Test Bank For Investments Analysis and Management, 15th Edition by Charles P. Jones, Gerald R. Jense

File: ch01: Understanding Investments

Multiple Choice 1.

Which of the following is the best definition of wealth?

a. b. c. d.

The sum of all current and future income The total of all assets and all income The total of assets and income less any liabilities The sum of current income and the present value of future income

Ans: d Difficulty: Moderate Ref: Establishing a Framework for Investors 2.

Gold coins would be classified as:

a. b. c. d.

real assets. indirect assets. personal assets. financial assets.

Ans: a Difficulty: Easy Ref: Establishing a Framework for Investors 3.

Technically, investments include:

a. b. c. d.

only financial assets. only marketable assets. financial and real assets that are marketable or non-marketable. only financial and real assets that are marketable.

Ans: c Difficulty: Easy Ref: Establishing a Framework for Investors 4.

The retirement plans that guarantee retirees a set amount of money each month are known as: a. b. c. d.

401(k) plans. self-directed plans. defined-benefit plans. defined-contribution plans.

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Ans: c Difficulty: Moderate Ref: Establishing a Framework for Investors 5.

The investment professionals that arrange the sale of new securities are called:

a. b. c. d.

arbitragers. traders. investment bankers. specialists.

Ans: c Difficulty: Moderate Ref: The Importance of Studying Investments 6.

Another name for stockbrokers is:

a. b. c. d.

specialists. financial advisors. security analysts. portfolio managers.

Ans: b Difficulty: Moderate Ref: The Importance of Studying Investments 7.

Investment professionals who take companies public, arrange mergers and acquisitions, and participate in municipal bond issues are: a. b. c. d.

registered representatives. security analysts. investment bankers. portfolio managers.

Ans: c Difficulty: Moderate Ref: The Importance of Studying Investments 8.

One reason for the declining importance of pension funds is the:

a. b. c. d.

decrease in pension benefits for workers. downsizing of U.S. companies. large number of conversions into self-directed plans. increasing number of federal regulations that restrict pension fund portfolios.

Ans: c Difficulty: Difficult Ref: The Importance of Studying Investments Chapter One Understanding Investments

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9.

Most financial advisors are registered with the Securities and Exchange Commission as:

a. b. c. d.

registered representatives. registered investment advisors. registered financial planners. registered securities consultants.

Ans: b Difficulty: Moderate Ref: The Importance of Studying Investments 10.

A Chartered Financial Analyst designation is a(n)

a. b. c.

SEC-approved and awarded designation. certification of a successful investing record. professional designation awarded for meeting recognized standards of conduct and competency. professional designation awarded by the brokerage industry.

d.

Ans: c Difficulty: Easy Ref: The Importance of Studying Investments 11.

Underlying all investments is the tradeoff between:

a. b. c. d.

expected return and actual return. low risk and high risk. actual return and high risk. expected return and risk.

Ans: d Difficulty: Moderate Ref: Understanding the Investment Decision Process 12.

Which of the following investment areas relies heavily on mathematical and statistical models?

a. b. c. d.

Security analysis Portfolio management Institutional investing Retirement planning

Ans: b Difficulty: Moderate Ref: Understanding the Investment Decision Process Chapter One Understanding Investments

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13.

Most investors are risk averse, which means:

a.

they will assume more risk only if they are compensated by higher expected return. they will always invest in the investment with the lowest possible risk. they actively seek to minimize their risks. they avoid the stock market due to the high degree of risk.

b. c. d.

Ans: a Difficulty: Moderate Ref: Understanding the Investment Decision Process 14.

Which of the following would be considered a risk-free investment?

a. b. c. d.

Gold Equity in a house High-grade corporate bonds U.S. Treasury bills

Ans: d Difficulty: Easy Ref: Understanding the Investment Decision Process 15.

Security analysis is most concerned with:

a. b. c. d.

analysis of the overall securities market and its direction. valuation and analysis of individual securities. purchasing securities at the best price. determination of the investor’s required return.

Ans: b Difficulty: Moderate Ref: Understanding the Investment Decision Process 16.

In general, the ex ante risk-return tradeoff:

a. b. c. d.

slopes upward. slopes downward. is flat. is impossible to determine.

Ans: a Difficulty: Moderate Ref: Understanding the Investment Decision Process

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17.

International investing:

a. b. c. d.

is only practical for institutional investors. increases the overall risk of a stock portfolio. always leads to higher returns than a domestic portfolio. can reduce risk due to increased diversification.

Ans: d Difficulty: Moderate Ref: Understanding the Investment Decision Process 18.

Investment decision making traditionally consists of two steps:

a. b. c. d.

investment banking and security analysis. buying and selling. risk and expected return. security analysis and portfolio management.

Ans: d Difficulty: Difficult Ref: Understanding the Investment Decision Process 19.

Which of the following statements concerning global stock market capitalization is true? a. b. c. d.

The United States accounts for roughly 65 percent of stock market capitalization worldwide.

The United States accounts for roughly 40 percent of stock market capitalization worldwide.

The United States accounts for roughly 25 percent of stock market capitalization.

It is expected that the United States will increase its future percentage of global stock market capitalization.

Ans: b Difficulty: Moderate Ref: Important Considerations in the Investment Decision Process for Today's Investor 20.

Regulation FD applies to disclosure between:

a. b. c. d.

private companies and public officials. public companies and investment professionals. public companies and public officials. private companies and investment professionals.

Ans: b Difficulty: Moderate Ref: Important Considerations in the Investment Decision Process for Today's Investor

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21.

Which of the following statements is true regarding multi-national corporations?

a. b. c. d.

Exxon Mobil earns the majority of its profits from its overseas operations.

Google currently derives the majority of its earnings from outside the U.S. Wal-Mart earns the majority of its profits from outside the U.S. Coca-Cola has no overseas operations and no earnings outside the U.S.

Ans: a Difficulty: Difficult Ref: Important Considerations in the Investment Decision Process for Today's Investor 22.

The rise of the Internet has:

a. b. c. d.

greatly increased the cost of security trading. significantly democratized the flow of investment information. led to fewer discount brokers. led to large amounts of security fraud.

Ans: b Difficulty: Moderate Ref: Important Considerations in the Investment Decision Process for Today's Investor 23.

Which of the following professionals would be considered an institutional investor? a. b. c. d.

Investment banker Security analyst Stockbroker Portfolio manager

Ans: d Difficulty: Difficult Ref: Important Considerations in the Investment Decision Process for Today's Investor 24.

The risk-free rate of return (RF) equals:

a. b. c. d.

0.0%. the rate on the bonds of financially sound corporations. the average of the last 3 years’ inflation rate. the return on Treasury securities.

Ans: d Difficulty: Difficult Ref: Important Considerations in the Investment Decision Process for Today's Investor

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25.

Which of the following is not a benefit of geographic diversification?

a. b.

Gaining exposure to currencies other than the U.S. dollar.

Some global markets have growth rates higher than the U.S., offering potentially higher returns.

Global markets behave completely independently of U.S. markets.

Many global markets are not highly correlated with U.S. markets.

c. d.

Ans: c Difficulty: Difficult Ref: Important Considerations in the Investment Decision Process for Today's Investor

True-False Questions 1.

A 401(k) plan is an example of a defined-benefit retirement plan.

Ans: False Difficulty: Moderate Ref: The Importance of Studying Investments 2.

Investors always seek to minimize their risk of investing.

Ans: False Difficulty: Moderate Ref: Understanding the Investment Decision Process 3.

Both 401(k) plans and IRAs are self-directed retirement plans.

Ans: True Difficulty: Easy Ref: Understanding the Investment Decision Process 4.

The two major considerations in investing are return and timing.

Ans: False Difficulty: Easy Ref: Understanding the Investment Decision Process 5.

Risk is defined as the possibility of loss.

Ans: False Difficulty: Difficult Ref: Understanding the Investment Decision Process 6.

The minimum actual return necessary to induce investors to invest is known as the expected return.

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Answer: False Difficulty: Difficult Ref: Understanding the Investment Decision Process 7.

Investors unwilling to assume risk should be satisfied with the rate of inflation as their investment return.

Answer: False Difficulty: Difficult Ref: Understanding the Investment Decision Process 8.

Security analysts are typically employed only at brokerage houses.

Answer: False Difficulty: Moderate Ref: Importance of Studying Investments 9.

Financial planners must pass a standardized test and possess certain credentials.

Ans: False Difficulty: Easy Ref: Importance of Studying Investments 10.

Many Wall Street jobs tend to be cyclical in nature.

Ans: True Difficulty: Easy Ref: Importance of Studying Investments 11.

Due to the Internet, institutional investors have gained in importance.

Ans: False Difficulty: Difficult Ref: Important Considerations in the Investment Decision Process for Today's Investor

Short-Answer Questions 1.

Briefly explain the difference between expected returns and realized returns and between ex ante returns and ex post returns.

Answer:

Difficulty:

Expected returns are mean returns based on probability distributions dealing with the future. Realized returns are the returns that actually occurred in the past. Ex ante returns are in the future. Ex post returns are in the past.

Moderate

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2.

What are some of the career opportunities in the investment industry?

Answer:

Difficulty: 3.

Define risk in the context of investments.

Answer: Difficulty: 4.

Difficulty:

They may include these items in their portfolios since risk-averse is not the same thing as risk avoidance. Risk-averse investors would expect a higher return from these assets as they are riskier than many other assets.

Moderate

Martha Stewart was banned from serving as an officer of a public corporation, sentenced to 5 months in prison, and fined $30,000. Why?

Answer: Difficulty: 6.

Risk is the chance that the actual return on an investment will differ from its expected return.

Moderate

Will risk-averse investors ever include commodity futures or options in their portfolios? Explain.

Answer:

5.

Investment banker, merger and acquisition specialist, security traders, sales people, security analyst, portfolio manager, registered investment advisor and financial planner.

Moderate

Contrary to popular belief, she was not charged with insider trading but obstruction of justice due to her efforts to hide her alleged insider trading.

Moderate

A 25-year old college graduate is participating in a 401(k) retirement plan and wishes to minimize risk by eliminating stock-based mutual funds and other equities from his investment portfolio. What will this probably do to his ending retirement funds in 40 years?

Answer:

Difficulty:

If he minimizes risk, then he will also minimize return. His retirement fund will likely be much smaller than if he chose to take more risk over the long run.

Moderate

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Critical Thinking/Essay Questions 1.

What are some of the steps involved in valuing a company’s common stock?

Answer:

Difficulty: 2.

The investor must evaluate the overall economy, industry and individual company, since all have an impact on the value of the stock. In addition, the expected return and appropriate risk must be estimated, based upon the expected future cash flows of the company. And lastly, the efficiency of stock markets must be considered and whether the current market value of the stock is greater or less than its perceived economic value.

Difficult

What are some of the reasons driving so many individual investors to manage their own investments today versus the conventional route of investing through a financial advisor or stockbroker?

Answer:

Difficulty:

The emergence of the Internet has produced a host of online, discount brokers offering ultra low-cost commissions, sometimes free trades, and real-time quotes on stocks and bonds. There is also now a preponderance of websites offering information on corporate news and SEC filings, which helps investors become more self-sufficient if they so choose.

Also, extreme levels of market volatility seen in the last two decades have eroded the wealth of many investors, including whatever portion was being professionally managed by mutual funds or through financial advisors. That begs the question of whether professional management or advice is worth the cost in the face of such tremendous wealth erosion.

Many investors have decided to go out on their own, using a discount broker.

Moderate

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Files: ch02, Chapter 2: Investment Alternatives

Multiple Choice Questions 1.

The largest single institutional owner of common stocks is:

a. b. c. d.

mutual funds. insurance companies. pension funds. commercial banks.

Ans: c Difficulty: Moderate Ref: Organizing Financial Assets 2.

Which of the following is not a characteristic of the primary nonmarketable financial asset owned by most individuals?

a. b. c. d.

High liquidity High return Often issued by the U.S. government Low risk

Ans: b Difficulty: Moderate Ref: Nonmarketable Financial Assets 3.

Savings accounts are:

a. b. c. d.

negotiable but are not liquid. marketable but are not liquid. liquid but are not personal. liquid but are not marketable.

Ans: d Difficulty: Difficult Ref: Nonmarketable Financial Assets 4.

Nonmarketable financial assets that protect against inflation include:

a. b. c. d.

nonnegotiable certificates of deposit (CDs). money market deposit accounts (MMDAs).

Series EE US government savings bonds.

US government savings bonds, I bonds.

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Ans: d Difficulty: Moderate Ref: Nonmarketable Financial Assets 5.

Treasury bills are traded in the:

a. b. c. d.

money market. capital market. government market. regulated market.

Ans: a Difficulty: Easy Ref: Money Market Securities 6. a. b. c. d.

Which of the U.S. Treasury securities is always sold at a discount?

Treasury bills Treasury notes Treasury bonds Treasury inflation protected securities (TIPS)

Ans: a Difficulty: Moderate Ref: Money Market Securities 7.

Which of the following statements regarding money market instruments is not true?

a. b. c. d.

They tend to be highly marketable.

They have maturities from 1 to 3 years.

They tend to have a low probability of default.

Their rates tend to move together.

Ans: b Difficulty: Moderate Ref: Money Market Securities 8.

Which of the following would not be considered a capital market security?

a. b. c. d.

A 20-year corporate bond A common stock A 6-month Treasury bill A mutual fund share

Ans: c Difficulty: Moderate Ref: Capital Market Securities

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9.

The coupon rate is another name for the:

a. b. c. d.

market interest rate. current yield. stated interest rate. yield to maturity.

Ans: c Difficulty: Easy Ref: Fixed-Income Securities 10.

Zero-coupon bonds are similar to Treasury bills in that both:

a. b. c. d.

are issued exclusively by the U.S. Treasury. are money-market securities. are capital-market securities. are sold at less than par.

Ans: d Difficulty: Moderate Ref: Fixed-Income Securities 11.

Each point on a corporate bond quote represents:

a. b. c. d.

$100.

1 percent of $100.

1 percent of $1000. $1000.

Ans: c Difficulty: Difficult Ref: Fixed-Income Securities 12.

Treasury STRIPS are most similar to which type of corporate security?

a. b. c. d.

Preferred stock Premium bond High-yield bond Zero-coupon bond

Ans: d Difficulty: Moderate Ref: Fixed-Income Securities

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13.

Bonds trade on an accrual interest basis. This means an investor:

a. b.

can sell a bond at any time without losing the interest that has accrued. can buy a bond at any time and gain the interest accrued from the time of the last payment. can sell a bond at any time and retain the interest portion of the bond. can buy a bond at any time and receive an immediate interest check.

c. d.

Ans: a Difficulty: Moderate Ref: Fixed-Income Securities 14.

Bonds called in are likely to be:

a. b. c. d.

bonds already in default. replaced with new bonds that have a lower interest rate. replaced with new bonds that have a higher interest rate. junk bonds.

Ans: b Difficulty: Moderate Ref: Fixed-Income Securities 15.

What will a bond be worth on the day it matures?

a. b. c. d.

$0 $100 Its face value (plus remaining coupon, if applicable) Its remaining coupon, if applicable

Ans: c Difficulty: Moderate Ref: Fixed-Income Securities 16.

Which of the following statements is true regarding an investment in mortgagebacked securities?

a. b. c. d.

There is little default risk.

The stated maturity is generally 10 years.

They receive a fixed payment per month.

They are not subject to prepayment.

Ans: a Difficulty: Moderate Ref: Fixed-Income Securities

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17.

A municipal bond issued to finance a toll bridge would most likely be a:

a. b. c. d.

general obligation bond. revenue bond. special assessment bond. zero-coupon bond.

Ans: b Difficulty: Easy Ref: Fixed-Income Securities 18.

What is the major difference between municipal bonds and other types of bonds?

a. b. c. d.

Municipal bonds are always insured; other bonds are not.

Unlike other bonds, municipal bonds sell at a discount.

Municipal bond interest is tax-exempt; interest on other bonds is not.

There is no brokerage commission on municipal bonds unlike other bonds.

Ans: c Difficulty: Moderate Ref: Fixed-Income Securities 19.

For an investor with a 28% marginal tax rate, what return would a corporate bond have to pay to provide the same after-tax return as a municipal bond paying 5%?

a. b. c. d.

1.40% 2.50% 5.00% 6.94%

Ans: d Difficulty: Moderate Ref: Fixed-Income Securities 20.

Interest on bonds is typically paid:

a. b. c. d.

monthly. quarterly. semi-annually. annually.

Ans: c Difficulty: Moderate Ref: Fixed-Income Securities

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21.

Treasury bonds generally have maturities of:

a. b. c. d.

5 to 15 years.

5 to 30 years.

10 to 20 years.

10 to 30 years.

Ans: d Difficulty: Easy Ref: Fixed-Income Securities 22.

A corporate bond with a rating of BBB- is considered to be which of the following?

a. b. c. d.

Non-investment grade Investment grade Speculative grade Junk or high-yield

Ans: b Difficulty: Difficult Ref: Fixed-Income Securities 23.

An unsecured bond is known as a(n):

a. b. c. d.

debenture. indenture. mortgage bond. junk bond.

Ans: a Difficulty: Moderate Ref: Fixed-Income Securities 24.

Which of the following 10-year bonds would have the lowest yield?

a. b. c. d.

AAA-rated corporate bond AAA-rated insured municipal bond U.S. Treasury bond AAA-rated mortgage-backed bond

Ans: b Difficulty: Difficult Ref: Fixed-Income Securities

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25.

For U.S. companies, dividends are typically paid:

a. b. c. d.

monthly. quarterly. semi-annually. yearly.

Ans: b Difficulty: Easy Ref: Equity Securities 26.

If an investor states that Intel is overvalued at 65 times, he is referring to Intel’s:

a. b. c. d.

earnings per share. dividend yield. book value.

P/E ratio.

Ans: d Difficulty: Difficult Ref: Equity Securities 27.

Which of the following is a security that represents shares of a foreign company, which are held in a bank?

a. b. c. d.

Convertible bond American Depository Receipt (ADR) Asset-backed security LEAPS

Ans: b Difficulty: Easy Ref: Equity Securities 28.

Which of the following statements regarding common stocks is true?

a. b. c. d.

The par value of common stock is usually $100.

The market value of common stock is equal to its book value.

Dividends on common stock are at the discretion of the company.

Common stock has a senior claim on company assets.

Ans: c Difficulty: Moderate Ref: Equity Securities

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29.

If a preferred stock issue is cumulative, this means:

a. b. c.

unpaid preferred stock dividends are paid at the end of the year. unpaid preferred stock dividends are legally binding on the corporation. unpaid preferred stock dividends must be paid in the future before common stock dividends can be paid. unpaid preferred stock dividends are never repaid.

d.

Ans: c Difficulty: Moderate Ref: Equity Securities 30.

Which of the following statements is true regarding asset-backed securities?

a. b. c. d.

They offer relatively high yields.

They have relatively long maturities.

They generally have low credit ratings.

Each traunche has the same risk.

Ans: a Difficulty: Moderate Ref: Asset Backed Securities 31.

What is the biggest difference between an option and a futures contract?

a. b. c.

Options are traded on exchanges, whereas futures are not.

Options give investors a way to manage portfolio risk, while futures do not.

Options can be used by speculators to profit from price fluctuations, while futures cannot.

Options give their holders the right to buy or sell, whereas futures contracts are obligations to buy or sell.

d.

Ans: d Difficulty: Difficult Ref: Derivative Securities 32.

The premium on an option is the:

a. b. c. d.

par value of the option. price of the option. book value of the option. price at which a security may be bought or sold using the option.

Ans: b Difficulty: Moderate Ref: Derivative Securities

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33.

If a call option has a $10 strike price, and the underlying stock is trading at $11, then the option is considered:

a. b. c. d.

in the money. at the money. out of the money. worthless.

Ans: a Difficulty: Easy Ref: Derivative Securities

True-False Questions 1.

Direct investing involves trades made by directly purchasing shares of a financial intermediary.

Ans: False Difficulty: Moderate Ref: Organizing Financial Assets 2.

An example of indirect investing would be buying shares in a mutual fund.

Ans: True Difficulty: Easy Ref: Organizing Financial Assets 3.

Nonmarketable investments would include savings accounts at banks and Treasury bills.

Ans: False Difficulty: Moderate Ref: Nonmarketable Financial Assets 4.

Marketable securities all fall into the category of capital market securities.

Ans: False Difficulty: Moderate Ref: Nonmarketable Financial Assets 5.

All U. S. government securities are considered marketable securities.

Ans: False Difficulty: Easy Ref: Money Market Securities

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6.

Money market securities generally carry a low chance of default.

Ans: True Difficulty: Moderate Ref: Money Market Securities 7.

The money market rate most often used as a benchmark for the risk-free rate is the money market deposit account rate.

Ans: False Difficulty: Easy Ref: Money Market Securities 8.

The rate spreads between the different money market securities of the same term tend to be quite large.

Ans: False Difficulty: Difficult Ref: Money Market Securities 9.

Treasury notes represent the nontraded debt of the U.S. government.

Ans: False Difficulty: Moderate Ref: Fixed-Income Securities 10.

The capital market includes both fixed-income and equity securities.

Ans: True Difficulty: Easy Ref: Fixed-Income Securities 11.

Term bonds have a single maturity.

Ans: True Difficulty: Easy Ref: Fixed-Income Securities 12.

The return on a zero-coupon bond is derived from the difference between the purchase price of the bond and its par value.

Ans: True Difficulty: Difficult Ref: Fixed-Income Securities

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13.

The deeper the discount on a zero-coupon bond, the lower the effective return.

Ans: False Difficulty: Moderate Ref: Fixed-Income Securities 14.

If a bond has a coupon greater than the current market yield, it should be selling at a premium.

Ans: True Difficulty: Difficult Ref: Fixed-Income Securities 15.

Callable bonds attract investors because they can be redeemed early.

Ans: False Difficulty: Moderate Ref: Fixed-Income Securities 16.

TIPS adjust for inflation by adjusting the rate of interest paid on the bond.

Ans: False Difficulty: Difficult Ref: Fixed-Income Securities 17.

The major attraction of municipal bonds is their extremely low risk.

Ans: False Difficulty: Moderate Ref: Fixed-Income Securities 18.

Investors in high tax brackets would be unlikely to invest in municipal bonds.

Ans: False Difficulty: Moderate Ref: Fixed-Income Securities 19.

In the case of a corporate bankruptcy, bondholders are paid before any distributions are paid to preferred or common stockholders.

Ans: True Difficulty: Moderate Ref: Fixed-Income Securities 20.

Bond ratings are primarily used to assess interest rate risk.

Ans: False Difficulty: Moderate Ref: Fixed-Income Securities

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21.

The major bond rating service is Dun & Bradstreet.

Ans: False Difficulty: Easy Ref: Fixed-Income Securities 22.

The earnings retention rate is calculated as 1 – dividend yield.

Ans: False Difficulty: Easy Ref: Equity Securities 23.

The par value on common stock sets the value that stockholders will receive in case of bankruptcy.

Ans: False Difficulty: Easy Ref: Equity Securities 24.

LEAPS have maturity dates up to 10 years.

Ans: False Difficulty: Easy Ref: Equity Securities 25.

Most futures contracts are not exercised.

Ans: T Difficulty: Moderate Ref: Equity Securities 26.

Convertible bonds give their investors the right to convert the bond into common stock at their discretion.

Ans: True Difficulty: Easy Ref: Fixed-Income Securities Short-Answer Questions 1.

Distinguish between direct and indirect investing.

Answer: Difficulty: Ref:

Direct investing – buy bonds and stocks; Indirect investing – buy mutual funds, contribute to pension plans, buy life insurance policies.

Easy Organizing Financial Assets

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2.

Compare the cash flows an investor expects from coupon bonds, zero-coupon bonds, and preferred stock.

Answer:

Difficulty: Ref: 3.

How is the earnings retention rate related to the dividend payout rate?

Answer: Difficulty: Ref: 4.

Difficulty: Ref:

Difficulty: Ref:

If a stock is trading at 12 times earnings, it is cheaper than the one trading at 20 times earnings in the sense investors get $1 of earnings for only a $12 investment in buying the stock.

Moderate Equity Securities

What are two direct and one indirect method for individuals to invest in foreign stocks?

Answer: Difficulty: Ref: 7.

Stock splits do not affect total value of equity or the individual accounts, other than the number of shares outstanding and the par value.

Moderate Equity Securities

In what sense is a stock selling for 12 times earnings “cheaper” than a stock with a P/E ratio of 20?

Answer:

6.

Earnings retention rate = 1 - dividend payout rate Moderate Equity Securities

How is the total book value of equity affected by stock splits?

Answer:

5.

Coupon bonds – annuity of interest payments plus lump sum of principal at maturity Zero-coupon bonds – principal at maturity Preferred stock – annuity ad infinitum (perpetuity) Moderate Fixed-Income Securities

Buy securities directly through exchanges or as American depository receipts and indirectly through mutual funds.

Moderate Organizing Financial Assets, Equity Securities

Explain how writing option contracts (both puts and calls) can generate income for owners of the underlying stock.

Answer: Difficulty: Ref:

The writer keeps the option premium regardless of whether or not the option is exercised.

Moderate Derivative Securities

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8.

Rank (lowest to highest) the following securities in terms of the risk-expected return tradeoff from the investors’ viewpoint: common stock, corporate bonds, U.S. Treasury bonds, preferred stock.

Answer: Difficulty: Ref: 9.

What are some advantages of asset-backed securities to investors?

Answer: Difficulty: Ref: 10.

U.S. Treasury bonds, corporate bonds, preferred stock, common stock Moderate Fixed-Income Securities, Equity Securities

High yields with manageable risk.

Moderate Fixed-Income Securities

Who benefits from a futures contract, a call contract, and a put contract, if prices fall?

Answer: Difficult: Ref:

The seller of the futures contract, the writer of the call contract, and the buyer of the put contract.

Moderate Derivative Securities

Essay Questions 1.

Does the options market help stabilize or destabilize the stock market? Explain.

Answer: Difficulty: Ref: 2.

Options should be a stabilizing force if options are used to hedge stock positions. Options might be destabilizing if used for speculation.

Difficult Equity Securities, Derivative Securities

How do asset-backed securities improve the flow of funds from savers to borrowers?

Answer: Difficulty: Ref:

Asset-backed securities can be sold to a broader market of investors than the underlying securities.

Moderate Fixed-Income Securities

Problems 1.

What rate would a taxable corporate bond have to pay to be comparable to a municipal bond with a coupon rate of 7 percent if the investor is in the 28 percent tax bracket?

Answer: Difficulty: Ref:

Taxable equivalent yield is 0.07/(1-0.28) = 9.72% Easy Fixed-Income Securities

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2.

A corporate investor in the 34% marginal income tax bracket can buy bonds issued by a petroleum exploration company yielding 10.606%. The investor should be willing to buy tax-exempt municipal bonds of similar quality yielding what percent or higher?

Answer: Difficulty: Ref: 3.

The par value of Blaze, Inc. common stock is $0.50, the earnings per share is $4, the stock price is $60, and the dividend per share is $1. Calculate the dividend yield.

Answer: Difficulty: Ref: 4.

Dividend yield = $1/$60 = 0.0167 = 1.67% Moderate Equity Securities

The par value of Blaze, Inc. common stock is $0.50, the earnings per share is $4, the stock price is $60, and the dividend per share is $1. Calculate the payout ratio.

Answer: Difficulty: Ref: 5.

10.606 x (1.0-0.34) = 7.00 percent Easy Fixed-Income Securities

Payout rate = $1/$4 = 0.25 = 25% Moderate Equity Securities

The par value of Inferno, Inc. common stock is $0.50, the earnings per share is $6, and it trades at a P/E of 15. What is Inferno, Inc.’s stock price?

Answer: Difficulty: Ref:

Stock price is EPS x P/E = $6 x 15 = $90 Moderate Equity Securities

Chapter Two Investment Alternatives

24

File: ch03, Chapter 3: Indirect Investing

Multiple Choice Questions 1.

Which of the following is not a characteristic of investments companies?

a. b. c. d.

Pooled investing Diversification Managed portfolios Reduced expenses

Ans: d Difficulty: Moderate Ref: Investing Indirectly 2.

In order to avoid paying income taxes, an investment company must:

a. b. c. d.

be classified as a non-profit organization. invest only in municipal bonds. pass on interest, dividends, and capital gains to the stockholders. be registered as a closed-end investment company.

Ans: c Difficulty: Moderate Ref: Investing Indirectly 3.

Investment companies must register with the SEC under the provisions of the:

a. b. c. d.

Securities Act of 1933.

Securities Exchange Act of 1934.

Maloney Act of 1938.

Investment Company Act of 1940.

Ans: d Difficulty: Easy Ref: What is an Investment Company?

4.

The most popular type of investment company is a:

a. b. c. d.

unit investment trust. mutual fund. closed-end investment company. real estate investment trust.

Ans: b Difficulty: Easy Ref: Three Major Types of Investment Companies Chapter Three Indirect Investing

23

5.

An unmanaged fixed-income security portfolio handled by an independent trustee is known as a:

a. b. c. d.

junk bond fund. closed-end investment company. unit investment trust. hedge fund.

Ans: c Difficulty: Moderate Ref: Three Major Types of Investment Companies 6.

Which of the following is a major objective of unit investment trusts?

a. b. c. d.

Capital preservation Capital gains Current income Tax deferment

Ans: a Difficulty: Moderate Ref: Three Major Types of Investment Companies 7.

A major difference between a closed-end investment company and an open-end investment company is that:

a. b. c. d.

closed-end investment companies are generally much riskier. their security portfolios are substantially different. closed-end investment companies are passive investments and open-ends are not. the capitalization of closed-end companies is more fixed.

Ans: d Difficulty: Moderate Ref: Three Major Types of Investment Companies 8.

Which of the following generally do not trade on stock exchanges?

a. b. c. d.

Unit investment trusts Closed-end investment companies Open-end investment companies Exchange traded funds

Ans: c Difficulty: Moderate Ref: Three Major Types of Investment Companies

Chapter Three Indirect Investing

24

9.

Which of the following statements concerning the trend in investment company growth is true?

a. b. c. d.

The recent trend shows more growth in closed-end investment companies.

The recent trend shows more growth in unit investment trusts.

The recent trend shows more growth in open-end investment companies.

The recent trend shows more growth in exchange traded funds.

Ans: d Difficulty: Easy Ref: Three Major Types of Investment Companies 10.

Which of the following is not one of the features of exchange traded funds (ETFs)?

a. b. c. d.

They are mostly passive portfolios.

They cannot be traded during the day.

They often track a particular sector of the market.

Their price cannot vary from net asset value (NAV).

Ans: b Difficulty: Moderate Ref: Three Major Types of Investment Companies 11.

It is not important to have a secondary market for mutual funds because:

a. b. c. d.

investors hold the securities until maturity. investors trade between themselves. investors sell their shares back to the company. banks will convert investor shares to cash for bank customers.

Ans: c Difficulty: Easy Ref: Three Major Types of Investment Companies 12.

Which of the following ETFs (exchange traded funds) provides exposure to 500 U.S. large-capitalization companies?

a. b. c. d.

Spider Clubs Cubes Diamonds

Ans: a Difficulty: Moderate Ref: Three Major Types of Investment Companies

Chapter Three Indirect Investing

25

13.

Which of the following is not true regarding ETFs?

a. b. c. d.

They trade on exchanges like individual stocks.

They can be bought on margin or sold short.

ETFs have been adversely affected by growth in closed-end funds.

Assets held in ETFs exceed assets held in mutual funds.

Ans: c Difficulty: Moderate Ref: Three Types of Investment Companies 14.

A group of mutual funds with a common management are known as:

a. b. c. d.

fund syndicates. fund conglomerates. fund families. fund complexes.

Ans: d Difficulty: Easy Ref: Three Major Types of Mutual Funds 15.

Which of the following is not true regarding money market funds?

a. b. c. d.

They charge no sales charge, redemption fee, or management fee.

Their maximum average maturity is 90 days.

Normally, there are no capital gains or losses on their shares.

They represent a relatively low risk investment.

Ans: a Difficulty: Difficult Ref: Three Major Types of Mutual Funds 16.

If a mutual fund holds a substantial amount of Treasury bills, it is probably a:

a. b. c. d.

tax-exempt fund. conservative bond fund. bond income fund. money market mutual fund.

Ans: d Difficulty: Easy Ref: Three Major Types of Mutual Funds

Chapter Three Indirect Investing

26

17.

Which of the following is true regarding value funds and growth funds?

a.

Value funds seek stocks that are cheap by fundamental standards while growth funds seek stocks with high current earnings.

Growth funds typically outperform value funds.

Value funds and growth funds tend to perform well at different times.

Value funds typically have higher P/E ratios than growth funds.

b. c. d.

Ans: c Difficulty: Difficult Ref: Three Major Types of Mutual Funds 18.

Index funds provide low-cost, passive investment exposure in a similar fashion to:

a. b. c. d.

hybrid mutual funds. money market mutual funds. exchange-traded funds. equity income funds.

Ans: c Difficulty: Moderate Ref: Three Major Types of Mutual Funds 19.

Net asset value takes into account:

a. b. c. d.

both realized and unrealized capital gains. only realized capital gains. only unrealized capital gains. neither realized or unrealized capital gains.

Ans: a Difficulty: Difficult Ref: The Details of Indirect Investing 20.

If NAV > market price of a fund, then the fund:

a. b. c. d.

is selling at a discount. is selling at a premium. is an index fund. is an ETF.

Ans: a Difficulty: Moderate Ref: The Details of Indirect Investing

Chapter Three Indirect Investing

27

21.

A load fee is a(n):

a. b. c. d.

type of income tax. management fee. origination fee. sales charge.

Ans: d Difficulty: Moderate Ref: The Details of Direct Investing 22.

A 12b-1 fee is a:

a. b. c. d.

redemption fee. sales charge. distribution fee. load fee.

Ans: c Difficulty: Difficult Ref: The Details of Direct Investing 23.

No-load funds sell:

a. b. c. d.

at net asset value. below net asset value. above net asset value. at a discount.

Ans: a Difficulty: Easy Ref: The Details of Direct Investing 24.

No-load funds charge no sales fee because:

a. b. c. d.

they are legally prohibited from doing so. they charge a redemption fee instead. they have no sales force. they charge a 12b-1 fee instead.

Ans: c Difficulty: Moderate Ref: The Details of Direct Investing

Chapter Three Indirect Investing

28

25.

Which of the following types of mutual fund shares typically do not charge a front-end sales charge but do impose a redemption fee that declines over time?

a. b. c. d.

Class A shares Class B shares Class C shares Class D shares

Ans: b Difficulty: Difficult Ref: The Details of Direct Investing 26.

Which brokerage firm was charged in 2004 with allowing late trading of mutual funds for some of its clients?

a. b. c. d.

Merrill Lynch E. F. Hutton Charles Schwab Edward D. Jones

Ans: d Difficulty: Moderate Ref: The Details of Direct Investing 27.

Which of the following statements regarding mutual funds is true?

a. b. c. d.

Higher-performing funds generally have higher expenses.

Stock funds generally have higher expenses than bond funds.

Index funds generally have higher expenses than non-index funds.

Lower performing funds generally have higher expenses.

Ans: d Difficulty: Difficult Ref: The Details of Direct Investing 28.

In the mutual fund industry, the most common performance measure is a hypothetical rate of return that assumes performance is constant over the entire period and is known as the:

a. b. c. d.

cumulative total return. average annual total return. total indexed return. compounded geometric return.

Ans: b Difficulty: Moderate Ref: Investment Company Performance

Chapter Three Indirect Investing

29

29.

On average, which type of mutual fund is expected to have the highest performance?

a. b. c. d.

Money market funds Bond funds Equity funds Municipal bond funds

Ans: c Difficulty: Easy Ref: Investment Company Performance 30.

Which of the following types of funds tend to keep 25% of its assets in the securities of U.S. companies?

a. b. c. d.

Emerging markets funds Single-country funds International funds Global funds

Ans: d Difficulty: Difficult Ref: Investing Internationally Through Investment Companies 31.

Single-country funds have traditionally:

a. b. c. d.

outperformed international funds. underperformed international funds. been open-end. been closed-end.

Ans: d Difficulty: Moderate Ref: The Future of Indirect Investing 32.

The 2 largest fund supermarkets are:

a. b. c. d.

Merrill Lynch and Charles Schwab.

Edward D. Jones and Vanguard.

Vanguard and Fidelity.

Charles Schwab and Fidelity.

Ans: d Difficulty: Moderate Ref: The Future of Indirect Investing

Chapter Three Indirect Investing

30

33.

A portfolio of directly-owned individual securities guided by an investment manager is known as a(n):

a. b. c. d.

IRA. IMA. SMA. DCA.

Ans: c Difficulty: Moderate Ref: The Future of Indirect Investing 34.

Unregulated companies that seek to exploit various market opportunities and require a substantial investment from investors are known as:

a. b. c. d.

derivatives. options. hedge funds.

MMFs.

Ans: c Difficulty: Moderate Ref: The Future of Indirect Investing

True-False Questions 1.

Each investor in an investment company shares in the returns of the fund's portfolio and also shares in the cost of running the fund.

Answer: Difficulty: Ref: 2.

Buying shares of a mutual fund is an example of indirect investing.

Answer: Difficulty: Ref: 3.

True Easy Investing Indirectly

True Easy Investing Indirectly

To qualify as a regulated investment company, a fund must distribute at least 50 percent of its taxable income to the shareholders.

Answer: Difficulty: Ref:

Chapter Three Indirect Investing

False Moderate Investing Indirectly

31

4.

Under the Securities Act of 1933, investment companies are required to register with the SEC.

Answer: Difficulty: Ref: 5.

Most unit investment trusts are considered active investments.

Answer: Difficulty: Ref: 6.

False Moderate Three Major Types of Investment Companies

Investment company managers seek to increase assets under management (AUM) since the cost of overseeing additional amounts of money rises less than the revenue rate.

Answer: Difficulty: Ref: 10.

True Moderate Three Major Types of Investment Companies

Closed-end investment companies typically sell additional shares of their own stock every few years.

Answer: Difficulty: Ref: 9.

False Moderate Three Major Types of Investment Companies

For investors, ETFs generally offer greater tax efficiency than most mutual funds.

Answer: Difficulty: Ref: 8.

False Moderate What is an Investment Company?

ETFs are managed investment portfolios that offer investors targeted diversification.

Answer: Difficulty: Ref: 7.

False Moderate What is an Investment Company?

True Moderate Three Major Types of Mutual Funds

Approximately 85 percent of money market assets are in non-taxable funds.

Answer: Difficulty: Ref:

Chapter Three Indirect Investing

False Moderate Three Major Types of Mutual Funds

32

11.

You would expect a value fund to buy stock based on a sound earnings record while growth funds might invest in companies with no earnings record at all.

Answer: Difficulty: Ref: 12.

Load funds generally outperform no-load funds.

Answer: Difficulty: Ref: 13.

True Easy Three Major Types of Mutual Funds

No-load funds charge a one-time expense fee to cover all operating expenses.

Answer: Difficulty: Ref: 17.

True Moderate Three Major Types of Mutual Funds

Investors desiring no-load funds must generally seek them out since there is no sales force.

Answer: Difficult: Ref: 16.

False Moderate Three Major Types of Mutual Funds

A 12b-1 fee is used to cover a fund's cost of distribution.

Answer: Difficulty: Ref: 15.

False Difficult Three Major Types of Mutual Funds

Both open-end and closed-end investment company shares may sell at a discount from NAV.

Answer: Difficulty: Ref: 14.

True Moderate Three Major Types of Mutual Funds

False Difficult Three Major Types of Mutual Funds

The net asset value of a mutual fund does not consider unrealized capital gains.

Answer: Difficulty: Ref:

Chapter Three Indirect Investing

False Difficult The Details of Indirect Investing

33

18.

Index funds tend to have lower expenses than other funds because they do not incur the costs of professional portfolio management.

Answer: Difficulty: Ref: 19.

Total return for a mutual fund includes capital gains less any reinvested dividends.

Answer: Difficulty: Ref: 20.

True Moderate The Details of Indirect Investing

False Difficult Investment Company Performance

Morningstar ranks mutual funds based on their performance relative to comparable funds.

Answer: True Difficulty: Moderate Ref: Investment Company Performance 21.

Under the Morningstar rating system, one class of mutual fund shares can have a different rating than another share class of the same mutual fund.

Answer: Difficulty: Ref: 22.

Survivorship bias occurs when mutual funds are merged or liquidated, and only the performance of the surviving funds is reported.

Answer: Difficulty: Ref: 23.

True Moderate Investment Company Performance

Global funds tend to hold a higher percentage of their portfolio in U.S. securities than do international funds.

Answer: Difficulty: Ref: 24.

True Moderate Investment Company Performance

True Difficult Investing Internationally Through Investment Companies

Hedge funds typically require a large initial investment and may have restrictions on how quickly investors can withdraw their funds.

Answer: Difficulty: Ref:

Chapter Three Indirect Investing

T Moderate Future of Indirect Investing

34

Short-Answer Questions 1.

Briefly explain the fees charged by mutual funds.

Answer: Difficulty: 2.

What are the main differences between a closed-end and an open-end investment company?

Answer:

Difficulty: 3.

Difficulty:

The FDIC insures accounts at banks from bank failures. The SIPC provides insurance against the brokerage company going bankrupt.

Moderate

Would one expect to find higher P/E ratios in an aggressive growth fund or in growth and income fund?

Answer:

Difficulty: 5.

A closed-end investment company has a fixed number of shares, and the price depends on supply and demand. An open-end fund’s shares outstanding increase as long as new investors contribute money, and the price is the net asset value of the securities owned.

Moderate

What is the difference between the insurance offered by the Securities Investor Protection Corporation (SIPC) and that offered by the Federal Deposit Insurance Corporation (FDIC)?

Answer:

4.

Load fees are sales charges, management fees include advisory fees and operating expenses, and 12b-1 fees are marketing expenses.

Moderate

One would expect higher P/Es in an aggressive growth fund because investors are willing to pay a high current price for expected future growth.

Moderate

Would you recommend that a 65-year old retiree invest all of his/her retirement assets in an income fund?

Answer:

Difficulty:

Chapter Three Indirect Investing

No. The retiree should hold a diversified portfolio of assets that includes growth stocks (for inflation protection), alternative assets, and money market securities in addition to income stocks.

Difficult

35

6.

You have a publication listing alternative growth funds with their most recent 12-month total returns. Is this a good predictor of future performance for the funds?

Answer:

Difficulty: 7.

How is the individual investor’s income tax position affected by owning investment company shares compared to owning securities directly?

Answer:

Difficulty: 8.

No. The best fund last year may or may not be in the rankings next year.

The literature is divided on the usefulness of past performance in predicting fund performance in the future. Some investors prefer longerrun performance measures such as five-year or ten-year compounded returns, but none are sure-fire guides to future performance.

Difficult

An investor holding mutual fund shares will pay taxes on capital gains if the fund sells appreciated securities, even if the investor does not sell any fund shares. However, the investor will pay taxes on dividend income in either case. Investment companies are intermediaries that pass on income and capital gains/losses to the shareholder.

Difficult

Does one mutual fund provide all the diversification that an investor needs?

Answer:

Difficulty:

A single fund typically has many (perhaps several hundred) securities of a particular asset type (e.g. common stock), which should provide adequate diversification for risks affecting that security type. Nonetheless, investors should hold various types of funds that hold securities in other asset classes (e.g. real estate, bonds, money market securities, foreign securities, etc.).

Moderate

Fill-in-the-blank Questions 1.

The ___________________________________ requires most investment companies to register with the Securities and Exchange Commission (SEC), the primary federal agency regulating investment companies.

Answer: Difficulty: Ref:

Investment Company Act of 1940 Moderate What is an Investment Company?

2.

List the four distinct types of investment companies: ____________________, _____________________, _____________________, and _____________________.

Answer: Difficulty: Ref: Chapter Three Indirect Investing

UIT (unit investment trust), ETF (exchange-traded fund), closed-end fund, and mutual fund (open-end fund) Moderate What is an Investment Company?

36

3.

List the four basic types of mutual funds: _________________________, __________________, _________________, and ___________________.

Answer: Difficulty: Ref:

money market funds, equity (stock) funds, bond funds, and hybrid (balanced) funds (holding a mix of stocks and bonds, etc.)

Moderate Types of Mutual Funds

4.

Three common costs incurred by Class A shares are: ______________________, ________________________, and ________________________.

Answer:

Difficulty: Ref: 5.

front-end sales charge, 12b-1 distribution fee (typically smaller than for other share classes), and annual expense ratio (also typically smaller than for other share classes) Difficult The Details of Indirect Investing

An investor who buys shares in a closed-end fund for less than the fund’s net asset value is said to be buying shares at a _____________________.

Answer: Difficulty: Ref:

discount Easy The Details of Indirect Investing

Critical Thinking/Essay Questions 1.

Is an investor able to achieve significant diversification by purchasing a singlecountry fund?

Answer:

Difficulty: 2.

The fund itself might be well diversified within that country if the fund owns a wide variety of securities. However, an investor seeking international diversification would not be well diversified in terms of country risk and exchange-rate risk.

Moderate

What are some advantages investors seek by buying mutual funds or closed-end investment company shares rather than through purchasing securities directly?

Answer:

Difficulty:

Chapter Three Indirect Investing

Substantial diversification even for a small amount of funds, professional management, record keeping, international exposure, efficient & low-cost reinvestment of investment income, capability to participate in the money market with a small investment.

Difficult

37

Problems 1.

An environmentally-friendly balanced mutual fund began the year with a net asset value (NAV) of $12.25 per share. During the year, it received $1.00 of dividend and interest income, $0.25 in realized capital gains, and $0.50 in unrealized capital gains. Ninety percent of the income and all of the realized capital gain were distributed to shareholders. Calculate the year-end NAV.

Answer:

Beginning NAV

$12.25

Income from investment operations net investment income net realized and unrealized gain ($.25 + .50) Total income from investment operations

$1.00 0.75 $1.75

Less distributions to shareholders from net investment income (90% x $1) from net realized capital gain Total distribution

($0.90) (0.25) ($1.15)

Ending NAV

$12.85

Difficulty: Moderate 2.

An equity mutual fund began the year with a net asset value (NAV) of $6.50 per share. During the year, it received $0.15 of dividend income, $1.25 in realized capital losses, and $0.50 in unrealized capital gains. Ninety percent of the income was distributed to shareholders. Calculate the fund’s year-end NAV.

Answer:

Difficulty:

Chapter Three Indirect Investing

Beginning NAV

$6.50

Income from investment operations net investment income net realized and unrealized gain (-$1.25 + .50) Total income from investment operations

$0.15 (0.75) ($0.60)

Less distributions to shareholders from net investment income (90% x $.15) from net realized capital gain Total distribution

($0.135) - _ ($0.135)

Ending NAV

$5.77

Moderate

38

3.

You invested $10,000 10 years ago into Fly-By-Night Fund, which has reported performance (average annual total return) of 11.12% over this 10-year period.

What would your ending wealth position be?

Answer:

Difficulty:

Chapter Three Indirect Investing

On a financial calculator: 10000 PV, 11.12 i/y, 10 N, compute FV; FV = $28,702.67 (ending wealth). Subtract your initial investment of $10,000, which results in $18,702.67 cumulative total dollar return.

Moderate

39

File: ch04, Chapter 4: Securities Markets and Market Indexes Multiple Choice Questions 1.

The issue of common stock of which there are already shares publicly held is known as:

a. b. c.

an IPO. a secondary market issue. an EPO. a seasoned issue.

d.

Ans: d Difficulty: Easy Ref: The Primary Markets 2.

In a firm commitment underwriting arrangement, the risk of placing the security is typically assumed by the:

a. b. c. d.

issuer of the security. investment bankers. commercial bankers. institutional investors.

Ans: b Difficulty: Easy Ref: The Primary Markets 3.

What document summarizes information about a new security issue?

a. b. c. d.

The syndicate offer The IPO The prospectus The shelf registration

Ans: c Difficulty: Easy Ref: The Primary Markets

Chapter Four Securities Market

38

4.

Investment bankers are compensated by:

a. b. c. d.

the underwriting spread. commissions paid by the buyers of the security. commission paid by the sellers of the security. guaranteed investment contracts.

Ans: a Difficulty: Moderate Ref: The Primary Markets 5.

A major appeal for U.S. firms selling bonds in private placements is potential:

a. b. c. d.

lower interest expense. greater regulatory protection. savings from not registering with the SEC or incurring underwriting costs. fewer restrictions on subsequent borrowing activities.

Ans: c Difficulty: Moderate Ref: The Primary Markets 6.

Automatic shelf registration refers to the practice of allowing seasoned issuers to file registration statements with the SEC that become effective immediately upon:

a. b. c. d.

the filing of a “base prospectus,” enabling efficient stock issue. the filing of a “base prospectus,” enabling efficient debt issue. the filing of a “base prospectus,” enabling efficient stock or debt issue. the filing of a “red herring prospectus,” enabling efficient stock or debt issue.

Ans: c Difficulty: Difficult Ref: The Primary Markets 7.

Investment bankers operate in the:

a. b. c. d.

primary market. secondary market. tertiary market. fourth market.

Ans: a Difficulty: Easy Ref: The Primary Markets

Chapter Four Securities Market

39

8.

NASDAQ stocks:

a. b. c. d.

are generally foreign stocks. trade via the Blue Sheets. are sometimes not listed on organized exchanges. represent less than 1,000 companies.

Ans: c Difficulty: Easy Ref: The Secondary Markets 9.

Which exchange member is assigned to a specific trading post?

a. b. c. d.

Commission broker Floor trader Specialist Dealer

Ans: c Difficulty: Easy Ref: The Secondary Markets 10.

The NYSE is now part of a:

a. b. c. d.

not-for-profit corporation. quasi-federal agency. publicly-owned company. government-sponsored agency.

Ans: c Difficulty: Moderate Ref: The Secondary Markets 11.

A block trade is defined as a transaction involving at least:

a. b. c. d.

1,000 shares.

5,000 shares.

10,000 shares.

1 million shares.

Ans: c Difficulty: Moderate Ref: The Secondary Markets

Chapter Four Securities Market

40

12.

A type of trading involving a basket of 15 stocks or more and often used in conjunction with arbitrage strategies is called:

a. b. c. d.

swapping. program trading. day trading. insider trading.

Ans: b Difficulty: Moderate Ref: The Secondary Markets 13.

Which of the following statements regarding the NASDAQ Stock Market is not true?

a. b. c. d.

It was less affected by the 2008 financial crisis than the NYSE. NASDAQ dealers make a market by posting offers to buy or sell securities.

Stocks listed on the NYSE may also trade on NASDAQ. NASDAQ’s electronic trading system provides instantaneous transactions.

Ans: a Difficulty: Difficult Ref: The Secondary Markets 14.

A computerized trading network that matches buy and sell orders electronically entered by customers is a(n):

a. b. c. d.

national market system. electronic communication network. internet investment service. global investment network.

Ans: b Difficulty: Moderate Ref: The Secondary Markets

Chapter Four Securities Market

41

15.

BATS is a(n):

a. b. c. d.

security market regulatory agency. electronic communication network. exchange traded fund (ETF). security exchange.

Ans: d Difficulty: Moderate Ref: The Secondary Market 16.

NASDAQ listed stocks tend to be concentrated in the:

a. b. c. d.

aerospace industry. energy industry. technology industry. telecommunications industry.

Ans: c Difficulty: Moderate Ref: The Secondary Markets 17.

Some OTC stocks are traded through the:

a. b. c. d.

blue sheets. red sheets. pink sheets green sheets.

Ans: c Difficulty: Easy Ref: The Secondary Markets 18.

Which of the following statements about the NYSE is true?

a. b. c.

The NYSE is the oldest and most prominent primary market in the U.S. Specialists account for over 50 percent of the seats on the NYSE. The NYSE is the oldest and most prominent secondary market in the U.S. Institutional investors do not trade on the NYSE.

d.

Ans: c Difficulty: Difficult Ref: The Secondary Markets

Chapter Four Securities Market

42

19.

In-house trading refers to:

a. b. c. d.

trades made only on the floor of the exchanges. direct trades made between OTC dealers. trades by fund managers without the use of brokers or exchanges. trades made between specialists on the NYSE.

Ans: c Difficulty: Moderate Ref: The Secondary Markets 20.

The price that a dealer offers a stock for sale is known as the:

a. b. c. d.

the bid quote. the ask quote. the closing price. the specialist price.

Ans: b Difficulty: Moderate Ref: The Secondary Markets 21.

The difference between the bid and the ask price is known as the:

a. b. c. d.

commission. premium. quote. spread.

Ans: d Difficulty: Moderate Ref: The Secondary Markets 22.

The largest electronic screen-based equity securities market in the U.S. is known as:

a. b. c. d.

BATS. Instinet.

Amex.

NASDAQ.

Ans: d Difficulty: Moderate Ref: The Secondary Markets

Chapter Four Securities Market

43

23.

The Dow Jones Industrial Average consists of high quality stocks that are considered to be:

a. b. c. d.

OTC stocks. cyclical stocks. blue-chip stocks. defensive stocks.

Ans: c Difficulty: Easy Ref: Stock Market Indexes 24.

A criticism of the Dow Jones Industrial Average (DJIA) is that:

a. b. c. d.

it includes too few stocks. it is a value-weighted average. it is an equal-weighted average. it includes too many risky stocks.

Ans: a Difficulty: Moderate Ref: Stock Market Indexes 25.

Which of the following is a major difference between the S&P 500 Index and the Dow Jones Industrial Average (DJIA)? Relative to the DJIA, the S&P 500:

a. b. c. d.

includes stocks with a much smaller average market capitalization. includes more foreign firms. is a much broader index. is more stable.

Ans: c Difficulty: Difficult Ref: Stock Market Indexes

Chapter Four Securities Market

44

26.

Which of the following limits the usefulness of the S&P 500 Index as a market benchmark?

a. b. c. d.

It is too heavily weighted with NYSE stocks to be representative.

It is too difficult to calculate for the average investor.

Its use of a base year in its calculations affects its performance.

Its performance can be greatly affected by a small number of stocks.

Ans: d Difficulty: Difficult Ref: Stock Market Indexes 27.

A market capitalization-weighted index obtains the current market value of each stock by:

a. b. c. d.

averaging the trade price for each day. multiplying price times shares outstanding. multiplying price times daily volume. dividing earnings by shares outstanding.

Ans: b Difficulty: Moderate Ref: Stock Market Indexes 28.

For a given percentage change in price, which of the following stocks would have the greatest impact on the Dow Jones Industrial Average (DJIA)? The stock with the:

a. b. c. d.

largest market capitalization highest stock price per share largest number of shares outstanding largest amount of free float

Ans: b Difficulty: Moderate Ref: Stock Market Indexes

Chapter Four Securities Market

45

29.

The S&P 500 Index is a:

a. b. c. d.

price-weighted index that is adjusted for free float. price-weighted index that is not adjusted for free float. capitalization-weighted index that is adjusted for free float. capitalization-weighted index that is not adjusted for free float.

Ans: c Difficulty: Moderate Ref: Stock Market Indexes 30.

Most trading of bonds in the secondary market takes place on:

a. b. c. d.

the NYSE. the American Stock Exchange. the OTC. the CME.

Ans: c Difficulty: Difficult Ref: Bond Markets 31.

Relative to the yields on corporate bonds issued in the primary market, the yields on comparable corporate bonds trading in the secondary market are:

a. b. c. d.

much lower. exactly the same. slightly higher. similar.

Ans: d Difficulty: Moderate Ref: Bond Markets 32.

The type of bond with the thinnest secondary market is:

a. b. c. d.

agency bonds. corporate bonds.

Treasury bonds. municipal bonds.

Ans: d Difficulty: Moderate Ref: Bond Markets

Chapter Four Securities Market

46

True-False Questions 1.

A large public offering is often handled by a syndicate of investment banking firms, with one lead managing underwriter.

Answer: Difficulty: Ref: 2.

In private placements, new security issues are sold directly to financial institutions.

Answer: Difficulty: Ref: 3.

True Moderate The Secondary Markets

Smaller companies with fewer publicly held shares are more likely to meet the listing requirements of the NYSE.

Answer: Difficulty: Ref: 7.

False Difficult The Primary Markets

The NASDAQ 100 Composite Index is a value-weighted index.

Answer: Difficulty: Ref: 6.

True Easy The Primary Markets

Stocks traded on NASDAQ are bought and sold from specialists, who are often affiliated with brokerage firms.

Answer: Difficulty: Ref: 5.

True Easy The Primary Markets

False Easy The Secondary Markets

Prices of stocks traded on the NYSE are determined through supply and demand.

Answer: Difficulty: Ref:

True Moderate The Secondary Markets

Chapter Four Securities Market

47

8.

Orders on NASDAQ come from market makers, ECNs, and on-line brokers.

Answer: Difficulty: Ref: 9.

All OTC stocks are included in the NASDAQ.

Answer: Difficulty: Ref: 10.

True Moderate The Secondary Markets

Normal stock exchange hours in the U.S. are 9:30 a.m. to 4 p.m. Eastern Standard Time.

Answer: Difficulty: Ref: 12.

False Moderate The Secondary Markets

ECNs offer the advantages of automation, lower costs, and anonymity to its members.

Answer: Difficulty: Ref: 11.

True Moderate The Secondary Markets

True Easy The Secondary Markets

The DJIA adjusts for stock splits by adjusting the market value of included stocks.

Answer: Difficulty: Ref:

False Moderate Stock Market Indexes

Fill-in-the-Blank Questions 1.

The S&P 500 comprises approximately ___ percent of the market capitalization of all U.S. publicly traded companies.

Answer: Difficulty: Ref:

75 Moderate Stock Market Indexes

Chapter Four Securities Market

48

2.

The DJIA is a _______-weighted index.

Answer: Difficulty: Ref:

price Easy Stock Market Indexes

Short-Answer Questions 1.

What is the difference between a seasoned issue and an IPO?

Answer: Difficulty: 2.

What are the major advantages of a private placement for the issuer of securities?

Answer:

Difficulty: 3.

The issuer avoids SEC registration, which saves time. In addition, investment banking fees are normally avoided, since they are not typically incurred in private placements.

Moderate

What are the major similarities and differences between a specialist and a dealer?

Answer:

Difficulty: 4.

A seasoned issue is the sale of a publicly traded company, while an IPO represents the first time an issuer has sold securities to the public.

Moderate

Both have their own inventory of selected securities and both can make a profit (or loss) from the trades made from their own inventory.

However, the specialist does not set the security’s price as the dealer does. In addition, the specialist operates on the exchanges, while the dealer operates on the OTC market.

Difficult

What factors does the NYSE consider important in determining if a company should be listed on the exchange?

Answer:

Difficulty:

The exchange pays close attention to the degree of national interest in the company, its relative position and stability in the industry, and its prospects for maintaining that relative position.

Moderate

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49

5.

What is the Nasdaq National Market System?

Answer:

Difficulty: 6.

What is the difference between a price-weighted index and a capitalizationweighted (value-weighted) index?

Answer:

Difficulty: 7.

A price-weighted series gives more weight to higher priced stocks, whereas under a value-weighted approach, each stock’s importance is based on relative market value, not price per share.

Moderate

Why do the DJIA and the S&P 500 have a high correlation?

Answer: Difficulty: 8.

The Nasdaq/NMS, which is a component of the Nasdaq market, is a combination of the competing market makers in OTC stocks and the up- to-the-minute reporting of trades.

Moderate

Because both are comprised largely of large, prominent NYSE stocks.

Easy

What is Instinet and what does it offer for investors?

Answer:

Difficulty:

It is the original electronic communication network (ECN) and offers anonymous trading and access to more than 40 equity markets worldwide.

Moderate

Critical Thinking/Essay Questions 1.

How do you think the globalization of the securities markets will impact the NYSE and the Nasdaq? What specific developments do you foresee happening soon for the global marketplace?

Answer:

Difficulty:

There will be a higher correlation between the various international markets. Major events, such as the European debt crisis, will impact markets worldwide, including the NYSE and Nasdaq. Investors will have greater access to the global marketplace and will be able to trade foreign securities much easier. This will increase the overall volume of securities trading.

Moderate

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2.

What impact does the increasing amount of institutional investing have on the securities markets today, and what role do you think institutional investors will play in the future?

Answer:

Difficulty: 3.

Institutional investors increase the volume of trading and volatility of the markets. Since most institutional investors, especially fund managers, are judged on short-term performance, they are more likely to trade in and out of positions in order to bolster their return. They provide a great deal of information to individual investors, often free.

They are likely to continue to dominate certain sectors of the market, such as IPOs and private equity.

Difficult

An NYSE market maker awaits news of a merger involving one of the stocks in which she makes a market. Why does she set the bid-ask spread higher?

Answer: Difficulty:

Insiders who have knowledge about the outcome of the merger may trade on superior knowledge at the market maker’s expense.

Difficult

Problems 1.

Global Stock Index is a value-weighted index with just 2 stocks in the index: ABC stock and XYZ stock.

ABC ended 2015 at a price of $55 and had 1 million shares outstanding. XYZ stock ended 2015 at a price of $32 and had 4 million shares outstanding.

ABC ended 2016 at a price of $29 (after a 2-for-1 split). XYZ stock closed at $35 for 2016.

Calculate the new value of the index.

Solution: 2015

Stock Price ABC $55 XYZ $32

x

#shares 1 million = 4 million =

Market value $55,000,000 128,000,000 183,000,000

2016

Stock Price x ABC $29 XYZ $35

#shares 2 million = 4 million =

Market value $58,000,000 140,000,000 198,000,000

Chapter Four Securities Market

51

New value of index: 198,000,000 183,000,000 Difficulty:

Chapter Four Securities Market

x 100 = 1.082 x 100 = 108.2

Difficult

52

File: ch05, Chapter 5: How Securities are Traded

Multiple Choice Questions

1. Raymond James and Edward Jones are examples of: a. b. c. d.

discount brokers. wholesale brokers. full-service brokers. blue-chip brokers.

Ans: c Difficulty: Easy Ref: Brokerage Transactions 2.

Which of the following statements is true regarding full-service brokers?

a. b. c. d.

They typically seek clients with at least $25,000 in their accounts.

They derive only a small percentage of their revenues from commissions.

They compete primarily on price and services offered.

Less than 10 percent of U.S. households now use a full-service broker.

Ans: b Difficulty: Moderate Ref: Brokerage Transactions 3.

Which of the following statements regarding commissions charged by full-service brokers is not true?

a. b. c. d.

Commissions vary by product.

The more complicated the transaction, the higher the commission.

The commission on many bonds is already built into the trade.

There is no commission on U.S. Treasury securities.

Ans: d Difficulty: Moderate Ref: Brokerage Transactions

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53

4.

Which of the following statements regarding discount brokers is true?

a. b. c. d.

Discount brokers do not offer access to foreign securities.

Discount brokers only execute orders on stock transactions.

Discount brokers frequently offer limited investment advice.

Discount brokers do not offer SIPC protection.

Ans: c Difficulty: Moderate Ref: Brokerage Transactions 5.

Which of the following accounts often requires an annual fee?

a. b. c. d.

A cash account A wrap account A margin account All of the above require an annual fee

Ans: b Difficulty: Moderate Ref: Brokerage Transactions 6.

For an investor holding individual securities, which of the following generally requires a relatively large minimum investment, usually $100,000 or higher?

a. b. c. d.

A cash account An asset management account A margin account A wrap account

Ans: d Difficulty: Moderate Ref: Brokerage Transactions 7.

A newer variation of the wrap account is the:

a. b. c. d.

mutual fund wrap account. asset allocation wrap account. small-cap wrap account. index wrap account.

Ans: a Difficulty: Easy Ref: Brokerage Transactions

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54

8.

Which of the following laws eliminated all fixed commissions?

a. b. c. d.

Securities Exchange Act of 1934 Securities Acts Amendments of 1975 Investor Advisor Act of 1940 Securities Investor Protection Act of 1970

Ans: b Difficulty: Moderate Ref: Brokerage Transactions 9.

Direct stock purchase programs (DSPs) are an outgrowth of:

a. b. c. d.

electronic trading. dividend reinvestment plans. increased NASDAQ trading. decreased regulation.

Ans: b Difficulty: Easy Ref: Brokerage Transactions 10.

Treasury bonds can be purchased without paying transaction costs through:

a. b. c. d.

the U.S. Federal Reserve Bank.

Treasury Direct.

DSPs. discount brokers.

Ans: b Difficulty: Easy Ref: Brokerage Transactions 11.

Algorithmic trading:

a. b. c. d.

is a form of technical analysis, which is also called charting. involves high frequency trading involving the use of ECNs. is a form of analysis arbitrage to identify mispriced securities. uses computer programs to determine quantity, price, and timing for trades.

Ans: d Difficulty: Moderate Ref: How Orders Work

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12.

Designated market makers (DMMs) are required to:

a. b. c. d.

maintain a bid-ask spread no greater than 1 cent per share. maintain a fair and orderly market. buy when most others are selling, and vice versa. sell excess inventory to maintain a strictly neutral position.

Ans: b Difficulty: Difficult Ref: How Orders Work 13.

The NYSE maintains circuit breakers to protect investors from unusual market activity. One of these circuit breakers is:

a. b. c. d.

a trading halt. a price adjustment at market opening to correct order imbalances. a price adjustment at market closing to correct order imbalances. a mid-day price adjustment to correct order imbalances.

Ans: a Difficulty: Moderate Ref: How Orders Work 14.

FINRA’s objective is to:

a. b. c. d.

protect the bid-ask spread and exchange participants’ profits. protect corporations and investors. protect investors and ensure market integrity. ensure market integrity and protect the stock exchanges from loss.

Ans: c Difficulty: Easy Ref: How Orders Work 15.

The Securities Investor Protection Corporation (SIPC) insures customer accounts at member brokers against brokerage failure as follows:

a. b. c. d.

securities totaling $250,000, cash totaling $100,000 securities totaling $250,000, cash totaling $250,000 securities totaling $500,000, cash totaling $100,000 securities totaling $500,000, cash totaling $250,000

Ans: d Difficulty: Moderate Ref: How Orders Work

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56

16.

The NYSE minimum deposit for margin accounts is:

a. b. c. d.

$2,000. $10,000. $50,000. $100,000.

Ans: a Difficulty: Moderate Ref: Margin 17.

Margin accounts cannot be used to:

a. b. c. d.

purchase securities using leverage. borrow money to fund a frivolous vacation. provide overdraft protection. take physical delivery on maturity of a futures contract.

Ans: d Difficulty: Moderate Ref: Margin 18.

Open limit orders, if not cancelled or renewed, remain in effect for:

a. b. c. d.

one week. one month. six months. twelve months.

Ans: c Difficulty: Difficult Ref: How Orders Work 19.

If an investor is attempting to buy a stock that is very volatile, it is generally best to use a:

a. b. c. d.

market order. limit order. stop-loss order. contingency order.

Ans: b Difficulty: Moderate Ref: How Orders Work

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57

20.

An order that must be filled immediately in its entirety, or otherwise must be canceled, is known as:

a. b. c d.

an immediate or cancel order. an all or none order. a fill or kill order. a full or bust order.

Ans: c Difficulty: Moderate Ref: How Orders Work 21.

The NYSE is:

a. b. c. d.

a free agent market. an agency auction market. a negotiated market. a dealer market.

Ans: b Difficulty: Moderate Ref: How Orders Work 22.

The independent, quasi-judicial agency of the U.S. government that administers laws in the securities field and protects investors and the public in securities transactions is:

a. b. c. d.

FINRA. the SIPC. the Federal Reserve Bank. the SEC.

Ans: d Difficulty: Easy Ref: How Orders Work

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58

23.

Which of the following statements regarding specialists is FALSE? Specialists:

a. b. c. d.

are expected to maintain a fair and orderly market in their assigned stocks. perform a dual role as brokers and dealers. must be approved by the Federal Reserve Board. must often go "against the market."

Ans: c Difficulty: Difficult Ref: How Orders Work 24.

Ms. Brown sold short 100 shares of common stock at $78 per share. The price has declined to $69. The outlook for the stock is mixed, so she would like to cover her short position if the stock moves up as much as $1, but hold if it continues down. Ms. Brown should place a:

a. b. c. d.

sell stop order at $70. buy stop order at $70. sell limit order at $70. buy limit order at $70.

Ans: b Difficulty: Difficult Ref: How Orders Work 25.

Mr. King has researched a small company whose stock is selling at $7.50. He wants to buy 1,000 shares but thinks that he might get the stock at $7.25. To try to buy the stock at the lower price, he should place a:

a. b. c. d.

sell stop order at $7.25. buy stop order at $7.25. sell limit order at $7.25. buy limit order at $7.25.

Ans: d Difficulty: Difficult Ref: How Orders Work 26.

A sell stop order is placed:

a. b. c. d.

above the current price. below the current price. at the current price. at the breakeven point.

Ans: b Difficulty: Moderate Ref: How Orders Work Chapter Five How Securities Are Traded

59

27.

Which of the following institutions has helped to eliminate the use of stock certificates by placing stock transactions on computers?

a. b. c. d.

Federal Reserve Securities Exchange Commission Depository Trust Company Federal Depository Insurance Corporation

Ans: c Difficulty: Moderate Ref: How Orders Work 28.

The law that requires that all new issues being offered for public sale to be registered with the SEC is the:

a. b. c. d.

Securities Act of 1933.

Securities Exchange Act of 1934.

Maloney Act of 1936.

Securities Investor Protection Act of 1970.

Ans: a Ref: Moderate Ref: Investor Protection in the Securities Markets 29.

Which of the following statements regarding the SEC is not true?

a. b. c. d.

The SEC is an independent, quasi-judicial agency of the U.S. government.

The SEC has the power to disapprove securities for lack of merit.

The SEC has eleven regional offices and several hundred examiners.

The SEC administers all U.S. securities laws.

Ans: b Difficulty: Moderate Ref: How Orders Work 30.

A trading halt on the NYSE occurs:

a. b. c.

only when the SEC officially declares one is necessary. when the market declines more than 10 percent during the day. to allow a company to announce important news or where there is a significant order imbalance between buyers and sellers in a security. any time designated market makers exhaust their capital.

d.

Ans: c Difficulty: Difficult Ref: How Orders Work

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60

31.

Which of the following statements regarding arbitration of broker-client disputes is not true?

a. b. c. d.

There is a cost to arbitration.

Arbitration is a binding process that can determine damages.

It is advised that investors hire a lawyer for the arbitration process.

Arbitration rulings are frequently appealed.

Ans: d Difficulty: Moderate Ref: How Orders Work 32.

The initial margin requirement on security trades is set by the:

a. b. c. d.

SEC. FINRA. SIPC. Federal Reserve.

Ans: d Difficulty: Easy Ref: Margin 33.

Since 1974, the initial margin requirement for stocks has been:

a. b. c. d.

30 percent.

40 percent.

50 percent.

60 percent.

Ans: c Difficulty: Easy Ref: Margin 34.

The interest rate charged on margin accounts is determined by:

a. b. c. d.

adding a percentage to the broker call rate. adding a percentage to the margin interest rate. subtracting a percentage to the broker call rate. subtracting a percentage to the margin interest rate.

Ans: a Difficulty: Moderate Ref: Margin

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61

35.

Margin call price is the amount borrowed divided by:

a. b. c. d.

number of shares x (1 – initial margin proportion). number of shares x (1 – maintenance margin proportion). current value of the shares purchased x (1 – initial margin proportion). current value of the shares purchased x (1 – maintenance margin proportion).

Ans: b Difficulty: Moderate Ref: Margin 36.

If maintenance margin is not maintained, the broker will:

a.

sell sufficient securities to ensure the portfolio is compliant with maintenance margin requirements. sell sufficient securities to ensure the portfolio is compliant with initial margin requirements. contact the investor with a margin put. contact the investor with a margin call.

b. c. d.

Ans: d Difficulty: Easy Ref: Margin

NOTE: Questions 37-38 are based on the following information: An investor buys 100 shares of Walmart at $45 per share on margin with an initial margin of 70% and a maintenance margin of 25%. In two months, the stock goes to $56.

37.

What is the actual margin when the stock price is $56?

a. b. c. d.

65.9% 75.9% 79.9% 80.9%

Solution: 5600-1350 5600

Ans: b Difficulty: Difficult Ref: Margin

Chapter Five How Securities Are Traded

62

=

38.

Below what stock price will a margin call occur?

a. b. c. d.

$13.50 $54.00 $42.00 $18.00

Solution =

1350 100(1-.25)

= $18

Ans: d Difficulty: Difficult Ref: Margin 39.

Which of the following statements is true regarding short sales?

a. b. c. d.

An investor can only remain in a short position for 6 months or less.

Short sales can be done on either a cash or margin account.

Short sellers borrow the stock sold short from the exchanges.

Dividends paid during the short sale must be covered by the seller.

Ans: d Difficulty: Difficult Ref: Short Sales 40.

Which of the following statements regarding the short interest ratio is true?

a. b. c. d.

It is calculated as the total shares sold short divided by total shares outstanding.

It indicates the dollar amount needed to cover all short positions.

The higher the ratio, the more bullish investors are.

It is calculated as the amount of shares sold short divided by average trading volume.

Ans: d Difficulty: Moderate Ref: Short Sales Fill-in-the-blank Questions 1.

The SIPC limit for insurance coverage on cash is _____________________.

Ans: Difficulty: Ref: 2.

$250,000 Moderate Investor Protection in the Securities Markets

The NYSE regulatory triad consists of: ________________________, _________________, and _______________________.

Ans: Difficulty: Ref:

the Exchange/NYSE (self-regulation), the SEC, and member firms Moderate Investor Protection in the Securities Markets

Chapter Five How Securities Are Traded

63

True-False Questions 1.

Most full-service stockbrokers derive over 80% of their income from customer commissions.

Ans: Difficulty: Ref: 2.

Charles Schwab, Fidelity, and Vanguard are examples of premium discount brokers.

Ans: Difficulty: Ref: 3.

True Moderate Brokerage Transactions

Dollar cost averaging, in which additional shares are purchased over time, is one advantage of dividend reinvestment plans.

Ans: Difficulty: Ref: 6.

True Moderate Brokerage Transactions

Negotiated commissions are the norm for institutional investors; whereas most individual investors pay specified commissions set by the brokerage firm.

Ans: Difficulty: Ref: 5.

True Easy Brokerage Transactions

All asset management accounts offer automatic reinvestment of credit balances in shares of a money market or other fund.

Ans: Difficulty: Ref: 4.

False Easy Brokerage Transactions

True Moderate Brokerage Transactions

Buying Treasury securities through the Treasury Direct Program eliminates all brokerage commissions and other fees.

Ans: Difficulty: Ref:

False Moderate Brokerage Transactions

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64

7.

Specialist trading on the NYSE now accounts for the majority of share volume.

Ans: Difficulty: Ref: 8.

“Street names” are the nicknames used for commonly-held securities, such as “IBM” for International Business Machines.

Ans: Difficulty: Ref: 9.

False Moderate How Orders Work

The Securities and Exchange Commission is a division of the Department of Justice.

Ans: Difficulty: Ref: 13.

False Moderate How Orders Work

Most securities are sold on a regular way basis, which means the settlement date is one week after the trade date.

Ans: Difficulty: Ref: 12.

False Easy How Orders Work

A sell stop loss order is placed above the current market price.

Ans: Difficulty: Ref: 11.

False Easy How Orders Work

The use of stock certificates, compared to book-entry systems, is on the rise due, in part, to increased computer fraud.

Ans: Difficulty: Ref: 10.

False Moderate How Orders Work

False Easy Investor Protection in the Securities Markets

Insider trading often occurs when mergers and takeovers are imminent.

Ans: Difficulty: Ref:

True Moderate Investor Protection in the Securities Markets

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65

14.

If a security issue is registered with the SEC, there is less chance the investor will lose money on the investment.

Ans: Difficulty: Ref: 15.

Trading delays and trading halts are types of circuit breakers employed by the NYSE.

Ans: Difficulty: Ref: 16.

True Moderate Margin

A margin call occurs anytime the equity position of the margin account falls below the initial margin.

Ans: Difficulty: Ref: 20.

False Easy Investor Protection in the Securities Markets

Under margin accounts, investors can purchase more stock without putting up additional cash by leveraging the value of the eligible shares.

Ans: Difficulty: Ref: 19.

False Difficult Investor Protection in the Securities Markets

Under SIPC, customer accounts with brokerage firms are insured for up to $1 million.

Ans: Difficulty: Ref: 18.

True Moderate Investor Protection in the Securities Markets

“Circuit breakers” are program traders that attempt to bypass the exchange regulations.

Ans: Difficulty: Ref: 17.

False Moderate Investor Protection in the Securities Markets

False Moderate Margin

Most short sales are executed by the broker acting as the “lender” of the security sold.

Ans: Difficulty: Ref:

True Easy Short Sales

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66

21.

Investors who sell short are expecting the price of the security to fall.

Ans: Difficulty: Ref: 22.

Specialists often sell short to meet public buy orders.

Ans: Difficulty: Ref: 23.

True Easy Short Sales

True Moderate Short Sales

The short interest ratio indicates the number of days it would take for short sellers to cover all the shares sold short.

Ans: Difficulty: Ref:

True Moderate Short Sales

Short-Answer Questions 1.

What is the chief advantage of a market order?

Answer: A market order is executed immediately.

Difficulty: Easy 2.

What are the advantages to investors of keeping their securities in street name?

Answer: Difficulty: 3.

Investors don't have to worry about lost certificates, and it simplifies recordkeeping.

Easy

What costs and risks are incurred in using a margin account that are not present in a cash account?

Answer:

Difficulty:

There is the cost of interest on the amount borrowed and the risk of losing the borrowed funds as well as your original equity, and dividend payments must be covered on the borrowed stock.

Moderate

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67

4.

What is the rationale for different margin requirements on different types of securities? (For example, 50 percent on common stock, and 30 percent on bonds)

Answer:

Difficulty: 5.

What is insider trading? Does it only affect large investors?

Answer:

Difficulty: 6.

Difficulty:

Difficulty:

By and large the expression applies. Full-service brokers offer advice and suggest securities, whereas discount brokers simply handle the transaction.

Moderate

What are two methods of investing in stocks without a broker?

Answer: Difficulty: 9.

No. Losses due to a brokerage firm bankruptcy (causing an investor’s account to be worth less than full value) are covered.

Moderate

Does the expression “you get what you pay for” apply to full-service brokers and discount brokers?

Answer:

8.

Insider trading is a breach of fiduciary responsibility by "insiders" such as officers and directors of corporations who trade on corporate information that is not available to the public. Both large and small investors can be charged with possessing "material, nonpublic information."

Difficult

Mr. Whiner bought 1,000 shares of Sure-Fire, Inc. common stock at $85 and sold it three months later at $73. He lost $12,000 plus commissions on this ill-fated stock purchase. He then contacted the SIPC saying that he wanted to file a claim for his investment losses. Is this loss covered by SIPC? What losses are covered?

Answer:

7.

In general, the higher the risk of loss, the higher the margin requirement.

This is why stocks have higher margins than bonds. Margins on futures, however, are very small and do not follow this logic.

Moderate

Automatic dividend reinvestment plans and no-load stock purchase programs.

Moderate

Small investors often pay brokerage commissions according to the broker’s chart of fees. How can this be when rates are negotiable?

Answer:

Difficulty:

Small investors are free to negotiate with the broker, but often they negotiate from a position offering little power. It’s not worth it to the brokerage house to negotiate every small trade.

Difficult

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68

10.

What are some of the functions of the NASD?

Answer:

Difficulty:

The NASD is the major organization licensing stockbrokers as well as providing compliance examinations of member firms. In addition, the NASD provides automated market surveillance, reviews member advertising and underwriting arrangements. and provides for arbitration of disputes between member firms and their clients.

Moderate

Critical Thinking/Essay Questions 1.

Compare and contrast the functions and responsibilities of an NYSE designated market maker (specialist) with those of an OTC dealer.

Answer:

Difficulty: 2.

Specialists must maintain a fair and orderly market on the NYSE. They keep limit orders. They buy and sell from their own accounts as dealers to maintain a continuous market. OTC dealers buy and sell from their own accounts to satisfy public demand, thereby making markets in the securities. Specialists are more restricted in their trading by the NYSE, while the OTC dealers choose which securities to make a market in and when to buy and sell.

Moderate

What is the difference between the potential gains and losses on long positions versus the potential gains and losses on short sales?

Answer:

Difficulty:

On long positions, the potential gain is unlimited because there is no limit to how high a stock price can go. The potential loss on a long position is just what you paid for the stock. With short sales, however, the potential gain is limited since you make a gain on a short sale when the stock falls and stocks can only fall to 0. But the potential loss is unlimited since you lose money on a short sale when the stock's price rises and there is again no limit to how high a stock price can go.

Difficult

Chapter Five How Securities Are Traded

69

Problems 1.

An investor purchases 100 shares of a $60 stock when the initial margin requirement is 50 percent and the maintenance margin is 30 percent. a. b. c. d.

How much must the investor put up initially in order to purchase the stock?

Calculate the actual margin if the price of the stock drops to $55.

At what stock price will a margin call occur?

If the stock price falls to $58, is the account restricted?

Solution:

(a)

initial margin = 50 percent; 50% of ($60 x 100) = $3000 in equity

(b)

actual margin =

$5500 - $3000 $5500 = 45.5 percent

(c)

A margin call occurs when the actual margin declines below the maintenance margin. This point can be found (with a 30 percent maintenance margin) as follows:

MC price = Amount borrowed_____________ = # of shares (1-maintenance margin)

3000 100(1-.3) = 3000/70 = $42.86

If the stock price declines below $42.86, a margin call will be issued. (d)

At a price of $58, the account is restricted since the margin will be below the initial margin requirement but above the maintenance margin.

Margin at 58 = 5800 - 3000 5800 = 48% Difficulty: 2.

Difficult

An investor short sells 100 shares of stock short at $40. a. b.

Solution:

Difficulty:

Ignoring commissions, at what price will the investor earn $700?

Ignoring commissions, what is the gain or loss if the stock price goes to $53 and the investor closes out the position? (a)

When the stock drops 7 points to $33, the investor will earn $700.

(b)

If the stock goes to $53, the loss will be:

purchase at $53 x 100 shares sold short at $40 x 100 shares loss Moderate

Chapter Five How Securities Are Traded

= = =

70

$(5300) 4000 ($1300)

3.

Joe Edwards purchased 150 shares of XYZ at $100 per share. Currently, the stock is selling at $120. If he wants to be assured of a profit of at least $4050, what type of order should he place and at what price per share?

Solution:

Difficulty:

4.

Profit per share = $4050/150 shares = $27 He should place a limit order to sell the shares at a price of $127 (original price of $100 + $27) Moderate

An investor who short sold 120 shares of stock at $150 per share wishes to realize a gross profit of $2400. At what price must the investor cover the short sale?

Solution:

Difficulty:

Sales Proceeds from short sale = Gross Profit desired = Purchase Price of 120 shares must be

$150 x 120

=

$18,000 - 2,400 $15,600

He must cover the short sale at a price of $130 ($15,600/120 shares) to have a $2,400 profit Difficult

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File: Ch.06, Chapter 6: The Risks and Returns from Investing

Multiple Choice Questions 1.

Total return is equal to:

a. b. c. d.

capital gain + price change. yield + income. capital gain - loss. yield + price change.

Ans: d Difficulty: Easy Ref: Return 2.

Which of the following is not part of the yield component of total return?

a. b. c. d.

Dividend payment on common stock Coupon interest payment on bonds Capital gain upon sale of stock Dividend payment on preferred stock

Ans: c Difficulty: Easy Ref: Return 3.

Investors should be willing to invest in riskier investments only:

a. b. c. d.

if the expected holding period is short term. if there are no safe alternatives except for holding cash. if the expected return is adequate for the risk level. if they are speculators.

Ans: c Difficulty: Easy Ref: Risk 4.

If interest rates are expected to rise, you would expect:

a. b. c. d.

bond prices to fall more than stock prices. bond prices to rise more than stock prices. stock prices to fall more than bond prices. stock prices to rise and bond prices to fall.

Ans: a Difficulty: Moderate Ref: Risk Chapter Six The Risks and Returns from Investing

70

5.

An impending recession is an example of:

a. b. c. d.

interest rate risk. inflation risk. market risk. financial risk.

Ans: c Difficulty: Moderate Ref: Risk 6.

Financial risk is most closely associated with:

a. b. c. d.

the use of equity financing by corporations. the use of debt financing by corporations. equity investments held by corporations. debt investments held by corporations.

Ans: b Difficulty: Moderate Ref: Risk 7.

Political stability is the major factor concerning:

a. b. c. d.

exchange-rate risk. systematic risk. nonsystematic risk. country risk.

Ans: d Difficulty: Moderate Ref: Risk 8.

Liquidity risk:

a. b. c. d.

is the risk that investment bankers normally face. is lower for small OTC stocks than for large NYSE stocks. is a risk associated with secondary market transactions. increases whenever interest rates increase.

Ans: c Difficulty: Moderate Ref: Risk

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9.

The housing bubble and resulting credit crisis of 2008 is an example of:

a. b. c. d.

nonsystematic risk. systematic risk. inflation risk. political risk

Ans: b Difficulty: Easy Ref: Risk 10.

If a U.S. investor buys foreign stock, his dollar-denominated return will increase if the dollar:

a. b. c. d.

appreciates relative to the foreign currency. depreciates relative to the foreign currency. remains unchanged relative to the foreign currency. moves to a net gain position relative to all foreign currencies.

Ans: b Difficulty: Difficult Ref: Risk 11.

New financial disclosure regulations affecting the brokerage industry are a type of:

a. b. c. d.

market risk. financial risk. business risk. liquidity risk.

Ans: c Difficulty: Moderate Ref: Risk 12.

Which of the following corresponds most closely with an increase in interest rates?

a. b. c. d.

Business risk Financial risk Liquidity risk Inflation risk

Ans: d Difficulty: Moderate Ref: Risk

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13.

Assume an investor purchases a bond when the Euro is quoted at $0.96 per Euro and sells the bond when the Euro is quoted at $1.12 per Euro. Relative to the dollar, the Euro has:

a. b. c. d.

appreciated, and the investor has gained from the currency move. appreciated, and the investor has lost from the currency move. depreciated, and the investor has gained from the currency move. depreciated, and the investor has lost from the currency move.

Ans: a Difficulty: Difficult Ref: Currency and Returns 14.

To calculate the return on a stock that pays a year-end dividend, an investor should:

a. b. c. d.

divide the stock’s sale price by its purchase price and subtract 1. add the dividend and sale price, divide by the purchase price and subtract 1. divide the sale price by the purchase price and add the dividend yield. divide all cash flows received by the selling price and subtract 1.

Ans: b Difficulty: Moderate Ref: Measuring Returns 15.

Which of the following is true regarding the cumulative wealth index? It:

a.

is measured by adding up the total returns over the holding period and dividing by the investment. uses a beginning index value (often set to $1, but it can be set to any amount). is the present value of the future cash flows expected from the investment. uses the arithmetic mean as the rate of growth of one’s wealth.

b. c. d.

Ans: b Difficulty: Difficult Ref: Measuring Returns 16.

Adding 1 to return produces the:

a. b. c. d.

arithmetic mean. return relative. cumulative wealth index. geometric mean.

Ans: b Difficulty: Difficult Ref: Measuring Returns

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73

17.

In deriving changes in wealth over time, the return relative solves the problem of:

a. b c. d.

inflation. negative returns. interest rates. tax differences.

Ans: b Difficulty: Moderate Ref: Measuring Returns 18.

If the Dow Jones Industrials had a price appreciation of 6 percent one year and yet total return for the year was 9 percent, the difference would be due to:

a. b. c. d.

the tax treatment of capital gains. the cumulative wealth effect. dividends. inflation.

Ans: c Difficulty: Moderate Ref: Measuring Returns 19.

In order to determine the compound growth rate of an investment over some period, an investor would calculate the:

a. b. c. d.

arithmetic mean. geometric mean. calculus mean. arithmetic median.

Ans: b Difficulty: Moderate Ref: Summary Statistics for Returns 20.

A major difference between real and nominal returns is that:

a. b. c. d.

real returns adjust for inflation, and nominal returns do not. real returns use actual cash flows, and nominal returns use expected cash flows. real returns adjust for commissions, and nominal returns do not. real returns show after-tax returns, and nominal returns show before-tax returns.

Ans: a Difficulty: Moderate Ref: Summary Statistics for Returns

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74

21.

When most people refer to mean rate of return, they are referring to the:

a. b. c. d.

holding period rate of return. arithmetic average rate of return. geometric average rate of return. cumulative average rate of return.

Ans: b Difficulty: Easy Ref: Summary Statistics for Returns 22.

Which of the following statements regarding the arithmetic mean and the geometric mean is true?

a. b. c. d.

The arithmetic mean is always a better measure of average performance.

The geometric mean is always a better measure of average performance.

The arithmetic mean is a better measure of performance over single periods.

The geometric mean is the best estimate of the expected return for the next period.

Ans: c Difficulty: Difficult Ref: Summary Statistics for Returns 23.

The equity risk premium is the difference between the expected return:

a. b. c. d.

on stocks and bonds. on high-grade stocks and low-grade stocks. on stocks and the risk-free rate. on a stock market index and the inflation rate.

Ans: c Difficulty: Moderate Ref: Measuring Risk 24.

Which of the following statements about the expected equity risk premium is true?

a. b. c. d.

It is occasionally negative.

There is no direct way to measure it.

It decreases as investor uncertainty increases.

It increases as the risk-free rate increases.

Ans: b Difficulty: Difficult Ref: Measuring Risk

Chapter Six The Risks and Returns from Investing

75

25.

The standard deviation of a security measures the:

a. b. c. d.

systematic risk of the security. unsystematic risk of the security. total risk of the security. risk per unit of return for the security.

Ans: c Difficulty: Moderate Ref: Measuring Risk 26.

Present value is based on the concept of:

a. b. c. d.

compounding. systematic risk. duration. discounting.

Ans: d Difficulty: Easy Ref: Compounding and Discounting 27.

Over the past 50 years, which of the following financial assets showed the greatest amount of price volatility, as measured by standard deviation?

a. b. c. d.

Small-cap stocks Large-cap stocks Treasury bonds Treasury bills

Ans: a Difficulty: Moderate Ref: Realized Returns and Risks from Investing 28.

A number of prominent observers expect the equity risk premium in the future to be:

a. b. c. d.

considerably lower than that of the past. considerably higher than that of the past. very similar to the historical average. very similar to the recent value.

Ans: a Difficulty: Difficult Ref: Realized Returns and Risks from Investing

Chapter Six The Risks and Returns from Investing

76

29.

If you invest in German bonds and the Euro becomes stronger during your holding period, then:

a. b. c. d.

you will be able to buy back fewer dollars when you redeem your bond. your dollar-denominated return will increase. your-dollar denominated return will decrease. your return will be the interest you receive.

Ans: b Difficulty: Difficult Ref: Taking A Global Perspective 30.

As the dollar falls,

a. b. c. d.

foreign investors owning U.S. stocks suffer.

U.S. investors owning U.S. stocks suffer.

U.S. investors owning foreign stocks suffer. foreign investors owning foreign stocks suffer.

Ans: a Difficulty: Moderate Ref: Taking A Global Perspective

True-False Questions 1.

Another name for a capital gain is yield.

Ans: False Difficulty: Easy Ref: Return 2.

Return and risk are inversely related.

Ans: False Difficulty: Easy Ref: Risk 3.

The less the variability of return, the greater the risk.

Ans: False Difficulty: Easy Ref: Risk

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77

4.

Bond prices and interest rates are inversely related.

Ans: True Difficulty: Moderate Ref: Risk 5.

It is generally easier to predict interest rate risk than market risk.

Ans: True Difficulty: Difficult Ref: Risk 6.

New regulations concerning auto emissions would be a type of market risk for the auto industry.

Ans: False Difficulty: Moderate Ref: Risk 7.

International mutual funds offer investors global diversification without exchange rate risk.

Ans: False Difficulty: Difficult Ref: Risk 8.

A Chinese stock denominated in Chinese yuan will have an increase in its dollar-denominated return if the Chinese yuan strengthens against the dollar.

Ans: True Difficulty: Difficult Ref: Taking A Global Perspective 9.

Holding interest rates constant, a narrowing of the equity risk premium implies a decline in the rate of return on stocks because the amount earned beyond the riskfree rate is reduced.

Ans: True Difficulty: Moderate Ref: Summary Statistics for Returns 10.

The most common measure of inflation is the Producer Price Index.

Ans: False Difficulty: Easy Ref: Summary Statistics for Returns

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78

11.

The standard deviation of returns, calculated as the square root of the variance of returns, is a measure of total risk of an asset or portfolio.

Ans: True Difficulty: Moderate Ref: Measuring Risk 12.

Both present value and future value are based upon the concept of the time value of money.

Ans: True Difficulty: Easy Ref: Compounding and Discounting

Short-Answer Questions 1.

Assume you are a U. S. citizen who purchases $20,000 worth of bonds of the Deep Shaft Mining Company in Kenya. What sources of risk can you identify with this investment?

Answer: Difficulty: Ref: 2.

What common variable is used in the calculation of both the cumulative wealth index and the geometric mean return? How is the common variable calculated?

How is it used in each?

Answer:

Difficulty: 3.

Business risk, country risk, political risk, exchange-rate risk.

Moderate Types of Risk

Return (R) is used in both calculations.

R = [CFt + (PE - PB)]/PB. CWIn = WI0 (1 + R1)(1 + R2) . . . (1 + Rn) G = [(1 + R1)(1 + R2) . . . (1 + Rn)] 1/n - 1 Difficult

When should an investor use the arithmetic mean return? The geometric mean return?

Answer:

Difficulty:

The arithmetic mean is better for single period returns, whereas, the geometric mean is better for multiple periods. Furthermore, the arithmetic mean is better for investors that rebalance their holdings, whereas the geometric mean is better for investors that buy and hold.

Moderate

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79

4.

What is the best measure of risk for a sole proprietorship?

Answer:

Difficulty: 5.

The best measure of risk for a sole proprietorship (a single asset) is standard deviation of returns to capture total risk, since there is no diversification.

Moderate

What was the effect on foreign investors owning U.S. stocks when the dollar fell in 2008?

Answer: Difficulty:

Foreign investors owning U.S. stocks suffered from the unfavorable currency movement as well as decline in the U.S. stock markets.

Moderate

Fill-in-the-blank Questions 1.

CFt + (PE - PB) CFt + PC TR = -------------- = --------PB PB

where CFt PE PB PC

Answer:

Difficulty:

= ______________________________________________ = ______________________________________________ = ______________________________________________ = ______________________________________________

cash flows during measurement period t, price at the end of period t (or sale price), purchase of asset or price at the beginning of the period, change in price during the period Moderate

Critical Thinking/Essay Questions 1.

The returns and risk measures in this chapter are calculated from historical data.

Are such measures good predictors of the future? What are some circumstances that could change to impact future return and risk? How can an investor use these return and risk measures to help construct a portfolio?

Answer:

Difficulty:

Historical risk and returns are a starting point for the analyst to assess future prospects. The return and risk parameters for individual companies can change due to changes in management, product decisions, competition, regulation, changes in financial structure, etc. An analyst can use historical data and temper it with judgment about the future for constructing a portfolio.

Moderate

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80

2.

What is the major drawback of a return measure? Why is it the most common return calculation used by investors?

Answer:

Difficulty:

The return measure does not consider the change in the value of the currency over time. Since many investors do not consider inflation in their calculations, and the total return measure is a quick way to measure return, it is widely used by investors.

Moderate

Problems 1.

A stock is purchased for $50 on January 1 and sold on December 31 for $72. A $5.00 per share dividend is paid at the end of the year.

(a)

Calculate the R.

Solution:

Difficulty:

(a)

R

=

(Dividend + Change in Price)/ Beginning Price

=

($5 + $22)/$50

=

0.54 or 54 percent

Moderate

2.

The S&P 500 showed the following Rs for a 6 year period: 11.1 percent, -5.2 percent, 20.3 percent, 26.7 percent, -12.4 percent, and 2.2 percent.

(a) (b)

Calculate the arithmetic mean return for the 6-year period.

Calculate the geometric mean return for the 6-year period.

Solution: (a) Arithmetic mean = X/n = [11.1 + (-5.2) + 20.3 + 26.7 + (-12.4) + 2.2]/6 = 42.7/6 = .0712 or 7.12 percent (b)

To calculate the geometric mean, convert to RRs and obtain the product of the six RRs. G

Difficulty: 3.

= [1.111 x .948 x 1.203 x 1.267 x .876 x 1.022]1/6 - 1 = [1.4372] 1/6 - 1 = 1.0623 - 1 = .0623 or 6.23 percent Difficult

Calculate FV of $100,000 at the end of 64 years given an interest rate of 10.38%.

Solution: Future Value = = $100,000 (1.1038) 64 = $100,000 (555.8849840) = $55,588,498.40 Difficulty:

Present Value (1 + r)n or on a financial calculator: 100000 PV, 64N, 10.38 Int, Solve for FV = $55,588,498,40

Easy

Chapter Six The Risks and Returns from Investing

81

4.

John Crossborder buys 1 share of Telmex at 140 pesos when the value of the peso is stated in dollars at $0.35. One year later, Telmex is selling for 155 pesos and paid a dividend of 5 pesos at yearend. If after one year the value of pesos is $0.29, what is John's rate of return in U. S. dollars?

Solution:

Return Relative in pesos = [(155 - 140 + 5)/140] + 1.0 = 1.1429 Domestic R

Difficulty: 5.

=

1.1429[0.29/0.35] - 1 = -0.0531 or -5.31%

Difficult

If you deposit $1,000 today at 12 percent, how much will you have in 10 years?

Solution:

Using a financial calculator: 1000 PV, 12 interest rate, 10 N, solve for FV = $3,105.85

Difficulty:

Easy

6.

What is the present value of $20,000 to be received in 40 years if the interest rate is 9 percent?

Solution:

Using a financial calculator: 20000 FV, 9 interest rate, 40 N, solve for PV = $636.75

Difficulty:

Easy

Chapter Six The Risks and Returns from Investing

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File: Ch.07, Chapter 7: Portfolio Theory

Multiple Choice Questions 1.

With a continuous probability distribution:

a. b. c. d.

a probability is assigned to each possible outcome. possible outcomes are constantly changing. an infinite number of possible outcomes exist. there is no variance.

Ans: c Difficulty: Moderate Ref: Dealing With Uncertainty 2.

The expected value is the:

a. b. c. d.

inverse of the standard deviation. correlation between a security’s risk and return. weighted average of all possible outcomes. same as the discrete probability distribution.

Ans: c Difficulty: Easy Ref: Dealing With Uncertainty 3.

Which of the following involves the interrelationship between security returns as well as the expected returns and variances of those returns?

a. b. c. d.

Random diversification Correlating diversification Friedman diversification Markowitz diversification

Ans: d Difficulty: Moderate Ref: Introduction to Modern Portfolio Theory 4.

Which of the following would be considered a random variable?

a. b. c. d.

Expected value Correlation coefficient between two assets One-period rate of return for an asset Beta

Ans: c Difficulty: Easy Ref: Dealing With Uncertainty Chapter Seven Portfolio Theory

82

5.

Given the following probability distribution, calculate the expected return of security XYZ. Security XYZ's Potential return 20% 30% -40% 50% 10%

a. b. c. d.

Probability 0.3 0.2 0.1 0.1 0.3

16 percent 22 percent 25 percent 18 percent

Ans: a Difficulty: Difficult Solution: E(R) = Ripri = (20)(0.3)+ (30)(0.2)+(- 40)(0.1)+(50)(0.1) +(10)(0.3)= 16%.

Ref: Dealing With Uncertainty 6.

Probability distributions:

a. b. c. d.

are always discrete. are always continuous. can be either discrete or continuous. are always symmetric.

Ans: c Difficulty: Easy Ref: Dealing With Uncertainty 7.

The bell-shaped curve, or normal distribution, is considered:

a. b. c. d.

discrete. downward sloping. linear. continuous.

Ans: d Difficulty: Easy Ref: Dealing With Uncertainty

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83

8.

Each individual asset’s weight in the portfolio is found by:

a. b. c. d.

dividing the asset’s standard deviation by its expected value. calculating the percentage of the asset’s value to the total portfolio value. calculating the return of the asset as a percent of total portfolio return. dividing the asset’s expected value by its standard deviation.

Ans: b Difficulty: Moderate Ref: Portfolio Return and Risk 9.

Which of the following statements regarding expected return of a portfolio is true? It can:

a. b. c. d.

be higher than the weighted average expected return of the individual assets. be lower than the weighted average return of the individual assets. never differ from the weighted average expected return of the individual assets. not be calculated.

Ans: c Difficulty: Moderate Ref: Portfolio Return and Risk 10.

In order to determine the expected return of a portfolio, all of the following must be known except:

a. b. c. d.

the probabilities of expected returns of the individual assets. the weight of each individual asset in the portfolio. the expected return of each individual asset. the variance of return of each individual asset and correlation of returns between assets.

Ans: a Difficulty: Difficult Ref: Portfolio Return and Risk 11.

Which of the following is true regarding the expected return of a portfolio?

a. b. c. d.

It is a weighted average only for stock portfolios.

It can only be positive.

It can never be above the highest individual asset return.

It is always below the highest individual asset return.

Ans: c Difficulty: Moderate Ref: Portfolio Return and Risk

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84

12.

Which of the following is true regarding random diversification?

a. b.

Investment characteristics are considered important in random diversification.

The net benefit of random diversification eventually disappears as more securities are added.

Random diversification, if done correctly, can eliminate all risk in a portfolio.

Random diversification eventually removes all company specific risk from a portfolio.

c. d.

Ans: b Difficulty: Difficult Ref: Analyzing Portfolio Risk 13.

Company specific risk is also known as:

a. b. c. d.

market risk. systematic risk. non-diversifiable risk. diversifiable risk.

Ans: d Difficulty: Moderate Ref: Analyzing Portfolio Risk 14.

The relevant risk for a well-diversified portfolio is:

a. b. c. d.

interest rate risk. inflation risk. business risk. market risk.

Ans: d Difficulty: Easy Ref: Analyzing Portfolio Risk 15.

Which of the following statements about the correlation coefficient of the returns for two securities is not true?

a. b. c. d.

It is a statistical measure.

It measures the relationship between the two securities’ returns.

It determines the cause of the relationship between the two securities’ returns.

Its value falls between -1 and +1.

Ans: c Difficulty: Difficult Ref: Analyzing Portfolio Risk

Chapter Seven Portfolio Theory

85

16.

Two stocks with perfect negative correlation will have a correlation coefficient of:

a. b. c. d.

+1.0 -2.0 0.0 –1.0

Ans: d Difficulty: Easy Ref: Analyzing Portfolio Risk 17.

Security A and Security B have a correlation coefficient of 0. If Security A’s return is expected to increase by 10 percent, Security B’s:

a. b. c. d.

return should also increase by 10 percent. return should decrease by 10 percent. return should be zero. expected return is impossible to determine from the above information.

Ans: d Difficulty: Moderate Ref: Analyzing Portfolio Risk 18.

Which of the following portfolios has the least reduction of risk?

a. b. c. d.

A portfolio with securities all having positive correlation with each other.

A portfolio with securities all having zero correlation with each other.

A portfolio with securities all having negative correlation with each other.

A portfolio with securities all having skewed correlation with each other.

Ans: a Difficulty: Moderate Ref: Analyzing Portfolio Risk 19.

The major difference between the correlation coefficient and the covariance is that the correlation coefficient:

a. b.

can be positive, negative, or zero, whereas the covariance is always positive. measures the relationship between securities, whereas the covariance measures the relationship between a security and the market. is a relative measure showing association between security returns, whereas the covariance is an absolute measure showing association between security returns. is a geometric measure, and the covariance is a statistical measure.

c. d.

Ans: c Difficulty: Difficult Ref: Analyzing Portfolio Risk

Chapter Seven Portfolio Theory

86

20.

Which of the following statements regarding portfolio risk and number of stocks is generally true?

a. b. c. d.

Adding more stocks increases risk.

Adding more stocks decreases risk, but does not eliminate it.

Adding more stocks has no effect on risk.

Adding more stocks decreases only systematic risk.

Ans: b Difficulty: Moderate Ref: Analyzing Portfolio Risk 21.

When returns are perfectly positively correlated, the risk of the portfolio is:

a. b. c. d.

zero. the weighted average of the individual security’s risk. equal to the correlation coefficient between the securities. infinite.

Ans: b Difficulty: Moderate Ref: Analyzing Portfolio Risk 22.

Portfolio risk is most often measured by professional investors using the:

a. b. c. d.

expected value. portfolio’s beta. weighted average of the individual asset’s risk. portfolio’s standard deviation.

Ans: d Difficulty: Easy Ref: Analyzing Portfolio Risk 23.

A change in the correlation coefficient of the returns of two securities in a portfolio causes a change in:

a. b. c. d.

both the expected return and the risk of the portfolio. only the expected return of the portfolio. only the risk level of the portfolio. neither the expected return nor the risk level of the portfolio.

Ans: c Difficulty: Moderate Ref: Analyzing Portfolio Risk

Chapter Seven Portfolio Theory

87

24.

Markowitz's main contribution to portfolio theory is that risk is:

a. b. c. d.

the same for each type of financial asset. a function of credit, liquidity, and market factors. not quantifiable. influenced more by covariance than variance when portfolios are large.

Ans: d Difficulty: Moderate Ref: Analyzing Portfolio Risk 25.

Owning two securities instead of one will not improve a portfolio’s risk-return tradeoff if the two securities are:

a. b. c. d.

perfectly positively correlated with each other. perfectly independent of each other. perfectly negatively correlated with each other. of the same category, e.g. blue chips.

Ans: a Difficulty: Easy Ref: Analyzing Portfolio Risk 26.

When the covariance is positive, the correlation will be:

a. b. c. d.

positive. negative. zero. impossible to determine.

Ans: a Difficulty: Easy Ref: Analyzing Portfolio Risk 27.

Calculate the risk (standard deviation) of the following two-security portfolio if the correlation coefficient between the two securities is equal to 0.5.

Security A Security B a. b. c. d.

Variance 10 20

Weight (in the portfolio) 0.3 0.7

17.0 percent 5.4 percent 2.0 percent 3.7 percent

Solution:

Chapter Seven Portfolio Theory

p

= = =

[w1212 + w2222 + 2(w1)(w2)(1,2)12]1/2 [(0.3)2(10) + (0.7)2(20) + 2(0.3)(0.7)(0.5)(10)1/2(20)1/2]1/2 88

=

3.7%

Ans: Difficulty: Ref:

d Difficult Analyzing Portfolio Risk

28.

The major problem with the Markowitz model is its:

a. b. c. d.

lack of accuracy. predictability flaws. complexity. inability to handle large number of inputs.

Ans: c Difficulty: Difficult Ref: Calculating Portfolio Risk 29.

With a discrete probability distribution:

a. b. c. d.

a probability is assigned to each possible outcome. possible outcomes are constantly changing. an infinite number of possible outcomes exist. there is no variance.

Ans: a Difficulty: Moderate Ref: Dealing With Uncertainty

True-False Questions 1.

Standard deviations for well-diversified portfolios are reasonably steady over time.

Ans: True Difficulty: Moderate Ref: Dealing With Uncertainty 2.

A probability distribution shows the likely outcomes that may occur and the probabilities associated with these likely outcomes.

Ans: True Difficulty: Easy Ref: Dealing With Uncertainty 3.

Portfolio risk is a weighted average of the individual security risks.

Ans: False Difficulty: Moderate Ref: Portfolio Return and Risk

Chapter Seven Portfolio Theory

89

4.

A negative correlation coefficient indicates that the returns of two securities have a tendency to move in opposite directions.

Ans: True Difficulty: Easy Ref: The Components of Portfolio Risk 5.

Investments in commodities such as precious metals may provide additional diversification opportunities for portfolios consisting primarily of stocks and bonds.

Ans: True Difficulty: Moderate Ref: Analyzing Portfolio Risk 6.

According to the Law of Large Numbers, the larger the sample size, the more likely it is that the sample mean will be close to the population expected value.

Ans: True Difficulty: Moderate Ref: Analyzing Portfolio Risk 7.

Throwing a dart at the WSJ and selecting stocks on this basis would be considered random diversification.

Ans: True Difficulty: Easy Ref: Analyzing Portfolio Risk 8.

Portfolio risk can be reduced by reducing portfolio weights for assets with relatively high positive correlations.

Ans: True Difficulty: Moderate Ref: Calculating Portfolio Risk 9.

If an analyst uses ex post data to calculate the correlation coefficient and covariance and uses them in the Markowitz model, the assumption is that past relationships will continue in the future.

Ans: True Difficulty: Difficult Ref: Obtaining the Data 10.

In the case of a four-security portfolio, there will be 8 covariances.

Ans: False Difficulty: Moderate Ref: Obtaining the Data Chapter Seven Portfolio Theory

90

11.

The correlation coefficient identifies what causes the relative movement in returns between two securities.

Ans: False Difficulty: Easy Ref: The Components of Portfolio Risk 12.

In a portfolio consisting of two perfectly negatively correlated securities, the highest attainable expected return will consist of a portfolio containing 100% of the asset with the highest expected return.

Ans: True Difficulty: Difficult Ref: The Components of Portfolio Risk

Short-Answer Questions 1.

Are the expected return and standard deviation of a portfolio both weighted averages of the individual security’s expected returns and standard deviations?

If not, what other factors are required?

Answer:

Difficulty: 2.

How is the correlation coefficient important in choosing among securities for a portfolio?

Answer:

Difficulty: 3.

The expected return is a weighted average. The portfolio standard deviation is not a weighted average; it also depends on the correlation coefficients among the securities.

Moderate

If security returns are highly correlated (high positive correlation), diversification does little to reduce risk of returns. The lower the correlation coefficients among the securities, the more advantage is gained from diversification.

Moderate

Why was the Markowitz model impractical for commercial use when it was first introduced in 1952? What has changed by the 1990s?

Answer:

Difficulty:

Chapter Seven Portfolio Theory

The volume of calculations required for a large portfolio was physically impractical in the 1950s. By the 1990s, the proliferation of computers has made the volume of calculations practical.

Moderate

91

4.

Provide an example of two industries that might have low correlation with one another. Give an example that might exhibit high correlation.

Answer:

Difficulty: 5.

When constructing a portfolio, standard deviations, expected returns, and correlation coefficients are typically calculated from historical data. Why may that be a problem?

Answer:

Difficulty: 6.

Low correlation might be found between large appliances and retail food markets in that retail food is somewhat steady through economic ups and downs, while appliances tend to fall off during economic slow downs. High correlation might be found between auto manufacturers and steel manufacturers.

Moderate

The problem is that historical patterns may not be repeated in the future.

We are planning a portfolio for the future and would like to have future (ex ante) data but have only historical (ex post) data.

Moderate

A portfolio consisting of two securities with perfect negative correlation in the proper proportions can be shown to have a standard deviation of zero. What makes this riskless portfolio impossible to achieve in the real world?

Answer:

Difficulty:

Perfect negative correlation is not achievable in most cases since most securities have positive correlation or low correlation. Even if it were observed for a period of time, it could not be counted on to hold for long in the future.

Difficult

Fill-in-the-blank Questions 1.

Markowitz diversification, also called _____________ diversification, removes _________________ risk from the portfolio.

Answer: Difficulty: 2.

An efficiently diversified portfolio still has _____________________ risk.

Answer: Difficulty: 3.

efficient, idiosyncratic (also known as company specific, unsystematic, or diversifiable) Difficult

market (also known as systematic or non-diversifiable) Difficult

The major problem with the Markowitz model is that it requires a full set of ___________ between the asset returns in order to calculate portfolio variance.

Answer: Difficulty: Chapter Seven Portfolio Theory

covariances or correlations Moderate 92

4.

The number of covariances in the Markowitz model is ________ ; the number of unique covariances is [n (n-1)]/2.

Answer: Difficulty:

n(n-1) Difficult

Critical Thinking/Essay Questions 1.

Conventional wisdom has long held that diversification of a stock portfolio should be across industries. Does the correlation coefficient indirectly recommend the same thing?

Answer:

Difficulty: 2.

Correlation coefficients between securities in different industries represent the extent to which their fortunes depend on mutual factors.

The correlation coefficients, then, simply give investors a way to measure conventional wisdom.

Difficult

Why is it more difficult to put Markowitz diversification into effect than random diversification?

Answer:

Difficulty:

Chapter Seven Portfolio Theory

It requires more quantitative analysis and generally the use of a computer software program. In addition, it is more difficult to find securities with either negative correlation or low correlation than it is to simply select securities in different industries and sectors as is done in random diversification.

Moderate

93

Problems 1.

Calculate the expected return and risk (standard deviation) for General Fudge for 200X, given the following information: Probabilities 0.20 Possible Outcomes 20%

Solution:

E(Ri) = = =

0.15 15%

0.50 11%

0.15 -5%

.20(.20) + .15(.15) + .50(.11) + .15(-.05) .04 + .0225 + .055 + (-.0075) .11 or 11% m

 = [  [ R i − E( R i )] 2 pri ]1 / 2 i =1

(1) (2) Possible Outcome ER .20 .11 .09 .15 .11 .04 .11 .11 .00 -.05 .11 -.16

(3) R-ER .0081 .0016 .0000 .0256

 = (.00570)1/2 = 7.55 percent Difficulty:

Chapter Seven Portfolio Theory

Moderate

94

(4)

(5)

(6)

(R-ER)2 .20 .15 .50 .15

Prob.

(4) x (5) .00162 .00024 .00000 .00384 .00570

File: Ch.08, Chapter 8: Portfolio Selection Multiple Choice Questions 1.

According to the Markowitz model, rational investors will seek efficient portfolios because these portfolios are optimal based on:

a. b. c. d.

expected return. risk. expected return and risk. transactions costs.

Ans: c Difficulty: Easy Ref: Building a Portfolio Using Markowitz Principles 2.

Under the Markowitz model, investors:

a. b. c. d.

are assumed to be risk-seekers. are not allowed to use leverage. are assumed to be institutional investors. are always better off if they select portfolios consisting of multiple securities.

Ans: b Difficulty: Moderate Ref: Building a Portfolio Using Markowitz Principles 3. a. b. c. d.

Which of the following is not an assumption of Markowitz portfolio theory?

A single investment period Investor preferences are based only on expected return and risk Low transactions costs The availability of a risk-free asset

Ans: d Difficulty: Moderate Ref: Building a Portfolio Using Markowitz Principles 4.

The Markowitz model assumes that investors are “risk averse”, which means that they:

a. b. c. d.

will not take a “fair gamble.” will take a “fair gamble.” will take a “fair gamble” fifty percent of the time. will never assume investment risk.

Ans: a Difficulty: Easy Ref: Building a Portfolio Using Markowitz Principles Chapter Eight Portfolio Selection

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5.

An indifference curve shows:

a. b. c. d.

the one most desirable portfolio for an investor. all combinations of portfolios that are equally desirable to an investor. all combinations of portfolios that are equally desirable to all investors. the one most desirable portfolio for all investors.

Ans: b Difficulty: Difficult Ref: Building a Portfolio Using Markowitz Principles 6.

Which of the following statements regarding indifference curves is not true?

a. b.

Investors have a finite number of indifference curves.

The greater the slope of the indifference curve, the greater the risk aversion of the investor.

The indifference curves for all risk-averse investors will be upward sloping.

Indifference curves cannot intersect.

c. d.

Ans: a Difficulty: Difficult Ref: Building a Portfolio Using Markowitz Principles 7.

The optimal portfolio for a risk-averse investor:

a. b.

cannot be determined. occurs at the point of tangency between the highest indifference curve and the highest expected return. occurs at the point of tangency between the highest indifference curve and the efficient set of portfolios. occurs at the point of tangency between the highest expected return and lowestrisk efficient portfolio.

c. d.

Ans: c Difficulty: Difficult Ref: Building a Portfolio Using Markowitz Principles 8.

The efficient set of portfolios represents:

a. b. c. d.

investor preferences, whereas indifference curves reflect portfolio possibilities. portfolio possibilities, whereas indifference curves reflect investor preferences. investor risk, whereas indifference curves reflect portfolio return. portfolio return, whereas indifference curves reflect investor preferences.

Ans: b Difficulty: Moderate Ref: Building a Portfolio Using Markowitz Principles

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9.

According to the Markowitz model, an efficient portfolio is one that has the:

a. b. c. d.

largest expected return for the smallest level of risk. largest expected return and zero risk. largest expected return for a given level of risk. smallest level of risk.

Ans: c Difficulty: Moderate Ref: Building a Portfolio Using Markowitz Principles 10.

Portfolios lying on the upper right portion of the efficient frontier are likely to be chosen by:

a. b. c. d.

aggressive investors. conservative investors. risk-averse investors. defensive investors.

Ans: a Difficulty: Difficult Ref: Building a Portfolio Using Markowitz Principles 11.

A portfolio which lies below the efficient frontier is described as:

a. b. c. d.

optimal. unattainable. dominant. dominated.

Ans: d Difficulty: Easy Ref: Building a Portfolio Using Markowitz Principles 12.

The optimal portfolio is the efficient portfolio with the

a. b. c. d.

lowest risk. highest risk. highest utility. least investment.

Ans: c Difficulty: Moderate Ref: Building a Portfolio Using Markowitz Principles

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13.

Indifference curves for a risk-averse individual:

a. b. c. d.

will be the same as the indifference curves for any other risk-averse individual. have a negative slope. frequently intersect. are convex.

Ans: d Difficulty: Moderate Ref: Building a Portfolio Using Markowitz Principles 14.

In the past 20 years, the benefits of international diversification have:

a. b. c. d.

increased. decreased. disappeared. become more volatile.

Ans: b Difficulty: Moderate Ref: The Global Perspective - International Diversification 15.

Different investors estimate the inputs to the Markowitz model differently because:

a. b. c. d.

every investor has his/her own risk/return preferences. every investor has access to different information about securities. there is an inherent uncertainty in security analysis. there is a random selection process used by individual investors.

Ans: c Difficulty: Difficult Ref: Some Important Conclusions About the Markowitz Model 16.

Which of the following is not true regarding Markowitz portfolio theory? The Markowitz model:

a. b.

is considered a three-parameter model. implies that no portfolio on the efficient frontier dominates any other portfolio on the efficient frontier. is cumbersome to work with due to the large variance-covariance matrix needed for a set of stocks. generates an entire set, or efficient frontier, of portfolios.

c. d.

Ans: a Difficulty: Moderate Ref: Some Important Conclusions About the Markowitz Model

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17.

Which of the following is true regarding the Markowitz model?

a. b. c.

It fully addresses the use of leverage.

The inputs to the model are the portfolio asset weights.

An investor’s optimal portfolio occurs where the investor’s indifference curve is tangent to the efficient frontier.

Markowitz diversification is inefficient diversification.

d.

Ans: c Difficulty: Moderate Ref: Some Important Conclusions About the Markowitz Model 18. a. b. c. d.

As a measure of market risk, the beta for the S&P 500 is generally considered to be: -1.0.

1.0.

0. impossible to determine.

Ans: b Difficulty: Easy Ref: Alternative Methods of Obtaining the Efficient Frontier 19.

Which of the following portfolios cannot be on the efficient frontier?

a. b. c. d.

A: expected return of 10 percent; standard deviation of 8 percent B: expected return of 18 percent; standard deviation of 13 percent C: expected return of 38 percent; standard deviation of 38 percent D: expected return of 15 percent; standard deviation of 14 percent

Ans: d Difficulty: Moderate Ref: Alternative Methods of Obtaining the Efficient Frontier 20.

Asset allocation is one of the most widely used applications of:

a. b. c. d.

the Capital Asset Pricing Model. random diversification. passive portfolio approach. modern portfolio theory.

Ans: d Difficulty: Easy Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision

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21.

Because of increasing correlation between U.S. markets and foreign markets, most professional investors now recommend:

a. b. c. d.

zero exposure to foreign markets for the foreseeable future. replacing foreign stock exposure with U.S. Treasury bonds. maintaining some reasonable exposure to foreign markets. replacing foreign stock exposure with sovereign debt from investment grade countries.

Ans: c Difficulty: Difficult Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision 22.

The only asset class to provide systematic protection against inflation is:

a. b. c. d.

bonds. real estate. foreign stocks.

TIPS.

Ans: d Difficulty: Easy Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision 23.

Which of the following statements is true regarding TIPS?

a. b. c. d.

As inflation changes, the interest rate on the bond is adjusted.

The correlation between TIPS and the S&P 500 Index has often been negative.

TIPS are more volatile than regular Treasury bonds of similar maturity.

The return on TIPS is often lower than the inflation rate.

Ans: b Difficulty: Difficult Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision 24.

Based on recent history, an investor would have a lower risk level with a portfolio consisting of:

a. b. c. d.

all stocks. all bonds. some stocks and some bonds.

Impossible to tell.

Ans: c Difficulty: Moderate Ref: Asset Allocation and the Individual Investor

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25.

Systematic risk is also called:

a. b. c. d.

diversifiable risk. market risk. random risk. company-specific risk.

Ans: b Difficulty: Easy Ref: The Impact of Diversification on Risk 26.

Which of the following statements about diversification is most accurate? The purpose of diversification is to:

a. b. c. d.

increase a portfolio’s expected return. reduce a portfolio’s non-diversifiable risk. reduce a portfolio’s systematic risk. reduce a portfolio’s total risk.

Ans: d Difficulty: Moderate Ref: The Impact of Diversification on Risk 27.

Which of the following would not be considered a source of systematic risk?

a. b. c. d.

A hostile takeover An increase in inflation A decrease in GDP A panic on Wall Street

Ans: a Difficulty: Moderate Ref: The Impact of Diversification on Risk 28.

An index commonly used as a proxy for developed market international equities is the:

a. b. c. d.

MSCI EAFE Index.

MSCI Emerging Markets Index.

Russell 1000 Index.

FTSE NAREIT Index.

Ans: a Difficulty: Moderate Ref: The Global Perspective - International Diversification

Chapter Eight Portfolio Selection

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29.

Which of the following best approximates the typical correlation between the S&P 500 and the MSCI EAFE Index?

a. b. c. d.

-50% 0% 25% 70%

Ans: d Difficulty: Moderate Ref: The Global Perspective – International Diversification 30.

Bob holds a portfolio of 20 stocks from different industries, whereas Sharon holds only one stock in her portfolio. Assuming they each add a stock to their portfolio, which of the following is most likely? Relative to Bob’s portfolio, Sharon’s portfolio will experience the:

a. b. c. d.

larger increase in total risk. larger increase in return. larger decrease in total risk. larger decrease in market risk.

Ans: c Difficulty: Moderate Ref: The Impact of Diversification on Risk 31.

Gordon holds a portfolio of U.S. equities and is considering adding several alternative ETFs that are tied to different asset classes. Adding which of the following ETFs would produce the largest reduction in the risk of Gordon’s portfolio?

a. b. c. d.

A real estate ETF An emerging markets ETF An EAFE ETF A U.S. bond ETF

Ans: d Difficulty: Moderate Ref: The Global Perspective – Diversification

Chapter Eight Portfolio Selection

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32.

Based on the historic evidence, which of the following is the most supported reason for adding gold to a portfolio of U.S. stocks?

a. b. c. d.

To increase the portfolio’s expected return.

To reduce the portfolio’s risk.

To increase the portfolio’s expected return and reduce its risk.

To increase the portfolio’s expected return and maintain its risk.

Ans: b Difficulty: Moderate Ref: The Impact of Diversification on Risk

True/False Questions 1.

Because of its complexity, the Markowitz model is no longer used by institutional investors.

Ans: False Difficulty: Easy Ref: Building a Portfolio Using Markowitz Principles 2.

When using the Markowitz model, aggressive investors would select portfolios on the left end of the efficient frontier.

Ans: False Difficulty: Moderate Ref: Building a Portfolio Using Markowitz Principles 3.

Markowitz derived the efficient frontier as an upward-sloping straight line.

Ans: False Difficulty: Moderate Ref: Building a Portfolio Using Markowitz Principles 4.

A major assumption of the Markowitz model is that investors base their decisions strictly on expected return and risk.

Ans: True Difficulty: Easy Ref: Building a Portfolio Using Markowitz Principles 5.

Under the Markowitz model, the risk of a portfolio is measured by the standard deviation of the portfolio returns.

Ans: True Difficulty: Moderate Ref: Building a Portfolio Using Markowitz Principles

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6.

Asset allocation explains less than 50 percent of the variance in quarterly returns for a typical pension fund.

Ans: False Difficulty: Moderate Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision 7.

A well-diversified portfolio will typically consist of a mix of small, mid, and large cap stocks, both U.S. and foreign, as well as corporate and U.S. Treasury bonds, real estate, and commodities.

Ans: True Difficulty: Moderate Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision 8.

It would be impossible to combine an asset allocation plan with Markowitz analysis.

Ans: False Difficulty: Moderate Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision 9.

Real estate has never been shown to be positively correlated with the performance of stocks.

Ans: False Difficulty: Moderate Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision 10.

Based on recent research, it seems reasonable that approximately 10 securities are needed to ensure adequate diversification.

Ans: False Difficulty: Moderate Ref: The Impact of Diversification on Risk 11.

Academic research shows asset allocation decisions explain approximately 90% of the variation in returns in a portfolio, whereas individual security analysis, including “stock picking,” explains only about 10%.

Ans: True Difficulty: Moderate Ref: Selecting Optimal Asset Classes – The Asset Allocation Decision

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12.

The Markowitz model does not depend on the assumption of normally distributed security returns.

Ans: False Difficulty: Difficult Ref: Building a Portfolio Using Markowitz Principles

Short-Answer Questions 1.

Explain what is efficient about the efficient frontier.

Answer: Difficulty: 2.

What variable is manipulated to determine efficient portfolios, and why are the other variables not changed at will?

Answer: Difficulty: 3.

Security weights. Other variables are characteristics of the individual securities, not a portfolio decision.

Easy

Discuss the importance of the asset allocation decision for portfolio performance.

Answer:

Difficulty: 4.

Any portfolio on the efficient frontier offers the highest return for any given level of risk or the lowest risk for any given level of return.

Easy

Deciding what percentage of portfolio funds will be invested in each country and each class of assets (e.g., bonds and stocks) is referred to as the asset allocation decision and accounts for more than 90 percent of the variance in quarterly returns for large pension funds.

Moderate

Distinguish between systematic and unsystematic risk. What are two other names for each? Give examples of each.

Answer:

Difficulty:

Systematic risk is also called market risk or nondiversifiable risk (e.g., inflation, war). Unsystematic risk is also called nonmarket (unique) risk or diversifiable risk (e.g. poor product design, law suit).

Moderate

5.

Suppose you interview two different portfolio managers about their efficient sets of portfolios. Is it possible, or even probable, that they would have two different efficient sets? Why? Answer: Difficulty:

Yes. Two different managers are likely to estimate inputs to the model differently and come out with different answers.

Difficult

Chapter Eight Portfolio Selection

104

Problems 1.

Given the following information, calculate the expected return of Portfolio ABC. Expected return of stock A = 10%, Expected return of stock B = 15%, Expected return of stock C = 6%. 40 percent of the portfolio is invested in A, 40 percent is invested in B and 20 percent is invested in C.

Solution: Difficulty: 2.

Expected return of the portfolio = .10 (.40) + .15 (.40) + .06 (.20) = .112 = 11.2% Moderate

Assume ABC are all positively correlated. A fourth stock is being considered for addition to the portfolio, either stock D or stock E. Both D and E have expected returns of 12%. If stock D is positively correlated with ABC, and E is negatively correlated with ABC, which stock should be added to the portfolio? Why?

Solution:

Difficulty:

Add stock E. The expected return of the portfolio would be the same with either stock and by adding E, the overall risk of the portfolio would be lowered.

Moderate

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105

File: Ch.09, Chapter 9: Asset Pricing Models

Multiple Choice Questions 1.

The Capital Asset Pricing Model:

a. b. c. d.

has serious flaws because of its complexity. shows the relationship between risk and expected return. was developed by Markowitz in the 1930s. is a discounted-cash-flow valuation model.

Ans: b Difficulty: Moderate Ref: Capital Market Theory 2.

Which of the following is not one of the assumptions of the CMT?

a. b. c. d.

All investors have the same one-period time horizon.

There are no personal income taxes.

There is no interest rate charged on borrowing.

There are no transaction costs.

Ans: c Difficulty: Moderate Ref: Capital Market Theory 3.

Which of the following is an assumption of the CMT?

a. b. c. d.

Single investors can affect the market by their buying and selling decisions.

There is no inflation.

Investors prefer capital gains over dividends.

Different investors have different probability distributions for assets.

Ans: b Difficulty: Moderate Ref: Capital Market Theory 4.

Which of the following statements regarding investors and the CMT is true?

a. b. c. d.

Investors recognize that all the assumptions of the CMT are unrealistic.

Investors recognize that all of the CMT assumptions are not unrealistic.

Investors are not aware of the assumptions of the CMT model.

Investors recognize the CMT is useless for individual investors.

Ans: b Difficulty: Moderate Ref: Capital Market Theory

Chapter Nine Asset Pricing Models

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5.

Which of the following is generally used as a proxy for the risk-free rate of return?

a. b. c. d.

Savings account Certificate of deposit Treasury security AAA-rated bond

Ans: c Difficulty: Easy Ref: Capital Market Theory 6.

What does it mean when the CAPM is called "robust?"

a. b.

The CAPM requires no assumptions.

Even if the CAPM’s major assumptions are relaxed, most of its conclusions still hold.

The CAPM is based on realistic assumptions.

No other model can represent stock returns better than the CAPM.

c. d.

Ans: b Difficulty: Difficult Ref: Capital Market Theory 7.

When markets are in equilibrium, the CML is upward sloping:

a. b. c. d.

because it shows the optimum combination of risky securities. because the price of risk must always be positive. because it contains all securities weighted by their market values. because investors expect returns to increase over time.

Ans: b Difficulty: Moderate Ref: The Equilibrium Return-Risk Tradeoff 8.

Which of the following statements about the CML is most accurate? The CML can be downward sloping:

a. b. c. d.

ex post. when investors expect the stock market to decline. when the SML is upward sloping. when the risk premium for the market is very high.

Ans: a Difficulty: Difficult Ref: The Equilibrium Return-Risk Tradeoff

Chapter Nine Asset Pricing Models

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9.

Which of the following statements about the difference between the SML and the CML is true?

a. b.

The intercept of the CML is the origin, whereas the intercept of the SML is RF. The CML applies to efficient portfolios, whereas the SML applies to all portfolios or securities.

The CML can be downward sloping, whereas that is impossible for the SML. The CML and the SML are essentially the same except for the price of risk.

c. d.

Ans: b Difficulty: Difficult Ref: The Equilibrium Return-Risk Tradeoff 10.

The separation theorem states that:

a. b. c. d.

systematic risk is separate from unsystematic risk. individual security risk is separate from portfolio risk. the investment decision is separate from the financing decision. the borrowing portfolio is separate from the lending portfolio.

Ans: c Difficulty: Moderate Ref: The Equilibrium Return-Risk Tradeoff 11.

The SML can be used to analyze the relationship between risk and required return for:

a. b. c. d.

all assets. only inefficient portfolios. only efficient portfolios. only individual securities.

Ans: a Difficulty: Easy Ref: The Equilibrium Return-Risk Tradeoff 12.

Which of the following is the correct calculation for the required rate of return under the CAPM?

a. b. c. d.

Beta × (market risk premium) Beta + market risk premium Risk-free rate + risk premium Risk-free rate × (market risk premium)

Ans: c Difficulty: Moderate Ref: The Equilibrium Return-Risk Tradeoff

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13.

Under the CMT, the relevant risk to consider with any security is:

a. b. c. d.

its correlation with other securities in the portfolio. its covariance with the market portfolio. its deviation from the portfolio required rate of return. its variance from the risk-free rate of return.

Ans: b Difficulty: Difficult Ref: The Equilibrium Return-Risk Tradeoff 14.

Select the correct statement regarding the market portfolio.

a. b. c. d.

It is readily and precisely observable.

It has no unsystematic risk.

It has no systematic risk.

It should be composed of stocks or bonds.

Ans: b Difficulty: Moderate Ref: The Equilibrium Return-Risk Tradeoff 15.

Under the separation theorem, investors should:

a. b. c. d.

hold the same portfolio of risky assets. have different optimal portfolios of risky assets. hold the same percentage of their portfolio in risk-free securities. borrow at the risk-free rate to achieve a lower risk portfolio.

Ans: a Difficulty: Difficult Ref: The Equilibrium Return-Risk Tradeoff 16.

The slope of the CML is the:

a. b. c. d.

standard deviation of the market portfolio. market price of risk for efficient portfolios. risk-free rate. risk premium for the market portfolio.

Ans: b Difficulty: Moderate Ref: The Equilibrium Return-Risk Tradeoff

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17.

Securities with betas greater than l should have:

a. b. c. d.

greater than average diversifiable risk. lower than average diversifiable risk. required returns higher than the market return. no systematic risk.

Ans: c Difficulty: Moderate Ref: The Equilibrium Return-Risk Tradeoff 18.

Which of the following statements is most accurate? The:

a. b. c. d.

CML plots individual stocks and efficient portfolios.

CML plots both efficient and inefficient portfolios.

SML plots individual securities and efficient portfolios, only.

SML plots individual securities, inefficient portfolios, and efficient portfolios.

Ans: d Difficulty: Moderate Ref: The Equilibrium Return-Risk Tradeoff 19.

Select the incorrect statement regarding the CML.

a.

The CML is an equilibrium relationship for efficient portfolios and individual securities.

The CML represents the risk-return tradeoff for efficient portfolios.

The intercept of the CML is the reward to investors for deferring consumption.

The CML relies on standard deviation as the measure of risk.

b. c. d.

Ans: a Difficulty: Moderate Ref: The Equilibrium Return-Risk Tradeoff 20.

The expected return on the market for next period is 11 percent. The risk-free rate is 4 percent, and Alpha Company has a beta of 1.1. The market risk premium is:

a. b. c. d.

7.7 percent.

7 percent.

11 percent.

12.1 percent.

Solution: Market risk premium = 11 – 4 = 7 percent Ans: b Difficulty: Easy Ref: The Equilibrium Return-Risk Tradeoff

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21.

The expected market return is 16 percent. The risk-free rate of return is 7 percent, and BC Co. has a beta of 1.1. BC’s required rate of return is:

a. b. c. d.

17.6 percent.

16.0 percent.

16.9 percent.

23.0 percent.

Solution: required return = 7 + 1.1(16 – 7) = 16.9 percent Ans: c Difficulty: Moderate Ref: The Equilibrium Return-Risk Tradeoff 22.

The expected market return is 9 percent. The risk-free rate is 1 percent, and XYZ Co. has a beta of 1.4. XYZ’s risk premium is:

a. b. c. d.

8 percent.

11.2 percent.

12.2 percent.

10.3 percent

Solution:

risk premium = 1.4(9 – 1)

= 11.2 percent

Ans: b Difficulty: Moderate Ref: The Equilibrium Return-Risk Tradeoff 23.

If markets are efficient and in equilibrium:

a. b. c. d.

all securities would lie on the SML. any security that plots below the SML would be considered undervalued. any security that plots above the SML would be considered overvalued. no security would lie on the SML.

Ans: a Difficulty: Moderate Ref: The Equilibrium Return-Risk Tradeoff 24.

If a certain stock has a beta greater than 1.0, it means:

a. b. c. d.

the stock's return has greater than average sensitivity to the market return. the stock would be an attractive holding during a bear market. an investor will earn a higher return on the stock than the market returns. the stock is less risky than the market portfolio.

Ans: a Difficulty: Easy Ref: The Equilibrium Return-Risk Tradeoff Chapter Nine Asset Pricing Models

110

25.

For which of the following models is beta the slope term?

a. b. c. d.

Risk-free model CAPM CML Market model

Ans: d Difficulty: Easy Ref: Estimating the SML 26.

Under the Market model, the regression line that results when the return of a security is plotted against the market index return is the:

a. b. c. d.

SML. CML. characteristic line. slope.

Ans: c Difficulty: Moderate Ref: Estimating the SML 27.

Which of the following is an implication of the CAPM?

a. b. c. d.

A security with a beta of 0 has an expected return of 0.

Investors are not compensated for bearing diversifiable risk.

The risk-return relationship is nonlinear.

There are two risk factors that drive asset returns.

Ans: b Difficulty: Difficult Ref: Tests of the CAPM 28.

Which of the following is not an assumption of both the arbitrage pricing theory (APT) and the CAPM?

a. b. c. d.

Investors have homogeneous beliefs.

Investors are risk-averse utility maximizers.

Borrowing and lending can be done at the rate RF. Markets are perfect.

Ans: c Difficulty: Difficult Ref: Arbitrage Pricing Theory

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29.

Which of the following is not a characteristic of the risk factors in the APT?

a. b. c. d.

The factors must be readily observable in risk/return space.

Each factor must have a pervasive influence on stock returns.

The factors must influence expected return.

Factors must be unpredictable.

Ans: a Difficulty: Moderate Ref: Abritrage Pricing Theory 30.

Which of the following might be used as a factor in an APT factor model?

a. b. c. d.

The risk-free rate Expected inflation Unanticipated deviations from expected inflation Loss by fire at a company’s manufacturing plant

Ans: c Difficulty: Difficult Ref: Abritrage Pricing Theory 31.

The arbitrage pricing theory (APT):

a. b. c. d.

considers only one factor and is a narrower model than the CAPM. considers more factors than the CAPM and is a broader model. is useful only for well-diversified portfolios of common stock. is easy to implement because the factors are readily observable.

Ans: b Difficulty: Moderate Ref: Abritrage Pricing Theory 32.

The APT is based on the:

a. b. c. d.

law of averages. law of attraction. law of accelerating return. law of one price.

Ans: d Difficulty: Easy Ref: Abritrage Pricing Theory

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33.

Positive theory refers to a theory that:

a. b. c. d.

explains how economic participants should act. describes how economic participants act. is optimistic. has been shown to have high explanatory power as a result of empirical testing.

Ans: b Difficulty: Easy Ref: Capital Market Theory

True/False Questions 1.

The most volatile stocks have betas near zero.

Ans: False Difficulty: Easy Ref: The Equilibrium Return-Risk Tradeoff 2.

Using the separation theorem, it is necessary to match each investor's indifference curves with a particular efficient portfolio.

Ans: False Difficulty: Difficult Ref: The Equilibrium Return-Risk Tradeoff 3.

The CML indicates the required return for each portfolio risk level.

Ans: True Difficulty: Moderate Ref: The Equilibrium Return-Risk Tradeoff 4.

A security that plots above the SML would be a good security to sell short.

Ans: False Difficulty: Difficult Ref: The Equilibrium Return-Risk Tradeoff 5.

Beta is a measure of systematic risk and relates one security's return to another security's return.

Ans: False Difficulty: Easy Ref: The Equilibrium Return-Risk Tradeoff

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6.

The CML states that all investors should invest in the same portfolio of risky assets.

Ans: True Difficulty: Moderate Ref: The Equilibrium Return-Risk Tradeoff 7.

Most professional investors use the S&P 500 as a general gauge of total market performance.

Ans: True Difficulty: Easy Ref: The Equilibrium Return-Risk Tradeoff 8.

Tests of the CAPM suggest the trade-off between expected return and risk is an upward-sloping straight line.

Ans: True Difficulty: Moderate Ref: Estimating the SML 9.

In a declining market, a portfolio manager should attempt to increase the overall beta of the portfolio.

Ans: False Difficulty: Moderate Ref: Tests of the CAPM 10.

Unlike the CAPM, the APT does not assume borrowing and lending at the riskfree rate.

Ans: True Difficulty: Moderate Ref: Arbitrage Pricing Theory 11.

With the APT, risk is defined in terms of a stock's sensitivity to basic economic factors.

Ans: True Difficulty: Moderate Ref: Arbitrage Pricing Theory 12.

Like the CAPM, the APT assumes a single-period investment horizon.

Ans: False Difficulty: Moderate Ref: Arbitrage Pricing Theory

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13.

None of the asset-pricing models assume that the market is perfect.

Ans: False Difficulty: Moderate Ref: Arbitrage Pricing Theory 14.

The APT is based on the law of one price, which states two identical assets cannot sell at different prices.

Ans: True Difficulty: Easy Ref: Arbitrage Pricing Theory 15.

The introduction of risk-free borrowing and lending changes the nature of the original Markowitz efficient frontier by turning the efficient frontier into a straight line.

Ans: True Difficulty: Moderate Ref: Check Your Understanding 16.

The characteristic line is the regression fitting total returns for a stock against total returns for the marketand is sometimes calculated using excess returns.

Ans: True Difficulty: Moderate Ref: Estimating the SML 17.

Like CAPM, APT does not assume a single-period investment horizon.

Ans: False Difficulty: Moderate Ref: Arbitrage Pricing Theory

Short-Answer Questions 1.

How are securities chosen and in what proportions are they represented in the market portfolio M?

Answer: Difficulty:

All assets are included in portfolio M in proportion to their market value.

In practice, the S&P 500 is often used as a proxy for the market portfolio.

Moderate

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2.

What is the formula for the slope of the CML? What does it represent?

Answer:

Difficulty: 3.

An analyst determined that for the past two quarters the risk-free rate has exceeded the return on the market portfolio. Does this information disprove the CML?

Answer:

Difficulty: 4.

Difficulty:

Difficulty:

Investors will recognize the security as a good buy (undervalued) and will start buying it, increasing demand. The price will be bid up until the return drops to 18 percent as required by the SML. Difficult

Two points define a straight line. What two points could be most readily identified to estimate the SML?

Answer: Difficulty: 7.

One would expect the betas of defensive securities to be near zero or even negative.

Moderate

At a given point in time, the SML dictates that a security with a beta of 1.10 should require a return of 18 percent. Analysts determine that a particular stock with an observed beta of 1.10 has an expected return of 20 percent. Outline the scenario that will bring the security’s return into equilibrium.

Answer:

6.

No, it merely shows that actual returns often diverge from expected returns. The CML is founded on expected values, so that proof or disproof does not lie in historical values.

Difficult

Some securities are considered to be “defensive” in that they tend to hold their value or increase in value when the majority of securities are losing value, such as during a recession. What could one conclude about the betas of defensive securities?

Answer:

5.

The slope is [E(RM) – RF]/M. It represents the expected return-risk tradeoff for efficient portfolios on the CML. It is the price of risk for efficient portfolios.

Moderate

The risk-free rate because the beta is defined as zero and the expected market return because the beta is defined as 1.00.

Difficult

Betas of individual securities are unstable over time. What are some characteristics that could cause a company’s beta to change over time?

Answer: Difficulty:

A few examples include earnings, cash flow, management, financial leverage, sales growth, and product mix.

Moderate

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8.

What are the assumptions in the CAPM? Can these be relaxed without destroying the conclusions of the model?

Answer:

Difficulty: 9.

Assume a risk-free rate of 5 percent and an expected market return of 15 percent.

Now suppose that the SML shifts, changing slope, so that kRF is still 5 percent but kM is now 16 percent. What does this shift suggest about investors’ risk aversion?

If the slope were to change downward, what would that suggest?

Answer:

Difficulty: 10.

(1) homogeneous expectations, (2) one-period time horizon, (3) borrow lend at RF, (4) no transactions costs, (5) no personal income taxes, (6) no inflation, (7) investor-price takers, and (8) capital markets in equilibrium. Assumptions can be relaxed and still reach most of the same general conclusions.

Difficult

It suggests that investors are more averse to risk than before the shift.

They now require a risk premium of 11 percent (16 - 5), whereas they previously required 10 percent (15 - 5) on the market portfolio. A downward shift would indicate less aversion to risk.

Difficult

Why is market risk sometimes said to be the “relevant” risk for a portfolio manager? What is the measure of market risk?

Answer:

Difficulty:

Market risk, measured by beta, is non-diversifiable and must be dealt with by the portfolio manager. Diversifiable risk should be diversified away and should not pose a problem. Market risk, therefore, is considered to be relevant to the portfolio manager’s job of balancing risk and return.

Moderate

Critical Thinking/Essay Questions 1.

Compare the capital market line and the security market line.

Answer: CML efficient portfolios, consists of RF and M

Difficulty:

SML securities and portfolios

CML and SML both indicate an upward sloping expected return-risk tradeoff.

Moderate

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2.

Compare the security market line model and the arbitrage pricing theory.

Answer:

Difficulty: 3.

SML is a one-factor model, the factor being the market risk premium. The APT accommodates more factors (often three to five are used), such as unanticipated changes in inflation, industrial production, etc. Unlike the CAPM, the APT does not assume a single-period investment horizon, any taxes, borrowing and lending at RF, investor selection on basis of expected return and variance. Both CAPM and APT assume homogeneous beliefs, risk-averse utility maximizers, perfect markets, and returns generated by a factor model.

Difficult

If the risk-free lending rate is lower than the borrowing rate, what would the shape of the CML and efficient frontier look like?

Answer:

Difficulty:

The CML would go from the risk-free rate on the Y intercept to the point tangent to the highest attainable point on the efficient frontier, and along a line from the borrowing rate on the Y axis tangent to the highest attainable point on the efficient frontier, but starting at that point of tangency and running to the right. That portion of the efficient frontier that lies between the two line segments would also be part of the new efficient frontier. The resulting CML would consist of two line segments plus a curve between.

Moderate

Problems 1.

The expected return for the market is 12 percent, with a standard deviation of 20 percent. The expected risk-free rate is 8 percent. Information is available for three mutual funds, all assumed to be efficient, as follows: Mutual Funds Affiliated Omega Ivy (a) (b)

σ(%) 15 17 19

Based on the CML, calculate the market price of risk.

Calculate the expected return on each of these portfolios.

Solution: (a)

Market price of risk = slope of CML = (12 - 8)/20 = .20

(b)

8 + .2(15) = 11 percent 8 + .2(17) = 11.4 percent 8 + .2(19) = 11.8 percent

Affiliated Omega Ivy Difficulty: Difficult

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2.

Given an expected return for the market of 12 percent, with a standard deviation of 20 percent, and a risk-free rate of 8 percent, consider the following data: Stock 1 2 3 (a) (b)

Beta 0.8 1.2 0.6

Ri(%) 12 13 11

Calculate the required return for each stock using the SML. Assume that an analyst, using fundamental analysis, develops the estimates labeled Ri for these stocks. Which stock would be recommended for purchase?

Solution: (a)

Difficulty:

3.

Stock 1 Stock 2 Stock 3

8 + 0.8(4) = 11.2 percent 8 + 1.2(4) = 12.8 percent 8 + 0.6(4) = 10.4 percent

(b) Based on the analyst’s estimates, all three stocks are considered undervalued because Estimated(R) > Required(R) for each of them.

Therefore, the analyst should recommend all three; however, Stock 1 offers the greatest abnormal return.

Difficult

The market has an expected return of 13 percent and the risk-free rate is 5.5 percent. If Morgan Stanley has a beta of 1.85, what is the required return for Morgan Stanley?

Solution: Difficulty:

.055 + 1.85 (.13-.055) = .055 + .1388 = .1938 = 19.38% Moderate

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File: ch10, Chapter 10: COMMON STOCK VALUATION

Type: Multiple Choice

1.

What are two major approaches used to value stocks?

a. b. c. d.

Discounted cash flow techniques and absolute valuation techniques Discounted cash flow techniques and relative valuation techniques Compound free cash flow techniques and relative valuation techniques Markowitz diversification techniques and relative valuation techniques

Ans: b Difficulty: Easy Ref: Overview 2.

Which of the following is not one of the steps in using discounted cash flow to value a company?

a. b. c. d.

Estimate the amount and timing of the future stream of cash flows Estimate an appropriate discount rate Use a present value model to calculate an intrinsic value Compare the intrinsic value to the relative value metric

Ans: d Difficulty: Easy Ref: Discounted Cash Flow Models 3.

Which measure relies on the cash flow remaining after capital expenditures and after interest and principal repayments on debt have been made?

a. b. c. d.

Free cash flow to the firm Weighted average cost of capital Economic value added Free cash flow to equity

Ans: d Difficulty: Easy Ref: Other Discounted Cash Flow Approaches

4.

Which of the following is not a term used to describe the denominator in the discounted cash flow model?

a. b. c. d.

Discount rate Compounding rate Required rate of return Capitalization rate

Ans: b Difficulty: Moderate Ref: The Dividend Discount Model 5.

Janice is evaluating a stock that currently pays a dividend of $0.25 per share. She expects this level of dividend to continue indefinitely, and she has determined that 5% is the appropriate required return for the stock. What is the most she should pay for the stock?

a. b. c. d.

$1.25 per share $2.50 per share $5.00 per share $7.50 per share

Ans: c Difficulty: Easy Ref: The Dividend Discount Model 6.

Sam is evaluating a stock that is expected to pay a $1.25 per share dividend at the beginning of next year. He expects the dividend to grow by 10% per year and has determined that 12% is an appropriate required return for the stock. What is the highest amount he should pay for the stock?

a. b. c. d.

$1.25 $12.50 $15.00 $62.50

Ans: d Difficulty: Moderate Ref: The Dividend Discount Model

7.

Carl is evaluating a stock that just paid a dividend of $2.00 per share. He expects this dividend to grow by 4% per year, and he has determined that 11% is the appropriate required return. What is the most he should pay for the stock?

a. b. c. d.

$18.18 $18.91 $28.57 $29.71

Ans: d Difficulty: Moderate Ref: The Dividend Discount Model 8.

Which of the following increases the price an investor is willing to pay for stock?

a. b. c. d.

The investor increases his estimate of the constant growth rate for dividends.

The investor decreases his estimate of the constant growth rate for dividends.

The investor increases his estimate of the required rate of return.

The investor assumes a higher beta for the stock.

Ans: a Difficulty: Easy Ref: The Dividend Discount Model 9.

Charlie is valuing a common stock with forecast dividends as shown below. He thinks that 10% is an appropriate discount rate. What is the most he should pay for the stock?

D1 $2.00

a. b. c. d.

D2 $2.40

$60.20 $63.25 $65.42 $84.01

Ans: c Difficulty: Difficult Ref: The Dividend Discount Model

D3 $2.76

D4 $3.17

Later 6% growth

10.

Mr. & Mrs. Jones plan to buy stock to earn the funds needed for their son’s college education. They will sell the stock in 7 years to pay tuition. What amount should they use as an estimate for the stock price when they sell in year 7?

a. b. c. d.

The discounted value of the dividends for years 1 through 6.

The discounted value of all the dividends from year 7 on.

The discounted value of all dividends from year 1 on.

The price that is currently quoted in the stock market.

Ans: b Difficulty: Easy Ref: The Dividend Discount Model 11.

Stephen used the dividend discount model to determine that the price of a stock should be $23.50. Stephen checks on the internet and finds the latest price quoted for the stock is $27.00. What should he do?

a. b. c. d.

Buy the stock at $27.00 Sell the stock at $27.00, or sell short if he does not own it Do nothing, as his estimate of the intrinsic value may be off as much as 15% Buy the stock at $23.50 because that is all it is worth

Ans: b Difficulty: Easy Ref: Other Discounted Cash Flow Approaches 12.

When using the free cash flow to the firm (FCFF) model, which of the following should be used as the discount rate?

a. b. c. d.

The required return on equity The before-tax cost of debt The after-tax cost of equity The weighted average cost of capital

Ans: d Difficulty: Difficult Ref: Other Discounted Cash Flow Approaches

13.

What is the major difficulty with using discounted cash flow approaches to estimate a stock’s intrinsic value?

a. b. c. d.

Prices in the stock market move from moment to moment.

Small changes to the assumptions of k or g result in major changes in the estimated value.

It is extremely unlikely that a stream of cash flows will continue to grow at the same rate.

The relative valuation techniques are more accurate approaches.

Ans: b Difficulty: Easy Ref: The Target Price and Relative Valuation Approach 14.

Which of the following is not used in relative valuation comparisons?

a. b. c. d.

The relative value measure from past periods.

The relative value measure for the industry under consideration.

The relative value measure for a comparable firm.

The relative value measure derived from the DCF model.

Ans: d Difficulty: Easy Ref: The Target Price and Relative Valuation Approach 15.

Which of the following descriptions of the price/earnings ratio is the most accurate?

a. b. c. d.

Investors are generally more pessimistic about the prospects for high P/E stocks.

Historically, the average P/E for the market as a whole has been approximately 10.

Companies with high growth rates generally have higher P/E ratios.

All else the same, investors prefer to purchase stocks with relatively high P/E ratios.

Ans: c Difficulty: Easy Ref: The Target Price and Relative Valuation Approach 16.

What is used as “earnings” in the price/earnings ratio?

a. b. c. d.

The net income shown in the company’s most recent annual report Earnings from the firm’s last four published quarterly income statements The firm’s estimated earnings for the next 12 months All of these definitions of earnings are used by analysts

Ans: d Difficulty: Easy Ref: The Target Price and Relative Valuation Approach

17.

Which factor is least likely to explain why one company has a higher P/E ratio than another?

a. b. c. d.

The company has a higher growth rate of earnings.

The company has a higher required rate of return.

The company has a higher current ratio.

The company has a higher return on equity.

Ans: b Difficulty: Easy Ref: The Target Price and Relative Valuation Approach 18.

Which of the following is most likely to increase a company’s P/E ratio?

a. b. c. d.

The company announces a new product, which will increase sales and profits.

The company’s beta increases.

The expected inflation rate increases.

Interest rates increase for all borrowers.

Ans: a Difficulty: Easy Ref: The Target Price and Relative Valuation Approach 19.

Sometimes analysts use other ratios such as price-to-book or price-to-sales ratio. Which of the following is a weakness of the use of these ratios?

a. b. c. d.

Some companies are structured very differently, especially across industries.

A price-to-book value less than one cannot be assessed.

A high price-to-sales ratio cannot be assessed.

The price-to-sales ratio cannot be used for companies that report a net loss.

Ans: a Difficulty: Easy Ref: Which Approach to Use 20.

Which of the following is frequently used as a measure of cash flow in the P/CF ratio?

a. b. c. d.

Revenue Gross Profit EBITDA Income from continuing operations

Ans: c Difficulty: Easy Ref: The Target Price and Relative Valuation Approach

21.

Seaside Boats currently earns $4.00 per share and has a retention ratio of 75%. It is expected to have a constant growth rate of 5 percent per year. The required rate of return is 15 percent. What is the intrinsic value of this stock?

a. b. c. d.

$10 $10.50 $40 $42

Ans: b Difficulty: Moderate Ref: The Dividend Discount Model 22.

Tanex Inc. has a return on assets (ROA) of 12%, a return on equity (ROE) of 15%, and a dividend payout ratio of 60%. Based on the sustainable growth formula, Tanex’s estimated growth is:

a. b. c. d.

4.8%.

6.0%.

7.2%.

9.0%.

Ans: b Difficulty: Moderate Ref: The Constant Growth Rate Model 23.

Hannett Inc. has a stock price of $40 and just reported earnings of $3 per share.

The firm maintains a constant dividend payout of 65% and has an expected return on equity (ROE) of 16%. Based on the constant growth model, Hannett’s expected rate of return is closest to:

a. b. c. d.

10.50%.

10.75%.

13.10%.

13.50%.

Ans: b Difficulty: Difficult Ref: The Dividend Discount Model

24.

Riza Corporation’s preferred stock has a par value of $100 and a dividend rate of 6%. If the required return on the stock is 8%, its intrinsic value is closest to:

a. b. c. d.

$75. $94. $133. $300.

Ans: a Difficulty: Moderate Ref: The Dividend Discount Model 25.

Rita has calculated the discounted value of the free cash flows to the firm (FCFFs) for a company that has no preferred stock. What additional adjustment(s) does she have to make to her calculated discounted value to derive an estimate of the firm’s stock price?

a. b. c. d.

Subtract the value of debt and divide by shares outstanding Add the value of debt and divide by shares outstanding Subtract the value of capital expenditures and divide by shares outstanding Divide by shares outstanding

Ans: a Difficulty: Moderate Ref: Other Discounted Cash Flow Approaches 26.

Which of the following is a component of the formula used to derive a firm’s enterprise value?

a. b. c. d.

EBITDA Accounts receivable Bonds Fixed assets

Ans: c Difficulty: Easy Ref: The Target Price and Relative Valuation Approach

27.

Stan expects Terta Corp. to pay its first dividend of $3 in five years. He expects the dividend to grow at 6% thereafter, and his required return on the stock is 9.5%. The largest amount that Stan should pay for the stock is closest to:

a. b. c. d.

$54. $60. $68. $86.

Ans: b Difficulty: Moderate Ref: The Dividend Discount Model 28.

To estimate the intrinsic value of a security, investors should rely on:

a. b. c. d.

the approach that they are most comfortable using. the approach that is easiest to apply and interpret. the approach that generally gives the most conservative value. more than one approach.

Ans: d Difficulty: Moderate Ref: Which Approach to Use? 29.

Sara estimated the revenue per share for Firm A as $5.50 and estimated the appropriate P/B ratio, P/E ratio, and P/S ratio as 1.9, 14.5, and 2.6, respectively.

What is the estimated intrinsic value for Firm A?

a. b. c. d.

$10.45 $79.75 $14.30 $2.12

Ans: c Difficulty: Moderate Ref: Which Approach to Use?

Type: True False 1.

The only reliable way to value a common stock is to discount the future flow of dividends at a discount rate appropriate to the riskiness of the company.

Ans: False Difficulty: Easy Ref: Which Approach to Use

2.

The required return needed to discount a stock’s future cash flows can be determined using the CAPM.

Ans: True Difficulty: Easy Ref: The Dividend Discount Model 3.

No one knows with precision which valuation model to apply for any particular stock.

Ans: True Difficulty: Easy Ref: Some Final Thoughts on Valuation 4.

Technology stocks generally have P/E ratios that are higher than the market average.

Ans: True Difficulty: Moderate Ref: Bursting the Bubble on New Economy Stocks – A Lesson in Valuation 5.

If a stock’s dividend growth rate or discount rate changes even a small amount, the change in the price calculated by the constant growth model can be very large.

Ans: True Difficulty: Easy Ref: The Dividend Discount Model 6.

Investors will arrive at the same intrinsic valuation for common stocks because valuation is based on an objective approach.

Ans: False Difficulty: Moderate Ref: Some Final Thoughts on Valuation 7.

Economic value added (EVA) indicates the amount by which a company’s operating profit exceeds its cost of capital.

Ans: True Difficulty: Moderate Ref: Relative Valuation Metrics 8.

Many analysts prefer to use a relative valuation technique, such as comparing P/E ratios, because these techniques are more grounded in theory than the DCF approaches.

Ans: False Difficulty: Moderate Ref: Which Approach to Use

9.

The P/E ratio is one of the most widely used measures to assess the financial attractiveness of potential stock investments.

Ans: True Difficulty: Easy Ref: Which Approach to Use 10.

An increase in interest rates generally reduces P/E ratios and stock prices.

Ans: True Difficulty: Moderate Ref: Summary 11.

Historically, the average P/E for the S&P 500 is approximately 16.

Ans: True Difficulty: Moderate Ref: Relative Valuation Metrics 12.

The P/B ratio is considered relatively useful for firms with high levels of intangible assets.

Ans: False Difficulty: Difficult Ref: Which Approach to Use?

File: Ch.11, Chapter 11: Common Stocks: Analysis and Strategy,

Multiple Choice Questions 1.

According to the general consensus of investment managers, what percentage of a typical investor’s portfolio should be invested in international markets?

a. b. c. d.

5 to 10 10 to 20 20 to 30 30 to 50

Ans: d Difficulty: Moderate Ref: A Global Perspective 2.

For adequately diversified common stock portfolios, what percent of the variability in returns is accounted for by market effects?

a. b. c. d.

30 50 70 90

Ans: d Difficulty: Moderate Ref: The Impact of the Overall Market on Stocks 3.

From 1989 to 2015, the Japanese stock market lost what percent of its value?

a. b. c. d.

20 30 40 50

Ans: d Difficulty: Moderate Ref: The Impact of the Overall Market on Stocks

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4.

Which of the following is the biggest factor explaining the variation in returns to individual stocks and stock portfolios?

a. b. c. d.

Aggregate market movements Beta Standard deviation Financial risk

Ans: a Difficulty: Moderate Ref: The Impact of the Overall Market on Stocks 5.

The required return for a common stock is defined as the:

a. b. c. d.

expected return based on probabilities assigned to different scenarios. maximum expected return based on estimates of its cash flows. minimum expected return necessary to induce an investor to purchase the stock. mean return for the stock over the past ten years.

Ans: c Difficulty: Easy Ref: The Impact of the Overall Market on Stocks 6.

Which of the following models provides investors with a method of calculating a required return for a stock?

a. b. c. d.

DuPont model Risk premium model Fisher model Capital asset pricing model

Ans: d Difficulty: Moderate Ref: The Impact of the Overall Market on Stocks 7.

A bear market is characterized by a decline of:

a. b. c. d.

10% or more in the stock market.

20% or more in the stock market.

40% or more in the stock market.

50% or more in the stock market.

Ans: b Difficulty: Moderate Ref: The Impact of the Overall Market on Stocks

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8.

When building a portfolio, what are the two basic components of an investor’s investment decision?

a. b. c. d.

Risk and return Buying and selling Cash flows and capital gains Asset allocation and security selection

Ans: d Difficulty: Moderate Ref: Building Stock Portfolios 9.

If investors become more pessimistic about market conditions, what impact is anticipated for the required return on equities? The required return will:

a. b. c. d.

decrease. increase. stay the same. there is not enough information to answer the question.

Ans: b Difficulty: Moderate Ref: Checking your Understanding 10.

The most important decision when building a diversified stock portfolio is:

a. b. c. d.

individual security selection. asset allocation. minimization of risk. maximization of expected return.

Ans: b Difficulty: Easy Ref: Building Stock Portfolios 11.

A passive investment strategy attempts to:

a. b. c. d.

achieve returns available in various market sectors at minimum risk. achieve maximum returns available in various market sectors. achieve minimum risk in various market sectors. achieve returns available in various market sectors at minimum cost.

Ans: d Difficulty: Moderate Ref: The Passive Strategy

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12.

If security markets are fully efficient, the best common stock strategy is:

a. b. c. d.

a rotation strategy. a buy low, sell high strategy. an active strategy. a passive strategy.

Ans: d Difficulty: Moderate Ref: The Passive Strategy 13.

Passive common stock strategies attempt to minimize:

a. b. c. d.

capital losses. transactions costs, including time spent managing the portfolio. market risk. company and industry risk.

Ans: b Difficulty: Moderate Ref: The Passive Strategy 14.

Investors following a passive strategy use which of the following as the best estimate of a security’s value?

a. b. c. d.

The value derived from the dividend discount model The value derived from the Fisher model The current market price The estimated EPS multiplied by the appropriate P/E multiple

Ans: c Difficulty: Easy Ref: The Passive Strategy 15.

Which of the following statements regarding a buy-and-hold strategy are true?

a. b. c. d.

There are no selection choices to be made under this strategy.

This strategy is applicable only to large portfolios.

There is no reinvestment decision to make under this strategy.

This strategy produces relatively low transactions and search costs.

Ans: d Difficulty: Moderate Ref: The Passive Strategy

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16.

Which of the following is not considered a passive equity investment:

a. b. c. d.

investing in a sector ETF. investing in an S&P 500 index mutual fund. investing in a multi-strategy hedge fund. investing in a Russell 2000 index mutual fund.

Ans: c Difficulty: Easy Ref: The Passive Strategy 17.

Which of the following statements concerning index funds and actively managed funds is true?

a. b. c. d.

Their performance is about equal.

They tend to have an inverse relationship.

Actively managed funds tend to outperform index funds.

Index funds tend to outperform actively managed funds.

Ans: d Difficulty: Difficult Ref: The Passive Strategy 18.

A significant advantage of index funds is their:

a. b. c. d.

lower market price than other types of funds. superior sector rotation approach. tax efficiency. minimization of risk.

Ans: c Difficulty: Moderate Ref: The Passive Strategy 19.

A fund that uses futures to hold the S&P 500 Index and invests the remainder in bonds would be an example of:

a. b. c. d.

a value index fund. a derivatives index fund. an enhanced index fund. an active index fund.

Ans: c Difficulty: Difficult Ref: The Passive Strategy

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20.

One of the most famous investment advisory services since 1965 is:

a. b. c. d.

the Wall Street Journal.

Standard and Poor’s Corporate Records.

Moody’s. the Value Line Investment Survey.

Ans: d Difficulty: Moderate Ref: The Active Strategy 21.

The central focus of a security analyst’s job is to:

a. b. c. d.

ascertain the accuracy of financial statements of selected companies. find growth stocks. forecast a specific company’s return. determine the market demand for a specific company’s stock.

Ans: c Difficulty: Moderate Ref: The Active Strategy 22.

An analyst employed by a pension fund to identify stocks to be purchased is referred to as:

a. b. c. d.

a sell-side analyst. a buy-side analyst. an institutional analyst. a money manager.

Ans: b Difficulty: Easy Ref: The Active Strategy 23.

What evidence, gathered during the 1990s, about analysts was instrumental in motivating changes in market regulations?

a. b. c. d.

They were paid too much.

They were unable to accurately pinpoint earnings.

They gave buy recommendations to win investment banking business.

They shared private information about companies with investors.

Ans: c Difficulty: Moderate Ref: The Active Strategy

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24.

The so-called "global settlement" negotiated by the SEC, NYSE, and NASD with a number of brokerage firms was intended to:

a. b. c. d.

ensure more disclosure of relevant information to investors. separate investment banking from analyst research. stop the practice of buy, sell, or hold recommendations in analysts' reports. stop the practice of trading on inside information.

Ans: b Difficulty: Difficult Ref: The Active Strategy 25.

Which strategy involves shifting the weights of securities in a portfolio to take advantage of security groups expected to do relatively better than others?

a. b. c. d.

Portfolio management Technical analysis Momentum strategy Sector rotation

Ans: d Difficulty: Moderate Ref: The Active Strategy 26.

Market timers attempt to earn abnormal returns by:

a. b. c. d.

adjusting the ratio of aggressive equity securities to defensive equity securities. shifting the mix of short-term securities to long-term securities. varying the percentage of portfolio assets in equity securities. adjusting the ratio of money market securities to capital market securities.

Ans: c Difficulty: Difficult Ref: The Active Strategy 27.

Which of the following does not represent a requirement for conducting effective sector rotation?

a. b. c. d.

Developing an accurate assessment of current economic conditions.

Having a knowledge and understanding of the phases of the business cycle.

Having an understanding of the political environment.

Having expertise in technical analysis.

Ans: d Difficulty: Difficult Ref: The Active Strategy

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28.

Which of the following statements regarding defensive stocks is true?

a. b. c. d.

They are often expected to have above-average future growth.

They often have high P/E multiples.

They are expected to be adversely affected by high interest rates.

They often produce necessary items such as food and prescription drugs.

Ans: d Difficulty: Moderate Ref: The Active Strategy 29.

Sector rotation:

a. b. c. d.

is a form of passive investing. is an active strategy similar to stock selection. varies the percentage of equities in the portfolio in order to earn abnormal returns. is not dependent on an accurate assessment of current economic conditions.

Ans: b Difficulty: Easy Ref: The Active Strategy 30.

Historically, sell-side equity research has tended to assign:

a. b. c. d.

very unfavorable ratings to target companies. unfavorable ratings to target companies. favorable ratings to target companies. neutral ratings to target companies.

Ans: c Difficulty: Easy Ref: The Active Strategy 31.

Which of the following types of funds is especially popular with investors following a momentum strategy?

a. b. c. d.

Sector funds Managed funds Global funds Index

Ans: a Difficulty: Moderate Ref: The Active Strategy

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32.

Commodity ETF’s are mainly used as speculative plays by:

a. b. c. d.

hedge fund traders. conservative investors. mutual fund managers. value investors.

Ans: a Difficulty: Moderate Ref: The Active Strategy 33.

What is usually considered the biggest risk of market timing?

a. b. c. d.

Getting out of the market too soon Generating high transactions costs Failing to adjust for short-term corrections Being out of the market at critical times

Ans: d Difficulty: Difficult Ref: The Active Strategy 34.

What condition is supported if, after considering transactions costs, stock prices reflect their approximate fair value?

a. b. c. d.

After-cost efficiency Economic efficiency Market equilibrium Mean-variance efficiency

Ans: b Difficulty: Moderate Ref: Rational Markets and Active Strategies 35.

If security prices fully reflect all relevant available information, the security market is said to be:

a. b. c. d.

rational. in equilibrium. effective. efficient.

Ans: d Difficulty: Moderate Ref: Rational Markets and Active Strategies

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36.

The Coffeehouse Portfolio suggests investors hold:

a.

50% bonds, 50% equities (including the S&P 500, Large Cap Value, International, Small Cap, and Small Cap Value stocks).

40% bonds, 60% equities (including the S&P 500, Large Cap Value, International, Small Cap, Small Cap Value, and REITs).

60% bonds, 40% equities (in two index funds).

40% bonds, 60% equities (in two index funds).

b. c. d.

Ans: b Difficulty: Difficult Ref: A Simple Strategy – The Coffeehouse Portfolio 37.

Which of the following statements about analysts’ earnings forecasts is correct?

Analysts’ long-term forecasts tend to be too:

a. b. c. d.

high, whereas their near-term forecasts tend to be too low. high, and their near-term forecasts also tend to be too high. low, whereas their near-term forecasts tend to be too high. low, and their near-term forecasts also tend to be too low.

Ans: a Difficulty: Difficult Ref: Analyst Earnings Estimates

True-False Questions 1.

A general guideline is that investors should probably have at least 20 percent of their portfolio invested in emerging markets.

Ans: False Difficulty: Moderate Ref: A Global Perspective 2.

Market risk is the single most important risk affecting the price movements of common stocks.

Ans: True Difficulty: Moderate Ref: The Impact of the Overall Market on Stocks 3.

The nominal risk-free rate is calculated by subtracting an expected inflation premium from the real risk-free rate.

Ans: False Difficulty: Moderate Ref: The Impact of the Overall Market on Stocks

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4.

A utility stock is likely to have a beta lower than the overall market.

Ans: True Difficulty: Moderate Ref: The Impact of the Overall Market on Stocks 5.

A common asset allocation for a number of institutional investors using only two asset classes is 60 percent equities and 40 percent bonds.

Ans: True Difficulty: Moderate Ref: Building Stock Portfolios 6.

One of the major benefits of employing a buy and hold strategy is the savings on trading costs.

Ans: True Difficulty: Easy Ref: Passive Strategy 7.

As evidence about the efficiency of stock markets has grown, so have index funds.

Ans: True Difficulty: Moderate Ref: Passive Strategy 8.

Index funds are considered relatively tax efficient since they rarely have shortterm gains.

Ans: True Difficulty: Moderate Ref: Passive Strategy 9.

Buy-side analysts will more likely have a potential conflict of interest in a stock than a sell-side analyst.

Ans: False Difficulty: Easy Ref: The Active Strategy 10.

The primary emphasis in fundamental security analysis is on expected sales of the company.

Ans: False Difficulty: Moderate Ref: The Active Strategy

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11.

Due to advances in technology and better understanding of stocks and financial markets, security analysts' estimates have become more accurate.

Ans: False Difficulty: Moderate Ref: The Active Strategy 12.

Under new SEC rules adopted in 2002, price targets for stocks are to be shown.

Ans: True Difficulty: Moderate Ref: The Active Strategy 13.

Sector rotation would be very successful in a truly efficient market.

Ans: False Difficulty: Easy Ref: The Active Strategy 14.

Security analysts receive all of their information from the management of the company.

Ans: False Difficulty: Easy Ref: The Active Strategy 15.

If security prices fully reflect all the relevant information that is available and usable, then the security market is considered to be efficient.

Ans: True Difficulty: Moderate Ref: Rational Markets and Active Strategies

Short-Answer Questions 1.

With respect to proper diversification in asset allocation, what are the general guidelines for a U.S. investor's portfolio regarding foreign securities?

Answer: Difficulty: Ref:

Generally, 30-50 percent of the portfolio in international markets with a relatively minor exposure to emerging markets.

Easy A Global Perspective

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2.

How is the required rate of return utilized in stock analysis?

Answer:

Difficulty: Ref: 3.

An investor using the buy-and-hold strategy will receive dividends to reinvest.

What dividend option do many companies offer that would make this strategy even more passive?

Answer:

Difficulty: Ref: 4.

Difficulty: Ref:

One must choose which stocks to buy-and-hold and must reinvest any dividends received throughout the holding period. An investor that buys an index fund must choose which index fund, but eliminates having to choose individual securities. The fund reinvests dividends and capital gains and provides diversification for even very small investors.

Moderate The Passive Strategy

What are the major reasons investing in index funds works, according to Burton Malkiel?

Answer:

Difficulty: Ref: 6.

Many companies offer dividend reinvestment plans (DRIPs) in which dividends are reinvested in more stock of the company rather than being paid out as cash dividends. This would relieve the investor of deciding how and when to reinvest cash dividends.

Moderate The Passive Strategy

Compare and contrast the passive strategies of buy-and-hold and buying index funds.

Answer:

5.

The required rate of return is the minimum expected return needed to attract investors to purchase the security. The required return is critical information for the potential investor and a focus of the security analyst’s job.

Moderate The Impact of the Overall Market on Stocks

Securities markets are very efficient; Index funds are cost efficient and have low expense and low trading costs; and index funds have a tax advantage since they defer the realization of capital gains.

Moderate The Passive Strategy

What is meant by the term “defensive stocks?” Give some examples.

Answer:

Defensive stocks are those that tend to be fairly stable in downward phases of the business cycle. Examples include food, soft drinks, beer, and pharmaceuticals.

Difficulty: Ref:

Easy The Active Strategy

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7.

How could one invest indirectly in sectors and practice sector rotation?

Answer:

Difficulty: Ref: 8.

There are sector funds that invest in stocks of companies in particular sectors or industries. The investor still has to choose which sectors and which funds in those sectors for investment. The investor would have to change funds to accomplish sector rotation.

Moderate The Active Strategy

In an upward trending market, what sectors might investors consider to increase absolute returns?

Answer:

Difficulty: Ref:

Investors should hold high beta stocks if they expect an “up market”, which would typically include emerging markets, small caps, and growth sectors like technology.

Moderate The Active Strategy

Critical Thinking/Essay Questions 1.

What is the paradox regarding fundamental analysis in regard to the efficient market hypothesis (EMH)?

Answer:

Difficulty: Ref: 2.

The EMH implies that securities are at or very near their intrinsic value at any given time. Fundamental analysis, then, can help establish riskexpected return parameters, but will not uncover mispriced securities. The paradox is that the very fact that fundamental analysis is done is the main contributing factor to the securities being fairly priced.

Difficult The Active Strategy

What are the four broad stock sectors? What is sector rotation? Explain what changes in the business cycle would prompt one to rotate from one sector to another.

Answer:

Difficulty: Ref:

The four sectors are (1) interest-sensitive stocks, (2) consumer durable stocks, (3) capital goods stocks, and (4) defensive stocks. Sector rotation is selling stocks in one sector and buying stocks in a different sector when the business cycle changes in order to be invested in the group that does the best during that cycle. For example, capital goods stocks should do well in a booming economy, but not so well in a recession, because businesses will curtail spending on capital goods. Defensive stocks tend to be fairly stable in both up and down cycles, because people tend to eat, drink, and buy medicine regardless of the economy.

Difficult The Active Strategy

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File: ch12, Chapter 12: MARKET EFFICIENCY Type: Multiple Choice 1.

What is meant by the statement that an efficient market prices securities “correctly?” a. b. c. d.

The prices reported by the securities exchanges accurately reflect real transactions.

Riskier securities are priced to yield higher returns.

The expected return on securities is equal to the risk-free rate of return.

Both buyers and sellers agree that the prices are fair.

Ans: b Difficulty: Easy Ref: The Concept of an Efficient Market 2.

What is the most important determinant of stock price in an efficient market?

a. b. c. d.

Information about past events and beliefs about future events The trading system that connects buyers and sellers within the market The number of traders participating in the market The ability of investors to perfectly adjust prices based on new information

Ans: a Difficulty: Easy Ref: The Concept of an Efficient Market 3.

A characteristic of an efficient market is that:

a. b. c. d.

prices adjust perfectly to new information. announced information events tend to be dependent on one another. investors are price takers. individual investors have the ability to affect security prices.

Ans: c Difficulty: Easy Ref: The Concept of an Efficient Market 4.

An efficient market requires that:

a. b. c. d.

all investors are rational and react quickly to new information. information can be obtained at a considerable cost by investors. new information does not have a significant effect on market prices. investors react quickly and fully to new information.

Ans: d Difficulty: Medium Ref: The Concept of an Efficient Market

5.

In an efficient market, the expected abnormal return on a security is:

a. b. c. d.

equal to zero. equal to the risk-free rate of return. equal to the security’s required return. greater than the security’s required return.

Ans: a Difficulty: Medium Ref: The Concept of an Efficient Market 6.

Which of the following statements regarding Warren Buffett’s wager with Protege Funds is most accurate?

a. b. c. d.

The index fund is outperforming the hedge funds, thus supporting market efficiency.

The index fund is outperforming the hedge funds, thus countering market efficiency.

The index fund is underperforming the hedge funds, thus supporting market efficiency.

The index fund is underperforming the hedge funds, thus countering market efficiency.

Ans: a Difficulty: Medium Ref: The Concept of an Efficient Market 7.

A test which investigates whether publicly available financial accounting information can be used to generate abnormal returns is a direct test of:

a. b. c. d.

weak form market efficiency. semi-strong form market efficiency. strong form market efficiency. mean variance market efficiency.

Ans: b Difficulty: Easy Ref: How to Test for Market Efficiency 8.

Using technical analysis to consistently earn abnormal returns is consistent with which form of the Efficient Market Hypothesis?

a. b. c. d.

None Weak form Semi-strong form Strong form

Ans: a Difficulty: Medium Ref: How to Test for Market Efficiency

9.

What is meant by the expression stock prices follow a “random walk?”

a. b. c. d.

The best prediction of next period’s price change is last period’s price change.

Stock price changes do not depend statistically on prior price changes.

Stock price changes tend to be positive.

Stock price changes do not reflect market information.

Ans: b Difficulty: Medium Ref: How to Test for Market Efficiency 10.

According to the strong form of the efficient market hypothesis, which investors should expect to earn abnormal returns?

a. b. c. d.

Investors with superior analytic ability Investors with access to nonpublic information Investors with access to public and nonpublic information No investors

Ans: d Difficulty: Medium Ref: Forms of Market Efficiency 11.

Research suggests company insiders earn abnormal returns on their stock transactions.

What does this research mean for the efficient market hypothesis (EMH)?

a. b. c. d.

Insider trading has nothing to do with the EMH. Profitable insider trading contradicts all forms of the EMH. Profitable insider trading contradicts only the weak form of the EMH. Profitable insider trading contradicts only the strong form of the EMH

Ans: d Difficulty: Medium Ref: How to Test for Market Efficiency 12.

Which of the following is the best definition of “behavioral finance?”

a. b. c. d.

Behavioral finance studies how financial market participants behave.

Behavioral finance studies the ethical behavior of investors.

Behavioral finance studies what investors should do to optimize performance.

Behavioral finance studies how investor biases and emotions affect stock prices.

Ans: d Difficulty: Easy Ref: Behavioral Finance

13.

Which of the following is an investment strategy that relies on the “overreaction hypothesis?”

a. b. c. d.

Buy and hold Value investing Momentum Contrarian

Ans: d Difficulty: Medium Ref: Market Anomalies 14.

What is meant by the “disposition effect?”

a. b. c. d.

Investors are more likely to sell winners than losers.

Investors are more likely to sell losers than winners.

Investors sell both winners and losers too soon.

Investors hold both winners and losers too long.

Ans: a Difficulty: Easy Ref: Behavioral Finance 15.

Research suggests that low P/E stocks outperform high P/E stocks. Why is this finding an anomaly?

a. b. c. d.

Low P/E stocks tend to have higher risk than high P/E stocks.

Low P/E stocks are temporarily out of favor but may have strong prospects.

The low P/E effect contradicts the Efficient Market Hypothesis.

Low P/E stocks are often weak companies.

Ans: c Difficulty: Medium Ref: Market Anomalies 16.

Which of the following best describes the so-called size effect?

a. b. c. d.

On average, small cap stocks return more than large cap stocks.

On average, large cap stocks return more than small cap stocks.

On average, small cap stocks earn abnormal returns.

Small cap stocks tend to perform exceptionally well during bull markets.

Ans: c Difficulty: Difficult Ref: Market Anomalies

17.

The momentum effect indicates that stocks with the:

a. b. c. d.

best long-term past performance will continue to perform well. best short-term past performance will continue to perform well. worst long-term past performance will reverse course and perform well. worst short-term past performance will reverse course and perform well.

Ans: b Difficulty: Medium Ref: Market Anomalies 18.

Which of the following observations is most consistent with the EMH?

a. b. c. d.

The January effect The random walk The low P/E effect The success of the Value Line Investment Survey

Ans: b Difficulty: Medium Ref: Market Anomalies 19.

The January effect can be largely attributed to the exceptional performance of:

a. b. c. d.

low P/E stocks in January. winner stocks in January. loser stocks in January. small stocks in January.

Ans: d Difficulty: Easy Ref: Some Conclusions about Market Efficiency 20.

Which of the following is not an investor trading bias?

a. b. c. d.

Loss aversion Framing Overconfidence Mean reversion

Ans: d Difficulty: Medium Ref: Behavioral Finance

21.

In tests of market efficiency, CAR refers to:

a. b. c. d.

cumulative average return. compound average return. compound annual return. cumulative abnormal return.

Ans: d Difficulty: Medium Ref: How to Test for Market Efficiency 22.

The SUE effect suggests that superior performance is associated:

a. b. c. d.

with stocks exhibiting strong recent price performance. with stocks exhibiting weak long-term past price performance. with stocks that have beat their earnings estimate. with stocks that have low price multiples.

Ans: c Difficulty: Ref: Market Anomalies 23.

The overconfidence bias tends to encourage investors to:

a. b. c. d.

trade too much. trade too infrequently. sell winners to early. hold losers to long.

Ans: a Difficulty: Medium Ref: Behavioral Finance 24.

The value effect suggests that investors can earn abnormal returns by holding stocks with:

a. b. c. d.

low price multiples. high price multiples. small size and strong recent performance. large size and strong recent performance.

Ans: a Difficulty: Ref: Market Anomalies

25.

Data mining refers to the search for security return patterns by:

a. b. c. d.

regressing firm stock returns against firm price multiples. calculating CARs relative to firm earnings announcements. applying various investment techniques to a set of return data. applying filter tests to very large samples of return data.

Ans: c Difficulty: Ref: Tests of Market Efficiency

Type: True/False 1.

The financial markets in the U.S. are less efficient than financial markets in less developed countries.

Ans: False Difficulty: Easy Ref: The Concept of an Efficient Market 2.

Evidence indicates that the majority of actively-managed, large cap equity funds outperform the S&P 500 Index.

Ans: False Difficulty: Easy Ref: Some Conclusions about Market Efficiency 3.

Efficient markets imply investors can not earn abnormal returns.

Ans: True Difficulty: Medium Ref: Market Anomalies 4.

Financial economists have tested various technical trading rules and found they fail to earn consistent abnormal returns.

Ans: True Difficulty: Easy Ref: How to Test for Market Efficiency

5.

“Event studies” study return patterns around specific events such as stock splits or dividend announcements.

Ans: True Difficulty: Medium Ref: The Concept of an Efficient Market 6.

The SEC has laws to punish insider trading, which implies that the SEC believes in the strong form of the Efficient Market Hypothesis.

Ans: False Difficulty: Difficult Ref: How to Test for Market Efficiency 7.

If a public company reports earnings substantially lower than expected, the stock should subsequently earn a positive abnormal return.

Ans: False Difficulty: Easy Ref: Market Anomalies 8.

Historically, stock returns for companies with low P/E ratios have been better than returns for stocks with high P/E ratios.

Ans: True Difficulty: Easy Ref: Market Anomalies 9.

On average, small, less well-known companies have lower long-run returns than larger, more well-known companies.

Ans: False Difficulty: Easy Ref: Market Anomalies 10.

To have strong form market efficiency, semi-strong form efficiency is necessary.

Ans: True Difficulty: Easy Ref: The Concept of an Efficient Market

11.

Behavioral finance integrates sociology with finance. It argues that investors often make systematic mistakes when processing social information about market participants.

Ans: False Difficulty: Medium Ref: Behavioral Finance 12.

One explanation for the January effect is that tax-induced sales in December temporarily depress prices, and these prices tend to recover in January.

Ans: True Difficulty: Medium Ref: Market Anomalies

File: Ch. 13, Chapter 13: Economy Market Analysis

Multiple Choice Questions a)

What portion of the world’s market capitalization (world’s GDP) is comprised of U.S. firms?

a. b. c. d.

1/5 world market cap, (1/4 world GDP) 1/4 world market cap, (1/3 world GDP) 1/3 world market cap, (1/3 world GDP) 1/2 world market cap, (2/3 world GDP)

Ans: c Difficulty: Easy Ref: Taking a Global Perspective 2.

The value of goods and services produced by foreign-owned business on U.S. land is included in:

a. b. c. d.

U.S. GDP, only.

U.S. GNP, only. both U.S. GDP and U.S. GNP. neither U.S. GDP, nor U.S. GNP.

Ans: a Difficulty: Moderate Ref: Taking a Global Perspective 3.

Which of the following is included in Gross Domestic Product (GDP)?

a. b. c. d.

The value of final goods, only The value of final goods and services, only The value of final goods, services, and labor, only The value of final goods, services, labor, and capital

Ans: b Difficulty: Easy Ref: Assessing the Economy

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4.

Historically, the average revision in the Bureau of Economic Analysis’ GDP growth rate forecast from its advance to final estimate has been approximately:

a. b. c. d.

1/4 of a percentage point.

2/3 of a percentage point.

1 percentage point.

5 percentage points.

Ans: b Difficulty: Moderate Ref: Assessing the Economy 5.

The advance estimate by the Bureau of Economic Analysis predicts direction of quarterly change in real GDP growth approximately what percent of the time?

a. b. c. d.

10% 25% 50% 90%

Ans: d Difficulty: Moderate Ref: Assessing the Economy 6.

The period from a peak to a trough in economic activity is:

a. b. c. d.

a cycle. an inflection point. a recession. a depression.

Ans: c Difficulty: Moderate Ref: Assessing the Economy 7.

In the U.S., since the end of World War II, the typical business cycle consists of an expansion of how many months?

a. b. c. d.

10 23 35 57

Ans: d Difficulty: Moderate Ref: Assessing the Economy

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8.

In the U.S., since the end of World War II, the typical business cycle contraction has had a duration of:

a. b. c. d.

10 months.

21 months.

32 months.

46 months.

Ans: a Difficulty: Moderate Ref: Assessing the Economy 9.

The National Bureau of Economic Research (NBER) is:

a. b. c. d.

a division of the Department of Commerce of the U.S. Government. an association of academic and professional economic forecasters. a unit within the U.S. Federal Reserve. a private nonprofit organization.

Ans: d Difficulty: Moderate Ref: Assessing the Economy 10.

Which of the following is not a component of GDP?

a. b. c. d.

Business investment spending Government investment spending Net exports Financial transactions

Ans: d Difficulty: Moderate Ref: Assessing the Economy 11.

In the U.S., the largest component of GDP is:

a. b. c. d.

government spending. business investment. consumer spending. real estate expenditures.

Ans: c Difficulty: Easy Ref: Assessing the Economy

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12.

Which of the following is not a type of index of general economic activity?

a. b. c. d.

Lagging indicators Emerging indicators Leading indicators Coincident indicators

Ans: b Difficulty: Moderate Ref: Assessing the Economy 13.

Which of the following is considered a leading indicator of a country’s economy?

a. b. c. d.

Unemployment rate Stock prices Money supply Interest rate spread

Ans: b Difficulty: Moderate Ref: Assessing the Economy 14.

The institution most involved with the U.S. money supply and interest rates is:

a. b. c. d.

the Treasury Department. the Federal Reserve. the Department of Commerce. the U.S. Mint.

Ans: b Difficulty: Easy Ref: Assessing the Economy 15. When speculation pushes asset prices to unsustainable highs, this is known as a: a. b. c. d.

crash. contraction. recession. bubble.

Ans: d Difficulty: Easy Ref: Assessing the Economy

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16.

Stock investors pay attention to the bond market because:

a. b. c. d.

it is more stable than the stock market. it provides signals about interest rate expectations. it is a more accurate measure of overall economic activity. it is privy to more government information, especially from the Federal Reserve.

Ans: b Difficulty: Moderate Ref: Assessing the Economy 17.

When interest rates fall, bond prices:

a. b. c. d.

rise. fall. remain unchanged. rise or fall depending on the expected inflation premium.

Ans: a Difficulty: Easy Ref: Assessing the Economy 18.

Many investors view an inverted yield curve as a precursor to:

a. b. c. d.

an accelerating economy. a slowing economy. a recession. rising inflation.

Ans: c Difficulty: Easy Ref: Assessing the Economy 19.

Which of the following is a publication that compiles consensus economic forecasts?

a. b. c. d.

The Wall Street Journal's Economic Letter The Conference Board's Economic Forecast The Kiplinger Letter Blue Chip Economic Indicators

Ans: d Difficulty: Moderate Ref: Assessing the Economy

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20.

In the early stages of a business cycle, the yield curve is usually:

a. b. c. d.

upward sloping. flat. downward sloping. humped.

Ans: a Difficulty: Moderate Ref: Assessing the Economy 21.

With a steep, upward-sloping yield curve, investors expect:

a. b. c. d.

inflation rates and interest rates to increase. inflation rates to increase and interest rates to decrease. inflation rates to decrease and interest rates to increase. inflation rates and interest rates to decrease.

Ans: a Difficulty: Moderate Ref: Assessing the Economy 22.

Traditionally, when have stock prices generally peaked?

a. b. c. d.

Two years before the start of a recession One year before the start of a recession At the start of a recession One year after the start of a recession

Ans: b Difficulty: Moderate Ref: The Stock Market and the Economy 23.

Current stock prices reflect:

a. b. c. d.

investors' confidence in the current economy. investors' confidence in the current administration. investors' expectations of the future. investors' attitudes about the past market.

Ans: c Difficulty: Moderate Ref: The Stock Market and the Economy

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24.

When investors say that “the market” is up, they are usually referring to:

a. b. c. d.

the DJIA. the NYSE. the NASDAQ. GDP.

Ans: a Difficulty: Easy Ref: The Stock Market and the Economy 25.

The relationship between the stock market and the business cycle is generally considered reliable, but the stock market tends to give false signals about:

a. b. c. d.

business cycle peaks (booms). business cycle troughs (recessions). business cycle inflection points between peaks and troughs. ex post stock market returns.

Ans: b Difficulty: Difficult Ref: The Stock Market and the Economy 26.

Which of the following actions is the Federal Reserve most likely to take to stimulate the economy?

a. b. c. d.

Selling bonds Buying bonds Increasing spending Reducing the reserve requirement

Ans: b Difficulty: Moderate Ref: Assessing the Economy 27.

Traditionally, how many months before an economic recovery have stock prices started increasing?

a. b. c. d.

3-5, with 4 typical 5-7, with 6 typical 8-10, with 9 typical 10-12, with 11 typical

Ans: a Difficulty: Moderate Ref: The Stock Market and the Economy

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28.

Assume the dividend payout ratio on the S&P 500 is 40 percent when the rate on long-term T-bonds is 9 percent, and investors demand an equity risk premium of 8 percent. If the growth rate of dividends is expected to be 10 percent, what is the price of the market index if the earnings expectation is $30?

a. b. c. d.

$384.00 $213.44 $266.56 $171.43

Solution:

D1 k P0

= = = =

0.40($30) = $12 0.09 + 0.08 = 0.17 D1/(k – g) 12/(0.17 - 0.10) = $171.43

Ans: d Difficulty: Difficult Ref: The Stock Market and the Economy 29.

P/E ratios are generally depressed when interest rates:

a. b. c. d.

are high and inflation expectations are low. are low and inflation expectations are high. are high and inflation expectations are high. are low and inflation expectations are low.

Ans: c Difficulty: Moderate Ref: The Stock Market and the Economy 30.

If the trailing P/E for the S&P 500 is 18 and the forward P/E for the S&P 500 is 15, which of the following is true?

a. b. c. d.

The stock market is expected to decrease The stock market is expected to increase Corporate earnings are expected to decrease Corporate earnings are expected to increase

Ans: d Difficulty: Difficult Ref: Making Market Forecasts

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31.

The Fed model, which uses the E/P ratio in its calculations:

a. b. c. d.

is relatively complex. uses the yield on the 3-month Treasury bill as the risk-free rate. assumes investors can easily switch between stocks and bonds. is used by the Federal Reserve to assess its monetary policy.

Ans: c Difficulty: Difficult Ref: Making Market Forecasts 32.

Which of the following types of yield curves is typically considered to be associated with an economic expansion?

a. b. c. d.

A steep, upward-sloping yield curve A flat yield curve An inverted yield curve A positively skewed yield curve

Ans: a Difficulty: Moderate Ref: Making Market Forecasts 33.

Warren Buffett thinks long-term movements in stock prices are caused by which of the following two economic variables?

a. b. c. d.

Interest rates and corporate profits Interest rates and the value of the dollar Inflation and unemployment Inflation and growth in GDP

Ans: a Difficulty: Difficult Ref: Making Market Forecasts 34.

Which of the following statements regarding market P/E ratios is true?

a. b. c. d.

P/E ratios are higher when interest rates are lower.

P/E ratios are higher when dividend yields are higher.

P/E ratios are higher when inflation is higher.

P/E ratios are higher when unemployment is lower.

Ans: a Difficulty: Moderate Ref: Making Market Forecasts

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35.

The earnings yield, which is used in the Fed model, is the:

a. b. c. d.

same as the dividend yield. inverse of the dividend yield. same as the P/E ratio. inverse of the P/E ratio.

Ans: d Difficulty: Moderate Ref: Making Market Forecasts 36.

Which of the following are the two components of the Fed’s dual mandate?

a. b. c. d.

Interest rates and stock prices Gold prices and interest rates Unemployment and the inflation rate GDP growth and money supply growth

Ans: c Difficulty: Moderate Ref: Assessing the Economy

True-False Questions 1.

Despite political, cultural, and economic differences, foreign markets are driven largely by the same factors that drive U.S. markets.

Ans: True Difficulty: Moderate Ref: A Global Perspective 2.

The longest peacetime expansion ran from 1991 to 2000.

Ans: True Difficulty: Moderate Ref: Assessing the Economy 3.

To value the market, an investor must analyze both corporate earnings and multipliers.

Ans: True Difficulty: Moderate Ref: Assessing the Economy

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4.

Most analysts agree that using the money supply as an indicator of future economic activity is accurate.

Ans: False Difficulty: Moderate Ref: Assessing the Economy 5.

The stock market is a leading indicator of the economy because investors discount future cash flows.

Ans: True Difficulty: Moderate Ref: Assessing the Economy 6.

On average, the typical business cycle in the United States leads the stock market’s turning point by a few months.

Ans: False Difficulty: Moderate Ref: Assessing the Economy 7.

Investors should keep a watch on the Federal Reserve because of the effect of Fed policy actions on interest rates and security returns.

Ans: True Difficulty: Easy Ref: Assessing the Economy 8.

The Dow Jones Industrial Average provides the best representation of the performance of U.S. stocks.

Ans: False Difficulty: Moderate Ref: The Stock Market and the Economy 9.

P/E ratios are generally low when interest rates and inflation are high.

Ans: True Difficulty: Moderate Ref: The Stock Market and the Economy 10.

If interest rates rise, the risk-free rate declines.

Ans: False Difficulty: Moderate Ref: The Stock Market and the Economy

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11.

If the economy is prospering, investors expect corporate earnings to rise.

Ans: True Difficulty: Easy Ref: The Stock Market and the Economy 12.

When using the P/E valuation model, it is important to remember that the multiplier is more volatile than the earnings component.

Ans: True Difficulty: Moderate Ref: The Stock Market and the Economy 13.

Assuming a constant P/E ratio, the growth in stock prices should equal the growth in earnings.

Ans: True Difficulty: Moderate Ref: Making Market Forecasts 14.

According to available evidence, investors lose more by missing a bull market than by staying in a bear market.

Ans: True Difficulty: Moderate Ref: Making Market Forecasts 15.

Stock prices have almost always risen as the business cycle is approaching a trough.

Ans: True Difficulty: Moderate Ref: Making Market Forecasts 16.

Over the past 30 years, the average P/E ratio for the S&P 500 has been 20.

Ans: False Difficulty: Moderate Ref: Making Market Forecasts 17.

During periods of restrictive Federal Reserve monetary policy, the stock market usually performs poorly.

Ans: True Difficulty: Moderate Ref: Making Market Forecasts

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Short-Answer Questions 1.

Why is the stock market a leading indicator of the economy? Use the constantgrowth dividend discount model in your explanation.

Answer:

Difficulty: Ref: 2.

Why do stock investors pay attention to the bond market?

Answer: Difficulty: Ref: 3.

No. P/Es vary too much from year to year.

Easy The Stock Market and the Economy

The financial news reports that the market is overvalued at a near record high based on the earnings multiplier. What does that mean to you?

Answer:

Difficulty: Ref: 5.

The bond market provides daily information about the economy through interest rates. This information is useful to stock investors.

Easy Assessing the Economy

Is it useful to do a trend analysis of P/E ratios of the S&P 500 Composite Index over time and extrapolate it to project future expected P/Es?

Answer: Difficulty: Ref: 4.

Stock prices are based on investors’ expectations about the future and are, therefore, indicators of the future. The model P0 = D1/(k – g) shows that the current price depends on future dividends, thus making market prices a leading indicator of the economy.

Moderate Assessing the Economy

This suggests that prices are increasing faster than earnings, thus P/E ratios (also called earnings multipliers) are higher than usual. Some analysts would prepare for the market to fall back to more “normal” P/E levels, meaning that price declines are in store. Others would expect the exuberance to continue.

Moderate The Stock Market and the Economy

Use the constant-growth dividend discount model to explain why stock prices have an inverse relationship to interest rates.

Answer:

Difficulty: Ref:

The stock price (P0) based on the model P0 = D1/(k – g) decreases as the required rate of return (k) increases. The required rate of return (k) increases as interest rates increase.

Moderate The Stock Market and the Economy

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6.

Why is there an inverse relationship between P/Es and dividend yield?

Answer:

Difficulty: Ref: 7.

Price is in the numerator of P/E and in the denominator in dividend yield.

Dividends are paid from earnings, which links the other variable in each ratio.

Moderate The Stock Market and the Economy

Explain how dividend yield on the S&P 500 Index can be used to make market forecasts.

Answer:

Difficulty: Ref:

When the dividend yield drops to unusually low levels, many investors believe the market is expected to rise in the near future. Investors will purchase stocks and sell lower yielding bonds, causing prices to adjust.

Moderate Making Market Forecasts

Fill-in-the-blank Questions 1.

Approaches to assessing the stock market’s likely direction include application of the ________________ model, also called the Fed model.

Answer: Difficulty: Ref: 2.

E/P Moderate Making Market Forecasts

According to Warren Buffett, the two critical economic variables are: _______________ and _________________.

Answer: Difficulty: Ref:

interest rates, expected corporate profits.

Moderate Making Market Forecasts

Critical Thinking/Essay Questions 1.

How does the increased globalization of business and finance affect business cycles and the leading, lagging, and coincident economic indicators?

Answer:

Difficulty: Ref:

It may be that economic cycles may be more attuned to global economics instead of domestic economics. Likewise, traditional domestic economic indicators may lose some of their effectiveness as global business places more influence over the domestic economy.

Difficult Making Market Forecasts

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2.

What are the implications of the article “Overcoming the Bear Market Blues” for investors?

Answer:

Difficulty: Ref:

Two points emerge: The first is that the investor is better off in the market than out of the market waiting for the right time to invest, because one has more to lose by missing the bull markets than by avoiding the bear markets. The second point is that depressed markets are the best time to buy, so investors should overcome their emotional inclination to sell when the market is down.

Moderate Making Market Forecasts

Problems 1.

Assume that the dividends to be paid on a particular market index next period are expected to be $20. Investors require 15 percent to invest in stocks, and expect dividends to grow at 10 percent per year. What is the value of this index?

Solution:

P0 = D1/(k – g) = 20/(0.15 – 0.10) = $400

Difficulty:

Moderate

2.

Value Line's estimated dividends on its Industrial Composite for 201X are $2.00 while estimated earnings are $4.30. The expected spread between k and g is 4%. (a) (b)

Solution:

Difficulty:

What is the P/E ratio?

What is the estimated price for this Index?

(a)

P/E

= (D1/E1) / (k – g) = 11.63

=

(2.00/4.30) / (0.04)

(b)

P

= (P/E) (EPS) = $50

=

(11.63)(4.30)

Moderate

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3.

The earnings per share on a composite stock index this past year was $3.25. The earnings are expected to grow at a constant rate of 7 percent forever. The dividend payout ratio is expected to continue at its current rate of 35 percent, and the dividend yield is expected to be 4 percent. Calculate the intrinsic value of the composite stock index.

Solution:

D1

= = =

D1/P0 = 1.22/P0 = P0 =

D0(1 + g) (D0/E0)(E0)(1 + g) (0.35)(3.25)(1.07) = $1.217 Dividend Yield 0.04 $30.43

Difficulty: Moderate

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File: Ch. 14, Chapter 14: Industry Analysis

Multiple Choice Questions 1.

The second step in the fundamental analysis of common stock is:

a. b. c. d.

company analysis. economy analysis. industry analysis. business cycle analysis.

Ans: c Difficulty: Easy Ref: Introduction 2.

Standard & Poor's new Global Industry Classification Standard divides firms into:

a. b. c. d.

10 economic sectors.

24 economic sectors.

68 economic sectors.

154 economic sectors.

Ans: a Difficulty: Moderate Ref: What is an Industry?

3.

Standard and Poor's new Global Industry Classification Standard includes approximately:

a. b. c. d.

10,000 companies.

25,000 companies.

60,000 companies.

100,000 companies.

Ans: b Difficulty: Moderate Ref: What is an Industry?

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4.

A well-known and widely used system that classified industries for more than 60 years was the:

a. b. c. d.

Commercial Industrial Classification system.

National Industrial Classification system.

Standard Industrial Classification system.

American Industrial Classification system.

Ans: c Difficulty: Easy Ref: What is an Industry?

5.

Which of the following has 10 economic sectors, 24 industry groupings, 64 industries and 139 sub-industries?

a. b. c. d.

SIC NAICS GICS Value Line Investment Survey

Ans: c Difficulty: Moderate Ref: What is an Industry?

6.

Industry analysis is important because:

a. b. c. d.

companies can only do as well as their industry. industries often have an inverse relationship to the market. industries perform very differently over time. companies in declining industries lose money.

Ans: c Difficulty: Moderate Ref: The Importance of Sector/Industry Analysis

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7.

Based on past evidence, if an industry has the number one ranking on price performance, which of the following statements is most accurate? The investor should:

a. b. c. d.

not expect that same industry to be ranked number one again next year. expect that industry to maintain its top ranking for five years or more. expect that industry to do well over the next 10 to 20 years. expect that industry to drop out of the top ten rankings within five years.

Ans: a Difficulty: Moderate Ref: The Importance of Sector/Industry Analysis 8.

Which life cycle stage generally sees industries improving their products, lowering prices, and starting to attract considerable investment funds?

a. b. c. d.

Pioneering stage Expansion stage Stabilization stage Declining stage

Ans: b Difficulty: Moderate Ref: Analyzing Sectors/Industries 9.

At what stage of a company’s life cycle does an investor typically stand to earn the highest return? a. b. c. d.

Pioneering stage Expansion stage Stabilization stage Declining stage

Ans: a Difficulty: Moderate Ref: Analyzing Sectors/Industries

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10.

Which of the following is not one of the stages of the industry life cycle?

a. b. c. d.

Expansion Destabilization Declining Pioneering

Ans: b Difficulty: Moderate Ref: Analyzing Sectors/Industries 11.

The basic competitive forces facing industries include all of the following except:

a. b. c. d.

bargaining power of suppliers. threat of government regulation. rivalry between existing competitors. threat of substitute products.

Ans: b Difficulty: Difficult Ref: Analyzing Sectors/Industries 12.

Which of the following is a limitation of the life cycle approach to security analysis?

a. b. c. d.

It focuses on sales rather than stock prices.

It focuses on the past more than the present.

It does not consider the risk in the different cycles.

It does not consider quantitative factors.

Ans: a Difficulty: Moderate Ref: Analyzing Sectors/Industries

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13.

At what stage in the industry life cycle do financial policies become firmly established?

a. b. c. d.

Pioneering stage Expansion stage Stabilization stage Declining stage

Ans: b Difficulty: Moderate Ref: Analyzing Sectors/Industries 14.

The U.S. is moving from an:

a. b. c. d.

agricultural society to an industrial society. agricultural society to an information society. industrial society to an information society. information society to an industrial society.

Ans: c Difficulty: Moderate Ref: Analyzing Sectors/Industries 15.

When conducting industry analysis, investors should consider the historical data for all of the following except:

a. b. c. d.

sales growth. earnings growth. interest rates. price performance.

Ans: c Difficulty: Moderate Ref: Analyzing Sectors/Industries 16.

Which of the following statements about the industry life cycle is incorrect?

a. b. c. d.

Companies may stay in one phase for a significant period of time.

All industries can be classified accurately into a specific phase.

The general framework may not apply to some industries.

The approach does not explicitly lead to a stock price determination.

Ans: b Difficulty: Moderate Ref: Analyzing Sectors/Industries

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17.

The most important point of Michael Porter's analysis is that industry profitability is a function of:

a. b. c. d.

economic conditions. the level of interest rates. the industry structure. the industry beta.

Ans: c Difficulty: Moderate Ref: Analyzing Sectors/Industries 18.

Which of the following is not among the qualitative factors that should be analyzed to assess an industry's future?

a. b. c. d.

Historical performance Competition Growth rate of sales Structural changes

Ans: c Difficulty: Moderate Ref: Analyzing Sectors/Industries 19.

Regarding the qualitative aspects of industry analysis, the breakup of AT&T in 1984 would be considered a:

a. b. c. d.

structural change. government effect. competitive effect. cyclical effect.

Ans: b Difficulty: Easy Ref: Analyzing Sectors/Industries

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20.

The food industry would be considered a:

a. b. c. d.

growth industry. defensive industry. cyclical industry. countercyclical industry.

Ans: b Difficulty: Moderate Ref: Using Sector/Industry Analysis as an Investor 21.

Which of the following types of industries is likely to be least affected in a recession?

a. b. c. d.

Expansionary Interest-rate sensitive Defensive Countercyclical

Ans: c Difficulty: Moderate Ref: Using Sector/Industry Analysis as an Investor 22.

Which of the following industry categories is said to be "bought to be sold?"

a. b. c. d.

Cyclical Defensive Growth Countercyclical

Ans: a Difficulty: Moderate Ref: Using Sector/Industry Analysis as an Investor 23.

Which of the following is not considered an interest-rate sensitive industry?

a. b. c. d.

Building industry Banking industry Financial services industry Tobacco industry

Ans: d Difficulty: Easy Ref: Using Sector/Industry Analysis as an Investor

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24.

Which of the following sectors was most adversely affected by the accounting changes requiring the expensing of stock options?

a. b. c. d.

Manufacturing Technology Energy Utilities

Ans: b Difficulty: Moderate Ref: Using Sector/Industry Analysis as an Investor 25.

Which of the following types of industries would be expected to perform the worst during an economic contraction?

a. b. c. d.

Growth Defensive Cyclical Value

Ans: c Difficulty: Difficult Ref: Using Sector/Industry Analysis as an Investor 26.

Which decade is commonly referred to as the “lost decade” due to the poor performance of U.S. stocks?

a. b. c. d.

The 1970s The 1980s The 1990s The 2000s

Ans: d Difficulty: Easy Ref: Summary

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27.

Which of the following industries would you have most liked to have been invested in over the past 25 years?

a. b. c. d.

Steelworks Consumer durables Mining and minerals Food

Ans: d Difficulty: Moderate Ref: Using Sector/Industry Analysis as an Investor 28.

Which industry has been devastated by changes in EPA regulations since 2010?

a. b. c. d.

Telecom Coal Chemicals Oil

Ans: b Difficulty: Easy Ref: Using Sector/Industry Analysis as an Investor 29.

Which of the following sectors has the highest beta?

a. b. c. d.

Food Utilities Automobiles Drugs, soap, perfumes and tobacco

Ans: c Difficulty: Moderate Ref: Using Sector/Industry Analysis as an Investor

True-False Questions 1.

The Value Line Investment Survey covers approximately 60 industries.

Ans: False Difficulty: Moderate Ref: What is an Industry?

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184

2.

The NAICS puts companies into industries based on the activity in which they are primarily engaged.

Ans: True Difficulty: Moderate Ref: The NAICS Classification System 3.

It is a relatively simple matter of finding industries that will perform well in the short run.

Ans: False Difficulty: Moderate Ref: The Importance of Sector/Industry Analysis 4.

In the expansion stage, products become more standardized.

Ans: False Difficulty: Difficult Ref: Analyzing Sectors/Industries 5.

One limitation of the life cycle approach is that all companies fall into a specific category.

Ans: False Difficulty: Easy Ref: Analyzing Sectors/Industries 6.

The expansion stage of the industry life cycle is probably of most interest to investors because growth is rapid and risk is tolerable.

Ans: True Difficulty: Moderate Ref: Analyzing Sectors/Industries 7.

Since performance is not always consistent, an industry's track record should not be of much concern to investors.

Ans: False Difficulty: Moderate Ref: Analyzing Sectors/Industries

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185

8.

A company’s founders, friends, and family are typically the main investors in the pioneering stage of any company.

Ans: True Difficulty: Easy Ref: Analyzing Sectors/Industries 9.

The food industry is a good example of a countercyclical industry.

Ans: False Difficulty: Moderate Ref: Using Sector/Industry Analysis as an Investor 10.

Growth industries often perform well during economic setbacks.

Ans: True Difficulty: Moderate Ref: Using Sector/Industry Analysis as an Investor 11.

Countercyclical and defensive are different terms for the same industry type.

Ans: False Difficulty: Moderate Ref: Using Sector/Industry Analysis as an Investor 12.

Mature industries typically have much higher P/E ratios than growth industries, which are riskier.

Ans: False Difficulty: Moderate Ref: Using Sector/Industry Analysis as an Investor 13.

The North American Industry Classification System (NAICS) was developed using a production-oriented approach, resulting in companies being classified into industries based on the activity in which they are primarily engaged.

Ans: True Difficulty: Easy Ref: The NAICS Classification System

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186

Short-Answer Questions

1.

How can historical performance help the analyst assess the future prospects for an industry?

Answer:

Difficulty: Ref: 2.

In which stage of the industry life cycle is it easiest for the analyst to assess industry prospects and identify the leading companies?

Answer:

Difficulty: Ref: 3.

The stabilization or maturity stage is the easiest to analyze because the industry has a long-term track record of performance in various economic scenarios. The major players in the industry are well-known, established companies with limited growth prospects. There are few new products or new entrants, as the barriers to entry are high with an already crowded playing field.

Moderate Analyzing Sectors/Industries

What are four basic aspects of qualitative assessment of industries?

Answer: Difficulty: Ref: 4.

Historical performance tells the analyst where the industry has been. It provides a starting point. The analyst adds judgment and information about new products, markets, competition, etc. to reach an opinion about the future prospects of the industry for the future.

Moderate Analyzing Sectors/Industries

Historical performance, competition, government effects, and structural changes.

Easy Analyzing Sectors/Industries

What are the five competitive factors identified in the Michael Porter model?

Answer:

Difficulty: Ref:

The threat of new entrants, bargaining power of buyers, rivalry between existing competitors, threat of substitute products or services, and bargaining power of suppliers.

Easy Analyzing Sectors/Industries

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187

5.

Give several examples of government effects on industries.

Answer:

Difficulty: Ref: 6.

When should companies in cyclical industries be bought?

Answer:

Difficulty: Ref: 7.

An investor would like to buy cyclical stocks in a recession when earnings prices are low relative to historical standards. Interestingly, P/E ratios are often high because earnings are depressed relatively more than prices. When the economy strengthens, so will company earnings and prices.

Moderate Using Sector/Industry Analysis as an Investor

Differentiate between defensive industries and countercyclical industries.

Answer:

Difficulty: Ref: 8.

For example, deregulation in the financial services industry has removed barriers to competition among institutions; allowing supermarket banking, where the customer can have checking and savings, borrow money, make securities investments, and buy insurance all under one roof. Another example is the public and government sentiment against tobacco products and coal, which has led to increased federal regulation, taxes, and law suits against coal and tobacco companies.

Moderate Analyzing Sectors/Industries

Defensive industries are least affected by recessions and economic downturns; whereas, countercyclical industries go against the business cycle.

Easy Using Sector/Industry Analysis as an Investor

Would it be useful to the analyst to compare industry data to basic economic data such as the GDP or consumer spending?

Answer:

Difficulty: Ref:

An analyst often looks for industries that are growing faster than the economy as a whole or gaining an increasing share of consumer dollars. A relevant economic measure can be found for specific industries.

Moderate Using Sector/Industry Analysis as an Investor

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188

Critical Thinking/Essay Questions 1.

What industries do you think will be the growth industries of the next decade?

Answer:

Difficulty: Ref: 2.

This one is certainly open-ended and open to debate. A few possibilities include computer hardware and software, communications in various forms, anything related to the Internet, robotics, genetic engineering, financial services, and medical services. Global and domestic possibilities abound. The greatest ones will be products or services that do not yet exist.

Moderate Using Sector/Industry Analysis as an Investor

Portfolio diversification often focuses on cross-industry diversification to pick up correlation coefficients and risk-expected return characteristics that create the portfolio effect. Suggest a realignment of "industry" classifications to reflect fundamental relationships sought through the more casual traditional industries.

Answer:

Difficulty: Ref:

"Industries" might be defined in terms of riskiness relative to the market (i.e. betas) or to specific economic variables (i.e. correlation coefficients) rather than on the types of products they produce. The resulting new "industries" might be much the same as the old ones, but there might be greater ease in asset allocation. Mutual fund annual reports would categorize companies according to betas or correlation coefficients rather than according to traditional industries (e.g. aerospace, pharmaceuticals, etc.).

Difficult Using Sector/Industry Analysis as an Investor

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File: Ch. 15, Chapter 15: Company Analysis

Multiple Choice Questions 1.

The last step in top-down fundamental analysis is to:

a. b. c. d.

analyze individual industries. analyze individual companies. analyze individual securities. perform technical analysis

Ans: b Difficulty: Easy Ref: Company Analysis 2.

Which of the following is not one of the relative valuation multipliers used in fundamental analysis?

a. b. c. d.

P/E ratio P/S ratio P/M ratio P/B ratio

Ans: c Difficulty: Easy Ref: Fundamental Analysis 3.

When analyzing stocks, the variable of interest to most investors is:

a. b. c. d.

beta. profit margins. dividend yield. earnings per share.

Ans: d Difficulty: Moderate Ref: Fundamental Analysis 4.

EPS are of higher quality if:

a. b. c. d.

the company is a blue chip. the auditor's reputation is high. they were derived using conservative principles.

FASB has approved them.

Ans: c Difficulty: Moderate Ref: The Accounting Aspects of Earning Chapter Fifteen Company Analysis

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5.

Which of the following is shown on the balance sheet on a lower of cost or market value basis?

a. b. c. d.

Cash Stockholders’ equity Marketable securities Treasury stock

Ans: c Difficulty: Moderate Ref: The Accounting Aspects of Earnings 6.

Which of the following statements regarding retained earnings is not true?

a. b. c. d.

It is part of stockholders’ equity.

It represents spendable funds for a company.

It designates that part of previous earnings not paid out as dividends.

It is irrelevant in security valuation.

Ans: b Difficulty: Moderate Ref: The Accounting Aspects of Earnings 7. a. b. c. d.

The auditor's report: guarantees accuracy of the financial statements. guarantees the quality of the earnings. attests that the statements are a fair presentation of financial position. includes a recommendation on the stock.

Ans: c Difficulty: Moderate Ref: The Accounting Aspects of Earnings 8.

On a company’s balance sheet, shareholder’s equity is measured in:

a. b. c. d.

book value. market value. current value. non-depreciated value.

Ans: a Difficulty: Moderate Ref: The Accounting Aspects of Earnings

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9.

Fixed assets consist of:

a. b. c. d.

cash and marketable securities. property, plant, and equipment. intangible assets, like goodwill. shareholders' equity.

Ans: b Difficulty: Easy Ref: The Accounting Aspects of Earnings 10.

Which of the following approaches best indicates how EPS should be computed?

Take after-tax net income and divide by:

a. b. c. d.

current common shares outstanding. previous years common shares outstanding. treasury shares outstanding. average common shares outstanding.

Ans: d Difficulty: Moderate Ref: The Accounting Aspects of Earnings 11.

The generally accepted accounting principles (GAAP) require that EPS be calculated using a:

a. b. c. d.

conservative treatment. liberal treatment. standard set of rules developed by the accounting profession. standard set of rules developed by the SEC.

Ans: c Difficulty: Easy Ref: The Accounting Aspects of Earnings 12.

The key item for investors on the income statement is:

a. b. c. d.

sales. interest expense. cost of goods sold. net income from continuing operations.

Ans: d Difficulty: Moderate Ref: The Accounting Aspects of Earnings

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13.

Earnings derived under GAAP and shown on the income statement are known as:

a. b. c. d.

reported earnings. certified earnings. audited earnings. verified earnings.

Ans: a Difficulty: Moderate Ref: The Accounting Aspects of Earnings 14.

Which of the following is not one of the parts of the cash flow statement?

a. b. c. e.

Cash flow from operating activities Cash flow from sales activities Cash flow from investing activities Cash flow from financing activities

Ans: b Difficulty: Moderate Ref: The Accounting Aspects of Earnings 15.

Which of the following mandated that firms, starting in 2004, must submit an annual report to the SEC outlining the effectiveness of their internal accounting controls?

a. b. c. d.

SEC Amendments Act SIPC Glass-Stegall Act Sarbanes-Oxley Act

Ans: d Difficulty: Easy Ref: The Accounting Aspects of Earnings 16.

Which of the following represents an estimate of the rate at which a company can grow from internal sources?

a. b. c. d.

Return on assets Sustainable growth rate Adjusted EPS Return on equity

Ans: b Difficulty: Moderate Ref: The Accounting Aspects of Earnings

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17.

Which statement about the quality of reported EPS is false?

a.

Earnings quality assessments are difficult to make and require considerable expertise in accounting and financial analysis.

Reported EPS is not the precise figure that it first appears to be.

It is necessary to make adjustments to reported EPS figures when making cross-sectional comparisons.

Quality of earnings is generally consistent among companies in the same industry.

b. c. d.

Ans: d Difficulty: difficult Ref: The Accounting Aspects of Earnings 18.

One way to calculate EPS is:

a. b. c. d.

ROA x book value per share.

ROE x book value per share.

ROA ÷ book value per share.

ROE ÷ book value per share.

Ans: b Difficulty: Moderate Ref: Analyzing a Company’s Profitability 19.

The two components of EPS are:

a. b. c. d.

ROA and leverage. book value per share and leverage.

ROE and book value per share. leverage and profit margin.

Ans: c Difficulty: Difficult Ref: Analyzing a Company’s Profitability 20.

The two components of ROE are:

a. b. c. d.

ROA and book value per share.

ROA and leverage.

ROA and profit margin. leverage and book value.

Ans: b Difficulty: Moderate Ref: Analyzing a Company’s Profitability

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21.

ROA is the product of:

a. b. c. d.

net income margin and asset turnover. book value and asset turnover. leverage and book value. net income margin and leverage.

Ans: a Difficulty: Moderate Ref: Analyzing a Company’s Profitability 22.

Which of the following statements is true?

a. b. c. d.

Asset turnover is not related to ROA Leverage affects EPS ROA is a function of asset turnover and leverage EPS is solely a function of ROE

Ans: b Difficulty: Difficult Ref: Analyzing a Company’s Profitability 23.

A firm’s sustainable growth rate can be calculated as the product of:

a. b. c. d.

return on assets and the return on equity. dividend payout ratio and leverage. retention rate and the return on equity. net profit margin and asset turnover.

Ans: c Difficulty: Difficult Ref: Analyzing a Company’s Profitability 24.

If a firm's ROA and ROE are equal, it can be concluded that the firm is:

a. b. c. d.

losing money. liquid enough to pay some extra dividends. financed by all equity. financed by a high proportion of debt.

Ans: c Difficulty: Moderate Ref: Analyzing a Company’s Profitability

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25.

Which of the following is true regarding earnings estimates?

a. b. c. d.

Management at most firms updates estimates monthly Analysts typically rely on the estimates provided by management Some firms have chosen not to provide estimates of earnings Most analysts arrive at very similar estimates of earnings

Ans: c Difficulty: Moderate Ref: Earnings Estimate 26.

Which of the following is true regarding earnings forecasts made by analysts versus forecasts made by statistical models? The evidence tends to:

a. b. c. d.

support analysts' forecasts in terms of accuracy over statistical models. support statistical models' forecasts in terms of accuracy over analysts’ forecasts. support both types of forecasts equally. not support either type of forecast in terms of accuracy.

Ans: a Difficulty: Difficult Ref: Earnings Estimate 27.

Which of the following is not true regarding earnings estimates?

a. b. c.

Some companies provide guidance on forthcoming earnings announcements.

The guidance number plays a major role in the consensus estimate.

The variance of actual reported earnings from the consensus had typically constituted the "whisper" forecast.

All of the above are true.

d.

Ans: c Difficulty: Difficult Ref: Earnings Estimate 28.

If the dividend growth rate increases for a firm, its P/E should:

a. b. c. d.

increase. stay the same. decrease. increase or decrease depending how it relates to economic growth.

Ans: a Difficulty: Moderate Ref: The P/E Ratio

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29.

How would you explain P/E ratio differences among companies? By differences in investor:

a. b. c. d.

expectations about the future growth of the market. estimates of the recent growth of earnings. expectations about the future growth of earnings. estimates about the recent growth of dividends.

Ans: c Difficulty: Moderate Ref: The P/E Ratio 30.

If business risk decreases for Megabucks, Inc., its P/E should:

a. b. c. d.

increase. stay the same. decrease. increase or decrease depending on the level of interest rates.

Ans: a Difficulty: Difficult Ref: The P/E Ratio 31.

Other things equal, if the:

a. b. c. d.

required rate of return increases, the P/E ratio will rise. risk premium increases, the P/E ratio will rise. risk-free rate rises, the P/E ratio will fall. dividend payout increases, the P/E ratio will fall.

Ans: c Difficulty: Difficult Ref: The P/E Ratio 32.

Other things equal, if the:

a. b. c. d.

expected growth rate increases, the P/E ratio will decline. risk-free rate rises, the required rate will decline. required rate rises, the P/E ratio will decline. risk premium rises, the required rate will decline.

Ans: c Difficulty: Difficult Ref: The P/E Ratio

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33.

Low P/E stocks are generally associated with:

a. b. c. d.

mature companies. cyclical companies. young fast-growing companies. growth companies.

Ans: a Difficulty: Moderate Ref: The P/E Ratio 34.

In modern investment analysis, the market risk of a stock is measured by its:

a. b. c. d.

beta. standard deviation. leverage. coefficient of variation.

Ans: a Difficulty: Moderate Ref: Fundamental Security Analysis in Practice 35.

The investment advisory service best known for evaluating mutual funds is:

a. b. c. d.

Standard & Poor's.

Moody's.

Morningstar.

Value Line Investment Survey.

Ans: c Difficulty: Easy Ref: Fundamental Security Analysis in Practice 36.

Which of the following methods of security analysis involves the use of a computer program to imitate the brain?

a. b. c. d.

Decision trees Program trading Day traders Neural networks

Ans: d Difficulty: Moderate Ref: Fundamental Security Analysis in Practice

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37.

The balance sheet shows a corporation’s portfolio of assets and:

a. b. c. d.

its liabilities, over an accounting period. its labilities, at a moment in time. its liabilities and owner’s equity, over an accounting period. its liabilities and owner’s equity, at a moment in time.

Ans: d Difficulty: Moderate Ref: The Accounting Aspects of Earnings 38.

Which of the following would be found in the “cash flows from investing activities” portion of a firm’s statement of cash flows?

a. b. c. d.

Changes in accounts receivable Depreciation Net borrowings Capital expenditures

Ans: d Difficulty: Difficult Ref: The Accounting Statements 39.

The cash flow statement consists of the following parts:

a. b. c. d.

cash holdings from revenue, operations, investing, and financing activities. cash flows from revenue, operations, investing, and financing activities. cash holdings from operations, investing, and financing activities. cash flows from operations, investing, and financing activities.

Ans: d Difficulty: Moderate Ref: The Accounting Statements 40.

In what portion of the statement of cash flows would an investor look to find whether a firm had repurchased common shares?

a. b. c. d.

Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities Cash flows from trading activities

Ans: c Difficulty: Difficult Ref: The Accounting Statements

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41.

Firm ABC and Firm XYZ both have ROEs of 18%; however, Firm ABC has a much higher ROA than Firm XYZ. Which of the following do we know to be true? Relative to Firm ABC, Firm XYZ has a higher:

a. b. c. d.

debt ratio. total asset turnover ratio. current ratio. net profit margin.

Ans: a Difficulty: Difficult Ref: Using Financial Statements in Analysis 42.

Firm ABC and Firm XYZ both have ROAs of 12%; however, Firm ABC has a much higher ROE than Firm XYZ. Which of the following do we know to be true? Relative to Firm ABC, Firm XYZ has a lower:

a. b. c. d.

debt ratio. total asset turnover ratio. current ratio. net profit margin.

Ans: a Difficulty: Difficult Ref: Using Financial Statements in Analysis 43.

Garner Inc. and Tanex Corp. are competitors in the equipment manufacturing industry. Garner has a P/S ratio of 3.2, whereas Tanex has a P/S ratio of 1.8.

Which of the following best justifies the difference in P/S ratios between the two firms? Relative to Garner, Tanex has a:

a. b. c. d.

higher total asset turnover. lower beta. lower net profit margin. lower total asset turnover.

Ans: c Difficulty: Difficult Ref: The Multiplier

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44.

Which of the following would increase a firm’s current calculated FCFF?

a. b. c. d.

An increase in net borrowings A decrease in net borrowings An increase in fixed capital investment A decrease in fixed capital investment

Ans: d Difficulty: Moderate Ref: Using Financial Statements in Analysis 45.

Which of the following would increase a firm’s PEG ratio?

a. b. c. d.

An increase in the firm’s P/E A decrease in the firm’s net profit margin An increase in the firm’s growth A decrease in the firm’s fixed capital investment

Ans: a Difficulty: Difficult Ref: The Multiplier

True/False Questions 1.

It is necessary to determine a point estimate of the intrinsic value of a stock when using relative valuation techniques.

Ans: False Difficulty: Moderate Fundamental Analysis 2.

Since extraordinary items affecting earnings are typically non-recurring, investors should disregard their impact on earnings when evaluating the stock.

Ans: False Difficulty: Moderate Ref: The Accounting Aspects of Earnings 3.

The auditor's report guarantees the accuracy of the earnings reported in the financial statements.

Ans: False Difficulty: Moderate Ref: The Accounting Aspects of Earnings

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4.

To estimate the intrinsic value of a company, investors could use the dividend discount model to estimate intrinsic value, or an earnings multiplier model based on a forecast of next year’s EPS and what is thought to be an appropriate P/E ratio.

Ans: True Difficulty: Moderate Ref: Fundamental Analysis 5.

EBITDA, sometimes called operating profit, is often emphasized by biotech companies because of their lack of real profitability.

Ans: True Difficulty: Moderate Ref: The Accounting Aspects of Earnings 6.

International Financial Reporting Standards (IFRS) are now used by most countries.

Ans: True Difficulty: Moderate Ref: The Accounting Aspects of Earnings 7.

Free cash flow represents money left after all the bills are paid and dividend payments are made.

Ans: True Difficulty: Easy Ref: The Accounting Aspects of Earnings 8.

Leverage can magnify returns to the stockholders but also increase potential losses to the stockholders.

Ans: True Difficulty: Moderate Ref: Analyzing a Company's Profitability 9.

If a company’s net income margin decreases, a company can maintain its ROA by increasing its asset turnover.

Ans: True Difficulty: Moderate Ref: Analyzing a Company's Profitability 10.

Investors interested in buying stocks that report bad news and suffer a sharp decline should buy the first day bad news is reported.

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Ans: False Difficulty: Difficult Ref: Earnings Estimates 11.

Some companies, tend to provide low guidance, contributing toward consistently positive earnings surprises.

Ans: True Difficulty: Easy Ref: Earnings Estimates 12.

A positive earnings surprise occurs when the forecasted earnings are greater than the actual earnings of a company.

Ans: False Difficulty: Easy Ref: Earnings Estimates 13.

The P/E ratio can be expected to change as the expected dividend payout ratio changes.

Ans: True Difficulty: Moderate Ref: The P/E Ratio 14.

Other things being equal, as k rises, the P/E ratio will also rise.

Ans: False Difficulty: Moderate Ref: The P/E Ratio 15.

Some analysts believe that the P/E ratio of a company that is fairly valued will equal its expected growth rate.

Ans: True Difficulty: Moderate Ref: The P/E Ratio 16.

Regardless of how closely a company adheres to good accounting practices and auditors do their job, investors need to examine “Notes to the Financial Statements” on 10-K and 10-Q Reports to understand the company’s financial situation.

Ans: True Difficulty: Easy Ref: The Accounting Aspects of Earnings

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Short-Answer Questions 1.

What is the relationship of the Financial Accounting Standards Board and the Securities and Exchange Commission?

Answer:

Difficulty: Ref: 2.

When an investor buys a share of common stock he/she buys a claim of ownership. How is this claim represented on the balance sheet?

Answer:

Difficulty: Ref: 3.

Difficulty: Ref:

The internal growth rate is the growth rate depending on earnings retention as the only source of new capital. It is calculated as g = b × r = (1 – payout ratio) × (ROE).

Moderate Analyzing a Company's Profitability

How accurate are professional earnings estimates? Do purely mechanical models give better results than analysts who add subjective assessment to the data?

Answer:

Difficulty: Ref: 5.

The claim appears in the common equity section. The three most common accounts are common stock, capital paid in excess of par, and retained earnings. The book value of equity is calculated from the entire common equity section.

Moderate Analyzing a Company's Profitability

What is the internal (sustainable) growth rate? How is it calculated?

Answer:

4.

The FASB and the SEC are separate organizations. The FASB is a selfregulatory body of the accounting profession that sets accounting standards. The SEC is part of the federal government that requires companies to disclose financial data presented under FASB’s standards.

Moderate The Accounting Aspects of Earnings

According to a study by Dreman and Berry, the average annual error in earnings estimates was 44 percent during the period studied (1974-1990).

Only 25 percent of the consensus estimates came within plus or minus 5 percent of reported earnings. Analysts consistently beat purely mechanical models. Subjective assessment of the future is required.

Difficult Earnings Estimates

What are “earnings surprises?” How do they affect stock prices?

Answer:

Difficulty: Ref:

An earnings surprise occurs when a firm’s actual earnings beat forecasted earnings. The SUE model formalizes the surprise factor. Stock prices react up (to positive surprises) or down (to negative surprises).

Moderate Earnings Estimates

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6.

Can an investor that wants to use the approach of projected earnings and P/Es find help in Value Line?

Answer: Difficulty: Ref: 7.

What three variables affect the P/E ratio? How does each affect it?

Answer:

Difficulty: Ref: 8.

Using the model P/E = (D1/E1)/(k – g), the variables are the dividend payout ratio, D1/E1, the required rate of return, k, and the dividend growth rate, g. If the dividend payout ratio increases (decreases), the P/E increases (decreases), other things the same. If the required rate of return increases (decreases), the P/E decreases (increases). If the growth rate increases (decreases), the P/E increases (decreases).

Moderate The P/E Ratio

Should an investor seek companies with low P/Es or high P/Es?

Answer:

Difficulty: Ref: 9.

Yes. In fact Value Line projects EPS, dividends, dividend payout, growth rates and prices.

Easy The P/E Ratio

Investors differ in their philosophies. Investors who seek low P/E companies are “value” investors. They think that the stocks are undervalued and will eventually gain full valuation. On the other hand, “growth” investors seek high P/E stocks as ones with high growth prospects.

Moderate The P/E Ratio

How could unexpected inflation affect the P/E ratio?

Answer:

Difficulty: Ref:

Unexpected inflation would increase the risk-free rate of return, RF, which would increase the required return, k, on stocks. This would reduce P/E ratios.

Moderate The P/E Ratio

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Critical Thinking/Essay Questions

1.

What is meant by “quality of earnings,” and how does it affect the equity analyst’s job?

Answer:

Difficulty: Ref:

2.

Quality of earnings generally has to do with the accounting standards applied. Generally speaking, conservative standards result in a higher quality of earnings than liberal standards. Conservative methods often produce higher expenses and lower EPS. An analyst has a hard time comparing the earnings of companies prepared under differing methods.

An analyst might be willing to apply a higher P/E to higher quality earnings in projecting a future stock price.

Difficult The P/E Ratio

In the model P/E = (D1/E1)/(k – g), the P/E should increase if the dividend payout ratio increases, other things the same. If the payout ratio was intentionally increased by the board of directors, other things are likely not to stay the same.

What is likely to happen to the dividend growth rate and the required return?

Answer:

Difficulty: Ref:

If more earnings are paid out, then there is less to retain. If there is less earnings retention, then there is a relatively smaller equity base to support earning assets. This would reduce growth. The effect of a higher payout on the required return is the center of considerable controversy, but one scenario would suggest less risk and slower growth, and a reduced required return.

Moderate The P/E Ratio

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Problems 1.

Don Jorge Shipping Inc. has net income of $40 million, total assets of $300 million, and sales of $800 million. Its equity is $190 million.

(a) (b) (c)

Calculate ROA. Calculate ROE. If the book value per share is $7.00, what is EPS?

Solution:

Difficulty:

(a)

ROA = = = =

net income margin x turnover 40/800 x 800/300 0.05 x 2.67 0.1333 or 13.33 percent

(b)

ROE = = =

ROA x Leverage 0.1333 x 1.579 0.2105 or 21.05 percent

(c)

EPS

ROE x book value per share $7.00 x .2105 $1.474

= = =

Moderate

2.

Internet Industries expects to earn $5.00 for the coming year, and pay a $2.00 dividend. Its ROA is 13 percent, while its leverage factor is 1.7.

(a) (b)

Calculate the expected growth rate in dividends.

Given a required return of 17 percent, determine the estimated price for High Tech, Inc. common stock.

Calculate the expected dollar dividend two periods from now.

(c)

Solution:

(b)

P0

Difficulty:

(a)

g b ROE g

= b×r = 1 - payout ratio = ROA x Leverage = .6 x .221

= =

D1/(k - g) 2.00/(0.17 - .1326)

(c)

D2

= =

=

D1(1 + g) $2.00 (1.1326)

Moderate

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204

= = =

1 - .4 = .6 .13 x 1.7 = .221 .1326 or 13.26 percent

$53.48

=

$2.265

3.

The risk-free rate is 10 percent, and the expected return for the stock market is 16 percent. Evergreen Inc. has a beta of 1.1, and investors expect dividends and earnings to grow at 8 percent per year. The current dividend is $1.20 and the payout ratio is 50 percent.

(a) (b)

Calculate the P/E ratio for Evergreen Inc. Estimate the price of the stock for the next year using the multiplier model.

Solution:

(a)

k

P/E

(b) Difficulty:

4.

P1

= =

RF + B(RM - RF) .10 + 1.1(.16 - .10)

= =

(D1/E1)/(k – g) ($1.30/$2.59)/(0.166 - .08)

= 5.814

= =

P/E x E1 5.81 x $2.59

= $15.07

= 0.166

Moderate

Calculate the required return on DCM Inc.’s stock if its current price is $35 per share, next year's expected dividend is $2.00 per share, its return on equity is 12 percent, and its dividend payout ratio is 55 percent.

Solution:

g

P0 k

Difficulty:

= retention rate x ROE= (1 - dividend payout ratio) x ROE = (1 - 0.55) x 12 = 0.45 x 12 = .054

= = = Moderate

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D1 / (k – g) or D1 / P0 + g 2 / 35 + .054

205

= 0.11114 or 11.114 percent

5.

A company has sales of $220 million, which are expected to increase by 15 percent next year and 12 percent the year after. The company expects to have a net profit margin of 8 percent each year, a payout ratio of 60 percent, and a constant 3 million shares outstanding. Assume the stock is expected to trade at a P/E ratio of 14 at the end of the second year, and the investor requires a 14 percent return. Based on the justified P/E, what is the estimated price of the stock today?

Solution: Current Growth rate Sales Net Profit (8% of sales) Number of shares outst.

EPS DPS (60% of EPS)

Year 1 + 15% $253m $20.24m 3m $6.75 $4.05

Stock price in year 2 = P2 = =

EPS in year 2 x P/E at end of year 2 7.556 x 14 $105.784

Year 2 + 12% $283.36m $22.67m 3m $7.556 $4.534

Stock price today = PV of D1 + PV of D2 + PV of P2 P0 = [$4.05/(1.14)] + [4.534/(1.14)2] + [105.784/(1.14)2] = $3.55 + $3.49 + $81.397 = $88.437 Difficulty: Difficult

6.

Upon analyzing the financial statements of Jain Industries, you discover that it is currently retaining 60 percent of its earnings (which were $6 this past year), and is experiencing a ROE of almost 20 percent. Assuming a risk-free rate of 4 percent and a risk-premium for Jain of 8 percent, how much would you be willing to pay for Jain Industries stock on the basis of the P/E ratio approach?

Solution:

Difficulty:

k = RF + RP = 6 + 8 = 14 % g = retention rate x ROE = 0.6 x 20 = 12 % D1/E1 = (1 – retention rate) = (1 – 0.6) = 0.4 P/E = (D1/E1) / (k – g) = 0.4 / (0.14 – 0.12) = 20 EPS1 = EPS0(1 + g) = 6(1 + 0.12) = $6.72 Intrinsic value = Justified P/E x Expected EPS = (20)(6.72) = $134.40 Difficult

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7.

Assume the following for Mighty Manufacturing Company:

Operating efficiency Net income Net income margin Total asset turnover Leverage Retention rate (a) (b) (c)

0.1 $50,000,000 0.05 3 1.5 0.3

Calculate ROA. Calculate ROE. Find the growth rate of dividends.

Solution: (a)

= = = = = =

The letter m is used to denote millions.

Net income margin = 0.05 = Sales =

Net income/Sales $50m/sales $1,000m

Total asset turnover 3 TA

Sales/Total assets $1,000m/TA $333.333m

= = =

ROA = = = (b)

Leverage

Net income/Total assets $50m/$333.333m 0.15 or 15 percent

=

Total assets / Equity 1.5 = $333.333m / Equity Equity = $222.222m ROE = = =

(c)

g

Difficulty: 8.

= = = =

Net income / Equity $50m / $222.222m 0.225 or 22.5 percent

b×r Retention rate x ROE 0.3(0.225) 0.0675 or 6.75 percent

Moderate

Find the P/E ratio of a stock with an ROE of 15 percent, a book value per share of $5.00, and a current stock price of $30.00.

Solution:

EPS

Difficulty:

P/E = Moderate

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= =

ROE × (Book value) 0.15 × ($5) = $0.75 per share $30 / $0.75

=

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40

Ch. 16, Chapter 16: Technical Analysis

Multiple Choice Questions 1.

The oldest approach to common stock selection is:

a. b. c. d.

technical analysis. fundamental analysis. stochastic analysis. value analysis.

Ans: a Difficulty: Easy Ref: Introduction 2.

Technical analysis reflects the idea that stock prices:

a. b. c. d.

move upward over time. move inversely over time. move in trends. move randomly.

Ans: c Difficulty: Easy Ref: What is Technical Analysis?

3.

Technical analysis is sometimes called market or:

a. b. c. d.

external analysis. internal analysis. stochastic analysis. qualitative analysis.

Ans: b Difficulty: Moderate Ref: What is Technical Analysis?

4.

The two primary tools of a technical analyst are:

a. b. c. d.

level of the market index and volume. economic indicators and level of the market index. price and earnings. price and volume.

Ans: d Difficulty: Moderate Ref: What is Technical Analysis?

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5.

What do technical analysts believe is the best source of data to use in analyzing stocks?

a. b. c. d.

Corporate earnings growth prospects Insider buying and selling of shares Current P/E ratios versus historical ratios The market itself

Ans: d Difficulty: Moderate Ref: What is Technical Analysis?

6.

Technical analysis differs from fundamental analysis in that technical analysis:

a. b. c. d.

is aimed at the market, while fundamental analysis is aimed at individual stocks. is based on published market data and focuses on internal factors. focuses on the long-term trends of production. does not consider price and volume.

Ans: b Difficulty: Easy Ref: What is Technical Analysis?

7.

Which of the following is not an assumption made by technical analysts?

a. b. c. d.

Changes in trend are caused by shifts in supply and demand relationships.

Stock price movements are independent of one another.

Security prices tend to move in trends.

Supply and demand of securities are determined by various factors.

Ans: b Difficulty: Difficult Ref: What is Technical Analysis?

8.

Which of the following is not true regarding the Dow Theory?

a. b. c. d.

It is intended to forecast the start of a primary movement.

It does not forecast how long a movement will last.

It has a very high success rate.

It is subject to many criticisms.

Ans: c Difficulty: Moderate Ref: Stock Price and Volume Techniques

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9.

A support level is a price range:

a. b. c. d.

at which a significant increase in demand for a stock is expected. at which a significant increase in supply of a stock is expected. below which a stock price cannot go. above which a stock price cannot go.

Ans: a Difficulty: Moderate Ref: Stock Price and Volume Techniques 10.

Which of the following is not one of the three major variables to be decided by the investor in order to construct a moving average?

a. b. c. d.

Price to be used Time period to be used Weight to be used Type of moving average to be constructed

Ans: c Difficulty: Moderate Ref: Stock Price and Volume Techniques 11.

In order to have confirmation of a major market trend under the Dow Theory, the:

a. b. c. d.

industrial and utility averages must confirm each other. transportation and utility averages must confirm each other. utility average must lead the transportation average. transportation and industrial average must confirm each other.

Ans: d Difficulty: Moderate Ref: Stock Price and Volume Techniques 12.

One of the primary tools of a technical analyst is:

a. b. c. d.

sell-side research. buy-side research.

Value Line earnings estimates. charts of stock price and volume.

Ans: d Difficulty: Moderate Ref: Stock Price and Volume Techniques

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13.

Which of the following is true regarding the resistance level?

a. b. c. d.

Resistance levels tend to develop due to profit taking.

It is the level at which a significant decrease in demand is expected.

It is the level at which a significant increase in supply is expected.

Resistance levels usually develop after a stock reaches a new low.

Ans: c Difficulty: Difficult Ref: Stock Price and Volume Techniques 14.

Volume and specific calendar time are not considered important in a:

a. b. c. d.

logarithmic price and volume chart. point and figure chart. nominal price and volume chart. moving average convergence and divergence chart.

Ans: b Difficulty: Easy Ref: Stock Price and Volume Techniques 15.

One rule of thumb is that a stock is attractive when its relative strength has improved for at least:

a. b. c. d.

1 month.

2 months.

3 months.

4 months.

Ans: d Difficulty: Difficult Ref: Stock Price and Volume Techniques 16.

A period of correction is often followed by a period of:

a. b. c. d.

channel lines. momentum. reversals. consolidation.

Ans: d Difficulty: Moderate Ref: Stock Price and Volume Techniques

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17.

What is usually shown at the bottom of a bar chart?

a. b. c. d.

A point and figure chart Advance/decline line Closing price Volume

Ans: d Difficulty: Easy Ref: Stock Price and Volume Techniques 18.

Which of the following is a characteristic of the short interest ratio?

a. b. c. d.

It is calculated daily as well as weekly.

It is often interpreted without any additional information.

It has had a value between 2 and 3 in recent times.

It is considered to be a measure of investor sentiment.

Ans: d Difficulty: Moderate Ref: Technical Indicators 19.

The breadth of the market is typically measured by which of the following:

a. b. c. d.

200-day moving average.

50-day moving average. the put-call ratio. the advance-decline line.

Ans: d Difficulty: Moderate Ref: Technical Indicators 20.

A high short interest ratio is generally interpreted as:

a. b. c. d.

a bullish signal. evidence of a downside breakout. a bearish signal. evidence of the presence of odd-lot individual investors.

Ans: a Difficulty: Easy Ref: Technical Indicators

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208

21.

A daily accumulation of stocks advancing or declining is used in:

a. b. c. d.

volume of trading analysis. relative strength analysis. breadth of market analysis. short interest analysis.

Ans: c Difficulty: Moderate Ref: Technical Indicators 22.

Which of the following is not a contrary trading rule?

a. b. c. d.

Relative strength ratio Investment advisory opinions Mutual fund liquidity positions Put/call ratio

Ans: a Difficulty: Difficult Ref: Technical Indicators 23.

The short interest ratio is found by dividing the number of shares sold short by the average:

a. b. c. d.

number of shares outstanding in the market. daily volume of trading on the exchange. number of stocks reaching new lows. daily number of stocks bought long.

Ans: b Difficulty: Difficult Ref: Technical Indicators 24.

A put/call ratio of 0.70 indicates:

a. b. c. d.

puts have a cost 70% less than the cost of calls. there are 7 puts purchased for every one call purchased. there are 70% more puts purchased than calls. there are 7 puts purchased for every 10 calls purchased.

Ans: d Difficulty: Moderate Ref: Technical Indicators

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25.

Technicians that utilize the CBOE put/call ratio generally believe:

a. b. c. d.

option investors tend to be losers. option investors tend to be winners. option investors are true technicians. option investors possess inside information.

Ans: a Difficulty: Easy Ref: Technical Indicators 26.

Which of the following would be considered a strong bearish signal?

a. b. c. d.

High mutual fund liquidity Bullish advisory opinion Low short interest ratio Bearish advisory opinion

Ans: b Difficulty: Moderate Ref: Technical Indicators 27.

Which of the following indicates the market is at its peak, according to contrarians?

a. b. c. d.

The short-interest ratio is low The bearish sentiment index is around 20 percent Mutual fund liquidity is low The number of stocks hitting all-time highs is low

Ans: c Difficulty: Difficult Ref: Technical Indicators 28.

Which of the following is not one of the factors to consider in performing a valid test of a technical trading rule?

a. b. c. d.

The transaction and other costs incurred by the rule.

The consistency of performance from the rule.

The holding period implied by the rule.

The risk inherent in the rule.

Ans: c Difficulty: Moderate Ref: Testing Technical Analysis Strategies

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29.

If an investor buys a stock when its price has increased 2 percent from its previous price, the investor is employing:

a. b. c. d.

a contrarian indicator. a filter rule. a sentiment indicator. relative strength analysis.

Ans: b Difficulty: Difficult Ref: Testing Technical Analysis Strategies 30.

If a trading rule has been tested on data other than that used to produce the rule and found to be accurate, this is known as:

a. b. c. d.

consistency. relative strength. out-of-sample validity. a filter rule.

Ans: c Difficulty: Moderate Ref: Testing Technical Analysis Strategies 31.

Conclusions about technical analysis suggest that:

a. b. c. d.

it is difficult to justify technical analysis. it has been found to be completely deficient. stock price movements repeat themselves constantly. there is complete agreement about the interpretation of technical signals.

Ans: a Difficulty: Easy Ref: Testing Technical Analysis Strategies 33.

Which of the following statements about the put/call ratio is most accurate?

a. b. c. d.

A negative ratio is bullish.

Investors interpret a ratio greater than 1 to be a bearish indicator.

Investors interpret a relatively low ratio to be a bearish indicator.

Investors interpret a relatively high ratio to be a bearish indicator.

Ans: d Difficulty: Moderate Ref: Technical Indicators

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34.

Historical tests of filter rules indicate that:

a. b. c. d.

several filters were profitable before commissions, but not after. several filters were profitable before and after commissions. no filters were profitable even before commissions. all filters were profitable before commissions, but not after.

Ans: a Difficulty: Difficult Ref: Testing Technical Analysis Strategies 35.

Assume an individual writes down Hs and Ts to simulate 100 coin flips. On average, how will this series appear relative to the result of 100 actual coin flips?

Relative to the actual coin flips, the simulated series will:

a. b. c. d.

contain too many runs with too much length per run. contain too many runs with not enough length per run. contain too few runs with too much length per run. contain too few runs with not enough length per run.

Ans: d Difficulty: Difficult Ref: Some Conclusions about Technical Analysis 36.

In a candlestick chart, what does it mean if the candlestick is shaded?

a. b. c. d.

It is a bearish indicator.

It is a bullish indicator.

It means the stock’s closing price was above its opening price.

It means the stock’s opening price was above its closing price.

Ans: d Difficulty: Moderate Ref: Technical Indicators 37.

Which of the following is generally viewed as a bearish indicator for a stock?

a. b. c. d.

It has a relatively high short-interest ratio.

Its 50-day moving average price has penetrated the 200-day average from above.

Following a price drop, the price penetrates the moving average from below.

It has an increasing relative strength ratio.

Ans: b Difficulty: Difficult Ref: Technical Indicators

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True/False Questions 1.

Technical analysis utilizes a top-down, fundamental approach to common stock analysis.

Ans: False Difficulty: Moderate Ref: What Is Technical Analysis?

2.

Technical analysis focuses on timing and on the short run.

Ans: True Difficulty: Easy Ref: What Is Technical Analysis?

3.

Technical analysts agree with fundamental analysts regarding the usefulness of accounting data.

Ans: False Difficulty: Moderate Ref: What Is Technical Analysis?

4.

The Dow Theory is intended to forecast the start but not the duration of a primary movement.

Ans: True Difficulty: Easy Ref: Stock Price and Volume Techniques 5.

A bar chart is the simplest type of chart used in technical analysis.

Ans: True Difficulty: Easy Ref: Stock Price and Volume Techniques 6.

The bearish-sentiment index is calculated as the ratio of advisory services that are bearish to the total number with an opinion.

Ans: True Difficulty: Easy Ref: Stock Price and Volume Techniques 7.

Relative strength analysis is popular because it is generally not subject to conflicting interpretations.

Ans: False Difficulty: Moderate Ref: Stock Price and Volume Techniques

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8.

If a trend exhibits support and resistance levels simultaneously that appear well defined, the trend lines are referred to as channel lines.

Ans: True Difficulty: Moderate Ref: Stock Price and Volume Techniques 9.

Secondary movements are often termed technical corrections.

Ans: True Difficulty: Moderate Ref: Stock Price and Volume Techniques 10.

The cash position of mutual funds is a contrarian indicator.

Ans: True Difficulty: Moderate Ref: Technical Indicators 11.

A put/call ratio greater than the typical upper limit would be interpreted as a bullish signal by the contrarians.

Ans: True Difficulty: Moderate Ref: Technical Indicators 12.

A filter rule specifies a breakpoint for a stock or average and trades are made when the price move is greater than the filter.

Ans: True Difficulty: Easy Ref: Testing Technical Analysis Strategies 13.

In the 1990s, many investment firms hired numerous fundamental analysts and very few technical analysts. Following the market downturns of 2000, 2001, and 2008, investment firms realized their mistake and hired far more technical analysts than fundamental analysts.

Ans: False Difficulty: Moderate Ref: The Ebb and Flow of Technical Analysis

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214

Short-Answer Questions 1.

Explain how profit taking and support levels are related.

Answer:

Difficulty: Ref: 2.

How does a point-and-figure chart compress many price changes into a small space?

Answer: Difficulty: Ref: 3.

Difficulty: Ref:

(a) The price is above the moving average, moves toward the average but average flattens out. The price penetrates the average from below. (b) Actual prices rise through the moving average on high volume. (c) The stock price falls below the moving average while it is rising.

Difficult Stock Price and Volume Techniques

What are support and resistance levels?

Answer:

Difficulty: Ref: 5.

By recording only “significant” price changes, defined as $1 or $2 or more. Thus, moves of ¼, ½, and so forth are not recorded.

Moderate Stock Price and Volume Techniques

Explain three specific buy signals using a moving average.

Answer:

4.

The scenario is as follows: The stock price increases. Profit taking follows, driving the price down. When investors see the price as low enough, they buy, stopping the price from dropping further, thus establishing the support level.

Moderate Stock Price and Volume Techniques

If a stock price is falling, a support level is a price at which sufficient demand is expected to materialize to keep the stock price from dropping further. If a stock price is rising, a resistance level is a price at which sufficient supply is expected to emerge to keep the price from rising any higher.

Moderate Stock Price and Volume Techniques

How is relative strength calculated and used?

Answer:

Difficulty: Ref:

The relative strength of a stock is a ratio of the stock’s price to a market index, industry index, or average price of the stock itself. If a stock is doing well relative to the industry, for example, it is expected to continue to do so in the future. A change in relative strength, however, is often followed by a change in the stock’s price trend. The relative strength of an industry to the market can be considered as well as the relative strength of individual stocks.

Moderate Stock Price and Volume Techniques

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6.

Investors who sell short expect to make money when the stock price goes down.

How, then, can a high short-interest ratio be considered bullish?

Answer: Difficulty: Ref: 7.

Institutional investors are often considered to have the “smart money,” while small, individual investors are not so well informed about the market. Which two sentiment indicators treat both institutions and individuals alike?

Answer:

Difficulty: Ref: 8.

Difficulty: Ref:

Risk, transactions costs, consistency, and out-of-sample validity.

Easy Technical Indicators

What is the advance-decline line? What does it tell the technician?

Answer:

Difficulty: Ref: 10.

The odd-lot theory asserts that one should do the opposite of odd-lot investors because they are usually wrong. Similarly, the mutual fund liquidity technique asserts that mutual fund managers act like odd-lotters, buying when they should be selling and vice versa. When the funds accumulate large amounts of cash, they apparently think the market is going down, and they do not want to be holding all stocks. The contrarians argue that the opposite will occur.

Moderate Technical Indicators

What four factors should be considered in testing technical trading rules?

Answer:

9.

Short sales must be covered, which creates demand for the stock at some point in the future.

Easy Technical Indicators

The net advance for a day is the number of stocks that advanced in price minus the number that declined in price. It is also called the breadth of the market. The advance-decline line must be used in conjunction with a market average, such as the DJIA. If the advance-decline line and the index diverge, then the trend is near an end, according to technical analysts.

Moderate Technical Indicators

Discuss the difference in beliefs about price adjustments toward equilibrium in technical analysis and the Efficient Market Hypothesis.

Answer:

Difficulty: Ref:

Technical analysis depends on trends over time as prices adjust slowly toward new equilibrium levels. The EMH is based on information being quickly and completely reflected in security prices.

Moderate Some Conclusions about Technical Analysis

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Critical Thinking/Essay Questions 1.

Which forms of the Efficient Market Hypothesis addresses the information used in technical and fundamental analysis? Do studies of technical analysis methods tend to support or refute the EMH?

Answer:

Difficulty: 2.

The weak form EMH addresses market data used in technical analysis and the semi-strong form addresses publicly available financial and other data used in fundamental analysis. Studies tend to support EMH and refute the predictive power of technical tools, though not all agree with the findings.

Apparently, technicians do not agree.

Moderate

How can relative strength analysis be helpful in a top-down approach to security analysis?

Answer:

Difficulty:

Analysts can use industry relative strength to identify industries that are outperforming the market, then use company relative strength to identify companies that are outperforming the industry.

Moderate

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217

File ch17.rtf Chapter 17 Bond Yields

Type: Multiple Choice

1.

In finding a bond’s value, the rate used to discount the bond’s future cash flows is:

a. b. c. d.

the bond’s required rate of return. the firm’s weighted average cost of capital. the firm’s after-tax cost of debt. the bond’s coupon rate

Ans: a Difficulty: Easy Ref: Bond Prices 2.

Which of the following statements is most accurate? The real risk-free rate of interest is the:

a. b. c. d.

rate quoted for the shortest term federal government securities. rate quoted for the longest term federal government securities. the rate on federal government securities adjusted to remove the effects of inflation. the rate on federal government securities adjusted to remove the effects of taxes.

Ans: c Difficulty: Moderate Ref: Bond Yields and Interest Rates 3.

What is meant by the real risk-free rate of interest? It is the:

a. b. c. d.

opportunity cost of foregoing consumption. rate actually used in the market, not in textbooks. rate quoted on long-term Treasury bonds. the nominal risk-free interest rate, multiplied by 1 minus the marginal tax rate.

Ans: a Difficulty: Moderate Ref: Bond Yields and Interest Rates

4.

The yield-to-maturity calculation assumes that coupon payments are reinvested at the:

a. b. c. d.

coupon rate on the bond. bond’s current yield. bond’s yield to maturity. forward interest rate.

Ans: c Difficulty: Moderate Ref: Measuring Bond Yields 5.

What is meant by “yield to maturity”? It is measured as the:

a. b. c. d.

coupon payment divided by the face value of the bond. coupon payment divided by the current price of the bond. rate that equates the bond’s current price with the PV of its expected future cash flows. rate that equates the bond’s face value with the PV of its expected future cash flows.

Ans: c Difficulty: Moderate Ref: Bond Yields and Interest Rates 6.

An investor has three sources of dollar returns from a bond investment. Which of the following is not included among the three sources?

a. b. c. d.

The semi-annual coupon payments The interest earned on reinvesting the coupon payments The principal paid at maturity The interest earned on reinvesting the last coupon and the principal

Ans: d Difficulty: Difficult Ref: Bond Yields and Interest Rates 7.

Which of the following is a situation in which an investor will not receive the promised yield to maturity?

a.

The investor holds the bond until maturity and reinvests coupon payments at the original yield to maturity.

Interest rates do not change during the life of the bond.

The issuer calls the bond prior to original maturity.

The realized compound yield equals the promised yield to maturity.

b. c. d.

Ans: c Difficulty: Difficult Ref: Measuring Bond Yields

8.

Which of the following is included in the “realized compound yield”?

a. b. c. d.

The bond coupon payments, only.

The bond coupon and principal payments, only.

The bond principal payment, only.

The bond coupon and principal payments and the reinvestment income.

Ans: d Difficulty: Moderate Ref: Measuring Bond Yields 9.

What is the difference between the yield-to-maturity (YTM) and the realized compound yield (RCY)?

a. b.

They are actually the same concept.

The YTM is the actual return, whereas, the RCY is the expected return at the beginning of the investment.

The RCY is the actual return, whereas, the YTM is the expected return at the beginning of the investment.

The YTM considers only coupon payments, whereas, the RCY includes all the bond’s cash flows.

c. d.

Ans: c Difficulty: Moderate Ref: Measuring Bond Yields 10.

If a bond has a coupon rate that is greater than the bond’s YTM, the bond:

a. b. c. d.

will sell at a premium. will sell at par. will sell at a discount. will not be called.

Ans: a Difficulty: Easy Ref: Investments Intuition

11.

Assume an investor buys an 8 percent, semi-annual, 10-year bond at par. He sells it two years later after market interest rates have decreased to 6 percent. The investor’s capital gain is closest to:

a. b. c. d.

$41. $124. $126. $149.

Ans: c Difficulty: Difficult Ref: Measuring Bond Yields 12.

Assume an investor is considering purchasing an 8 percent semiannual bond with 8 years remaining to maturity when market rates are 6%. The bond’s value is closest to:

a. b. c. d.

$502. $798. $1,000. $1,126.

Ans: d Difficulty: Difficult Ref: Bond Prices 13.

What happens to the price of bonds if interest rates go up?

a. b. c. d.

The price of bonds goes up.

The price of bonds stays the same.

The price of bonds goes down.

The direction of price change depends on the shape of the yield curve.

Ans: c Difficulty: Easy Ref: Bond Price Changes 14.

Which of the following bonds will be most sensitive to changes in market interest rates?

a. b. c. d.

A bond with an 8 percent semiannual coupon and 8 years to maturity A bond with a 6 percent semiannual coupon and 8 years to maturity A bond with an 8 percent semiannual coupon and 6 years to maturity A bond with a 6 percent semiannual coupon and 6 years to maturity

Ans: b Difficulty: Moderate Ref: Bond Price Changes

15.

Relative to a decrease in interest rates, an increase in interest rates of the same size will produce:

a. b. c. d.

a larger percentage change in a bond’s price. a smaller percentage change in a bond’s price. the same sized change in a bond’s price. no change in the bond’s price since its coupon rate is fixed.

Ans: b Difficulty: Difficult Ref: Measuring Bond Yields 16.

To achieve the maximum price impact from an estimated interest rate decrease, a bond buyer should purchase bonds with relatively:

a. b. c. d.

high coupon rates and long maturities. high coupon rates and short maturities. low coupon rates and long maturities. low coupon rates and short maturities.

Ans: c Difficulty: Moderate Ref: Bond Price Changes 17.

Sam holds a $1 million bond portfolio with an average maturity of 9 years, whereas Walt holds a $1 million bond portfolio with an average maturity of 3 years. If interest rates increase substantially, Sam’s portfolio will experience the:

a. b. c. d.

larger decline in value of the two portfolios. larger increase in value of the two portfolios. smaller decline in value of the two portfolios. smaller increase in value of the two portfolios.

Ans: a Difficulty: Moderate Ref: Bond Price Changes

18.

Six years ago, Carl purchased an 8% coupon bond that had 10 years to maturity for $1,150. Since the bond purchase, the required return on the bond has remained constant.

If Carl sells the bond now, the price he receives for the bond will be:

a. b. c. d.

$1,150. between $1,000 and $1,150. higher than $1,150. less than $1,000.

Ans: b Difficulty: Moderate Ref: Bond Price Changes 19.

Relative to interest rates, bond prices have:

a. b. c. d.

an inverse and linear relationship. a direct and linear relationship. an inverse and convex relationship. an inverse and concave relationship.

Ans: c Difficulty: Moderate Ref: Bond Price Changes 20.

Based on which of the following term structure theories are forward rates most useful?

a. b. c. d.

Expectations theory Liquidity preference theory Preferred habitat theory Market segmentation theory

Ans: a Difficulty: Moderate Ref: Term Structure Theories 21.

If the yield curve has a steep upward slope, investors expect:

a. b. c. d.

interest rates to increase and inflation rates to decrease. interest rates to decrease and inflation rates to increase. interest rates to increase and inflation rates to increase. interest rates to decrease and inflation rates to decrease.

Ans: c Difficulty: Moderate Ref: The Term Structure

22.

Assume a bond has a YTM of 8% and its YTM increases by 2 basis points. What is the new YTM on the bond?

a. b. c. d.

8.002% 8.020% 8.200% 10.000%

Ans: b Difficulty: Easy Ref: Bond Yields

Type: True False 1.

Both stocks and bonds are valued by summing the discounted future flows of interest (or dividends) and the repayment of principal (or sale of the stock).

Ans: True Difficulty: Moderate Ref: Bond Yields and Interest Rates 2.

Bond traders use the term “basis point” to mean one percentage point in interest rate.

Ans: False Difficulty: Easy Ref: Bond Yields and Interest Rates 3.

The vast majority of corporate bonds pay floating rates on a quarterly basis.

Ans: False Difficulty: Easy Ref: Measuring Bond Yields 4.

Reinvestment risk represents the possibility that future payments cannot be reinvested at the assumed rate.

Ans: True Difficulty: Easy Ref: Investments Intuition

5.

A financial crisis or an accounting scandal can just as easily cause yield spreads to widen as weak earnings at a company.

Ans: True Difficulty: Moderate Ref: Bond Price Changes 6.

As interest rates increase, long bonds will decrease in price more slowly than shorter bonds.

Ans: False Difficulty: Moderate Ref: Bond Price Changes 7.

If interest rates rise, then price risk and reinvestment risk decline.

Ans: False Difficulty: Moderate Ref: Measuring Bond Yields

Fill-in-the-Blank Questions 1.

The term structure of interest rates denotes the relationship between _____________ and _________________ for a specific category of bonds at a particular point in time.

Ans: market yields (YTM), and time to maturity Difficulty: Moderate Ref: Bond Yields and Interest Rates 2.

The three most prominent theories proposed to explain the term structure of interest rates are: __________________, __________________, and __________________.

Ans: expectations theory, liquidity preference theory, and preferred habitat theory Difficulty: Difficult Ref: Bond Yields and Interest Rates 3.

Risk premiums, or yield spreads, refer to the issue characteristics of bonds. They are the result of which 7 factors: 1) ______ 2) ______3) ______4) ______5) ______6) _____7) _____ Ans: quality/risk of default, time-to-maturity, call features, coupon rates, marketability, tax treatments, and countries Difficulty: Difficult Ref: Bond Yields and Interest Rates

4.

Yield spreads vary inversely with the: ______________________________.

Ans: business cycle Difficulty: Moderate Ref: Bond Yields and Interest Rates

Critical Thinking/Essay Questions 1.

Correct bond calculations in the United States usually involve semiannual periods because bond interest is typically paid twice a year.

P=

n ct FV  ------------ + -----------t=1 (1 + ytm)t (1 + ytm)n

P n ytm c FV

= the current market price of the bond = the number of semiannual periods to maturity = the semiannual yield to maturity to be solved for = the semiannual coupon in dollars = the face value (maturity or par value) which in this discussion is always $1,000

where

What does this formula imply about the term structure of interest rates? How would real-world bond investors price bonds to correct for this?

Ans:

It implies that the term structure of interest rates is perfectly flat, which we never see in practice. To value a bond in the real world, you will use a series of spot interest rates, i.e., one for each coupon payment and for the terminal principal repayment. You can get these spot rates from U.S. Treasury Bills and strips, where strips are U.S. Treasury Notes and Bonds that have been separated into individual coupon and principal payments and are traded separately from one another.

Difficulty: Difficult

Ch. 18, Chapter 18: Bonds: Analysis and Strategy Multiple Choice Questions

1.

Bond investors can avoid the losses caused by rising interest rates by:

a. b. c. d.

buying zero coupon bonds. buying Treasury bonds with maturities of one year or longer. holding bond funds until maturity. holding individual bonds until maturity.

Ans: d Difficulty: Easy Ref: Why Buy Bonds?

2.

Which of the following statements is true regarding investments in bonds?

a. b. c. d.

Shorter maturity bonds generally return more than longer maturity bonds.

Treasury bonds generally return more than corporate bonds of the same maturity.

Longer maturity bonds generally return more than shorter maturity bonds.

Higher-rated bonds generally return more than lower-rated bonds.

Ans: c Difficulty: Moderate Ref: Why Buy Bonds?

3.

The introduction of the Euro:

a. b. c. d.

increased the transactions cost of trading foreign bonds. decreased the transactions cost of trading foreign bonds. had no effect on the transactions cost of trading foreign bonds. had a minimal effect on the transactions cost of trading foreign bonds.

Ans: b Difficulty: Moderate Ref: Why Buy Bonds?

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4.

Which of the following is considered to have the biggest impact on bond yields?

a. b. c. d.

Economic growth Business cycles Inflation Federal Reserve actions

Ans: c Difficulty: Moderate Ref: Important Considerations in Managing Bond Portfolios 5.

The term structure of interest rates is also known as the:

a. b. c. d.

yield to maturity. probability distribution. yield differential. yield curve.

Ans: d Difficulty: Easy Ref: Important Considerations in Managing Bond Portfolios 6.

Bond investors expecting interest rates to rise should shift their portfolios toward:

a. b. c. d.

shorter term bonds. longer term bonds. higher quality bonds. lower quality bonds.

Ans: a Difficulty: Difficult Ref: Important Considerations in Managing Bond Portfolios 7.

Floating rate bonds often have yields tied to the:

a. b. c. d.

London Interbank Offered Rate (LIBOR).

Federal Reserve discount rate.

European Central Bank (ECB) borrowing rate.

Federal Funds overnight lending rate.

Ans: a Difficulty: Moderate Ref: Why Buy Bonds?

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8.

Historically, the yield curve has most often been:

a. b. c. d.

upward sloping. downward sloping. flat. bell-shaped.

Ans: a Difficulty: Easy Ref: Important Considerations in Managing Bond Portfolios 9.

Duration is a measure that relates a:

a. b. c. d.

bond’s price to its time to maturity. bond’s price to its coupon rate. bond’s yield to maturity to its time to maturity. bond’s price to its yield to maturity.

Ans: d Difficulty: Moderate Ref: Managing Price Volatility 10.

During periods of economic expansion, the spread between corporate bonds and U.S. Treasuries generally:

a. b. c. d.

widens. narrows. stays the same. becomes negative.

Ans: b Difficulty: Moderate Ref: Active Management Strategies 11.

The yield on a small, regional corporate bond is generally higher than the yield on a large, national corporate bond mainly due to:

a. b. c. d.

differences in coupon rates. differences in quality. differences in tax treatments. differences in marketability.

Ans: d Difficulty: Easy Ref: Important Considerations in Managing Bond Portfolios

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230

12.

Which of the following statements concerning yield spreads is not true?

a. b. c. d.

Yield spreads may be positive or negative.

Yield spreads are often calculated across bond maturities.

Yield spreads are influenced by the level of interest rates in the market.

Yield spreads can change over time.

Ans: b Difficulty: Moderate Ref: Important Considerations in Managing Bond Portfolios 13.

Which of the following statements about the bond market is not true?

a. b. c. d.

Short maturities sacrifice price appreciation opportunities.

Longer maturities have greater price fluctuations.

Short maturities serve to protect the investor when rates are rising.

Long term interest rates are more volatile than short term interest rates.

Ans: d Difficulty: Difficult Ref: Important Considerations in Managing Bond Portfolios 14.

The yield curve is normally plotted using Treasury securities because:

a. b. c. d.

they have a wide range of maturities. it is easier to obtain accurate and complete data on them. they have no default risk. it is easier to obtain historical data on them.

Ans: c Difficulty: Moderate Ref: Important Considerations in Managing Bond Portfolios 15.

Which form of interest rate forecasting involves evaluating bonds to determine which will perform best over a selected holding period?

a. b. c. d.

Horizon analysis Yield-to-maturity analysis Yield curve analysis Bond immunization analysis

Ans: a Difficulty: Moderate Ref: Active Management Strategies

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231

16.

Which of the following would not be expected to cause yield spreads to widen?

a. b. c. d.

The firm is involved in an accounting scandal.

The firm issues equity to repurchase debt.

A financial crisis, such as the 2008 crisis, occurs.

The firm is subject to litigation.

Ans: b Difficulty: Moderate Ref: Active Management Strategies 17.

Which of the following is an active bond strategy?

a. b. c. d.

Bond swaps Barbell investing Buy-and-hold Ladder investing

Ans: a Difficulty: Easy Ref: Passive Management Strategies 18.

Under a laddering approach, investors mitigate the effects of an interest rate increase by:

a. b. c. d.

purchasing bonds in two maturity groups, long or short. purchasing bonds with the same maturity date but with a variety of coupon rates. purchasing bonds with a variety of maturity dates. purchasing bonds with a variety of YTMs.

Ans: c Difficulty: Difficult Ref: Passive Management Strategies 19.

Regardless of its maturity date, it is very unusual for a coupon-paying bond to have a duration greater than:

a. b. c. d.

2 years.

4 years.

7 years.

10 years.

Ans: d Difficulty: Difficult Ref: Managing Price Volatility

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20.

During recessions, yield spreads tend to:

a. b. c. d.

narrow, whereas they generally widen during economic expansions. widen, whereas they generally narrow during economic expansions. narrow, and they also generally narrow during economic expansions. widen, and they also generally widen during economic expansions.

Ans: b Difficulty: Moderate Ref: Important Considerations in Managing Bond Portfolios 21.

Which of the following terms describes a change in investors’ preferences away from risky assets towards safer bonds?

a. b. c. d.

Immunization Flight to safety Laddering Convexity

Ans: b Difficulty: Moderate Ref: Important Considerations in Managing Bond Portfolios 22.

Which of the following is not a passive bond strategy?

a. b. c. d.

A barbell strategy A bond swap strategy A buy and hold strategy An indexing strategy

Ans: b Difficulty: Difficult Ref: Bond Strategies 23.

A bond strategy that attempts to immunize the portfolio from interest rate risk is based on the concept of:

a. b. c. d.

buy and hold. horizon analysis. duration. indexing.

Ans: c Difficulty: Moderate Ref: Immunization

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23.

A portfolio is said to be immunized if:

a. b. c. d.

the present value of its cash flows equals the its principal value. the duration of the portfolio is equal to its maturity. the present value of its cash flows is greater than its principal value. the duration of the portfolio is equal to the investor’s investment horizon.

Ans: d Difficulty: Difficult Ref: Immunization 25.

Which form of duration should be used when evaluating a floating-rate bond?

a. b. c. d.

Macaulay duration Modified duration Effective duration Convexity duration

Ans: c Difficulty: Moderate Ref: Duration 26.

Which of the following statements regarding classical immunization is false?

a. b. c. d.

It is easy to implement.

It requires frequent rebalancing.

It is not a passive bond strategy.

It faces real-world problems in its implementation.

Ans: a Difficulty: Moderate Ref: Immunization 27.

Immunization is a strategy in which bond investors:

a. b. c. d.

buy only high-quality bonds. attempt to avoid default risk. attempt to avoid call and convertible risk. attempt to avoid reinvestment and price risk.

Ans: d Difficulty: Moderate Ref: Immunization

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28.

James has a 10-year investment horizon. To achieve an immunized position, his bond portfolio will have an average duration that is:

a. b. c. d.

greater than 10 years and have an average maturity that is less than 10 years. equal to 10 years and have an average maturity that is less than 10 years. less than 10 years and have an average maturity that is equal to 10 years. equal to 10 years and have an average maturity that is greater than 10 years.

Ans: d Difficulty: Difficult Ref: Immunization 29.

Interest rate risk is composed of:

a. b. c. d.

market risk and default risk. price risk and credit risk. price risk and reinvestment risk. default risk and liquidity risk.

Ans: c Difficulty: Moderate Ref: Immunization 30.

A bond investor has $100,000 and has determined 5 years is his maximum term. He puts $20,000 in one-year bonds, $20,000 in two-year bonds, etc. up to $20,000 in five-year bonds. This is an example of:

a. b. c. d.

a barbell strategy. a laddering strategy. an immunization strategy. a term management strategy.

Ans: b Difficulty: Easy Ref: Passive Management Strategies 31.

Which of the following statements regarding the duration of a coupon bond is false?

a. b. c. d.

YTM and duration are inversely related.

Coupon rate and duration are inversely related.

Duration is a weighted average time to recovery of all coupon payments.

Duration increases with time to maturity but at a decreasing rate.

Ans: c Difficulty: Difficult Ref: Managing Price Volatility Chapter Eighteen Bonds: Analysis and Strategy

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32.

Relative to actively-managed bond funds, a major advantage of bond index funds is their:

a. b. c. d.

higher performance. ability to shelter income from taxes. lower expense ratios. lower duration.

Ans: c Difficulty: Moderate Ref: Passive Management Strategies 33.

Buying a bond (for example, with fixed-rate coupon payments) and simultaneously selling another (for example, with variable rate interest payments) is an example of:

a. b. c. d.

a bond ladder strategy. a bond swap. an interest rate futures transaction. an immunization strategy.

Ans: b Difficulty: Moderate Ref: Active Management Strategies 34.

Which of the following European countries experienced a debt crisis in recent years?

a. b. c. d.

Germany Great Britain Greece France

Ans: c Difficulty: Easy Ref: Important Considerations in Managing a Bond Portfolio 35.

A zero-coupon bond has 10-years to maturity and a YTM of 8%. If the YTM instantaneously increases to 9%, what happens to the bond’s price and duration?

a. b. c. d.

The price decreases and the duration increases.

The price increases and the duration decreases.

The price decreases and the duration decreases.

The price decreases and the duration stays the same.

Ans: d Difficulty: Difficult Ref: Managing Price Volatility

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36.

A coupon bond has 10-years to maturity and a YTM of 8%. If the YTM instantaneously increases to 9%, what happens to the bond’s price and duration?

a. b. c. d.

The price decreases and the duration increases.

The price increases and the duration decreases.

The price decreases and the duration decreases.

The price decreases and the duration stays the same.

Ans: c Difficulty: Moderate Ref: Managing Price Volatility 37.

Using its modified duration, the price of a coupon bond is forecasted to change from $990 to $925 due to an increase in interest rates. If the bond’s convexity is considered, the new forecasted price of the bond will be:

a. b. c. d.

higher than $925. lower than $925. equal to $925.

Cannot be determined.

Ans: a Difficulty: Moderate Ref: Managing Price Volatility 38.

If two coupon bonds are equivalent in all other respects, which will have the higher convexity?

a. b. c. d.

The bond with the higher coupon.

The bond with the longer maturity.

The bond with the greater yield.

The bond with the lower credit rating.

Ans: b Difficulty: Difficult Ref: Managing Price Volatility 39.

Which of the following 10-year, 8% bonds will offer the highest YTM?

a. b. c. d.

AAA-rated, callable bond AAA-rated, non-callable bond BBB-rated, callable bond BBB-rated, non-callable bond

Ans: c Difficulty: Moderate Ref: Important Considerations in Managing a Bond Portfolio Chapter Eighteen Bonds: Analysis and Strategy

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True-False Questions 1. If interest rates rise, reinvestment rates rise, whereas bond prices decline.

Ans: True Difficulty: Moderate Ref: Why Buy Bonds?

2. A weaker dollar increases the value of dollar-denominated assets to foreign investors.

Ans: False Difficulty: Difficult Ref: Why Buy Bonds?

3. An increase in expected inflation tends to decrease bond prices.

Ans: True Difficulty: Easy Ref: Important Considerations in Managing a Bond Portfolio 4.

The term structure of interest rates shows the relationship between yields of several categories of bonds, such as municipals and corporates, and their maturities.

Ans: False Difficulty: Moderate Ref: Important Considerations in Managing a Bond Portfolio 5. The term structure of interest rates shows the relationship between bond return and time to maturity.

Ans: True Difficulty: Difficult Ref: Important Considerations in Managing a Bond Portfolio 6. A commercial bank that always invests in short-term bonds in order to meet deposit withdrawals is a good example of a firm following the liquidity preference theory.

Ans: False Difficulty: Difficult Ref: Important Considerations in Managing a Bond Portfolio 7. A bond swap involves the simultaneous selling of one bond and buying another.

Ans: True Difficulty: Moderate Ref: Important Considerations in Managing a Bond Portfolio Chapter Eighteen Bonds: Analysis and Strategy

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8. A noncallable bond would be expected to have a higher yield to maturity than a comparable callable bond.

Ans: False Difficulty: Moderate Ref: Important Considerations in Managing a Bond Portfolio 9.

The size of yield spreads tends to remain constant over time.

Ans: False Difficulty: Moderate Ref: Important Considerations in Managing a Bond Portfolio 10. Yield spreads were at their widest during the Great Depression.

Ans: True Difficulty: Easy Ref: Important Considerations in Managing a Bond Portfolio 11. One of the most cost-effective methods of passive bond investing is buying into a bond ETF. Ans: True Difficulty: Moderate Ref: Passive Management Strategies 12. Under the ladder approach, bond investors purchase bonds with different maturities in order to gain some protection from default risk.

Ans: False Difficulty: Difficult Ref: Passive Management Strategies 13. For a zero coupon bond, duration is the same as time to maturity.

Ans: True Difficulty: Easy Ref: Managing Price Volatility.

14. Holding maturity constant, a decrease in rates will raise bond prices on a percentage basis more than a corresponding increase in rates will lower bond prices.

Ans: True Difficulty: Difficult Ref: Managing Price Volatility.

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15. Convexity is used to correct the approximate percentage change in bond value, calculated using modified duration.

Ans: True Difficulty: Moderate Section: Managing Price Volatility.

16. An investor desiring a bond investment that changes as little as possible as interest rates change should seek a bond with long duration rather than a strip.

Ans: False Difficulty: Moderate Section: Managing Price Volatility.

Short-Answer Questions

1.

Why are upward sloping yield curves more consistent with the usual risk-return tradeoff than downward sloping yield curves?

Answer: Long-term bonds have more interest-rate risk than short-term bonds. Thus the added risk of long-term is rewarded with higher returns on an upward sloping yield curve.

Difficulty: Moderate Ref: Important Considerations in Managing a Bond Portfolio 2.

What are the two components of interest-rate risk? How do they work to immunize a portfolio?

Answer: The two parts are price risk and reinvestment rate risk. Together immunization can occur because they offset each other. When interest rates go down, bond prices go up, but the income from reinvestment goes down. The two offset one another.

Difficulty: Moderate Ref: Immunization 3.

What are two passive management strategies? Two active strategies?

Answer: Passive – buy and hold and indexing.

Active – forecasting interest rate changes and identifying mispricing.

Difficulty: Easy Ref: Passive Management Strategies, Active Management Strategies

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4.

A client tells you that he strongly believes that interest rates in general will fall abruptly over the next six months. He asks you to recommend bonds for a portfolio to provide capital gains on the interest rate move. Generally, what would you suggest? What if he expected rates to rise?

Answer: He will get the biggest price increase from low-coupon, long-term bonds if rates fall.

If rates rise, he will experience capital losses, so he should hold cash or short-term securities.

Difficulty: Difficult Ref: Managing Price Volatility 5.

What are the advantages and disadvantages of index funds for an individual bond investor?

Answer: Many aggressively managed funds do not beat the market performance. Index funds should have lower advisory fees and operating expenses because indexing is a passive management approach. Bond funds can result in capital losses, unlike individual bonds held to maturity.

Difficulty: Moderate Ref: Passive Management Strategies 6.

Why is immunization considered to be a hybrid strategy?

Answer: Immunization is a hybrid between passive and active management strategies. It appears passive in that the initial portfolio is chosen so that the portfolio duration is equal to the portfolio’s designated time horizon. It must be actively managed, however, in that it must be rebalanced frequently to maintain the duration equal to the investment horizon.

Difficulty: Difficult Ref: Immunization

Critical Thinking/Essay Questions

1.

Immunization is intended to protect a portfolio against interest rate risk. What should be done? How does it work?

Answer: The portfolio duration should be set equal to a specified time horizon. It works because losses (gains) from price changes are offset by changes in income from reinvestment.

Difficulty: Moderate Ref: Immunization

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Problems 1.

You are asked to invest $30 million in a bond portfolio consisting of only two bonds.

Bond A has a duration of 4.36 years, and bond B has a duration of 6.50 years. The portfolio is to have an investment horizon of 5 years. How much of each bond issue would you have to buy to immunize the portfolio?

Solution: The portfolio’s duration must equal the investment horizon. The portfolio’s duration is the weighted average of the bonds' durations.

Let W be the weight of bond A. Then (1 – W) is the weight of bond B. W(4.36) + (1 – W)(6.50) = 5 2.14W = 1.5 W = 0.70 Invest in 70 percent bond A and 30 percent bond B. Difficulty: Moderate

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Ch.19, Chapter 19: OPTIONS

Multiple Choice Questions 1.

Put and call options on gold are considered:

a. b. c. d.

commodity derivatives. financial derivatives. forward contracts. futures contracts.

Ans: a Difficulty: Easy Ref: Overview 2.

One important reason for the existence of derivatives is that they:

a. b. c. d.

help reduce market volatility by making speculation more difficult. have valuable tax benefits. contribute to market completeness. are risk-free.

Ans: c Difficulty: Moderate Ref: Why Have Derivative Securities?

3.

Which of the following is not a reason for investors to trade options?

a. b. c. d.

Options eliminate leverage.

Options require a smaller investment than stock investments.

Options allow investors to trade on overall market movements.

Options can reduce risk.

Ans: a Difficulty: Moderate Ref: Introduction to Options 4.

The standard option contract is for:

a. b. c. d.

10 shares of stock.

50 shares of stock.

100 shares of stock.

1 share of stock.

Ans: c Difficulty: Easy Ref: Introduction to Options Chapter Nineteen Options

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5.

For Grace to maximize her potential return from a bullish view on a stock, she should:

a. b. c. d.

buy calls on the stock. write calls on the stock. buy puts on the stock. write puts on the stock.

Ans: a Difficulty: Easy Ref: Introduction to Options 5.

For Gordon to maximize his potential return from a bearish view on a stock, he should:

a. b. c. d.

buy calls. write calls. buy puts. write puts.

Ans: c Difficulty: Easy Ref: Introduction to Options 7.

John plans to acquire shares of ABC Corp. by purchasing and exercising a call option. Which of the following statements regarding John’s strategy is correct?

a. b. c. d.

John will experience no gain or loss from implementing the strategy.

John faces no risk from the strategy.

If John implements the strategy, it will not impact ABC’s shares outstanding.

John will pay no commission to implement the strategy.

Ans: c Difficulty: Moderate Ref: Introduction to Options 8.

LEAPS are typically:

a. b. c. d.

more expensive than short-term options. cheaper than short-term options. only available for major indexes, not individual stocks. long-term options, with maturities between 5 and 10 years.

Ans: a Difficulty: Moderate Ref: Introduction to Options

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9.

The exercise price on an option is also known as the:

a. b. c. d.

premium. strike price. theoretical value. spot price.

Ans: b Difficulty: Easy Ref: Introduction to Options 10.

Which of the following statements is true regarding American and European options?

a. b. c. d.

American options can be exercised only at expiration.

American options can be exercised only in the last week prior to expiration.

European options can be exercised only at expiration.

European options can be exercised any time prior to expiration.

Ans: c Difficulty: Moderate Ref: Introduction to Options 11.

Which of the following statements is true regarding the writer of a call contract?

a. b. c. d.

The call writer expects the stock to move upward.

The call writer expects the stock to remain the same or move down.

The call writer expects the stock to split.

The call writer expects to sell the stock prior to expiration of the option.

Ans: b Difficulty: Difficult Ref: Introduction to Options 12.

To hedge a short sale, an investor could:

a. b. c. d.

buy a call. write a call. buy a put. write a put.

Ans: a Difficulty: Moderate Ref: Introduction to Options

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13.

Options sold on exchanges are protected against:

a. b. c. d.

stock dividends and splits. cash dividends. interest rate movements. inflation.

Ans: a Difficulty: Easy Ref: Introduction to Options 14.

Other things equal, after an option is created, its:

a. b. c. d.

time value approaches zero as time passes. time value increases into its expiration date. value moves inversely with the volatility of the underlying stock. value will be zero whenever it is out of the money.

Ans: a Difficulty: Moderate Ref: Introduction to Options 15.

A writer of a call can terminate the contract before expiration by:

a. b. c. d.

writing a second call. buying a put. buying a comparable call. writing a put.

Ans: c Difficulty: Difficult Ref: Introduction to Options 16.

A call option written against stock owned by the writer is said to be:

a. b. c. d.

naked. in the money. out of the money. covered.

Ans: d Difficulty: Easy Ref: Payoffs and Profits from Basic Option Positions

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17.

The writer of a naked call faces:

a. b. c. d.

an unlimited potential loss. a specified potential loss. no chance of loss because this is a conservative strategy. an unlimited potential gain.

Ans: a Difficulty: Difficult Ref: Payoffs and Profits from Basic Option Positions 18.

To provide insurance against declining prices on previously purchased stock, an investor could:

a. b. c. d.

buy a call. write a put. buy a stock index option. buy a put.

Ans: d Difficulty: Moderate Ref: Some Basic Option Strategies 19.

Which of the following statements about portfolio insurance is false?

a. b.

There are several methods of insuring a portfolio.

It seeks to provide a minimum return while offering the opportunity to participate in rising prices.

Futures are typically not used to hedge stock portfolios.

Puts and calls typically are not used to insure portfolios.

c. d.

Ans: c Difficulty: Moderate Ref: Some Basic Option Strategies 20.

Which of the following is not a determinant of the value of a call option in the Black-Scholes model?

a. b. c. d.

The interest rate The exercise price of the stock The price of the underlying stock The beta of the underlying stock

Ans: d Difficulty: Moderate Ref: Option Valuation

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21.

If the price of the common stock exceeds the exercise price of a call, the call is said to be:

a. b. c. d.

naked. out of the money. in the money. covered.

Ans: c Difficulty: Moderate Ref: Option Valuation 22.

Which of the following is true regarding option pricing?

a. b. c. d.

The longer the maturity of the option, the higher the premium The more volatile the underlying stock, the lower the premium Option prices are less volatile than equity prices European options are more valuable than American options

Ans: a Difficulty: Moderate Ref: Option Valuation 23.

An option is a wasting asset because as its expiration date approaches, its:

a. b. c. d.

intrinsic value approaches zero. time value approaches zero. intrinsic value approaches its time value. price approaches zero.

Ans: b Difficulty: Difficult Ref: Option Valuation 24.

Gordon is considering purchasing either a call or a put option on XYZ stock.

Each of the options has an exercise price of $40 and XYZ is trading at $44.50 per share. Which of the following statements about the options is correct?

a. b. c. d.

The put option is in the money, whereas the call option is out of the money.

The call option is in the money, whereas the put option is out of the money.

Both the put and the call option are in the money.

Both the put and the call option are out of the money.

Ans: b Difficulty: Moderate Ref: Option Valuation

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25.

Sam is considering purchasing a call option on ABC stock. The call has a premium of $3, an exercise price of $50, and ABC is trading at $51 per share.

Which of the following statements about the call option is correct?

a. b. c. d.

The call has an intrinsic value of $1 and a time value of $2.

The call has an intrinsic value of $0 and a time value of $3.

The call has an intrinsic value of $3 and a time value of $2.

The call has an intrinsic value of $0 and a time value of $1.

Ans: a Difficulty: Difficult Ref: Option Valuation 26.

Stock A has a volatile price history, and Stock B has a stable price history. Stock A and Stock B are both trading at $25 per share. Which of the following 1-month options should sell for the highest price?

a. b. c. d.

A call option on Stock A with a $30 exercise price.

A call option on Stock B with a $30 exercise price.

A put option on Stock A with a $30 exercise price.

A put option on Stock B with a $30 exercise price.

Ans: c Difficulty: Difficult Ref: Option Valuation 27.

Which of the following market participants seeks to earn a return without assuming risk by constructing riskless positions?

a. b. c. d.

A speculator A call writer A put writer An arbitrageur

Ans: d Difficulty: Moderate Ref: Option Valuation 28.

Which of the following statements about call options is false?

a. b. c. d.

A call is in the money if the stock price exceeds the exercise price.

A call has no time value if its intrinsic value is zero.

If a call is out of the money, its intrinsic value is zero.

If a call is in the money, its intrinsic value is zero.

Ans: c Difficulty: Moderate Ref: Option Valuation Chapter Nineteen Options

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29.

Which of the following statements is true regarding equity options contracts?

a. b. c. d.

The majority of options contracts are standardized.

Investors typically create options contracts to trade amongst themselves.

Options contracts are typically customized to suit the needs of each investor.

Options are available on all publicly-traded U.S. stocks.

Ans: a Difficulty: Moderate Ref: Option Valuation 30.

Which of the following statements regarding options is true?

a. b. c. d.

An American option’s premium should not decline below its intrinsic value.

If a call is in the money, its time value is zero.

The speculative premium reflects the option’s immediate value.

If a call is out of the money, its time value is zero.

Ans: a Difficulty: Moderate Ref: Option Valuation 31.

A stock has a price of $68 per share. A two-month put (strike price = $70) on the stock is available at a $6 premium. The intrinsic value on the put is:

a. b. c. d.

$0 and its time value is $6. $0 and its time value is $4. $2 and its time value is $4. $4 and its time value is $2.

Ans: c Difficulty: Difficult Ref: Option Valuation 32.

In the Black-Scholes option pricing model:

a. b. c. d.

all of the inputs except two are observable. all of the inputs except one are observable. none of the inputs in the model are observable. all of the inputs in the model are observable.

Ans: b Difficulty: Difficult Ref: Option Valuation

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33.

Concerning stock index options, which of the following statements is false?

a. b. c. d.

Index options appeal to speculators due to the leverage they offer.

Investors can write index options.

If exercised, the holder of a stock index call receives the underlying stock.

Index options are settled in cash.

Ans: c Difficulty: Difficult Ref: An Investor's Perspective on Puts and Calls 34.

The way to protect a stock portfolio from a bear market is to:

a. b. c. d.

buy stock index calls. buy stock index puts. write stock index calls. write stock index puts.

Ans: b Difficulty: Difficult Ref: An Investor's Perspective on Puts and Calls 35.

At expiration, the writer of a stock index call option that was written at the money will be required to:

a. b. c. d.

deliver the underlying stocks in the index if the index value moves up. deliver the underlying stocks in the index if the index value moves down. deliver a cash value if the index value moves up. deliver a cash value if the index value moves down.

Ans: c Difficulty: Moderate Ref: An Investor's Perspective on Puts and Calls 36.

Walt wrote a put option that had a $15 strike price on ABC stock when the stock price was $16 per share. The option premium was $3. What is the maximum profit (per share) that Walt can make on his option position?

a. b. c. d.

$2 $3 $15 $16

Ans: b Difficulty: Moderate Ref: Payoffs and Profits from Basic Option Strategies

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37.

Carl purchased a call option on Apex stock that had a premium of $4, an exercise price of $25, and six-months to expiration. When he purchased the option, Apex was selling at $27 per share. What profit (per share) would Carl earn on his option transaction if Apex sells at $31 per share at expiration?

a. b. c. d.

$0 $2 $4 $6

Ans: b Difficulty: Moderate Ref: Payoffs and Profits from Basic Option Strategies 38.

Gwen wrote a put option with a $15 strike price on RDX stock when the stock price was $16 per share. The option premium was $3. What is the maximum loss (per share) that Gwen could experience on her option position?

a. b. c. d.

$3 $12 $14 $15

Ans: b Difficulty: Moderate Ref: Payoffs and Profits from Basic Option Strategies 39.

Texa Inc. is trading at $23 per share and has options available with a $30 strike price. Which of the following options will have the highest premium?

a. b. c. d.

A call option on Texa with a 1-month expiration A put option on Texa with a 1-month expiration A call option on Texa with a 3-month expiration A put option on Texa with a 3-month expiration

Ans: d Difficulty: Difficult Ref: Option Valuation 40.

The Options Clearing Corporation (OCC):

a. b. c. d.

always has a net position of zero. acts as a dealer in options, standing ready to buy or sell from its inventory. selects the broker with the largest holdings to honor the exercise of an option. uses first in, first out to select a broker to honor the exercise of an option.

Ans: a Difficulty: Moderate Ref: Introduction to Options Chapter Nineteen Options

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41.

Which of the following inputs in the Black-Scholes option pricing model is not observed?

a. b. c. d.

The interest rate The time to expiration The stock price The variability of the stock

Ans: d Difficulty: Moderate Ref: Option Valuation 42.

With regard to options, which of the following is not true of the hedge ratio?

a. b. c. d.

It indicates the change in the option price for a $1 change in stock price.

It represents the ratio of options written to shares held long in a riskless portfolio.

It is frequently greater than 1.

It is commonly referred to as the option’s delta.

Ans: c Difficulty: Moderate Ref: Option Valuation

True/False Questions

1.

An option buyer has three courses of action available: write a similar option to close the position, exercise the option, or let the option expire unexercised.

Ans: True Difficulty: Moderate Ref: Understanding Options 2.

The Options Clearing Corporation does not ensure fulfillment of option obligations.

Ans: False Difficulty: Easy Ref: Understanding Options 3.

The writer of a call, like the buyer of a put, is bearish about the stock price.

Ans: True Difficulty: Easy Ref: Understanding Options

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4.

Options traded on organized exchanges are protected against cash dividends.

Ans: False Difficulty: Moderate Ref: Understanding Options 5.

Options can be purchased on margin.

Ans: True Difficulty: Moderate Ref: Understanding Options 6.

A protective put is a strategy in which an investor with a long position in stock buys one or more puts.

Ans: True Difficulty: Moderate Ref: Understanding Options 7.

If the price of the underlying stock equals the strike price of the call option at maturity, the call buyer has a breakeven transaction.

Ans: False Difficulty: Moderate Ref: Payoffs and Profits from Basic Option Strategies 8.

If the price of the underlying common stock is less than the exercise price of a call, it is in the money.

Ans: False Difficulty: Easy Ref: Option Valuation 9.

There is a positive relationship between the price of a put option and the volatility of the underlying common stock.

Ans: True Difficulty: Difficult Ref: Option Valuation 10.

Writing a naked call is potentially riskier than writing a naked put.

Ans: True Difficulty: Difficult Ref: Option Valuation

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11.

According to the Black Scholes option pricing model, option value is a function of stock price, exercise price, time to maturity, interest rate, and volatility of the underlying asset.

Ans: True Difficulty: Easy Ref: Option Valuation

Short-Answer Questions 1.

What organizational feature of options trading prevents individual traders from having to worry about defaults if options are exercised?

Answer: Difficulty: Ref: 2.

What is meant by portfolio insurance?

Answer:

Difficulty: Ref: 3.

Portfolio insurance involves strategies to provide the portfolio a minimum return while allowing it to participate in rising prices. Securities used in implementing the strategy usually include options, futures, and synthetic options. Futures on indexes are commonly used to offset stock portfolio losses.

Moderate Understanding Options

An investor wants to hedge the Apple stock he holds in his portfolio. How can he use a covered call to do this?

Answer:

Difficulty: Ref: 4.

All contracts are effectively bought and sold through the Options Clearing Corporation, which stands behind the contracts.

Easy Understanding Options

The investor owns the stock and will profit if it increases in value or lose if it decreases. He can write a call and receive the premium from it. The premium will partially offset the loss if the stock price declines. If the stock price increases, he may be called upon to sell it at the exercise price.

This would limit his potential gains.

Difficult Understanding Options

An investor wants to hedge the Microsoft stock he holds in his portfolio. How can he use a protective put to do this?

Answer:

Difficulty: Ref: Chapter Nineteen Options

The investor owns the stock and will profit if it goes up and lose if it goes down. He buys a put. If the stock increases in value, he gains on the stock and loses the premium he paid for the put. If the stock goes down, he can exercise the put and sell the stock at the exercise price.

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5.

How can the owner of a large stock portfolio use options on individual stocks to enhance the income from the portfolio?

Answer:

Difficulty: Ref: 6.

What is a hedge ratio?

Answer:

Difficulty: Ref: 7.

Difficulty: Ref:

This principle expresses the relationship between the prices of puts and calls on the same stock that must hold if arbitrage is to be ruled out. In other words, unless the price of the put and call have a certain relationship to each other, there will be opportunities for earning riskless profits (arbitrage).

Difficult Option Valuation

List five options exchanges.

Answer:

Difficulty: Ref: 9.

The hedge ratio for a call is N(d1) from the Black-Scholes model. It is commonly called delta. It shows the change in the price of the option for a $1 change in the price of the underlying stock. The hedge ratio for a put is N(d1) – 1. This knowledge helps the portfolio manager determine how many options contracts are needed to protect the portfolio from price fluctuations.

Difficult Option Valuation

What is put-call parity? How is it related to arbitrage?

Answer:

8.

The owner of a portfolio may enhance the portfolio’s income by writing calls for the premium received. If the purchaser exercises the option, however, the writer will have to deliver the stock.

Moderate Payoffs and Profits from Basic Option Strategies

Chicago Board Options Exchange (CBOE), the American Exchange, the Philadelphia Exchange (now known as NASDAQ OMX PHLX), the International Securities Exchange (ISE) in New York, and NYSE Arca.

Difficult Understanding Options

What type of equity derivatives are created by corporations?

Answer: Difficulty: Ref:

Chapter Nineteen Options

Warrants.

Difficult Summary

253

Critical Thinking/Essay Questions 1.

What makes the risk-expected return profile attractive to speculators who purchase put and call options? What is the risk-expected return profile for writers of naked put and call options?

Answer:

Difficulty: 2.

What are the variables in the Black-Scholes option pricing model? How is each related to the price of the call option?

Answer:

Difficulty: 3.

Put and call options offer leverage compared to purchasing the common stock. The upside for puts and calls is unlimited because the potential increase (decrease) in the stock price is unlimited. The downside on options is limited to a 100 percent loss because no margin is allowed.

The loss on highly levered futures contracts can be far more. Thus, the advantage of options to speculators is the unlimited upside and the limited downside. In addition, speculators can enter this market with very small amounts of cash compared to the investment required for the stocks themselves.

The writer of naked options faces unlimited loss because the stock price can move up without limit or down to zero. The upside gain is limited to the amount received for the option.

Difficult

Price of underlying stock. The higher the stock price, the higher the option price.

Exercise price. The higher the exercise price, the lower the option price.

Time remaining to expiration. The longer the time, the higher the option price.

Interest rate. The higher the interest rate, the higher the call option price and the lower the put option price.

Volatility of underlying stock. The higher the volatility, the higher the option price.

Difficult

How could an investor create 100 shares of artificial stock (i.e., a portfolio with the same payoffs as 100 shares of common stock)?

Answer:

Difficulty:

Chapter Nineteen Options

Buy 1 long call and write 1 put contract (for 100 shares each), where the call and put have the same exercise price and time to maturity, plus a long investment of an amount equal to the exercise price in T-bills at the risk free rate, also with the same time to maturity. The resulting portfolio has the same payoffs on maturity as the underlying stock.

Difficult

254

Problems 1.

AB Flex Inc. stock is currently trading at $38. The time left until expiration of a call and put trading on the stock is 6 months, and the strike price is $45. If the call is currently trading at $1.96 and the Treasury bill rate is 10 percent per year, what price should the put sell for?

Solution:

Difficulty: 2.

Use put-call parity.

Price of put = = = = Difficult

EP/(ert) – CMP + CP 45/(e0.1*0.5) – 38 + 1.96 45/1.051271 – 38 + 1.96 6.77

SCORP has puts and calls available for trading for the expiration months of June, September, and December. For the trading day May 2, 201X, SCORP closed at $40 per share. Strike prices for SCORP are $35, $40, and $45. The following prices (in $s) for the 9 call options (3 expiration dates and 3 strike prices) for this date are (in scrambled order): A. B. C. D. E.

5.50 4.00 2.06 6.38 3.13

F. G. H. I.

4.88 0.75 7.25 2.44

Fill in the following matrix of prices for these calls, using LETTERS ONLY (i.e., A through I)

$35 $40 $45

June September ________ ________ ________ ________ ________ ________

Solution: June $35 A $40 E $45 G Difficulty:

Chapter Nineteen Options

September D B C

December ________ ________ ________

December H F I

Difficult

255

3.

An investor has the alternative of buying 100 shares of XYZ at $50 per share or investing the same amount of money in XYZ 6-month calls priced at $5.

Calculate the profit or loss from each strategy if XYZ rises to $60 within a week.

Solution:

Buying the stock gain = $10 per share x 100 shares = $1000

Buying 10 option contracts ($5000 to invest/$500 per option contract): gain

= 10 options contracts x assumed $10 gain per share on options = 10 x 1000 per contract = $10,000 Difficulty: Moderate

4.

ABC, which closed at $151, has call options trading in April, July, and October with the following values: ------------Calls------------Options/Strike April July October ABC 140 11.25 11.75 13.00 151 150 1.50 3.00 4.00 151 160 0.75 1.50 2.00 (a) (b) (c)

Calculate the intrinsic value of the April 150 call.

Calculate the intrinsic value of the April 140 call.

Assume ABC rises to $156, what is the minimum price for April 150 call?

Answer:

(a) (b) (c)

Intrinsic value = Intrinsic value = Minimum value=

Difficulty:

Moderate

151 - 150 151 - 140 156 - 150

= = =

$1.00 $11 $6

5.

Listed below are the option quotes on JUP, Inc. in January of this year.

-------Calls--------------Puts-------Options/Strike March June March June JUP 35 3.50 4.00 0.50 1.13 37 40 1.50 2.00 4.50 5.00 37 45 1.00 1.50 8.38 s 37 50 0.50 r r s

(a) (b) (c)

Which calls are in the money?

Which puts are in the money?

Why are investors willing to pay $3.50 for the March 35 call but only $0.50 for the March 35 put?

Calculate the intrinsic value of the June 35 call.

Calculate the intrinsic value of the March 40 put.

(d) (e)

Chapter Nineteen Options

256

Solution: (a) In-the-money calls have E<S. Since S= 37 only the March 35 call is in the money. (b)

In-the-money puts are those whose E>S. Hence, the March 40, March 45 and June 40 puts are in-the-money.

(c)

Investors are willing to pay $3.50 for the March 35 call option because it has an intrinsic value of $2 and the rest is speculative premium. Investors probably expect the stock to go up by March. On the other hand, the March 35 put is outof-the money, i.e. its intrinsic value is zero. There is still some chance that the price may drop below 35, at which time the investor may make a profit. Hence, there is a small speculative premium of $0.50 on the put option.

(d)

Intrinsic Value of June 35 Call = Stock Price - Exercise Price = 37 - 35 = $2

(e) Intrinsic Value of the March 40 put = Exercise Price - Stock Price = 40 - 37 = $3 Difficulty: Difficult

6.

Use the Black-Scholes model to calculate the theoretical value of a DBA December 45 call option. Assume that the risk free rate is 6 percent, the stock has a variance of 36 percent, there are 91 days until expiration of the contract, and DBA stock is currently selling at $50 in the market.

CMP[N(d1)] – [EP/ert][N(d2)]

Solution:

Value of Call =

Where CMP EP = r = t = N(d1) =

= Current market price = Strike price = $90 risk-free rate = 0.06 time till maturity in years = cumulative density function of d1 d1

=

ln(CMP/EP) + t1/2

$100

91/365 = (r + 0.52)t

2 = N(d2) =

variance of the stock's annual rate of return = cumulative density function of d2 d2 = d1 - t1/2

d1

=

ln(100/90)

= =

[0.10536 + 0.06]/0.3 0.5512

d2

=

N(d1) = N(d2) =

Chapter Nineteen Options

+ [0.06 + 0.5(.36)](0.25) (0.36)1/2 (0.25)1/2

0.5512 - 0.6(0.5) = 0.5512 - .3 = 0.2512 0.7088 (from standard normal table) 0.5987 (from standard normal table)

257

0.25

0.36

Value of the call = [$100(.7088)] - [$90/e(0.06)(0.25)][.5987] = 70.88 - [90(.9851)(.5987)] = $70.88 - $53.08 = $17.80 Difficulty: Difficult

7.

You buy 1,000 shares of Sunbeam at $11.13 and write 10 calls at a premium of $4.38 with a strike price of $7.50. The stock goes to $20 in 6 months. You receive an $0.08 dividend per share. If the calls are exercised (which is the likely assumption), what is your percentage return?

Loss on selling stock = sell stock at 7.5 x 1,000 bought stock at 11.13 x 1,000

= $7,500 = 11,130 (3,630)

Dividends received = .08 x 1,000 = $80 Premium received on writing calls = 4.38 x 100 x 10 = $4,380 Total return = $830 Percentage return = $830/11,130 = 7.5% Difficulty:

Chapter Nineteen Options

Moderate

258

Ch.20, Chapter 20: FUTURES

Multiple Choice Questions 1.

The forward price is:

a. b. c. d.

the price agreed upon today for deferred delivery of an asset. the spot price of an asset at the time it is delivered in the future. the future value of the spot price of an asset. a multiple of the current spot market price.

Ans: a Difficulty: Moderate Ref: An Overview of Futures Markets 2.

A forward contract differs from a futures contract in that:

a. b. c. d.

a forward contract is for a shorter period of time. a forward contract does not specify the selling price. a forward contract is not standardized. a forward contract is non-binding.

Ans: c Difficulty: Moderate Ref: Understanding Futures Markets 3.

Futures contracts are regulated by the:

a. b. c. d.

Securities Exchange Commission.

National Association of Security Dealers.

National Association of Commodity Dealers.

Commodity Futures Trading Commission.

Ans: d Difficulty: Easy Ref: Understanding Futures Markets 4.

A futures contract is:

a. b. c. d.

a negotiable, nonmarketable instrument. a security, like a stock or bond. a standardized, transferable agreement providing for deferred delivery of an asset. not a legal contract, and therefore its terms can be changed.

Ans: c Difficulty: Easy Ref: Understanding Futures Markets

Chapter Twenty Futures

257

5.

The underlying asset type that futures contracts were first traded on were:

a. b. c. d.

stock indexes. foreign currencies. commodities. government bonds.

Ans: c Difficulty: Easy Ref: Understanding Futures Markets 6.

Which of the following variables is not established on a futures contract?

a. b. c. d.

Contract size Contract premium Delivery date Specified grade

Ans: b Difficulty: Easy Ref: Understanding Futures Markets 7.

Futures trade on the:

a. b. c. d.

spot market. over-the-counter market. forward exchanges. futures exchanges.

Ans: d Difficulty: Easy Ref: The Structure of Futures Markets 8.

Futures exchange members:

a. b. c. d.

trade strictly for their own accounts. trade strictly for others. can trade for their own accounts or for others. are not allowed to trade on the exchange where they are members.

Ans: c Difficulty: Moderate Ref: The Structure of Futures Markets

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258

9.

Who assumes the other side of every futures transaction?

a. b. c. d.

The dealer The futures exchange The commodity producer The clearinghouse

Ans: d Difficulty: Moderate Ref: The Structure of Futures Markets 10.

As an economic function of futures markets, what does “price discovery” mean?

a. b. c. d.

The futures price and spot price converge over time.

The spot price is a discounted value of the futures price.

The futures price provides information about the expected future spot price.

In equilibrium, the spot price and futures price are equal.

Ans: c Difficulty: Moderate Ref: The Structure of Futures Markets 11.

In the case of a futures contract, buyers can settle a contract:

a. b. c. d.

only by taking delivery. only by arranging an offsetting contract. either by delivery or offset. by a combination of delivery and offset.

Ans: c Difficulty: Easy Ref: The Mechanics of Trading 12.

Approximately what percentage of futures contracts are offset prior to delivery?

a. b. c. d.

25 50 75 95

Ans: d Difficulty: Moderate Ref: The Mechanics of Trading

Chapter Twenty Futures

259

13.

When trading futures, margin:

a. b. c. d.

is seldom used. indicates that credit is being extended. serves as a down payment. in effect, is a performance bond.

Ans: d Difficulty: Moderate Ref: The Mechanics of Trading 14.

Which of the following is a characteristic of futures contracts?

a. b. c. d.

They are marked to market daily.

They can be sold short but only on an uptick.

They are handled by specialists on futures exchanges.

They have no daily price limits.

Ans: a Difficulty: Easy Ref: The Mechanics of Trading 15.

The initial margin required for futures trading:

a. b. c. d.

is only put up by the seller. is only put up by the buyer. is put up by the party initiating the transaction, either the buyer or the seller. must be put up by both the buyer and the seller.

Ans: d Difficulty: Moderate Ref: The Mechanics of Trading 16.

Which of the following statements about futures trading is incorrect?

a. b. c. d.

There are no specialists on futures exchanges.

All futures contracts are eligible for margin trading.

Trading is halted for the day if the price reaches the daily limit.

The uptick rule applies to the shorting of futures contracts.

Ans: d Difficulty: Moderate Ref: The Mechanics of Trading

Chapter Twenty Futures

260

17.

How often are futures contracts marked to market?

a. b. c. d.

Daily Weekly Monthly Quarterly

Ans: a Difficulty: Moderate Ref: The Mechanics of Trading 18.

The number of unliquidated futures contracts at any point in time is called:

a. b. c. d.

margin. open interest. hedged position. marked to market position.

Ans: b Difficulty: Moderate Ref: The Mechanics of Trading 19.

To protect the value of a bond portfolio against a rise in interest rates using bond futures contracts, the portfolio owner should execute a:

a. b. c. d.

long hedge. duration hedge. short hedge. maturity hedge.

Ans: c Difficulty: Moderate Ref: Using Futures Contracts 20.

An investor planning to buy bonds in the future and wishing to lock in the current price using bond contracts should enter a:

a. b. c. d.

long hedge. short hedge. basis hedge. margin hedge.

Ans: a Difficulty: Moderate Ref: Using Futures Contracts

Chapter Twenty Futures

261

21.

The difference between the cash price and the futures price on the same asset or commodity is known as the:

a. b. c. d.

basis. spread. yield spread. premium.

Ans: a Difficulty: Easy Ref: Using Futures Contracts 22.

Speculators in the futures market:

a. b. c. d.

make the market more volatile. contribute liquidity to the market. engage mainly in short positions. serve no real economic function.

Ans: b Difficulty: Moderate Ref: Using Futures Contracts 23.

One difference between a hedger and a speculator is that the hedger:

a. b. c. d.

may experience either a profit or a loss. may not close out his position by taking an opposite position. does not have to put up margin. faces a risk without the futures contract.

Ans: d Difficulty: Moderate Ref: Using Futures Contracts 24.

Which of the following is not a potential advantage of speculating in futures?

a. b. c. d.

Leverage Ease of transacting Low transactions costs High and narrow probability distribution of expected returns

Ans: d Difficulty: Moderate Ref: Using Futures Contracts

Chapter Twenty Futures

262

25.

Interest rate futures are not currently available on which of the following securities?

a. b. c. d.

Corporate bonds Treasury notes One-month LIBOR rate Eurodollars

Ans: a Difficulty: Moderate Ref: Financial Futures 26.

Which of the following statements about the basis risk on futures is correct?

a. b. c. d.

Basis risk is often completely eliminated by hedging.

Although the basis fluctuates over time, it can be precisely predicted.

The basis is approximately zero on the maturity date of the contract.

A hedge will reduce risk as long as the basis does not fluctuate.

Ans: c Difficulty: Difficult Ref: Financial Futures 27.

Stock-index futures can be used to hedge against which of the following types of risks?

a. b. c. d.

Diversifiable risk Systematic risk Unsystematic risk Company specific risk

Ans: b Difficulty: Easy Ref: Single Stock Futures 28.

An investor who sells a T-bond futures contract is expecting to profit from:

a. b. c. d.

an increase in the price of the T-bond. an increase in the level of interest rates. interest rates remaining unchanged. the coupon payments from the T-bond.

Ans: b Difficulty: Difficult Ref: Financial Futures

Chapter Twenty Futures

263

29.

Which of the following represents the most popular stock-index futures position that is used to benefit from a stock market decline?

a. b. c. d.

A short position in the S&P 500 contract A long position in the S&P 500 contract A short position in the DJIA contract A long position in the DJIA contract

Ans: a Difficulty: Moderate Ref: Single Stock Futures 30.

An attempt to exploit differences between the prices of a stock index futures contract and the prices of the underlying stocks is known as:

a. b. c. d.

index programming. arbitrage speculation. index arbitrage. program speculation.

Ans: c Difficulty: Moderate Ref: Stock-Index Futures 31.

The basis is equal to the:

a. b. c. d.

cash price. futures price. cash price + futures price. cash price – futures price.

Ans: d Difficulty: Moderate Ref: Using Futures Contracts 32.

Which of the following statements about derivatives is correct?

a. b. c. d.

Both futures and options represent zero-sum games.

Futures represent a zero-sum game, but options do not.

Options represent a zero-sum game, but futures do not.

Neither options nor futures represents a zero-sum game.

Ans: a Difficulty: Easy Ref: The Mechanics of Trading

Chapter Twenty Futures

264

True/False Questions 1. Investors in futures can take either a long, short, or neutral position.

Ans: False Difficulty: Easy Ref: Understanding Futures Markets 2. Japan, which banned financial futures in 1985, is now very active in developing futures exchanges.

Ans: True Difficulty: Moderate Ref: Understanding Futures Markets 3. The National Futures Association is the federal agency which regulates the futures markets.

Ans: False Difficulty: Moderate Ref: Understanding Futures Markets 4. Futures are essentially standardized forward contracts.

Ans: True Difficulty: Easy Ref: Understanding Futures Markets 5. Futures contracts are handled by specialists on futures exchanges.

Ans: False Difficulty: Moderate Ref: The Mechanics of Trading 6. Most futures contracts are settled by delivery.

Ans: False Difficulty: Easy Ref: The Mechanics of Trading 7. In a margin account, if the account balance falls below the maintenance margin, a margin call is triggered.

Ans: True Difficulty: Easy Ref: The Mechanics of Trading

Chapter Twenty Futures

265

8. Investors can speculate on interest rate declines by purchasing interest rate futures.

Ans: True Difficulty: Moderate Ref: The Mechanics of Trading 9. With futures, hedging requires one to simply take an opposite position.

Ans: True Difficulty: Moderate Ref: Using Futures Contracts 10. The DJIA is the most popular stock-index futures contract.

Ans: False Difficulty: Moderate Ref: Financial Futures 11. An anticipatory hedge is when an investor anticipates a falling market and liquidates his position.

Ans: False Difficulty: Difficult Ref: Financial Futures 12. A pension fund holds $10 million in T-bonds. In order to protect against a rise in interest rate, the pension fund should use a short hedge in T-bond futures.

Ans: True Difficulty: Difficult Ref: Financial Futures 13. Index arbitrage attempts to exploit the differences between the prices on two different stock indices.

Ans: False Difficulty: Difficult Ref: Financial Futures 14. Program trading generally involves positions in both stocks and stock-index futures.

Ans: True Difficulty: Difficult Ref: Financial Futures

Chapter Twenty Futures

266

15. Stock-index futures may be settled either by cash or by delivery of securities.

Ans: False Difficulty: Easy Ref: Financial Futures 16. U.S. futures trading is regulated primarily by the CFTC. Ans: T Difficulty: Easy Ref: Financial Futures 17. Futures exchanges standardize nonstandard forward contracts, establishing such features as contract size, delivery dates, and grades that can be delivered. Only the price and number of contracts are left for futures traders to negotiate.

Ans: True Difficulty: Moderate Ref: The Structure of Futures Markets 18. The calendar or time spread is also known as the intramarket spread, and involves contracts for two different settlement months, such as buying a March contract and selling a June contract.

Ans: True Difficulty: Moderate Ref: Financial Futures 19. The intermarket spread is also known as a quality spread, involving two different markets, such as buying an NYSE contract and selling an S&P contract for the same month.

Ans: True Difficulty: Moderate Ref: Financial Futures 20. The initial margin requirement on an SSF contract is 50 percent.

Ans: False Difficulty: Moderate Ref: Single Stock Futures

Chapter Twenty Futures

267

Short-Answer Questions 1.

Explain the difference between a forward contract and a futures contract.

Answer:

Difficulty: Ref: 2.

What is the role of the clearinghouse in futures trading?

Answer:

Difficulty: Ref: 3.

The clearinghouse assumes the position between the buyer and seller in every trade. Every trade is effectively made with the clearinghouse instead of with another party. The clearinghouse ensures the integrity of every trade. If either the buyer or seller defaults, the clearinghouse makes good on the transaction, allowing an orderly market to proceed. The clearinghouse makes it possible for traders to reverse their positions by buying or selling an opposite transaction.

Moderate The Structure of Futures Markets

Explain a long position and a short position in futures trading.

Answer:

Difficulty: Ref: 4.

A forward contract is an individual agreement for the delivery of an item for a specified price at a specified future date. Forward contracts are not standardized. Futures contracts are standardized, transferable agreements for the delivery of specified grades, amounts, and delivery dates. Futures are traded in organized markets.

Moderate Understanding Futures Markets

A buyer who agrees to purchase an item at contract maturity has a long position. The seller who agrees to deliver the item at contract maturity has the short position.

Easy The Mechanics of Trading

Compare the obligation entered into in a futures contract to the obligation in an options contract.

Answer:

Difficulty: Ref:

Chapter Twenty Futures

The buyer in an options contract has the choice of whether or not to exercise the contract. The seller of the option is obligated to deliver if the buyer chooses to exercise the option. Both the buyer and seller are obligated to take or make delivery in a futures contract. The obligation can be offset, however, by buying or selling an opposite contract.

Moderate The Mechanics of Trading

268

5.

Briefly discuss the concept of margin in futures trading.

Answer:

Difficulty: Ref: 6.

What are the methods of settling a futures contract?

Answer:

Difficulty: Ref: 7.

Difficulty: Ref:

All profits and losses are credited and debited to investors’ accounts daily.

This is called marking to market. If an account has gains, the excess can be withdrawn. If the equity value falls below the maintenance margin level, a margin call will be issued. The process is known as daily resettlement.

Moderate The Mechanics of Trading

What is the difference between hedgers and speculators in the futures markets?

Answer:

Difficulty: Ref: 9.

A purchaser of a futures contract can take delivery of the commodity or, in the case of financial futures, settle in cash. The alternative usually taken, however, is to offset the contract by selling an identical contract (or buying one if the trader was short). Thus, the trader has one obligation to deliver and one to receive, so they offset one another. Delivery actually occurs in less than five percent of contracts.

Moderate The Mechanics of Trading

What is meant by the term "marked to market"?

Answer:

8.

The item being traded is not transferred at the time of the futures contract, so the margin is not a down payment. Instead, it is a performance bond. It is common for the margin to be in the range of two to ten percent of the value of the contract.

Moderate The Mechanics of Trading

Hedgers face the risk of buying or selling commodities or financial instruments before entering the futures markets. Hedgers enter the futures markets in an attempt to reduce an already existing risk. Speculators face no risk before entering the futures market. They enter a high-risk contract in expectation of high returns.

Moderate Using Futures Contracts

What is the focus of speculators who spread stock-index futures?

Answer:

Difficulty: Ref: Chapter Twenty Futures

Stock-index spreaders think that the prices of different index futures are out of equilibrium and soon will adjust. They are interested in relative, not absolute, price changes. Intramarket spreads use two contracts on the same index with different settlement months. Intermarket spreads use two contracts on different indexes with the same expiration dates.

Moderate Financial Futures 269

Critical Thinking/Essay Questions 1.

What economic functions are fulfilled by futures?

Answer:

Difficulty: Ref: 2.

Are futures – commodity, interest-rate, stock-index, or currency – appropriate for most individual investors?

Answer:

Difficulty: Ref: 3.

Forward contracts have long allowed two parties to make an agreement for future delivery of some commodity at an agreed upon price, addressing the risk of intervening price fluctuations. Futures contracts transfer the risk of price fluctuations from hedgers to speculators. Speculators absorb excess supply or demand, contribute to the liquidity of the markets, and reduce price variability over time. Hedgers are glad to transfer the risk and accept lower expected returns, whereas the speculator seeks the high end of the risk-expected return tradeoff.

Moderate Financial Futures

Futures are appropriate for sophisticated institutional investors or businesses wanting to hedge a position. Futures are very dangerous for individual speculators because of the extremely high leverage, rapid price changes, and high commissions. Individual speculators are no match for the professionals on the floor of the exchanges. The professionals' knowledge, expertise, and ability to buy or sell instantaneously put them at an advantage over the individual.

Moderate Financial Futures

Do options on futures serve any economic purpose, or are they just sophisticated games?

Answer: Difficulty: Ref:

Chapter Twenty Futures

Options on futures transfer risk just as futures contracts do. Thus, they do serve an economic purpose.

Easy Financial Futures

270

Problems 1.

Assume an investor buys one June NYSE Composite Index futures contract on May 1 at a price of 72. The position is closed out after four days. The prices on the three days after purchase were 72.5, 72.1 and 72.2. The initial margin is $3500.

(a) (b) (c)

Calculate the current equity on each of the next three days.

Calculate the excess equity for those three days.

Calculate the final gain or loss on this position.

Solution: The initial margin is $3500.

Each point in price is equivalent to 20 ticks worth $25 each, or $500. (a) Equity on day of purchase = $3500 Increase in equity after day one (price is 72.5)=(72.5-72=.5 or 10 ticks worth $250) Equity after one day = 250 + 3500 = $3750 Decrease in equity after day 2 (price is 72.1) = (72.1 - 72.5 = -.4 or 8 ticks worth - $200) Equity after day two = -200 + 3750 = $3550 Increase in equity after day 3 (price is 72.2) = (72.2 - 72.1 = .1 or 2 ticks worth $50) Equity after day three = +50 + 3550 = $3600 (b) The excess equity is $250, $50, $100. (c) The final gain is $3600 - $3500 = $100.

Difficulty: Moderate 2.

(a) (b) (c)

Assume a portfolio manager holds $2 million (par value) of 9 percent T-bonds that mature in 5 to 10 years. The current market price is 77, for a yield of 12 percent. Fearing a rise in interest rates over the next three months, the manager seeks to protect this position by hedging in futures.

If T-bond futures are available at 67, what is the gain or loss from a simple hedge of 20 contracts if the price three months later is 60?

What is the gain or loss on the cash position if the bonds are priced at 68 three months hence?

What is the net effect of this hedge?

Solution: (a) Since the manager is long in the cash market, the correct hedge is a short futures position.

This problem ignores weighted hedges. The $2 million face value represents $2,000,000/$1000 = 2000 bonds, which at a current price of 77 is worth $1,540,000.

The manager sells 20 contracts at a current price of 67, for a total transaction value of 20($67,000) = $1,340,000. Repurchasing the futures three months later at a price of 60 results in a total cost of 20($60,000) = $1,200,000.

Beginning sale $67,000 x 20 = Ending purchase $60,000 x 20 = Gain from short futures =

Chapter Twenty Futures

271

$1,340,000 1,200,000 $140,000

(b)

As noted in (a), there are 2000 bonds. If the bonds are priced at 68 three months later, the cash market position is:

Beginning: $770 x 2000 = Ending: $680 x 2000 = Loss from long bonds = (c)

$1,540,000 $1,360,000 $180,000

The net effect of this hedge is a loss of $40,000.

Gain from short futures Loss from long bonds Net loss Difficulty:

= =

$140,000 from part (a) 180,000 from part (b) $40,000

Difficult

3.

An investor just sold seven contracts of June corn on the CBOT. The price per bushel is $1.64, and each contract is for 5000 bushels. The performance bond (initial margin deposit) is $2000 per contract with the maintenance margin at $1250.

(a) (b)

How much does the investor have to deposit on the investment?

If the price of the futures on the three days following the contract sale are: 1.60, 1.66, and 1.68 calculate the current equity on each of the next three days.

If the investor closes out his position on the fourth day, what is his final gain or loss over the four days in dollars and as a percentage of investment?

(c)

Solution:

(a)

Position on Day 1 (purchase day) Market value of futures sold $1.64 x 5000 x 7=$57,400 Initial margin or total deposit at time of purchase $2000 x 7 = $14,000 (b) Position on Day 2 Market value of futures $1.60 x 5000 x 7= $56,000 Price when sold (from part a) $57,400 Gain (loss) (Note: A decrease in price creates a gain on a short position.) $1,400 Current equity (initial margin + gain)

$14,000 + 1,400

Position on Day 3 Market value of futures Price when sold (from part a) Gain (loss) Current equity (initial margin + gain)

$1.66 x 5000 x 7=

$14,000 - 700

Position on Day 4 Market value of futures Price when sold (from part a) Gain (loss) Chapter Twenty Futures

=

=

$1.68 x 5000 x 7=

272

$15,400

$58,100 $57,400 ($700) $13,300

$58,800 $57,400 ($1,400)

Current equity (initial margin + gain)

$14,000 – 1,400

(c) Final gain or loss Price at time of short sale Price at time of purchase to cover Gain (loss) Rate of Return over the 4 days = (1,400)/14,000 = -10 percent Difficulty:

Chapter Twenty Futures

=

$1.60 x 5000 x 7 = $1.68 x 5000 x 7 =

=

Moderate

273

Loss/Initial Deposit

$12,600

$57,400 58,800 ($1,400)

Ch.21, Chapter 21: PORTFOLIO MANAGEMENT

Multiple Choice Questions 1.

Which of the following is not part of the portfolio management process?

a. b. c. d.

Determining investor objectives, constraints, and preferences Selling weak performing securities from the portfolio Forming expectations for the economy and its sectors Developing and implementing a strategy

Ans: b Difficulty: Easy Ref: Managing Your Financial Assets 2.

The first step of the portfolio management process is:

a. b. c. d.

to assess market conditions. to determine investor objectives, constraints, and preferences. to develop strategies and implement them. portfolio construction.

Ans: b Difficulty: Moderate Ref: Managing Your Financial Assets 3.

The document that describes an investor’s objectives and constraints is:

a. b. c. d.

the prospectus. the indenture. the investment policy statement. the portfolio optimization contract.

Ans: c Difficulty: Easy Ref: A Perspective on Investing in Financial Assets 4.

In order to protect principal against possible loss caused by distressed selling, individuals are typically recommended to have a:

a. b. c. d.

1-month emergency fund.

2-month emergency fund.

6-month emergency fund.

12-month emergency fund

Ans: c Difficulty: Moderate Ref: What Issues do Investors Face in Financial Planning?

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5.

The phases of the life cycle for setting individual investment objectives are:

a. b. c. d.

accumulation, consolidation, retirement, and estate planning. accumulation, consolidation, retirement, and gifting. accumulation, consolidation, spending, and retirement. accumulation, consolidation, spending, and gifting.

Ans: d Difficulty: Difficult Ref: Investor Objectives 6.

Which of the following is not true regarding the life-cycle approach to investment?

a. b. c. d.

It is most appropriate for institutions.

It automatically becomes more conservative as the investor nears retirement age.

It is suited to 401(k) plans.

It can be implemented using life-cycle (also known as target-date) funds.

Ans: a Difficulty: Moderate Ref: Managing Your Financial Assets 7.

The components of the investment policy statement (IPS) include the:

a. b. c. d.

minimum investment and maximum fees.

SEC guidelines for prudent investor actions. objectives, constraints, and preferences. asset allocation parameters and time horizons.

Ans: c Difficulty: Easy Ref: Managing Your Financial Assets 8.

Which of the following is not one of the phases of the life-cycle theory of asset allocation?

a. b. c. d.

Accumulation Consolidation Gifting Retirement

Ans: d Difficulty: Moderate Ref: Investor Objectives

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9.

According to the life-cycle approach, investors normally assume a moderate trade-off between risk and return in the:

a. b. c. d.

accumulation phase. consolidation phase. spending phase. gifting phase.

Ans: b Difficulty: Moderate Ref: Investor Objectives 10.

Which of the following is not among the usual constraints and preferences considered when formulating an investment policy statement?

a. b. c. d.

Avoidance of so-called “sin” stocks (alcohol, tobacco, firearms, etc.)

Liquidity needs Economic assessment Time horizon

Ans: c Difficulty: Moderate Ref: Managing Your Financial Assets 11.

Living expenses are covered from accumulated assets rather than from earned income in the:

a. b. c. d.

accumulation phase of the life cycle. consolidation phase of the life cycle. spending phase of the life cycle. saving phase of the life cycle.

Ans: c Difficulty: Moderate Ref: Investor Objectives 12.

In the investment policy statement (IPS), investor objectives focus on:

a. b. c. d.

accumulation and consolidation. return and taxes. risk and return. security selection and asset allocation.

Ans: c Difficulty: Moderate Ref: Investor Objectives

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13.

Which act governs employer-sponsored retirement plans?

a. b. c. d.

Investors Advisors Act Investment Company Act Security Investors Protection Act Employment Retirement Income Security Act

Ans: d Difficulty: Moderate Ref: What Issues do Investors Face in Financial Planning?

14.

One aspect of the tax considerations in asset allocation is that:

a. b. c. d.

capital gains are often taxed at a higher rate than dividend and interest income.

Roth accounts offer a tax savings in the year they are opened. investors are exempt from taxes on capital gains once they reach age 65. taxes on capital gains are deferred until the gain is realized.

Ans: d Difficulty: Moderate Ref: What Issues do Investors Face in Financial Planning?

15.

Based on empirical evidence, which of the following is the most important aspect in explaining portfolio performance?

a. b. c. d.

Security selection Market timing Transactions costs Asset allocation

Ans: d Difficulty: Moderate Ref: Implementing Investing Strategies 16.

Which of the following is not a major consideration in the asset allocation process?

a. b. c. d.

Return requirements Risk tolerance Ease of monitoring progress Time horizon

Ans: c Difficulty: Easy Ref: Implementing Investing Strategies

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17.

The life-cycle theory of asset allocation proposes that as investors progress through life their:

a. b. c. d.

asset allocation will tend to become more conservative. earnings increase in their 20s, reach a peak at about age 45, then decline. assets must grow geometrically in order to achieve reasonable goals. asset allocation should remain fixed in order to avoid short-sighted adjustments.

Ans: a Difficulty: Easy Ref: Implementing Investing Strategies 18.

Relative to a conservative allocation, an aggressive asset allocation would contain larger proportions of:

a. b. c. d.

value stocks and bonds. bonds and large-cap stocks. small-cap and international stocks. defensive stocks.

Ans: c Difficulty: Moderate Ref: Implementing Investing Strategies 19.

Relative to their holdings in their early careers, conservative retirees likely have greater holdings of:

a. b. c. d.

small-cap stocks. international stocks. cyclical stocks. low-beta stocks.

Ans: d Difficulty: Moderate Ref: Implementing Investing Strategies 20.

Historically, the annual return on the U.S. stock market has averaged approximately:

a. b. c. d.

3.0% 7.0% 10.0% 15.0%

Ans: c Difficulty: Moderate Ref: Checking Your Understanding

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21.

The Markowitz model identifies the set of portfolios that offers the:

a. b. c. d.

highest return for any given level of risk. least-risk for conservative investors. long-run approach to wealth accumulation for young investors. risk-free alternative for risk-averse investors.

Ans: a Difficulty: Moderate Ref: Implementing Investing Strategies 22.

A market timing approach that increases the proportion of funds in stocks when the stock market is expected to rise, and increases cash when stocks are expected to fall is a:

a. b. c. d.

strategic asset allocation. tactical asset allocation. portfolio optimization. liquidity timing allocation.

Ans: b Difficulty: Easy Ref: Implementing Investing Strategies 23.

Which of the following investors should allocate a relatively high portfolio weight to municipal bonds?

a. b. c. d.

A tax-exempt institution An individual investor in the accumulation phase of the life cycle An individual investor with high liquidity needs An individual investor in a high tax bracket

Ans: d Difficulty: Moderate Ref: Implementing Investing Strategies 24.

An investor with high liquidity needs and a short time horizon should have a relatively high allocation to:

a. b. c. d.

real estate. bonds. money market securities. low beta stocks.

Ans: c Difficulty: Moderate Ref: Implementing Investing Strategies

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25.

Investor expectations about expected returns from various asset classes should start with:

a. b. c. d.

long-term rates of return of those asset classes. last month’s rate of return of those asset classes. last year’s rate of return of those asset classes. the correlation of returns from asset classes over the past two years.

Ans: a Difficulty: Moderate Ref: Investor Expectations as Part of Financial Planning 26.

Which of the following is an advantage of monitoring and rebalancing a portfolio over time?

a. b. c. d.

Lower commissions Lower taxes A portfolio that is better aligned with objectives A portfolio with greater expected return

Ans: c Difficulty: Moderate Ref: Financial Planning on an Ongoing Basis, and Rebalancing a Portfolio of Financial Assets 27.

The "lockup" problem involved in rebalancing refers to the problem that:

a. b. c. d.

retirement accounts cannot be liquidated prior to retirement. trust accounts cannot be traded without incurring administrative costs. taxable accounts are subject to capital gains taxes if appreciated assets are sold. illiquid fixed income securities must be held until maturity.

Ans: c Difficulty: Difficult Ref: Rebalancing a Portfolio of Financial Assets 28.

An individual investor’s marginal tax rate is:

a. b. c. d.

higher than the investor’s effective tax rate. lower than the investor’s effective tax rate. equal to the investor’s effective tax rate. higher than the investor’s effective tax rate only when the investor is wealthy.

Ans: a Difficulty: Moderate Ref: Issues in Financial Planning

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29.

Investors following a constant proportion portfolio insurance (CPPI) investment strategy:

a. b. c. d.

increase their allocation to stocks after stock prices rise. increase their allocation to bonds after stock prices rise. increase their allocation to cash after stock prices rise. hedge their portfolio after stock prices rise.

Ans: a Difficulty: Moderate Ref: Basic Investment Management Strategies 30.

Over the past 10 years, Gordon has maintained his portfolio as 40% bonds and 60% stocks. The strategy Gordon has followed over this period is best described as:

a. b. c. d.

constant proportion portfolio insurance (CPPI). buy-and-hold. constant mix. portfolio optimization.

Ans: c Difficulty: Moderate Ref: Basic Investment Management Strategies 31.

Once a year, Rita resets the weights of her largest client’s portfolio to 50% debt and 50% equity. Which of the following best describes Rita’s actions with respect to the client’s portfolio? Rita is following a:

a. b. c. d.

buy-and-hold approach with calendar rebalancing. constant mix approach with calendar rebalancing. constant proportion portfolio insurance approach with corridor rebalancing. buy-and-hold approach with corridor rebalancing.

Ans: b Difficulty: Moderate Ref: Basic Investment Management Strategies 32.

Which of the following statements about investment strategies is true? Constant proportion portfolio insurance is a:

a. b. c. d.

contrarian strategy, whereas constant mix is a momentum strategy. momentum strategy, whereas constant mix is a contrarian strategy. contrarian strategy as is constant mix. momentum strategy as is constant mix.

Ans: b Difficulty: Difficult Ref: Basic Investment Management Strategies Chapter Twenty-one Portfolio Management

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True/False Questions 1.

To avoid problems of underperformance, passive investing through the use of indexed mutual funds and ETFs is generally the way to go for most individuals.

Ans: True Difficulty: Moderate Ref: Minimize Costs and Effort, and Improve Performance, When Managing a Portfolio of Financial Assets 2.

Monitoring and revision are part of the portfolio management process.

Ans: True Difficulty: Moderate Ref: Managing Your Financial Assets 3.

The Prudent Man Rule, which applies to fiduciaries, is a relatively new concept in investment management.

Ans: False Difficulty: Moderate Ref: What Issues do Investors Face in Financial Planning?

4.

Retirement programs offer tax sheltering for individual U.S. investors.

Ans: True Difficulty: Easy Ref: What Issues do Investors Face in Financial Planning?

5.

In order to arrive at an investment policy, it is necessary to determine whether the market is headed for a bull or bear market.

Ans: False Difficulty: Moderate Ref: Formulate an Appropriate Investment Policy 6.

Pension funds are governed by the prudent man rule since specific pension fund legislation has never passed.

Ans: False Difficulty: Moderate Ref: What Issues do Investors Face in Financial Planning?

7.

The long-term geometric mean return for the S&P 500 is between 15 and 20%.

Ans: False Difficulty: Moderate Ref: Check Your Understanding Chapter Twenty-one Portfolio Management

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8.

Financial plans should be monitored and updated on an ongoing basis. Examples of changes that can necessitate financial plan updating include changes in wealth, time horizon, liquidity requirements, tax circumstances, and regulations.

Ans: True Difficulty: Easy Ref: Financial Planning on an Ongoing Basis 9.

Common stocks are not always an inflationary hedge, but have a long history of strong performance over time.

Ans: True Difficulty: Moderate Ref: Investor Objectives 10.

Retirees would likely have a greater percentage of their wealth in common stock than would a recent college graduate.

Ans: False Difficulty: Moderate Ref: Investor Objectives 11.

An efficient set of portfolios offers maximum risk for any level of return.

Ans: False Difficulty: Moderate Ref: Implementing Investing Strategies 12.

The consolidation phase of the life cycle begins when the investor reaches retirement.

Ans: False Difficulty: Moderate Ref: Investor Objectives 13.

Under the life cycle approach, the lowest risk and lowest return should come during the spending and gifting stages.

Ans: True Difficulty: Moderate Ref: Investor Objectives 14.

The spending phase of the life cycle is avoided by investors who follow the prudent man rule.

Ans: False Difficulty: Moderate Ref: Implementing Investing Strategies Chapter Twenty-one Portfolio Management

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15.

Rebalancing is difficult for many investors because it represents a contrarian strategy.

Ans: True Difficulty: Difficult Ref: Rebalancing a Portfolio of Financial Assets 16.

An investor’s marginal tax rate is equal to total taxes paid divided by total income.

Ans: False Difficulty: Easy Ref: What Issues do Investors Face in Financial Planning?

17.

Portfolio performance evaluation is an important determinant of your success in financial planning.

Ans: True Difficulty: Easy Ref: Determining the Success of Your Financial Planning

Short-Answer Questions 1.

What are the steps in the portfolio management process?

Answer:

Difficulty: Ref: 2.

(1) Identify objectives, constraints, and preferences for investor.

(2) Capital market expectations are considered and quantified.

(3)Develop and implement strategies for optimal combinations of assets.

(4) Portfolio factors are monitored (5) The portfolio is rebalanced as needed (6) Portfolio performance is measured Moderate Portfolio Management as a Process

What are the differences between individual investors and institutional investors?

Answer:

Difficulty: Ref:

(1) Their definition of risk differs.

(2) Individuals have personalities, whereas institutions are somewhat removed from the personalities of the shareholders or beneficiaries.

(3) Goals and assets are more precise for institutions.

(4) Institutions face more constraints than individuals.

(5) Taxes are more important for individuals.

Moderate Portfolio Management as a Process

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3.

Give an example of how individual investors’ preferences are taken into account by institutional managers?

Answer:

Difficulty: Ref: 4.

How does the prudent investor rule affect asset allocation?

Answer:

Difficulty: Ref: 5.

Mutual funds have stated objectives that cater to specific individual goals.

Examples include tax-exempt municipal bonds funds, aggressive growth funds, growth and income funds, and so forth.

Moderate Portfolio Management as a Process

Whenever there is an investment advisor, the advisor is required to act with “prudence, discretion, and intelligence” in his/her duties. This rule is applied to the portfolio as a whole.

Moderate Formulate An Appropriate Investment Policy

What is the difference between strategic asset allocation and tactical asset allocation?

Answer:

Difficulty: Ref:

Given an investor’s objectives, constraints, and preferences, along with the manager’s forecasts of economic and market conditions, strategic asset allocation represents the optimal allocation for the future. Tactical asset allocation involves somewhat short-term moves away from the strategic allocation to take advantage of near-term perceived opportunities. For example, if a regulatory change is expected to provide an opportunity in a particular equity sector.

Moderate Developing and Implementing Investing Strategies

Critical Thinking/Essay Questions 1.

Explain the life-cycle theory of portfolio policies.

Answer:

Difficulty:

There are 4 different phases of investing, and each has different characteristics and different investing strategies.

Accumulation Phase: Net worth is small, but investors have a long time to invest and can afford to take larger risks.

Consolidation Phase: Income often exceeds expenses, and an investment portfolio can be accumulated. A Moderate risk-return tradeoff is expected. Spending Phase: Living expenses are often covered from accumulated assets rather than from earned income. Safety is more important now. Gifting Phase: The purpose of investment changes as investors pass on accumulated wealth. Low risk is still evident.

Moderate

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2.

Mr. Baker, a single person in early retirement, owns a house, a well-used car, and minimal life insurance. He has pension assets of about half a million dollars. He wants it all in tax-exempt municipal bonds so that “I won’t lose any money, and I won’t have to pay taxes.” Considering the life-cycle theory of asset allocation, would you suggest any alternatives to this client?

Answer:

Difficulty:

Considering the client’s need for income, bonds are a good choice, but the entire pension plan should not be in municipals. Munis are not necessarily safe. His assets suggest that he is not in a high tax bracket, which does not indicate the need for tax sheltering all of his income. The after-tax yield on alternative, taxable bonds should be compared to the tax exempts.

Since he may have a long time to live, he needs some protection from inflation. Allocating some of the portfolio to large-cap stocks would provide some inflation protection without subjecting all of the assets to stock market fluctuations. Some cash is needed for liquidity, and a small allocation to more risky stocks might sweeten his later years.

Difficult

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Ch. 22, Chapter 22: Evaluation of Investment Performance

Multiple Choice

1.

What is the major question when evaluating the performance of an individual’s portfolio?

a. b. c. d.

Does the portfolio align with the investor’s characteristics?

Does the expected return of the portfolio meet the needs of the investor?

Is the return on the portfolio adequate to compensate for its risk?

Is the portfolio’s risk in line with the personal characteristics of the investor?

Ans: c Difficulty: Difficult Ref: Performance Measurement Issues 2.

Which of the following represents the alternative portfolio that reflects the objectives of the portfolio under management?

a. b. c. d.

Market average index Efficient portfolio Benchmark portfolio Performance standard

Ans: c Difficulty: Moderate Ref: Performance Measurement Issues 3.

Which of the following indices is most appropriate as a benchmark portfolio for a large-cap mutual fund?

a. b. c. d.

Wilshire 5000 S&P 500 Dow Jones Industrial Average Russell 2000

Ans: b Difficulty: Easy Ref: Performance Measurement Issues

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4.

Which of the following measures indicates the percentage of the variation in a portfolio's returns that is explained by variation in the market's returns?

a. b. c. d.

Standard deviation Coefficient of determination Beta Alpha

Ans: b Difficulty: Moderate Ref: Performance Measurement Issues 5.

If we are to assess performance carefully, we must do so on what kind of basis?

a. b. c. d.

Quarterly Annual Attribution-weighted Risk-adjusted

Ans: d Difficulty: Moderate Ref: Performance Measurement Issues 6.

The Global Investment Performance Standards (GIPS®) were created by:

a. b. c. d.

the CFA Institute. the Securities and Exchange Commission (SEC).

Morningstar. the Federal Reserve.

Ans: a Difficulty: Moderate Ref: Performance Measurement Issues 7.

The reward-to-variability ratio (Sharpe ratio) measures:

a. b. c. d.

return above the risk-free rate. excess return per unit of total risk. total risk per unit of excess return. return above the risk-free rate relative to beta.

Ans: b Difficulty: easy Ref: Risk-Adjusted Measures of Performance

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8.

Which of the following statements about the Sharpe ratio and Treynor ratio is most accurate? The Sharpe ratio is based on:

a. b. c. d.

total risk, whereas the Treynor ratio is based on systematic risk. systematic risk, whereas the Treynor ratio is based on total risk. unsystematic risk, whereas the Treynor ratio is based on systematic risk. total risk, whereas the Treynor ratio is based on unsystematic risk.

Ans: a Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 9.

Assume Portfolio A and Portfolio B are well-diversified; however, Portfolio A has a higher standard deviation than Portfolio B. Based on this information, the Sharpe ratio will give Portfolio A:

a. b. c. d.

the higher rank, and the Treynor ratio will give Portfolio B the higher rank. the lower rank, and the Treynor ratio will give Portfolio B the lower rank. the same rank as the rank assigned by the Treynor ratio. a rank that varies directly based on the overall market risk.

Ans: c Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 10.

According to Jensen's differential return measure, what is alpha?

a. b. c. d.

The intercept of the SML line The intercept of the CML line A measure of the superior or inferior performance on a portfolio The actual excess return on a portfolio during one period

Ans: c Difficulty: Difficult Ref: Risk-Adjusted Measures of Performance 11.

A portfolio with a beta of 0.8 earned a return of 13 percent when the risk-free rate was 6 percent and the market returned 9 percent. The portfolio’s Treynor measure is closest to:

a. b. c. d.

1.8.

3.8.

5.0.

8.8.

Ans: d Difficulty: Difficult Ref: Risk-Adjusted Measures of Performance

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12.

Which of the following measures uses the standard deviation and evaluates portfolio performance on the basis of both return and diversification.

a. b. c. d.

Jensen’s alpha Treynor measure M2 Sharpe ratio

Ans: d Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance *The information in the following table is to be used to answer questions 13-17.

Fund

Standard Deviation Fund 1 1.97 Fund 2 2.97 Fund 3 3.82 Fund 4 3.50 * Significant at the 5 percent level

Beta 1.0 0.8 1.2 1.4

Jensen’s Alpha 1.3 0.6* -3.5* 4.2

13.

Which fund’s returns are best explained by the market's returns?

a. b. c. d.

Fund 1 Fund 2 Fund 3 Fund 4

Ans: a Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 14.

Which of the funds has the most market risk?

a. b. c. d.

Fund 1 Fund 2 Fund 3 Fund 4

Ans: d Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance

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R2 0.95 0.80 0.90 0.65

15.

Which fund has the most total risk?

a. b. c. d.

Fund 1 Fund 2 Fund 3 Fund 4

Ans: c Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 16.

Based on Jensen’s performance measure, which fund significantly outperformed?

a. b. c. d.

Fund 1 Fund 2 Fund 3 Fund 4

Ans: b Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 17.

Which fund is least well-diversified?

a. b. c. d.

Fund 1 Fund 2 Fund 3 Fund 4

Ans: d Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 18.

Superior portfolio performance can result from:

a. b. c. d.

the ability to select undervalued securities, only. the ability to time market turns, only. superior selectivity or timing performance. neither superior selectivity nor timing because the market is too efficient.

Ans: c Difficulty: Easy Ref: Risk-Adjusted Measures of Performance

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19.

The information ratio is calculated as the ratio of:

a. b. c. d.

mean active return to tracking risk. alpha to beta. excess return to portfolio standard deviation. portfolio excess return to tracking risk.

Ans: a Difficulty: Difficult Ref: Risk-Adjusted Measures of Performance 20.

Relative to the Sharpe ratio, the Sortino ratio will make a portfolio’s performance look more favorable if the portfolio has experienced:

a. b. c. d.

fewer extreme negative returns relative to extreme positive returns. fewer extreme positive returns relative to extreme negative returns. an equal number of extreme positive and extreme negative returns. virtually no extreme negative or extreme positive returns.

Ans: a Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 21.

Based on Jensen's measure, superior portfolio performance is exhibited by a:

a. b. c. d.

statistically significant positive alpha. statistically significant negative alpha. zero alpha. low positive alpha.

Ans: a Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 22.

Which of the following is true regarding M2? It produces a measure of portfolio performance that:

a. b. c. d.

is adjusted for systematic risk. can be compared directly to the risk-free rate. can be compared directly with the market return. indicates what would be possible if the portfolio was fully leveraged.

Ans: c Difficulty: Difficult Ref: Risk-Adjusted Measures of Performance

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23.

One approach to style analysis which uses the features of the stocks in the portfolio is known as:

a. b. c. d.

returns-based style analysis. asset allocation style analysis. holdings-based style analysis. mix-based style analysis.

Ans: c Difficulty: Moderate Ref: Style Analysis and Performance Attribution 24.

Which of the following is the largest recognized problem with style analysis?

a. b. c. d.

Funds frequently do not maintain style consistency over time.

Comparing style across funds is nearly impossible.

It is very difficult to determine the style a fund is following.

There are too many alternative means to calculate a fund’s style.

Ans: a Difficulty: Moderate Ref: Style Analysis and Performance Attribution 25.

Which organization has issued minimum standards for the reporting of investment performance?

a. b. c. d.

FINRA Securities and Exchange Commission (SEC) Association for Security Analysts and Portfolio Managers Chartered Financial Analyst Institute

Ans: d Difficulty: Difficult Ref: Money Managers and Performance Presentations 26.

To claim GIPS compliance in reporting portfolio performance, the standards require:

a. b. c. d.

a 5-year performance record, or since inception if the fund is less than 5-years old. that the majority of the firm’s funds meet GIPS standards. that the majority of the firm’s portfolios are included in the performance record. a firm build toward a minimum record of 20 years of reported performance.

Ans: a Difficulty: Easy Ref: Money Managers and Performance Presentations

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27.

Performance attribution separates return performance into the following two sources:

a. b. c. d.

security analysis and portfolio management. money market and capital market securities. traditional assets and alternative assets. asset allocation and security selection.

Ans: d Difficulty: Moderate Ref: Style Analysis and Performance Attribution 28.

Which measure calculates performance relative to a benchmark portfolio?

a. b. c. d.

Sortino ratio M2 Information ratio Sharpe ratio

Ans: c Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 28.

Which of the following statements about portfolio return calculation is most accurate? Time-weighted returns are best for measuring the returns of a:

a. b. c. d.

fund manager, whereas money-weighted returns are best for a portfolio owner. portfolio owner, whereas money-weighted returns are best for a fund manager. fund manager, whereas money-weighted returns are no longer used in practice. portfolio owner, whereas money-weighted returns are generally used in practice.

Ans: a Difficulty: Moderate Ref: Return Calculations 29.

Which of the following statements about return calculation is most accurate?

a. b. c. d.

Time-weighted returns are always higher than money-weighted returns.

Money-weighted returns are always higher than time-weighted returns.

The GIPS require that time-weighted returns are reported for most asset classes.

The time-weighted return is equivalent to the IRR.

Ans: c Difficulty: Moderate Ref: Return Calculations

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30.

Carl invested $100,000 in a fund, which earned 8% over the next year. At the end of the year, he invested an additional $50,000 and the fund earned 18% over the next year. Carl withdrew no money from the fund. Which of the following statements about time-weighted return (TWR) and money-weighted return (MWR) is most accurate?

a. b. c. d.

TWR is greater than MWR, and MWR is the more appropriate measure for Carl.

MWR is greater than TWR, and MWR is the more appropriate measure for Carl.

TWR is greater than MWR, and TWR is the more appropriate measure for Carl.

MWR is greater than TWR, and TWR is the more appropriate measure for Carl.

Ans: b Difficulty: Moderate Ref: Return Calculations

True/False Questions 1.

Standard deviation, beta, and coefficient of determination are readily available for mutual funds from sources like Morningstar.

Ans: True Difficulty: Easy Ref: Performance Measurement Issues 2.

The money-weighted rate of return is equivalent to the internal rate of return.

Ans: True Difficulty: Moderate Ref: Performance Measurement Issues 3.

The time-weighted rate of return is affected by any cash flows to the portfolio.

Ans: False Difficulty: Moderate Ref: Performance Measurement Issues 4.

Total risk of a portfolio is measured by the beta coefficient.

Ans: False Difficulty: Moderate Ref: Performance Measurement Issues 5.

When evaluating the performance of a mutual fund holding several S&P 500 stocks, one should always use the S&P 500 as the benchmark.

Ans: False Difficulty: Moderate Ref: Performance Measurement Issues Chapter Twenty-Two Evaluation of Investment Performance

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6.

The higher the Sharpe ratio, the better the risk-adjusted portfolio performance.

Ans: True Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 7.

Sharpe's measure is a ratio of excess return to total risk.

Ans: True Difficulty: Difficult Ref: Risk-Adjusted Measures of Performance 8.

Treynor's measure is a ratio of excess return to systematic risk.

Ans: True Difficulty: Difficult Ref: Risk-Adjusted Measures of Performance 9.

The use of the Treynor measure implies that total risk is the proper measure of risk in performance evaluation.

Ans: False Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 10.

Jensen's measure of performance is based on the CAPM.

Ans: True Difficulty: Easy Ref: Risk-Adjusted Measures of Performance 11.

Investors who have all their assets in one portfolio of securities should rely on the Sharpe measure rather than the Treynor measure.

Ans: True Difficulty: Easy Ref: Risk-Adjusted Measures of Performance 12.

Jensen's alpha is a risk-adjusted performance measure.

Ans: True Difficulty: Easy Ref: Risk-Adjusted Measures of Performance

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13.

Modigliani-squared is a return adjusted for volatility that allows returns between portfolios to be compared.

Ans: True Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 14.

Performance attribution seeks to determine the detailed investment style adopted by a money manager.

Ans: False Difficulty: Easy Ref: Style Analysis and Performance Attribution 15.

The purpose of performance attribution is to assess the risk of a portfolio.

Ans: False Difficulty: Moderate Ref: Style Analysis and Performance Attribution 16.

GIPS requires compliant history for at least 10 years, or since inception, if less than 10 years.

Ans: False Difficulty: Moderate Ref: Money Managers and Performance Presentations 17.

GIPS® was created to obtain global acceptance of a standard for fair presentation.

Ans: True Difficulty: Easy Ref: Money Managers and Performance Presentations 18.

The coefficient of determination, also known as R-squared, is used to denote the degree of diversification.

Ans: True Difficulty: Easy Ref: Performance Measurement Issues 19.

GIPS® requirements include: uniformity in certain performance calculations and disclosures; inclusion of all actual fee-paying discretionary portfolios in composites with similar objectives; compliant history for at least 5 years, or since inception if less than 5 years.

Ans: True Difficulty: Moderate Ref: An Overview of Performance Evaluation

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20.

Time-weighted, as opposed to money-weighted, return captures the rate of return actually earned by the fund manager.

Ans: True Difficulty: Moderate Ref: Summary

Short-Answer Questions 1.

Discuss how constraints on portfolio managers affect the portfolio results.

Answer:

Difficulty: Ref: 2.

What is the major difference between the Sharpe and Treynor measures?

Answer:

Difficulty: Ref: 3.

Sharpe used standard deviation as the risk measure to capture the overall risk of the portfolio. Treynor used beta as the risk measure to capture the sensitivity of the portfolio return relative to the market.

Moderate Risk-Adjusted Measures of Performance

How is regression analysis used to measure portfolio diversification?

Answer:

Difficulty: Ref: 4.

Portfolios, such as mutual funds or pension funds, have specific goals established for them. The goals themselves imply constraints in regard to risk, investment media, etc. Specific constraints are often delineated in the charter, management agreements, etc. Specific constraints might include, for example, not investing in futures or not investing in taxable bonds. All such factors mold the portfolio results Moderate Performance Measurement Issues

The portfolio’s returns are regressed against the market’s returns. The coefficient of determination, R2, indicates what percentage of the variance in the portfolio’s returns is attributable to the market’s returns. R2 can range from zero to 1.0. The higher the coefficient of determination, the better the diversification of the portfolio.

Difficult Risk-Adjusted Measures of Performance

What are the appropriate uses of the Sharpe and the Treynor performance measures?

Answer:

Difficulty: Ref:

Sharpe’s measure considers total risk and is appropriate for someone more interested in the total risk of the portfolio than in only market risk. Treynor’s measure, on the other hand, uses market risk and is appropriate for someone interested in portfolio performance relative to the market.

Moderate Risk-Adjusted Measures of Performance

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5.

Explain the characteristic line in excess return form for the Jensen alpha measure.

Answer:

Difficulty: Ref: 6.

Sharpe’s ratio measures the slope of the line between RF and the portfolio being evaluated. If the line is plotted between RF and a market index, where would superior portfolios lie? Inferior portfolios?

Answer: Difficulty: Ref: 7.

The chart has the excess return of the market (RM – RF) on the x-axis and the excess returns of the portfolio (Rp – RF) on the y-axis. The yaxis intercept is alpha. Alpha is the excess return on the portfolio above or below what is predicted by the portfolio’s beta and the SML. Difficult Risk-Adjusted Measures of Performance

Superior portfolios lie above the line and inferior ones below the line.

Moderate Risk-Adjusted Measures of Performance

What is performance attribution?

Answer:

Difficulty: Ref:

Performance attribution is an attempt to determine why a portfolio performed as it did. Performance is separated into two sources, asset allocation and security selection. A top-down approach is often used to look at various aspects of the portfolio management process, beginning with the policy statement for the portfolio.

Moderate Syle Analysis and Performance Attribution

Critical Thinking/Essay Questions 1.

A retired couple’s assets consist of a $100,000 house, a $400,000 securities portfolio, a $15,000 car, and personal effects. Would they be more concerned with the Sharpe measure or the Treynor measure for the portfolio?

Answer:

Difficulty:

Since the securities portfolio constitutes the major proportion of their assets, they would be more interested in Sharpe’s measure because it uses the standard deviation as the risk measure. The standard deviation measures total risk, systematic and unsystematic. This couple is interested in the safety of principal and income, regardless of the source of variability. If circumstances were different, so that the portfolio constituted a relatively small part of the couple’s total assets, they might turn their attention to the Treynor measure, which focuses on the market risk of the portfolio.

Difficult

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2.

What are some of the problems associated with using risk-adjusted portfolio performance measures?

Answer:

Difficulty:

(1) The Treasury bill rate may not be a good proxy for the risk-free rate. (2) A market index may not be a good proxy for the market as a whole. (3) Beta is not a clear-cut measure of risk. This may cause benchmark errors if the SML used is not the true SML. (4) Global investing increases the problem of benchmark error. (5) A long evaluation period is needed to rule out luck.

Moderate

Problems 1.

The following data are available for three portfolios and the market for a recent 10-year period:

Portfolio 1 2 3 S&P 500 RF a. b. c.

Average Annual Return (%) 14 16 20 12 6

Standard Deviation 21 24 28 20

Beta 1.15 1.00 1.25

R2 _ 0.70 0.98 0.90

Rank these portfolios using the Sharpe measure (3 = highest).

Rank these portfolios using the Treynor measure.

Which of these portfolios outperformed the market?

Solution:

(a) Sharpe Fund 1 (14 - 6)/21 = .38 Fund 2 (16 - 6)/24 = .42 Fund 3 (20 - 6)/28 = .50 Market (12 - 6)/20 = .30

Rank 1 2 3

(b) Treynor Fund 1 (14 - 6)/1.15 = .07 Fund 2 (16 - 6)/1.0 = .10 Fund 3 (20 - 6)/1.25 = .112 Market (16 - 6)/1.0 = .10

Rank 1 2 3

(c) Using Sharpe, all three funds outperformed the market. Using Treynor, only fund 3 outperformed the market, with fund 2 tying the market.

Difficulty: Difficult

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2.

Consider the five funds shown below: R2 _ 0.90 0.95 0.90 0.89 0.90

Fund _a_ __ 1 4.0 0.9 2 -1.6* 1.2 3 2.5 0.9 4 1.2 0.8 * 5 0.9 1.3 * Significant at the 5 percent level a. b c. d.

Which fund's returns are best explained by the market's returns?

Which fund had the largest total risk?

Which fund had the lowest market risk? The highest?

Which fund(s), according to Jensen's alpha, outperformed the market?

Solution: (a)

Fund 2. It has the highest R2.

(b)

Standard deviations are needed to answer this question.

(c)

Fund 4 had the lowest market risk (i.e., beta), while fund 5 had the highest.

(d) Difficulty:

Only fund 5 had a significantly positive alpha.

Difficult

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