Module 8 - FP513

All of the following are primary factors in the arbitrage pricing theory (APT) except A) unemployment rate. B) interest rates. C) inflation rate. D) changes in GDP

A) unemployment rate. These factors might include inflation, growth in GDP, major political upheavals, or changes in interest rates.

A portfolio consisting of 30% bonds, 20% growth stocks, 40% blue-chip conservative stocks, and 10% cash is most representative of which type of investment objective? A. Growth and income B. Current income C. Aggressive growth D. Capital preservation

A. Growth and income A portfolio consisting of 30% bonds, 20% growth stocks, 40% blue-chip conservative stocks, and 10% cash is most representative of a growth and income investment objectiv

If information is generated randomly and information announcements are independent A) price changes will be independent of each other and tend to move in a predictable fashion. B) prices will change quickly in response to the new random information. C) price changes will be influenced by the information about past prices and volume. D) prices will not reflect all fully available information.

B) prices will change quickly in response to the new random information. If information is generated randomly and information announcements are independent, prices will tend to fully reflect all available information. In addition, price changes will be independent of one another and tend to occur in random patterns.

All of the following are attributes of an economy that is coming out of recession except A. interest rates are rising. B. cyclical stocks are beginning to increase in price. C. personal incomes are increasing. D. unemployment is increasing.

D. unemployment is increasing. When an economy is coming out of a recession, hiring would be increasing and unemployment claims would be decreasing. All of the other choices are attributes of a recovering economy.

The semistrong form of the efficient market hypothesis states that current market prices reflect I. all available information on the history of prices. II. all publicly available information concerning a company. A) Both I and II B) Neither I nor II C) II only D) I only

A) Both I and II The semistrong form states that all publicly available information, including past stock price history, is reflected in current stock prices.

Which of the following statements describes a limitation of Monte Carlo simulation? A) Outcomes of a simulation can only be as accurate as the inputs to the model. B) Variables are assumed to be normally distributed but may not be normally distributed. C) A clearer understanding of short-term and long-term risk can be gained. D) Simulations do not consider possible input values that lie outside of historical experience.

A) Outcomes of a simulation can only be as accurate as the inputs to the model. Monte Carlo simulations can be set up with inputs that have any distribution and any desired range of possible values. However, a limitation of the technique is that its output can only be as accurate as the assumptions an analyst makes about the range and distribution of the inputs.

Henry, age 46, has $250,000 to invest in a long-term investment portfolio. He has come to his financial planner, Robbie, to ask for advice. He wants a diversified portfolio while simultaneously limiting risk, minimizing transaction costs, and managing taxes. Also, he desires a portfolio that is based on a passive management approach, but he would still like to include an active management component. Which of the following investment approaches would best suit Henry? A. Index funds B. Core and satellite C. Commodities D. Emerging markets

B. Core and satellite The core and satellite approach is the best choice for Henry. Emerging markets and commodities may be used in the satellite portion of the portfolio. Index funds generally are used in a passive portfolio approach.

Mike, a stock analyst, has determined several factors affecting the expected return on a stock. In addition, he has estimated their sensitivity coefficients and associated risk premiums. Factor | Sensitivity Coefficient | Risk Premium Unemployment 0.7 6% Inflation 0.8 4% Demand 1.2 5% Assuming the current risk-free rate of return is 3%, calculate the expected return of the stock using the arbitrage pricing theory (APT). A) 18.00% B) 13.40% C) 16.40% D) 12.20%

C) 16.40% The stock has an expected return of 16.40%, calculated as follows: using APT, ri = 0.03 + (0.7 × 0.06) + (0.8 × 0.04) + (1.2 × 0.05) = 0.1640, or 16.40%.

Calculate the expected rate of return for a stock with a beta of 2.0 when the risk-free rate is 6% and the return on the market is 12%. A) 24% B) 10% C) 18% D) 12%

C) 18% Using the capital asset pricing model (CAPM), the expected rate of return is 18% [6% + (12% - 6%)2.0].

What is the best choice for clients to use to finance an unanticipated financial crisis? A) Credit cards B) Retirement plan loan C) Money market mutual fund D) Home equity

C) Money market mutual fund Clients should establish an emergency fund, generally funded with highly liquid and marketable investments such as money market mutual funds, to finance any unanticipated financial emergencies.

Coretta, age 63, is an executive with ABC Corporation (a publicly traded company). She wants to retire within two years. Over the years, she has accumulated a large position in her company's stock. She is concerned that her portfolio may not be diversified enough to withstand a substantial decline in ABC's stock price. She would like to retain control over the proceeds and create a diversified portfolio. She has come to you for advice on how to handle this situation. Based on this information, which is the best choice for Coretta? A. Gift the stock to a family member. B. Sell the stock to a family member. C. Use an exchange fund. D. Sell the stock and transfer the proceeds to a charitable remainder trust.

C. Use an exchange fund. The best course of action for Coretta is to use an exchange fund. This fund permits investors with concentrated portfolios to contribute the stock to the fund. In exchange, the investor receives a proportional interest in the fund. All of the other choices will require Coretta to give up control of the proceeds.

Which of the following is NOT likely to be an advantage of a valid investment policy statement? A) Identifies and documents investment objectives and constraints B) Allows for a continual dynamic process in meeting investor objectives C) Promotes long-term discipline in investment decisions D) Provides for short-term strategy shifts in response to short-term dramatic value declines

D) Provides for short-term strategy shifts in response to short-term dramatic value declines The answer is provides for short-term strategy shifts in response to short-term dramatic value declines. The investment policy statement does not provide for shifts in strategy due to short-term value declines.

Which statement regarding indifference curves is CORRECT? A) Reflect happier investors when the curve is lower B) For risk-averse investors, show decreasing returns for increases in risk C) Represent the return patterns of two or more equally attractive stocks D) Represent all points where an investor is equally satisfied with the risk/return trade-off

D) Represent all points where an investor is equally satisfied with the risk/return trade-off Indifference curves express an individual's preference regarding two items: risk and return. The more risk averse an investor is, the steeper the slope is for that investor's indifference curve. Conversely, the less risk averse an investor is, the flatter the slope for that investor's indifference curve.

Your client, Mij Sato, is deeply concerned that the stock market will experience a correction next year. Mij is 40 years old, is married with no children and a significant amount of retirement savings already. He is concerned because his current portfolio allocation is 80% in stocks and 20% in fixed-income. What is the advisor's best course of action working with Mij? A. Move all stocks into fixed-income investments before the end of the year. B. Liquidate the stock positions in order to increase his cash position. C. Aim to target asset allocation strategies into a more conservative investment, like U.S. Treasuries. D. Keep a long-term perspective and maintain the current portfolio allocation strategy.

D. Keep a long-term perspective and maintain the current portfolio allocation strategy. When confronted with financial or economic crisis events, the best course of action is for clients to keep a long-term perspective and focus on long time horizons rather than reacting negatively to market events

Under the efficient market hypothesis, which of the following terms best describes the movement of stock prices? A) Random B) Statistical C) Diverse D) Predictable

A) Random Random walk is the term used to describe the pattern of movement of stock prices. Because only new information, which is unpredictable and random, will affect the price of a security, the pattern of price movements for a stock will be random.

An investor considering investing in a particular security is more concerned with A) expected return. B) actual return. C) trailing P/E ratio of the stock. D) historical return.

A) expected return. Expected return is what determines an asset's value. The expected return must be greater than the investor's required return to induce the investor to make the investment. Historical return is only important to the extent that it may impact future return.

All of the following affect an investor's risk tolerance except A) tax bracket. B) investment time horizon. C) family situation. D) years of experience with investing in the markets.

A) tax bracket. Tax concerns play an important role in investment planning; however, these constitute an investment constraint, not an investment objective (i.e., risk tolerance).

Which of the following statements regarding strategic and tactical asset allocation (TAA) is CORRECT? I. Strategic asset allocation involves selecting the proper asset allocation based on the risk tolerance of the client and rebalancing to keep the portfolio within the parameters of the desired strategic mix. II. TAA involves evaluating asset classes or industries with respect to their value and selling undervalued classes and purchasing overvalued classes. A. I only B. II only C. Both I and II D. Neither I nor II

A. I only TAA involves buying undervalued classes and selling overvalued classes.

George is considering adding ABC stock to his portfolio. ABC has a standard deviation of 4.5% and a beta of 0.85. If the market rate of return is 12% and the 90-day T-bill has a yield of 3%, what are the market risk premium and the stock risk premium for ABC? A. Market risk premium: 9%; stock risk premium: 7.65% B. Market risk premium: 9%; stock risk premium: 13.50% C. Market risk premium: 12%; stock risk premium: 7.65% D. Market risk premium: 12%; stock risk premium: 13.50%

A. Market risk premium: 9%; stock risk premium: 7.65% Market risk premium = rm - rf = 12% − 3% = 9%. Stock risk premium = (rm - rf) βi = 9% × 0.85 = 7.65%.

All of the following are primary factors in the arbitrage pricing theory (APT) except A. the unemployment rate. B. interest rates. C. the inflation rate. D. changes in GDP.

A. the unemployment rate. The four factors in APT are unexpected changes in inflation, GDP, interest rates, and market risk premiums

Which of the following are implications of the weak form of the efficient market hypothesis (EMH)? I. Stock prices fully reflect all historical price behavior. II. Consistently superior performance is common. III. Fundamental analysis may produce superior investment performance. IV. Fundamental and technical analysis can produce superior investment performance. A) I only B) I and III C) I and IV D) II and IV

B) I and III Technical analysis is not considered valuable under any of the forms of the EMH; fundamental analysis is considered valuable under the weak form only.

Which of the following statements regarding the efficient frontier is CORRECT? A) Combines all assets that can be held in a portfolio B) Shows all portfolios that offer the highest expected returns for each level of risk C) Represents an inferior set of assets or asset combinations available to investors D) Represents the assets or asset combinations with the least return for the given level of risk

B) Shows all portfolios that offer the highest expected returns for each level of risk Efficient frontiers take all of the possible combinations of assets that can be held in a portfolio into account in order to represent the set of portfolios that offer the highest expected return for a given amount of risk.

The area of the investment policy statement (IPS) that provides the specified return on an inflation-adjusted basis is best described as A. time horizon. B. return requirement. C. liquidity. D. unique preferences and circumstances.

B. return requirement The return requirement might include absolute or relative dollar or percentage returns on a before-tax or after-tax basis. Also included might be the requirement to provide the specified return on an inflation-adjusted basis.

clients are both moderate risk takers. Madeline concludes that based on all of the information gathered both of them should be able to cope with the volatility in the equity and bond markets Which of the following would be the most appropriate asset allocation for each of their individual portfolios within their respective IRAs? A Portfolio 1 50% smallcap growth fund 30% international stock fund 20% S&P 500 Index fund B Portfolio 2 10% US government securities fund 10% utilities fund 30% balanced fund 25% smalcap growth fund 25% highyield bond fund C Portfolio 3 10% smallcap growth fund 30% corporate bond fund 10% international growth fund 50% S&P 500 Index fund D Portfolio 4 25% Wilshire 5000 Index fund 25% highyield bond fund 25% asset allocation fund 25% international stock fund

C Portfolio 3 10% smallcap growth fund 30% corporate bond fund 10% international growth fund 50% S&P 500 Index fund The answer is Portfolio 3—10% small-cap growth fund, 30% corporate bond fund, 10% international growth fund, 50% S&P 500 Index fund. Portfolio 3, composed of 70% equities and 30% bonds, would be an appropriate allocation for a young couple with a moderate risk profile.

Identify the efficient market hypothesis that suggests an investor can achieve above-market returns by only utilizing insider information. A) Strong B) Weak C) Semistrong D) All of these forms

C) Semistrong The semistrong form suggests that fundamental analysis is of no value and only through the use of insider information can an investor achieve above-market returns.

Calculate the expected rate of return for Stock A based on the following information: Risk-free rate of return: 3.85% Factor | Sensitivity | Risk Premium Inflation 1.2 4.00% Industrial Production 0.9 5.75% PopulationGrowth 0.5 2.60% A) 7.97% B) 11.28% C) 12.35% D) 15.13%

D) 15.13% The expected rate of return for Stock A based on the arbitrage pricing model (APT) is calculated as follows: ri = 0.0385 + (1.2 × 0.04) + (0.9 × 0.0575) + (0.5 × 0.0260) = 0.0385 + 0.048 + 0.0518 + 0.013 = 0.1513, or 15.13%.

Which of the following correctly describes a lifecycle fund? A) A fund that invests in other funds, usually offering three portfolios with different levels of risk, such as conservative, moderate, and growth B) A fund that utilizes sector rotation to adjust the asset allocation based on where the economy is in its "life cycle" C) A fund that bases and adjusts its asset allocation based on the current phase of life of the investor D) A fund that bases and adjusts its asset allocation on a specific target date at which the investor will retire

D) A fund that bases and adjusts its asset allocation on a specific target date at which the investor will retire This is also known as a target-date fund.

In the Markowitz framework, an investor should most appropriately evaluate a potential investment based on its A) required return. B) expected return. C) intrinsic value compared to market value. D) effect on portfolio risk and return.

D) effect on portfolio risk and return. Modern portfolio theory concludes that an investor should evaluate potential investments from a portfolio perspective and consider how the investment will affect the risk and return characteristics of an investor's entire portfolio.

Select the CORRECT statements concerning the analysis of portfolio risk. I. Investors estimate the risk of a portfolio on the basis of the variability of returns. II. Markowitz used risk and expected return as the basis for determining efficient combinations of assets. III. For a given level of risk, investors prefer lower returns to higher returns. IV. Investors base decisions solely on expected return and risk. A) I, II, and IV B) II, III, and IV C) I only D) II and III

A) I, II, and IV Only statement III is incorrect. For a given level of risk, investors prefer higher returns to lower returns.

An investor selects an appropriate portfolio by choosing the portfolio A) at the point of tangency between the indifference curve and the efficient frontier. B) with the lowest risk. C) that lies below the efficient frontier. D) with the highest return.

A) at the point of tangency between the indifference curve and the efficient frontier. The investor will choose a portfolio represented by the highest point attainable on the indifference curve.

An investor analyzing a particular security is generally concerned with A) expected return. B) trailing P/E ratio of the stock. C) historical return. D) actual return.

A) expected return. Expected return is what determines an asset's value. The expected return must be greater than the investor's required return to induce the investor to make the investment. Historical return is only important to the extent that it may impact future return.

A well-crafted investment policy statement will take all of the following into account except A) hobbies the client intends to pursue in retirement. B) the client's time horizon. C) investments the client is especially interested in considering for her portfolio. D) anticipated liquidity needs.

A) hobbies the client intends to pursue in retirement. A properly crafted IPS will keep both the client and the advisor on track, and minimize any disagreements or confusion.

Which of the following statements regarding asset allocation is CORRECT? I. Asset allocation is the main determinant of a portfolio's total return. II. The purpose of strategic asset allocation is to determine an appropriate allocation based on the long-term financial goals of the client. A) II only B) Neither I nor II C) Both I and II D) I only

C) Both I and II Both of these statements are correct.

Which of these statements pertaining to the capital market line (CML) is CORRECT? I. Lending portfolio—As the investor proceeds back along the CML toward the risk-free rate of return, he is becoming conservative in making investments and is investing more in risk-free government securities II. Borrowing portfolio—As the investor proceeds along the CML, he is becoming more aggressive in making investments, including making use of margin and leverage A) II only B) Neither I nor II C) Both I and II D) I only

C) Both I and II The development of the capital market line allows investors to see that the risk and the potential return of various asset classes do increase along a relatively straight line.

JEM stock has a beta coefficient of 1.35 and the market has a rate of return of 8.50%. The 90-day U.S. Treasury bill rate of return is 1.75%. Based on the information provided, choose the CORRECT statements. I. The stock risk premium is 6.75%. II. The market risk premium is 9.11%. III. The expected rate of return is 10.86%. A) I, II, and III B) I and II C) III only D) I and III

C) III only The expected rate of return based on the capital asset pricing model is 10.86%, calculated as follows: ri = 0.0175 + (0.085 - 0.0175)1.35 = 10.86, or 10.86% The stock risk premium is 9.11%, (0.085 - 0.0175)1.35. The market risk premium is 6.75%, (0.085 - 0.0175).

The anticipation of inflation suggests that the investor should A) sell stocks of gold companies. B) avoid real estate investments. C) anticipate higher interest rates. D) buy bonds.

C) anticipate higher interest rates. Real assets, which includes gold and real estate, should do well in inflationary times. Bonds do poorly because interest rates will increase to fight inflation, and increases in interest rates cause bond prices to fall.

All of the following statements correctly evaluate market efficiency except A) the weak form of market efficiency involves market data, whereas the semistrong involve the assimilation of all public information and the strong form involves both public and private information. B) the efficient market hypothesis states that securities markets are efficient, with the prices of securities reflecting their current economic value. C) investors usually react slowly to new and random information pertaining to security's markets. D) an efficient market is one in which the prices of securities quickly and fully reflect all available information.

C) investors usually react slowly to new and random information pertaining to security's markets. Another condition that guarantees an efficient market is investors reacting quickly to new information.

Which of the following should be agreed upon between the client and the investment professional when making recommendations based on an investment policy statement? A) Permitted and excluded investments B) Return requirement C) Risk tolerance D) All of these

D) All of these The client and the investment professional should agree on return requirement, risk tolerance, and permissible investments. Other factors to incorporate are liquidity needs, asset allocation, time horizons, tax considerations, and laws and regulations.

Which of the following statements about the importance of risk and return in the investment objective is least accurate? A) The return and risk objectives have to be consistent with reasonable capital market expectations, as well as the client constraints. B) The return objective may be stated in dollar amounts even if the risk objective is stated in percentages. C) The investor's risk tolerance is likely to determine what level of return will be feasible. D) Expressing investment goals in terms of risk is more appropriate than expressing goals in terms of return.

D) Expressing investment goals in terms of risk is more appropriate than expressing goals in terms of return. The answer is expressing investment goals in terms of risk is more appropriate than expressing goals in terms of return. Expressing investment goals in terms of risk is not more appropriate than expressing goals in terms of return. The investment objectives should be stated in terms of both risk and return. Risk tolerance will likely help determine what level of expected return is feasible.

Which of the following statements regarding an efficient portfolio is CORRECT? I. Provides the highest return for a given level of risk II. Has the greatest risk for a given level of expected return III. Shows an investor's willingness to bear risk IV. Can be created with minimum transaction costs A) I, II, and III B) II and III C) III and IV D) I only

D) I only An investor should try to assemble an investment portfolio containing the optimum combination of risk and return. An efficient portfolio offers maximum return for a given level of risk. An investor's willingness to bear risk is reflected in indifference curves.

The weak form of the efficient market hypothesis: I. reinforces the value of technical analysis. II. implies that technical analysis is not worthwhile. III. implies that fundamental analysis is not worthwhile. IV. implies that inside traders cannot earn superior risk-adjusted returns. A) I and IV B) II and III C) I, III, and IV D) II only

D) II only The weak form implies that information contained in historical stock prices is fully incorporated into current stock prices; therefore, technical analysis (the study of historical prices and volume) is not worthwhile in predicting future prices. This form neither refutes fundamental analysis nor implies that traders using insider information cannot earn superior profits.

An investor who makes the assumptions that security prices reflect all available information, that organized exchanges can execute trades rapidly, that security prices change rapidly in response to new information, and that security prices follow random patterns is a believer in A) the capital asset pricing model. B) the arbitrage pricing theory. C) the constant growth hypothesis. D) the efficient market hypothesis.

D) the efficient market hypothesis. In its purest form, the efficient market hypothesis suggests that investors are unable to outperform the market on a consistent basis. The fundamental assumption of the theory is that current stock prices reflect all available information for a company and that prices rapidly (or immediately) adjust to reflect any new information.

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

D. 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

Which of the following would be the best choice for a client to use in order to finance an unanticipated financial crisis? A. None of these B. Retirement plan loan C. Personal line of credit D. Money market account

D. Money market account Clients should establish an emergency fund, generally funded with highly liquid and marketable investments such as a money market account, to finance any unanticipated financial emergencies.

Which of the following forms of the efficient market hypothesis (EMH) supports technical analysis? A. Weak B. Semistrong C. Strong D. None of these

D. None of these The EMH is in direct contradiction to technical analysis because the hypothesis is founded on the belief that all historical price and volume data (which are used by technical analysts) is already accounted for in the current stock price.

During a period of increasing inflation, which one of the following investments might be appropriate? A) Common stock of energy firms B) Common stock of financial firms C) None of these D) Long-term bonds

A) Common stock of energy firms Rising inflation causes interest rates to rise, which causes financial firms' cost of sales to rise, thereby restricting these firms' profits and depressing their stock prices. Rising inflation helps companies that hold and/or sell real assets, such as commodities and real estate, thereby causing these companies' stock prices to rise. Long-term bond prices fall as interest rates rise, which they generally do during periods of rising inflation.

An active approach to portfolio management is more likely to reward investors in which of the following asset classes? I. Emerging market equities II. U.S. large-cap stocks III. U.S. small-cap stocks IV. European large-cap stocks A) I and III B) I and II C) I only D) I, III, and IV

A) I and III Investors who follow an active approach to portfolio management will benefit most from a portfolio containing emerging market equities and U.S. small-cap stocks, which tend to be more volatile investments.

Which of the following statements correctly distinguishes an investor who practices indexing? I. The investor purchases index mutual funds. II. The investor is practicing an active form of portfolio management. III. The investor is attempting to beat the market (i.e., S&P 500). IV. Indexing and purchasing index funds tends to exhibit low administrative costs and a low turnover of existing assets. A) I and IV B) I, II, and III C) II, III, and IV D) II and III

A) I and IV In actuality, the investor is following a passive portfolio management style. The purpose of indexing is not to beat the market, but merely match its long-term performance.

Analyzing financial statements of a company and performing industry analysis would be beneficial under which of the following forms of the efficient market hypothesis (EMH)? I. Weak II. Semistrong III. Strong IV. Semiweak A) I only B) I and II C) I, II, and III D) III and IV

A) I only The weak form of the efficient market hypothesis (EMH) states that market prices incorporate all historical price information. However, fundamental analysis, such as analyzing financial statements, may be beneficial under the weak form of the EMH. Semiweak is not a form of the EMH.

Which of the following statements regarding the efficient market hypothesis (EMH) is CORRECT? I. The EMH suggests that active management should be used. II. Under the EMH, all publicly known information is incorporated into security A) II only B) I only C) Both I and II D) Neither I nor II

A) II only The EMH suggests that passive, not active, management should be used.

Which of the following characteristics are associated with the market anomaly known as the neglected-firm effect? I. Low price-to-earnings (P/E) ratio stocks outperform high P/E stocks. II. Stocks of foreign companies outperform known domestic stocks. III. Neglected-firm stocks underperform large capitalization stocks. IV. Stocks not frequently followed by analysts outperform widely followed stocks. A) IV only B) III and IV C) I only D) II and III

A) IV only When such companies can be found, the market for those companies may not be efficient, and investors who can take the time to analyze these companies may be able to take advantage of undervalued situations.

The current risk-free rate of return is 4%, and the market risk premium is 5%. One stock under consideration for investment has a beta of 1.3. Calculate the expected rate of return for both the market portfolio and the individual stock. A) Market = 9.00%; Stock = 10.50% B) Market = 11.70%; Stock = 10.50% C) Market = 6.92%; Stock = 11.70% D) Market = 10.50%; Stock = 9.00%

A) Market = 9.00%; Stock = 10.50% The answer is Market = 9.00%; Stock = 10.50%. The expected rate of return for the market portfolio is 9%, calculated as follows: Using the capital asset pricing model (CAPM), rp = 4% + (5% × 1.0). The market has a beta of 1.0 and the market risk premium, rather than the market return, is given. The expected rate of return for the stock is 10.50%, calculated as follows: Using CAPM, ri = 4% + (5% × 1.3) = 10.50%.

Ophelia is considering the purchase of the Quest Mutual Fund, which has a beta of 1.2, a standard deviation of 15, and a return of 11%. The current risk-free rate is 4%, and the market risk premium is 7%. Should Ophelia purchase the fund? A) No, because the fund has a negative alpha. B) Yes, because of the fund's Treynor ratio. C) Yes, because the fund has an 11% return. D) No, because of the fund's Sharpe ratio.

A) No, because the fund has a negative alpha. This question can be answered with or without a calculation. We have nothing to compare Quest Mutual Fund to, and both Sharpe and Treynor are comparative measures, so neither can be used to evaluate the fund. The answer "Yes, because the fund has an 11% return" just restates the return of the fund without taking risk into account. The calculation would be as follows: a = rp − [ rf (rm − rf) βp] a = 11 − [ 4 + 7 (1.2)] a = 11 − [12.40] a = −1.40 The fund has a negative alpha of 1.40, meaning the fund manager has not obtained the return she should for the amount of risk taken.

Stock Beta A 2.16 B 1.54 C 0.96 D 1.28 Risk-free rate of return is 2.75% Market rate of return = 6.75% The investor's required rate of return = 9.5% Based on the information provided, choose the stock that would offer the best investment opportunity. A) Stock A B) Stock C C) Stock B D) Stock D

A) Stock A Calculate the expected rate of return of each stock using the capital asset pricing model (CAPM) and compare the result to the investor's required rate of return. Stock A: E(r) = 2.75 + (6.75 - 2.75)2.16 = 11.39% Stock B: E(r) = 2.75 + (6.75 - 2.75)1.54 = 8.91% Stock C: E(r) = 2.75 + (6.75 - 2.75)0.96 = 6.59% Stock D: E(r) = 2.75 + (6.75 - 2.75)1.28 = 7.87% Based on a required rate of return of 9.5%, Stock A with an expected return of 11.39% is the best available investment opportunity.

Roger believes that an 11% return for the market next year would be good. The current market risk premium is 7.5% and the Treasury bill rate is 5.75%. The stock Roger has been following has the following characteristics: Standard deviation 18% Dividend yield 2.4% P/E ratio 17 P/E ratio relative to S&P 500 1.4 Beta 1.25 Using the CAPM formula, calculate the required rate of return for the stock and determine if the stock appears to meet Roger's criteria of investing in above-average-risk stocks only if he is rewarded for doing so. A) The required rate of return is 15.13%, and the stock meets Roger's criteria. B) The required rate of return is 12.31%, and the stock does not meet Roger's criteria. C) The required rate of return is 13.25%, and the stock meets Roger's criteria. D) The required rate of return is 11.00%, and the stock does not meet Roger's criteria.

A) The required rate of return is 15.13%, and the stock meets Roger's criteria. Required rate of return is 5.75% + (7.5%)1.25 = 15.13%. The fact that Roger believes 11% would be a good return is not relevant for computation of the required rate of return—only the computed market risk premium is relevant. The market return is computed as 7.5% + 5.75% = 13.25%. Roger will invest in an above-average risk stock (beta = 1.3) if he can be rewarded for taking the extra risk. The reward is the greater-than-market return of 15.13%.

Assets with expected returns that lie above the security market line (SML) A) are undervalued. B) should be sold. C) are overvalued. D) are valued correctly.

A) are undervalued. Assets that lie above the security market line (SML) are undervalued because their expected returns are higher than the required return represented by the SML.

All of the following statements concerning market efficiency are correct except A) investors usually react slowly to new and random information pertaining to securities markets. B) an efficient market is one in which the prices of securities quickly and fully reflect all available information. C) the weak form of market efficiency involves market data, whereas the semistrong involve the assimilation of all public information and the strong form involves both public and and private information. D) the efficient market hypothesis states that securities markets are efficient, with the prices of securities reflecting their current economic value.

A) investors usually react slowly to new and random information pertaining to securities markets. Another condition that guarantees an efficient market is investors reacting quickly to new information.

Jana believes that the allocation to emerging market equities in her portfolio has become overvalued, so she trims the holdings in that asset class and reinvests the proceeds in other asset classes that she believes are undervalued. Jana's approach to asset allocation can best be described as A) tactical asset allocation. B) core-satellite asset allocation. C) strategic asset allocation. D) dynamic asset allocation.

A) tactical asset allocation. Tactical asset allocation continuously adjusts the asset allocation and class mix in an attempt to take advantage of changing market conditions and overall investor sentiment.

All of the following statements regarding modern portfolio theory are correct except A) the optimal portfolio will always lie above the efficient frontier. B) the optimal portfolio has the lowest risk for a given level of return. C) the optimal portfolio offers the highest return for a given level of risk. D) the optimal portfolio for an investor depends upon the investor's ability to assume risk.

A) the optimal portfolio will always lie above the efficient frontier. The optimal portfolio will always lie on the investor's efficient frontier. This portfolio is found at the point of tangency of the investor's indifference curve and the efficient frontier.

Sally, Michael, and Anita use different methods for choosing assets for their investment portfolios. Sally uses technical analysis to determine when to buy and sell the stocks in her portfolio. Michael is committed to a passive investment strategy and a well-diversified portfolio of randomly selected stocks. Anita ignores historical volume and price information, but she reviews the financial statements of the firms in which she is interested. Which of the following statements best describes Sally, Michael, and Anita? I. Anita accepts the strong form of the efficient market hypothesis (EMH). II. Michael accepts the semistrong form of the EMH. III. Sally accepts the weak form of the EMH. IV. Both Anita and Sally accept the semistrong form of the EMH. A. II only B. I and IV C. II and III D. II, III, and IV

A. II only Under the weak form of the EMH, access to fundamental analysis and insider information can achieve superior results. Under the semistrong form of the EMH, only access to insider information can achieve superior results. Under the strong form of the EMH, not even access to insider information can achieve superior results. Anita uses fundamental analysis, which is supported only by the weak form of EMH. Michael does not use fundamental or technical analysis. His strategy is supported by both the semistrong and strong forms of the EMH. Sally uses technical analysis, which is rejected by all forms of the EMH.

Troy requires a 15% return to meet his financial goals. He is interested in a mutual fund with a beta of 1.3. If the market return has averaged 11% over the past 10 years and the Treasury bill rate is currently 4%, should Troy invest in this fund? A. No, the fund's expected rate of return is less than Troy's required rate of return. B. No, Troy's required rate of return is less than the fund's expected rate of return. C. Yes, the fund's expected rate of return is more than Troy's required rate or return. D. Yes, Troy's required rate of return is more than the fund's expected rate of return.

A. No, the fund's expected rate of return is less than Troy's required rate of return. Expected rate of return for the mutual fund using CAPM is as follows: rf + (rm - rf) βi = 0.04 + (0.11 − 0.04)1.3 = 0.131, or 13.1%. Because the expected rate of return is less than Troy's required rate of return, he should not purchase shares in the fund.

Patrick, age 57, has just retired from his job as a teacher. He is a widower and has three self-sufficient adult children. As part of his compensation plan, he has a cash balance retirement plan. He would like to transfer these assets to his broker and allocate the portfolio according to an income objective with low to moderate risk and a long-term time horizon. Which of the following portfolios should Patrick's financial advisor recommend? A. Portfolio 1—65% bond index fund, 20% S&P 500 Index fund, 10% international stock fund, 5% money market fund B. Portfolio 2—40% high-yield bond fund, 20% municipal bond fund, 20% U.S. government securities fund, 20% small-cap growth fund C. Portfolio 3—80% S&P 500 Index fund, 10% international bond fund, 10% money market fund D. Portfolio 4—25% Bond Index fund, 60% S&P 500 Index fund, 10% international stock fund, 5% money market fund

A. Portfolio 1—65% bond index fund, 20% S&P 500 Index fund, 10% international stock fund, 5% money market fund Because Patrick has recently retired, the portfolio should primarily provide income. In addition, his age necessitates a modest growth component to his portfolio. A portfolio consisting of 65% bonds, 30% stocks, and 5% money market is consistent with an income objective with low to moderate risk and a long-term time hori

John, your client, received notice that he will be laid off from his job in one month due to his company downsizing as a result of a slowing economy. What would be the best course for your client after his job loss? A) Cash in a growth mutual fund with a large unrealized capital gain. B) Apply for unemployment benefits. C) Take a loan from his 401(k) plan to pay for current expenses. D) Cancel his health insurance.

B) Apply for unemployment benefits. Cancelling his health insurance without reviewing any COBRA options would not be prudent. He will not be able to take a loan from his 401(k) plan after he terminates his employment. Cashing in his mutual fund may not be wise because any unrealized gain would become taxable.

Phil has computed a required return for the Pepsi stock he is considering purchasing. He believes that interest rates and inflation will change over the expected holding period. Therefore, he adjusted the required return for his projected changes in these factors. Which of the following stock market theories did Phil use? A) Dividend growth theory B) Arbitrage pricing theory C) Modern portfolio theory D) Black-Scholes pricing theory

B) Arbitrage pricing theory An investor using the APT starts with a required return for a security, possibly computed using the CAPM. The investor then adjusts the required return for a multitude of factors that may affect that particular security, such as interest rates, industrial production, and inflation.

Which of the following are reasons why a client's preferences, understanding, and experience may influence the management of his or her portfolio? I. These factors affect investment strategies that might be used by the planner. II. Consideration of these factors relieves the planner of any fiduciary duty. III. Consideration of these factors eliminates the need for due diligence of securities. IV. Investment choices must be checked for suitability, with these factors kept in mind. A) I and II B) I and IV C) I, II, and III D) II and III

B) I and IV Investment strategies used by a planner should tie closely to the client's goals, risk tolerance, investment preferences, and other intangible factors. Clients with little understanding may not tolerate complicated investment strategies and products. Unsuitability lawsuits are very common in the investment universe. By matching as closely as possible a client's suitability factors with investment products, an advisor may be able to defeat claims of unsuitability.

Which of the following statements concerning the purpose of an investment policy statement is CORRECT? I. An investment policy statement is a written document that establishes client objectives and sets limitations on the investment manager. II. The investment policy statement can be used as the basis to measure the manager's performance against the stated objectives and constraints. III. Possible investment strategies that should be pursued by an investment adviser on behalf of the client begin with the formulation of a complete and thorough investment policy statement. IV. An allocation among asset classes and their respective weights is a part of any investment policy statement. A) II and IV B) I, II, III, and IV C) I and III D) I, III, and IV

B) I, II, III, and IV All of these statements are correct. In addition, the investment policy statement can be provided to the portfolio manager to use in establishing and managing the characteristics of the client's portfolio.

Which of these statements regarding the capital asset pricing model (CAPM) are CORRECT? I. Standard deviation is used as the measure of risk on the security market line. II. The capital asset pricing model formula defines the security market line. III. Superior performance opportunity exists if a fund's position is above the security market line. IV. Both portfolio risk and return increase when investors substitute risky securities for risk-free assets. A) II, III, and IV B) II and III C) I and IV D) I, II, and IV

B) II and III Beta is used as the measure of risk on the security market line. If risky securities are added to the portfolio, both risk and return will increase. The capital market line slopes upward indicating that as more risk is undertaken, more return should be achieved.

Which of the following statements about the efficient market hypothesis (EMH) and associated anomalies are CORRECT? I. An investor purchasing a high price-to-earnings (P/E) ratio is exploiting the P/E effect anomaly. II. An investor studying annual reports and analysts' reports in his stock selection process believes that markets are weak-form efficient. III. An investor who buys the securities of firms that are not followed by many analysts is trying to benefit from the neglected-firm effect. IV. An investor who befriends the chauffeur of a firm's CEO to solicit information about the firm's plans before making investment decisions believes the markets are strong-form efficient. A) I and II B) II and III C) III and IV D) I and III

B) II and III The P/E effect suggests that portfolios consisting of stocks with low price-to-earnings ratios have higher average returns than do portfolios consisting of stocks with high P/E ratios. Strong-form market efficiency suggests that all public and private information is included in market prices. A person who solicits private information believes that it is possible to profit by making trading decisions based on private information and does not believe that the markets are efficient in the strong form. Weak-form efficiency suggests that all historical price and volume information is included in stock prices but that gains may be made by analyzing other publicly available information. An investor studying annual reports and analysts' reports to make stock selections indicates that the person is conducting fundamental analysis, because the investor believes that the markets are weak-form efficient.

Assume that the economic forecast for the coming year is expected to be one of increasing inflation and interest rates. The GDP is expected to be strong. Which of the following types of investments would be advisable for the coming year and why? I. Liquid investments, such as money market funds and short-term securities, to allow the investor flexibility to reinvest as rates increase II. Long-term debt, such as 20-year government bonds, to lock in current interest rates III. Stock in public utilities and durable goods firms, becausethey benefit from a rising interest rate environment IV. Tangible assets, such as gold, to keep pace with the rate of inflation A) I, III, and IV B) II and IV C) I, II, and III D) I and IV

B) II and IV Long-term bonds decrease in value in a rising interest rate environment. Stock in public utilities and durable goods firms does not benefit from a rising interest rate environment.

Which of the following is a written document that sets forth a client's objectives, sets limitations on the portfolio manager, provides guidance to the portfolio manager, and provides a means for evaluating performance? A) Risk-profile questionnaire B) Investment policy statement C) Financial planning disclosure D) New account form

B) Investment policy statement The investment policy statement sets forth a client's objectives, sets limitations on the portfolio manager, provides guidance to the portfolio manager, and provides a means for evaluating performance.

Your client is concerned that the stock market is overvalued and may experience a large market correction within the next year. The client is 45 years old, has significant retirement savings, little debt, and no dependents. The current retirement portfolio mix is 80% stock/20% fixed-income. What is the best course of action for your client to take regarding this concern? A) Liquidate the retirement portfolio and reposition the proceeds into cash. B) Maintain a long-term perspective and consider keeping the current portfolio allocation. C) Reposition all stock investments into fixed-income investments. D) Reallocate the retirement plan proceeds into a conservative target asset allocation portfolio focused on U.S. Treasuries.

B) Maintain a long-term perspective and consider keeping the current portfolio allocation. When confronted with financial or economic crisis events, the best course of action is for clients to keep a long-term perspective and focus on long time horizons rather than reacting negatively to market events.

Which statement regarding the concepts of modern portfolio theory (MPT) is NOT correct? A) For any given level of risk, investors prefer higher returns to lower returns. B) Markowitz used risk (as measured by beta) and expected return as the basis for determining appropriate assets or portfolios. C) Indifference curves represent the risk-reward trade-off that investors are willing to make. D) An infinite number of portfolios exist on the efficient frontier.

B) Markowitz used risk (as measured by beta) and expected return as the basis for determining appropriate assets or portfolios. The answer is Markowitz used risk (as measured by beta) and expected return as the basis for determining appropriate assets or portfolios. Harry Markowitz's theory uses standard deviation as a measure of portfolio risk.

A client has a portfolio of blue-chip stocks that were purchased many years ago by her spouse. The spouse is now deceased and the client is considering her needs for income and feels the dividend yield on the stocks is not sufficient. You have decided she should be in 60% fixed-income. Which of the following sets of factors related to the recommended changes in the portfolio is the most important for the portfolio advisor to review? A) Client goals, cash flows, and legal constraints B) Tax issues, risk tolerance level, and client goals C) Risk tolerance level, liquidity, and social investing D) Tax issues, liquidity, and legal constraints

B) Tax issues, risk tolerance level, and client goals Investments purchased years ago will probably have a low tax basis, which could affect decisions to sell them, or they may have become worthless, in which case they can be used as a tax deduction. Likewise, the risk level of the investment is probably unknown and may not be compatible with the client's risk tolerance level and goals.

According to the arbitrage pricing theory (APT), the return on a stock represents which of the following? A) The APT equals the market return if the expected rate of inflation is realized. B) The APT depends on the stock's responsiveness to unexpected changes. C) The APT is reduced through the construction of diversified portfolios. D) The APT is not related to the expected return on the stock.

B) The APT depends on the stock's responsiveness to unexpected changes. The APT is related to the expected return on the stock. The APT is not reduced by the construction of diversified portfolios. The APT does not take into consideration the market return if the expected rate of inflation is realized.

Which statement concerning an active portfolio management strategy is CORRECT? A) An actively managed portfolio has lower risk than a passive benchmark portfolio in most cases. B) The goal of active portfolio management is to earn a return that exceeds the risk-adjusted return of a passive benchmark portfolio. C) The key to success for an actively managed portfolio is to minimize trading activity. D) An actively managed portfolio has low total transaction costs.

B) The goal of active portfolio management is to earn a return that exceeds the risk-adjusted return of a passive benchmark portfolio. The answer is the goal of active portfolio management is to earn a return that exceeds the risk-adjusted return of a passive benchmark portfolio. This is net of transaction costs. Such a strategy also involves higher transaction costs and, usually, risk.

Which statement regarding portfolio theory is NOT correct? A) The optimal portfolio offers the highest return for a given level of risk. B) The optimal portfolio will always lie above the efficient frontier. C) The optimal portfolio has the lowest risk for a given level of return. D) The optimal portfolio for an investor depends upon the investor's ability to assume risk.

B) The optimal portfolio will always lie above the efficient frontier. The optimal portfolio is found at the point of tangency of the investor's indifference curve and the efficient frontier.

An active portfolio strategy is based on which of the following premises? A) The portfolio manager's access to corporate management B) The stock market is inefficient C) The investor's ability to obtain public information D) The stock market is efficient

B) The stock market is inefficient If the market is efficient, then a buy-and-hold strategy would be best. Only if the market is inefficient is it worth the costs involved in active management to attempt to generate superior returns.

In analyzing the position of a portfolio in terms of risk/return on the capital market line (CML), superior performance exists if the fund's position is ________ the CML, inferior performance exists if the fund's position is ________ the CML, and equilibrium position exists if it is ________ the CML. A) above; on; below B) above; below; on C) below; above; on D) below; on; above

B) above; below; on According to modern portfolio theory, the CML defines performance of a portfolio. All portfolios should plot on the CML in proportion to the risk of the portfolio. The Y axis is return and the X axis is the risk level. If a fund has superior performance, its return will be above the return level for the given risk level; if inferior, its return will be below the return level for the given risk level; and if it is in equilibrium, then it will plot exactly on the CML.

One implication of the efficient market hypothesis is that A) technical analysis, when combined with fundamental analysis, can lead to higher investment returns. B) although security markets are efficient, they are not necessarily equally efficient. C) nonfinancial markets are efficient. D) using public information can provide superior investment results.

B) although security markets are efficient, they are not necessarily equally efficient. Markets are efficient when many analysts follow a company, when information about a company is rapidly disseminated, and when no individual investor or analyst has information not readily available to any other investor or analyst. Some markets (e.g., foreign markets) may be less efficient, as may the markets for companies where few analysts follow a company, such as a small company that has few shares available for purchase by large institutional investors.

If information is generated randomly and information announcements are independent, A) price changes will be independent of each other and tend to move in a predictable fashion. B) prices will change very quickly in response to the new random information. C) price changes will be influenced by the information about past prices and volume. D) prices will not reflect all fully available information.

B) prices will change very quickly in response to the new random information If information is generated randomly and information announcements are independent, prices will tend to fully reflect all available information. In addition, price changes will be independent of one another and tend to occur random patterns.

Henry is constructing an asset allocation portfolio for his financial planning client, Gretchen, based on information obtained from completing a risk-profile questionnaire. Which of the following are considerations for Henry to keep in mind when developing portfolio alternatives for Gretchen? A) Construct portfolios that match Gretchen's risk tolerance. B) Choose the appropriate benchmark(s) for investment performance comparison. C) All of these are considerations. D) Develop portfolios that take her tax situation into consideration.

C) All of these are considerations. A financial planner should be aware of all of these considerations when constructing and monitoring an investment portfolio for a client.

Which of the following factors is NOT necessary for calculating the measure of risk that is used in Markowitz's efficient frontier? A) Correlation between each asset class and every other asset class B) The percentage of the portfolio invested in each asset class C) Beta for each asset class D) Standard deviation for each asset

C) Beta for each asset class The efficient frontier consists of efficient portfolios. An efficient portfolio has the highest return for a given level of risk. The risk measure is standard deviation; specifically, the standard deviation of a multi-asset portfolio. The other choices represent inputs needed to determine the standard deviation of a multi-asset portfolio. Beta is not used in the calculation.

In order to do an effective job of investment counseling, which of the following should be analyzed and reviewed? I. Financial goals II. Client tax situation III. Client financial statements IV. Client preferences, investment understanding, and experience A) I, II, and III B) I only C) I, II, III, and IV D) I and III

C) I, II, III, and IV All of these are parts of a comprehensive client analysis. In addition, the planner should discuss the risk tolerance and risk exposure of the client and the liquidity needs and the investment time horizon of the client.

In order to do an effective job of investment counseling, the investment adviser should examine and review the client's I. financial goals. II. risk tolerance and risk exposure. III. tax situation. IV. liquidity and marketability needs. A) I and II B) III and IV C) I, II, III, and IV D) I, II, and IV

C) I, II, III, and IV In order to do an effective job of investment counseling, the adviser should examine and review the client's financial goals, risk tolerance and risk exposure, tax situation, liquidity and marketability needs, and financial statements.

Indifference curves, which represent the risk-reward trade-off that the investor is willing to make, will I. cross the efficient frontier in two locations. II. lie tangent to the efficient frontier. III. will not intersect the efficient frontier. A) II and III B) I and II C) I, II, and III D) I only

C) I, II, and III The portfolio that lies at the point of tangency of an indifference curve and the efficient frontier is the optimal portfolio for the investor.

The random walk hypothesis is supported when I. future price changes are not correlated with past price changes. II. stock price changes are random but predictable. III. stock prices respond rapidly to new information. IV. past information is not useful in predicting future price changes. A) III only B) II, III, and IV C) I, III, and IV D) I, II, and IV

C) I, III, and IV The random walk hypothesis assumes that stock price changes are essentially random, and therefore unpredictable; or that successive stock returns are independent of past returns. Stock prices react quickly to new information. Past information is not relevant when predicting future price changes, hence, future price changes are not correlated with past price changes.

Which of the following steps are involved in the investment planning process? I. Establishment of a brokerage account II. Selection of assets for investment III. Implementation of investment plan IV. Determination of ability to invest A) I, II, and III B) I, III, and IV C) II, III, and IV D) I, II, and IV

C) II, III, and IV Establishing a brokerage account is not a necessary step in the investment process; however, it may be included in the implementation phase.

Which of the following statements regarding the capital market line (CML) is CORRECT? A) Uses beta as a risk measure B) Is not useful for diversified portfolios C) Provides a direct relationship between the risk and return for a well-diversified portfolio D) Describes the required return of individual stocks

C) Provides a direct relationship between the risk and return for a well-diversified portfolio The capital market line (CML) graphically depicts the relationship of risk and return for efficient well-diversified portfolios. The CML uses standard deviation as a risk measure.

While managing his portfolio, James's investment adviser attempts to take advantage of perceived market inefficiencies. His investment adviser is not concerned with James's long-term goals; rather, the interest lies in continuously changing the investment mix to take advantage of overall investor sentiment. Based on this information, choose the type of portfolio management style that the investment adviser is using to manage James's money. A) Strategic asset allocation B) Buy and hold C) Tactical asset allocation D) Portfolio ratio analysis

C) Tactical asset allocation Tactical asset allocation continuously adjusts the asset allocation in an attempt to take advantage of changing market conditions.

Richard has become very interested in the stock market and enjoys spending his spare time researching companies in the medical field. He believes studying and analyzing the industry, combined with his advanced exposure to trends and new innovations in medicine, will give him an advantage in achieving superior performance in medical stock investment opportunities. Choose the form of the efficient market hypothesis (EMH), if any, that Richard is considered subscribing to. A) Semistrong form B) None of these C) Weak form D) Strong form

C) Weak form Richard is subscribing to the weak form of the EMH because he believes fundamental analysis and insider information will yield superior performance.

A firm declares a $3.00 cash dividend to its shareholders. The firm has issued dividends of only $0.07 per share for each of the last 15 quarters, and market analysts anticipate a similar dividend this quarter. In an efficient market, one would expect A) a price increase before the announcement. B) no price change before or after the announcement. C) a price change upon the announcement. D) a price decrease after the announcement.

C) a price change upon the announcement. In an efficient market, the price of the stock will represent all public information. Because the increase in the dividend was not public knowledge until it was declared, no price change would take place before the announcement. A price change, representing the increase in dividends, would be expected immediately after the information became public.

The security market line (SML) A) indicates the market portfolio as the only optimal portfolio. B) plots diversifiable risk on the horizontal (X) axis. C) shows a security's expected return as a function of its systematic risk. D) presents the relationship between a security's return and the return of the market portfolio.

C) shows a security's expected return as a function of its systematic risk. The security market line (SML) shows the relationship between the rate of return and systematic risk (beta). Thus, the SML depicts a security's expected return as a function of its systematic risk. The intersection between the efficient frontier and a line from the risk-free rate depicts all the optimal portfolios composed of a combination of the market portfolio and the risk-free asset. The market portfolio is the only optimal portfolio comprised solely of risky securities.

After suffering an unexpected job loss and losing a $125,000 annual salary, your client, Joe, comes to you to review his asset allocation. In addition to possibly having a prolonged unemployment period, Joe, age 62, would like to retire within eight years. He is concerned about the allocation of the Section 401(k) plan at his prior employer which is 100% invested in an S&P 500 Index fund. The balance of the account is $2,500,000. Based on this information, what should you do next? A) Tell Joe to focus on finding a job and not be concerned with his asset allocation. B) Recommend Joe apply for early Social Security benefits to provide him with income during his job search. C) Have Joe complete any necessary paperwork to transfer his 401(k) plan assets to an IRA. D) Discuss Joe's risk tolerance and make appropriate changes to his plan's asset allocation.

D) Discuss Joe's risk tolerance and make appropriate changes to his plan's asset allocation. With retirement looming on the horizon, Joe should consider reducing the risk exposure in his retirement plan. Moving the 401(k) to an IRA could be a consideration, but this should not be an immediate planning recommendation. Recommending he take early Social Security benefits may not be prudent due to tax issues and locking in a lower monthly benefit for life.

The strong form of the efficient market hypothesis suggests which of the following? I. Inside information will not lead to superior investment results. II. Inside information will lead to superior investment results. III. Studying financial statements will not lead to superior investment results. IV. Studying financial statements will lead to superior investment results. A) I and IV B) II and III C) II and IV D) I and III

D) I and III The strong form says that all information, both public and private, is already reflected in the stock price, so nothing will produce superior results.

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

D) 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.

Which of the following correctly describes the efficient frontier in portfolio theory? A) It identifies the optimal portfolio for the investor. B) It illustrates the optimal tradeoff between long- and short-term capital gains. C) It quantifies systematic and unsystematic risk. D) It indicates the highest returns for given levels of risk

D) It indicates the highest returns for given levels of risk The optimal portfolio is the point on the efficient frontier that intersects with the investor's indifference curve.

When working with anxious clients who are concerned about widely fluctuating stock market prices, what is the most important service you can provide to them? A) Discussing their risk tolerance B) Referring them to a financial counselor C) Guaranteeing them a profit on their investments D) Managing their expectations

D) Managing their expectations Unrealistic expectations can be a function of a client's ignorance about financial markets and securities. By using your knowledge, you can educate clients about markets and securities so that expectations are realistic. Doing so also strengthens the client/planner relationship and allows you to demonstrate your expertise.

Which of the following is NOT considered a constraint when developing an investment policy statement? A) Time horizon B) Taxes C) Liquidity needs D) Market conditions

D) Market conditions An investment policy statement is a written document that sets forth a client's objectives and establishes certain limitations on the investment manager. The following are constraints of the investment policy statement: time horizon, liquidity needs, taxes, laws and regulations, and unique circumstances/preferences. Market conditions are not a constraint when developing an investment policy statement.

All of the following should be found in an investment policy statement (IPS) except A) the client's risk tolerance. B) the client's liquidity needs. C) the client's time frame. D) the actual investments.

D) the actual investments. Risk tolerance, time frame, and liquidity needs should all be found in the IPS; investments are not found in the IPS. The IPS is a roadmap and provides guidance for the adviser and client as to the type of investments that will be used (such as 15%-20% in large-cap U.S. stocks), but the actual investments are not specified in the IPS.

Which of the following would cause the risk premium an investor expects to earn on a stock to increase when using the capital asset pricing model (CAPM)? A) An increase in beta B) A decrease in covariance C) An increase in standard deviation D) An increase in the correlation coefficient

A) An increase in beta All other factors remaining equal, an increase in beta will cause the risk premium to increase. In addition, the resultant expected rate of return will increase.