FNCE 3030 Midterm 2 Review

(Q8) What is the maximum price that an investor should pay for a 10-year, $10,000 zero coupon bond, if the current yield to maturity on comparable debt is 4.375%? a. $6,516.81 b. $10,000.00 c. $6,755.64 d. $6,139.13

a. $6,516.81

(Q8) Given the duration of a $1,000 bond is 8.75 years, the current yield to maturity is 6.5%, and that yield to maturity is expected to increase by 50 basis points (i.e., +.5%) what is the dollar change in price if the current price of the bond is $974.60? a. - $40.04 b. + $39.85 c. - $39.85 d. + $40.04

a. - $40.04

(Q6) Based on the following data, what is the Stock A's Sharpe Ratio? Portfolio return = 12.6% Standard deviation = 26.3% Beta = 1.4 Risk-free rate = 3.2% a. .36 b. .60 c. .67 d. .11

a. .36

(Q6) Your client has a three-year investment horizon; therefore, you decide to use the last three years of historical market data in determining your expected return assumption. Based on the holding period returns, what is the arithmetic (time weighted) annual rate of return assumption you will use when entering data into your portfolio optimization analyzer? (Base your response on the following market data.) 3 years ago (begin price = $23.50; end price = $28.00) 2 years ago (begin price = $28.00; end price = $26.25) 1 year ago (begin price = $26.25; end price = $33.75) a. 13.8% b. 9.8% c. 10.5% d. 12.8%

a. 13.8%

(Q5) The greater an investor's belief in market inefficiency, then the greater the argument for: a. Active investing b. Investing in market indexes c. Passive investing d. Buy and hold

a. Active Investing Market efficiency implies that active investing is not profitable, after transaction costs and taxation. If you believe that the markets are inefficient then it creates the case that active investing can outperform. Buy and hold strategy and investing in market indexes are examples of passive investment strategy.

Which of the following hedge funds offer the best return-to-risk profile based on William Sharpe's information ratio given the fact that the benchmark offered an 8.5% return? (1) Fund A - 17.0% return, tracking error 6.8%, beta 1.8 (2) Fund B - 24.0% return, tracking error 9.3%, beta 2.1 (3) Fund C - 28.0% return, tracking error 12.8%, beta 2.7 (4) Fund D - 10.0% return, tracking error 3.5%, beta 1.3 a. Fund B b. Fund C c. Fund A d. Fund D

a. Fund B The information or appraisal ratio offers a measure to compare actively managed portfolios. The IR is equal to: (return of the active portfolio less the return of the benchmark) / tracking error. The tracking error measures the standard deviation between active portfolio and benchmark returns. Based on the data provided in this problem Fund B has an IR of 1.6667 ((24 - 8.5) / 9.3). The information ratios for Funds A, C and D are 1.2500, 1.5234 and .4286, respectively.

(Q8) Which of the following statements is INCORRECT? a. The lower the coupon rate of the bond, then the lower the price sensitivity to interest rate moves. b. The higher the initial yield to maturity of the bond, then the less sensitive the bond is to interest rate moves. c. The price of existing bonds moves inversely with market interest rates. d. The greater the term to maturity of the bond, then the greater the price sensitivity to interest rate moves.

a. The lower the coupon rate of the bond, then the lower the price sensitivity to interest rate moves. The lower the coupon rate of the bond, then the lower the price sensitivity to interest rate moves. Low coupon bonds have greater price sensitivity to interest rate moves compared to high coupon bonds. Refer to the class handout covering bond valuation.

(Q7) A firm in an industry that is very sensitive to the business cycle will likely have a stock beta a. greater than 1.0 b. equal to 1.0 c. less than 1.0 but greater than 0.0 d. equal to or less than 0.0 e. there is no relationship between beta and sensitivity to the business cycle

a. greater than 1.0 Cyclical stocks will have a greater volatility as compared to the overall market. In contrast, consumer stables will have a volatility less than one.

(Q6) Your friend, Ben, is an active investor who practices sector rotation based on the chart patterns of different sector ETFs. Right now he is over-weighted in consumer non-durable goods. This trading approach is an example of which of the following? a. tactical asset allocation b. trading optimization c. strategic asset allocation d. portfolio rebalancing

a. tactical asset allocation Strategic allocation is a long-term asset allocation approach, which factors in the person's financial need, risk tolerance, time horizon, financial capacity and investment knowledge. Typically, the investor would rebalance the portfolio based on rebalancing triggers (e.g., variance from targeted allocation, calendar-year rebalancing, after major market event). In contrast, tactical allocation involves active management aligned with external factors. For example, sector rotation is a tactical approach that would change the asset allocation mix based on an assessment of the macroeconomic environment and reallocating to sectors expected to out-perform in the period.

(Q8) What is the price of a callable $100,000, 4.8% semi-annual bond that matures in 18 years and is callable in 10 years, given a current market yield on similar debt of 5.4 and a call premium of 10%? a. $101,365.74 b. $101,279.77 c. $96,979.38 d. $95,410.41

b. $101,279.77

(Q8) What is the price of a $100,000, 4.8% semi-annual coupon bond that matures in 12 years, if the current yield to maturity is 5.4%? a. $105,425.25 b. $94,751.17 c. $94,800.01 d. $96,959.61

b. $94,751.17

(Q8) Given the duration of a bond is 8.62 years, the current yield to maturity is 6.5%, and the yield to maturity is expected to decrease by 25 basis points (i.e., 0.25%) what is the expected percent price change of the bond? a. +3.32% b. +2.02% c. -3.32% d. -2.02%

b. +2.02%

(Q6) Luke is the portfolio manager for the Front Range Value Fund. Last year his portfolio return was 9%, and the portfolio had a beta of 1.2. The S&P 500 Index had a 7.5% return. The T-bill rate was 2.3%. What is the alpha of the Fund? a. 2.76 b. 0.46 c. 1.50 d. 0.00

b. 0.46

(Q8) Which of the following strategies might immunize a portfolio for an investment horizon of 14 years? (1) Purchase several coupon paying bonds with maturities ranging from 16-18 years. (2) Purchase a zero-coupon bond maturing in 20 years. (3) Create a mixed portfolio of debt maturing in 14 years and equity securities. (4) Purchase a zero-coupon bond maturing in 14 years. a. 1 and 3 b. 1 and 4 c. 2 and 3 d. 4 only

b. 1 and 4 Immunizing a portfolio means matching the duration of liabilities to the duration of assets. You are told that the duration of liabilities is 14 years. Then you are asked to determine which of the asset portfolios might have a duration of 14 years. Let's walk through the possible answers: Statement 1: Coupon-paying bonds have durations less than the maturity date; so, a portfolio of coupon paying bonds with maturities between 16-18 years might immunize a cash flow need of 14 years. Statement 2: A zero-coupon bond maturing in 20 years has a duration of 20 years; therefore, this cannot be one of the possible answers. Now look down at the answer set. Cross off any answer set with (2) as a possibility. Statement 3: This says to put together a mixed portfolio of bonds and equity. Equity doesn't have a maturity, and while it provides growth potential is not a suitable portfolio holding if you purpose is to immunize. Look at the answer set. Cross off statement (3). You are down to two possible answers (50/50 chance). Statement 4: Yes. A zero-coupon bond with a maturity of 14 years is a perfect match. Either approach (1) or (4) might accomplish you goal of immunizing a liability mix with a duration of 14 years.

(Q7) What is the five-year spot rate, given a short rate of 2.24% in year one, a short rate of 2.48% in year two, a short rate of 2.62% in year three, a short rate of 3.05% in year four and a short rate of 3.62% in year five? a. 2.62% b. 2.80% c. 2.94% d. 3.05%

b. 2.80%

(Q6) Your client is considering a corporate bond with a 6.17% before-tax yield and a municipal bond with a 4.93% before-tax yield. At what marginal tax rate would the investor be indifferent between investing in the corporate and investing in the municipal bond? a. 28% b. 20.1% c. 15.4% d. 25.2%

b. 20.1%

(Q6) What is the investor's 3-year holding period return given the following information? Initial investment $20,000 Year 1 cash distributions $1,200 Year 2 cash distributions $1,500 Year 3 cash distributions $800 End-of-year-3 sale proceeds $24,600 a. 32.9% b. 40.5% c. 14.2% d. 17.5%

b. 40.5%

(Q8) What is the yield to maturity of a $10,000, 6.2% semi-annual bond that matures in 15 years, given a current market price of $9,531.43? a. 5.99% b. 6.70% c. 3.35% d. 6.20%

b. 6.70%

(Q8) Which of the following correctly describes a bond ladder? a. A fixed income portfolio where a portion of the portfolio is invested in short-term bonds and the remaining portion in long-term bonds. b. A fixed income portfolio where the individual bonds mature on different dates. c. A fixed income portfolio where the individual bonds are purchased at different times but mature on the same date. d. A bond that has a variable maturity date.

b. A fixed income portfolio where the individual bonds mature on different dates.

(Q8) Which of the following statements is correct? a. A convertible bond allows the investor to retain the bond and buy a set number of shares at a price specified in the bond's provisions. b. A stock right allows existing common shareholders to buy additional shares at a set price. c. A bond with warrant allows the investor to turn in the bond to the issuing company in exchange for a set number of company shares as specified in the bond's provisions. d. A callable bond allows the issuing company to recall the bond at any time before maturity.

b. A stock right allows existing common shareholders to buy additional shares at a set price. A stock right allows existing common shareholders to buy additional shares at a set price. The convertible bond is turned in to the company in exchange for a set number of shares. With a bond warrant, the investor retains the bond and exercises the warrant to buy a set number of shares (additional cash outflow) at a set price. Callable bonds will specify the earliest date that the debt can be recalled. There is typically a call premium associated with the call.

(Q5) According to the Vanguard study entitled "Putting a value on your value," which of the following represents the greatest component of alpha (i.e., value to client)? a. Formulating a workable budget b. Behavioral coaching c. Identifying a suitable asset allocation d. Rebalancing the portfolio mix e. Cost effective implementation

b. Behavioral coaching According to the study, behavioral coaching add 1.5% of value (150 basis points) each year.

(Q7) Which of the following combinations of monetary and fiscal policy would promote an economic expansion? a. Increase bank reserve requirements; decrease government spending b. Decrease the discount rate; decrease individual income tax rates c. Buy government securities (open market operations); increase corporate tax rates d. Increase the discount rate; increase individual tax rates

b. Decrease the discount rate; decrease individual income tax rates decrease the discount rate and interest rates If you want to help expand the economy then the government and Federal Reserve would want to increase money availability, lower rates, and stimulate economic activity. Decreasing the discount rate encourages "cheaper" money. Decreasing individual income tax rates increase the after-tax amount of disposable income.

(Q7) Which of the following statements about yield curves is INCORRECT? a. A yield curve depicts that market yield to maturity for similar bonds across time. b. During a recession you would expect the spread between investment-grade bonds and below-investment-grade bonds to be compressed (narrower). c. You would expect to see the flattening of a normal yield curve given market expectations of an impending economic recession. d. The yield curve for a U.S. Treasury bond would look different from that of a BBB-rated corporate bond.

b. During a recession you would expect the spread between investment-grade bonds and below-investment-grade bonds to be compressed (narrower). During a recession you would expect the spread between investment-grade bonds and below-investment-grade bonds to be compressed (narrower). The spread between investment and below-investment-grade bonds will widen during economic recessions. In contrast, during strong economic expansions the spread will narrow. The other statements are correct.

(Q5) Which of the following cognitive biases help explain why individuals value current consumption more than deferred gratification? a. Over-conservatism bias b. Hyperbolic discounting c. Ambiguity bias d. Anchoring bias e. Status quo or endowment effect

b. Hyperbolic discounting The tendency to discount the future value of something in the distant future more than reasonable. The more distant and more vague the item, then the greater the discount.

(Q5) Which form of efficient market hypothesis is supported by the January effect? a. Weak form efficiency b. None of these c. Strong form efficiency d. Semi-strong form efficiency

b. None of these In an efficient market, there should not be any anomalies.

(Q5) An investor recently profited from a series of trades. A new opportunity is considered, and the investor quickly decides on investing a large percentage of the portfolio. What heuristic probably impacted this aggressive investment decision. a. Endowment effect b. Sequential prospects c. Mental accounting d. Framing

b. Sequential prospects Sequential prospects suggest that risk perception changes based on prior experiences. Investors are more likely to take a gamble given a series of previous gains. In contrast, investors are more likely avoid the gamble if the previous prospects results in losses.

(Q6) According to the Brinson, Singer and Beebower study, which of the following is the most important decision that impacts long-term wealth accumulation? a. market timing b. asset allocation c. security selection d. portfolio hedging

b. asset allocation The study confirmed that the asset allocation impacted 91% of portfolio performance. That compares to 4.6% impact for security selection and 1.8% impact for market timing.

(Q6) Based on the life cycle investment strategy, at which stage of the economic life cycle would the investor be weighted in fixed income securities? a. consolidation stage (age 45-67) b. distribution stage (in retirement) c. never, the investment portfolio would always be weighted towards growth securities d. accumulation stage (age 20-45)

b. distribution stage (in retirement) The life cycle investment strategy is based on the premise that wealth is a function of human capital (earnings capacity) and financial wealth. The longer the time that the person has to generate income, then the more investments that should be in growth. In contrast, the lower the human capital the greater the focus on income-producing investments. During the distribution or spending stage, the investor needs to generate income to replace lost earnings and safety is of paramount concern.

(Q7) What would you expect to see at the end of a recession? a. high inflation and high unemployment b. low interest rates and high unemployment c. low inflation and low unemployment d. high inflation and high unemployment

b. low interest rates and high unemployment low interest rates and high unemployment At a market trough (end of a recession), you should expect to see low inflation, low interest rates and high unemployment. That pattern is flipped at a market peak. After a prolonged economic expansion, you should expect to see higher inflation, higher interest rates and low unemployment.

(Q7) Which of the following should occur as the business cycle moves from peak to recession? (1) Unemployment rises as corporations have to lay-off workers. (2) Fiscal and monetary policy shifts from controlling inflation to providing economic stimulus. (3) Economic indicators will turn negative; however, leading indicators will turn positive later in the recession as the economy reaches the trough of the cycle. (4) Stocks and bonds will both decrease in value. a. 1 and 2 b. 3 and 4 c. 1, 2 and 3 d. 1, 2, 3 and 4

c. 1, 2 and 3 Statements 1 and 2 are true. Unemployment rises and the Fed moves from controlling growth to stimulating economic activity. Statement 3 is also true. Coincidental and lagging indicators will remain negative; however, leading indicators will eventually turn positive as expectations for a recovery develop. Stock prices will decrease in value. Bond prices move inversely to interest rates; therefore, bond prices will increase as interest rates decrease.

(Q6) Your client has a three-year investment horizon; therefore, you decide to use the last three years of historical market data in determining your expected return assumption. Based on the holding period returns, what is the geometric (time weighted) annual rate of return assumption you will use when entering data into your portfolio optimization analyzer? (Base your response on the following market data. Also, calculate your answer based on four decimal places and round your final answer to two decimal places.) 3 years ago (begin price = $23.50; end price = $28.00) 2 years ago (begin price = $28.00; end price = $26.25) 1 year ago (begin price = $26.25; end price = $33.75) a. 9.80% b. 14.54% c. 12.81% d. 17.61%

c. 12.81%

Jake invested $10,000 in a mutual fund that returned 12% the first year. The second year he invested another $8,000 and the fund was up another 15%. Pleased with the growth of investments, he invested another $9,000 in year three and enjoyed another 9% increase. At the end of that year, the portfolio was valued at $37,460. What was Jake's average dollar-weighted return? a. 12% b. 49% c. 17% d. 26%

c. 17%

(Q6) Over the past year you earned a nominal rate of interest of 6.4 percent on your money. The inflation rate was 2.8 percent over the same period. What is the exact real rate of return that was earned? a. 3.70% b. 3.40% c. 3.50% d. 3.60%

c. 3.50%

(Q7) Given that the 3-year spot rate is 3.68%, the short rate in year one is 3.48% and the short rate in year two is 3.62%, then what is the forward rate for year 3? a. 3.59% b. 3.76% c. 3.94% d. 4.12%

c. 3.94%

(Q8) What is the duration of a $10,000 6% bond that matures in 5 years if the market yield to maturity is 6.4%? a. 4.49 years b. 4.53 years c. 4.46 years d. 4.32 years

c. 4.46 years

(Q7) All but one of the following are included within the index of leading economic indicators. Which of the following indicators is NOT a leading indicator of economic activity? a. Average weekly claims for unemployment insurance b. New manufacturing orders for consumer goods c. Consumer price index d. Number of new building permits e. S&P 500 stock prices

c. Consumer price index Leading indicators of economic activity include: the average weekly manufacturing hours, average weekly claims for unemployment insurance, manufacturing new orders for consumer goods, ISM Index of new orders, manufacturers new orders (nondefense capital goods), building permits, S&P 500 stock prices, leading credit index, interest rate spread and the average consumer expectations for business conditions. Coincidental indicators of economic activity (i.e., measures that turn positive during an economic expansion rather than at the end of the recession and start of the recovery or at the end of the expansion and beginning of the recovery) are: number of employees on non-agricultural payrolls, industrial production, personal income less transfer payments and manufacturing and trade sales. The lagging indicators include: the average duration of nonagricultural unemployment, inventory-to-sales ratio, change in labor cost per unit of output, average prime rate, commercial and industrial loans outstanding, ratio of consumer installment credit to personal income and the consumer price index (CPI).

(Q5) Your friend completed the Market Technician Association certification in technical analysis. Which form of market efficiency supports his efforts in applying the tenants of technical analysis to outperform? a. Semi-strong form efficiency b. Weak form efficiency c. None of these d. Strong form efficiency

c. None of these Weak form efficiency suggests that past information (i.e., technical analysis) cannot lead to consistent out-performance, but fundamental and insider information might. Semi-strong efficiency suggest that neither technical nor fundamental analysis can lead to consistent out-performance, but insider information might.

(Q6) Which of the following individual client factors influence the appropriate asset allocation mix? (1) Risk tolerance (2) Financial need (3) Time horizon (4) Financial capacity (5) Investment knowledge and experience (6) Individual preferences and constraints a. 3, 4 and 5 b. 1, 2, 3 and 6 c. 1, 2 and 6 d. 1, 2, 3, 4, 5 and 6

d. 1, 2, 3, 4, 5 and 6 All of these individual factors influence the appropriate asset allocation

(Q6) Based on the following data, what is the expected return of Stock A? Treynor ratio = .156 Standard deviation = .22 Beta = 1.2 Risk-free rate = 6% a. 9.4% b. 12.7% c. 18.8% d. 24.7%

d. 24.7%

(Q7) Given the following Treasury security data, then what is the best estimate of the one-year implied forward rate three years from now? Years to Maturity: Spot Rate: 1 5.0% 2 4.5% 3 4.1% 4 3.8% a. 2.91% b. 3.12% c. 3.20% d. 3.30%

d. 3.30%

(Q5) Which of the following is NOT a fundamental premise of prospect theory. a. Investors focus on change in wealth rather than wealth maximization b. When experiencing a loss, risk-averse investors will become more risk seeking c. The highest portfolio value becomes a reference point for portfolio evaluation d. Risk-averse investors are more focused on gains than losses

d. Risk-averse investors are more focused on gains than losses Key elements of prospect theory include 1) risk-averse investors focus on loss or gain more than on total terminal wealth, 2) investors focus on change in wealth, reset to a "reference point", 3) more pain is associated with losses than happiness associated with gains (loss aversion) and 4) investors tend to be risk-averse when experiencing gains but risk-seeking when experiencing a loss.

(Q5) "Stock prices adjust rapidly to the release of all new public information." This statement is an expression of which one of the following ideas?" a. technical analysis b. arbitrage pricing theory c. random walk hypothesis d. semi-strong form of efficient market theory

d. semi-strong form of efficient market theory Semi-strong form efficiency says that all past and current public information is efficiently (and quickly) incorporated into the stock price. This implies that technical and fundamental analysis cannot produce consistent, excessive profit. It does leave open the possibility that insider information may produce superior returns.

(Q8) What is the duration of a portfolio that contains the following securities? Bond F - $100,000, duration = 6.4 years Bond G - $250,000, duration = 11.8 years Bond H - $150,000, duration = 8.4 year a. 4.85 years b. 4.49 years c. 8.97 years d. 8.40 years e. 9.70 years

e. 9.70 years

(Q7) Which of the following sectors would you expect to outperform during a market recession? a. Auto manufacturer b. Financial firm c. Airline d. Hospitality company e. Food and beverage firm

e. Food and beverage firm Defensive industries tend to do well during a market recession. Examples of defensive industries include food, beverages, healthcare, and utilities. Cyclical industries tend to outperform during times of macro-economic expansion and macroeconomic peaks. Examples of cyclical industries include basic materials, hospitality, auto manufacturers, restaurants, furniture, airlines, financials, real estate.

(Q5) Market volatility creates an on-going roller-coaster of emotion. Which of the following emotional or cognitive biases best describe the sabotaging behavior of hanging onto losers, rather than harvesting the tax loss and then re-positioning the portfolio? a. Herding b. Representativeness c. Mental accounting d. Ambiguity aversion e. Regret avoidance

e. Regret avoidance Investors seek to avoid the pain of admitting to an investment mistake. This results in the tendency to hold onto securities that represent losses. Aversion to ambiguity reflects the tendency to become very conservative during conditions of uncertainty.

(Q5) In a highly efficient market, there should be no exceptions. However, evidence shows some persistent patterns that offer out-performance relative to a buy and hold strategy. Which of the following is NOT recognized market anomalies? a. January effect b. "Dogs of the Dow" c. Small firm effect d. Turn-of-the-month effect e. Low market multiple stocks f. International stock effect

f. International stock effect Anomalies are systems or patterns that outperform the passive or buy-and-hold strategy. The neglected-firm effect states that neglected small-cap stocks tend to outperform those firms that are covered by Wall Street. If true, the anomaly suggests that active investing in the small-cap sector may produce superior results over passive strategy. The "January Effect" is a calendar-related anomaly. It suggests that the first couple weeks of January offer abnormal return opportunities, especially for those purchasing smaller-cap securities. The explanation is often related to end-of-year tax-loss selling that sets up a price rebound opportunity. The turn-of-the-month effective shows that stocks, particularly large-cap stocks, tend to perform well at the end of the month and the first few trading days of the new month. The "Dogs of the Dow" and low market multiple effect are contrarian plays (i.e., shunned securities are set up for a price bounce once everyone that wanted to sell has done so).