represents a good investment. For example, if the Dividend Discount Model's value of a stock is $60 (i.e., the net present value), but it can be currently purchased for $50 (i.e., the current market value), it's undervalued by $10. For this reason, an investor should consider purchasing it.

An adviser is comparing two bonds of similar credit quality and duration for a client. The client is seeking a yield of 6.5%. After performing discounted cash flow analysis on each bond, the adviser has determined that Bond A is trading at a discount to its present value, while Bond B is trading at a premium to its present value. Which TWO of the following statements are TRUE? I. Bond A is priced attractively and should be purchased. II. Bond B is priced attractively and should be purchased. III. The investor will earn an annual interest rate greater than 6.5% with Bond A. IV. The investor will earn an annual interest rate greater than 6.5% with Bond B. a. I and IV b. I and III c. II and IV d. II and III

b. I and III Explanation: Discounted cash flow (DCF) analysis evaluates the present value of all coupon payments and the repayment of a bond's principal at a present value, based on a rate of return. This makes it possible to evaluate a bond's value against the investor's desired rate of return. The sum of each of the discounted cash flows, plus the present value of the bond's principal, determine the total value of the bond. By comparing this value to the current price of the bond, the adviser will be able to determine if the bond is an attractive investment for a client. If a bond is trading at a discount to its present value, the investor will earn more than the interest rate that has been used to calculate the present value. Conversely, a bond that is trading at a premium to its total present value will be worth less than the price of the bond. (The investor would be overpaying for the bond.)

An investor has purchased a U.S. government bond for $1,000. The bond is now worth $850. Which TWO of the following risks is a concern to this investor? I. Market risk II. Credit risk III. Currency risk IV. Opportunity risk a. II and III b. I and IV c. II and IV d. I and II

b. I and IV Explanation: There are certain types of risk that are common to any investment. Market risk and opportunity risk would be among these generic risks. Market risk is the day-to-day price fluctuation of a security trading in the marketplace. Opportunity risk is the risk that a better investment decision could have been made after the completion of a purchase or sale. U.S. government bonds would not be subject to credit risk or currency risk, unless the investor had purchased them with foreign currency.

A client is seeking a yield of 6.8%. An investment adviser has located two bonds with similar credit quality, duration, and the client s desired yield. After performing discounted cash flow analysis on each bond, the adviser has determined that Bond A is trading at a discount to its present value, while Bond B is trading at a premium to its present value. Which of the following statements is NOT TRUE? I. Bond A is priced attractively and should be purchased. II. Bond B is priced attractively and should be purchased. III. The investor will earn an annual interest rate greater than 6.8% on Bond B. IV. The investor will earn an annual interest rate greater than 6.8% on Bond A. a. II, III, and IV only b. II and III only c. II and IV only d. I and III only

b. II and III only Explanation: Discounted cash flow (DCF) analysis evaluates the present value of all coupon payments and the repayment of a bond's principal at a present value, based on a rate of return. This makes it possible to evaluate a bond's value against the investor's desired rate of return. The sum of each of the discounted cash flows, plus the present value of the bond's principal, determine the total value of the bond. By comparing this value to the current price of the bond, the adviser will be able to determine if the bond is an attractive investment for a client. If a bond is trading at a discount to its present value, the investor will earn more than the interest rate that has been used to calculate the present value. Conversely, a bond that is trading at a premium to its total present value will be worth less than the price of the bond. (The investor would be overpaying for the bond.)

Which of the following statements is TRUE regarding discounted cash flow? a. It is used to calculate the volatility of the market b. It is used to determine the attractiveness of an investment c. It can only be used to determine the value of common stock d. It can only be used to determine the value of a bond

b. It is used to determine the attractiveness of an investment Explanation: Discounted cash flow (DCF) analysis is a method of estimating the fair market price of an investment. If the investment is trading at a value lower than its discounted cash flow value, this would suggest it is attractive or undervalued. Research analysts use discounted cash flow analysis to determine the value of many different investment opportunities in the marketplace.

A mathematical technique that uses randomly generated scenarios, known as simulations, to determine the probability of possible returns, is known as the: a. Sharpe Ratio b. Monte Carlo Theory c. Capital Asset Pricing Model d. Random Walk Theory

b. Monte Carlo Theory Explanation: Monte Carlo is a technique which uses randomly generated scenarios, called simulations, to attempt to determine the probability of possible returns. It is one of several computer programs that has been developed recently to give investors different tools to help them manage their portfolios.

Use the following information to determine the TRUE statement. .....................................Present Value.......Market Price Project X.........................175...............................100 Project Y.........................135...............................145 a. Project X's return will exceed the discount rate. b. Project Y's return will exceed the discount rate. c. Project X's net present value is - $75. d. Project Y's net present value is + $10.

b. Project Y's return will exceed the discount rate. Explanation: An investment's net present value is the present or discounted value of the project's cash flows, less the investment's current market price (i.e., NPV = Present Value - Market Price). In this question, Project X has an NPV of +$75 (i.e., PV of $175 PV - market price of $100)). Project Y's net present value is - $10 (i.e., PV of $135 - market price of $145). If a project's net present value is positive, the project's return will exceed the discount rate that's used to calculated the present value of the project's cash flows (i.e., the discounted cash flows, or DCF). If a project's net present value is negative, the project's return will be less than the discount rate. Since the NPV on Project X is positive, its return will exceed the discount rate that was used to find its present value.

Which of the following is a measure of risk according to the Modern Portfolio Theory? a. Beta b. Standard deviation c. Correlation coefficient d. Alpha

b. Standard deviation Explanation: Under the Modern Portfolio Theory, an investment's risk can be measured by calculating its standard deviation from its expected return. Alpha is a measure of diversifiable risk, while beta is a measure of non-diversifiable risk in the Capital Asset Pricing Model.

All of the following are types of market efficiency under the Efficient Market Hypothesis, EXCEPT: a. Strong b. Systematic c. Weak d. Semi-strong

b. Systematic Explanation: The Efficient Market Hypothesis (EMH) explains three different forms -- strong, semi-strong, and weak form efficiency. EMH proposes that information which moves share prices is distributed fairly and quickly. Investors that believe that markets are efficient should invest passively (e.g., indexing) rather than actively (e.g., using technical analysis). The term "systematic" is often used to describe a category of investment risk, but it's not a form of efficient market.

Which of the following would NOT be an important consideration when conducting a capital needs assessment for a client? a. The client's future anticipated earnings b. The amount of anticipated volatility in the marketplace c. The client's life expectancy and retirement needs d. The rate of inflation

b. The amount of anticipated volatility in the marketplace Explanation: A capital needs assessment analyzes a client's future goals and needs. Retirement planning, college funding, and the risk of death before meeting a savings goal are all considered. A client's life expectancy, the rate of inflation, and her earnings will all affect the capital needs assessment. Market volatility may influence the securities on which recommendations are based, but not the capital needs assessment.

Which of the following statements BEST describes a discounted cash flow (DCF) analysis that could lead to a recommendation to a client? a. The evaluation of cash flows results in the fixed-income investment trading at a premium b. The calculation results in the present value of the future cash flows exceeding the current market value c. The calculation results in the present value of future cash flows being equal to the current market value d. The calculation provides the amount of additional income that the investor will receive from the investment

b. The calculation results in the present value of the future cash flows exceeding the current market value Explanation: Discounted cash flow (DCF) analysis is a method of estimating an appropriate price for an income-producing investment (e.g., a bond). The calculation begins by taking a bond's future cash flows (e.g., interest payments and principal) and "discounts" them back to the present value, using the present value formula. Once the calculation is done, a person can then compare his estimated value from the DCF analysis to the current market value. If the bond is currently trading for more than the DCF value, the investor is effectively required to pay more than what he thinks the bond is worth (i.e., it is overvalued). If the bond is trading for less than the DCF value, then it a good investment (i.e., it is undervalued). Undervalued bonds (those that can be purchased for less than their estimated value) represent the best investments. The reason for this is that an investor will actually be earning more than the discount rate that was used in the initial analysis. Remember, bonds do not pay more or less income based on DCF analysis. Discounted cash flow analysis is used to determine what the fixed interest payments are worth right now (i.e., in the present). DCF analysis also does not measure whether a bond is worth more or less than its par value, instead it compares an estimated value to the current market prices, which may be at a discount or premium.

Pete and Danielle are a married couple in their 20s. They both have jobs that pay well and they have begun to think about investing for retirement. Which of the following portfolio allocations would be most appropriate for them? a. 100% common stocks b. 50% bonds, 50% common stocks c. 10% bonds, 90% stock d. 80% bonds, 10% common stocks, 10% money market

c. 10% bonds, 90% stock Explanation: To amass the assets they will need at retirement, Pete and Danielle should include common stocks in their portfolio. A portfolio that is predominately bonds, will not likely produce the required long-term returns. However, a portfolio that mixes stocks and bonds is probably a better choice for the couple than one that is exclusively common stock. However, given their long time horizon (they are still in their 20s), Pete and Danielle can probably tolerate additional investment risk, so they can put the majority of their savings in stocks to increase their potential return. 10% bonds, 90% stock would be most appropriate given their goals and risk tolerance.

ABC Corporation is paying a $5 annual dividend on its preferred stock. The market price of the preferred stock is $80. The current yield is: a. 8.25% b. 7.35% c. 6.25% d. 5.00%

c. 6.25% Explanation: The current yield on common or preferred stock is found by dividing the annual dividend by the market price of the stock. In this example, the market price of the preferred stock is $80 and the annual dividend is $5. This equals a current yield of 6.25%. ($5 divided by $80 equals

Which of the following statements describes a semi-strong form efficient market? a. Market prices are rational and based on an assumption that investors will attempt to maximize their potential returns for the risk being assumed. b. All public and private information is reflected in securities prices. c. All public information, including historical data, is reflected in securities prices. d. Past market prices and data are fully reflected in securities prices.

c. All public information, including historical data, is reflected in securities prices. Explanation: The Efficient Market Hypothesis (EMH) explains three different forms -- strong, semi-strong, and weak form efficiency. In a weak form efficient market, all past prices and data are fully reflected in current prices. In a semi-strong form efficient market, all public data, including historical pricing, is reflected in current prices. In a strong form efficient market, both public and non-public (i.e., inside) information is reflected in current prices. The assumption that investors want to minimize risk and maximize returns is made in the Modern Portfolio Theory, not the Efficient Market Hypothesis.

Which of the following is a risk-adjusted return? a. Internal rate of return b. Beta c. Alpha d. Standard deviation

c. Alpha Explanation: The difference between an investment's expected return (as indicated by its hypothetical position on the Security Market Line) and its actual return is considered its alpha. An investment's alpha is also referred to as its risk-adjusted return. Some analysts believe that stocks with positive alphas represent buying opportunities, while negative alphas are signals to sell. Alpha is also used to evaluate the performance of portfolio managers. Managers whose portfolios show positive alphas are considered to be adding value with their management skills.

Which of the following is a type of unsystematic risk? a. Market risk b. Inflation risk c. Business risk d. Interest-rate risk

c. Business risk Explanation: Unsystematic or diversifiable risks are those that are unique to a certain investment or security. On the other hand, systematic or diversifiable risks are not unique to one investment and will affect all investments, although not always to the same level. Business risk is the risk that one particular company will do better or worse than expected, which will provide an investor with a higher or lower return. Business risk can be minimized by owning a diversified portfolio of stocks in many different companies. With diversification, one company's performance can be mitigated by the performance of the other stocks in a portfolio. All of the other choices will have an impact on all investments.

The S&P 500 is a(an): a. Inflation adjusted index b. Time-weighted index c. Capitalization-weighted index d. Price-weighted index

c. Capitalization-weighted index Explanation: The S&P 500 is a capitalization-weighted index. Indexes that are cap-weighted calculate their value based on the total value of the stocks, rather than the per share price. Market capitalization is determined by multiplying a company's shares outstanding x the price per share. The Dow Jones Industrial Average (DJIA) is a price-weighted index.

Which of the following metrics would allow a financial professional to calculate the fair market price of a bond? a. Debt capitalization ratio b. EBITDA c. Discounted cash flow d. Internal rate of return

c. Discounted cash flow Explanation: By comparing the discounted cash flow value to the current price of the bond, the adviser will be able to determine if the bond is overvalued, undervalued, or properly priced. If a bond is trading at a discount to its value based on the DCF, the investor will earn more than the current interest rate for comparably priced bonds. On the other hand, a bond that is trading at a premium to its DCF value will earn less than comparably priced bonds. (The investor would be overpaying for the bond.)

Analysts who base stock price valuations on calculations of the present value of estimated future dividend payments are using which of the following models? a. Dividend correlation model b. Expected return forecast model c. Dividend discount model d. Technical analysis

c. Dividend discount model Explanation: The dividend discount model attempts to evaluate what the current market value of a stock should be based on a calculation of the present value of a stock's predicted future dividend cash flows. If the actual market price is less than the calculated present value, the stock is undervalued and should be purchased. If the current market price is more than the calculated present value, the stock is overvalued.

An investment adviser is in the process of devising an asset allocation strategy for a client. The client has a short-term time horizon and may need to withdraw a substantial portion of the portfolio at any time. Investing a large portion in which of the following may be inappropriate? a. Money-market funds b. Commercial paper c. Equities d. Bonds

c. Equities Explanation: Over long periods, equities have historically provided higher returns than fixed income investments or money markets. However, short-term performance can be very unpredictable. Thus, the shorter an investor's time horizon, the less exposure she should have to equity securities.

An investor wants to know how much money he will have in 10 years if he invests $100,000 in a variable annuity today, assuming an annual average return of 6%. This investor needs to calculate the: a. Present value of money b. Dollar-weighted return c. Future value of money d. Time-weighted return

c. Future value of money Explanation: The investor is trying to determine the future value of money. He wants to know how much he will have in 10 years if he invests $100,000 today with an annual return of 6%.

Which of the following would NOT be considered an active portfolio management strategy? a. Tactical asset allocation b. Sector rotation c. Indexing d. Value investing

c. Indexing Explanation: An indexed portfolio attempts to mirror the composition of a benchmark index, such as the S&P 500 or the Russell 2000. Since buying or selling occurs only when funds are added to or withdrawn from the portfolio, transaction costs are minimized. Sector rotation refers to a strategy that attempts to time the movement of funds into different market sectors based on differences in performance in those segments. For example, an investor who anticipates that technology stocks have reached a peak, and that utility stocks will begin to advance, might move funds (rotate) from one sector to the other.

Desert Beverages has a beta of 1.3. Over the past year, Desert has returned 14% while the market as a whole has risen only 10%. A technical analyst would say that Desert Beverages has an alpha that is: a. Negative 1% b. Positive 2% c. Positive 1% d. Negative 2%

c. Positive 1% Explanation: Alpha is the amount either above or below the expected return as indicated by the beta. If a security outperforms the expected return, it is said to have a positive alpha. If it underperforms the expected return, it has a negative alpha. With the market advancing 10%, the expected return for a security with a beta of 1.3 would be 13%. Since Desert Beverages went up 14%, its actual return is 1% greater than the expected return.

Net present value is best described as: a. Cost above present value b. Market price above cost c. Present value above cost d. Cost above market price

c. Present value above cost Explanation: The net present value (NPV) of an investment is the difference between its present value and its costs (i.e., current market price). The present value of an investment is typically found by taking expected benefits (i.e., future cash flows) and discounting them by using the present value formula.

When analyzing strategic and tactical asset allocation, all of the following statements are TRUE, EXCEPT: a. Passive asset allocation requires a belief that markets are efficient. b. Unlike strategic asset allocators, tactical asset allocators believe they can time the market. c. Sector rotation is a form of strategic asset allocation, while buy-and-hold is a form of tactical asset allocation. d. Active asset allocation requires a belief that markets are inefficient.

c. Sector rotation is a form of strategic asset allocation, while buy-and-hold is a form of tactical asset allocation. Explanation: Sector rotation is a form of tactical asset allocation, not strategic, in which investors shift assets from one sector to another based on economic changes. Buy-and-hold is a form of strategic asset allocation. Strategic asset allocation is based on a client's risk tolerance and investment objectives. Strategic asset allocators tend to view the market as efficient and market-timing as expensive and ineffective. By contrast, tactical asset allocators believe that securities markets are not perfectly efficient and may try to use an active strategy to alter the portfolio's asset mix and take advantage of anticipated economic events. Tactical asset allocation uses this market timing approach in an attempt to beat the market.

When creating a portfolio for a client, an investment adviser first determines the client's investment objectives and risk tolerance. Based on this information, the adviser then constructs a portfolio containing specific percentages of uncorrelated investments. On a periodic basis thereafter, the adviser readjusts the portfolio to maintain the original investment mix. This approach is best described as: a. The prudent investor method b. Tactical asset allocation c. Strategic asset allocation d. Diversifying to manage risk

c. Strategic asset allocation Explanation: The allocation of assets into an optimal portfolio based on a client's risk tolerance and investment objectives is called strategic asset allocation. In theory, it is the best mix of assets, given the client's goals and level of risk aversion. Most strategic asset allocators also periodically rebalance the portfolio to restore the original asset mix.

According to the dividend discount model, when interest rates rise: a. The discount rate used in the model would fall, causing stock prices estimated by the model to fall b. The discount rate used in the model would fall, causing stock prices estimated by the model to rise c. The discount rate used in the model would rise, causing stock prices estimated by the model to fall d. The discount rate used in the model would rise, causing stock prices estimated by the model to rise

c. The discount rate used in the model would rise, causing stock prices estimated by the model to fall Explanation: The dividend discount model attempts to estimate the true value of stock prices by calculating the present value of future dividend payments. The model also attempts to explain the reaction of stock prices to interest-rate changes. If interest rates rise, the discount rate used in the present value calculation must be increased as well, causing the present value--the stock's hypothetical price--to decline. Falling interest rates would result in a lower discount rate and higher stock prices, as valued by the model.

An investment's discount rate is 10% and it has a positive NPV. Based on this information, which of the following is TRUE? a. The investment's rate of return is less than 10%. b. An investment's rate of return is always greater than the discount rate. c. The investment's rate of return is greater than 10%. d. The investment's rate of return is equal to 10%.

c. The investment's rate of return is greater than 10%. Explanation: The net present value (NPV) of an investment is the difference between its market price and its discounted cash flows. If the NPV of an investment is positive, it means the actual rate of return will be larger than the discount rate that's used on the cash flows. If the NPV is negative, it means the actual rate of return will be less than the discount rate that's used on the cash flows. Lastly, if the NPV is zero, it means the actual rate of return will equal the discount rate that's used on the cash flows.

Which of the following return calculations removes the distortions caused by the deposit and withdrawal of capital from an investment account over time? a. Current yield b. Dollar-weighted return c. Time-weighted return d. Expected return

c. Time-weighted return Explanation: Time-weighted returns eliminate biases caused by the inflow or outflow of investor money. It is often used to compare the performance of money managers. On the other hand, dollar-weighted returns provide a better idea of how an individual investor has done over time by eliminating the biases caused by superior performance in one year or inferior performance in another.

During the first quarter, TJG common stock paid a $.75 dividend. The stock's price fell from $75 per share at the beginning of the quarter to $67.50 per share at the end of the period. Based on these results, what is the stock's annualized total return? a. 2% b. -10% c. -9% d. -36%

d. -36% Explanation: he total return for a security is found by taking the ending value minus the beginning value plus any income. In this example, the ending value of the stock was $67.50 minus the beginning value of $75.00 plus $0.75 in dividends. Dividing this sum by the beginning value of $75.00 will equal a 9% loss for the quarter. Multiplying this by four quarters will equal an annualized loss of 36%.

An investor is in the 20% marginal tax bracket and has a yield of 10% on a portfolio. If the CPI is 5%, what's the investor's after-tax inflation-adjusted return? a. 8% b. 9.5% c. 4% d. 2.86%

d. 2.86% Explanation: The first step is to adjust the investor's yield for taxes. The formula for finding After-Tax Yield is: Nominal Yield x (100% - Tax Rate%). In this case, the investor's after-tax yield equals 8% [10% x (100% - 20%)]. The next step is to adjust the after-tax yield of 8% for inflation. The formula for finding Inflation-Adjusted Return is: [(1 + After-Tax Yield) ÷ (1 + Inflation Rate)] - 1. For this question, the inflation-adjusted return equals 2.86% [(1 + .08) ÷ (1 + .05)] - 1. An alternative method for calculating the inflation-adjusted return is: After-Tax Return - Inflation Rate, which equals 3% (8% - 5%). Obviously, this method is not as precise, but it's a more simple calculation. For exam purposes, it may be helpful to be prepared to calculate it using both methods to definitively find the correct answer. Returns that are adjusted for inflation are also referred to as "real returns."

Eight years ago, a person invested $4,000. During the eighth year, the investment had increased to $8,800, but finished the year at $8,000. What is the compounded return on investment achieved for the eight-year period? a. 8.25% b. 9.5% c. 8% d. 9%

d. 9% Explanation: The Rule of 72 can be used to find the annual return on the investment over the eight-year period. To approximate the compounded growth rate, 72 is divided by the number of years it takes for the funds to double. In this example, it took eight years for the money to double (from $4,000 to $8,000); therefore, 72 divided by 8 years equals a growth rate of 9%.

The manager of the XYZ Fund is permitted to move assets between the stock and bond markets, depending on economic conditions. Last year the manager had 70% of the fund's assets invested in stocks while only 30% in bonds. This year she has reversed the ratio. XYZ fund is most likely a(n): a. Hedge fund b. Balanced fund c. Equity income fund d. Asset allocation fund

d. Asset allocation fund Explanation: An asset allocation fund permits the manager to change investment strategies and vehicles, based on changing market/economic conditions.

Which statement best summarizes the benefits of a buy-and-hold compared with an active management strategy? a. Buy-and-hold investing attempts to profit as the economy moves from one part of the business cycle to another. b. Buy-and-hold investing focuses on investing in companies with low P/E ratios and high dividend payments. c. Buy-and-hold investing takes advantage of inefficiencies in stock prices. d. Buy-and-hold investing gives investors both lower transaction costs and lower tax liabilities.

d. Buy-and-hold investing gives investors both lower transaction costs and lower tax liabilities. Explanation: Buy-and-hold investing is a passive investment style that's appropriate for investors who believe that markets are efficient. This strategy will reduce transaction costs (i.e., no commissions), since investors will buy securities and hold them until they retire. Since investors are not going to be actively selling their securities, they don't incur any capital gains taxes until they retire. On the other hand, active management attempts to beat the market (e.g., S&P 500) by taking advantage of inefficiencies in stock market prices. Sector rotation (a type of active strategy) attempts to profit as the economy moves through the business cycle. Value investors buy stocks that have low P/E ratios and high dividend payments.

Which of the following factors is a disadvantage of a buy/hold strategy? a. Increased tax risk b. Higher management fees c. Low transaction costs d. Changing portfolio risk levels

d. Changing portfolio risk levels Explanation: While a buy/hold strategy has the advantage of minimizing capital gains taxes and transaction costs, the mix of assets can drift substantially from the original asset allocation, changing the risk levels of the portfolio. The risk level may eventually be outside the client's risk tolerance.

Melissa is listening to a group of individuals discussing trends in the current market. They are saying that they are fully invested and have no purchasing power and that they believe the market will continue to rise. Melissa, however, anticipates a market peak followed by a downturn. She is most likely a follower of which style of investing? a. The Sharpe Ratio b. The Random Walk Theory c. Momentum investing d. Contrarian investing

d. Contrarian investing Explanation: Melissa is an adherent to the contrarian style of investing. She goes against the wisdom of the majority.

Which of the following is/are affected by market risk? I. Companies II. Individual investors III. The entire market a. II and III only b. I and III only c. I only d. I, II, and III

d. I, II, and III Explanation: Market risk, also called systematic risk, refers to the risk inherent in all securities due to general market movements. Unlike the risk associated with individual securities (non-systematic risk), market risk cannot be avoided through diversification. Individual investors, companies that issue securities, and the entire market are affected by market risk.

Investors who subscribe to the Efficient Market theory, may invest in various indices. Which of the following indices is a small-cap benchmark? a. DJIA b. NASDAQ 1000 c. Nifty 50 d. Russell 2000

d. Russell 2000 Explanation: The Russell 2000 Index is comprised of 2,000 small- to mid-cap companies. The Nifty 50 and NASDAQ 1000 are not indices. The DJIA (Dow Jones Industrial Average) is a large-cap index that includes 30 of the largest publicly traded companies.

Several economic indicators show that the economy is headed into a recession. The manager of a mutual fund decides to reallocate the fund's portfolio, shifting money out of cyclical stocks and into consumer staples. This is an example of: a. Efficient Markets Theory (EMT) b. Modern Portfolio Theory (MPT) c. Risk-adjusted return d. Sector rotation

d. Sector rotation Explanation: The economy tends to follow a certain cycle--early recession, full recession, early recovery and full recovery. Investment managers who use sector rotation try to anticipate the next phase in the cycle and shift assets into industries that will benefit or outperform the market as a whole. Thus, a manager who believed that the economy was headed into a recession might shift assets out of cyclical stocks (businesses that tend to do well in good times) and instead invest in the securities of companies that make consumer staples, businesses that are recession-proof, and whose revenues tend to remain stable even when times are bad.

An investment adviser, concerned that the financial services sector is going to decline in value, rebalances his client's investment portfolios. This form of asset allocation is known as: a. Strategic asset allocation b. Market asset rebalancing c. Correlation allocation d. Tactical asset allocation

d. Tactical asset allocation Explanation: Tactical asset allocation is an active allocation strategy based on the anticipation of future trends or changes in economic events. Changes are made in the allocation of assets to take advantage of perceived events. One example is sector rotation, in which assets may be reallocated from one industry sector to another, as the business cycle changes.

When determining the risk premium on an investment, an investor would analyze the difference between: a. The mean return and dollar-weighted return b. The coupon rate of a bond and current interest rates c. The total return and annualized rate of return d. The total return and the risk-free rate of return

d. The total return and the risk-free rate of return Explanation: Total return - risk-free rate of return = risk premium. The risk premium is the amount of return earned in excess of the risk-free rate of return (i.e., the return on a T-bill).

Which of the following is generally considered the GREATEST risk when investing in a portfolio of fixed-income securities? a. Inflation or buying-power risk b. Market risk c. Liquidity risk d. Credit or default risk

a. Inflation or buying-power risk Explanation: While fixed-income securities are subject to market, credit, and liquidity risks, the greatest risk in buying and holding fixed-income securities over long periods is that their rate of return will not exceed the rate of inflation. As the rate of inflation rises, it will cause a bond's real rate of return to be less than its internal rate of return.

An investor purchased an 8% bond for $800. During the next year, the investor received the expected interest payments totaling $80. At the end of the period, the bond's market value was $900. What was the investor's total return for the period? a. 22.5% b. 8% c. 20.5% d. 10%

a. 22.5% Explanation: The total return of an investment equals the appreciation or depreciation of the investment, plus income received, divided by the investor's cost of the investment. In this question, the investor purchased an 8% bond for $800. During the year the investor received interest of $80 and the bond's market value increased by $100 ($900 - $800). Using the total return formula, the bond's total return would be 22.5% [($100 + $80) / $800].

Which of the following allocations would be the LEAST suitable for an investor with a 30-year time horizon, moderate risk tolerance, and the goal of long-term growth? a. 50% money-market funds, 50% long-term government bond funds b. 50% equity income funds, 30% small-cap funds, 10% global funds, 10% balanced funds c. 50% large-cap stock index funds, 25% small-cap funds, 25% emerging markets funds d. 75% large-cap stock funds, 25% international stock funds

a. 50% money-market funds, 50% long-term government bond funds Explanation: An investor with a long time horizon and a goal of growth should have some part of her portfolio in equity securities. An allocation with 50% money- market funds and 50% long-term government bonds is unlikely to meet this investor's goal.

A 30-year-old single mother has income of $25,000 and has put money into an equity fund for her 12-year-old son's college education. She wants to balance out the risk with a small bond investment and is hoping to avoid accessing any of this money until her son turns 18. Which of the following securities is the MOST appropriate for the mother? a. A government bond fund b. A high-yield corporate bond fund c. A 15-year zero-coupon bond d. A 15-year municipal bond

a. A government bond fund Explanation: The most appropriate choice for the mother is to invest in a government bond fund. Since U.S. government securities have no credit risk, this choice will balance out the risk of the equity fund. Additionally, the fund will offer the benefit of a diversified portfolio of government securities. Buying a zero-coupon bond is NOT appropriate. Zero-coupon bonds are a growth investment and the investor needs to diversify into something providing income and safety. Buying high-yield bond funds is too risky for a person who only makes $25,000 per year. Remember, high-yield bonds have high interest payments since the creditworthiness of the issuer is questionable.

Ann has two children, three and five. She wants to begin investing money for their college educations and consults an investment adviser representative. Which of the following would NOT be an appropriate recommendation? a. A variable life insurance policy b. A diversified common stock fund c. Opening an education IRA for each child d. Zero-coupon bonds

a. A variable life insurance policy Explanation: Life insurance is not a suitable recommendation for someone who is primarily interested in an investment.

Which of the following statements describes a strong form efficient market? a. All public and private information is reflected in securities prices. b. Market prices are rational and based on an assumption that investors will attempt to maximize their potential returns for the risk being assumed. c. Past market prices and data are fully reflected in securities prices. d. All public information, including historical data, is reflected in securities prices.

a. All public and private information is reflected in securities prices. Explanation: The Efficient Market Hypothesis (EMH) explains three different forms -- strong, semi-strong, and weak form efficiency. In a weak form efficient market, all past prices and data are fully reflected in current prices. In a semi-strong form efficient market, all public data, including historical pricing, is reflected in current prices. In a strong form efficient market, both public and non-public (i.e., inside) information is reflected in current prices. The assumption that investors want to minimize risk and maximize returns is made in the Modern Portfolio Theory, not the Efficient Market Hypothesis.

An investment adviser is evaluating the performance of three securities. The first increased in value by 3.5% over the last three months, the second appreciated by 6% in the last eight months, while the third showed a 12.5% increase in the last ten months. Which of the following is TRUE when comparing the performance of these investments? a. Annualizing the returns on each investment would allow them to be compared on a more equal footing b. The performance of these three investments cannot be compared unless they are all fixed-income securities c. The best measure of return would be the standard deviation of the returns compared to the average return d. A comparison of investment returns must be based on standard calculations described in SEC rules

a. Annualizing the returns on each investment would allow them to be compared on a more equal footing Explanation: When investments' performance information shows gross returns over different holding periods, the returns can be more easily compared by annualizing them, which means calculating the returns as if each had been held for one year.

An investor believes in the Random Walk Theory (Hypothesis). She most likely: a. Believes that the markets were too efficient to actively trade with superior results b. Would use tactical asset allocation c. Would try to time the market d. Would move her investments form one index fund to another depending on market conditions

a. Believes that the markets were too efficient to actively trade with superior results Explanation: A follower of the Random Walk Hypothesis believes that the market is too efficient to effectively trade with sustained returns exceeding the average return of the market. She would, therefore, most likely follow a buy and hold strategy, possibly in index funds. Market timing, even using index funds, is not taking a random walk approach.

The possibility that a company may perform poorly, causing its stock to decline in value is called: a. Business risk b. Market risk c. Opportunity risk d. Selection risk

a. Business risk Explanation: Business risk is the possibility that a corporation's business will not do well, causing its stock to drop in value, or even become worthless, if the company declares bankruptcy.

Which of the following terms BEST describes the process for calculating future value? a. Compounding b. Amortizing c. Annualizing d. Discounting

a. Compounding Explanation: To calculate future value, cash flows are compounded to determine the expected value at a future date. The process of compounding involves periodically reinvesting earnings on the principal. Amortization is an accounting term that's used to describe how a company recognizes certain costs/expenses over multiple years. Annualizing is a situation in which a return for a certain period is projected out over the year. Since interest is not always compounded on an annual basis, compounding is the best answer.

A project manager is evaluating a project and determines that she needs an internal rate of return of 10%. Currently, the project has a positive net present value (NPV). Based on this information, the project's estimated internal rate of return (IRR) must be: a. Greater than 10% b. Impossible to determine based on the information provided c. Equal to 10% d. Lower than 10%

a. Greater than 10% Explanation: When using the net present value calculation to determine if a project is a viable investment, a required minimum rate of return is established. In order for it to be viable, the cash contributed to the project plus the required rate of return need to be paid out of the project. If the NPV is positive, then the rate of return earned on the project is greater than required. However, if the NPV is negative, then the rate of return earned on the project is less than required.

If an investor's portfolio is comprised primarily of stocks that have high levels of retained earnings, low dividend payout ratios, and high price-to-earnings ratios, he is investing primarily in: a. Growth stocks b. Defensive stocks c. Stocks with a low beta d. A contrarian investment profile

a. Growth stocks Explanation: Growth stocks traditionally have high betas, high levels of retained earnings, low dividend payout ratios, and a high growth of earnings per share. This is the opposite of defensive stocks. A contrarian investment profile does not relate to the question. A contrarian investment profile means that a person is investing in the opposite direction of conventional wisdom. Examples of this would be investors who believed in the short interest theory or the odd-lot theory of investing.

Which TWO of the following statements are TRUE regarding a time-weighted rate of return? I. It may be used to compare the performance of two money managers. II. It is a way of calculating an investor's internal rate of return. III. It does not consider the inflows and outflows of cash. IV. It measures the average return that a client's investment earned. a. I and III b. II and IV c. I and IV d. II and III

a. I and III Explanation: Time-weighted return is used to compare the performance of two money managers. Since managers cannot control when investors either deposit or withdraw their funds, the time-weighted return does not consider inflows and outflows. Dollar-weighted return is used to calculate a client's internal rate of return and takes into account how much the client earned based on the amount of money invested.

In calculating the discount rate used to determine the discounted cash flow, which TWO choices are used? I. The Rule of 72 II. Time value of money III. Beta IV. Risk premium a. II and IV b. II and III c. I and III d. I and II

a. II and IV Explanation: The discount rate reflects the time value of money. As investors would rather have cash immediately, they must be compensated for the delay in recovering future payments. Also, the discount rate reflects a risk premium, because investors want to be compensated for the risk that the future cash flows may not be received. Beta is a measure of a stock's volatility. The Rule of 72 is used to determine how long it would take for an investment to double in value, given a rate of return, or the rate of return needed for an investment to double.

Which of the following asset management techniques would NOT be used to identify a security that is either undervalued or overvalued? a. Indexing b. Fundamental analysis c. Technical analysis d. Tactical management

a. Indexing Explanation: When a portfolio is indexed, the manager is attempting to match the performance of the market. An indexed portfolio is one with a composition that mirrors a benchmark index. Fundamental, technical, and tactical approaches all attempt to identify securities that are either overvalued or undervalued and use this information in an attempt to outperform the market.

After analyzing the financial sector, an analyst writes a report indicating that he expects a downturn in that sector. This could BEST be described as: a. Market risk b. Interest-rate risk c. Liquidity risk d. Business risk

a. Market risk Explanation: A downturn in the prices for an entire sector of the economy is a form of market risk. Business risk is the risk that one company, not an entire sector, will perform poorly.

In determining the standard deviation of a security, an analyst would look at all of the following information, EXCEPT the: a. One-year price target of the security b. Level of dispersion of prices c. Period of time to be analyzed d. Mean or average return of the security

a. One-year price target of the security Explanation: The one-year price target of a security is not relevant in determining a security's standard deviation. In computing standard deviation, an analyst looks backward rather than forward. What is important is the mean or average price over the selected period and the dispersion of prices from that mean over the selected period. The greater the standard deviation, the more variability of price exists from the mean. This indicates a higher level of price volatility and, therefore, higher risk.

Barry McKenna's equity portfolio was strongly correlated to the performance of the S&P 500 Index. Barry was concerned that the S&P was overdue for a correction, so he liquidated the portfolio and moved to short-term Treasury securities that were yielding 2%. After one year, the S&P 500 returned 8%. What is the BEST term to describe the difference in the Treasuries and the S&P 500 as it relates specifically to Barry's situation? a. Opportunity cost b. Reinvestment risk c. Interest-rate risk d. Systematic risk

a. Opportunity cost Explanation: The best choice here is opportunity cost. Opportunity cost is a term used in a variety of ways in economics. For purposes of the question, the focus here is on investment choices. Opportunity cost is the difference in return between an investment made and one that is not made. In this case, Barry invested in a Treasury and it returned 2% over the year. Barry gave up the opportunity of his old portfolio which returned 8%. In this situation, his opportunity costs are 6% (8% - 2%).

Which formula is used to perform discounted cash flow analysis for a bond? a. Present value b. Yield-to-maturity c. Future value d. Duration

a. Present value Explanation: Discounted cash flow analysis is a method for estimating the current market price of a bond, project, or business. Discounted cash flow analysis involves estimating or projecting future income (i.e., cash flows) and discounting them back to their present value using the present value formula. Duration measures a bond's risk relative to interest rates and the yield-to-maturity measures a bond's rate of return.

An investment adviser is constructing a diversified portfolio for a client. If the client requires liquidity, which of the following asset class would he least likely recommend? a. Prime real estate b. BBB rated debt securities c. Equity securities traded OTC d. Commodity option contracts

a. Prime real estate Explanation: Of the choices given, prime real estate is the least liquid asset. Commodities options are a type of investment that are included in the derivative asset class.

What does the Sharpe Ratio measure? a. Return of an asset based on the amount of risk being assumed b. The expected market price of an asset versus the actual price c. The expected return on an investment versus the actual return d. A portfolio's correlation with the market as a whole

a. Return of an asset based on the amount of risk being assumed Explanation: The Sharpe Ratio is a risk-adjusted rate of return which measures how much an investor earned on an investment compared with the risk being taken to achieve the return.

An advisory client is pessimistic and believes that the economy is about to go into a recession. He instructs his adviser to sell his holdings in housing and technology stocks and purchase utilities and consumer staples. This strategy is known as: a. Sector rotation b. Diversification c. Tax selling d. Leveraging

a. Sector rotation Explanation: Sector rotation is a strategy often used in anticipation of changes in the business cycle. If it is believed the economy is about to slow, profitable sectors to invest in would be consumer staples, or defensive stocks.

The Modern Portfolio Theory uses which of the following to measure volatility? a. Standard deviation b. Alpha c. Sharpe Ratio d. Beta

a. Standard deviation Explanation: The primary measure of volatility used in the Modern Portfolio Theory is standard deviation. Standard deviation is a statistical measures of the amount of variability or dispersion around an average. In simple terms, volatility is a reflection of the degree to which a security's price moves. A stock with a price that has wide fluctuations or moves erratically is volatile. On the other hand, a stock that maintains a relatively stable price has low volatility. Beta shows the sensitivity of a fund's, security's, or portfolio's performance in relation to the market as a whole. Alpha is considered a risk-adjusted return and represents the difference between an asset's expected return and its actual return. The Sharpe Ratio is a risk-adjusted return measurement that indicates the amount of return earned per unit of risk. The basic idea is to determine how much additional return is being received for the willingness to hold a risky asset.

Which of the following securities is most susceptible to interest-rate risk? a. T-bonds b. Common stock c. T-bills d. Commercial paper

a. T-bonds Explanation: Long-term bond prices are more sensitive to interest-rate risk than short-term bonds. For example, if an investor owns a bond with a 5% coupon and interest rates rise to 7%, he would be earning less than new investors. If the investor only needs to wait two months for his bond to mature, he will be able to invest at the higher interest rate relatively quickly. If the investor's bond has a long maturity and he must wait 20 years for his bond to mature, his disadvantage will last longer. Conversely, if interest rates fall, the long-term bond will earn more than the market interest rate for a longer period. The short-term bond will not be as valuable since the maturity comes sooner and its advantage over the market rate will not last as long.

If a portfolio manager has a diversified portfolio of large-cap stocks, it would use index options to reduce which of the following risks? a. Interest-rate risk b. Systematic risk c. Nonsystematic risk d. Timing risk

b. Systematic risk Explanation: If a portfolio manager wants to hedge a diversified stock portfolio from systematic (market) risk, it could buy puts or sell call options on the index. If the market declines as a whole, the puts would provide the best hedge by becoming more valuable and would offset the risk. In the event the overall market declines, the call options would provide only limited protection through the collection of the premium on the expiring call options.

Doug's portfolio is currently allocated in the following manner: 60% stocks, 30% bonds, and 10% cash. However, Doug believes that significant correction is imminent in the stock market since the Federal Reserve Board is going to raise interest rates. Doug decides to change his allocation to 30% stocks, 30% bonds and 40% cash. Doug's reallocation decision is an example of which of the following types of investing? a. Tactical asset allocation b. Buy-and-hold c. Strategic asset allocation d. Efficient frontier

a. Tactical asset allocation Explanation: This is an example of tactical asset allocation. Tactical asset allocation involves changing the balance in a portfolio (shifting the percentages so one asset class is more or less heavily represented) in anticipation of changing market or economic conditions. In contrast, strategic asset allocation assumes that the markets are efficient and it is impossible to time the market in this fashion.

An IAR is calculating the internal rate of return (IRR) of a client's investment. While performing the calculation, the IAR assumes that the reinvestment rate of cash flows will equal: a. The internal rate of return (IRR) b. The inflation rate c. The nominal interest rate d. The fed funds rate

a. The internal rate of return (IRR) Explanation: The internal rate of return (IRR) assumes all cash flows are invested at the internal rate of return. The IRR is the rate that makes the discounted value of cash inflows and outflows equal to zero. If an investor is choosing between two investments, she should choose the one with the higher IRR.

Currency risk is defined as: a. The possibility that changes in exchange rates will undermine the value of foreign investments for U.S. investors b. The result of an increasingly global marketplace for securities c. The possibility that a financial crisis in one region or country can spread to markets in other parts of the world d. The likelihood that another emerging market country will devalue its currency

a. The possibility that changes in exchange rates will undermine the value of foreign investments for U.S. investors Explanation: Currency risk (or exchange rate risk) is defined as the possibility that changes in exchange rates between currencies will undermine the value of foreign investments for U.S. investors.

Modern Portfolio Theory (MPT) defines risk as the: a. Variability of expected returns about the mean b. Slope of the regression line of portfolio returns versus the market c. Possibility that returns will be less than the rate of inflation d. Possibility of loss of principal

a. Variability of expected returns about the mean Explanation: In MPT, risk is defined as the degree to which investment returns deviate from what was expected or predicted. It is usually measured by the standard deviation of expected returns about the mean (δ), although its square, variance (δ2), is sometimes used.

During the first quarter of the year, XYZ common stock paid a $1 dividend, but the stock's price fell from $50 per share at the beginning of the quarter to $48 per share at the end of the period. Based on the quarterly results, what is the stock's annualized total return? a. -2% b. -8% c. 8% d. 2%

b. -8% Explanation: A security's total return takes into account the cash flow from dividends or interest, plus appreciation or minus depreciation, and divides by the original value. In this case, during the first quarter, the stock paid a $1 dividend, but its price fell by $2. To determine the quarterly return, $1 + (-$2) ÷ $50 = -2%. To annualize the return, the -2% quarterly return is multiplied by four, which equals a -8%.

If an investor was looking for an investment that provided a risk-free return, to then compute the risk-adjusted returns for a different investment, he would use the return being offered by: a. The federal funds rate b. 13-week T-bills c. AAA-rated corporate bonds d. The London Interbank Offered Rate (LIBOR)

b. 13-week T-bills Explanation: The 13-week Treasury bill yield is used as a proxy for the risk-free rate. Due to the short term to maturity, there is virtually no interest-rate risk and, since they are a direct obligation of the U.S. government, there is no credit risk.

An adviser's conservative client prefers to invest in a small number of securities without worrying about the periodic ups and downs in their value. The client also wants to reduce the cost of trading. The IA may recommend which of the following strategies? a. Dollar cost averaging b. A buy-and-hold strategy c. Portfolio turnover annually d. The use of margin

b. A buy-and-hold strategy Explanation: With a buy-and-hold strategy, the securities in the portfolio are held through both ups and downs in the market. This is suitable for a client who does not attempt to time the market, and it minimizes their costs though lower transaction costs and taxes. If the portfolio is rebalanced, e.g., annually, there may be taxes and transaction costs incurred. Dollar cost averaging is an investment strategy in which an investor's average cost for a security should be less than the average price when investing over a given period. Margin would not be suitable for a conservative client.

Which of the following descriptions BEST exemplifies using diversification to lower risk in a portfolio? a. A representative buys securities issued by federal, state, and local governments b. A representative buys equity securities in both U.S. and foreign markets c. A representative buys equity securities in large-cap companies within the same market sector d. A representative buys municipal, corporate, and U.S. government bonds

b. A representative buys equity securities in both U.S. and foreign markets Explanation: Diversification is best exemplified by purchasing investments in both U.S. and foreign markets. While all of the other choices would provide some diversification to a portfolio, buying securities from different countries would protect against the widest variety of risks.

An adviser is constructing a bond portfolio for a client whose goals are stable income and return of principal. The adviser determines that the appropriate benchmark to compare this portfolio's performance is the Wheyman Intermediate-term Government Bond Index. Which of the following statements is NOT TRUE regarding this decision? a. This portfolio should have low levels of risk to match the benchmark. b. Any returns of this portfolio that exceed the performance of the benchmark are measured by the beta of the portfolio. c. Choosing this index implies that mortgage-backed securities are not a large part of the portfolio. d. The client's goals of stable income and return of principal are not guaranteed by the choice of this benchmark.

b. Any returns of this portfolio that exceed the performance of the benchmark are measured by the beta of the portfolio. Explanation: When constructing a portfolio, an adviser typically starts by considering the securities in the benchmark and will then determine what additional securities may add value to the portfolio. The benchmark indicates not only the types of securities that should be included in the portfolio, but also the types that should be ignored. In this example, the choice of a government bond index as the benchmark for the client's portfolio is indicative of the fact that the portfolio should not include a large percentage of securities that have a high degree of risk. Since the benchmark is an intermediate-term government bond index, it is expected that it will offer a low return that is in line with the low level of risk that is typically associated with government bonds. Since a benchmark is simply a measuring stick for comparison purposes, choosing this benchmark does not guarantee that the goals will be met and it does not protect against bad investment decisions or market fluctuation. The beta of a portfolio is actually used to compare its volatility to the volatility of the market; it does not measure excess returns above a benchmark (which is measured by alpha). Another important point is that beta is not a measure to be used for fixed-income portfolios.

A retired investor has a large portfolio that consists entirely of GNMA pass-through securities held in a cash account at a broker-dealer. One of the primary risks of this portfolio is: a. Margin risk b. Asset concentration risk c. Credit risk d. Taxation risk

b. Asset concentration risk Explanation: Although Ginnie Maes are backed by the full faith and credit of the U.S. government, they are subject to a number of other risks, including interest-rate risk. In this case, the investor's exclusive concentration in Ginnie Maes produces additional risks, since a downturn in the mortgage-backed securities market would have a severe effect on this investor. Adequate diversification can reduce asset concentration risk.

A common investment strategy is dollar cost averaging. The objective of using this method of investment is the: a. Average cost of securities purchased is more than the average price of the securities purchased over a short period b. Average price of the securities purchased will be more than the average cost of the securities over a long period c. Average price of securities purchased is less than the average cost of the securities over a long period d. Average cost of the securities will be equal to the average price of the securities over a long period

b. Average price of the securities purchased will be more than the average cost of the securities over a long period Explanation: Dollar cost averaging involves investing the same amount of money, in the same securities, over a long period. The objective is that the average cost of the securities purchased should be less than the average price of the securities over that period, though a profit is not a guarantee.

Which TWO of the following types of risk cannot be mitigated by diversifying into various sectors? I. Systematic risk II. Nonsystematic risk III. Nondiversifiable risk IV. Business risk a. I and II b. I and III c. II and III d. II and IV

b. I and III Explanation: Systematic or nondiversifiable risk (market risk) is the risk associated with the entire market. The assumption is that, regardless of how many different securities an investor may hold, if the overall market declines, no amount of diversification will reduce the risk of loss. Business risk is the risk that circumstances or factors may have a negative impact on the operation or profitability of a given company. For example, a company may suffer due to increased competition, a decrease in demand for its goods or services, or adverse economic conditions.

When comparing asset allocation strategies, passive and active strategies can be characterized in which TWO ways? I. Some active strategies seek to restore the volatility of the portfolio to its original level if it deviates due to securities' price movements. II. Passive strategies are based on the premise that markets are inefficient. III. Some passive strategies seek to restore the volatility of the portfolio to its original level if it deviates due to securities' price movements. IV. Active strategies are based on the premise that markets are inefficient. a. I and III b. III and IV c. I and II d. II and III

b. III and IV Explanation: Active (tactical) asset allocation involves the belief that securities markets are not perfectly efficient may try to use an active strategy (i.e., market timing) to alter the portfolio's asset mix in an effort to take advantage of anticipated economic events. Conversely, passive (strategic) asset allocation involves buying and selling assets on a periodic basis. Through rebalancing, the intent is to restore or retain the original asset allocation—and its risk/reward characteristics.

Which of the following is NOT considered an active portfolio management strategy? a. Sector rotation b. Indexing c. Value investing d. Tactical asset allocation

b. Indexing Explanation: Investors who subscribe to the Efficient Market Hypothesis believe that market timing is ineffective. These investors usually favor passive asset allocation strategies, including buy-and-hold and market indexing strategies. Indexing involves maintaining investments in companies that are part of major stock (or bond) indexes, such as the DJIA and the S&P 500. Each of the other choices are references to active (tactical) asset allocation.

In order to better diversify a client's portfolio, an investment adviser recommends that its client invest in tangible assets, such as gold and silver. Which of the following risks is the adviser attempting to reduce? a. Business risk b. Inflation risk c. Any risks associated with the fact that the stock market may become illiquid and cause equity products to decrease in value d. Any risks associated with the fact that the expected rate of return may be in error

b. Inflation risk Explanation: When an adviser recommends that clients invest in tangible assets, such as precious metals (gold) and real estate, its general purpose is to help them hedge against inflation.

The results of discounted cash flow analysis would identify a potential purchasing opportunity when the value arrived at: a. Is lower than the current cost of the investment b. Is higher than the current cost of the investment c. Would not be effective under any circumstances d. Is equal to the current cost of the investment

b. Is higher than the current cost of the investment Explanation: When the results of a discounted cash flow calculation are higher than the market value of a potential investment, this signifies that the investment may be undervalued. This would lead to a potential purchasing opportunity.

What is the benefit of discounting the cash flows of a fixed-income security? a. It will measure the degree of price volatility that a bond will exhibit if interest rates increase b. It compares the price of a bond against the sum of the present values of the bond's future payouts c. An adviser can focus on a company's long-term growth potential and its ability to repay the bond's principal at maturity d. It provides the most accurate measurement of interest-rate fluctuations and volatility for bonds having maturities of 10 years or more

b. It compares the price of a bond against the sum of the present values of the bond's future payouts Explanation: A discounted cash flow evaluates each coupon payment and the repayment of a bond's principal at a present value, based on a rate of return. This makes it possible to evaluate a bond's value against the investor's desired rate of return. The sum of each of the discounted cash flows, plus the present value of the bond's principal, determines the total value of the bond. By comparing this value to the current price of the bond, the adviser will be able to determine if the bond is an attractive investment for a client.

An investor has a portfolio comprised of large-cap, mid-cap, and international equities. To which of the following risk is the investor LEAST exposed? a. Currency b. Money-rate c. Regulatory d. Market

b. Money-rate Explanation: In this question, the equity portfolio may be subject to business risk, regulatory risk, and currency risk. Business risk is simply the risk that a business may not be profitable or may be unable to meet its goals. Regulatory risk is based on the fact that changing laws could have a negative impact on the business. In this question, currency risk is being assumed since the portfolio consists of international equities, which may involve the need to exchange foreign currencies into U.S. dollars. However, since the portfolio consists of equities, money-rate (interest-rate) risk less likely to be a concern. Money-rate risk is more likely to be associated with bond portfolios.

Which of the following would NOT be considered an income strategy? a. One that sacrifices growth b. One that always excludes covered call writing c. One that minimizes risk while seeking steady income d. One that includes mostly bonds and preferred stocks in a portfolio

b. One that always excludes covered call writing Explanation: Eliminating covered call writing would not be appropriate for an income strategy. Writing covered calls is a conservative method of generating additional income in a portfolio. All of the other choices are consistent with an income strategy.

An investor takes money out of a money-market fund earning 5% in order to invest in an emerging growth stock fund that offers the possibility of higher returns. However, the stock fund's current yield is only 2%. The 3% difference in yields between the stock fund and the money-market fund is the investor's: a. Capital loss b. Opportunity risk c. Expected return d. Spread

b. Opportunity risk Explanation: Opportunity risk (cost) is what an investor forgoes by not taking an alternative course of action. In this situation, the investor is forgoing a 3% higher yield for the possibility of greater capital appreciation.

Which of the following statements describes a weak form efficient market? a. All public information, including historical data, is reflected in securities prices. b. Past market prices and data are fully reflected in securities prices. c. All public and private information is reflected in securities prices. d. Market prices are rational and based on an assumption that investors will attempt to maximize their potential returns for the risk being assumed.

b. Past market prices and data are fully reflected in securities prices. Explanation: The Efficient Market Hypothesis (EMH) explains three different forms -- strong, semi-strong, and weak form efficiency. In a weak form efficient market, all past prices and data are fully reflected in current prices. In a semi-strong form efficient market, all public data, including historical pricing, is reflected in current prices. In a strong form efficient market, both public and non-public (i.e., inside) information is reflected in current prices. The assumption that investors want to minimize risk and maximize returns is made in the Modern Portfolio Theory, not the Efficient Market Hypothesis.

All of the following statements regarding the Capital Asset Pricing Model (CAPM) are TRUE, EXCEPT it: a. Provides a mechanism to assess risk and return b. Predicts future values for the stock c. Was developed to explain the behavior of security prices d. Is based on the efficient market theory and assumes all investors act rationally

b. Predicts future values for the stock Explanation: CAPM does not establish a price objective for the stock. All of the other statements regarding this theory are true.

A client is in the 35% tax bracket. She has three children, ages 8, 12, and 16 and would like to invest in a 529 plan for the two oldest children. The client has $20,000 that she can invest in each account. If she anticipates her children will enter college at age 19, and will need $75,000 each for their college expenses over four years, an adviser would determine the future value of each account by inputting all of the following factors, EXCEPT the: a. Expected rate of interest b. Rate of inflation c. Principal amount invested d. Number of compounding periods

b. Rate of inflation Explanation: The inflation rate is not a factor in the calculation of the future value of an investment. Future value calculation: Pn = P0(1 + r)n Pn = Future Value n = Number of compounding periods r = Rate of Interest P0 = Original Principal

Which of the following metrics represents the basic measure of risk in Modern Portfolio Theory (MPT)? a. Alpha b. Standard deviation c. Correlation coefficient d. Beta

b. Standard deviation Explanation: In MPT, the standard deviation of an investment's expected return is used as the basic measure of risk. Standard deviation measures the degree of dispersion or variability of returns from the mean return. The greater the standard deviation a portfolio has, the greater the risk it will have.

An investor is concerned about investments that do not match her social values. Which of the following securities is the investor LEAST likely to purchase? a. Preferred shares of a pharmaceutical company b. Stock of an oil refining company c. Options on a stock of a company that manufactures wind turbines d. Bonds of a company that produces solar panels

b. Stock of an oil refining company Explanation: Investors that invest in a socially responsible way are typically concerned with civil and human rights, as well as the environment. In general, these investors stay away from, oil and gas companies and defense and weapons companies. Socially conscious investors tend to pick stocks and bonds of companies that provide green energy and use alternatives to fossil fuels (e.g., solar and wind).

Warren is a growth-oriented investor who is bullish on the long-term prospects of the U.S. stock market. He has diversified his portfolio in the following ways: individual stocks from various sectors, an S&P 500 Index fund, an aggressive growth fund, a fund of funds, and a variable annuity where he has invested in mid- and large-cap stock portfolios. What type of risk is his portfolio MOST subject to? a. Inflation risk b. Systematic risk c. Capital risk d. Business risk

b. Systematic risk Explanation: Systematic risk is market risk. This is the risk that a decline in the overall market will cause a similar decline in an individual's portfolio. Systematic risk cannot be diversified away. Warren owns many kinds of stocks, in many different market segments and sectors. However, if the overall market declines, Warren's portfolio will be affected. Many of the stocks he owns may also subject Warren to business risk and capital risk. But the overriding concern in this portfolio is a general market decline taking Warren's portfolio with it. As an adviser, you might suggest that Warren consider investing some of his portfolio in bonds and other investments outside of the stock market.

What's the formula for calculating total return? a. Coupon Rate - Inflation Rate b. (Return on Investments - Risk Free Rate)/Standard Deviation c. (Ending Value - Starting Value + Investment Income)/Starting Value d. Risk Free Rate + Beta(Return on Market - Risk Free Rate)

c. (Ending Value - Starting Value + Investment Income)/Starting Value Explanation: Total return measures an investor's return over his entire holding period. Total return incorporates capital gains or losses, adds investment income (e.g., dividends or interest) and then divides by the original investment.

An investment adviser determined that XYZ stock has the following potential future returns. There is a 25% chance that in a bull market, XYZ stock will return 20%. In a flat market (50% probability), the return should be 5%. The likelihood of a bear market is 25%, and expected returns would be a loss of 10%. What is the expected return for XYZ stock? a. 20% b. 15% c. 5% d. 10%

c. 5% Explanation: According to modern portfolio theory, the expected return is the sum of the weighted average of an investment's return. To find each weighted return, multiply the return by the likelihood of that return. For XYZ stock, the expected return is as follows: 20%x25%=5% 5%x50%=2.5% (10%)x25%=(2.5%) Expected return = 5% or (5% + 2.5% - 2.5%)

The annual percentage returns on ABC over the last 10 years have been: 7, 8, -9, 8, -4, 5, 6, 8, 10, and 12. What is the arithmetic mean? a. 7.5 b. 8 c. 5.1 d. -9 to 12

c. 5.1 Explanation: The arithmetic mean or average is found by taking the sum of the given set of data and dividing by the size of the data set. The sum of the data set would be 51, (7 + 8 + (-9) + 8 + (-4) + 5 + 6 + 8 + 10 + 12 = 51). Since the size of the data set is 10, divide 51 by 10 and the result will be a 5.1 arithmetic mean.

The annual percentage returns on ABC over the last 9 years have been: 7, -6, -3, 8, 6, 5, 11, 13 and 8. What is the median return? a. 5.4 b. 8 c. 7 d. 19

c. 7 Explanation: The median percentage return is the center point—the point on a data set where there are the same number of points above as below. In this question the median is 7. There are 4 points below (-6, -3, 5, and 6) and 4 points above (8, 8, 11, and 13). 5.4 is the mean or average of the data set. Since 8 appears more often than any other number in the data set, 8 would be the mode. 19 is the range or the difference between the lowest number and the highest number.

Which of the following securities would likely have the highest beta coefficient? a. A zero-coupon, 10-year U.S. Treasury bond b. A zero-coupon, 30-year U.S. Treasury bond c. A biotechnology company's common stock d. An electric utility company's common stock

c. A biotechnology company's common stock Explanation: Beta is a measurement of a security's volatility as compared to an index such as the S&P 500 Stock Index. A high beta (greater than one) indicates that a company is more volatile than the benchmark index. Utilities and other defensive industry stocks tend to have low betas.

If a portfolio manager is rebalancing a client's assets on a quarterly basis, this would be considered: a. Churning b. A tactical asset allocation strategy c. A strategic asset allocation strategy d. Too aggressive

c. A strategic asset allocation strategy Explanation: A strategic asset allocation strategy may include the periodic rebalancing of the portfolio on a monthly, quarterly or annual basis in order to keep the original asset allocation intact. A tactical asset allocation strategy is more dynamic and attempts to exploit inefficiencies in the markets by rebalancing the portfolio frequently in response to changes in economic and market conditions.

All the following are characteristics of passive asset allocation strategies, EXCEPT: a. Rebalancing of a portfolio when risk levels exceed the investor's preferences b. Minimal annual tax liabilities c. Altering a portfolio in anticipation of an economic event d. Low transaction costs

c. Altering a portfolio in anticipation of an economic event Explanation: A passive asset allocation strategy (e.g., buy and hold) is characterized by low transaction costs and minimal tax consequences. Systematic rebalancing, another passive strategy, alters the portfolio on a monthly, quarterly, or annual basis to restore an original strategic asset allocation if market movements have changed it. On the other hand, active (tactical) asset allocation strategies effect changes to a portfolio's allocation in anticipation of economic events.

A client would like to invest $250 a month and have broad exposure to the U.S. equity market. Which of the following recommendations would be most suitable? a. A DJIA exchange-traded fund b. An S&P 500 Index exchange-traded fund c. An S&P 500 Index mutual fund d. A managed closed-end fund

c. An S&P 500 Index mutual fund Explanation: Although all these investments would be suitable for a client seeking broad exposure to the U.S. equity market, the mutual fund would be the most cost-effective method for an investor who has $250 a month to invest to accomplish this goal. The closed-end fund and ETFs are purchased on an exchange, and the client pays the current market price plus a commission. Most index mutual funds do not charge the client a sales charge, (i.e., they are no-load). If the investor were purchasing a large dollar amount at one time, any of these funds might be appropriate.

An investor who believes in the Efficient Market Hypothesis most likely: a. Would try to time the market b. Would move her investments from one index fund to another depending on market conditions c. Believes that the markets were too efficient to actively trade with superior results d. Would use tactical asset allocation

c. Believes that the markets were too efficient to actively trade with superior results Explanation: A follower of the Efficient Market Hypothesis believes that the market is too efficient to effectively trade with sustained returns exceeding the average return of the market. She would, therefore, most likely follow a buy and hold strategy, possibly in index funds. Market timing, even with index funds, is not a way to follow the Efficient Market Hypothesis.

Frank is in a high tax bracket. He is presently setting up an investment program to provide for his retirement in approximately 30 years. Frank has informed his investment adviser that his major concern is inflation and that, over this 30-year period, inflation will depress the purchasing power of his assets, preventing Frank from continuing the lifestyle he hopes to enjoy. The most appropriate investment recommendation would be: a. High-yield preferred stock b. Fixed annuities c. Common stock d. Municipal bonds

c. Common stock Explanation: Fixed annuities primarily invest in U.S. government-issued debt and investment-grade corporate bonds. These are debt instruments, which have historically performed poorly in an inflationary environment. An investment in municipal bonds would give the investor tax-free interest, but not the inflation protection that the client is seeking. Although preferred stock is an equity instrument, it will perform similarly to debt instruments, due to the payment of a fixed dividend. Investments in common stock have, over long periods, historically outperformed the inflation rate and have provided investors with a better inflation-adjusted rate of return than interest-rate-sensitive instruments.

What is the name of the process by which an investor calculates the sum of the present values of projected cash flows to determine the fair market value of an investment? a. Net present value b. CAPM c. Discounted cash flows d. IRR

c. Discounted cash flows Explanation: When an investor takes an investment's future cash flows (e.g., dividends or interest payments) and calculates their present value, she is using discounted cash flow analysis. The process is referred to as discounting since the present value formula takes the future value and divides by the time value of money term, i.e., (1+r)^t. Net present value takes the process a step further by subtracting the actual market price of an investment by the fair market value that is found in the discounted cash flow analysis.

Paul and Mary Smith have discussed various portfolio allocations with their adviser Chuck. He has considered the Smiths' risk tolerance and expected return in order to recommend an efficient portfolio, that is, one in which the portfolio offers the: a. Average of expected returns for the lowest level of risk b. Greatest return based on the average Beta of each stock in relation to the total return c. Highest expected return for the lowest level of risk d. Lowest of expected returns based on its Beta for the least amount of investment

c. Highest expected return for the lowest level of risk Explanation: A portfolio that has a maximum expected return for any level of risk, or a minimum level of risk for any expected return is known as an efficient portfolio.

Which of the following statements is FALSE regarding discounted cash flow methods used to evaluate an investment? a. Discounted cash flow calculations consider cash inflows, outflows, and the time value of money b. Net present value is a discounted cash flow method c. Holding period return is a discounted cash flow method d. Internal rate of return is a discounted cash flow method

c. Holding period return is a discounted cash flow method Explanation: Holding period return does not discount or compound cash flows. Holding period return is calculated by adding any income, plus capital gains, minus capital losses, and dividing by the value of the initial investment.

If a security has a low beta, it will: I. Underperform the market when prices rise II. Underperform the market when prices fall III. Outperform the market when prices rise IV. Outperform the market when prices fall a. II and III b. I and III c. I and IV d. II and IV

c. I and IV Explanation: Beta measures a security's volatility in relation to the market. A stock with a low beta (less than 1) would be less sensitive to market movements. In a rising market, a low-beta security would lag in performance. However, when prices are declining, this security would do better as it would generally fall less than the market. A stock with a high beta (greater than 1) would be more sensitive to market movements. A high-beta stock would rise and fall faster than the overall market.

If an investment increases in value, which of the following statements would be TRUE? a. If it was held for less than one year, the holding period rate of return would be greater than the annualized return b. If held for more than one year, the holding period return would be less than the annualized return c. If it was held for less than one year, the annualized rate of return would be greater than the holding period return d. Regardless of the actual holding period, the holding period and annualized return are always identical

c. If it was held for less than one year, the annualized rate of return would be greater than the holding period return Explanation: The holding period rate of return states how much an investor earns over the period an investment is held. The annualized rate of return states how much an investor makes over a one-year period. If an investor had a 5% rate of return over six months, her holding period rate of return would be 5%; however, her annualized rate of return would be 10% (the 5% return earned over the six-month period multiplied by two). If the holding period had been more than one year, the opposite would be true--the holding period return would be larger than the annualized rate of return.

An investor purchased an A-rated corporate bond with a coupon of 5%. After one year, the total return is 3.50%. The most likely reason for this is: a. The credit rating of the bond was raised, lowering the yield of the bond b. The investor's payment of accrued interest at the time of purchase has lowered his effective return c. Interest rates have gone up d. Interest rates in the market dropped to 3.50% for A-rated issues

c. Interest rates have gone up Explanation: Total return on a bond equals interest received plus appreciation, or minus depreciation in value, divided by the investor's cost for the investment. If a customer purchased a 5% bond at par and sold the bond one year later for $985, he received $50 in interest, but the investment had declined in value by $15. The total return would be $50 minus $15, divided by the cost, which equals 3.50% ([$50 - $15] / $1,000).

A dollar-weighted return is also referred to as: a. Inflation-adjusted or real rate of return b. Time-weighted return c. Internal rate of return d. Total or holding period return

c. Internal rate of return Explanation: A dollar-weighted returns is the same as the internal rate of return (IRR). It represents the discount rate that will make the present value of future cash flows (i.e., interest payments and principal) equal to the current market price (i.e., current value).

Which of the following statements is accurate regarding dollar cost averaging? a. If employed, the average price will be less than the average cost b. It can only be set up through a payroll deduction plan c. It is a systematic, fixed-dollar method of investing d. The benefits can be obtained if one invests in a money-market fund

c. It is a systematic, fixed-dollar method of investing Explanation: Dollar cost averaging is a systematic approach in which an investor periodically contributes a constant dollar amount over a fixed period. Buying more shares when prices are low and fewer when prices are high results in the average cost of the securities purchased being less than the average of the prices paid (not the other way around). The benefits, lower cost than the average price, are only obtained when the value of the asset fluctuates and the investor buys more shares.

All of the following statements regarding discounted cash flow are NOT TRUE, EXCEPT: a. It can only be used to determine the value of common stock b. It is used to calculate the volatility of the market c. It is used to determine the attractiveness of an investment d. It can only be used to determine the value of a bond

c. It is used to determine the attractiveness of an investment Explanation: Discounted cash flow (DCF) analysis is a method of estimating the fair market price of an investment. If the investment is trading at a value lower than its discounted cash flow value, this would suggest it is attractive or undervalued. Research analysts use discounted cash flow analysis to determine the value of many different investment opportunities in the marketplace.

According to modern portfolio theory, a diversified portfolio should be comprised of assets that are: a. Alternative investments b. Optimally efficient c. Largely uncorrelated d. Highly liquid

c. Largely uncorrelated Explanation: Ideally, a diversified portfolio should be composed of assets that are largely uncorrelated--i.e., do not move in the same direction.

According to Modern Portfolio Theory, the expected return of an investment is the: a. Standard deviation of gains and losses over the life of the investment b. Income, including dividends and/or interest, that is more than 50% likely to be paid by the issuer in the next year c. Possible returns on the investment weighted by the likelihood that returns will occur d. Income, such as bond interest, that has been guaranteed by the issuer

c. Possible returns on the investment weighted by the likelihood that returns will occur Explanation: Modern Portfolio Theory (MPT) defines the expected return of an investment as the possible returns on the investment weighted by the likelihood that returns will occur.

You are the portfolio manager for Home Fund, Inc., a mortgage-backed securities mutual fund. Which type of risk concerns you in a falling-interest-rate environment? a. Credit risk b. Political risk c. Prepayment risk d. Homeowner's risk

c. Prepayment risk Explanation: Like most debt instruments, mortgage-backed securities (MBSs) are subject to interest-rate risk, the risk that the security's value will fall as interest rates rise. However, MBSs are also subject to risk when interest rates fall. Falling rates cause an increase in prepayments on the underlying mortgages, and this money must be reinvested in new, lower-coupon securities. This is known as prepayment risk. Mortgage-backed securities, and the funds that invest in them, tend to perform best when interest rates are stable.

A person who considers herself a contrarian investor would follow the: a. Random walk hypothesis b. Tactical allocation of funds c. Short interest theory d. Strategic allocation of funds

c. Short interest theory Explanation: In a contrarian investment style, investments are made in the opposite direction of conventional wisdom. The short interest theory proposes that when open short interest (uncovered short sales) increases, it is a bullish indicator. The short sellers will have depressed the price of the stock and at some point they must all reenter the market as buyers, causing the price of the stock to rise.

An investor who believes in the inherent efficiency of the markets would be least likely to adopt which of the following strategies? a. Strategic asset allocation b. Fundamental analysis c. Tactical asset allocation d. Indexing

c. Tactical asset allocation Explanation: Tactical asset allocation is a form of asset allocation that is based on the belief that markets are NOT efficient and that market timing can be beneficial (i.e., altering a portfolio to take advantage of changing economic conditions). For example, an investor who believes that interest rates are going to rise soon might reduce the number of fixed-income securities in his portfolio. (An increase in interest rates will cause existing bond prices to decrease.) A person who believes that the markets are inherently efficient (the efficient market hypothesis) is unlikely to engage in a market timing strategy. Instead, this type of investor is more likely to use a passive approach to investing, such as strategic asset allocation or indexing. Some proponents of the efficient market hypothesis do believe that fundamental analysis can be a useful tool in identifying investments that will outperform the market.

An advisory firm is evaluating an investment opportunity for a client. Current projections show that the net present value (NPV) is equal to zero and the client requires an internal rate of return of 6%. Based on this given information, what is the investment's internal rate of return (IRR)? a. The IRR is less than 6% b. The IRR is 0% c. The IRR is equal to 6% d. The IRR is greater than 6%

c. The IRR is equal to 6% Explanation: When using net present value (NPV) to evaluate a project, the value of the cash inflow is compared to the cash outflows returned by the project. If the NPV is zero, then the project is assumed to return all of the cash inflow plus the required rate of return.

An investor purchases a newly issued 8% Treasury bond at par but earns only a 6% total return over the next year. Which of the following is the MOST likely explanation for this? a. The bond was called by the Treasury b. The Treasury missed an interest payment c. The market value of the bond declined by 2% d. The purchaser did not reinvest the coupon payments

c. The market value of the bond declined by 2% Explanation: The total return from a security includes the cash flow from dividends or interest (yield), plus appreciation (growth) or minus depreciation (loss). If the total return was 6% and the interest return was 8% of the value at the beginning of the period, the value of the bond must have declined by 2% during the period. (8% + (-2%) = 6%.) The Treasuries that are callable are callable only in the last five years prior to maturity. U.S. government securities are the benchmark for credit quality.

An individual decides that he would like to adopt the Contrarian style of investing in his portfolio. Which of the following beliefs is NOT currently held by the investor? a. The companies that would be the focus of this investment approach tend to be less vulnerable to price declines in a bear market b. There is a greater opportunity for success by trading against market trends c. The most appropriate equities for this strategy are well-known companies with high P/E ratios d. This investment strategy seeks out well-financed, mature companies that are undervalued by the market for the wrong reasons

c. The most appropriate equities for this strategy are well-known companies with high P/E ratios Explanation: The Contrarian style of investing is one that bets against market trends and does not adhere to the prevailing consensus opinion. This particular investment style usually focuses on companies that are out of the mainstream and that have low P/E ratios.

In general, emerging markets differ from developed markets in all the following ways, EXCEPT: a. They are often not fully industrialized b. Their securities markets are primitive or nonexistent c. Their companies have low dividend payout ratios d. They have lower per capita incomes

c. Their companies have low dividend payout ratios Explanation: Emerging markets are markets that are just beginning to develop. They are typically characterized by primitive capital markets, underdeveloped industry, and relatively low personal income levels. There is strong growth potential in such markets but also above average risk factors.

You are interviewing prospective clients, Jack and Jill. They tell you they have approximately $10,000 to invest and would like to earn the type of returns that equity investments exhibit over the long term. However, they do not want their portfolio to be as volatile as the stock market. What would you tell them? a. They should purchase a long-term U.S. Treasury mutual fund instead of a stock fund b. They should invest in a variable annuity, since it is issued by an insurance company c. They cannot expect to earn the type of returns that equities produce over the long term without assuming a corresponding amount of risk d. Your firm is a member of SIPC, which will insure their account

c. They cannot expect to earn the type of returns that equities produce over the long term without assuming a corresponding amount of risk Explanation: One of the basic principles of investing is that risk and return are closely related. Historically, equities such as common stock have shown long-term returns of approximately 10% per year. However, the year-to-year variation in stock performance can be significant. Investments that are less volatile than stocks cannot be expected to produce the same returns over the long haul.

Your client has an annual income exceeding $250,000. He tells you that he wishes to retire in 18 years with a lump sum of at least $5,000,000. You tell him he can invest in zero-coupon municipal bonds that have a yield of 4%. If the client buys 5,000 bonds now, how much will he pay for each bond to achieve a yield of 4%? a. $125 b. $600 c. $250 d. $500

d. $500 Explanation: The rule of 72 is a shorthand method of determining how many years it will take an investor's money to double given a fixed rate of interest. If you divide 72 by the rate of interest, this approximates the number of years it will take for the money to double. At 4%, the money would double approximately every 18 years. This means the investor would need to invest $2,500,000 to have $5,000,000 in 18 years. $5 million dollars of bonds is equal to 5,000 bonds at a par value of $1,000. $2,500,000 divided by 5,000 equals $500.

A customer invested $25,000. After 20 years the investment is now valued at $100,000. How many years did it take to double in value? a. 5 b. 4 c. 7 d. 10

d. 10 Explanation: The $25,000 investment doubled twice, from $25,000 to $50,000, then to $100,000, over 20 years, or it doubled every 10 years.

An adviser is asked by her client the following question. "If I invest $50,000 today and it grows at an annual rate of 6%, how long will it take for me to reach $100,000?" The adviser replies: a. 8 years b. 5 years c. 14 years d. 12 years

d. 12 years Explanation: A quick way to determine how long it will take for funds to double is to use the Rule of 72. If we divide 72 by the annual growth rate, it will give us the number of years it would take for funds to double. 72 divided by 6 equals 12. It would take 12 years for $50,000 to grow to $100,000 at an annual growth rate of 6%.

A portfolio contains fixed-income instruments and common stock. At the beginning, the value of the portfolio was $240,000. Over the next two years, the portfolio received a total of $20,000 in interest and dividends. At the end of the second year, the portfolio was valued at $280,000. What is the annualized yield on the portfolio? a. 25% b. 16.60% c. 8.30% d. 12.50%

d. 12.50% Explanation: The formula for calculating total return is: ((Ending Value - Beginning Value) + Income) / Beginning Value In this question, the gain is $40,000 ($280,000 - $240,000) and the income is $20,000, for a total of $60,000. The $60,000 is then divided by the starting value of $240,000, which equals a total return of 25%. However, the 25% return is for two years of investing. Since the question is asking for the annualized return, the 25% return must be divided by the two years that the portfolio was invested, which equals an annualized return of 12.5%.

An investor buys a two-year U.S. Treasury note that has a 6% coupon. If the note is purchased at par and held to maturity, what is the real rate of return over the holding period, assuming the CPI is 3%? a. 6.3% b. 6% c. 3.3% d. 3%

d. 3% Explanation: An investor buys a two-year U.S. Treasury note that has a 6% coupon. If the note is purchased at par and held to maturity, what is the real rate of return over the holding period, assuming the CPI is 3%?

Which of the following yields results in the highest inflation-adjusted rate of return? a. A bond yields 6% when inflation is at 4%. b. A bond yields 12% when inflation is at 8%. c. A bond yields 10% when inflation is at 7%. d. A bond yields 8% when inflation is at 3%.

d. A bond yields 8% when inflation is at 3%. Explanation: The inflation-adjusted rate of return, also called the real interest rate, refers to yields adjusted for inflation (yield minus inflation rate). The highest inflation-adjusted rate of return is 5% (8% bond yield - 3% inflation rate = 5% real interest rate).

Which of the following is addressed in behavioral finance? a. An investor making large and sudden withdrawals b. Predicating market trends using historical pricing patterns c. The efficient distribution of information in stock prices d. An aversion to losses

d. An aversion to losses Explanation: Behavioral finance, which is a sub-category of behavioral economics, uses psychological biases to explain the behavior of individuals and markets. Unlike traditional financial theory, behavioral finance doesn't assume that all investors are rational. Some of the topics behavioral finance addresses include loss avoidance, confirmation bias, disposition bias, recency bias, and self-attribution. The Efficient Market Hypothesis (EMH) assumes that stock prices reflect all information and assumes that investors behave rationally. Predicting market trends on historical data is referred to as "technical analysis." While an investor making large withdrawals is not rational, it doesn't reflect a specific psychological bias that's covered in behavioral finance.

The original asset allocation of an investment portfolio was 10% cash, 40% bonds, and 50% stocks. A recent bear market, however, has altered this allocation to 10% cash, 50% bonds, and 40% stocks. The client's investment objectives and risk tolerance have not changed. The adviser recommends that the portfolio be systematically rebalanced by selling: a. Stocks and buying bonds with the proceeds b. Stocks and bonds and placing the proceeds in cash until market conditions stabilize c. Stocks and bonds and allocating 10% of the portfolio to alternative investments d. Bonds and buying stocks with the proceeds

d. Bonds and buying stocks with the proceeds Explanation: Systematic rebalancing is the process of buying and selling securities within a portfolio to restore its original asset allocation. Systematic rebalancing may be done either periodically (annually, quarterly, or monthly) or whenever market forces or different rates of return cause a significant change in the original asset allocation. In this case, a bear market has caused the value of the stocks in the portfolio to shrink so that this asset class now represents only 40% of the total portfolio. The adviser would rebalance the portfolio by selling bonds and buying stocks with the proceeds.

Which of the following is a type of non-systematic risk? a. Inflation risk b. Interest rate risk c. Market risk d. Business risk

d. Business risk Explanation: Business risk, a form of non-systematic risk, is the risk that a single company may lose its competitive advantage resulting in lower sales, corporate losses, and/or bankruptcy. Diversification is a method that may be used to protect investors from business risk.

Which TWO of the following choices are not considered an asset class? I. Annuities II. Stocks III. Cash IV. The S&P 500 Index V. Real estate a. I and III b. III and V c. II and V d. I and IV

d. I and IV Explanation: Asset classes include stocks, bonds, cash (money-market instruments), commodities, and real estate, but not annuities or indexes.

A company's stock experiences wild fluctuations due to unsubstantiated rumors about its products. After further analysis, the company's earnings and sales are better than average. The wild price swings may be described as: a. Market risk b. Interest-rate risk c. Liquidity risk d. Business risk

d. Business risk Explanation: Since the rumors are limited to the products of one specific company, this is an example of business risk. If the rumors affected the market as a whole, it would be an example of market risk. Additionally, an investor has the ability to diversify away from the risk these rumors present by purchasing stocks of several companies. The ability to diversify is a key component in handling business or unsystematic risk.

An investment adviser rebalances a client's portfolio by liquidating a single stock position and investing the proceeds into an index fund. Which of the following risks did the adviser reduce the MOST? a. Liquidity risk b. Inflation risk c. Market risk d. Business risk

d. Business risk Explanation: The best answer is business risk. By diversifying the client's assets from one company's stock into a basket of stocks (index), the risk associated with that single company's profits declining has been reduced.

Currently, many economic indicators are pointing to an imminent decline in the market. If an investor chooses to ignore the negative sentiment and increases her investment positions, she is using what style of investing? a. Market timing b. Bottom up c. Sector rotation d. Contrarian

d. Contrarian Explanation: An investor who uses the contrarian style of investing is going against market trends and conventional wisdom. Many contrarians search for stocks that are out of favor and have low P/Es.

Which of the following metrics is the MOST important when attempting to diversify a stock portfolio? a. Weighted average b. Standard deviation c. Asset allocation d. Correlation

d. Correlation Explanation: Correlation measures the degree to which two securities move in relation to each other. The greatest diversification benefit is found when a security is negatively correlated. Asset allocation is incorrect since the question relates to diversifying a stock portfolio. Asset allocation involves the process of building a portfolio that consists of multiple asset classes (e.g., stocks, bonds, cash equivalents, real estate).

If an investor's portfolio is comprised primarily of stocks that have low levels of retained earnings, high dividend payout ratios, and low price-to-earnings ratios, he is investing primarily in: a. Turn around situations b. Stocks with high standard deviations c. Growth stocks d. Defensive stocks

d. Defensive stocks Explanation: Defensive stocks traditionally have low betas, low levels of retained earnings, high dividend payout ratios, and a low growth of earnings per share. These attributes are opposite to those expected in growth stocks.

Under the Capital Asset Pricing Model, risk is defined as: a. Failure to accomplish the client's objective b. Loss of principal c. Loss of interest d. Deviation in returns

d. Deviation in returns Explanation: The Capital Asset Pricing Model (CAPM) measures risk using beta to measure systematic risk and alpha to measure nonsystematic risk. Risk is the variance in expected return, not the loss of client funds or failure to meet an objective.

An investor has a long-term goal of saving for his daughter's college education in 15 years. He is planning on investing regularly over the next several years in the Pluto Growth Fund to attain that goal. The investor acknowledges that he has not had much success picking individual stocks or predicting the market. Which of the following investment strategies might be MOST appropriate under these circumstances? a. Systematic rebalancing b. A market timing approach c. Buy and hold d. Dollar cost averaging

d. Dollar cost averaging Explanation: This investor seems to believe a market timing approach will not work for him. Since he intends to invest regularly over several years, a dollar-cost-averaging approach would probably be most appropriate. A buy-and-hold approach assumes the investor has a lump sum to invest up front. Systematic rebalancing is, by definition, an asset allocation approach. It would involve spreading funds over several asset classes, whereas this investor has chosen only one class, equities, to fund his investment program.

Which of the following terms relates to the graph of optimal portfolios resulting from a comparison of risk and return? a. Duration b. CAPM c. Alpha d. Efficient frontier

d. Efficient frontier Explanation: According to modern portfolio theory, a graph of optimal portfolios may be created known as an efficient frontier.

A client who is willing to accept market risk should be advised to accept which of the following investment recommendations? a. Creating an emergency fund that is separate from his portfolio and consists of U.S. Treasury bonds b. Buying insurance contracts that would protect him against market losses c. Creating a portfolio with a beta that is less than 1.0 d. Eliminating the unsystematic or diversifiable risk in his portfolio

d. Eliminating the unsystematic or diversifiable risk in his portfolio Explanation: Since the customer is willing to assume market risk, the best course of action is to eliminate unsystematic risk. All of the other choices are inappropriate since they either avoid or eliminate the market risk that the customer is willing to accept. Beta is the measure of the volatility of an asset/portfolio as compared to the volatility of the market. Generally, assets with a beta higher than 1 are more volatile than the market, while assets with a beta lower than 1 are less volatile than the market.

If an investor were to purchase several general obligation and revenue bonds issued by the state of New York, the investor could have diversification in all of the following, EXCEPT: a. Quality b. Maturity c. Purpose d. Geography

d. Geography Explanation: There would be no geographical diversification for the customer.

Which TWO of the following factors are used in a discounted cash flow (DCF) analysis? I. Present value of future cash flows II. Expected rate of return earned on reinvested cash flows III. Future value of current cash flows IV. Expected risk-free rate of return over the life of the investment a. II and IV b. I and III c. II and III d. I and II

d. I and II Explanation: Discounted cash flow analysis uses the present value formula and applies it to an investment with multiple future cash flows (e.g., the interest and principal payments of a bond). In order to find the present value of a single cash flow, an investor needs the future cash flows, an expected rate of return (i.e., discount rate), and the number of years until the future cash flow will be received. The risk free-rate of return is used in the Capital Asset Pricing Model (CAPM) formula and is generally not required when performing a discounted cash flow analysis.

Which of the following are TRUE regarding a comparison of strategic versus tactical asset allocation? I. Strategic asset allocation focuses on the client's investment objectives and risk tolerance, while tactical asset allocation focuses on economic and market conditions. II. Strategic asset allocation has a long-term outlook, while tactical asset allocation encompasses short-term decisions. III. Unlike strategic asset allocators, tactical asset allocators believe that investors can time the market. a. II and III only b. I and III only c. I and II only d. I, II, and III

d. I, II, and III Explanation: Asset allocation based on a client's risk tolerance and investment objectives is called strategic asset allocation. In theory, it is the best mix of assets given the client's goals and level of risk aversion, giving it a long-term outlook. Strategic asset allocators tend to view the market as efficient and market-timing as ineffective. By contrast, those who believe securities markets are not perfectly efficient may try to use an active strategy to alter the portfolio's asset mix, to take advantage of anticipated economic events. This market timing approach is sometimes called tactical asset allocation.

An investment adviser who believes that securities markets are efficient and that high transaction costs can substantially reduce returns would most likely favor which of the following portfolio management strategies? a. Low P/E ratios b. Growth investing c. Tactical asset allocation d. Indexing

d. Indexing Explanation: Those who think market timing is ineffective (i.e., markets are efficient) often favor passive strategies such as indexing. An indexed portfolio attempts to mirror the composition of a benchmark index, such as the S&P 500 or the Russell 2000. Since buying or selling occurs only when funds are added to or withdrawn from the portfolio, transaction costs are kept low.

A sector rotation strategy would include investing in which of the following? a. Technology stocks in a contracting economy b. Consumer goods stocks in an expanding economy c. Precious metals at the peak of the economy d. Industrial stocks in an expanding economy

d. Industrial stocks in an expanding economy Explanation: A sector rotation strategy involves investing in businesses that will grow along with the economy. Industrial stocks are cyclical and will rise and fall with the economy. The best time to buy technology stocks is right before an expansion, not during a contraction. Commodities help protect against inflation, but inflation is generally not anticipated if the market is peaking. Consumer goods companies make staples (e.g., groceries and household products) and would generally perform well during a recession.

In a down market, which of the following is a risk of using dollar cost averaging (DCA)? a. Sales must occur during a prolonged down market b. Purchases must cease during a prolonged down market c. Purchases are made at lower costs d. Investments are not protected against losses

d. Investments are not protected against losses Explanation: Dollar cost averaging involves making periodic investments of a fixed dollar amount into stocks or mutual funds. When prices fall, more shares will be purchased at a lower cost, which ensures that an investor's average cost will be less than his average price. This will increase performance when the market once again rises. However, investors should not sell and must continue making purchases during down markets. When prices fall, investors are not protected against losing money.

Which of the following is NOT a type of systematic risk? a. Inflation risk b. Market risk c. Interest-rate risk d. Liquidity risk

d. Liquidity risk Explanation: Liquidity risk is an example of unsystematic or diversifiable risk. Systematic risk is one that affects all asset classes in the same manner. Examples of systematic risk include market risk, interest-rate risk, and inflation risk. If there is an overall decline in the stock market, it will cause stock prices to go down (market risk). If market interest rates rise, it will cause bond prices to decline (interest-rate risk). And finally, an increase in the rate of inflation will generally cause the overall bond market to decline. The decline in the bond market is essentially tied to the market's anticipation of Federal Reserve Board action (i.e., raising interest rates).

While presenting a financial plan to a customer, an IAR talks about different types of risk. One of the primary risks mentioned by the IAR relates to the impact of current events, consumer confidence, and the general political climate. This risk is called: a. Inflation risk b. Reinvestment risk c. Nonsystematic risk d. Market risk

d. Market risk Explanation: Of the choices available, market risk is the best fit. Market risk is the general risk of investing in a given market or economy. Inflation is a form of systematic risk that affects all bonds. Nonsystematic, inflation, and reinvestment risks are not broad enough to cover the events mentioned.

All of the following risks are considered types of unsystematic risk, EXCEPT: a. Business risk b. Political risk c. Credit risk d. Market risk

d. Market risk Explanation: Remember, market risk is a form of systematic risk and cannot be avoided by securities investors. For example, if the overall stock market is declining, this will negatively affect all of the stocks in the market. Conversely, unsystematic risk is able to be reduced through appropriate diversification.

An investment adviser representative that uses an active asset allocation strategy might do which of the following? a. Buy only stocks with low P/E ratios b. Buy and hold c. Rebalance investor portfolios on a monthly basis d. Move a larger portion of the portfolio into bonds when anticipating falling interest rates

d. Move a larger portion of the portfolio into bonds when anticipating falling interest rates Explanation: An active allocator believes markets are not perfectly efficient and will therefore move monies amongst asset classes as conditions warrant. If interest rates are expected to fall, bond prices should rise, creating a trading opportunity in the bond market.

Currently, the price of gold is increasing as the price of Treasury bills is declining. These two assets are considered: a. Perfectly correlated b. Slightly correlated c. Uncorrelated d. Negatively correlated

d. Negatively correlated Explanation: When two investments are moving in the opposite direction, they are said to be negatively correlated. Those that move in the same direction are correlated. Those that show no pattern of correlation are uncorrelated.

While making cold calls on behalf of an investment adviser, an IAR speaks with a prospect who has invested a significant amount of his available funds into one mutual fund. After the client enters into a contract with the advisory firm, the IAR finds another fund with the same risk profile as the client's current investment, but it provides a higher return. What form of risk is presented in this scenario? a. Liquidity risk b. Financial risk c. Market risk d. Opportunity risk

d. Opportunity risk Explanation: The best answer to this question is opportunity risk. Opportunity risk is defined as the possibility of loss or diminished return that may arise when money is devoted to one investment followed by a superior investment becoming available. Financial risk and market risk are incorrect because, regardless of which fund is chosen, investors are subject to both of these risks. Since the investor is always able to redeem his mutual fund shares, liquidity risk is not a concern.

According to modern portfolio theory (MPT), the expected return of an investment is the: a. Income, such as bond interest, that has been guaranteed by the issuer b. Standard deviation of gains and losses over the life of the investment c. Return as measured by alpha d. Possible returns on the investment weighted by the likelihood of that return occurring

d. Possible returns on the investment weighted by the likelihood of that return occurring Explanation: MPT defines the expected return of an investment as the possible returns on the investment weighted by the likelihood of that return occurring.

An adviser is managing the portfolios of several clients who are invested in bonds. He anticipates that the economy is beginning to expand too rapidly and advises his clients to reallocate some of their holdings into money market instruments. What strategy is the adviser utilizing? a. Strategic asset allocation b. Sector rotation c. Asset class recharacterizations d. Tactical asset allocation

d. Tactical asset allocation Explanation: Tactical (active) asset allocation may be utilized by investors who believe that securities markets are not perfectly efficient. These investors may try to use an active strategy (i.e., market timing) to alter the portfolio's asset mix in an effort to take advantage of anticipated economic events. This market timing approach is primarily based on short-term decisions. On the other hand, periodically rebalancing a client's portfolio in an effort to maintain an optimal portfolio based on his risk tolerance and investment objectives is referred to as strategic (passive) asset allocation. Strategic asset allocators tend to view the market as efficient and market timing as ineffective, thereby taking a more long-term outlook. Sector rotation is an investment strategy that involves the movement of money from one industry or sector to another in an attempt to beat the market.

An investor has a total of $350,000 to invest, but he wants to invest $150,000 in a manner that will follow the business cycle. This type of investing is referred to as: a. Timing asset allocation b. Strategic asset allocation c. Technical asset allocation d. Tactical asset allocation

d. Tactical asset allocation Explanation: Tactical asset allocation shifts assets based on market timing, trends, and the business cycle. Technical analysis utilizes theories and pattern analysis, but it is a form of analysis, not a form of asset allocation. Strategic asset allocation uses a blend of particular securities that are rebalanced over time as the performance within the portfolio causes the weighting of the assets to shift outside the optimal percentages.

Which of the following statements BEST describes active portfolio management? a. The adviser buys and holds securities for the long term b. Based on research, the adviser buys stock for, or sells stock from, the portfolio c. The adviser attempts to benchmark or match the performance of the market d. The adviser attempts to exceed the performance of the market

d. The adviser attempts to exceed the performance of the market Explanation: If an investment adviser is using an active portfolio management technique, it is trying to choose a portfolio of securities that will exceed the market. On the other hand, passive asset management techniques often use indexing to match the performance of the market. All asset management techniques use research reports to some extent.

Which of the following statements BEST describes active portfolio management? a. The adviser attempts to benchmark or match the performance of the market. b. The adviser buys and holds securities for the long term. c. Based on research, the adviser buys stock for, or sells stock from, the portfolio. d. The adviser attempts to exceed the performance of the market.

d. The adviser attempts to exceed the performance of the market. Explanation: If an investment adviser is using an active portfolio management technique, it is trying to choose a portfolio of securities that will outperform the market. On the other hand, passive asset management techniques often use indexing to match the performance of the market. The choice which suggests that the adviser uses research to determine the stocks to buy for and/or sells from the portfolio is true of all asset management techniques (i.e., it's not exclusive to active management).

If an investment adviser recommends that its clients diversify their investments by purchasing gold coins, gold certificates, or gold futures, which of the following risks is the adviser trying to avoid? a. The risk associated with projecting returns over multiple asset classes b. The risk that a single stock will perform poorly and cause the portfolio to lose value c. The risk of the stock market losing liquidity during a market downturn d. The risk of some investments losing value or performing poorly due to inflation

d. The risk of some investments losing value or performing poorly due to inflation Explanation: Commodities investments, including futures, are a way to hedge against inflation risk. The risk that a single stock will perform poorly is referred to as business risk and may be diversified by purchasing stocks of multiple companies.