Chapter 7: Economic Factors, Business Information, Strategies, and Risks

inflation

+ prices CPI global definition: a decrease in the value of the monetary unit drives interest rates higher (bond yields higher) drives bond prices lower

high inflation

-- dollar buying power; -- demand for goods/services

recessions

2 straight quarters of decline + bankruptcies/bond defaults --hours worked + unemployment rate --consumer spending, home build, biz investment --down stockmarket --inflation rate + inventories --consumer demand --GDP

An investment is made of $10,000. At the end of the year, $500 in non-qualifying dividends has been received and the value of the investment is $10,500. If the investor is in the 30% tax bracket, the after-tax yield is: A) 5.0% B) 8.5% C) 6.5% D) 3.5% Your answer, 3.5%, was correct!. The only return (as far as yield is concerned) is the $500 of dividends. Remember, non-qualifying dividends do not "qualify" for the 15% rate. Subtracting 30% for taxes leaves $350 which, when divided by the $10,000 initial cost, is an after-tax yield of 3.5%. If the question had asked about total return, then the $500 unrealized profit would have been included, although there would have been no tax on it. Reference: 7.5.2.5 in the License Exam Manual.

NON QUALIFYING dividends do not qualify for 15% rate.

federal funds rate

banks charge each other for overnight loans of 1 $M or more Members of Federal Reserve System volatile listed daily

TEST TOPIC: safe haven investment in deflation

deflation in recessionary periods investors seek safe haven US GOVT SECURITIES hold value + capital appreciation

excessive trade deficit

devaluation of currency country will be converting its currency to obtain foreign currency to pay for increasing imports

decreases in inflation

drive bond prices higher bond yields decline

positive or normal yield curve

economic expansion interest rates will rise in the future

trade deficit

excess of one country's imports over its exports as reported in balance of payments

inflation causes

excessive demand monetary expansion

deflation

general decline in prices unemployment +++

consumer price index

general retail price level basket of goods published monthly bureau of labor and statistics most commonly used to measure inflation

fiscal policy

government uses spending and taxation to influence economy

mild inflation

gradually + prices = economic growth

One way in which internal rate of return (IRR) differs from most return computations is that A) its application to debt securities is limited B) it is always an annualized rate of return C) it takes into consideration the time value of money D) it takes into consideration the rate of inflation Your answer, it takes into consideration the time value of money, was correct!. The internal rate of return compounds returns and takes into consideration the time value of money. Real rate of return considers the inflation rate. Reference: 7.5.2.9 in the License Exam Manual.

internal rate of return = time value of money real return = inflation rate

protection for weakening US Dollar

invest in foreign securities ADRs dollar strengthens = ADR value declines

y bill rate is 3%, an investor decides to purchase a 20-year corporate bond at par with a coupon of 8%. If the corporate bond does not pay as expected, the investor's potential loss is considered: A) opportunity cost. B) purchasing power risk. C) duration risk. D) market cost. Your answer, opportunity cost., was correct!. When an investor forgoes the risk-free returns of the 90-day Treasury bill in favor of another investment, anything lost is considered the opportunity cost of passing up the "sure thing". Reference: 7.7.7 in the License Exam Manual.

opportunity cost difference between risk-free returns and 90 day t Bill sure thing

sharpe ratio

portfolio risk relative to the expected return of the market risk adjusted return expected rate of return --- risk free return/ standard deviation of portfolio

technical analysis

pricing and trading volume patterns in the market

FED DOES NOT SET THE PRIME RATE

prime rate set by major banks

monte carlo simulation

projected future events how selection technique performs under events relative to a standard benchmark

In order to compute the real rate of return for a security, it would be necessary to know all of the following EXCEPT A) the CPI. B) the beta of the security. C) the purchase price. D) the annual dividend. Your answer, the beta of the security., was correct!. The real rate of return is the actual return less the inflation rate as measured by the CPI. Reference: 7.5.2.6 in the License Exam Manual.

real rate of return CPI purchase price annual dividend

economics

social science description and analysis of production, distribution, and consumption of goods and services how people choose try to find combination of cost and benefit that maximizes our satisfaction

arithmetic mean

straight average

Adam Smith

strict hands off approach wages and prices will decline quickly enough during a recession to bring about recovery

duration

volatility of a bond re change in interest rates longer duration = greater volatility small duration= less price change

standard deviation

volatility of projected returns relative to the market

increase in real income

% increase in real income = % increase in income greater than rate of inflation. buying power +++

employment indicators

4% unemployemnt = full employment avg weekly unemployment claims avg workweek in manufacturing

monetary policy determined by

Board of Governors of Federal Reserve

Two of the major factors involved in the Capital Asset Pricing Model (CAPM) are interest rates risk tax rates time A) II and III B) I and III C) II and IV D) I and II Your answer, I and II, was incorrect. The correct answer was: II and IV CAPM is built on the theory that investors must receive a return commensurate with the amount of risk taken over a specified period of time. Reference: 7.4.6.2* in the License Exam Manual.

Capital Asset Pricing Model (CAPM) return commensurate with risk over a period of time risk time important considerations

If a company successfully gets its 7% debenture holders to exchange their 7% debentures for 7% preferred stock, what is the effect on EPS? A) Increase. B) Not enough information. C) No effect. D) Decrease. Your answer, Increase., was incorrect. The correct answer was: Decrease. The 7% payment is moved from a pre-tax deduction to an after-tax payment. This increases the amount of taxable income, thereby increasing the company's tax liability. The 7% payment remains the same. With an increased tax burden and everything else remaining the same, the EPS will decrease. Reference: 7.4.3.7 in the License Exam Manual.

Earnings per share decrease if debentures convert to equity. increased tax burden

If a U.S. corporation wishes to issue Eurodollar bonds, which of the following statements are TRUE? The corporation will be subject to currency risk. The corporation will not be subject to currency risk. The issue must be filed with the SEC. The issue need not be filed with the SEC. A) II and III. B) II and IV. C) I and IV. D) I and III. Your answer, II and III., was incorrect. The correct answer was: II and IV. Because Eurodollar bonds are denominated in U.S. dollars, a U.S. corporate issuer will not be subject to foreign exchange risk, regardless of the country of issuance. In addition, because the bonds are issued outside the U.S., the issue is not registered with the SEC.

Eurodollar bond issues are not subject to currency risk. These bonds are issued outside US and do not register with SEC.

economic indicators

GDP Gross domestic product: value of all final goods and services w/in US for 1 year GNP Gross National Product: citizen output only. not earnings abroad or by foreigners w/in borders GNP is primary measure today

Which of the following attributes of common stock best describes why internal rate of return (IRR) is not generally used to determine the return on common stock? A) Uneven cash flows and no maturity. B) Uneven cash flows. C) Common stock does not have a net present value. D) Uneven cash flows, no maturity date and price. Your answer, Uneven cash flows., was incorrect. The correct answer was: Uneven cash flows, no maturity date and price. Internal rate of return (IRR) best measures investments with a known price and maturity. The internal rate of return is the discount rate that makes the future value of an investment equal to its present value. The yield to maturity on a bond is actually its internal rate of return.

IRR is not applicable to stocks: uneven cash flows, no maturity date and price measures investments with known price and maturity discount rate that makes the future value of an investment equal to its present value. yiled to maturity on a bond is its IRR

Keynesian

John Maynard Keynes government intervention important General theory of employment, Interest and Money why recessions happen, how to recover: govt should run deficits to stimulate demand and employment low taxation and more govt spending

discount rate

NY Federal Reserve Bank charges for short term loans to member banks established by Federal Reserve Board, managed rate

fiscal policy determined by

President and Congress through budget and taxation process

A fundamental analyst would be interested in funds available for use in the business. Doing which of the following would have the greatest impact on future cash flow? A) Depreciation on assets used in the business. B) Retaining earnings. C) Amortizing goodwill. D) Retiring outstanding bonds. Your answer, Depreciation on assets used in the business., was incorrect. The correct answer was: Retiring outstanding bonds. The retirement of outstanding bonds means that there will be no future interest payments made. Since a major component of cash flow is a company's net income, this reduced expense would lead to increased income. Reference: 7.4.3.10 in the License Exam Manual.

Retirement of outstanding bonds has greatest impact on future cash flow

US dollar weakens

US exports competitive in foreign markets

US dollar strengthens

US exports less competitive in foreign markets

current ratio

ability of company to meet current obligations current assets/current liabilities

expected return

addition of all projected returns in the portfolio

macroeconomics

aggregates, GDP, growth of national economic output series 65 focuses on macro

nominal interest rate

amount borrower pays for loanable funds

when foreign money received in US

credit to the foreign account balance of US

when money leaves US

debit to the foreign account balance of US e.g. loans made to foreign governments or dividend paid on foreign investment in US

business cycles

expansion peak contraction trough

budget deficit

expenditures < tax revenues

Debts that will come due more than 1 year after the date on the balance sheet are known as: A) deferred charges. B) accounts payable. C) fixed (or long-term) liabilities. D) current liabilities. Your answer, fixed (or long-term) liabilities., was correct!. Debts that will come due more than 1 year after the date of the balance sheet are known as fixed (or long-term) liabilities. Current liabilities are debts that may come due within 1 year from the date on the balance sheet. Reference: 7.4.3.3.2 in the License Exam Manual.

fixed or long term liabilities come due more than 1 year after date of balance sheet

microeconomics

households, business firms, narrowly defined units

yield curve spread corp and govt bonds

if widening, recession expected investors seek US bonds if narrowing, economic expansion sell US bonds and buy AAA corporates

A significant increase in importing of goods into the United States would have what effect on the strength of the U.S. dollar? A) Fluctuation both ways. B) Strengthen. C) No effect. D) Weaken. Your answer, Fluctuation both ways., was incorrect. The correct answer was: Weaken. Importing tends to weaken the dollar because it indicates an outflow of money from the United States to foreign countries. Much of this outflow is in the form of debt. When our debt (deficit in balance of payments) gets too high, there is international concern about our ability to pay our debts and a reluctance in accepting U.S. dollars as payment for goods. Therefore, the dollar weakens.

importing weakens the dollar

total return

income + dividends + capital depreciation/ initial purchase price

core CPI

index of all items - food and energy = core CPI food and energy have short term volatility

inflation inertia

inflation does not react immediately to change

Federal Reserve

monitors money supply and adjusts as needed

geometric mean

more applicable for financial returns, compounding

prime rate

most preferential int rate on corporate loans US money center commercial banks

real rate of interest

nominal rate of interest -- expected rate of inflation

sector rotation

overweighting or underweighting industries per current business cycle

after tax return

return x (1-tax bracket)

flat yield curve

short and long term rates are equal economy peaking

budget surplus

tax revenues > expenditures

ADVANCE/DECLINE LINE An analyst interested in measuring the breadth of market movement as an indicator of future market direction would monitor the: A) betas of the S&P 500 stocks. B) Value Line Index. C) DJIA. D) advance/decline line. Your answer, advance/decline line., was correct!. The advance/decline line, which measures the number of stocks that have advanced versus the number of stocks that have declined, is an indicator of the breadth of the market's advance or decline.

technical analysis--indicator of future market direction based on breadth of market movement

beta

beta of >1 = higher highs, lower lows than market beta = 1 tracks market exactly beta < 1 = less volatile than the market

Which of the following would appear as assets on a corporation's balance sheet? Prepaid expenses Deferred tax credits Notes payable Notes receivable A) I and IV B) II and III C) I, II and IV D) I and III Your answer, I, II and IV, was incorrect. The correct answer was: I and IV Prepaid expenses, such as advertising, rent, or insurance, are listed as assets on the balance sheet. All receivables are assets, while payables are liabilities. Under current accounting practice, deferred tax credits are treated as a liability. Reference: 7.4.3.3.2 in the License Exam Manual.

Assets on a corporate balance sheet: Prepaid expenses notes receivable deferred tax credits are not assets, they are a liability

An investor buys a 5% AA-rated corporate bond. After 1 year, if his total return on the position is 4%, the most likely explanation for this is: A) the bond rating was downgraded. B) the investor paid accrued interest when he bought the bond diminishing his first year's return. C) interest rates decreased causing the bond price to increase. D) interest rates increased causing the bond price to decrease. Your answer, interest rates decreased causing the bond price to increase., was incorrect. The correct answer was: interest rates increased causing the bond price to decrease. Total return is computed by adding together the income received plus any capital gain or loss. Since the bond is purchased at par, selling the bond at a loss is the only way the investor's total return could be less than the coupon rate. When interest rates go up, bond prices go down. Reference: 7.5.2.2 in the License Exam Manual.

Total return = income received + capital gain or loss selling this bond at a loss is the only way the total return could be less than the coupon rate when interest rates bond prices go down.

broker call loan rate

call loan rate, call money rate slightly higher than other short term rates callable on 24 hour notice

In order to calculate an investor's holding period return, it is necessary to know: value of the portfolio at the beginning of the period. value of the portfolio at the end of the period. income received during the period. capital appreciation or depreciation over the period. A) I and II. B) I, II, III and IV. C) I, II and III. D) III and IV. Your answer, I, II, III and IV., was incorrect. The correct answer was: I, II and III. An investor's holding period return is the total return received over the specified holding period. That return includes any income plus or minus any gain or loss. In terms of calculating, when you know the beginning and ending values, that tells you the capital appreciation or depreciation. Reference: 7.5.2.3. in the License Exam Manual.

careless mistake knowing beginning and ending value determines appreciation or depreciation

A method of valuing an investment, particularly debt securities, by calculating what future cash returns will be worth at the time they are received, based on estimates of future inflation and interest rates is known as A) dividend discount model B) net present value C) yield to maturity D) discounted cash flow Your answer, net present value, was incorrect. The correct answer was: discounted cash flow This is the basic definition of discounted cash flow, a useful tool in determining the value of debt securities. Reference: 7.6.5.2 in the License Exam Manual.

discounted cash flow = for a debt instrument in particular future cash returns will be worth at time received, based on estimates of future inflation and interest rates

An analyst using the dividend growth model would take into account all of the following factors EXCEPT: A) the current dividend. B) the growth of the dividend. C) the current earnings per share. D) the investor's required rate of return. Your answer, the investor's required rate of return., was incorrect. The correct answer was: the current earnings per share. The dividend growth model is a stock valuation model that deals with dividends and their growth, discounted to today. The value of the stock equals next year's dividends divided by the difference between the required rate of return and the assumed constant growth rate in dividends.

dividend growth model stock valuation model for dividend growth discounted to today. current dividend growth of the dividend investor's required rate of return

If you knew a given stock had a 40% chance of earning a 10% return, a 40% chance of earning 20%, and a 20% chance of earning -10%, the stock would have a(n): A) expected rate of return of 10%. B) annualized return of 10%. C) real rate of return of 10%. D) total return of 10%. Your answer, expected rate of return of 10%., was correct!. The expected return is computed by taking the probability of each possible return outcome and multiplying it by the return outcome itself. In this example, if you knew a given stock had a 40% chance of earning a 10% return, a 40% chance of earning 20%, and a 20% chance of earning -10%, the expected return would be equal to 10%: = (0.4 × 0.1) + (0.4 × 0.2) + (0.2 × -0.1), = .04 + .08 = .12 − .02, = 0.10, = 10%. You will not have to do this calculation on the exam, but you should know the concept. Reference: 7.5.2.7 in the License Exam Manual.

expected rate of return probability of each outcome X the return outcome

inflation increases

interest rates +++ bond prices --- bond yields +++

inflation decrease

interest rates --- bond prices +++ bond yields ---

fundamental analysis

issuer financial statements + economic conditions

peak

leads to decline from peak -- GDP --unemployment rate, slowdown in hiring --consumer spending/business investment + inflation rate

quick ratio

liquidity measure of a firm can the company survive if it cannot liquidate its inventory current assets--inventory/ current liabilities

CPI consumer price index

market basket purchased by customers as compared to same base period basket

federal funds rate market rate

market rate determined by demand for bank reserves by deposit based financial inst.

balance of payments

measures national import and export transactions debts: payments and liabilities made to foreign cretis: payments and obligations received from foreign

expansion

sales, manufacturing, wages GDP increases rapidly, businesses reach productive capacity they reach PEAK

supply-side economics

supply creates demand by providing jobs and wages reduced prices will increase product demand increases demand for labor until excess supply til excess labor reduced

Sector rotation would most likely be employed by an investment adviser using which of the following investment styles? A) Buy and hold. B) Strategic. C) Contrarian. D) Tactical. Your answer, Tactical., was correct!. Sector rotation is the practice of moving portfolio assets from those industries that have reached their peak in the current economic cycle to those that are now on the upswing. Buy and hold, as the name implies, does not involve constant trading and strategic is a passive technique as well. Contrarian investors go opposite the trend which is not the case here. Reference: 7.1.2.1.2 in the License Exam Manual.

tactical management rotates sectors

TIPS Treasury Inflation Protected Security

treasure inflation protected security principal amount changes final value=ending accrued principal + last coupon payment

Milton Friedman: Monetarists

money supply determines price levels, economic activity too few dollars after too many goods =deflation too many dollars chasing few goods = inflation moderately increasing controlled one supply = price stability price stability = managers are more efficient resource allocators than US Government, leads to stable business cycle

inverted yield curve

term of security increases, yield decreases due to sharp increase in short-term rates will fall shortly Federal Reserve Board tightens credit in overheated economy predicts rates will fall

A portfolio manager's performance is often measured against a benchmark such as the S&P 500. A manager whose performance beats the benchmark by taking greater risk than the S&P 500 may not have had superior returns as measured on a: A) total-return basis. B) risk-adjusted basis. C) inflation-adjusted basis. D) expected-return basis. Your answer, inflation-adjusted basis., was incorrect. The correct answer was: risk-adjusted basis. Unless the portfolio's performance is better than the extra risk taken, the manager has not beaten the performance benchmark, the S&P 500, on a risk-adjusted basis. Risk-adjusted return is calculated by computing the Sharpe ratio. Total return comprises the yield plus the growth in value of an investment over time and is not related to risk. The expected return is an estimate of the probable return an investment may yield, whereas inflation-adjusted return is the nominal return reduced by the inflation rate. Neither of these returns is related to risk. Inflation-adjusted returns are often compared to a benchmark such as the Consumer Price Index (CPI). Unadjusted rates of return are called nominal rates of return.

Risk adjusted return

An investment adviser representative has a client who prefers the safety of securities guaranteed by the U.S. Government, yet is concerned about volatility due to uncertainties in the future direction of interest rates. Which of the following recommendations would best address these concerns? A) 8% Treasury bond maturing in 2036. B) 6% Treasury bond maturing in 2035. C) Treasury STRIPS, maturing in 2036. D) 5% Treasury bond, maturing in 2037. Your answer, 6% Treasury bond maturing in 2035., was incorrect. The correct answer was: 8% Treasury bond maturing in 2036. Generally speaking, those bonds with the highest coupons have the shortest duration, therefore, are the least subject to interest rate risk. STRIPS, which are zero-coupon bonds, are the most volatile since they have the longest duration. The actual calculation of the duration of each of the other bonds given is beyond the scope of this exam. Reference: 7.6.5 in the License Exam Manual.

bonds with highest coupons have shortest duration: least subject to interest rate risk STRIPS are zero-coupon bonds are most volatile have the longest duration

One of your clients is viewing a stock held in her portfolio and wishes to know how to calculate the holding period return for that security. In order to do that, she must know the: date the stock was purchased and the date it was sold. dividends received during the holding period. purchase price. current market price. A) II, III and IV. B) I, II and III. C) I, II, III and IV. D) III and IV. Your answer, I, II, III and IV., was incorrect. The correct answer was: II, III and IV. Holding period return is the total return on an investment over the period it was held. In order to compute this, one must know the income received (dividends) plus any capital appreciation (the difference between the purchase price and the sale price if sold, or current market price if still held). If you read the question carefully, it refers to a security "held" in her portfolio. Therefore, we don't have a sale date. Reference: 7.5.2.3 in the License Exam Manual.

careless mistake don't know when it was sold holding period is current and original price

trough

decline levels off from -- to + GDP +unemployment rate + overtime, temp workers +consumer durable good spending +housing moderate or --inflation rate

An investor originally purchased a debt security at par value. Unfortunately, the value has fallen to $920 even though the company has reported record earnings. This decline in value would be representative of what type of risk? A) Purchasing power risk. B) Timing risk. C) Credit risk. D) Interest rate risk. Your answer, Credit risk., was incorrect. The correct answer was: Interest rate risk. This decline in value is most likely due to interest rate risk, which indicates that as prevailing interest rates rise, the price of existing debt instruments declines. Purchasing power risk is essentially synonymous with inflation risk, and credit risk is the danger that the issuer may default on its debt service, something that seems unlikely considering the recent earnings reports. Reference: 7.7.3 in the License Exam Manual.

for a corporate debt instrument: declining value in the face of record earnings is due to interest rates have risen

economic indicators The Conference Board releases information about the economy on a monthly basis. Included are a number of different indicators. Economic indicators can be leading, lagging, or coincidental, which indicates the timing of their changes relative to how the economy as a whole changes. Which of the following is a coincident economic indicator? A) Stock market prices as measured by the S&P 500. B) Machine tool orders. C) Agricultural employment. D) Industrial production. Your answer, Industrial production., was correct!. Industrial production is a coincident indicator. The stock indices and manufacturing orders are leading indicators; economists do not use agricultural employment as an indicator. Reference: 7.3.6.2 in the License Exam Manual.

industrial production = coincident stock indices and manufacturing orders = leading

An agent for a well known broker/dealer has taken it upon herself to look for investment opportunities for her clients. Her research indicates that, in spite of record earnings, the stock of GEMCO, Inc. is poised for a price reversal. Should this analysis prove correct, this would be an example of: A) regulatory risk. B) market risk. C) reinvestment risk. D) financial risk. Your answer, financial risk., was incorrect. The correct answer was: market risk. Market risk is the uncertainty that the market price of a stock will drop even when earnings are strong. Most stocks follow the "market" and this would appear to be no exception. Financial risk concerns itself with financing, particularly debt, so it is related to credit risk. Nothing in this question infers anything about financing difficulties. Reference: 7.7.1 in the License Exam Manual.

market risk = uncertainty that stock price will maintain despite record earnings

An analyst has been charting previous 9 year's returns for a stock and displays the following results: 5%, 5%, 8%, -3%, 10%, 12%, 5%, 17% and 22%. If you were asked the mode of these returns, you would reply: A) 9%. B) 8%. C) 10%. D) 5%. Your answer, 5%., was correct!. The mode of a series of number is that number that has the largest number of occurrences. In this case, 5% appears three times, more than any other number. Note that the mode is not similar to the mean (in this example 9%) or the median (in this case 8%). Reference: 7.5.2.11.3 in the License Exam Manual.

mode= number with largest occurrences

inflation adjusted return

nominal return -- inflation rate

yield curve analysis

normal = long term inters rates are higher than short term interest rates: upward sloping normal yield curve term of security increases, yield increases

construct a yield curve

use bonds of a single issuer over VARYING maturities US 90 Day T -bill and end with 10 yr note and 30 yr bond

DURATION: lowest coupon = highest duration Assuming all of the following mature at about the same time, which of the following bonds should experience the greatest price decline if interest rates rise by 1%? A) Treasury bond issued at par carrying a 5% coupon. B) Treasury bond issued at par carrying a 6% coupon. C) Treasury bond issued at par and carrying a 4% coupon. D) Treasury bond issued at par carrying a 7% coupon. Your answer, Treasury bond issued at par carrying a 7% coupon., was incorrect. The correct answer was: Treasury bond issued at par and carrying a 4% coupon. This is an example of duration. With approximately equal maturity dates, the bond with the lowest coupon will always have the longest duration. The longer the duration, the greater susceptibility to price changes due to fluctuations in interest rates. Reference: 7.6.5 in the License Exam Manual.

with = maturity dates bond with lowest coupon will have longest duration. longer the duration, greater volatility due to changes in interest rates