Portfolio/ Fixed Income Basics
A customer is invested in a diversified portfolio of small-cap, mid-cap and large-cap stocks of companies based in the United States. Which index fund could the customer use to further diversify this portfolio?
EAFE The EAFE Index stands for Europe, Australasia, and the Far East. It consists of companies of developed countries in these areas - so these are all companies outside of North America. Investing in an EAFE ETF would give the customer international exposure and further diversify his or her U.S. based portfolio against market risk, since companies in international markets would typically be affected by different events than U.S. companies. The S&P 500, DJIA, and Russell 2000 all consist of U.S. companies.
The "generally recognized" asset classes for investment are: Stocks; Bonds; Cash; Real Estate; and Commodities.
Each one is an investment type with similar risk/return characteristics. Diamonds could be viewed as a subset of the "commodities" asset class (and a very expensive commodity at that). The S&P 500 Index stocks would be a subset of the stocks asset class. As far as annuities go, many insurance companies promote them as an "asset class" or as an alternative asset class, however they are not part of the generally accepted definition.
A customer buys a new issue TIPS with a 3% coupon rate. If the CPI during the first year increases by 2%, the customer will receive annual interest the next year of:
$30.60 TIPS stands for Treasury Inflation Protection Security. The coupon rate at issuance is 3% and the security is issued at par. Each year, the principal amount is adjusted upwards by that year's inflation rate, so that the adjusted principal amount at the end of Year 1 will be: $1,000 x 1.02 = $1,020. The 3% coupon is applied to the adjusted principal amount, so 3% of $1,020 = $30.60 in interest that will be paid in Year 2: If there is inflation each year, the principal is continually adjusted upwards and the annual interest payment will increase. At maturity, the holder is returned the higher adjusted principal amount.
A stock whose price moves down 5% when the market as a whole moves up by 10% has a beta coefficient of:
-.50 A stock with a positive "beta" moves in the same direction as the market; a stock with a negative "beta" moves in the opposite direction to the market. If a stock moves down 10% when the market moves up 10%, it has a beta of -1.00. If a stock moves down 5% when the market moves up 10%, it has a beta of -.50. If a stock moves down 20% when the market moves up 10%, it has a beta of -2.00. There are very few "negative" beta stocks - these are counter-cyclical stocks such as credit collection companies and pawnshops (when times are bad, these stocks do well; and vice-versa).
During a given period of time, the overall stock market, which has a Beta of 1, is up 10% in value. XYZ stock, which has a Beta of 1.55, is up 15.50% during the same period. Assuming that the risk-free rate of return is "0," the "alpha" of XYZ stock is:
0 In its most simplistic form, alpha is the excess return of an investment as compared to the risk-adjusted return of the market. To find alpha, the following are compared:The excess actual rate of return given by this investment over the risk-free rate of return.Actual Return of Specific Investment - Risk-Free-Return = 15.50% - 0% = 15.50%.The excess return of the benchmark index over the risk-free rate of return:Market Index Return - Risk-Free Return = 10% - 0% = 10%. If we ignore "risk" as measured by "beta" - then the excess return of the investment as compared to the excess return of the benchmark index is 15.50% - 10% = 5.50%. However, this investment had excess risk because its beta was 1.55 as compared to the market beta of 1. Alpha adjusts for this. To compute "alpha" we must compare the rate of return that the "benchmark index" would have given if it had the same "beta" as this stock. Since this stock has a beta of 1.55 x 10% excess benchmark return = 15.50% risk-adjusted excess benchmark return of the market index. Since the actual excess return of the stock was 15.50%, this stock has an "alpha" of "0" - the actual excess return of the stock (15.50%) minus the expected risk-adjusted excess return of the benchmark index (15.50%). This means that, on a risk adjusted basis, an investment in the stock was no better than an investment in the benchmark index. An alpha of more than "0" indicates that the investment outperformed the market on a risk-adjusted basis. A negative alpha indicates that the investment underperformed the market on a risk adjusted basis.
Compute the non-compounded annualized inflation adjusted rate of return for the following investment held for 3 years. Initial Investment Value: $5,000Ending Investment Value: $4,400Dividends Received Over The Period: $900Inflation Rate Over The Period: 6%
0 The original investment is $5,000. Over 3 years, the customer lost $600 on the investment and received $900 in dividends, for a net return of $300, earned over 3 years. Annualized, the customer earned $100 per year on $5,000 invested = 2%. However, the rate of inflation over 3 years was 6%, or 2% per year (ignoring compounding). Therefore, the inflation adjusted rated of return over the 3 year period is 2% - 2% = 0%.
Which TWO of following investments offer tax benefits? I Municipal bonds II REITs III Real Estate IV Index Funds
1+3 Municipal bonds offer interest income that is free of federal income tax and free of state and local income taxes when purchased by a resident of that state. Thus, they offer a tax benefit. Direct investment in real estate permits the owner to deduct depreciation and mortgage interest cost, so this is a tax benefit. REITs and Index Funds do not allow for "flow-through" of loss deductions and they do not offer an exemption from federal income taxation on either interest or dividend income that is distributed to shareholders.
A stock is quoted as follows: Bid 18.95 Ask 19.00 1 0 x 10 The spread for a round turn trade is: I $.05 II $5 III $50 IV $500
1+3 The size of the quote is "10 x 10" = 10 round lots of 100 shares = 1,000 shares both bid and offered. If the dealer sells 1,000 shares at $19.00 and buys 1,000 shares at $18.95 (a round turn trade), the dealer makes a spread of $.05 on 1,000 shares = $50. Review
A broadly diversified portfolio: I is subject to market risk II is not subject to market risk III can have its systematic risk reduced by the purchase of index puts IV cannot have its systematic risk reduced because it is fully diversified
1+3 ndex options can be used to hedge a portfolio. If index puts are bought, then a drop in the market lowering the portfolio's value will be offset by a gain in the value of the index puts. This strategy hedges against market risk, also known as systematic risk. Non-systematic risk is the risk that any one security will perform poorly. The larger the portfolio, the lower the effect of non-systematic risk.
In an over-the-counter agency trade, the member firm executing the order: I is a broker II is a dealer III charges a mark-up IV charges a commission
1+4 In an over-the-counter agency transaction, the firm acts as a broker, matching a customer who wishes to buy with a seller (and vice-versa). For this service, the member firm earns a commission. In contrast, in an over-the-counter principal transaction, the member firm sells a security out of its inventory to a customer who wishes to buy; or buys a security into its inventory from a customer who wishes to sell. In this transaction, the firm acts as a dealer, and marks-up the stock to the customer who wishes to buy; or marks-down the stock from the customer that wishes to sell. Review
Broker-dealers are permitted to execute the following over-the-counter transactions? I Agency trades where the customer is charged a commission II Agency trades where the customer is charged a mark-up or mark-down III Principal trades where the customer is charged a commission IV Principal trades where the customer is charged a mark-up or mark-down
1+4 In over-the-counter transactions, for effecting an agency trade, only a commission can be charged; while in a principal transaction, only a mark-up or mark-down can be charged. It is prohibited to charge a commission in a principal transaction. Similarly, it is prohibited to charge a mark-up in an agency transaction. Furthermore, it is prohibited to charge both a commission; and a mark-up or mark-down; in any transaction.
Mutual fund performance charts show: I Time Weighted Average Return II Dollar Weighted Average Return III a return that is affected by investor cash inflows and outflows IV a return that is not affected by investor cash inflows and outflows
1+4 Time Weighted Average Return is used by mutual funds on their performance charts to show average annual investment returns. It measures how well the fund manager performed in increasing the dollars that have been invested. Additional cash moving into the fund or out of the fund does not affect the computation. This is the average annual return that would be provided from a "buy and hold" strategy. Dollar Weighted Average Return is the same as the Internal Rate of Return. It is the discount rate that takes all of the cash flows from the investment. Dollar Weighted Return takes into account the impact of cash inflows and outflows from purchases and sales as well as growth in assets. The classic comparison of these 2 returns is where a fund receives a large cash inflow after a period of superior performance (which attracted the new investors to the fund) and then suffers a period of poor performance. Time Weighted Average Return shown over the following periods will be much higher than the Dollar Weighted Average Return experienced by the new investors. For example, $100 is invested in a fund at the beginning of the year with a $10 per share NAV = 10 shares purchased. After 6 months, the NAV per share increases to $20 per share and the happy customer invests another $100 (5 more shares). At the end of the year, the NAV falls back to $10 and the investor sells all 15 shares. In this example, the Time Weighted Average Return will be 0% (because the NAV per share was the same at year beginning and year end). However, this customer invested a total of $200 and sold the shares for $150 at year end, experiencing a $50 loss. This equals an annualized dollar weighted average return (IRR) of approximately -25%. If the investor did not make the additional cash deposit at mid year and did not sell the shares at year end, then the 2 measures would have been the same.
Under Modern Portfolio Theory, the efficient set of investments found by CAPM are those with the: I Highest expected return II Lowest expected return III Highest level of risk relative to the expected level of return IV Lowest level of risk relative to the expected level of return
1+4 Modern Portfolio Theory uses "CAPM" - the Capital Asset Pricing Model - to find the best investments in the market. The efficient set of investments are those that give the highest expected return relative to their risk-class. Risk in the model is based on the standard deviation of returns. The best investments are those that give the highest expected return relative to the level of risk assumed (lower is better). When these "best" investments are plotted out on a graph where the vertical axis is expected return and the horizontal axis is risk, the result is an upward sloping line called the "efficiency frontier." Any investments made that lie on the line or above give the best "bang for the buck" - the greatest return per unit of risk assumed. Those that are below the line are inferior investments.
A customer buys 100 shares of ABCD stock at $16.00 per share. At the end of the year, the stock is valued at $12.00. During the year, the stock paid $.30 in quarterly dividends. The stock's dividend yield is:
10% Dividend yield is based on the current market share price, not on cost of the stock. The formula is: Latest Annual Dividends/ Current Market Price = $1.20 / $12.00 = .10 = 10% Annual Dividend / Current Share Price
At the beginning of the year, a portfolio has a value of $400,000. 6 months later the portfolio is valued at $420,000. The annual percentage return on the portfolio is:
10% This portfolio has grown in value from $400,000 to $420,000 over 6 months. Thus, the portfolio has grown by $420,000/$400,000 = 5% over 6 months. Since this is a 6 month return, an annualized rate of return is 2 times 5% or a 10% annual rate of return.
A 50 year old customer receives an inheritance of $1,000,000 which he places with an investment adviser to invest with the objective of safety of principal and a moderate level of income. As of the end of the first year, the portfolio is worth $1,300,000. As of the end of the second year, the portfolio is worth $1,200,000. Ignoring compounding, the approximate annual return on investment is:
10% This portfolio started with a $1,000,000 investment. The fact that it was worth $1,300,000 at the end of the first year is irrelevant to the question. The portfolio depreciated by $100,000 in the second year and had a second year-ending value of $1,200,000. Thus, over the course of 2 years, the portfolio had a net increase of $200,000 - or an average yearly increase of $100,000 / $1,000,000 original investment = 10% annual rate of return.
A $1,000 par TIPS is issued with 5 years to maturity. The coupon rate on the bond is 3.50%. If the inflation rate for the next 5 years is 2.50%, the bond will be worth how much in 5 years?
1131 TIPS is a Treasury Inflation Protection Security. Aside from receiving the 3.50% coupon ($35 annual interest) paid to the bondholder, the principal is adjusted upwards by the inflation rate each year, and at maturity, the holder receives the inflated principal amount. $1,000 inflated by 2.50% annually equals: $1,000 x 1.025 x 1.025 x 1.025 x 1.025 x 1.025 = $1,131. (Note, while in reality the principal gets adjusted semi-annually, to simplify the calculation, we are adjusting the principal annually.)
A customer has a 10-year investment time horizon and has $5,000 available for investment each year over that time frame. The customer wishes to have $100,000 at the end of that time. In order to accumulate $100,000 at the end of 10 years, the approximate rate of return on investment would need to be:
12 There are a number of ways to deal with this question. This customer is investing $5,000 a year in each of the next 10 years, for a total investment of $50,000. Using the "Rule of 72" dividing the Rate of Return into 72 gives the approximate number of years needed for an investment to double. Thus, if an investment is returning 7.2% (72/7.2), it would double in 10 years. However, all $50,000 is not being invested in the first year - rather, it is being invested at the rate of $5,000 per year over 10 years, for an average aggregate investment value of $25,000 ($50,000/2) over the 10 years. For $25,000 to become $100,000 over 10 years, it must double to $50,000 and double again to $100,000. Thus, the approximate rate of return would need to be double 7.2% = 14.4%. But it would be a bit lower than this, since any earnings are compounding at a much higher interest rate than 7.2%. Of the 4 choices offered, the highest is 12% - all the other choices are lower - so this must be the answer. Another way of proving this is to do the math: $5,000 invested for 10 years at 12% would be worth $5,000 x (1.12)10 = $15,529 10 years out$5,000 invested for 9 years at 12% would be worth $5,000 x (1.12)9 = $13,865 9 years out$5,000 invested for 8 years at 12% would be worth $5,000 x (1.12)8 = $12,380 8 years out$5,000 invested for 7 years at 12% would be worth $5,000 x (1.12)7 = $11,053 7 years out$5,000 invested for 6 years at 12% would be worth $5,000 x (1.12)6 = $9,869 6 years out$5,000 invested for 5 years at 12% would be worth $5,000 x (1.12)5 = $8,812 5 years out$5,000 invested for 4 years at 12% would be worth $5,000 x (1.12)4 = $7,868 4 years out$5,000 invested for 3 years at 12% would be worth $5,000 x (1.12)3 = $7,025 3 years out$5,000 invested for 2 years at 12% would be worth $5,000 x (1.12)2 = $6,272 2 years out$5,000 invested for 1 year at 12% would be worth $5,000 x (1.12) = $5,600 1 year outAdding up the future values: $98,273 This is a lot of work to do to answer a question. Since the 4 choices are so far apart, using the "approximate" method is just fine.
Which of the following are components of common stockholders' equity? I Common at Par II Capital in Excess of Par III Retained Earnings IV Intangibles
123
Monte Carlo simulation analyzes potential portfolio returns achieved based upon which of the following varying factors? I interest rates II inflation rates III equity returns
123 Monte Carlo simulation is a computer-driven "decision-tree" analysis of possible portfolio returns that can be achieved based on varying factors, such as differing future interest rate levels; equity return levels; inflation rate levels, etc. It assesses the probability of getting the desired portfolio return over a long time horizon, during which these variables can change thousands of times.
Which of the following customers is considered to be long 100 shares of ABC stock? I A customer who has bought 100 ABC shares in a regular way trade that has not yet settled II A customer who owns 1 ABC call contract III A customer who owns two ABC convertible bonds, convertible into 50 shares each, who has given irrevocable instructions to convert IV A customer who owns 100 ABC warrants and has exercised those warrants
134 A customer is considered to be long stock once the stock has been purchased. The transaction does not have to settle for the customer to be considered to be long. A customer is considered to be long if he owns options or warrants and has exercised. Choice II is not considered a long stock position since the call has not been exercised, while Choice IV is a long position because the warrants have been exercised. A customer is considered to be long stock if the customer owns a convertible security and gives irrevocable instructions to convert (Choice III).
Which of the following are advantages of "DRIPs"? I Additional shares of the issuer are purchased with no commission charges II The investor gets to decide the timing of additional stock purchases in that issuer III The investor can add to an existing position in that issuer without having to place an order through a broker IV The process of buying additional shares via a DRIP allows for dollar cost averaging
134 DRIP" stands for "Dividend Re-Investment Plan." These are plans offered by corporate issuers that give shareholders the ability to reinvest cash dividends paid by the company in additional shares of that company. This is a feature similar to automatic reinvestment of dividends at NAV in a mutual fund. There are no commission charges on reinvested dividends and fractional shares can be purchased. The issuer's DRIP allows the shareholder to build an increasing position in that issuer's stock over time in a passive fashion. Because additional shares are purchased periodically with the reinvested dividends, this is a form of dollar cost averaging. The disadvantage of a DRIP is that the investor cannot determine the timing of these incremental purchases. Review
Which of the following are needed to calculate the Sharpe Ratio? I Risk measured by variability of return II Actual rate of return on an investment III Real Rate of Return IV Rate of return on an investment with zero risk
134 a risk measurement that compares the "extra return" achieved (Total Return - Risk Free Rate of Return) for the "extra risk" assumed (Standard Deviation) by choosing a given investment. Expressed as a ratio of Return/Risk, the higher the ratio, the greater the incremental return achieved relative to the incremental risk assumed.
EFFE stock has a beta of +1.5. The expected market rate of return is 10% and the risk-free rate of return is 2%. The standard deviation of returns is 1%. Using the Capital Asset Pricing Model (CAPM), what is the expected rate of return for EFFE stock?
14 2 + 1.5 (10-2) CAPM finds the "expected return of an investment" using the formula: Expected Return of An Investment =Risk-Free Rate of Return + Risk Premium* *Risk Premium is: Beta x (Expected Market Return- Risk-Free Rate of Return) Basically, the Risk Premium is the excess of the expected market rate of return over the risk-free rate of return multiplied by the risk level of the investment as measured by beta. Because the expected market rate of return is 10% and the risk-free rate of return is 2%, the risk premium is 8% x 1.5 beta = 12%. Thus, the Expected Return of The Investment is: 2% Risk-Free Rate of Return + 12% Risk Premium = 14%. Note that Standard Deviation has nothing to do with the formula and is a distractor in the question.
Which risks are unique to mortgage backed securities? I Interest rate risk II Contraction risk III Credit risk IV Extension risk
2+4 Mortgage backed securities pass through the monthly mortgage payments to the certificate holders. Because the homeowners have the right to prepay their mortgages without penalty, when market interest rates drop, the homeowners refinance their mortgages, and these early principal repayments are passed-through to the certificate holders. Thus, the certificates pay off much earlier than expected as the expected maturity shortens (this is also called contraction risk or call risk). The certificate holders that receive the early principal payments will now have to reinvest them in new MBSs, which will be yielding less because market interest rates have declined. Extension risk is an opposite risk. If market interest rates have risen after a mortgage pool is created, the homeowners sit tight and don't move. Thus, the anticipated rate of prepayments built into the security slows down and the maturity extends. The certificate holder winds up earning a lower than market rate of interest for much longer than he or she ever expected! Review
Which security would be expected to have the greatest duration?
20 year; zero-coupon bond Duration is a measure of price volatility of a fixed income security. As maturity lengthens or the coupon rate drops, duration increases. These are the securities which are most greatly affected by interest rate risk. Of the choices given, the security that would have the greatest duration is the 20 year, zero-coupon bond - it has the longest maturity and lowest coupon rate.
When the price of a bond increases, which of the following statements regarding yields are TRUE? I Yield to call increases II Yield to call decreases III Yield to maturity increases IV Yield to maturity decreases
24 When the price of a bond increases, yield to maturity drops. Similarly, because the bond is more expensive, yield to call will also fall.
Arrange the following in order of claim priority in a corporate liquidation: I Common stockholders II Preferred stockholders III Secured bondholders IV Unsecured bondholders
3421 Mortgage bond holders, unpaid wages and taxes, debenture holders, preferred stockholders The priority of claim to corporate assets in a liquidation is: Secured creditors, unpaid wages and taxes, trade creditors, unsecured bondholders, preferred stockholders, common stockholders. Review
A portfolio manager generates a 10% rate of return on a "small cap" portfolio, compared to an 8% rate of return on the benchmark portfolio and a 6% rate of return on the Standard and Poor's 500 index over the same period. The passive rate of return on the portfolio is:
8 The "passive" rate of return is that achieved by investing in an appropriate index fund. Here, the benchmark index has an 8% rate of return - this is the return that any passive investor could achieve by investing in an index fund that mimics that index.
If market interest rates decline, which statement is TRUE?
A bond's yield to maturity will fall A bond's yield to call will fall A bond's prices will rise
Real rate of return
Actual Rate of Return - Inflation the actual rate of return achieved on an investment minus the inflation rate. If an investor earns 5% on a "safe" investment; and the inflation rate is running at 2%; then the real rate of return is 3%. It is the same as the incremental return earned, above and beyond, the inflation rate.
Question:A portfolio of securities with a beta of 1.5 has produced an average annual return of 18%. Which investment should the portfolio manager consider adding?
A stock with a 10% growth rate and a beta of .8 The portfolio has generated a 18% return by taking on extra risk (beta of 1.5 is .5 above the market risk level of 1). If we divide the return by the beta, the market return for the portfolio would be 18% / 1.5 = 12%. Any investment that exceeds this amount (risk adjusted) is a good one for the portfolio. Choice A: 6% / .6 Beta = 10% risk adjusted returnChoice B: 10% / .8 Beta = 12.50% risk adjusted returnChoice C: 12% / 1.5 Beta = 8% risk adjusted returnChoice D: 20% / 2 Beta = 10% risk adjusted return
Momentum investing
A technical theory that states that stocks that have growing market momentum tend to keep on moving in the same direction. Thus, a stock that has a rapid upward price movement would be expected to continue to rise rapidly in price - so this is a stock that should be bought. A money manager that employs momentum investing makes investment decisions based on the: earnings trends of the company
When looking at the Net Worth of a corporation, this is best described as:
Accounting Value Net Worth of a corporation is all assets minus all liabilities. Net worth is simply the accounting value of common stockholder's equity. Liquidation value is not the same thing as accounting value. Liquidation value bases value as of today's market value. Common stockholder's equity (book value) is based on accounting as of the date each transaction happened, which could be years in the past. Thus, if the market values of those assets or liabilities booked years in the past have moved dramatically, then "book value" really has little meaning.
What is a margin account?
An account where a broker-dealer uses cash or client stock as collateral for a line of credit to buy additional stock for that client A margin account is a brokerage account where the customer buys stock by either putting up half of the purchase amount in cash; or deposits fully-paid securities equal to 100% of the purchase amount; with the balance of the purchase amount lent by the broker-dealer to the customer. Margin accounts cannot be offered by investment advisers or banks. Note that an investment adviser or bank can have a brokerage firm as a subsidiary or affiliate to offer a margin account to a client. Finally, issuers cannot lend money to individuals to buy that issuer's stock! Review
Current yield
Annual Income / Market Price.
Investment "A" is purchased in May and sold at a gain in the July following. Investment "B" is purchased in June and sold at a gain in the October following. In order to compare the return of investment "A" to investment "B," which measure should be used?
Annualized return . Investment A has been held for 2 months and then sold at a gain; while Investment B has been held for 4 months and then sold at a gain. To compare them, their returns must be annualized. Dollar weighted return is another name for Internal Rate of Return. Holding period return is a non-annualized rate of return that is earned over the life of the investment. Total return includes the "total" of both dividends and capital gains as the components of investment return.
Return on investment (ROI)
Average Annual Cash Flow / Initial Investment Outlay the percentage return given by an investment, computed by taking the annual cash flows generated by the investment, averaging them, and then dividing the average annual cash flow by the initial investment amount. the annual compounded investment return necessary to increase the value of an asset to a specified future amount. This considers the time value of money, and is the same as internal rate of return.
An example of a passive long term bond investment strategy is: A buy and hold B a barbell C a ladder D interest rate anticipation
Buy and Hold Since long term bonds are more volatile than short term bonds as market interest rates move, a long term bond investor should be a "buy and hold" investor. As long as the bond is held to maturity, the bondholder will not experience a market value loss due to an interest rate rise. This is a "passive" strategy because it does not require a manager to decide when to change the portfolio composition. When constructing a bond portfolio, "laddering" the portfolio means that the portfolio is structured with short-term; intermediate term; and long-term investments. As the short-term bonds mature, the proceeds are reinvested either in new short-term, intermediate-term or long-term bonds, depending on anticipated movements in interest rates (if rates are expected to rise, then the proceeds are invested in short-term bonds, which will fall the least from a market interest rate rise; if rates are expected to fall, then the proceeds are invested in long term bonds, which will rise the most from a market interest rate fall; if rates are expected to be stable, then the proceeds are invested in intermediate term bonds). Thus, there is active portfolio rebalancing going on as interest rates move - so this is an example of an interest rate anticipation strategy. A barbell strategy is a similar strategy, using only short term and long term bonds (the 2 ends of the barbell). Thus, a barbell, a ladder, and interest rate anticipation, are all "active" strategies.
Which statement is TRUE regarding a portfolio that has a "Beta" of 1?
Changes in the value of the portfolio should be both in the same direction and the same velocity as price movements in the market A portfolio with a "beta" coefficient of +1 is one that moves in both the same direction and same velocity as the market as a whole. A portfolio with a "beta" coefficient of +2 is one that moves in the same direction as the market as a whole, but which moves twice as fast as the market. A portfolio with a "beta" coefficient on -1 is one that moves at the same velocity as the market as a whole, but it moves in the opposite direction to the market. There are very few "negative" beta stocks - gold stocks being one of them. When the stock market "tanks," investors flee to safety - gold - so these stocks rise when the market falls, and vice-versa.
Inertial inflation is:
Contractually based Inertial inflation is inflation that is contractually embedded in the economy. For example, COLAs (Cost of Living Adjustments) in union and government employment contracts are tied to increases in the inflation rate. Inertial inflation can be "self-fulfilling" because as wages rise due to COLAs, this creates inflationary pressure on prices of goods and services, so their prices rise, which triggers another COLA increase, etc. In periods of sustained inflation, bonds do terribly because interest rates rise, and stocks don't fare well either. Tangible assets such as real estate are the best investments in periods of sustained inflation. When prices in an economy are adjusted with relation to a price index by force of contract, this is called:
Which of the following represents "leverage"?
Debt / Equity
If tax rates fall, the value of municipal bonds will:
Decrease If tax rates fall, the value of "tax-free" municipal bonds will decrease. Lower tax rates make tax-free interest income less valuable.
A 7% coupon bond is being offered on an 8% basis. If interest rates for similar bonds fall below 8%, the basis for this bond will:
Decrease This is pretty simple. A basis quote is a yield to maturity quote. If market yields are rising, the basis quote will rise, forcing the bond's price down. If market yields are falling, the basis quote will fall, forcing the bond's price up.
All of the following risks are essentially equivalent for long term corporate bonds EXCEPT:
Default Risk
The market theory that states that technical and fundamental analysis is of no use in selecting stocks for a portfolio is known as the:
Efficient market theory . Efficient market theory is an academic approach to securities pricing in the market that states that securities prices instantaneously and fully reflect all available information. Thus, the use of analysis to find "undervalued" stocks is futile.
Total return
Ending value minus beginning value, plus or minus cash flow, divided by beginning value is: the percentage return, including both dividends and capital appreciation, on money invested in a security.
A bond is rated Aaa by Moody's. The bond is:
Highest Quality Investment Grade
The primary risk associated with holding a long-term U.S. Government STRIP is:
Inflation (purchasing power risk)
2 years ago a woman leased a new car by putting $2,000 down and signing a 48 month lease at $500 per month. She has received a letter from the lease company saying that she can complete the lease right now by making a single $10,000 payment and keep the car for 2 more years; or she can finish the lease by making the remaining 24 monthly payments of $500. Assuming that this customer can earn 6% by investing in Treasury securities, and ignoring any tax consequences, to determine the best option, the method to be used is:
Internal Rate of Return This customer can get out of the lease by making a $10,000 payment now; or can continue to make $500 per month payments for the next 24 months, paying a total of $12,000 to complete the lease. One method to compute the best option (lowest cost) would be to use net present value - but this is not given as a choice! The customer can pay off the lease now by paying $10,000 now - this is the present value of this payment. Using NPV and a 6% risk-free rate of return, the present value of continuing the lease payments is: $6,000 paid in 1 year1.06= $5,660 NPV for year 1 payments$6,000 paid in 2 years1.06(2)= $5,340 NPV for year 2 paymentsTotal NPV = $5,660 + $5,340 = $11,000 Paying off the lease in one payment costs $10,000; while the net present cost of continuing the lease is $11,000. The up-front $10,000 payment is the best alternative (assuming that the customer has the $10,000 on hand!). Since NPV is not given as a choice, we have to evaluate the cost of each option by another method. The customer can either pay $10,000 now; or can make 24 more monthly payments of $500. If we can find the interest rate that discounts these monthly payments to $10,000; then we know the true interest cost implicit in continuing to make the monthly payments (this is the Internal Rate of Return). This is done using a financial calculator or by interpolation. Just as an example, assume that we try a 12% interest rate to discount the payments: $6,000 paid in 1 year1.12= $5,357 NPV for year 1 payments$6,000 paid in 2 years1.12(2)= $4,783 NPV for year 2 payments This gives us a Net Present Value of $5,357 + $4,783 = $10,140, which is darn close to the $10,000 we must pay now to terminate the lease. Thus, the interest cost of continuing to make the $500 payments is about 12%. If we can borrow money somewhere else at a cheaper interest rate than 12%; or if we are not earning at least 12% on our investments; then we should pay off this lease with the single $10,000 payment now!
What rate would NOT be used to find the present value of a TIPS?
Internal Rate of Return of the bond's cash flows Finding the present value of a TIPS (Treasury Inflation Protection Security) is the same thing as calculating the market price of a TIPS using discounted cash flows. The coupon rate (nominal rate) on a TIPS is the interest rate at issuance that will price the instrument at par. This is the same as the "real rate" of return at that point in time (the real rate has the current inflation deducted out, because there is no "inflation risk" on a TIPS). Assume that the 30-year Treasury Bond is issued with a 3% coupon rate when the inflation rate is 1%. The "real" rate of return is 2%, and this would be the interest rate on a 30-year TIPS issued at that time. Assuming that this interest rate is 2% for a 30 year TIPS. If there is no inflation, the annual cash flow received for each of the next 29 years will be 2% of $1,000 = $20; and in year 30, the customer will receive $1,020 ($1,000 principal without any inflation adjustment plus another $20 of interest). If these cash flows are discounted at the coupon rate of 2%, the price of the bond will be par. If there is inflation, then the principal amount is adjusted upwards in that year for the CPI increase, and the cash flow received in that year also increases, since the 2% coupon is applied against the increased principal amount. Because the cash flows are increasing due to inflation, when they are discounted at the 2% coupon rate, this means that the bond will be valued above par. Conversely, if there is deflation, then the principal amount is adjusted downwards in that year for the CPI decrease, and the cash flow received in that year also decreases, since the 2% coupon is applied against the decreased principal amount. Because the cash flows are decreasing due to deflation, when they are discounted at the 2% coupon rate, this means that the bond will be valued below par.
Which of the following risks is the primary concern when investing in a municipal bond?
Legislative (regulatory) risk is the risk of law changes; primarily the risk of tax law changes. Since the interest income from municipal bonds is exempt from Federal income tax, the main risk associated with these securities is that the Federal government may attempt to tax their interest income (this has already happened with certain types of municipal bonds). Also note that these securities are subject to purchasing power risk, market risk, and credit risk; but this is not the "primary" concern with these investments. Legislative
When the market price of a security has reached equilibrium, transaction costs will be:
Lower When a stock has found its equilibrium price in the market, this means that there is active trading occurring and that the number of buyers and sellers is balanced. In such a market, the spread is minimized, and this is a cost of trading (aside from commission costs). Note that when markets are rapidly rising, which happens when buyers outnumber sellers, market makers are continually revising their quotes, and their spreads tend to be wider as they are doing this. The same is true when markets are rapidly falling. So transaction costs in "fast moving" markets tend to be higher (because spreads are wider); while transaction costs in stable markets tend to be lower.
Mean Median Mode
Mean: the simple average of a sequence of numbers (or investment returns for exam purposes). Given a sequence of 5 annual investment returns - 2%, 4%, 6%, 8%, and 8%, the arithmetic mean is 2% + 4% + 6% + 8% + 8% = 28% / 5 = 5.60% Median: given a sequence of numbers, the median is the "centerpoint" number. For example, given the following sequence of numbers - 2, 4, 4, 6, 8, 8, 10, the central number is 6 - this is the median of the number sequence. Mode: given a sequence of numbers, the mode is the number that occurs most often. For example, given the following sequence of numbers - 2, 4, 4, 6, 7, 8, the mode is 4 because it occurs twice, while each of the other numbers only occurs once.
Dollar cost averaging is used most often by:
Mutual Fund Investors Dollar cost averaging (DCA) is most often used by mutual fund investors, because the periodic investment of a fixed dollar amount (say $500 per month) can buy both full and fractional shares. It is not used by hedge funds, because they time the market (they don't make fixed investments at fixed intervals) and use aggressive, leveraged strategies, such as short selling. UITs are not suitable for dollar cost averaging because they are usually fixed bond portfolios that are bought and held to maturity. ETFs are usually passively managed index funds. These could be effectively dollar cost averaged, but they can only be purchased in full shares, not fractional shares, so mutual funds are still better for DCA. Review
When looking at the Price/Book Value ratio of a corporation, "Book Value" is best described as:
Net Accounting Value The Price/Book Value Ratio of a corporation is the company's Market Price (per share) / Common Stockholders' Equity (per share). While the "price" is the market value per share, book value is simply the accounting value of common stockholders' equity. Liquidation value is not the same thing as accounting value. Liquidation value bases value as of today's market value. Common stockholders' equity is based on accounting as of the date each transaction happened, which could be years in the past. Thus, if the market values of those assets or liabilities booked years in the past have moved dramatically, then "book value" really has little meaning.
All of the following investment company terms are synonymous EXCEPT: A Bid B Redemption Price C Net Asset Value D Offering Price
Offering Price Bid, Redemption Price, and Net Asset Value are all the same terms for investment company shares. This is the price at which a customer can sell (redeem) his or her shares.
What would be the best stock recommendation during a period of recession?
Pharmaceutical Pharmaceuticals are a classic defensive stock. Drug prescriptions are not affected by the economic cycle - whether times are good or bad, people will buy their drugs to maintain their health. Consumer goods stocks include department stores and such, and these are deferrable purchases in a time of recession. Oil usage declines in a time of recession because people drive less and there is less trucking commerce. Finally, defense stock performance depends on fiscal policy - how much money the government is spending on defense programs. How they do in a time of recession has nothing to do with consumer behavior - it really depends on whether the government is spending more on defense or less on defense at that point in time.
An investor knows that he must pay back the principal of a $50,000 loan that he got from a close relative to buy a house. The loan matures in 10 years. To make sure that the client has the funds to pay back the loan in 10 years, you recommend that the customer buy 50M of 10-year Treasury STRIPS. This is an example of:
Portfolio immunization Portfolio immunization is the strategy of managing a portfolio to make it worth a specific amount at a stated date in the future. This strategy is typically used to fund a known future liability. Since this customer needs $50,000 in 10 years, buying a zero-coupon obligation (a STRIPS in this example) will give the customer the needed principal amount 10 years from now. The intent of bond portfolio immunization is to eliminate interest rate risk. If the customer were to buy, say, a conventional 30-year Treasury bond to pay off this liability in 10 years, and interest rates rose substantially in the meantime, those bonds would drop in value, and the needed funds would not be there in 10 years. The bottom line is that to immunize a portfolio, the duration of the bonds used to fund the future liability must match the length of time until the liability must be paid.
positive financial leverage
Positive financial leverage occurs when the customer borrows money at a lower interest rate to make an investment generating a higher rate of return.
Which recommendation is suitable for an investor who believes that the economy will experience an extended period of inertial inflation?
Real Estate Inertial inflation is inflation that is contractually embedded in the economy. For example, COLAs (Cost of Living Adjustments) in union and government employment contracts are tied to increases in the inflation rate. Inertial inflation can be "self-fulfilling" because as wages rise due to COLAs, this creates inflationary pressure on prices of goods and services, so their prices rise, which triggers another COLA increase, etc. In periods of sustained inflation, bonds do terribly because interest rates rise, and stocks don't fare well either. Tangible assets such as real estate are the best investments in periods of sustained inflation.
Sharpe ratio
Risk Adjusted Rate of Return / Standard Deviation a risk measurement that compares the "extra return" achieved (Total Return - Risk Free Rate of Return) for the "extra risk" assumed (Standard Deviation) by choosing a given investment. Expressed as a ratio of Return/Risk, the higher the ratio, the greater the incremental return achieved relative to the incremental risk assumed.
Systematic risk vs. Non-systematic risk
Systematic risk: also called market risk, the risk that a decline in the overall market will adversely affect the value of a portfolio. Diversification does not protect against this type of risk. Non-systematic risk: the risk component of a portfolio that can be diversified away. As more and more stocks are added to the portfolio, the portfolio becomes the "market" and is left only with systematic, or market, risk. . Non-systematic risk in a portfolio is the risk that can be diversified away. A fully diversified portfolio's price movements will mirror those of the market as a whole. Such a portfolio has a "beta" of 1.00. This portfolio has market risk only, also called "systematic" risk. This is the risk that cannot be diversified away (but one can hedge against a market downturn by buying puts). The portion of a portfolio "beta" that is more than 1.00 is the non-systematic risk component. This is inherent in a portfolio that is not fully diversified. Such a portfolio will rise faster than the overall market during market upswings; and will fall faster than the overall market during market downswings.
If an investor believes that inflation rates will be rising in the foreseeable future, he might rebalance his portfolio to include:
Tangible Assests . In times of inflation, interest rate levels rise, so bond prices fall; and stock prices fall as well, since companies typically cannot raise prices to consumers fast enough to cover their increasing costs, causing profits to suffer. In times of inflation, any security that gives a fixed return, such as fixed annuities and certificates of deposit, are a bad bet. The payout on these instruments remains fixed over time, yet costs are rising. Tangible assets, such as real estate, collectibles, etc. tend to keep pace with inflation; as overall prices inflate, their prices inflate as well. This is the best choice of the ones offered.
Given the formula: ( Corporate Yield %) x (1 - Tax Bracket %) = X X is equal to the:
Tax-Free Equivalent Yield he formula for the Tax-Free Equivalent Yield is: Tax-Free Yield = Taxable Yield x (100% - Tax Bracket %) For example, if a customer is in the 30% tax bracket, and can purchase a corporate taxable bond yielding 10%, this is the same as earning 7% on a tax-free investment. Tax-Free Yield = 10% x (100% - 30%) = 10% x .7 = 7% Because the 30% of the 10% earned on a taxable investment will go to pay taxes, there is 7% left "after-tax." A non-taxable municipal bond yielding 7% gives the equivalent return.
manager tenure
The length of time that the current fund manager has been the portfolio manager of a fund is called: When looking at the performance of a mutual fund over many years, a key factor is the length of time that the investment adviser has been managing that fund. Typically, a long-tenured adviser who has produced good investment returns can be expected to do so in the future. Investment advisers with a short tenure do not have a proven track record; and if there is a change of investment adviser, this can be a red flag to potential investors, because the new adviser does not yet have a track record.
What happens to the rate of return calculation on a non-callable bond if the rate of interest stays the same and the time intervals shorten?
The rate of return increases When the question is stating that the "time intervals shorten," this means that the time period between each interest payment received shortens. For example, assume that a 10% bond will pay interest semi-annually, instead of annually. At the end of each 6 months, $50 of interest will be received, instead of receiving $100 every 12 months. Because the first $50 interest payment received can immediately be reinvested over the next 6 months until the second $50 payment is received, this will produce a higher rate of return than receiving the $100 payment at the end of the year. Thus, the actual rate of return will increase if time intervals shorten, because the interest is actually being received more quickly, and can be reinvested faster, increasing the rate of return.
How Often Rebalanced/ How its invested
The terms "active" and "passive" are most often used when looking at the management of a stock portfolio. An actively managed portfolio has its investments selected by a professional manager; whereas a passive portfolio has a composition that is matched to a market index. However, "active" and "passive" can also be used to refer to the frequency of portfolio rebalancing. A portfolio that is rebalanced once annually is said to be "passive;" a portfolio that is rebalanced more frequently or as market conditions move is said to be "active." These terms can be combined to describe both the frequency of rebalancing (active or passive) and the underlying investment style (active or passive). Therefore, a portfolio that is: rebalanced monthly and actively managed is called: "Active/Active;" rebalanced annually and actively managed is called: "Passive/Active;" rebalanced monthly and invested in index funds is called: "Active/Passive;" and rebalanced annually and invested in index funds is called: "Passive/Passive."
The method for computing return as shown in a mutual fund performance chart is:
Time Weighted Average Return Time weighted average return is the measure used for mutual fund performance charts (Total Return, which shows dividends and capital gains as continually reinvested). It reflects the growth that would be achieved from a 1-time investment into the fund and then holding that investment over time - this is a buy and hold strategy. This method is consistent when comparing one fund's performance to another fund's performance. assumes investment of a fixed amount, ignoring additional deposits or withdrawals of cash at different points in time In contrast,
An individual is considering leasing a new automobile. Which quantitative method is used to calculate the monthly payment?
Time value of money A monthly lease payment consists of 2 components - the monthly depreciation amount and the cost of the money borrowed to finance the lease. Since the borrowing charge is the interest rate on a loan, based on the number of years that the car will be leased, this computation uses the "time value of money" to compute the compound interest paid on the financed amount. The Rule of 72 is an oversimplified rule that states that if one takes the interest rate being earned on an investment and divides it into 72, then the result is the number of years that it will take for the investment to double in value. For example, if an investment earns 10%, then it will take 72 / 10 years = 7.2 years for the investment value to double. Net present value takes future cash flows and discounts them by today's interest rate to arrive at today's "net present value" (essentially, this is the opposite of compound interest). Internal rate of return is the interest rate needed to discount future cash flows to "0" - it is the true yield to maturity of an investment.
Value investing Vs. Growth Investing
Value: the selection of equity investments based on finding undervalued issues using fundamental analysis. (see Fundamental analysis; compare Growth investing) The investment strategy that involves paying a lower price for a security based on the expectation that the market is mispricing the issue is: Growth investing the selection of equity investments based solely on earnings or stock price growth over time, ignoring technical or fundamental factors. An investment strategy where a higher price is paid for a stock based upon expected returns is:
3 Forms of Efficient Market Theory
Weak Form: States that prices reflect all past publicly available information, but that this has no validity for predicting future price movements. It essentially states that price movements are random. This implies that technical analysis is basically useless to improve returns, but fundamental analysis still has potential value. ex: states that one cannot detect mispriced assets and consistently outperform the market through technical analysis of past prices? Semi-Strong Form: States that prices respond rapidly to publicly available information, so that no potential gains can be made by trading on that information. This implies that anyone with inside information has an inherent advantage and can profit by trading on it. ex: states that stock prices respond rapidly to publicly available information, so that no potential gains can be made by trading on that information? Strong Form: States that prices respond rapidly to both publicly available and private information, so that no one can profit by trading on this information. ex those who believe that stock prices rapidly reflect both public and non-public information?
An investor buys a $50,000, 10% corporate bond maturing in 2046 for $62,500. The bond is callable starting in the year 2021. What is the most appropriate measure for calculating yield?
YTC This investor is paying $62,500 for a 10% bond with a face value of $50,000. Thus, the investor is paying 25% more than par for the bond. Because of the premium, these bonds are currently yielding 8% ($100 annual interest received / $1,250 purchase price per bond = 8%). This issuer would call these bonds, since the issuer is paying 10%; yet if the issuer were to sell new bonds in the current market, it would only have to pay 8%. This bond is very likely to be called, so using the call date is the appropriate time frame to be used to compute the yield on the bond.
An investor buys a $30,000, 10% corporate bond maturing in 2046 for $24,000. The bond is callable starting in the year 2021. What is the most appropriate measure for calculating yield?
YTM
Duration
a statistical measure of the sensitivity of a bond's price movements to a given move in market interest rates. The greater a bond's duration, the more volatile the bond's price movements in response to market interest rate changes.
Standard deviation
a statistical measure of the variability of returns from an investment. The higher the standard deviation, the greater the range of potential returns from an investment over a fixed time frame. For example, returns from U.S. Government securities have a very low standard deviation; returns from small capitalization stock investments have a very high standard deviation.
Which investment cash flows for an investment with a 3 year time horizon would have the highest net present value?
Year 1 - $1,500; Year 2 - $1,000; Year 3 - $500; Total = $3,000 Each of these investments is returning $3,000 over a 3-year time frame. Net present value discounts these annual cash flows to today's value (the reverse of compound interest). Using net present value, the investment that returns the cash earlier is more valuable - Choice D. To illustrate this, assume that the market rate of interest is 10%. The net present value of Choice A's cash flows is: Year 1Year 2Year 3$500(1.1)+$1,000(1.1)2+$1,500(1.1)3= $5001.1+$1,0001.21+$1,5001.331= $2,408 The net present value of Choice D's cash flows is: Year 1Year 2Year 3$1,500(1.1)+$1,000(1.1)2+$500(1.1)3= $1,5001.1+$1,0001.21+$5001.331= $2,566
A value fund manager has decided that she needs to increase the fund's cash holding by liquidating some positions. To decide which positions to sell and the best time to do this, the manager would use:
a combination of both fundamental and technical analysis Fundamental analysis is used to decide which stocks to buy or sell, based on "fundamental" factors such as earnings, dividends, products, etc. Once that decision is made, it is always best to buy when the price is low or sell when the price is high. Technical analysis uses stock price chart patterns to identify a market "top" or a market "bottom." Once the sell decision is made, it would be best to wait for a market "top" to sell at the highest price possible.
Monte Carlo simulation
a computer simulation that allows one to evaluate the impact of changes in multiple variables simultaneously on the expected performance of an investment over a specified time frame.
Alpha
a measure of a stock's price movement relative to the stocks in its industry, and independent of general market movements. A stock with a high "alpha" moves faster than the average of the stocks in its grouping; a stock with a low "alpha" moves slower than the average of the stocks in its grouping. "Alpha" measures the portion of an investment's return arising from "stock specific" risk - that is, the portion that of the return that is not variable with the market as a whole. It takes the risk level assumed by that investment for the return achieved and compares it to the benchmark index return, which is "beta-adjusted" to the same risk level. If the portfolio manager achieved an excess return, this is a "positive" alpha and the portfolio manager added value. If the portfolio achieved a lower return, this is a "negative alpha" and the portfolio manager produced an inferior return as compared to the beta-adjusted benchmark return. Beta measures covariance with the market as a whole - a stock with a "beta" of 1.30 means that if the market rises by 10%, the stock should rise by 30% more, or 13%. Delta and Gamma are measures of options premium volatility.
Top down approach
a method of investing that looks at the overall economy to identify sectors that appear to have the best growth potential; once identified, investments are made in those specific sectors in the hopes of achieving the greatest potential return. (compare Bottom up approach) An investment adviser that makes investment decisions by first selecting industries that are likely to outperform the market based on the current economic environment and then selecting specific companies within those industries based on product lines, market share, management strategy, etc., is using the:
Bottom up approach
a method of investing that looks for specific companies that are likely to have exceptional performance, regardless of overall economic conditions. Once these companies are selected, then the potential impact of overall economic conditions would be considered prior to making an investment. (compare Top down approach) The investment approach that searches for individual stocks that are likely to have exceptional performance potential, prior to considering the impact of general economic factors, is known as the: A
Dollar cost averaging
a strategy whereby a person invests the same amount of money at regular intervals in a stock or a mutual fund without regard for the price fluctuations of the security. Over time, this investment strategy usually results in an investor's average cost per share for the security being lower than the security's average price per share over the same period.
Investment policy statement
a summary of the chosen investments and asset allocation percentages that have been decided upon in order to meet the investor's financial goals, taking into account the investor's risk tolerance and investment time horizon. The policy statement outlines expected investment returns and variances and compares these to a benchmark portfolio.The statement does not include the fees that the adviser will earn. These would be disclosed separately to the customer.
Beta
also called the Beta coefficient, the relative volatility of a particular stock relative to the overall market as measured by the Standard & Poor's 500 index. If a stock's Beta coefficient is +1, this means that its price rises and falls in direct relationship to the movement of the index. A Beta that is less than +1 indicates a stock is less volatile than the overall market; while a Beta of greater than +1 indicates that a stock is more volatile. A - Beta indicates that the stock's price moves in the opposite direction to the market as a whole. (compare Alpha)
Active return vs Passive return
the excess return achieved by an asset manager above the specified benchmark (compare Passive return) the return achieved by an asset manager to match the specified benchmark (compare Active return)
A "contrarian" is
an analyst that goes against the conventional wisdom. A contrarian believes that when prices are moving up quickly, it's time to sell; and that when prices are moving down rapidly, it's time to buy. The "idea" is that these signal either an "overbought" market that is ripe for a decline, or an "oversold" market where prices have dropped too far and are ready for a rebound. A very large short interest (that is, lots of investors have sold that stock short) indicates an "oversold" market, hence prices have been pushed too low and it is time to buy. Review
Keynesian theory
an economic theory postulated by John Maynard Keynes that the level of economic growth is determined by the level of fiscal stimulus provided by the government.
Monetarist theory
an economic theory postulated by Milton Friedman that the level of economic growth is determined by monetary policy, that is, the actions the Federal Reserve Board. (compare Keynesian theory, Supply-side theory)
Supply-side theory
an economic theory, popularly known as Reaganomics since it came into use during the Reagan administration, that is a mirror image of Keynesian theory. It postulates that reducing fiscal stimulus (reduction of government spending) and reducing taxes will give entrepreneurial individuals the incentive to form businesses, resulting in an expanding economy
Index fund managers:
attempt to exceed the investment performance of the securities that comprise the index This is an interesting question. While investors expect an index fund to generate a yield that matches the chosen index, in reality, the fund manager must exceed this return because of the expenses associated with managing the fund. Assume that the Standard and Poor's 500 index rises by 10% in a year and that an S&P 500 index fund has an expense ratio of .25% (primarily management fees). Thus, the manager of the fund must have a gain of 10.25% in the fund to yield 10% to investors after expenses are deducted. The way that the manager can do this is to sell covered calls to generate extra income against positions held in the portfolio; and the manager can slightly alter the weighting of stocks in the portfolio to those that he or she believes will outperform the overall index over the coming time period.
The weighting of the Standard and Poor's 500 Index is:
based on the market capitalization of each company included in the index . The Standard and Poor's 500 Index consists of the 500 largest companies headquartered in the United States, based on market capitalization (Current share price x # of shares outstanding).
Equity risk premium
the excess return earned above the risk-free rate of return for investing in equity securities The equity risk premium in a stock portfolio is the excess of return earned over the risk-free rate of return. Assume that the stock portfolio earns 10% and the risk-free rate of return is 4% (say on U.S. Treasury securities). Then the equity risk premium is 10% - 4% = 6%. Thus, the risk-free return is subtracted from the portfolio's total return to arrive at the equity risk premium.
Future value
the original principal amount of an investment plus any interest accrued during a specific time period. The Future Value is dependent upon the amount of time the investment is held and the interest rate earned over the investment's life. (also known as Compound value)
An investment approach where an active bond fund manager will switch to a defensive strategy if the portfolio falls below a predetermined point is known as:
contingent portfolio immunization Do not confuse bond portfolio immunization with "contingent" bond portfolio immunization. Portfolio immunization protects a bond portfolio against interest rate risk. It is the strategy of managing a portfolio to make it worth a specific amount at a stated date in the future. This strategy is typically used to fund a known future liability, and often uses a top-credit rated zero coupon bond that matures at the obligation due date as the funding vehicle. Contingent bond portfolio immunization is an "active management" strategy where the manager attempts to select bonds that will outperform a benchmark index; but if the portfolio drops below a predetermined value, the manager shifts to a defensive strategy, buying top-credit rated bonds with a lower rate of return, but this assures, at least, a minimum return rate. Also note that while there is contingent portfolio immunization, there is no such thing as contingent portfolio rebalancing.
The interest rate applied to a loan represents the:
cost of money The interest rate charged on loans is the "cost" of money. The higher the interest rate, the higher the "cost" of borrowing money, and vice-versa.
The difference between a security's bid and ask prices represents the:
cost of trading The difference between a security's bid and ask price is the "spread," which is not given as a choice. The ask price is always higher than the bid, and this represents one of the costs of trading. For example, assume that the current best bid-ask for a security is $30 - $31. The stock can be bought at $31, but if the customer were to immediately resell that position, he or she would only receive $30. The $1 spread is a cost of trading. Basically, this is the compensation that the market making firm earns. Note that there are other costs to trading as well, namely commissions or mark-ups added to the actual transaction price to compensate the retail broker who sends the trade to the market making firm.
Market risk
for equity securities, the risk that the value of the stocks will drop due to a sell-off in the market for bonds, the risk that a rise in interest rates will cause the market prices of bonds to drop (see Interest rate risk) in portfolio management, the risk inherent in a portfolio that cannot be diversified away (see
An investor in the U.S. that makes investments in emerging markets stocks is an example of:
diversifying Emerging markets stocks are stocks of 3rd world countries that are rapidly growing (such as the BRIC countries - Brazil, Russia, India, and China). A U.S. based investor would allocate of portion of investment funds to these assets to diversify the portfolio. Rebalancing is the restoration of strategically set allocation percentages as values move over time. Sector rotating is the strategy of allocating funds to those economic sectors that will do well in the current phase of the economic cycle. For example, when the economy is entering a recession, the investor may rotate out of industrial stocks into defensive stocks such as food and pharmaceuticals. "Averaging" means "dollar cost averaging" - where fixed dollar amounts are invested at even intervals in the same investment. This results in the weighted average price per share being less than the straight mathematical average price over the same period, as long as stock prices are fluctuating. Review
During periods when interest rates are rising, which of the following fixed income securities offers the greatest protection from "interest rate risk"?
high coupon bonds with long maturities The basic truths regarding bond price volatility and interest rate movements are: The longer the maturity, the greater the bond's price volatility in response to interest rate movements. The lower the coupon rate, the greater the bond's price volatility in response to interest rate movements. The farther away from par that the bond is priced, the greater the bond's price volatility in response to interest rate movements. This question only examines the second factor, since the maturities are equivalent for all choices, and no mention is made of whether the bonds are trading at a discount or a premium. The bond with the lowest price volatility will be the one with the highest coupon rate. Bonds with low coupon rates exhibit greater price volatility. Thus, to minimize price volatility due to interest rate movements ("interest rate risk"), high coupon bonds are appropriate.
Internal rate of return
in a direct participation program (DPP) offering, the computation of the real investment yield considering the time value of money; calculated by finding the implicit interest rate that discounts that program's projected annual cash flows to a present value of "0."
Tracking error
in a passively managed investment that is designed to "mirror" a designated index, the risk that the portfolio returns fall short of the index results (or exceed them). The deviation between a portfolio's return and the benchmark return is known as the "tracking error" (this can be either positive or negative). Here is an example of how tracking error occurs and can be managed. Index fund managers, who seek to match the performance of a benchmark index, must, in reality, do better than the benchmark index results to cover the costs of operating the fund (e.g., brokerage costs, administrative costs, etc.). They cannot be completely passive in their approach because then they will always underperform the index (the "tracking error"). Therefore, in order to boost their yield up to cover these expenses, they must employ a bit of active asset management - in essence, making disproportionately large bets on stocks in the index that they think will outperform the index - in order to juice up their returns enough to cover fund expenses. The idea is that the positive tracking error from the actively managed positions will more than offset the negative tracking error built into the passively managed positions.
Dark pools are operated by:
institutional broker-dealers Dark pools are operated by the larger broker-dealers (e.g., Goldman Sachs) and there are some that are independent companies (e.g., Liquidnet). They allow institutions to buy or sell very large blocks without displaying their orders in a display system such as NASDAQ. They are called dark pools because the size of the trade and the identity of the institution are not displayed. This avoids the problem that could occur where the display of a very large order in such a system, by itself, could move the market. If there is a match in a dark pool and a trade results, it still must be reported to the appropriate tape.
Question:The quantitative method of evaluating investments that finds the interest rate that discounts periodic cash inflows and outflows to a present value of "0" is:
internal rate of return The internal rate of return of an investment is the implicit interest rate that discounts the cash flows generated by the investment to a value of "0." This is the true "yield" of the investment, considering the time value of money.
If the market rate of interest is 10%, the net present value of $1,000 to be received 2 years from now is:
less than $1,000 The net present value of $1,000 to be received 2 years from now, given that the market rate of interest is 10%, is $1,000 / 1.21 (which is 1.1 x 1.1, considering that interest is compounding at a 10% rate for 2 years) = $826.44. Another way of looking at this is that $826.44 received today will be worth $1,000 2 years from now, if it is invested at a 10% rate of return. $826.44 x 1.1 = $909.09 value after 1 year $909.09 x 1.1 = $1,000 value after 2 years
Dollar weighted average return
most often used by mutual fund investors, it is the rate of return achieved by the investor, taking into the account the timing of investor's cash inflows into the fund and cash withdrawals from the fund. (Compare: Time weighted average return) Dollar weighted average return accounts for all cash flows (deposits) into the fund and all cash redemptions from the fund made by that investor. It is the same as the Internal Rate of Return, and will vary with the timing of each investor's deposits and withdrawals. Because investors often "chase" past performance, they will buy a fund "too late" (after the fund has posted its best performance and now enters a period of lesser performance) and will sell "too soon." Thus, for the individual investor, Dollar weighted average return is often lower than Time weighted average return.
The Dividend Discount Model values common stock based on the:
net present value of anticipated future dividend payments
If total liabilities of a company are subtracted from total assets of a company, the result is the company's:
net worth (net working capital) also called stockholder's equity, the excess of a company's total assets over and above its total liabilities on the balance sheet the difference between the total value of a person's assets and possessions - e.g., home, land, savings accounts, investments, etc. - and that person's total indebtedness - e.g., home mortgage, credit card debt, school loans, etc.
All of the following would be found in the footnotes to a company's financial statements EXCEPT:
operations overview The footnotes to a company's financial statements details the company's accounting policies (for example, when revenue is "booked," how inventories are valued) and gives additional supporting detail that adds "color" to the numbers presented in the income statement and balance sheet. For example, the balance sheet might show "capitalized leases" as a simple number in liabilities, but the footnotes will give the year-by-year upcoming lease payment obligations. The footnotes will include the details of the scheduled maturities of long term debt and also include an estimate of any potential legal liability. The footnotes do not include an operations overview - this is usually found as a management discussion before the financial statements are presented.
All of the following are contrarian economic indicators EXCEPT:
price/earnings ratio Market indicators used by contrarians include the short interest level (a large short interest indicates an "oversold" market, so it's time to buy); the level of odd lot sales versus purchases (the theory is that small investors trade odd lots and they are wrong); and the put /call ratio (a high ratio indicates an oversold market, so it is time to buy). The price/earnings ratio is a fundamental value measure.
An investor has a broadly diversified portfolio of blue chip stocks. The use of index options to hedge the portfolio:
reduces systematic risk
The Dividend Discount model values common stock by discounting future dividends by the:
required rate of return The Dividend Discount Model is a way of finding the theoretical price of common stock. It takes the anticipated future dividends to be paid by the company and discounts them to present value. Instead of having to discount each year's anticipated dividend payment, the formula can be reduced to one similar to that for a perpetuity. The reduced formula is: Expected Next Year Dividend Rate/ Required Rate of Return for Equity Investors - Dividend Growth Rate For example, assume a company is expected to pay a $1 dividend next year. If the required rate of return is 8% and the expected dividend growth rate is 3%, then the projected price of the common stock is $1 Dividend / 8% - 3% = $1/.05 = $20.
Geometric Mean
the compounded annualized value of a sequence of numbers (or investment returns for exam purposes). Given a sequence of 5 annual investment returns - 2%, 4%, 6%, 8%, and 8%, the geometric mean is 1.02 x 1.04 x 1.06 x 1.08 x 1.08 = 31.16%. The compounded annual rate of return that will produce this result is 5.57%. Note that this differs from the simple arithmetic mean return, which is 2% + 4% + 6% + 8% + 8% = 28% / 5 = 5.60% Geometric mean considers compounding of annual returns, as compared to arithmetic mean, which is a simple average. The rate of return that considers compounding of returns of the time horizon of an investment is:
Tactical asset allocation
the permitted variation from the fixed percentage of assets to be placed in each asset class given to the asset manager under an asset allocation scheme. Timing is the important factor in which portfolio management strategy?
Historically, as the economic cycle is reaching a peak, consumer goods companies tend to outperform other investment segments. From this peak, as the economy starts a recessionary phase, utilities tend to outperform other investment segments. To capitalize on this, an investor buys consumer goods stocks when the economy is peaking and then sells those stocks and buys utility stocks as the economy enters a recessionary phase. This is an example of:
sector rotation As the economy moves through the stages of the business cycle, certain industries outperform other segments of the market. Sector rotation is a form of tactical asset allocation where assets are reallocated to investments that are expected to perform well at a particular time, based on where the economy is in the business cycle. For example, when the business cycle is at the beginning of an expansionary phase, technology stocks have tended to outperform, so the allocation to this asset class would be increased. When the business cycle is at the beginning of a recessionary phase, telecom stocks have tended to outperform, so the allocation to this asset class would be increased.
Capital asset pricing model
sometimes abbreviated "CAPM," a methodology for finding the most efficient investments - those that give the greatest return for the amount of risk assumed. The model identifies the most efficient investments as those that give a rate of return equal to the "risk free" rate of return (the rate of return for investments only having systematic risk) plus a premium for any non-systematic risk inherent in the investment CAPM (Capital Asset Pricing Model) attempts to find the Expected Return of an Investment by breaking the return down into 2 components. These are the Risk-Free Rate of Return and the Risk Premium. The Risk Premium increases with the risk of that investment. The risk premium is the "beta" of the investment times the excess of the expected market rate of return over the risk-free rate of return. The higher the "risk" as measured by "beta," the higher the expected return of that investment. Duration measures bond price volatility as market interest rates move. The Sharpe Ratio measures the incremental investment return that is achieved for assuming incremental risk. Beta is a correlation coefficient that measures the correlation of a specific stock's price movement against the movement of a relevant stock index. It is used in the CAPM formula, but by itself, does not measure expected return.
Growth stock
stocks of new, expanding companies whose market values are expected to appreciate rapidly. A company whose common stock is described as a growth stock is usually characterized by a low dividend payout ratio and high retained earnings ratio. Such companies retain most of the earnings to fund future growth - the marketplace does not demand much of a dividend payout from such companies, because the value of the stock is appreciating.
Net present value
takes the expected annual cash flows from an investment over the years and discounts them, using the market rate of interest compounded over time, to today's "present value." This is basically the opposite of future value. A positive net present value indicates that the projected earnings generated by a project or investment - in present dollars - exceeds the anticipated costs, also in present dollars. It is assumed that an investment with a positive NPV will be profitable, and an investment with a negative NPV will result in a net loss. This concept is the basis for the Net Present Value Rule, which dictates that only investments with positive NPV values should be considered. NPV=TVECF−TVIC where: TVECF=Today's value of the expected cash flows TVIC=Today's value of invested cash
Cyclical stock
the common stock of companies whose market value and performance changes directly with the phases of the business cycle. Examples include companies that produce durable goods or that are involved in building homes. (compare Counter-cyclical stock)
Counter-cyclical stock
the common stock of companies whose market value and performance move opposite to the phases of the business cycle. Companies that produce basic food products are counter-cyclical because when peoples' income declines, they eat out less and eat in more. (compare Cyclical stock)
Strategic asset allocation
the determination of the percentage of assets to be placed in each asset class under an asset allocation scheme. (see Asset allocation; compare Tactical asset allocation) The setting of specific goals for an investment plan to be created for a customer is known as:
Time value of money
the potential to earn interest on money affecting its relative value. For example $1 received today is the same as $1.10 received 1 year from now, if market rates of interest are 10%.
Bond A and Bond B both have an 8% coupon. Bond A matures in 2 years, while Bond B matures in 10 years. If market interest rates rise:
the price of Bond B will fall faster than the price of Bond A As market interest rates rise, the prices of fixed income securities fall, but not at equal rates. As market interest rates rise, the longer the maturity of the bond, the faster the price will fall; and the lower the coupon rate, the faster the price of the bond will fall. Since the coupon is the same for both bonds, the price of the longer maturity bond (B) will fall faster as market interest rates rise.
Active asset management
the pursuit of investment returns in excess of the specific benchmark return. Active asset managers believe that undervalued stocks exist in the marketplace, and that by investing in them, they can surpass the performance of a similar index fund. Active asset managers believe that by performing fundamental analysis, they can find undervalued companies - that is, companies that are not "efficiently priced."
Passive asset management
the pursuit of investment returns to match, but not exceed, the specific benchmark return. Passive asset managers believe that undervalued stocks do not exist in the marketplace, and that they can only match the performance of a similar index fund. (compare Active asset management) " Passive asset managers believe that the market is basically efficient, and that one cannot consistently find "undervalued securities" - so why bother. Instead, just invest in an asset that mimics the index - that is, an index fund. This will do as well as the "market" with much lower expenses than those associated with "active" asset management.
Opportunity cost
the rate of return forgone, as compared to investing in an alternative security. For example, an investor that is currently earning 5% on a given security; and who could earn 7% on another comparable security in the same risk class; is incurring an opportunity cost of 2%.
Expected rate of return
the rate of return that an investment is "expected" to return. It is computed by assigning probabilities to various scenarios for that investment's potential returns. To find expected rate of return, apply the probability of each outcome to the investment return associated with that outcome and add them up.
Portfolio rebalancing
the reallocation of funds in an asset allocation model from overperforming asset classes to those that have underperformed. In this manner, the percentage allocations to each asset class are kept within the desired range.
Risk free rate of return
the return that can be achieved by investing in an asset class that has no risk, such as Treasury Bills.
Business risk
the risk that an issuer's business declines, often due to technological change, bad business decisions, and law changes. In turn, the value of that issuer's securities declines.
Arithmetic mean
the simple average of a sequence of numbers (or investment returns for exam purposes). Given a sequence of 5 annual investment returns - 2%, 4%, 6%, 8%, and 8%, the arithmetic mean is 2% + 4% + 6% + 8% + 8% = 28% / 5 = 5.60%
Efficient market theory
the theory that all information about an issuer is available to all participants in the market at the same time and that the prices of securities directly reflect investor expectations based on this information. Therefore, attempting to profit from buying undervalued stocks or selling short overvalued stocks is futile. Most accepted is the "semi-strong" version of this theory, which states that market valuations reflect all "publicly known" information about an issuer; but do not reflect information known only by "insiders" - the officers and directors of that company
After-tax rate of return
the yield an investment would provide after paying federal taxes. R * (1 - T) R= Rate of return T= Tax bracket
Using the CAPM approach to making an investment decision, an investor will:
use the risk-free rate of return as the baseline return and add to it an estimated risk premium based on the beta coefficient of that investment to find the expected return of that investment
An investment of $1,000 is projected to give an annual return of $100 for 5 years, at which point the $1,000 invested will be returned. The comparable market rate of return for 5-year investments is 5%. Based on this information, the Net Present Value of the investment:
will be positive . Net Present Value of an investment takes the projected cash flows from an investment and discounts them back to today's present value, using the market rate of return as the discount factor. Since this investment is generating a 10% annual rate of return; but these returns are discounted by a 5% market rate of return, the NPV, in percentage terms, will be 5%. As long as the NPV is positive, the investment is projected to generate a better than market rate of return and should be made.
The closest approximation of the internal rate of return on a bond is the bond's:
yield to maturity The internal rate of return on a bond is the interest rate that will discount the bond's cash flows to the purchase price of the bond. It is the same as the bond's yield to maturity.
