Unit 22
An analyst has prepared a lengthy research report on KLUM Corporation and concluded that the stock has a 50% chance of returning 4%, a 20% chance of returning 2%, and a 30% chance of returning -10%. Based on this information, you could calculate the probable return of this stock as A) -0.6% B) +5.4% C) +0.6% D) +3.0%
A) -0.6% We simply multiply the individual returns by the likely percentage and then add them together. 50% of 4% equals +2%. 20% of 2% equals +0.4%. 30% of minus 10% equals -3%. The sum is 2% + 0.4% = 2.4%, minus 3% equals an expected return of -0.6%. Yes, it is possible that you will have a question with a probable return that is negative.
What is the total return on a 1-year, newly issued (365 days to maturity) zero-coupon bond priced at 950? A) 5.26% B) 5.26% plus the implied coupon rate C) 5.00% D) The return cannot be determined without knowing current interest rates
A) 5.26% To determine the total return on this zero-coupon bond, the $50 capital appreciation is divided by the cost of the bond (in this case, $50 divided by $950 equals a total return of 5.26%). Total return of a zero-coupon bond is made up entirely of the difference between the cost of the bond and the sale or maturity price of the bond.
Your firm's market analyst believes the current bullish market in equities will continue. Your moderately conservative clients should consider investing in an ETF or index fund tracking the A) S&P 500. B) Russell 2000. C) Dow Jones 15 utilities. D) MSCI EAFE.
A) S&P 500. The S&P 500 represents the largest companies and, as a result, is most suitable for a growth-oriented investor with a moderate risk tolerance. The Russell 2000 is the small-cap benchmark and carries more than a moderate level of risk as does the MSCI EAFE index which is composed of foreign securities. Utilities are for those who are more than moderately conservative. Furthermore, utilities, being defensive issues, are likely to participate in a bullish market to a very small degree.
If you knew a given stock had a 40% chance of earning a 10% return, a 40% chance of earning 20%, and a 20% chance of earning −10%, the stock would have A) a probable rate of return of 10% B) an annualized return of 10% C) a total return of 10% D) a real rate of return of 10%
A) a probable rate of return of 10% The probable return is computed by taking the probability of each possible return outcome and multiplying it by the return outcome itself. In this example, if you knew a given stock had a 40% chance of earning a 10% return, a 40% chance of earning 20%, and a 20% chance of earning -10%, the expected return would be equal to 10%: = (0.4 × 0.1) + (0.4 × 0.2) + (0.2 × −0.1) = 0.04 + 0.08 = 0.12 − 0.02 = 0.10 = 10% You probably will not have to do this calculation on the exam, but you should know the concept.
The total return of a mutual fund is equal to A) the return attained by reinvestment of all dividend and capital gains distributions plus unrealized gains or minus unrealized losses B) annualized fund dividends divided by the current POP C) the reinvestment of all unrealized dividend and capital gain income D) all realized and unrealized capital appreciation
A) the return attained by reinvestment of all dividend and capital gains distributions plus unrealized gains or minus unrealized losses As with all securities, total return includes unrealized gains or losses. In the case of mutual funds, the total return also assumes reinvestment of all dividend and capital gains distributions.
An investor purchases a TIPS bond with a 4% coupon. If, during the first year, the inflation rate is 9%, the approximate principal value of the security at the end of that year will be A) $1,090. B) $1,092. C) $1,045. D) $1,040.
B) $1,092. The principal value of a TIPS bond is adjusted semiannually by the inflation rate. The exact calculation would be $1,000 × 104.5% × 104.5%, which equals $1,092.025. Each six months, the interest is paid on that adjusted principal, and that is why the security keeps pace with inflation. Obviously, the answer must be something a bit higher than $1,090 because of the semiannual compounding.
A portfolio manager whose universe of stocks is those with market caps of $4 - $6 billion would most likely be graded against A) Nasdaq 100. B) S&P 400. C) S&P 500. D) Dow Jones Composite Average.
B) S&P 400. Stocks with a market capitalization between $2 billion and $10 billion are considered mid-cap stocks. The S&P 400 is the index for those.
The Sharpe ratio is a measurement of a portfolio's A) after-tax rate of return B) risk-adjusted return C) inflation-adjusted return D) holding period return
B) risk-adjusted return The Sharpe ratio measures the risk-adjusted return. A higher Sharpe ratio indicates that, based on the risk taken, the investor's return is better than expected.
An investor invests a total of $30,000 and creates a portfolio of 3 different stocks placing 1/3 of his investment into each security. From his holding in Company A, he receives a dividend of $600; from Company B, a dividend of $500; and from Company C, no dividend. One year later, the market price of the Company A stock has increased by 20%, Company B's stock increased by 10%; and Company C's stock has remained the same. What is the investor's total return on this portfolio? A) 3.67% B) 10% C) 13.67% D) 4.56%
C) 13.67% Total return includes both appreciation (growth) and income (dividends). Let's go step by step. Company A's $10,000 original investment increases by 20%, or $2,000 plus dividends of $600. Company B's $10,000 original investment increases by 10%, or $1,000 plus dividends of $500. Company C's $10,000 original investment is unchanged and there is no dividend. Therefore, we have appreciation of $3,000 plus dividend income of $1,100. That is a total return of $4,100 on an investment of $30,000, or 13.67%.
Which of the following indices or averages is based on the prices of only 65 stocks (30 industrial, 20 transportation, and 15 utility)? A) Wilshire 5,000 B) S&P Composite C) Dow Jones Composite Average D) Value Line
C) Dow Jones Composite Average The most widely quoted and oldest measures of changes in stock prices are the Dow Jones averages. They are also the smallest in terms of the number of stocks included in the averages with only 65 stocks. It is the only price-weighted index on the exam; all of the others are cap-weighted.
An investor is reviewing his portfolio. To compute the real rate of return on an investment, it would be necessary to know all of the following except A) the rate of inflation B) the gain (or loss) recognized on the asset C) the tax bracket of the investor D) the income received from holding the asset
C) the tax bracket of the investor An investor's real rate of return is computed by dividing the total return received by the cost and then subtracting the inflation rate. If there is no realized gain, it is simply the nominal return based on the income minus the inflation rate. The investor's tax bracket is needed to compute after-tax returns.
An investor buys 100 shares of KAPCO stock for $120 per share. During the year, he receives $260 in dividends and, at the end of the year, the stock is worth $13,000. The investor's holding period return is A) 8.33%. B) 9.69%. C) 2.17%. D) 10.50%.
D) 10.50%. Explanation Holding period return is computed by dividing the total return from income (dividends or interest) plus appreciation (or minus depreciation), by the original cost. In this example, the investor received $260 in income and has $1,000 of appreciation. That is a total return of $1,260 divided by $12,000 or 10.50%.
Using the following information, compute the inflation-adjusted rate of return for an investor holding the ABC Corporation's 20-year bond: Coupon rate 5%, paid semi-annually Rating Aa Maturity date December 1, 2046 CPI 2% Par value $1,000 Purchase price 90 Call date December 1, 2033 Call price 101 A) 4.50% B) 2.50% C) 5.56% D) 3.56%
D) 3.56% Explanation The inflation-adjusted rate of return is the actual return (income received divided by the purchase price) less the inflation rate as measured by the CPI. In this example, the bond pays $50 per year on an investment of $900. That is an actual return of 5.56%. Subtracting the CPI of 2% gives us an inflation-adjusted, or real, rate of return of 3.56%.
Which of the following is a method for determining the internal rate of return to an investor based on cash flow in and out of the portfolio? A) Time-weighted return B) Discounted cash flow C) Dollar cost averaging D) Dollar-weighted return
D) Dollar-weighted return Explanation The dollar-weighted return measures the internal rate of return (IRR) of a portfolio's actual performance between 2 dates, including all cash inflow and outflows. Because of this, the IRR of a portfolio can be significantly affected by both the timing and the size of any contribution or distribution. Luck in the timing of the investor's inflows or outflows can drastically swing numbers one way or the other.
Your client is considering the purchase of a small-cap fund. Which of the following benchmarks would be most appropriate for comparing the fund's performance? A) DJIA B) Wilshire 5,000 C) S&P 500 D) Russell 2,000
D) Russell 2,000 Explanation The Russell 2,000 is a value-weighted index of stock price performance of 2,000 small capitalization corporations.
Probable return is A) the one discount rate that equates the future value of an investment with its net present value B) the difference between an investment's present value and its cost C) the current worth of future income discounted to reflect what that income is worth today D) an estimate of all of the possible returns an investment is expected to yield
D) an estimate of all of the possible returns an investment is expected to yield Explanation The probable return is computed by taking the various likely returns for an investment and adding them together. The difference between an investment's present value and its cost is the NPV. The current worth of future income discounted to today is used to determine present value. The one discount rate that equates the future value of an investment with its NPV is the internal rate of return (IRR).
An investment advisory firm tracks its performance against the S&P 400. From this, you could determine that this firm concentrates on A) Nasdaq securities. B) small-cap securities. C) large-cap securities. D) mid-cap securities.
D) mid-cap securities. Explanation The S&P 400 is known as the mid-cap index.
One measure of an investor's total return is called holding period return. The computation includes both income and appreciation and is used for both debt and equity securities. An investor's holding period return would exceed the bond's yield to maturity if A) the investor purchased a put option on the bond. B) the bond was called at a premium. C) the bond was redeemed at a discount. D) the coupons were reinvested at a rate exceeding the yield to maturity.
D) the coupons were reinvested at a rate exceeding the yield to maturity. Explanation The calculation of yield to maturity assumes reinvestment of the bond's interest at the coupon rate. Therefore, if the investor were able to do better than that, the holding period return would be increased. This is part of the concept of internal rate of return (IRR) which takes into consideration the time value of money (compounding). It is tempting to answer a call at a premium and that might, in fact, increase the total return, but we have no idea when the call takes place, at what price and the original purchase price of the bond. Just keep it simple—if the question says you can earn more than the YTM, your return will be higher than the quoted YTM.
