Checkpoint Exam U20

Which of the following investment styles would be most suitable for a long-term investor who seeks capital growth but is concerned about execution costs? A) Growth style B) Buy/hold C) International D) Market timing

B) Buy/hold A buy-and-hold style would be appropriate for the long-term investor because long-term gains are taxed at a lower rate, and execution costs are reduced by not buying and selling frequently. U20LO5

Due to an inheritance, one of your clients now owns a large position in LMN stock. She is concerned that the stock may decline in the coming months while she is deciding what to do with the investment. What type of investment strategy could she employ to protect the stock from substantial downside risk? A) Write call options on LMN stock B) Diversify into an index fund C) Purchase put options on LMN stock D) Purchase call options on LMN stock

C) Purchase put options on LMN stock The best way to protect a long stock position against a potential substantial loss is to purchase put options on that stock. This is generally referred to as a protective put or portfolio insurance. Assuming the strike price is the same as the current market, the holding is fully protected and the investor's loss on the option is limited to the amount of the premium paid for the puts. Writing calls on LMN also offers protection against loss, but that protection is limited to the premium received on the calls. This question refers to substantial loss, and the puts are the only way to protect against that. Once the client decides what she wants to do with the stock, she may decide to diversify into an index fund, but that does not answer the immediate need expressed in the question. U20LO12

Which two of the following would you expect of a growth stock? I. High price/earnings ratio II. Low price/earnings ratio III. High dividend payout ratio IV. Low dividend payout ratio A) II and III B) II and IV C) I and III D) I and IV

D) I and IV Growth stocks are stocks of companies that plow their earnings back into further product development. They sell at a high price-earnings ratio and pay out little or nothing as a percentage of their earnings in dividends. U20LO5

The capital asset pricing model (CAPM) is used by many to assess the expected return of a security. If the current risk-free rate is 2%, the current return on the market is 10%, and a particular stock's beta is 1.5 with a standard deviation of 3.2, the expected return would be A) 14% B) 18.2% C) 15% D) 12%

A) 14% The formula for this computation is as follows: 10% (the return on the market is a beta of 1.0) minus the risk-free rate of 2%, or 8%. Then, multiply that by the beta of this stock (1.5) to arrive at 12%. That is, the stock should return 12% above the risk-free rate of 2%, or 14%. The standard deviation is not relevant to this computation. U20LO9

The capital asset pricing model (CAPM) is used by many to assess the expected return of a security. If the current risk-free rate is 2%, the current return on the market is 10%, and a particular stock's beta is 1.5 with a standard deviation of 3.2, the expected return would be A) 12% B) 14% C) 18.2% D) 15%

B) 14% The formula for this computation is as follows: 10% (the return on the market is a beta of 1.0) minus the risk-free rate of 2% or 8%. Then, multiply that by the beta of this stock (1.5) to arrive at 12%. That is, the stock should return 12% above the risk-free rate of 2%, or 14%. The standard deviation is not relevant to this computation. U20LO9

A corporation sponsors a defined benefit pension plan. The assets of the plan are invested in a diversified portfolio of large-cap stocks. Which of the following options positions would be most appropriate if the corporation wished to protect their ability to meet their obligations to employees? A) Sell S&P 500 index calls B) Buy S&P 500 index calls C) Buy S&P 500 index puts D) Sell S&P 500 index puts

C) Buy S&P 500 index puts In a defined benefit plan, the corporation is assuming the investment risk. Regardless of the security, the best way to protect a long position is to buy a put, either on that security or on an index with a close correlation. In this case, with a portfolio of large-cap stocks, the S&P 500 index would seem to be the appropriate option to use. U20LO12

Which of the following would an investor who believes in MPT probably select for a client? A) ABC, with a return of 11% and a standard deviation of 15 B) DEF, with a return of 13% and a standard deviation of 18 C) JKL, with a return of 15% and a standard deviation of 15 D) GHI, with a return of 13% and a standard deviation of 20

C) JKL, with a return of 15% and a standard deviation of 15 Modern portfolio theory (MPT) proponents believe that the most appropriate investments are those that offer the greatest return with the lowest risk. JKL has delivered the highest return with a standard deviation (risk) equal to that of ABC (which has a much lower return). U20LO8

A high-risk investment strategy is the short sale of stock. Each of the following is a method of offering some degree of protection A) selling a put on the short stock. B) buying a call on the short stock. C) buying a put on the short stock. D) entering a buy stop order for the short stock.

C) buying a put on the short stock. The risk in selling a stock short is that the price of the stock will rise rather than fall. Those who purchase put options have the same market view as those who sell short—they will profit if the price of the security declines. Buying a put would be the equivalent of "doubling down" on your bet. The best way to hedge (protect) a short stock position is to purchase a call option on the security because that gives you a guaranteed "buy-back" price regardless of how high the stock's price rises. If you sell a put on the stock and the price rises, the put will expire and the seller will have the premium to partially offset any loss. If the short seller enters a buy stop order, once the price rises (or goes through) the stop price, a market order to buy the stock will be entered and the position will be closed out preventing any further loss. U20LO12

An individual is a participant in the 403(b) plan offered by his employer. If he were to invest $200 per month into one of the growth subaccounts offered under the plan, he would be A) following a constant ratio plan B) rebalancing C) dollar cost averaging D) maintaining a constant dollar plan

C) dollar cost averaging Dollar cost averaging is the investment formula where an investor invests the same amount at regular intervals. U20LO11

A customer who follows a strict dollar cost averaging program to acquire shares in a diversified common stock mutual fund should achieve A) significant reduction of market risk due to enhanced diversification B) allocation among various funds within a single investment company's family of funds C) lower average cost to acquire fund shares relative to the fund's average price over the buying period D) reasonable assurance against loss of principal, presuming the customer dollar cost averages over an extended period

C) lower average cost to acquire fund shares relative to the fund's average price over the buying period By investing a constant amount of dollars at regular intervals, the investor buys fewer shares when the fund's price rises and more shares when the share price drops, thereby lowering the average cost. U20LO11

A portfolio manager who routinely shifts portfolio assets to take advantage of the business cycle is said to be engaging in A) rebalancing B) asset allocation C) sector rotation D) correlation

C) sector rotation Sector rotation is the practice of moving out of those industries that are heading for a decline and into those whose fortunes are likely to rise as the economy follows the business cycle. U20LO3

Two portfolios have the same expected return of 10%. Portfolio A has a standard deviation of 5% and Portfolio B has a standard deviation of 18%. Under modern portfolio theory (MPT), A) neither portfolio would be preferred because both portfolios have the same 10% expected return B) neither portfolio would be acceptable because the risk is too high for the expected return C) Portfolio B would be preferred by investors because its standard deviation is more than 3 times that of Portfolio A D) Portfolio A would be preferred by investors because the portfolio has the same return as Portfolio B but bears less risk

D) Portfolio A would be preferred by investors because the portfolio has the same return as Portfolio B but bears less risk Portfolio A would be preferred by investors because it has the same return (10%) as Portfolio B but bears less risk. One of the assumptions of MPT is that investors prefer less risk rather than more risk per unit of return. Because Portfolio A has a smaller standard deviation than that of Portfolio B, it has less risk. Standard deviation measures the volatility of a security. The larger the standard deviation, the larger the security's returns are expected to deviate from its average return and, hence, the greater the risk. U20LO8