Quiz #3
Market risk is the same as: A. systematic risk B. non-systematic risk C. credit risk D. selection risk
The best answer is A. Market risk is the same as systematic risk. This risk cannot be diversified away.
A technical analyst would consider which of the following? A. Price / earnings ratios B. Efficient market Theory C. Consumer Confidence Index D. Advance / Decline Theory
The best answer is D. The Advance / Decline Theory measures the relative strength of the market by comparing the number of issues advanced to the number of issues declined and is a technical indicator. The Price / Earnings ratio measures how many times the market price of a stock is relative to its earnings. This is a fundamental factor. The "Efficient Market" Theory holds that prices of securities in the market fully reflect all publicly available information, so that undervalued or overvalued securities should not exist. Thus, securities selection based on any type of analytical method is irrelevant. The Confidence Index is not a technical indicator - rather it is a fundamental indicator of consumer sentiment.
What formula finds the "expected return" of an investment? A. CAPM B. Duration C. Sharpe Ratio D. Standard Deviation
The best answer is A. CAPM (Capital Asset Pricing Model) attempts to find the Expected Return of an Investment by breaking the return down into 2 components. These are the Risk-Free Rate of Return and the Risk Premium. The Risk Premium increases with the risk of that investment. The risk premium is the "beta" of the investment times the excess of the market rate of return over the risk-free rate of return. The higher the "risk" as measured by "beta," the higher the expected return of that investment. Duration measures bond price volatility as market interest rates move. The Sharpe Ratio measures the incremental investment return that is achieved for assuming incremental risk. Standard deviation measures risk by assessing the variability of investment returns.
In 2015, a customer buys 5 GE 10% debentures, M '25, at 85. The interest payment dates are Feb 1st and Aug 1st. The bonds are callable as of 2017 at 103. If the bonds are called prior to maturity, which statement is TRUE? A. The yield to call will be higher than the yield to maturity B. The yield to call will be lower than the yield to maturity C. The yield to call will be the same as the yield to maturity D. The yield to call will depend on the current market price of the bond at the time of the call
The best answer is A. If the bonds are called prior to maturity, the yield to call will be higher than the yield to maturity since the discount will be earned faster and the bondholder will receive the call premium. Assume that the bonds are called in 2017. Yield to call uses the same formula as YTM computed to the call date. The Yield to Call will be: $100 + $90 ($150 disc + $30 prem/2 yrs to call) ------------------------------------------------------------------- = ($850 + $1030) / 2 $190 -------- = 20.21% $940 For the exam, you must know that yield to call will be higher than yield to maturity if the bond is trading at a discount; and yield to call will be lower than yield to maturity if the bond is trading at a premium.
An investor buys land in rural North Dakota. He would be MOST concerned with which risk? A. Liquidity risk B. Regulatory risk C. Inflation risk D. Business risk
The best answer is A. Land is an illiquid investment. It can be very hard to sell. If the investor wants to get out, it may not be possible. Also note that regulatory risk is another good choice, but not as good as liquidity risk. The investor might want to develop the land for profit, but this means getting zoning approvals, environmental impact approvals, etc. All of these require compliance with local regulations and the anticipated project might not be approved by the town or might become uneconomic due to zoning restrictions. Land is a tangible asset that typically holds its value in inflationary times. Business risk is the risk a negative business event or business failure and has no relevance here.
The Net Present Value of an investment is greater than "0." This means that the: A. rate of return from the investment is greater than the discount rate used in the computation B. rate of return from the investment is lower than the discount rate used in the computation C. investment will produce a return that is greater than the rate of inflation D. investment will produce a return that is lower than the rate of inflation
The best answer is A. Net Present Value takes all the cash flows that will be generated by an investment and discounts them back to their "present value." The rate of interest used to discount the cash flows to be received is the current market rate of interest. - If the computation results in an NPV of "0," then the rate of return of the investment equals the discount rate used. - If the computation results in an NPV of more than "0," then the rate of return of the investment exceeds the discount rate used. - If the computation results in an NPV of less than "0," then the rate of return of the investment is lower than the discount rate used. The computation has nothing to do with the inflation rate.
A customer buys a 2-year maturity, 10% coupon bond at par. If market interest rates rise to 12%, then the bond's price will fall by approximately: A. 1.7% B. 3.4% C. 8.8% D. 9.7%
The best answer is B. The customer bought this 2-year bond at par with a coupon rate of 10%. If market interest rates rise to 12%, then the present value of the bond's cash flows will fall as follows (rounded): Year 1: $100 / 1.12 = $89.29 Year 2: $1100 / (1.12)2 = $876.91 Total Net Present Value = $89.29 + $876.91 = $966.20 The bond will fall in price by $33.80 from $1,000 par, for a fall of 3.4%.
The formula for the risk adjusted rate of return is: A. (Rate of return - Rate of inflation) / Amount invested B. (Rate of return - Risk free rate of return) / Amount invested C. (Rate of inflation - Rate of return) / Amount invested D. (Risk free rate of return - Rate of return) / Amount invested
The best answer is B. The risk adjusted rate of return is the excess return that is earned from an investment, over and above, the risk free rate of return. If the risk free rate of return on Treasury bills is 4%; and the investment is yielding 10%; then the risk adjusted rate of return is 10% - 4% = 6%. Thus, the risk adjusted rate of return is the: Risk Adjusted Rate of Return = Return Achieved - Risk Free Rate of Return -------------------------------------------------------------- Dollar Amount Invested
What happens to the rate of return calculation on a non-callable bond if the rate of interest stays the same and the time intervals are changed? I Shortening the time intervals will increase the rate of return II Shortening the time intervals will decrease the rate of return III Lengthening the time intervals will increase the rate of return IV Lengthening the time intervals will decrease the rate of return A. I and III B. I and IV C. II and III D. II and IV
The best answer is B. When the question is stating that the "time intervals shorten," this means that the time period between each interest payment received shortens. When the question is stating that the "time intervals lengthen," this means that the time period between each interest payment received lengthens. For example, assume that a 10% bond will pay interest semi-annually, instead of annually. At the end of each 6 months, $50 of interest will be received, instead of receiving $100 every 12 months. Because the first $50 interest payment received can immediately be reinvested over the next 6 months until the second $50 payment is received, this will produce a higher rate of return than receiving the $100 payment at the end of the year. Thus, the actual rate of return will increase if time intervals shorten, because the interest is actually being received more quickly, and can be reinvested faster, increasing the rate of return. Conversely, if the time intervals lengthen, because the actual interest payments are being received more slowly and are reinvested more slowly, the rate of return declines.
An "inverted saucer" formation is a(n): A. uptrend B. downtrend C. reverse upward trend D. reverse downward trend
The best answer is C. An inverted saucer is bearish since the market has topped out and is trending down. It is an uptrend that has reversed itself.
All of the following risks are essentially equivalent for long term corporate bonds EXCEPT: A. Interest rate risk B. Market risk C. Default risk D. Inflation risk
The best answer is C. Interest rate risk is the risk that market interest rates rise, forcing bond prices down. This is the same as market risk for bonds. In an inflationary environment, market interest rates rise, so bond prices are forced down. Thus, these 3 risks are very similar for bonds. Default risk is specific to each corporate bond issuer, so it is the exception in this question.
The formula for Net Working Capital is: A. (Total Assets - Inventory) / Total Liabilities B. Total Assets - Total Liabilities C. (Current Assets - Inventory) / Current Liabilities D. Current Assets - Current Liabilities
The best answer is D. Current Assets - Current Liabilities = Net Working Capital
Federal Reserve actions can directly influence which of the following? I Discount Rate II Federal Funds Rate III Money Multiplier IV Money Velocity A. I and II only B. III and IV only C. I, II, III D. I, II, III, IV
The best answer is D. Federal Reserve actions can directly influence the discount rate, which can be raised or lowered by the Federal Reserve. The discount rate is that charged to member banks to borrow reserves from the Fed. The Federal Reserve directly influences the Federal Funds rate by its daily open market operations. To raise the Federal Funds rate (overnight loan rate for reserves bank to bank), the Fed will engage in reverse repos (matched sales) with bank dealers. To lower the Federal Funds rate, the Fed will engage in repurchase agreements with bank dealers. The Fed can directly influence the money multiplier by changing reserve requirements of member banks. The larger the percentage reserve requirement, the lower the money multiplier (since banks must keep a larger portion of deposits on reserve, and so, can loan out less). The Federal Reserve can also directly influence the velocity of money. This is the speed with which deposits clear from bank to bank. The Fed imposes maximum clearance times among member banks, and can tighten or loosen these. (The "faster" the velocity, the greater the aggregate funds available at any moment in time.)
