Chapter 15- STC

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

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

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

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

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

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

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

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

Which of the following is a risk-adjusted return? A. Alpha B. Standard deviation C. Beta D. Internal rate of return

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Which of the following approaches to portfolio management is most closely associated with market timing? A. Tactical asset allocation B. Value investing C. Passive management D. Strategic asset allocation

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

An investor who believes in the inherent efficiency of the markets would be least likely to adopt which of the following strategies? A. Tactical asset allocation B. Strategic asset allocation C. Fundamental analysis D. Indexing

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

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

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

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

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

Which of the following return calculations removes the distortions caused by the deposit and withdrawal of capital from an investment account over time? A. Time-weighted return B. Dollar-weighted return C. Current yield D. Expected return

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

Which of the following is a measure of non-systematic risk? A. Theta B. Beta C. Alpha D. Gamma

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

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

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

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

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

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

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

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

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

An investment has a 25% chance of earning an 8% return, a 50% chance of earning a 4% return, and a 25% chance of earning a 4% loss. What is this investment's expected return? A. 4% B. 3% C. 1% D. 8%

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

An investor is in the 20% marginal tax bracket and has a yield of 10% on a portfolio. If the CPI is 5%, what's the investor's approximate after-tax inflation-adjusted return? A. 9.5% B. 3% C. 8% D. 4%

B. 3% The first step is to adjust the investor's yield for taxes. The formula for finding After-Tax Yield is: Nominal Yield x (100% - Tax Rate%). In this case, the investor's after-tax yield equals 8% [10% x (100% - 20%)]. The next step is to adjust the after-tax yield of 8% for inflation. The formula for Inflation-Adjusted Return is: Bond Yield - Inflation Rate. In this question, start with the after-tax yield of 8% and subtract by the inflation rate of 5% (i.e., CPI), which is 3% (8% - 5%). Returns that are adjusted for inflation are also referred to as "real returns."

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

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

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

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

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

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

Which of the following metrics is the MOST important when attempting to diversify a stock portfolio? A. Weighted average B. Correlation C. Standard deviation D. Asset allocation

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

Under the Capital Asset Pricing Model, risk is defined as: A. Loss of interest B. Deviation in returns C. Loss of principal D. Failure to accomplish the client's objective

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

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

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

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

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

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

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

Which TWO of the following choices are not considered an asset class? Annuities Stocks Cash The S&P 500 Index Real estate A. III and V B. I and IV C. II and V D. I and III

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

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

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

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

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

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

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

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

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

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

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

Which of the following metrics represents the basic measure of risk in Modern Portfolio Theory (MPT)? A. Beta B. Standard deviation C. Alpha D. Correlation coefficient

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

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

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

What's the best indicator of a successful mutual fund? A. The returns of the portfolio over the previous year B. Tenure of the manager C. The fund's expense ratio D. The turnover rate in the portfolio

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

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

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

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

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

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

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

If a money market fund pays 1% per year for four years, what's its total return? A. 0.01 B. 0.14 C. 0.04 D. 0.1

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

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

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

A married couple are both in their 20s and have well-paying jobs. The couple has begun to think about investing for retirement. In this case, which of the following portfolio allocations is the MOST appropriate? A. 50% bonds, 50% common stocks B. 100% common stocks C. 5% money market, 5% bonds, 90% large-cap equity ETF D. 80% bonds, 10% common stocks, 10% money market

C. 5% money market, 5% bonds, 90% large-cap equity ETF Investors who are in their 20s and saving for retirement should primarily be invested in equities to produce long-term growth. As with all portfolios, at least some diversification is a good idea; therefore, the allocation with 5% money market, 5% bonds, and 90% large-cap equity ETF is the most appropriate for this couple. In general, investing 100% of a client's assets into anything, even if it's a conservative investment, is not suitable.

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

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

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

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

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

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

The S&P 500 is a(an): A. Inflation adjusted index B. Time-weighted index C. Capitalization-weighted index D. Price-weighted index

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

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

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

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

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

Which of the following is NOT considered an active portfolio management strategy? A. Sector rotation B. Value investing C. Indexing D. Tactical asset allocation

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

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

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

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

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

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

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

Which of the following is NOT a type of systematic risk? A. Inflation risk B. Interest-rate risk C. Liquidity risk D. Market risk

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

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

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

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

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

Which formula is used to perform discounted cash flow analysis for a bond? A. Future value B. Duration C. Present value D. Yield-to-maturity

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

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

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

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

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

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

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

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

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

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

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

If the net present value of an investment is greater than 0: A. The discount rate used to calculate the present value is the internal rate of return B. The current market value is more than the discounted cash flows C. The current market value is less than the discounted cash flows D. The investment is overvalued

C. The current market value is less than the discounted cash flows Net present value is the difference between the present value of an investment's cash flows (e.g., interest payments), MINUS the market value of the investment (i.e., NPV = PV Cash Flows - Market Price). If the net present value is greater than 0, the present value of the cash flows is worth more than the purchase price and, therefore, the investment is undervalued (i.e., NPV is greater than 0 if PV of Cash Flows is more than the Market Price).

According to the dividend discount model, when interest rates rise: A. The discount rate used in the model would fall, causing stock prices estimated by the model to rise B. The discount rate used in the model would rise, causing stock prices estimated by the model to rise C. The discount rate used in the model would rise, causing stock prices estimated by the model to fall D. The discount rate used in the model would fall, causing stock prices estimated by the model to fall

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Which of the following is a type of unsystematic risk? A. Inflation risk B. Interest-rate risk C. Market risk D. Business risk

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

Which of the following factors is a disadvantage of a buy/hold strategy? A. Low transaction costs B. Higher management fees C. Increased tax risk D. Changing portfolio risk levels

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

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

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

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

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

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

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

Which of the following terms relates to the graph of optimal portfolios resulting from a comparison of risk and return? A. CAPM B. Duration C. Alpha D. Efficient frontier

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

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

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

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

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

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

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

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

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

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

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

All of the following risks are considered types of unsystematic risk, EXCEPT: A. Business risk B. Credit risk C. Political risk D. Market risk

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

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

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

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

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

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

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

Net present value is best described as: A. Market price above cost B. Cost above market price C. Cost above present value D. Present value above cost

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

Which of the following is a measure of risk according to the Modern Portfolio Theory? A. Correlation coefficient B. Beta C. Alpha D. Standard deviation

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

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

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

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

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

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

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

If the net present value of an investment is less than 0: A. The investment is undervalued. B. The current market value is less than the discounted cash flows. C. The discount rate used to calculate the present value is the internal rate of return. D. The current market value is more than the discounted cash flows.

D. The current market value is more than the discounted cash flows. Net present value is the difference between the present value of an investment's cash flows (e.g., interest payments), less the market value of the investment (i.e., NPV = PV Cash Flows - Market Price). If the net present value is less than 0, the present value of the cash flows is worth less than the purchase price and the investment is overvalued (i.e., NPV is less than 0 if PV of Cash Flows is less than the Market Price).

What information is required in order to determine an investment's internal rate of return (IRR)? A. The risk-free rate B. The general market return C. The money supply in the overall economy D. The positive and negative cash flows from an investment

D. The positive and negative cash flows from an investment The internal rate of return (IRR) is a projected, compounded, annual return on an investment. The IRR is calculated by estimating the present value of all future cash outflows (e.g., purchase price of investment) and cash inflows (e.g., interest, dividends, par value, sale price). The IRR only considers factors that are specific to the investment and not external factors (e.g., risk-free rate, return on the overall market, or economic conditions).

A client bought 100 shares of stock for $30 and sold the shares one year later at $26. If the investor also collected $200 in dividends, what's the total return? A. 6.67% B. -13.33% C. 13.33% D. -6.67%

D. -6.67% To calculate the investor's total return, any gain or loss on the investment, plus income received from the investment (e.g., dividends), is divided by the original investment (i.e., Total Return = (Ending Value - Beginning Value + Income) ÷ Original Investment). In this question, the investor lost $4 per share ($26 sale - $30 purchase). or $400 in total ($4 loss x 100 shares). Since the investor received $200 in dividends, she only lost $200 total ($400 loss - $200 dividends). Therefore, the total return is -6.67% (-$200 loss ÷ $3,000 original investment).

When is the internal rate of return (IRR) used? A. When determining the rate that makes the net present value of an investment zero B. When estimating the future cash flows C. When measuring the profitability of an investment portfolio relative to the portfolio's risk D. When calculating a bond's price relative to its yield

A. When determining the rate that makes the net present value of an investment zero The internal rate of return (IRR) is a rate that makes the present value of an investment equal to the market price of the investment. In other words, the IRR is the rate that makes the net present value (NPV) of an investment equal to zero.

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

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