Unit 21 Checkpoint Exam

If the expected return on the market is 20% and the risk-free rate is 4%, a stock with a beta coefficient of 0.8 would have an expected rate of return under CAPM of A) 16.8%. B) 12.8%. C) 19.2%. D) 16.0%.

A) 16.8%. The formula is the risk-free rate (0.04) plus the product of the stock's beta (0.8) and the difference between the expected return on the market and the risk-free rate (0.20 - 0.04). In this case, it would be 0.04 + 0.8 (0.16) or 0.04 +0.128 = 0.168

Which of the following statements regarding a bond ladder strategy is correct? A) A bond ladder strategy is a relatively easy way to immunize a portfolio against interest rate risk. B) A bond ladder strategy involves the purchase of very long-term and very short-term bonds. C) A laddered portfolio of bonds will provide lower yields than a portfolio consisting entirely of short-term bonds. D) A bond ladder strategy is generally more aggressive than a bond barbell strategy.

A) A bond ladder strategy is a relatively easy way to immunize a portfolio against interest rate risk. A bond ladder strategy is a relatively easy way to immunize (protect) a portfolio against interest rate risk. By holding many positions across the yield curve, the individual is diversified in the event that yields behave differently in one part of the curve than in another. The laddered portfolio will generally provide higher (not lower) yields than a portfolio consisting entirely of short-term bonds. Purchasing very long-term and very short-term bonds describes the bond barbell strategy, not the bond ladder strategy.

Customer A and Customer B each have an open account in a mutual fund that charges a front-end load. Customer A has decided to receive all distributions in cash, while Customer B automatically reinvests all distributions. How do their decisions affect their investments? Receiving cash distributions may reduce Customer A's proportional interest in the fund. Customer A may use the cash distributions to purchase shares later at NAV. Customer B's reinvestments purchase additional shares at NAV rather than at the offering price. Due to compounding, Customer B's principal will be at greater risk. A) I and III B) I and IV C) II and IV D) II and III

A) I and III If the customer elects to receive distributions in cash while other investors purchase shares through reinvestment, his proportional interest in the fund will decline. Automatic reinvestment is always at NAV.

Which of the following describes an investment management style? A) Large capitalization B) Margin C) Current income D) Rebalancing

A) Large capitalization Large capitalization style distinguishes between investing in a small cap company versus a large capitalization company. Current income is an investment objective and not an investment management style. Rebalancing is used to bring asset allocations back to their desired weightings. Margin can be used in a number of investment management styles.

Which of the following are asset classes? A) REITs B) Forward contracts C) Options D) Large cap stock funds

A) REITs The general consensus is that the major classes, for purposes of an asset allocation program, are equity, debt, cash (or cash equivalents), real estate, and commodities. Large cap stock funds are not a seperate asset class; they are a way to invest in the asset class known as equity. Derivatives, such as options, are not generally considered an asset class, and it is the actual commodity (precious metals, oil, and so forth), not a forward or futures contract, that is the asset class. Most agree that REITs can serve as a proxy for real estate itself.

Your client owns 500 shares of RMBN purchased at $11.94 per share. The stock is now selling for $12.70 per share and the client is concerned that the market may turn downward. You could suggest protecting the profit by A) buying 5 RMBN 12.50 puts. B) buying 5 RMBN 12.50 calls. C) selling 5 RMBN 12.50 puts. D) buy 1 RMBN 12.50 put.

A) buying 5 RMBN 12.50 puts. The best way to hedge (protect) a profit on a long position is the purchase of puts with a contract value equal to the number of shares held. Because the client owns 500 shares, that would mean buying 5 puts. If the stock should fall, the investor knows that $12.50 per share can be realized by exercising the put. If the stock continues to rise, then the investor can allow the puts to expire and continue to participate in the growth.

An investor does not wish to attempt to time the market, so she invests $300 each month into the GEMCO Growth Fund. Over the past 5 months, her purchase prices have been $10, $12, $15, $20, and $25. On the basis of this information, if she were to stop investing at this point and sell her shares 2 months from now when the NAV is $15 per share and the public offering price is $15.79, it would be correct to state that her A) cost basis for tax purposes was $14.71. B) average cost per share was $16.40. C) realized loss would be $1.40 per share. D) proceeds were $15.79 per share.

A) cost basis for tax purposes was $14.71. This client is taking advantage of dollar cost averaging. Each month, the $300 investment acquires a different number of shares. Take a look at the math below: Month 1: $300 @ $10 per share = 30 shares Month 2: $300 @ $12 per share = 25 shares Month 3: $300 @ $15 per share = 20 shares Month 4: $300 @ $20 per share = 15 shares Month 5: $300 @ $25 per share = 12 shares Total cost is $1,500. Total number of shares is 102. She spent $1,500 and bought a total of 102 shares. Dividing her cost ($1,500) by the number of shares (102) results in a cost per share of $14.71 and that is her cost basis for tax purposes. When redeeming, she would receive the NAV of $15 per share, not the POP. There is no loss here because the proceeds of $15 per share exceed the cost of $14.71.

An investment adviser (IA) explaining modern portfolio theory (MPT) to a client might make all of the following statements except A) if one security has a higher return than another, and, at the same time has a higher risk, choose it. B) if one security has a higher return than another and, at the same time has a lower risk, choose it. C) if two securities offer the same rate of return, choose the one with the lower risk. D) if two securities offer the same risk, choose the one with the higher return.

A) if one security has a higher return than another, and, at the same time has a higher risk, choose it. The goal of MPT is to maximize the return for any given amount of risk. Therefore, always look for a choice giving the highest return for the least risk. Although it is true that the security with the higher risk should have the higher return, a follower of MPT is most likely to recommend securities only when the security offers the highest return with the lowest risk.

An optimal portfolio is one which A) lies on the efficient frontier. B) is diversified in such manner as to nearly eliminate systematic risk. C) offers the greatest reward for the highest risk. D) works well in bull markets, but suffers when there is a market reversal.

A) lies on the efficient frontier. In portfolio design, the collection of efficient portfolios is called the efficient set or the efficient frontier. This efficient frontier is plotted as a curve. The objective is for the portfolio to lie on the curve. Then, by being on the efficient frontier, the optimal portfolio has been created; one in which there is the highest return for the least risk. Remember, systematic risks are considered non-diversifiable ones. It is the unsystematic risks that can be reduced through diversification.

Your client's child is entering college next year. Which of the following would be the most appropriate recommendation? A) A U.S. Treasury note mutual fund B) A five-year laddered portfolio of U.S. Treasury notes C) A large-cap growth fund D) A zero-coupon bond maturing in five years

B) A five-year laddered portfolio of U.S. Treasury notes Most would agree that with a regularly scheduled commitment for tuition and other expenses associated with a college education, there is a need for not only income, but also (and perhaps more importantly) assurance that when the bills are due, the principal will not have fluctuated. That would be best accomplished through a laddered portfolio where each year there are T-notes maturing. The growth fund would be attractive if the time horizon was long (this one is very short). The zero-coupon bond will not provide any money until five years from now, and this client needs cash flow starting in one year. The mutual fund does not offer the guaranteed repayment of principal that the ladder does.

Published studies have shown that much of the performance of a portfolio can be attributed to which of the following factors? A) Security selection B) Asset allocation C) Other factors D) Market timing

B) Asset allocation A study conducted by Sharpe and Markowitz revealed that 91.5% of the returns achieved by the average investor were based upon the allocation of assets among various investment classifications. Market timing and security selection did account for some of the remaining percentages, but asset allocation proved to be the most important factor.

One of the asset allocation classes is fixed income securities. When an IAR is determining which securities to fill that portion of the client's portfolio, which of the following would not be included? A) Municipal bonds B) Preferred stock C) Mortgage-backed securities D) Treasury bonds

B) Preferred stock Although generally referred to as a fixed income security due to its fixed dividend, for asset allocation purposes, preferred stock is included in the equity class. Historically, Treasury bonds have a negative correlation to preferred stock (about ‒0.20), while the S&P 500 has a correlation of about +0.60.

If an investor practices value investing, which of the following stock types is the investor least likely to purchase? A) A stock that has exhibited a high dividend yield in the past B) A stock that is presently selling for ⅔ of net tangible assets C) A stock with an above-average price-to-earnings ratio D) A stock with negative earnings in the most recent quarter

C) A stock with an above-average price-to-earnings ratio A growth investor looks for stocks with above average price-to-earnings ratios. Conversely, a value investor focuses on stocks with low P/E ratios, a low price-to-book value, and historically high dividend yields. It is not unusual for value investors to hunt for companies that have been beaten down because of a bad earnings report (a loss) for a quarter.

All of the following are examples of a portfolio diversified through asset allocation except A) Daniella's portfolio consists of shares of common stock, municipal bonds, and money market funds. B) Dawson's portfolio consists of shares of preferred stock, Treasury bonds, and Treasury bills. C) Daniel's portfolio consists of shares of common stock in 52 different corporations. D) Dakota's portfolio consists of shares of common stock, corporate bonds, and jumbo CDs.

C) Daniel's portfolio consists of shares of common stock in 52 different corporations. Although Daniel's portfolio is diversified, it is diversified within a single asset class: equity. Asset allocation means diversifying the portfolio using at least the three primary asset classes: equity, debt, and cash or cash equivalents. Remember, even though preferred stock is generally considered a fixed-income security, for the purpose of asset allocation, it is part of the equity class, not debt. Each of the other three portfolios contain equity, debt, and cash equivalents (money market securities).

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

C) Index funds An individual who believes in the EMH will likely invest in index funds. Inherent in this strategy is a belief that an investor cannot outperform the market with active portfolio management techniques. The remaining choices all incorporate an active portfolio management philosophy. For example, the sector fund manager is regularly shifting assets from one sector to another depending on the business cycle. A balanced fund manager is buying and selling securities to keep the balance (the proper percentage mix) between the equity and the debt securities in the portfolio.

An adviser who does not believe he can time the market, or pick those securities that will outperform their benchmarks, would have which of the following as the most important portfolio consideration? A) Maximizing current income to provide a solid base for total return B) Looking for asset classes that will outperform their benchmarks C) Minimizing investment expense and proper asset allocation D) Selecting stocks that are expected to outperform their benchmarks

C) Minimizing investment expense and proper asset allocation This adviser is following a passive management style. As such, the goal is to match the specified benchmarks as closely as possible. In order to do that, expenses must be kept to a minimum (the benchmark has no expense) and the index that is chosen must have a very high correlation to the benchmark.

One of the offshoots of the capital asset pricing model (CAPM) is the Capital Market Line (CML). The equation for the CML uses which of the following? A) Beta B) Correlation coefficient C) Standard deviation D) Alpha

C) Standard deviation The CML provides an expected return for a portfolio based on the expected return of the market, the risk-free rate of return, and the standard deviation of the portfolio in relation to the standard deviation of the market. The equation for the CML uses the expected return of the portfolio; risk-free rate; return on the market; standard deviation of the market; and standard deviation of the portfolio.

Sector rotation would most likely be employed by an investment adviser using which of the following investment styles? A) Strategic B) Buy and hold C) Tactical D) Contrarian

C) Tactical Sector rotation is the practice of moving portfolio assets from those industries that have reached their peak in the current economic cycle to those that are now on the upswing. Buy and hold, as the name implies, does not involve constant trading and strategic is a passive technique as well. Contrarian investors go opposite the trend which is not the case here.

The dividend discount model is A) primarily used by technical analysts. B) the inverse of the price/earnings ratio. C) an analytical tool used to value a common stock using the present value of future dividends. D) based on the dividend payout ratio.

C) an analytical tool used to value a common stock using the present value of future dividends. There are two widely accepted forms of common stock price valuation using dividends: the dividend discount model and the dividend growth model. Neither would be used by technicians because they rely on fundamentals.

An investor is long 100 shares of XUZ common stock. If the investor wishes to generate some additional income while also creating a partial hedge, the recommended strategy would be to A) buy additional XUZ stock. B) go short an XUZ call. C) go long an XUZ call. D) go short an XUZ put.

B) go short an XUZ call. The only way to generate income with options is to sell them (take a short position). Selling the call brings in a premium which creates a partial hedge to the extent of the premium received. A full hedge would be accomplished by purchasing an XUZ put, but that would not generate income and the question is looking for a partial hedge.

One popular method used to predict the expected return of a stock is the capital asset pricing model. Analysts using CAPM rely on all of these except A) the risk-free rate available in the market. B) the standard deviation of the stock. C) the expected return on the market. D) the beta coefficient of the stock.

B) the standard deviation of the stock. Under the CAPM, using the SML, we can determine the expected return of any given stock by taking the risk-free rate and adding to that the product of that stock's beta coefficient and the difference between the expected return on the market and the risk-free rate. Standard deviation is not a factor in this computation.

Which of the following bond strategies is the least active? A) Ladder B) Barbell C) Yield curve D) Bullet

D) Bullet The least active strategy is the one requiring the lowest level of activity on the part of the investor. The bullet strategy involves investing in bonds at various intervals with all of the bonds maturing at or about the same time (such as when a child is entering college). As such, the only activity is buying bonds every couple of years. Barbell and ladder strategies have bonds maturing at regular intervals requiring an active role in reinvesting the principal. All three of these require the investor to purchase bonds at different times, but the bullet strategy is the only one not concerned with the mechanics of collecting the matured principal and reinvesting it. Yield curve is not a specific strategy.

A mutual fund investor is using a dollar cost averaging strategy. For the average price per share to exceed the investor's average cost, which of the following conditions must be present? The market price per share fluctuates with each purchase. A fixed dollar amount is invested at regular intervals. A fixed number of shares is purchased monthly. A constant dollar value is maintained in the account. A) II and III B) I and III C) II and IV D) I and II

D) I and II Dollar cost averaging requires investing of a fixed amount of money at regular intervals. This procedure results in a lower average cost per share than average price paid if the mutual fund price fluctuates. The constant dollar plan involves buying and selling to maintain a constant dollar amount of either equity or debt securities in the account.

Proponents of which of the following technical theories assume that small investors are usually wrong? A) Short interest B) Advance/decline C) Breadth of market D) Odd lot

D) Odd lot Odd lots are usually traded by small investors; some analysts believe small investors are generally wrong.

A securities analyst does not believe that markets are highly efficient. This analyst most likely follows which of the following investing strategies? A) Passive B) Indexing C) Strategic D) Tactical

D) Tactical Those who believe that stock markets are not efficient believe that they can beat the market. That is the style followed by active or tactical managers. Those who believe in efficient markets would be passive or strategic investors such as those who buy index funds.

The use of futures to hedge against a price increase is best referred to as A) a trimmed hedge. B) a short hedge. C) a neutral hedge. D) a long hedge.

D) a long hedge. Just as with stock options, the strongest hedge is always accomplished by buying (going long) on the opposite side. When the investor is afraid the price will rise, going long (benefits if the price does rise) fixes the purchase price regardless of how high the price might rise.

In contrast to the strategic approach, tactical asset allocation A) consistently provides higher net returns whether the market is performing well or in decline. B) is used to determine an appropriate allocation based on the long-term financial goals of the client. C) offers significant commission savings by generally qualifying for a lower commission schedule than a strategic manager. D) continuously adjusts the asset allocation and class mix in an attempt to take advantage of changing market conditions.

D) continuously adjusts the asset allocation and class mix in an attempt to take advantage of changing market conditions. This is what tactical or active management is all about: timing the market and changing the portfolio to try to beat it. Although the manager may qualify for a lower commission per trade, the volume of trading causes the overall commission expense to be much higher than with strategic. There is no evidence that tactical managers consistently outperform strategic ones.

Diversifying a portfolio could be expected to provide all of the following benefits except A) improving returns. B) reducing overall risk. C) dampening volatility. D) reducing transaction costs.

D) reducing transaction costs. If there is one negative about portfolio diversification it is that assembling a group of 15 to 20 securities (generally considered to be the minimum for beneficial diversification) will generate higher transaction costs than concentrating on a smaller group.

An analyst using the dividend growth model would take into account all of the following factors except A) the growth of the dividend. B) the current dividend. C) the investor's required rate of return. D) the current earnings per share.

D) the current earnings per share. The dividend growth model is a stock valuation model that deals with dividends and their growth, discounted to today. The value of the stock equals next year's dividends divided by the difference between the required rate of return and the assumed constant growth rate in dividends. The earnings-per-share figure is irrelevant because the company may be retaining most or all of its earnings and paying a small dividend or no dividend.

As a technique in portfolio management, portfolio diversification reduces A) market risk. B) interest rate risk. C) systematic risk. D) unsystematic risk.

D) unsystematic risk. Unsystematic risk, such as business risk, can be almost eliminated with a well-diversified portfolio. Systematic risks, such as interest rate risk and market risk, are not helped by diversification. For example, no matter how many bonds you hold in your portfolio, if interest rates go up, they'll all drop in price. On the other hand, holding many bonds limits the overall loss should one or two issuers default.

An investment adviser is doing some research on a company and notices that the current market price is $21 per share. The most recently reported EPS is $3 and the company is paying a $0.26 quarterly dividend. On the balance sheet, the company is carrying a significant amount of cash. This company would probably be attractive to this adviser if his investment style was A) passive. B) contrarian. C) growth. D) value.

D) value. This is an example of the kind of company appealing to those who follow a value style of portfolio management. The company is selling at a low P/E ratio of 7 to 1 ($21/$3) with a liberal dividend yield of 4.95% ($1.04/$26). The high cash balance only adds to the value.

According to the efficient market hypothesis, information found when reading the Wall Street Journal would be considered A) strong-form market efficiency. B) semi-strong form market efficiency. C) random walk. D) weak-form market efficiency.

D) weak-form market efficiency. The closer to inside information, the stronger the information. Anything published in widely read media would be considered very weak.