Investments Analysis and Management, 12th Edition Jones Test Bank

Investments Analysis and Management, 12th Edition BY Jones

Email: richard@qwconsultancy.com

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 are known as: a. b. c. d.

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

Ans: c Difficulty: Moderate Chapter One Understanding Investments

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month

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

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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 (an)

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 is heavily tied to work using 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

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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 17.

International investing:

a.

is only practical for institutional investors.

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b. c. d.

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 85 percent of stock market capitalization worldwide.

The United States accounts for roughly 50 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 percentage of stock market capitalization in the world over time.

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 21.

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

a.

Both Exxon Mobil and Hewlett Packard earn roughly 70% of their profits from their overseas operations.

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b. c. d.

Google currently derives about 95% of its earnings from the U.S. Wal-Mart earns nearly 50% of its profits outside the U.S. Coca-Cola has no overseas operations and no earnings outside the U.S. at all

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 number of 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 (RFR) equals: a. 3.5% b. the return on long-term Treasury bonds c. the average of the last 3 years’ inflation rate d. the return on short-term Treasury bills

Ans: d Difficulty: difficult Ref: Important Considerations in the Investment Decision Process for Today's Investor 25.

All of the following are benefits of geographic diversification in investment portfolios EXCEPT: a. b. c. d.

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.

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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: F 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.

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

Investors enjoyed the best 5 consecutive years in the stock market history over the period 1996-2000.

Answer: False Chapter One Understanding Investments

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Difficulty: Moderate Ref: Understanding the Investment Decision Process 8.

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 9.

Security analysts are typically employed only at brokerage houses.

Answer: False Difficulty: Moderate Ref: Importance of Studying Investments 10.

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

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

Many Wall Street jobs tend to be cyclical in nature..

Ans: True Difficulty: Easy Ref: Importance of Studying Investments 12.

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

Ans: F 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 an ex post returns.

Answer:

Difficulty: 2.

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

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

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Answer:

Difficulty: 3.

Define risk in the context of investments?

Answer: Difficulty: 4.

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

Moderate

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:

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? 5.

Answer: Contrary to popular belief, she was not charged with insider trading but obstruction of justice as a result of her efforts to hide her alleged insider trading.

Difficulty: Moderate 6.

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

Critical Thinking/Essay Questions 1.

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

Answer:

Difficulty:

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

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2.

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 decade 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 one of the characteristics of the primary nonmarketable financial assets 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 ---------- but are not------------.

a. b. c. d.

negotiable; liquid. marketable; liquid. liquid; personal liquid; marketable

Ans: d Difficulty: difficult Ref: Nonmarketable Financial Assets 4. a. b. c. d.

Nonmarketable financial assets that protect against inflation include: Nonnegotiable certificates of deposit (CDs) Money market deposit accounts (MMDAs) Series EE US government savings bonds US government savings bonds, I bonds

Ans: d Difficulty: Moderate Ref: Nonmarketable Financial Assets

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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 9.

The coupon rate is another name for the:

a. b.

market interest rate. current yield.

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c. d.

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 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 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 buy a bond at any time and receive an immediate interest check

c. d.

Ans: a

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Difficulty: Moderate Ref: Fixed-Income Securities 14.

Bonds called in are likely to be:

a. b. c. d.

bonds already in default reissued as new bonds with a lower interest rate reissued as new bonds with 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 17. a. b. c. d.

A municipal bond issue that was sold to finance a toll bridge would most likely be a: general obligation bond. revenue bond. special assessment bond. zero-coupon bond.

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

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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.

An investor who pays taxes at the 28% marginal tax rate would need to earn what coupon rate on a corporate bond similar in all respects other than taxes to a 5% coupon municipal bond:

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 semiannually annually

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

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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:

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, AAA rated bonds would have the lowest yield?

a. b. c. d.

corporate bond. insured municipal bond.

U.S. Treasury bond. mortgage-backed bond.

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

a. b. c. d.

earnings per share dividend yield book value P/E ratio

Ans: d

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Difficulty: difficult Ref: Equity Securities 27.

---------------- represent shares of foreign companies kept in banks.

a. b. c. d.

convertible bonds American Depository Receipts (ADRs) asset-backed securities 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 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 (ASB)?

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

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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 contract are obligations to buy or sell

d.

Ans: d Difficutly: 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 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: F Difficulty: Moderate Ref: Organizing Financial Assets

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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: F Difficulty: Moderate Ref: Nonmarketable Financial Assets 4.

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

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

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

Ans: F Difficulty: Easy Ref: Money Market Securities 6.

Money market securities generally carry a low chance of default.

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

The money market security most often used a benchmark for the risk-free rate is 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: F Difficulty: difficult Ref: Money Market Securities 9.

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

Ans: F

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Difficulty: Moderate Ref: Fixed-Income Securities 10.

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

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

Term bonds have a single maturity.

Ans: T 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: T Difficulty: difficult Ref: Fixed-Income Securities 13.

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

Ans: F 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: T Difficulty: difficult Ref: Fixed-Income Securities 15.

Callable bonds attract investors because they can be redeemed early.

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

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

Ans: F Difficulty: difficult Ref: Fixed-Income Securities

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17.

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

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

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

Ans: F 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: T Difficulty: Moderate Ref: Fixed-Income Securities 20.

Bond ratings are primarily used to assess interest rate risk.

Ans: F Difficulty: Moderate Ref: Fixed-Income Securities 21.

The major bond rating service is Dun & Bradstreet.

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

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

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

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

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

LEAPS have maturities dates up to 10 years.

Ans: F Difficulty: Easy

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bonds.

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 whenever they choose.

Ans: T Difficulty: Easy Ref: Fixed-Income Securities

Short-Answer Questions 1.

Distinguish between direct and indirect investing.

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

Difficulty: Easy 2.

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

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) Difficulty: Moderate Answer:

3.

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

Answer: Earnings retention rate = 1 - dividend payout rate Difficulty: Moderate Ref: Equity Securities 4.

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

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

Difficulty: Moderate Ref: Equity Securities

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accounts,

5.

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

Answer: If a stock is trading at 12 times earnings, 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.

Difficulty: Moderate Ref: Equity Securities 6.

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

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

Difficulty: Moderate Ref: Organizing Financial Assets, Equity Securities 7.

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

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

Difficulty: Moderate Ref: Derivative Securities 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, options, preferred stock..

Answer: U. S. Treasury bonds, corporate bonds, preferred stock, common stock, options Difficulty: Moderate Ref: Fixed-Income Securities, Equity Securities, Derivative Securities 9.

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

Answer: High yields with manageable risk.

Difficulty: Moderate 10.

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

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

Difficult: Moderate Ref: Derivative Securities

Essay Questions

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1.

Do the stock options markets help stabilize or destabilize the stock markets?

Explain.

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

Difficulty: difficult Ref: Equity Securities, Derivative Securities 2.

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

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

Difficulty: Moderate Ref: Fixed-Income Securities 1.

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

Ans: Taxable equivalent yield is 0.07/(1-0.28) = 9.72% Difficulty: Easy Ref: Fixed-Income Securities 2.

A corporate investor in a 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?

Ans: 10.606 x (1.0-0.34) = 7.00 percent Difficulty: Easy Ref: Fixed-Income Securities 3.

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

Ans: Dividend yield = $1/$60 = 0.0167 = 1.67% Difficulty: Moderate Ref: Equity Securities 4.

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

Ans: Payout rate = $1/$4 = 0.25 = 25% Difficulty: Moderate Ref: Equity Securities

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5.

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?

Ans: Stock price per share is Earnings per share x P/E = $6 x 15 = $90 Difficulty: Moderate Ref: Equity Securities

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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. a. b. c. d.

In order to avoid paying income taxes, an investment company must: 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. closed-end companies have a more fixed capitalization.

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

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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 characteristics of exchange traded funds (ETFs)?

a. b. c. d.

They are mostly passive portfolios.

They are sometimes managed portfolios.

They often track a particular sector of the market.

They are priced based on Net Asset Value.

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 till maturity. investors trade between themselves. investors sell their shares back to the company. banks will cash their shares as long as they have accounts at the bank.

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

Which of the following ETF’s (exchange traded fund) 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 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.

b.

Chapter Three Indirect Investing

26

c. d.

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

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

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 21.

A loading fee is a:

a. b. c. d.

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

Ans: d Difficulty: Moderate Chapter Three Indirect Investing

27

Ref: The Details of Direct Investing 22.

A 12b-1 fee is a:

a. b. c. d.

redemption fee. sales charge distribution fee. loading 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-loads 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 25.

Which of the following types of mutual fund shares typically does not charge a front-end sales charge but does 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

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28

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 fund expenses and performance is true?

a. b. c. d.

The higher-performing funds generally have the highest expenses.

The stock funds generally have higher expenses than bond funds.

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

The lower performing funds generally have the highest 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 which 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 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

Chapter Three Indirect Investing

29

30.

Which of the following types of funds tends 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 33.

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

a. b. c. d.

IRA. IMA. SMA. DCA.

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

Chapter Three Indirect Investing

30

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.

SMAs.

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

True-False Questions 1.

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

Ans: T Difficulty: Easy Ref: Investing Indirectly 2.

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

Ans: T Difficulty: Easy Ref: Investing Indirectly 3.

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

Ans: F Difficulty: Moderate Ref: Investing Indirectly 4.

Under the Securities Act of 1933, investment companies are required to register with the SEC. Ans: F Difficulty: Moderate Ref: What is an Investment Company?

5.

Most unit investment trusts are considered active investments.

Ans: F Difficulty: Moderate Ref: What is an Investment Company?

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31

6.

ETFs are managed investment portfolios that offer investors targeted diversification.

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

Many ETFs report little or no capital gains over the years giving them greater tax efficiency than many mutual funds.

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

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

Ans: F Difficulty: Moderate Ref: Three Major Types of Investment Companies 9.

Almost 70 percent of all U.S. households owned mutual funds as of 2005.

Ans: F Difficulty: Easy Ref: Three Major Types of Mutual Funds 10.

Investment company managers seek to increase the size of the funds being managed since the cost of overseeing additional amounts of money rises less than the revenue rate.

Ans: T Difficulty: Moderate Ref: Three Major Types of Mutual Funds 11.

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

Ans: F Difficulty: Moderate Ref: Three Major Types of Mutual Funds 12.

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.

Ans: T Difficulty: Moderate Ref: Three Major Types of Mutual Funds

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32

13.

Loaded funds generally outperform the no-load funds.

Ans: F Difficulty: Difficult Ref: Three Major Types of Mutual Funds 14.

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

Ans: F Difficulty: Moderate Ref: Three Major Types of Mutual Funds 15.

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

Ans: T Difficulty: Moderate Ref: Three Major Types of Mutual Funds 16.

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

Ans: T Difficult: Easy Ref: Three Major Types of Mutual Funds 17.

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

Ans: F Difficulty: Difficult Ref: Three Major Types of Mutual Funds

18.

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

Ans: F Difficulty: Difficult Ref: The Details of Indirect Investing 19.

Index funds tend to have lower expenses than other funds because they don’t incur the costs of professional portfolio management.

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

Chapter Three Indirect Investing

33

20.

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

Ans: F Difficulty: Difficult Ref: Investment Company Performance 21.

Under its new system, Morningstar ranks funds against comparable funds in approximately 50 categories.

Ans: T Difficulty: Moderate Ref: Investment Company Performance 22.

It is possible under the new Morningstar ratings that one class of shares of a mutual fund can have a different rating that another class of shares of the same mutual fund.

Ans: T Difficulty: Moderate Ref: Investment Company Performance 23.

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

Ans: T Difficulty: Moderate Ref: Investment Company Performance 24.

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

Ans: T Difficulty: Difficult Ref: Investing Internationally Through Investment Companies 25.

The major advantage of Separately Managed Accounts (SMA) is control and the direct owner may be able to specify investment restrictions.

Ans: T Difficulty: Difficult Ref: Future of Indirect Investing 26.

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

Ans: T Chapter Three Indirect Investing

34

Difficulty: Moderate Ref: Future of Indirect Investing

Short-Answer Questions 1.

Briefly explain the fees charged by funds.

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

Difficulty: Moderate 2.

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

Answer: 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 increase as long as new investors contribute money, and the price is the net asset value of the securities owned.

Difficulty: Moderate 3.

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: The FDIC insures accounts at banks from bank failures.

The SIPC provides insurance against the brokerage company going bankrupt.

Difficulty: Moderate 4.

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

Answer: 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.

Difficulty: Moderate 5.

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

Answer: Probably not. The retiree will probably have a long time to live and should consider investing part of the portfolio in growth funds to provide protection against inflation.

Difficulty: Moderate

Chapter Three Indirect Investing

35

6.

You have decided to invest in an aggressive growth fund for long-run future needs. You have a publication listing a number of such funds with their most recent 12-month total returns. Is this a good predictor of future performance?

Answer:

Not necessarily. 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 longer-run performance measures such as five-year or ten-year compounded returns, but none are sure-fire guides to future performance.

Difficulty: Difficult 7.

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

Answer: The investor’s tax position should be the same whether he/she invests indirectly through an investment company or directly in the securities themselves.

The investment companies are intermediaries that pass on income and losses to the shareholder.

Difficulty: Difficult 8.

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

Answer: One fund typically has many (perhaps several hundred) securities, which should provide adequate diversification for risks that are unique to any particular company. Nonetheless, some investors prefer to invest in several funds in order to participate in more than one market and to gain some protection from market risk in a particular market.

Difficulty: 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: Investment Company Act of 1940 Difficulty: Moderate Section: What is an Investment Company?

2.

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

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

Chapter Three Indirect Investing

36

3.

List the four basic types of mutual funds: _______________________________, ______________________________, _______________________________, and ____________________________________.

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

Difficulty: Moderate Section: Types of Mutual Funds 4.

Three common characteristics of Class A shares are: ______________________, ____________________________________, and _____________________________ .

Answer: 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) Difficulty: Difficult Section: The Details of Indirect Investing 5.

An investor who buys shares in a closed fund for less than the net asset value per share of the fund is said to be buying shares at a _____________________.

Answer: discount Difficulty: Easy Section: The Details of Indirect Investing Critical Thinking/Essay Questions 1.

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

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

Difficulty: Moderate 2.

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

Answer: Substantial diversification even for a small amount of funds, professional management (questioned by some), international securities, capability to participate in the money market with a small investment.

Difficulty: Moderate Chapter Three Indirect Investing

37

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 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.

Ans:

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 aggressive equity mutual fund began the year with a net asset value (NAV) of $6.50 per share. During the year it received $0.15 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 year-end NAV.

Ans:

Beginning NAV

$6.50

Income from investment operations net investment income net realized and unrealized gain (-$1.25 + .50) Total income from investment operations Less distributions to shareholders from net investment income (90% x $.15) from net realized capital gain Total distribution Difficulty: Moderate 3.

$0.15 (0.75) ($0.60)

($0.135) - _ ($0.135)

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?

Ans: on a financial calculator: 10000 PV, 11.12 interest rate, 10 N,

Chapter Three Indirect Investing

38

0 pmt, solve for FV = $28,702.67. Subtract your initial investment of $10,000, which results in $18,702.67 cumulative total dollar return.

Difficulty: Moderate

Chapter Three Indirect Investing

39

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

The sale of a new issue of common stock of which there are already shares publicly held is known as: a. an IPO. b. a secondary market issue. c. an EPO. d. a seasoned new issue.

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.

The ___________ summarizes information about a new security issue.

a. b. c. d.

syndicate offer IPO prospectus shelf rule

Ans: c Difficulty: Easy Ref: The Primary Markets 4.

Investment bankers are compensated by:

a. b. c.

the underwriting spread commissions paid by the buyers of the security commission paid by the sellers of the security

Chapter Four Securities Market

38

d.

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 an underwriting spread fewer restrictions on subsequent borrowing activities

Ans: c Difficulty: Moderate Ref: The Primary Markets 6. Automatic Shelf Registration refers to the practice of allowing: a. well-seasoned issuers to file shelf registration statements with the SEC that become effective immediately, or the filing of a “base prospectus,” enabling efficient stock issue b. well-seasoned issuers to file shelf registration statements with the SEC that become effective immediately, or the filing of a “base prospectus,” enabling efficient debt issue c. well-seasoned issuers to file shelf registration statements with the SEC that become effective immediately, or the filing of a “base prospectus,” enabling efficient stock or debt issue d. well-seasoned issuers to file shelf registration statements with the SEC that become effective immediately upon filing of a “red herring prospectus,” enabling efficient stock or bond 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

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39

Ref: The Primary Markets 8.

NASDAQ stocks:

a. b. c. d.

are generally foreign stocks. trade via the Blue Sheets. are not generally 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.

According to its website, NYSE Euronext accounts for nearly what percent of the world’s publicly traded equity securities? a. b. c. d.

nearly 25% nearly 33% nearly 40% nearly 50%

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

The NYSE is now part of a:

a. b. c. d.

not-for-profit corporation. a quasi-federal agency. a publicly-owned company. a multinational company.

Ans: c Difficulty: Moderate

Chapter Four Securities Market

40

Ref: The Secondary Markets 12.

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 share

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

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 14.

Which of the following is not true regarding the NYSE Amex?

a. b. c. d.

It specializes in technology and biotech stocks It trades only ETFs It specializes in small- and mid-cap stocks It is an Over-the-Counter (OTC) market

Ans: c Difficulty: Moderate Ref: The Secondary Markets 15. true?

Which of the following statements regarding the Nasdaq Stock Market is not

a. b.

It was less affected by the 2000-2002 market decline than the NYSE NASDAQ dealers make a market by standing ready to buy and sell securities Stocks listed on the NYSE may also trade on NASDAQ

c.

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41

d.

NASDAQ’s electronic trading system provides instantaneous transactions

Ans: a Difficulty: Difficult Ref: The Secondary Markets 16.

A computerized trading network that matches buy and sell orders electronically entered by customers is a: a. b. c. d.

National Markets System Electronic Communications Network Internet Investment Service Global Investment Network

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

The original electronic network, started in 1969 for brokers, dealers, exchange specialists and institutional investors only is known as: a. b. c. d.

ReadiMarket National Market System OTC Worldwide lnstinet

Ans: d Difficulty: Moderate Ref: The Secondary Market 18.

NASDAQ tends to list stocks concentrated in this industry: to be concentrated in these two industries: a. b. c. d.

aerospace. energy. technology. telecommunications.

Ans: c Difficulty: Moderate Ref: The Secondary Markets

Chapter Four Securities Market

42

19.

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 20.

The fastest growing region in the world is:

a. b. c. d.

Western Europe.

Latin America.

Eastern Europe. the Far East.

Ans: d Difficulty: Easy Ref: The Secondary Markets 21.

Which of the following statements about 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 22.

Europe's leading cross border exchange is:

a. b. c. d.

Deutsche Boerse Euromarket London Stock Exchange NYSE Euronext

Ans: d Difficulty: Moderate Ref: The Secondary Markets

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43

23.

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 24.

The price that some seller is trying to sell a stock for is known at 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 25.

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 26.

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

Pink Sheets Instinet Amex NASDAQ

Ans: d Difficulty: Moderate

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44

Ref: The Secondary Markets 27.

The Dow-Jones Industrial Average has historically consisted of high quality stocks that were considered to be: a. b. c. d.

OTC stocks cyclical stock blue-chip stocks defensive stocks

Ans: c Difficulty: Easy Ref: Stock Market Indexes 28.

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

a. b. c. d.

it has too few stocks in the average it is a value weighted method it adjusts for even small stock dividends it includes too many risky stocks

Ans: a Difficulty: Moderate Ref: Stock Market Indexes 29.

A major difference between the Standard & Poor’s 500 Index (S&P) and the Dow-Jones Industrial Average (DJIA) is that:

a. the S&P 500 is more dominated by OTC stocks than the DJIA b. the S&P 500 is more difficult to calculate than the DJIA c. the DJIA is a price-weighted rather than value-weighted index like the S&P 500 d. the S&P 500 is more stable than the DJIA Ans: c Difficulty: Difficult Ref: Stock Market Indexes 30.

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

a. b. c. d.

It is too 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.

Chapter Four Securities Market

45

Ans: d Difficulty: Difficult Ref: Stock Market Indexes 31.

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

a. b. c. d.

using the closing market price. multiplying price times shares outstanding. multiplying price times daily volume. dividing earnings by shares outstanding.

Ans: b Difficulty: Moderate Ref: Stock Market Indexes 32.

Most secondary bond trading takes place on:

a. b. c. d.

the NYSE the American Stock Exchange the OTC the Philadelphia Exchange

Ans: c Difficulty: Difficult Ref: Bond Markets 33.

The yields on corporate bonds issued in the primary market should be___________the yields on similar corporate bonds trading in the secondary market.

a. b. c. d.

much less than exactly the same as slightly higher than similar to

Ans: d Difficulty: Moderate Ref: Bond Markets 34.

The type of bonds with the thinnest secondary market is:

a.

agency bonds

Chapter Four Securities Market

46

b. c. d.

corporate bonds Treasury bonds municipal bonds

Ans: d Difficulty: Moderate Ref: Bond Markets 36.

The open-outcry system for trading securities is utilized in the:

a. b. c. d.

futures market municipal bond market Treasury bond market options market

Ans: a Difficulty: Easy Ref: Derivatives Markets

True-False Questions 1.

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

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

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

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

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

Ans: F Difficulty: Difficult Ref: The Primary Markets 5.

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

Chapter Four Securities Market

47

Ans: T Difficulty: Moderate Ref: The Secondary Markets 6.

Smaller companies with fewer publicly held shares are more likely to meet the listing requirements of the NYSE. Ans: F Difficulty: Easy Ref: The Secondary Markets 7.

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

Ans: T Difficulty: Moderate Ref: The Secondary Markets 8.

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

Ans: T Difficulty: Moderate Ref: The Secondary Markets 9.

All OTC stocks are included in the Nasdaq.

Ans: F Difficulty: Moderate Ref: The Secondary Markets 10.

By 2005, program trading accounted for over 70 percent of total NYSE volume.

Ans: F Difficulty: Difficult Ref: The Secondary Markets 11.

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

Ans: T Difficulty: Moderate Ref: The Secondary Markets 12.

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

Chapter Four Securities Market

48

Ans: T Difficulty: Easy Ref: The Secondary Markets 13.

The Dow Jones averages handle stock splits by adjusting the market value of the stocks.

Ans: F Difficulty: Moderate Ref: 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.

Ans: 75 Difficulty: Moderate Ref: Stock Market Indexes 2.

The DJIA is a ______________-weighted index.

Ans: price Difficulty: Easy Ref: Stock Market Indexes

Short-Answer Questions 1.

What is the difference between a seasoned new issue and an initial public offering?

Ans: A seasoned new issue is the sale of a publicly traded company while an IPO represents the first time an issuer has sold securities.

Difficulty: Moderate 2.

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

Ans: 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.

Difficulty: Moderate

Chapter Four Securities Market

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3.

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

Ans: 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.

Difficulty: Difficult 4.

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

Answer: 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.

Difficulty: Moderate 5.

What is the Nasdaq National Market System?

Answer: 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- tothe-minute reporting of trades.

Difficulty: Moderate 6.

What is the difference between a price-weighted index and a market-value index?

Answer:

Difficulty: 7.

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

Moderate

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

Answer: Because both are calculated primarily using NYSE stocks.

Difficulty: Easy 8.

What is Instinet and what does it offer for investors?

Answer: It is the original electronic trading network and offers anonymous trading and access to more than 40 equity markets worldwide.

Difficulty: Moderate

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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: 2.

There will be a higher correlation between international markets and international developments, such as the Asian crisis. Such events will have a greater impact on the NYSE and the Nasdaq than in times past.

Soon, 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

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

Answer:

Difficulty:

Institutional investors definitely increase the volume of trading and volatility of the markets. Since most institutional investors, especially the 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. Difficult

3.

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

Ans: Insiders who have knowledge about the outcome of the merger may trade on superior knowledge.

Difficulty: Difficult Ref: The Secondary Markets

Problems 1.

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

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ABC ended 2005 at a price of $55 and had 1 million shares outstanding. XYZ stock ended 2005 at a price of $32 and had 4 million shares outstanding.

ABC ended 2006 at a price of $29 (after a 2-for-1 split). XYZ stock closed at $35 for 2006.

Calculate the new value of the index.

Solution: 2005

stock price ABC $55 XYZ $32

X

#shares 1 million = 4 million =

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

2006

stock price ABC $29 XYZ $35

X

#shares 2 million = 4 million =

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

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. Merrill Lynch and UBS 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 $10,000 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 4.

Which of the following statements regarding discount brokers is true?

a. b. c. d.

All discount brokers offer on-line trading.

Discount brokers only execute orders on stock transactions.

Discount brokers may offer little investment advice.

Discount brokers do not offer SIPC protection.

Ans: c Chapter Five How Securities Are Traded

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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.

Which of the following 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 at a large brokerage firm

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 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

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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 bond buyers can purchase bonds transaction cost free through:

a. b. c. d.

U.S. Federal Reserve Bank Treasury Direct DSPs discount brokers

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

Algorithmic trading is:

a. b. c. d.

technical analysis, also called charting high frequency trading in ECNs analysisarbitrage involve the use of computer programs to initiate trade orders, including decisionmaking on security, quantity, price, and timing

Ans: d Difficulty: Moderate Ref: How Orders Work 12.

NYSE Specialists 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, or vice versa. selling off inventory and maintaining strictly neutral positions

Ans: b Difficulty: Difficult Ref: How Orders Work

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13.

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

a. b. c. d.

trading halt strict adherence to market opening strict adherence to market closing Stockwatch

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

The Financial Industry Regulatory Authority (FINRA) created in 2007 is the largest regulator for securities firms in the U.S. 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

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: c Difficulty: Moderate Ref: How Orders Work 16.

The NYSE requires customers to deposit a minimum of how much in securities for margin accounts a. b. c. d.

$2,000 $2,500 $5,000 $10,000

Ans: a Difficulty: Moderate Ref: Margin Chapter Five How Securities Are Traded

56

17.

Margin accounts cannot be used to:

a. b. c. d.

purchase securities using leverage borrow money from a brokerage account to fund a frivolous vacation provide overdraft protection take physical delivery of an underlying asset on maturity of a futures contract

Ans: d Difficulty: Moderate Ref: Margin 18.

Open 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 would be 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 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:

Chapter Five How Securities Are Traded

57

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.

FINRA b.

SIPC c.

The Federal Reserve Bank d.

SEC Ans: d Difficulty: Easy Ref: How Orders Work 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 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

Chapter Five How Securities Are Traded

58

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 27.

Which of the following 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

Chapter Five How Securities Are Traded

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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 nine regional offices and approximately 200 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.

when the SEC declares one when the market declines more than 10 percent during the day typically lasts less than an hour but can be longer—is called during the trading 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 specialists exhaust their capital

d.

Ans: d Difficulty: Difficult Ref: How Orders Work 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 current initial margin requirement on stock is:

Chapter Five How Securities Are Traded

60

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 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 place:

a.

a sell order on sufficient securities to ensure the portfolio is compliant with maintenance margin requirements a sell order on 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:

Chapter Five How Securities Are Traded

61

An investor buys 100 shares of Walmart at $45 per share on margin with an initial margin of 70 percent and a maintenance margin of 25% percent. In two months, the stock goes to $56.

37.

What is the actual margin of the stock when it’s at $56?

a. b. c. d.

65.9% 75.9% 79.9% 80.9%

Solution: 5600-1350 5600

=

Ans: b Difficulty: Difficult Ref: Margin 38.

Below what 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 sale 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 42.

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

a. b. c. d.

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

Ans: c Difficulty: Moderate Ref: Short Sales Chapter Five How Securities Are Traded

62

Fill-in-the-blank Questions 1.

The SIPC limit for insurance coverage on cash is _____________________.

Ans: $100,000 Difficulty: Moderate Ref: Investor Protection in the Securities Markets 2.

The NYSE regulatory triad consists of: _____________________________, _________________, and _______________________________________.

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

True-False Questions 1.

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

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

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

Ans: T Difficulty: Easy Ref: Brokerage Transactions 3.

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

Ans: T Difficulty: Moderate Ref: Brokerage Transactions 4.

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

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

Dollar cost averaging, in which more shares are purchased at low prices than at high prices, is one advantage of dividend reinvestment plans.

Chapter Five How Securities Are Traded

63

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

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

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

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

Ans: F Difficulty: Moderate Ref: How Orders Work 8.

The Specialist’s Electronic Book, which is part of the SuperDot system, records and reports limit and market orders.

Ans: T Difficulty: Moderate Ref: How Orders Work 9.

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

Ans: F Difficulty: Easy Ref: How Orders Work 10.

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

rise

Ans: F Difficulty: Easy Ref: How Orders Work 11.

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

Ans: F Difficulty: Moderate Ref: How Orders Work 12.

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

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64

settlement

Ans: F Difficulty: Moderate Ref: How Orders Work 13.

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

Ans: F Difficulty: Easy Ref: Investor Protection in the Securities Markets 14.

Insider trading often occurs when mergers and takeovers are imminent.

Ans: T Difficulty: Moderate Ref: Investor Protection in the Securities Markets 15.

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

Ans: F Difficulty: Moderate Ref: Investor Protection in the Securities Markets 16.

Sidecars, trading halts and Rule 80A are all types of circuit breakers employed by the NYSE. Ans: T Difficulty: Moderate Ref: Investor Protection in the Securities Markets 17.

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

Ans: F Difficulty: Difficult Ref: Investor Protection in the Securities Markets 18.

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

Ans: F Difficulty: Easy Ref: Investor Protection in the Securities Markets 19.

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

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65

Ans: T Difficulty: Moderate Ref: Margin 20.

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

falls

Ans: F Difficulty: Moderate Ref: Margin 21.

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

Ans: T Difficulty: Easy Ref: Short Sales 22.

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

Ans: T Difficulty: Easy Ref: Short Sales 23.

Specialists often sell short to meet public buy orders.

Ans: T Difficulty: Moderate Ref: Short Sales 24.

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

Ans: T Difficulty: Moderate Ref: Short Sales

Short-Answer Questions 1.

What is the chief advantage of a market order?

Answer: A market order is executed immediately.

Difficulty: Easy

Chapter Five How Securities Are Traded

66

2.

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

Answer: Difficulty:

Investors don't have to worry about lost certificates and it simplifies record keeping.

Easy

3.

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

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 corporate bonds) Answer:

Difficulty: 5.

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

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

Moderate

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

Answer:

Difficulty:

Insider trading is a breach of fiduciary responsibility by "insiders" such as officers and directors of corporations who trade on corporate information that is available to the public. Both large and small investors can be charged with possessing "material, nonpublic information."

Difficult

6.

Mr. Whiner bought 1,000 shares of Sure-Fire, Inc., common stock at 85 and sold 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: Difficulty:

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

Moderate

7.

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

Answer:

Difficulty:

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

Moderate

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67

8.

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

Answer: Difficulty:

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

Moderate

9.

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

Answer:

Difficulty: 10.

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

Difficult

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 a NYSE specialist with those of an OTC dealer.

Answer:

Difficulty:

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 choose which securities to make a market in and when to buy and sell.

Moderate

2.

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

Answer:

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, on the other hand, 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.

Chapter Five How Securities Are Traded

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Difficulty:

Difficult

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) How much must the investor put up initially in order to purchase the stock? (b) Calculate the actual margin if the price of the stock drops to $55. (c) At what stock price will a margin call occur? (d) 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 =

(c)

$5500 - $3000 $5500 = 45.5 percent 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-.30) = 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:

Difficult

2.

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

(a) (b)

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?

Solution:

(a)

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

Chapter Five How Securities Are Traded

69

$700.

(b)

Difficulty: 3.

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

= = =

$5300 4000 ($1300)

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.

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

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

(original price

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 - 2,400 $15,600

=

$18,000

He must cover the short sale at a price of $130 ($15,600/120 shares) to have a $2,500 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.

All of the following represent the yield component of total return EXCEPT:

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 term is short if there are no safe alternatives except for holding cash if the expected return is adequate for the risk level if they are true 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 Chapter Six The Risks and Returns from Investing

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Ref: Risk 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 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 9. a.

The recent housing bubble and resulting credit crisis of 2008 is a perfect example of: nonsystematic risk

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b. c. d.

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 in value. depreciates in value. remains unchanged. moves to a net gain position.

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.

If interest rates rose, you would expect ------------ to also rise.

a. b. c. d.

business risk financial risk liquidity risk inflation risk

Ans: d Difficulty: Moderate Ref: Risk 13.

The best return measure to use if you are trying to measure the total effect of returns over time given some stated beginning amount is the: a. b. c.

total return return relative cumulative wealth index

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d.

total yield

Ans: a Difficulty: Moderate Ref: Measuring Returns 14.

Total return as defined in the text is:

a. b. c. d.

the difference between the sale price and the purchase price of an investment. measured by dividing the sum of all cash flows received by the amount invested. the reciprocal of a return relative. measured by dividing all cash flows received by its selling price.

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.

The ----------- is 1 plus the total return.

a. b. c. d.

arithmetic mean return relative cumulative wealth index geometric mean

Ans: b Difficulty: Difficult Ref: Measuring Returns 17.

The return relative solves the problem of:

a. b c. d.

inflation negative returns interest rates tax differences

Ans: b Difficulty: Moderate Chapter Six The Risks and Returns from Investing

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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. profits.

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 cashflows and nominal returns use expected cashflows real returns adjust for commissions and nominal returns do not real returns show the highest possible return and nominal returns show the lowest possible return

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

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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:

a. b.

the difference between the expected return on stocks and bonds the difference between the expected return on high-grade stocks and low-grade stocks the difference between the expected return on stocks and the risk-free rate the difference between the expected return on a stock market index and the inflation rate

c. d.

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

Which of the following statements concerning the equity risk premium is true?

a. b. c. d.

Some scholars think it is too low There is no direct way to measure it It predicts high future returns on stocks It is expected to increase in the future

Ans: b Difficulty: Difficult Ref: Measuring Risk 25.

The standard deviation measures:

a. b. c. d.

systematic risk of a security. unsystematic risk of a security. total risk of a security. the equity risk premium.

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

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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 period 1926-2007, 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. be:

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

a. b. c. d.

Considerably lower than that of the past Considerably higher than that of the past Very similar to the historical average No change is expected from recent years

Ans: a, Difficulty: Difficult Ref: Realized Returns and Risks from Investing 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 or it matures your dollar-denominated return will increase your-dollar denominated return will decrease your return will be the interest you receive

Ans: b Difficulty: Difficult Chapter Six The Risks and Returns from Investing

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Response: See p. 6-15 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: F Difficulty: Easy Ref: Return 2.

Return and risk are inversely related.

Ans: F Difficulty: Easy Ref: Risk 3.

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

Ans: F Difficulty: Easy Ref: Risk 4.

Bond prices and interest rates are inversely related.

Ans: T Difficulty: Moderate Ref: Risk 5.

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

Ans: T Difficulty: Difficult Ref: Risk 6.

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

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Ans: F Difficulty: Moderate Ref: Risk 7.

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

Ans: F 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: T 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 risk-free rate is reduced.

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

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

Ans: F Difficulty: Easy Ref: Summary Statistics for Returns 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: T Difficulty: Moderate Ref: Measuring Risk 12.

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

Ans: T Difficulty: Easy Ref: Compounding and Discounting

Short-Answer Questions Chapter Six The Risks and Returns from Investing

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

Difficulty: Moderate Ref: Compounding and Discounting 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.

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

Answer: Difficulty: 4.

The arithmetic mean is better for single period returns, whereas, the geometric mean is better for multiple periods.

Moderate

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

Answer:

Difficulty: 5.

The total return (TR) is used in both calculations.

TR = [CFt + (PE - PB)]/PB. CWIn = WI0 (1 + TR1)(1 + TR2) . . . (1 + TRn) G = [(1 + TR1)(1 + TR2) . . . (1 + TRn)] 1/n - 1 difficult

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 2002?

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 Chapter Six The Risks and Returns from Investing

79

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 on this chapter are calculated from historical data.

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

Answer:

Difficulty:

2.

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

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

Answer:

Difficulty:

The total return measure does not account for the time value of money.

The cash flows received are not discounted using present value techniques. This is a serious flaw in the measure. However, 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 during the year.

(a) (b)

Calculate the TR. Calculate the RR.

Solution:

(a)

TR

=

(Dividend + Change in Price)/ Beginning Price

=

($5 + $22)/$50

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=

0.54 or 54 percent

(b)

RR

=

TR + 1.0

=

0.54

+ 1.0 = 1.54

OR RR = Difficulty:

($5 + 72)/$50 Moderate

= 77/50 = 1.54

2.

The S&P 500 showed the following TRs 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 12.4) + 2.2]/6 = 42.7/6 = .0712 or 7.12 percent (b)

= [11.1 + (-5.2) + 20.3 + 26.7 + (-

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

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

3.

Calculate the future value of $100,000 at the end of 64 years given an interest rate of 10.38 percent.

Solution: Future Value = = $100,000 (1.1038) 64 = $100,000 (555.8849840) = $55,588,498.40 Difficulty: 4.

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

Easy

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 during the year. If after 1 year the value of the pesos is $0.29, what will John's rate of return be in U. S. dollars?

Solution:

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

Difficulty:

Domestic TR = percent difficult

5.

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

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,

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Difficulty: 6.

solve for FV = $3,105.85 Easy

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

Solution: Difficulty:

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

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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.

-------------------is concerned with the interrelationships 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

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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: b Difficulty: Moderate Solution: E(R) = Ripri = (20)(0.3)+ (30)(0.2)+(- 40)(0.1)+(50)(0.1) +(10)(0.3)= 22%.

Ref: Dealing With Uncertainty 6.

Probability distributions:

a. b. c. d.

are always discrete. are always continuous. can be either discrete or continuous. are inverse to interest rates.

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 8.

Portfolio weights are found by:

a. b. c.

dividing standard deviation by expected value calculating the percentage each asset’s value to the total portfolio value calculating the return of each asset to total portfolio return

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d.

dividing expected value by the 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?

a. b. c.

It can be higher than the weighted average expected return of individual assets It can be lower than the weighted average return of the individual assets It can never be higher or lower than the weighted average expected return of individual assets Expected return of a portfolio is impossible to calculate

d.

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.

probabilities of expected returns of individual assets weight of each individual asset to total portfolio value expected return of each individual asset 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 12.

Which of the following is true regarding random diversification?

a. b.

Investment characteristics are considered important in random diversification The benefits of random diversification eventually no longer continue as more securities are added Random diversification, if done correctly, can eliminate all risk in a portfolio

c.

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d.

Random diversification eventually removes all company specific risk from a portfolio

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 idiosyncratic 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 regarding the correlation coefficient is not true?

a. b. c. d.

It is a statistical measure It measure the relationship between two securities’ returns It determines the causes of the relationship between two securities’ returns It is greater than or equal to -1 and less than or equal to +1

Ans: c Difficulty: Difficult Ref: Analyzing Portfolio Risk 16.

Two stocks with perfect negative correlation will have a correlation coefficient of:

a. b. c. d.

+1.0 -2.0 0 –1.0

Ans: d Chapter Seven Portfolio Theory

85

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, a. b. c. d.

Security B’s return should also increase by 10 percent Security B’s return should decrease by 10 percent Security B’s return should be zero Security B’s 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:

a.

the correlation coefficient can be positive, negative or zero while the covariance is always positive the correlation coefficient measures relationship between securities and the covariance measures relationships between a security and the market the correlation coefficient is a relative measure showing association between security returns and the covariance is an absolute measure showing association between security returns the correlation coefficient is a geometric measure and the covariance is a statistical measure

b. c.

d.

Ans: c Difficulty: Difficult Ref: Analyzing Portfolio Risk 20.

Which of the following statements regarding portfolio risk and number of stocks is generally true? a. b. c.

Adding more stocks increases risk Adding more stocks decreases risk but does not eliminate it Adding more stocks has no effect on risk

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d.

Adding more stocks increases 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 securities 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 beta weighted average of individual risk 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 24.

Markowitz's main contribution to portfolio theory is:

a. b.

that risk is the same for each type of financial asset that risk is a function of credit, liquidity and market factors risk is not quantifiable insight about the relative importance of variance and covariance in determining portfolio risk

c. d.

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Ans: d Difficulty: Moderate Ref: Analyzing Portfolio Risk 25.

Owning two securities instead of one will not reduce the risk taken by an investor 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.

Variance Security A Security B

a. b. c. d.

Weight (in the portfolio) 0.3 0.7

10 20

17.0 percent 5.4 percent 2.0 percent 3.7 percent

Solution:

Ans: Difficulty: Ref:

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

d Difficult Analyzing Portfolio Risk

28.

The major problem with the Markowitz model is its:

a.

lack of accuracy

Chapter Seven Portfolio Theory

88

=

3.7%

b. c. d.

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: T 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: T Difficulty: Easy Ref: Dealing With Uncertainty 3.

Portfolio risk is a weighted average of the individual security risks.

Ans: F Difficulty: Moderate Ref: Portfolio Return and Risk 4.

A negative correlation coefficient indicates that the returns of two securities have a tendency to move in opposite directions.

Ans: T Difficulty: Easy Ref: The Components of Portfolio Risk

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5.

Investments in commodities such as precious metals may provide additional diversification opportunities for portfolios consisting primarily of stocks and bonds.

Ans: T 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: T 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: T Difficulty: Easy Ref: Analyzing Portfolio Risk 8.

Portfolio risk can be reduced by reducing portfolio weights for assets with positive correlations.

Ans: T 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: T Difficulty: Difficult Ref: Obtaining the Data 10.

In the case of a four-security portfolio, there will be 8 covariances.

Ans: F Difficulty: Moderate Ref: Obtaining the Data 11.

The correlation coefficient explains the cause in the relative movement in returns between two securities.

Ans: F Difficulty: Easy Ref: The Components of Portfolio Risk Chapter Seven Portfolio Theory

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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: T Difficulty: Difficult Ref: The Components of Portfolio Risk

Short-Answer Questions 1.

Are the expected returns and standard deviation of a portfolio both weighted averages of the individual securities 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.

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: 4.

The expected return is a weighted average. The portfolio standard deviation is not a weighted average but also requires correlation coefficients among the securities.

Moderate

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

Provide an example of two industries that might have low correlation with one another. Give an example that might exhibit high correlation.

Answer:

Difficulty:

Chapter Seven Portfolio Theory

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

91

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.

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: efficient, idiosyncratic (also known as company specific, unsystematic, or diversifiable) Difficulty: Difficult 2.

An efficiently diversified portfolio still has _____________________ risk.

Answer: Difficulty: 3.

The major problem with Markowitz diversification model is that it requires a full set of ________________________ between the returns of all securities being considered in order to calculate portfolio variance.

Answer: Difficulty: 4.

market (also known as systematic or un-diversifiable) Difficult

covariances Moderate

The number of covariances in the Markowitz model is ________ ; the number of unique covariances is [n (n-1)]/2.

Answer: Difficulty:

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n(n-1) Difficult

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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 more Difficult to put Markowitz diversification into effect than random diversification?

Answer:

Difficulty:

It requires more quantitative analysis and generally the use of a computer software program. In addition, it is Difficulter 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

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) .1 m

 = [  [ R i − E( R i )]2 pri ]1 / 2 i =1

(1) Possible Outcome .20 .15 .11 -.05

Chapter Seven Portfolio Theory

(2) ER

(3)

(4) (PR-ER)2 .09 .04 .00 -.16

R-ER .11 .11 .11 .11

93

(5) Prob. .0081 .0016 .0000 .0256

(4) x (5) .20 .15 .50 .15

(6)

.00162 .00024 .00000 .00384 .00570

 = (.00570)1/2 = 7.55 percent Difficulty:

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Moderate

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File: Ch.08, Chapter 8: Portfolio Selection

Multiple Choice Questions 1.

According to Markowitz, 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 one of the assumptions of portfolio theory?

Liquidity of positions Investor preferences are based only on expected return and risk Low transactions costs A single investment period

Ans: d Difficulty: Moderate Ref: Building a Portfolio Using Markowitz Principles 4.

When the Markowitz model assumes that most investors are considered to be “risk averse”, this really 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

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Ans: a Difficulty: Easy Ref: Building a Portfolio Using Markowitz Principles 5.

An indifference curve shows:

a. b. c. d.

the one most desirable portfolio for a particular investor all combinations of portfolios that are equally desirable to a particular 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 investors 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 lowest risk efficient portfolios

c. d.

Ans: c Difficulty: Difficult Ref: Building a Portfolio Using Markowitz Principles 8.

Indifference curves reflect -------------- while the efficient set of portfolios represent ---------------.

a. b. c. d.

portfolio possibilities; investor preferences. investor preferences; portfolio possibilities. portfolio return; investor risk. investor preferences; portfolio return.

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Ans: b Difficulty: Moderate Ref: Building a Portfolio Using Markowitz Principles 9.

According to Markowitz, 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 Chapter Eight Portfolio Selection

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13.

Indifference curves:

a. b. c. d.

always curve to the left have a positive slope cannot intersect are convex

Ans: d Difficulty: Moderate Ref: Building a Portfolio Using Markowitz Principles 14.

The benefits of international diversification have ________since 1995.

a. b. c. d.

increased decreased disappeared become more volatile

Ans: b Difficulty: Moderate Ref: The Global Perspective - International Diversification 15.

Different investors will 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 the Markowitz theory?

a. b.

Markowitz portfolio theory is considered a three-parameter model Under the Markowitz model, no portfolio on the efficient frontier dominates any other portfolio on the efficient frontier The Markowitz model is cumbersome to work with due to the large variancecovariance matrix needed for a set of stocks Markowitz portfolio theory is a multi-period model generates an entire set, or efficient frontier, of portfolios

c. d.

Ans: a Difficulty: Moderate Chapter Eight Portfolio Selection

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Ref: Some Important Conclusions About the Markowitz Model 17.

Which of the following is true regarding the Markowitz Model as covered in this chapter?

a.

It fully addresses the use of leverage b.

Investors must have homogeneous expectations about model parameters c.

Investors must be better off if they invest in portfolios to the Northwest of the efficient frontier d.

Markowitz diversification is inefficient diversification Ans: c Difficulty: Moderate Ref: Some Important Conclusions About the Markowitz Model 18.

The single index model divides a security's return into _______ and ________ parts.

a. b. c. d.

supply; demand control; non-control company-related; industry-related micro; macro

Ans: d Difficulty: Moderate Ref: Alternative Methods of Obtaining the Efficient Frontier 19. 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 20.

Choose the portfolio from the following set that is not 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

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21.

The single-index model implies stocks covary only because of their common:

a. b. c. d.

currency relationship to each other relationship to the market desire to make a profit

Ans: c Difficulty: Moderate Ref: Alternative Methods of Obtaining the Efficient Frontier 22.

With the Single-index model, the difference between actual return and expected return given a particular market index is referred to as the:

a. b. c. c.

parameter unique part error term beta

Ans: c Difficulty: Moderate Ref: Alternative Methods of Obtaining the Efficient Frontier 23.

Under the Multi-Index Model, the industry relationship to stock prices would be assessed by the:

a. b. c. d.

market factor nonmarket factor beta unique part

Ans: b Difficulty: Moderate Ref: Alternative Methods of Obtaining the Efficient Frontier 24.

To implement the single-index model, estimates of the _______for each stock are needed.

a. b. c. d.

expected return standard deviation beta covariance

Ans: c Difficulty: Moderate Ref: Alternative Methods of Obtaining the Efficient Frontier

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25.

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 26.

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 27.

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 28.

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 TIPS always pay a premium over inflation

Ans: b Difficulty: Difficult Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision

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29.

Based on recent history, an investor would probably 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 30.

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 31.

Which of the following would not be considered a source of systematic risk?

a. b. c. d.

a hostile takeover a rise in inflation a fall in GDP a panic on Wall Street

Ans: a Difficulty: Moderate Ref: The Impact of Diversification on Risk 32.

An international index commonly used as a proxy for international equities that correlates approximately 80 percent with the S&P 500:

a. b. c. d.

MSCI EAFE Index MSCI Emerging Markets Index Russell 1000 Index FTSE NAREIT Index

Ans: b Difficulty: Moderate Ref: The Global Perspective - International Diversification

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33.

The S&P 500 typically is usually correlated at what percent with the MSCI EAFE Index

a. b. c. d.

70% 80% 90% 95%

Ans: c Difficulty: Moderate Ref: The Global Persepective – International Diversification

True/False Questions 1. Because of its complexity, the Markowitz model is no longer used by institutional investors.

Ans: F 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: F Difficulty: Moderate Ref: Building a Portfolio Using Markowitz Principles 3. Markowitz derived the efficient frontier as an upward-sloping straight line.

Ans: F 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 factors.

Ans: T 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 return.

Ans: T Difficulty: Moderate Ref: Building a Portfolio Using Markowitz Principles

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6.

The single index model requires (3n+2) total pieces of data to implement.

Ans: T Difficulty: Easy Ref: Alternative Methods of Obtaining the Efficient Frontier 7.

The Sharpe model was found to outperform the Markowitz model in longer time periods.

Ans: F Difficulty: Moderate Ref: Alternative Methods of Obtaining the Efficient Frontier 8.

Asset allocation accounts for less than 50 percent of the variance in quarterly returns for a typical pension fund.

Ans: F Difficulty: Moderate Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision 9.

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: T Difficulty: Moderate Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision 10.

It would be impossible to combine an asset allocation plan with Markowitz analysis.

Ans: F Difficulty: Moderate Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision 11.

Real estate has never been shown to be positively correlated with the performance of stocks.

Ans: F Difficulty: Moderate Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision 12.

Based on recent research, it seems reasonable that approximately 10-20 securities are needed to ensure adequate diversification.

Ans: F Difficulty: Moderate Chapter Eight Portfolio Selection

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Ref: The Impact of Diversification on Risk 13.

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: T Difficulty: Moderate Ref: Selecting Optimal Asset Classes – The Asset Allocation Decision 14.

The Markowitz Model does not depend on the assumption of normally distributed security returns.

Ans: F 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 nonsystematic 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). Nonsystematic risk is also called nonmarket (unique) risk or diversifiable risk (e.g. poor product design, law suit).

Moderate

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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

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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File: Ch.09, Chapter 9: Asset Pricing Models

Multiple Choice Questions 1.

The Capital Asset Pricing Model:

a. b.

has serious flaws because of its complexity. measures relevant risk of a security and shows the relationship between risk and expected return. was developed by Markowitz in the 1930s. discounts almost all of the Markowitz portfolio theory.

c. d.

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..

Ans: b Difficulty: Moderate Ref: Capital Market Theory 4.

Which of the following 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 Chapter Nine Asset Pricing Models

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Ref: Capital Market Theory 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 bill Treasury 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 most of the assumptions of the CAPM are relaxed, most of the conclusions will 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 will be 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 the CML indicates the required return for each portfolio risk level.

Ans: b Difficulty: Moderate Ref: The Equilibrium Return-Risk Tradeoff 8.

__________, the CML can be downward sloping.

a. b. c. d.

Ex post When investors are risk-lovers 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

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9.

Which of the following statements about the difference between the SML and the CML is TRUE? a. b. c. d.

The intercept of the CML is the origin while the intercept of the SML is RF. CML consists of efficient portfolios, while the SML is concerned with all portfolios or securities.

CML could be downward sloping while that is impossible for the SML. CML and the SML are essentially the same except in terms of the securities represented.

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. 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. 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. It:

a. b. c.

is readily and precisely observable. is a risky portfolio. is the lowest point of tangency between the risk-free rate and the efficient frontier. should be composed of stocks or bonds.

d.

Ans: b Difficulty: Moderate Ref: The Equilibrium Return-Risk Tradeoff 15.

Under the separation theorem, all investors should:

a.

hold the same portfolio of risky assets and therefore have the same risk/return combination. have different optimal portfolios. have the same portfolio of risky assets and achieve their own risk-return combination through borrowing and lending. hold the same portfolio of risky assets and the same expected return but at different levels of risk

b. c. d.

Ans: d Difficulty: Difficult Ref: The Equilibrium Return-Risk Tradeoff 16.

The slope of the CML is the:

a. b. c. d.

standard deviation for efficient portfolios. 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 17.

Securities with betas greater than l should have:

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a. b. c. d.

expected returns higher than the market. required returns higher than the market return. required returns lower than the market return. no systematic risk.

Ans: b Difficulty: Easy Ref: The Equilibrium Return-Risk Tradeoff 18.

The _________ is a plot of __________.

a. b. c. d.

CML . . . individual stocks and efficient portfolios CML . . . both efficient and inefficient portfolios, only SML . . . individual securities and efficient portfolios SML . . . individual securities, inefficient portfolios, and efficient portfolios.

Ans: c 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 in equilibrium for efficient portfolios.

The intercept of the CML is the reward per unit of time available to investors for deferring consumption.

Standard deviation is the measure of risk which determines a portfolio's equilibrium return.

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 of return 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 Chapter Nine Asset Pricing Models

109

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. Their 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 of return is 1 percent, and XYZ Co. has a beta of 1.4. The 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 truly 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 lies 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 that

a. b.

the stock's return is more volatile than that of the market portfolio. an investor can eliminate the risk by combining it with another stock that has a negative beta. an investor will earn a higher return on his stock than that on the market portfolio. the stock is less risky than the market portfolio.

c. d.

Ans: a Difficulty: Easy Chapter Nine Asset Pricing Models

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Ref: The Equilibrium Return-Risk Tradeoff 25.

A less restrictive form of the Single Index Model is the:

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: Easy Ref: Estimating the SML 27.

Which of the following is not one of the reasonable conclusions of the CAPM reached by a consensus of the empirical results?

a. b. c. d.

The intercept term is generally higher than the RF. The SML appears to be non-linear.

The slope of the CAPM is generally less steep than suggested by the theory.

CAPM is an imperfect model for the explanation of the cross section of security returns.

Ans: b Difficulty: Difficult Ref: Tests of the CAPM 28.

The arbitrage pricing theory (APT) and the CAPM both assume all except the following?

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: Abritrage Pricing Theory Chapter Nine Asset Pricing Models

111

29.

Risk factors in the APT must possess all of the following the characteristics except:

a. b. c. d.

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 practice 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 beta’s near zero.

Ans: F 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: F Difficulty: Difficult Ref: The Equilibrium Return-Risk Tradeoff 3.

The CML indicates the required return for each portfolio risk level.

Ans: T 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: F 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: F Difficulty: Easy Ref: The Equilibrium Return-Risk Tradeoff 6.

The CML states that all investors should invest in the same portfolio of risky assets.

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Ans: T 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: T Difficulty: Easy Ref: The Equilibrium Return-Risk Tradeoff 8.

Testing of the CAPM suggests the trade-off between expected return and risk is an upward-sloping straight line.

Ans: T 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: F Difficulty: Moderate Ref: Tests of the CAPM 10.

Unlike the CAPM, the APT does not assume borrowing and lending at the riskfree rate.

Ans: T 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: T Difficulty: Moderate Ref: Arbitrage Pricing Theory 12.

Like the CAPM, the APT assumes a single-period investment horizon.

Ans: F Difficulty: Moderate Ref: Arbitrage Pricing Theory 13.

None of the asset-pricing models assume that the market is perfect.

Ans: F Chapter Nine Asset Pricing Models

114

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: T Difficulty: Easy Ref: Arbitrage Pricing Theory 15.

With 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: T Difficulty: Moderate Ref: Check Your Understanding 16.

The characteristic line is the regression fitting total returns for a stock against total returns for the market, and is sometimes calculated using excess returns.

Ans: T Difficulty: Moderate Ref: Estimating the SML 17.

Like CAPM, APT does not assume a single period investment horizon, no taxes, borrowing and lending at the RF rate, and investors selecting portfolios based on expected return and variance.

Ans: F 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: 2.

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

What is the formula for the slope of the CML? What does it represent?

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Answer: Difficulty: 3.

Difficulty:

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.

risk

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:

4.

The slope is [E(RM) – RF]/M. It represents the expected returntradeoff for efficient portfolios on the CML. 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, 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:

(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

Difficulty: 9.

Suppose the SML has 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.

Suggest that investors are more averse to risk than before the shift. They now require a risk premium of 11 percent (16 percent- 5 percent), whereas, they previously required 10 percent (15 percent - 5 percent) 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 nondiversifiable 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 consisting of RF and M

Difficulty: 2.

SML securities and portfolios.

CML and SML both indicate an upward sloping expected return-risk tradeoff.

Moderate

Compare the security market line model and the arbitrage pricing theory.

Answer:

SML is a one-factor model, the factor being the market risk premium. The APT has more factors (often three to five), such as unanticipated changes

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Difficulty: 3.

in inflation, industrial production, etc. Unlike the CAPM, the APT does not assume a single-period investment horizon, any taxes, borrowing and lending at rate the 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)

SD(%) 15 17 19

Based on the CML, calculate the market price of risk.

Calculate the expected return on each of these portfolios.

Solution: (a)

Slope of CML = (12 - 8)/20 = .20

(b)

Affiliated Omega Ivy Difficulty: Difficult 2.

8 + .2(15) = 11 percent 8 + .2(17) = 11.4 percent 8 + .2(19) = 11.8 percent

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

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Beta

Ri(%) 118

1 2 3 (a) (b)

0.8 1.2 0.6

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:

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) Stock 3 is undervalued because E(R) > RR. Difficult

3.

The market has an expected return of 13 percent and the risk-free rate is 5.5 percent. If Merrill Lynch has a beta of 1.85, what is the required return for Merrill Lynch?

Solution: Difficulty:

.055 + 1.85 (.13-.055) = .055 + .1388 = .1938 = 19.38% Moderate

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File: Ch. 10, Chapter 10: Common Stock Valuation

Multiple Choice Questions 1. Relative valuation measures commonly used by market participants today include: a. b. c. d.

P/E ratio, Price/Book Value, and Sales/Price ratios Earnings per Share ratio Discounted Cash Flow Residual Income Valuation

Ans: a Difficulty: Moderate Ref: Overview 2. The estimated value of common stock is the: a. b. c. d.

present value of all expected cash flows. present value of all capital gains. future value of all dividend payments. present value of all dividend payments.

Ans: a Difficulty: Moderate Ref: Discounted Cash Flow Techniques 3.

Discounted cash flow techniques used in valuing common stock are based on:

a. b. c. d.

future value analysis. present value analysis. the CAPM. the APT.

Ans: b Difficulty: Easy Ref: Discounted Cash Flow Techniques 4.

All of the following are interchangeable terms except for:

a. b. c. d.

discount rate coupon rate required rate of return capitalization rate

Ans: b Difficulty: Moderate Ref: The Dividend Discount Model Chapter Ten Common Stock Valuation

119

5.

Which of the following is a problem using the dividend discount model to value common stock?

a. b. c. d.

The model does not account for the risk of the stock.

The model does not consider the present value of the dividends.

The model does not consider that dividends may not be paid The model does not account for small dividends.

Ans: c Difficulty: Moderate Ref: The Dividend Discount Model 6.

Infinite growth is a problem with the dividend discount model because:

a. b.

The expected stream of dividends is infinite At reasonably high discount rates, such as 12 percent, dividends received in the distant future (40 or 50 years from now) are worth very little today Dividend growth rates eventually become very small The statement is incorrect – infinite growth is not a problem with the dividend discount model because at reasonably high discount rates, such as 12 percent, dividends received in the distant future are worth very little today

c. d.

Ans: d Difficulty: Moderate Ref: The Dividend Discount Model 7.

The constant growth dividend model uses the:

a. b. c. d.

historical growth rate in dividends. historical growth rate in earnings. estimated growth rate in dividends. estimated growth rate in earnings.

Ans: c Difficulty: Moderate Ref: The Dividend Discount Model 8.

The zero-growth dividend model:

a. b. c. d.

gives the highest value for a common stock. is the most accurate model to use. is equivalent to the valuation model for preferred stock. assumes the highest required return possible.

Ans: c Difficulty: Easy Ref: The Dividend Discount Model

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9.

The dividend model that is most appropriate for a young company that pays small dividends now but is expected to increase dividends in a few years is the:

a. b. c. d.

zero-growth model. constant growth model. expansion growth model. multiple growth model.

Ans: d Difficulty: Moderate Ref: The Dividend Discount Model 10.

Under the multiple growth model, at least ------ different growth rates are used.

a. b. c. d.

two three four five

Ans: a Difficulty: Easy Ref: The Dividend Discount Model 11.

The constant growth rate model of the DDM implies that:

a. b. c. d.

earnings are not relevant to stock prices. the payout ratio remains fixed. the stock price grows at the same rate as dividends. the growth rate in dividends equates to zero (i.e., dividends remain a “constant” dollar amount over time).

Ans: c Difficulty: Difficult Ref: The Dividend Discount Model 12.

Which of the following is not one of the reasons two investors both using the constant growth version of the DDM on the same stock might arrive at different estimates of the stock's value?

a. b. c. d.

They used different expected returns.

They used different growth rates of dividends.

They used different required returns.

They assume a different payout ratio.

Ans: a Difficulty: Moderate Ref: The Dividend Discount Model

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13.

What is the estimated value of a stock with a required rate of return of 12 percent, a projected constant growth rate of dividends of 7 percent and expected dividend of $2.50? a. b. c. d.

$60 $15 $150 $5

Ans: a Difficulty: Moderate Solution: P0=D1/(k – g) = 2.50/(.12-.07)=$50 Ref: The Dividend Discount Model 14.

XYZ Company has expected earnings of $3.00 for next year and usually retains 40 percent for future growth. Its dividends are expected to grow at a rate of 10 percent indefinitely. If an investor has a required rate of return of 15 percent, what price would he be willing to pay for XYZ stock? a. b. c. d.

$12.50 $25.00 $30.00 $36.00

Ans: d Difficulty: Moderate Solution: P0=D1/(k – g)=($3*(1-.4))/(.15-.10)=$36 Ref: The Dividend Discount Model 15.

WWW Company currently (t = 0) earns $4.00 per share, and has a payout of 40 percent. Dividends are expected to grow at a constant rate of 4 percent per year.

The required rate of return is 15 percent. The price of this stock would be estimated at

a. b. c. d.

$57.14. $22.86. $15.13. $24.69.

Ans: c Difficulty: Moderate Solution: P0=D1/(k – g)=(4*(1-.6))*(1+.04))/(.15-.04)=$15.13 Ref: The Dividend Discount Model 16.

Seaside Toys currently earns $2.00 per share and currently pays $1.00 per share in dividends. 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.

$6.67

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b. c. d.

$7.00 $10.00 $10.50

Ans: d Difficulty: Moderate Solution: P0=D1/(k – g)=2*(1-.5)(1+.05)/(.15-.05)=$10.50.

Ref: The Dividend Discount Model 17. true?

Which of the following statements regarding intrinsic value and market price is

a.

If intrinsic value is greater than the current market price, the stock should be avoided or, if already held, sold. b. If intrinsic value is less than the current market price, the stock is undervalued. c. If intrinsic value is equal to the current market price, the stock is correctly valued. d. If the intrinsic value is greater than the current market price, the stock is considered speculative.

Ans: c Difficulty: Moderate Ref: Other Discounted Cash Flow Approaches 18.

Analysts often use a ________% rule in security valuation in recognition of the fact that estimating a security's value is an inexact process. a. b. c. d.

5 10 15 20

Ans: c Difficulty: Difficult Ref: Other Discounted Cash Flow Approaches 19.

Based on PSR rule of thumb, if PSR is less than 1, the stock is:

a. b. c. d.

over-priced a candidate for short-sale a bargain about to default

Ans: c Difficulty: Difficult Ref: Relative Valuation Metrics 20.

Which of the following situations indicates a signal to buy a stock?

a.

IV > CMP

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b. c. d.

IV < CMP IV = CMP Impossible to determine.

Ans: a Difficulty: Easy Ref: Other Discounted Cash Flow Approaches 21.

A major difference between the dividend discount model (DDM) and the free cash flow to equity model (FCFE) is that the FCFE:

a. b.

accounts for potential capital gains and the DDM does not. measures what a firm could pay out in dividends and the DDM measures what is actually paid. measures both dividend growth and stability and the DDM only measures the dividend growth. bases its calculations on future value techniques while the DDM uses present value calculations.

c. d.

Ans: c Difficulty: Difficult Ref: Other Discounted Cash Flow Approaches 22.

Which of the following models incorporates debt financing, including both the repayment and interest on existing debt as the sale of new debt, as well as preferred stock financing?

a. b. c. d.

FCFE model FCFF model constant growth rate model multiple growth rate model

Ans: b Difficulty: Difficult Ref: Other Discounted Cash Flow Approaches 23.

Under the P/E model, stock price is a product of:

a. b. c. d.

EPS and DPS P/E ratio and EPS EPS and required return P/E ratio and required return

Ans: b Difficulty: Easy Ref: Relative Valuation Techniques

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24.

A firm has net income of $1 million with 250,000 shares outstanding with a total market value of $8 million. What is its P/E ratio?

a. b. c. d.

4 8 16 32

Ans: b Difficulty: Moderate Solution: P/E=($8 million/250,000 shares)/($1 million/250,000 shares)=8 Ref: Relative Valuation Techniques 25.

Generally speaking, if interest rates fall and other factors remain constant, the P/E ratio of most companies company will: a. b. c. d.

become negative. increase. decrease. become more volatile.

Ans: b Difficulty: Moderate Ref: Relative Valuation Techniques 26.

Which of the following variables has an inverse relationship with the P/E ratio?

a. b. c. d.

payout ratio expected growth rate of dividends expected growth rate of earnings required rate of return

Ans: d Difficulty: Difficult Ref: Relative Valuation Techniques 27.

Which of the following changes will likely lead to a higher P/E, assuming other factors are equal? a. b. c. d.

A decrease in the dividend payout ratio An increase in growth rate of earnings An increase in the required rate of return A decrease in the dividend yield

Ans: b Difficulty: Moderate Ref: Relative Valuation Techniques 28.

Which of the following statements regarding P/E ratios is true?

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a. b. c. d.

Generally, the riskier the stock, the higher the P/E ratio.

In recent years, the small capitalization stocks had the highest P/E ratios.

As interest rates increase, P/E ratios are expected to decline.

Higher growth prospects often lead to lower P/E ratios.

Ans: b Difficulty: Difficult Ref: Relative Valuation Techniques 29.

Economic value added is the difference between:

a. b. c. d.

operating profits and cost of capital. operating profits and cost of equity. net profits and cost of capital. net profits and cost of equity.

Ans: a Difficulty: Difficult Ref: Relative Valuation Techniques 30.

Value stocks, such as those considered the Dogs of the Dow, will generally have:

a. b. c. d.

no dividend payments a low P/E ratio a low payout ratio a high required return

Ans: b Difficulty: Moderate Ref: Relative Valuation Techniques 31.

Book value is:

a. b. c. d.

the same as market value. a more accurate valuation technique than the dividend models. the accounting value of the firm as reflected in the financial statements. the same as liquidation value.

Ans: c Difficulty: Easy Ref: Relative Valuation Techniques 32.

A company has a price to sales ratio of 1.0, annual sales of $1 billion and 100 million shares of common stock outstanding. Its stock price is: a. b. c.

$10 $20 $17.52

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d.

$22.00

Ans: a Difficulty: Moderate Solution: P/S=$1 billion/100 million = $10 per share Ref: Relative Valuation Techniques 33.

Several analysts and empiricists recommend investing in stocks with what kind of price to book value ratios? a. b. c. d.

low. equal to one. high. equal to zero.

Ans: a Difficulty: Moderate Ref: Relative Valuation Techniques 34.

Which of the following statements concerning price to book value is true?

a. b. c.

There is an inverse relationship between price to book values and market prices.

It is calculated as the ratio of price to the book value of assets.

There is supporting evidence that stocks with low price to book values significantly outperform the market.

Price to book value ratios for many stocks range from 5.5 to 10.5.

d.

Ans: c Difficulty: Difficult Ref: Relative Valuation Techniques 35.

The price/sales ratio indicates:

a. b. c. d.

the amount of risk in the firm’s operations. what the market is willing to pay for a firm’s revenues. the price advantage a company has for its brand names. what the analysts see as the breakup value of the firm.

Ans: b Difficulty: Moderate Ref: Relative Valuation Techniques 36.

A relatively new valuation technique that emphasizes the difference between a firm’s operating profits and its cost of capital is called:

a. b. c. d.

the discounted dividend model. the capital asset pricing model. economic value added model. the market capitalization model.

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Ans: c Difficulty: Moderate Ref: Relative Valuation Techniques 37.

It is recommended that investors interested in the EVA approach should seek companies that have a return of capital in excess of ------- because this will likely exceed the cost of capital and the company is, therefore, adding value.

a. b. c. d.

10 20 30 40

Ans: b Difficulty: Difficult Ref: Relative Valuation Techniques

True-False Questions 1.

There are many ways to measure Earnings Per Share.

Ans: T Difficulty: Easy Ref: The Dividend Discount Model 2.

Relatively small changes in inputs used in DDM can change the estimated value by large percentage amounts.

Ans: T Difficulty: Moderate Ref: The Dividend Discount Model 3.

If all investors use the constant growth dividend model to value the same stock, they will all arrive at the same estimate of value.

Ans: F Difficulty: Difficult Ref: The Dividend Discount Model 4.

Unlike discounted cash flow techniques, relative valuation does not require comparatively strong assumptions about the inputs that lead to an estimate of stock value.

Ans: T Difficulty: Moderate Ref: The Dividend Discount Model Chapter Ten Common Stock Valuation

128

5.

If the growth rate in dividends is greater than the required rate of return, the price found under the constant growth model will be negative.

Ans: T Difficulty: Moderate Ref: The Dividend Discount Model 6.

Under the zero-growth dividend model, expected dividends are the same as current dividends.

Ans: T Difficulty: Easy Ref: The Dividend Discount Model 7.

If the intrinsic value of stock is greater than the current stock price, the stock is overvalued and should be sold short.

Ans: F Difficulty: Moderate Ref: Other Discounted Cash Flow Approaches 8.

Other things equal, the higher the required return, the lower the P/E.

Ans: T Difficulty: Moderate Ref: Relative Valuation 9.

EVA analysis reflects an emphasis on risk-adjusted return on capital.

Ans: T Difficulty: Moderate Ref: Relative Valuation 10.

Companies with significant intangible assets on their balance sheets may receive a slightly lower P/E ratio versus companies with Difficult assets.

Ans: T Difficulty: Difficult Ref: Relative Valuation 11.

Declining interest rates in the market should send P/E ratios, on average, higher.

Ans: T Difficulty: Easy Ref: Relative Valuation

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12.

You would expect a lower PSR for a retail company than for a biotechnology company.

Ans: T Difficulty: Moderate Ref: Relative Valuation 11.

A number of companies that formerly experienced rapid growth were unable to sustain high growth rates. These companies included Cisco, Dell, Yahoo, and Google.

Ans: T Difficulty: Easy Ref: The Dividend Discount Model 12.

The "New Economy" stocks of the 1990s, such as the experience of eToys, proved conclusively that old valuation principles do not apply today.

Ans: F Difficulty: Easy Ref: Bursting the Bubble on New Economy Stocks - A Lesson in Valuation 13.

Relative valuation methods tend to be more sophisticated, more formal and less intuitive than discounted cash flow techniques.

Ans: F Difficulty: Moderate Ref: Which Approach to Use? 14.

Morningstar reports a "fair value" for stocks based on a relative valuation analysis.

Ans: F Difficulty: Moderate Ref: Which Approach to Use? 15.

S&P’s Outlook reports intrinsic value for stocks based on a combination of relative valuation and discounted cash flow analysis.

Ans: T Difficulty: Moderate Ref: Which Approach to Use?

Short-Answer Questions

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130

1.

Why have dividends historically been important in the valuation of common stock?

Answer:

Dividends are the only cash payments a stockholder receives directly from a company. However, in recent years, so many blue-chip companies have reduced or eliminated their dividends, that this type of valuation process is proving to be less useful in modern finance.

Difficulty: Easy Ref: Which Approach to Use? 2.

The higher the payout ratio, the higher the P/E is expected to be, other things being equal. However, other things might not be equal. Give an example of something that might not be equal and how it would affect the P/E.

Answer:

A higher payout would lead to a higher dividend and higher price in the DDM. If the higher payout caused the growth to decrease because of lower earnings retention, the price and P/E might increase less or fall. The point is that the variables are not necessarily independent, and changing one may change others.

Difficulty: Difficult Ref: Which Approach to Use? 3.

The financial newscaster comments that the Stock X is overvalued at an earnings multiple of 60. What could cause a P/E this high?

Answer:

Either the price could be high relative to normal earnings or the earnings could be low with very high growth expectations.

Difficulty: Moderate Ref: Which Approach to Use? 4.

What are the implications for the usefulness of the P/E ratio if a company’s earnings are very low (like a few cents) or negative?

Answer:

Difficulty: Ref: 5.

Either very low or negative earnings cause P/E ratios to be distorted.

Earnings per share of one cent make a $5 stock to have a P/E of 500.

Negative earnings per share would cause a negative P/E, which doesn't make sense.

Difficult Which Approach to Use?

What variables must be estimated to use the dividend discount model? The P/E model?

Answer:

To use the DDM the analyst must project the growth rate at which the dividends are expected to grow ad infinitum. With this growth rate the next expected dividend can be projected. The investor’s required rate of return must also be estimated. To use the P/E model the analyst must project the next period earnings and the P/E ratio.

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Difficulty: Ref: 6.

Moderate Which Approach to Use?

You calculate the intrinsic value of a stock to be $27. You check The Wall Street Journal and find the actual price to be $30. What could differ in your analysis and the market’s valuation? If you are confident about your analysis, should you buy or not?

Answer:

Difficulty: Ref: 7.

Factors that could differ include the discount rate required by investors, the future dividend growth rate, and the next expected dividend. If you are confident about your valuation of $27, you should not buy the stock, which is overvalued.

Difficult Which Approach to Use? Why did investors favor large cap stocks in the mid to late 1990s?

Answer: Difficulty: Ref:

They were perceived as less risky during a time when an economic slowdown was predicted and they showed strong earnings growth.

Moderate Which Approach to Use?

Critical Thinking/Essay Questions 1.

Often “high-flyer” stocks have high P/E ratios, yet some analysts seek low P/E stocks. Are high or low P/E ratios more reliable as tools for valuation of stocks?

Answer:

Difficulty: Ref: 2.

Low P/E ratios are likely to be more stable than high P/Es, and, therefore, more reliable in valuation models. High P/Es may be distorted by temporarily high demand for a particular stock rather than by economically justified pricing. High P/Es can also be caused by temporarily depressed earnings. High P/Es, then, are subject to greater swings as prices fluctuate without any realistic tie to earnings potential.

Difficult Which Approach to Use?

Explain how (a) the payout rate, (b) the expected dividend growth rate, and (c) the required rate of return affect the P/E ratio.

Answer:

To answer this question, substitute the DDM into the P/E formula.

P0 = D1/(k – g) = D1/E1 E1 E1 k–g From the above formulation, one can see that (a) a higher payout will increase D1 causing a higher P/E, (b) a higher growth rate, g, will cause a higher P/E, and (c) the higher required rate of return, k, will cause a lower P/E. P/E

Chapter Ten Common Stock Valuation

=

132

Difficulty:

Moderate

Problems 1.

The Crazy Horse Corporation's stock is trading at $75. The firm paid out $2.20 in dividends during the last year. If the payout ratio of the firm is 45 percent, what is its price earnings ratio?

Solution:

Difficulty: 2.

= = =

DPS/EPS 2.20/EPS 4.89

P/E Moderate

=

75/4.89

=

15.34

A. T. Edwards paid an annual dividend of $1.25 last year. Investors expect the dividends to grow at a rate of 6 percent per year over the foreseeable future. If the required rate of return for this stock is 12 percent, what is its intrinsic value today?

Solution:

Difficulty: 3.

Payout ratio .45 EPS

P0

= = = = Moderate

[D0 (1+g)]/ (k-g) [(1.25)(1.06)]/(.12-.06) 1.325/.06 $22.08

Bronco Inc.'s common stock is currently selling for $42 and paying a dividend of $3. If the investors expect dividends to double in 8 years, what is the required rate of return for Western Inc?

Solution:

In order for dividends to double in 9 years the annual compound growth rate (g) must be:

(1 + g)8

= g

2 = 21/8 - 1

P0

=

=

0.0905 or 9.05 percent

[D0 (1+g)]/ (k-g)

Therefore,

Difficulty: 4.

k = Moderate

= D1/P0 + g = 0.1684 or 16.84 percent

3(1.0905)/42 + .0905

The current market price of the stock of a company, Stryker Ltd. is $30 per share.

The dividends for the next year are expected to be $4.00 per share and the investor is confident that the selling price of the stock will be $35 at the end of

Chapter Ten Common Stock Valuation

133

one year. What is the implied rate of return assuming dividends are growing at a constant rate?

Solution:

P0 = $30; D1 = $4; P1 = $35 P0

=

D1 / (k-g)

(k – g) =

D1/ P0 =

Now, P1 = 35 = (1 + g) = g = g =

D1(1 + g)/(k – g) 4(1 + g)/(0.1333) 1.1667 1.1667 – 1 0.1667

Therefore,

Difficulty: 5.

4/30

As determined previously, (k – g) = 0.1333 k = 0.1333 + g k = 0.1333 + 0.1667 Difficult

=

0.1333

=

0.2999 or 29.99 percent

The directors of MJ Inc. expect to pay a dividend of $2.00 (annual) a year from today. It is estimated that during the next four years (i.e. years 2 through 5), the dividend will grow at an annual rate of 16 percent (i.e. g1 = 16 percent). After that, the growth rate (g2) will be equal to 12 percent per year and continue at that rate indefinitely. Calculate the present value of the MJ's stock if the required rate of return is 15 percent.

Solution: Price of stock = (Sum of the Present value of dividends received in years 1-5) + (Present value of the price at the end of year 5) Year

Growth rate Expected dividend 1 .16 2.00 2 .16 2.32 3 .16 2.6912 4 .16 3.1217 5 .16 3.6212

P5

= =

D5(1 + g2)/( k – g2) 3.6212(1 + .12)/(.15 - .12)

Present value of P5 P0 Difficulty:

=

$135.19(0.497177)

= $8.85 + 67.21 Difficult

Chapter Ten Common Stock Valuation

PVIF,15%,n Present value .869565 1.73913 .756144 1.75425 .657516 1.76951 .571753 1.78484 .497177 1.80038 Sum = 8.84611

=

$76.06

134

=

$135.19

=

$67.21

6.

Brotech Unlimited sells at $40 per share, and its latest 12 month earnings were $8 per share, of which $3.20 per share were paid as dividends.

(a) (b)

What is Brotech's current P/E ratio?

If Brotech's earnings are expected to grow by 9 percent per year, what is the projected price for next year assuming that the P/E ratio remains constant?

If you had a required rate of return of 15 percent, expected the dividend payout ratio to remain constant, and dividends to grow at a rate of 9 percent, would you buy this stock? Explain your answer.

(c)

Solution:

(a) =

Current P/E = Current Price/Current earnings 5

=

(b)

=

E1 x P/E

$43.60

P1

(c) P0 $58.13

=

=

8(1.09) x 5

D1/(k - g)

=

=

40/8

3.20(1.09)/(.15 - .09) =

Yes, I would buy this stock since its intrinsic value of $58.13 is greater than its current price of $40.

Difficulty: Difficult 7.

Contemporary Casuals, Inc., (CCI) has a beta of 1.15, an expected dividend of $2.30, and an expected dividend growth rate of 5 percent for the foreseeable future. The S&P500 expected return is 18 percent, and the Treasury bill rate is 6 percent.

Solution:

Difficulty:

(a) (b)

Calculate the required return on Contemporary stock.

Calculate the price of Contemporary stock.

(a)

kCCI

= =

RF + CCI[E(RM) - RF] .06 + 1.15[.18 - .06] = 0.198 or 19.8 percent

(b)

P0

= =

D1/(k - g) 2.30/(0.198 - .06)

Moderate

Chapter Ten Common Stock Valuation

135

=

$16.67

File: Ch.11, Chapter 11: Common Stocks: Analysis and Strategy,

Multiple Choice Questions 1. A general consensus of analysts is that a typical investor should have between ___ and ______ percent of his/her portfolio in international markets. a. b. c. d.

5: 10 10: 20 20: 30 30: 40

Ans: b Difficulty: Moderate Ref: A Global Perspective 2. For adequately diversified common stock portfolios, market effects often account for -------- percent and more of the variability of the portfolio’s return. a. b. c. d.

60 70 80 90

Ans: d Difficulty: Moderate Ref: The Impact of the Overall Market on Stocks 3.

From 1989 to April 2003, the Japanese stock market lost what percent of its value? a. b. c. d.

50 60 70 80

Ans: d Difficulty: Moderate Ref: The Impact of the Overall Market on Stocks 4.

Which of the following is TRUE regarding fluctuations in both individual stock prices and portfolios of stocks? a. b. c.

aggregate market movements are the largest single factor explaining these fluctuations beta is the largest single factor explaining these fluctuations standard deviation of returns is the largest single factor explaining these

Chapter Eleven Common Stocks: Analysis and Strategy

135

d.

fluctuations financial risk is the largest single factor explaining these fluctuations

Ans: a Difficulty: Moderate Ref: The Impact of the Overall Market on Stocks 5.

The required rate of return for a common stock is defined as the:

a.

expected return given an assumed set of probabilities and expected cash flows on the stock. maximum expected return based on estimates of expected cashflows from the stock. minimum expected return necessary to induce an investor to purchase the stock. expected return after evaluation of the risk on the stock has been taken.

b. c.

Ans: c Difficulty: Easy Ref: The Impact of the Overall Market on Stocks 6.

The -------------- provides investors with a method of calculating a required return for a stock.

a. b. c. d.

dividend discount model risk-free rate Fisher model Capital Asset Pricing Model

Ans: d Difficulty: Moderate Ref: The Impact of the Overall Market on Stocks 7.

A bear market is one characterized by a decline of:

a. b. c. d.

10% or more.

15% or more.

20% or more.

25% or more.

Ans: c Difficulty: Moderate Ref: The Impact of the Overall Market on Stocks 8.

Individual investors consider the investment decision:

a. b.

based on market and economic conditions as consisting of asset allocation. based on market and economic conditions as consisting of asset allocation and security selection. based on objectives, constraints, and preferences, as consisting of asset allocation.

c.

Chapter Eleven Common Stocks: Analysis and Strategy

136

d.

based on objectives, constraints, and preferences, as consisting of asset allocation and security selection.

Ans: d Difficulty: Moderate Ref: Building Stock Portfolios 9.

If investors in the market become more pessimistic, it is expected that 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 to make when building a diversified stock portfolio is:

a. b. c. d.

individual security analysis. asset allocation. minimization of market risk. maximization of expected return.

Ans: d Difficulty: Easy Ref: Building Stock Portfolios 11.

The passive investment strategy does not try to find undervalued stocks nor time the market. Instead, it is concerned with: a. b. c. d.

achieving returns available in various market sectors at minimum risk. achieving maximum returns available in various market sectors. achieving minimum risk in various market sectors. achieving returns available in various market sectors at minimum cost.

Ans: d Difficulty: Moderate Ref: The Passive Strategy 12.

If security markets are totally efficient, the best common stock strategy to take is:

a. b. c. d.

an asset allocation approach. the modern portfolio theory. an active strategy. a passive strategy.

Chapter Eleven Common Stocks: Analysis and Strategy

137

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 dividend discount model.

Fisher model. current market price. current earnings per share.

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 lower transactions and search costs.

Ans: d Difficulty: Moderate Ref: The Passive Strategy 16.

Which of the following is NOT considered a passive equity investment:

a. b. c. d.

investing in a sector ETF. investing in a 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 Chapter Eleven Common Stocks: Analysis and Strategy

138

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. sector rotation. tax efficiency. minimization of risk.

Ans: c Difficulty: Moderate Ref: The Passive Strategy 19.

An index 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 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 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.

ascertain the accuracy of financial statements of selected companies.

Chapter Eleven Common Stocks: Analysis and Strategy

139

b. c. d.

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 search for stocks for the fund to invest in would be 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.

The Merrill Lynch case in 2002 confirmed that many analysts:

a. b. c. d.

were paid too much. were unable to accurately pinpoint earnings. gave buy recommendations to win investment banking business. shared private information about companies with investors.

Ans: c Difficulty: Moderate Ref: The Active Strategy 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. all of the above

Ans: b Difficulty: Difficult Ref: The Active Strategy 25.

----------- shifts the weights of securities in the portfolio to take advantage of areas expected to do relatively better than others.

a. b. c.

Portfolio management Technical analysis Momentum strategy

Chapter Eleven Common Stocks: Analysis and Strategy

140

d.

Sector rotation

Ans: d Difficulty: Moderate Ref: The Active Strategy 26.

Market timers attempt to earn excess 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 primary market securities to capital market securities.

Ans: c Difficulty: Difficult Ref: The Active Strategy 27.

How can investors reasonably justify buy actively managed funds instead of index funds?

a. b.

higher management fees usually suggests better performance the fund consistently outperformed the market, net of fees, and is expected to continue to do so the fund outperformed the S&P 500 by 4% last year the portfolio manager is new and considered a star analyst

c. d.

Ans: b Difficulty: Difficult Ref: The Active Strategy 28.

All of the following represent requirements for conducting effective sector rotation, EXCEPT

a. b. c. d.

an accurate assessment of current economic conditions. a knowledge and understanding of the phases of the business cycle. an understanding of the political environment. expertise in technical analysis.

Ans: d Difficulty: Difficult Ref: The Active Strategy 29.

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.

Chapter Eleven Common Stocks: Analysis and Strategy

141

Ans: d Difficulty: Moderate Ref: The Active Strategy 30.

Sector rotation is

a. b. c.

one form of passive investing. an active strategy similar to stock selection. an attempt to earn excess returns by varying the percentage of assets in the portfolio. not dependent on an accurate assessment of current economic conditions.

d.

Ans: b Difficulty: Easy Ref: The Active Strategy 31.

Historically, sell-side equity research has typically been _________to the target company?

a. b. c. d.

very unfavorable unfavorable favorable neutral

Ans: c Difficulty: Easy Ref: The Active Strategy 32.

____________ funds are especially popular with momentum investors.

a. b. c. d.

Sector Managed Global Index

Ans: a Difficulty: Moderate Ref: The Active Strategy 33.

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 Chapter Eleven Common Stocks: Analysis and Strategy

142

34.

What is usually considered the biggest risk of market timing?

a. b. c. d.

getting out of the market too soon high transactions costs failing to adjust for short-term corrections not being in the market at critical times

Ans: d Difficulty: Difficult Ref: The Active Strategy 35.

If stock prices reflect their approximate fair value after transactions costs are taken into account, this is known as:

a. b. c. d.

after-cost efficiency. economic efficiency. a market in equilibrium. an efficient market.

Ans: b Difficulty: Moderate Ref: Rational Markets and Active Strategies 36.

If security prices fully reflect all relevant information available and usable, a securities market is said to be:

a. b. c. d.

rational. in equilibrium. effective. efficient.

Ans: d Difficulty: Moderate Ref: Rational Markets and Active Strategies 37.

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

Chapter Eleven Common Stocks: Analysis and Strategy

143

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: F Difficulty: Moderate Ref: A Global Perspective 2.

Market risk is the single most important risk affecting the price movements of common stocks.

Ans: T Difficulty: Moderate Ref: The Impact of the Overall Market on Stocks 3.

The nominal risk-free rate of return is calculated by subtracting an expected inflation premium from the real risk-free rate of interest.

Ans: F Difficulty: Moderate Ref: The Impact of the Overall Market on Stocks 4.

A utility stock is more likely to have a beta lower than the overall market.

Ans: T 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: T 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: T Difficulty: Easy Ref: Passive Strategy 7.

As evidence about the efficiency of stocks markets has grown, so have index funds.

Chapter Eleven Common Stocks: Analysis and Strategy

144

Ans: T Difficulty: Moderate Ref: Passive Strategy 8.

Index funds are considered relatively tax efficient since they rarely have shortterm gains.

Ans: T 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: F Difficulty: Easy Ref: The Active Strategy 10.

The primary emphasis in fundamental security analysis is on expected sales of the company.

Ans: F Difficulty: Moderate Ref: The Active Strategy 11.

Due to advances in technology and better understanding of stocks and financial markets, security analysts' estimates have become more accurate.

Ans: F Difficulty: Moderate Ref: The Active Strategy 12.

Under new SEC rules adopted in 2002, price targets for stocks are to be shown.

Ans: T Difficulty: Moderate Ref: The Active Strategy 13.

Sector rotation would be very successful in a truly efficient market.

Ans: F Difficulty: Easy Ref: The Active Strategy 14.

Security analysts receive all of their information from the management of the company.

Ans: F Difficulty: Easy Chapter Eleven Common Stocks: Analysis and Strategy

145

Ref: The Active Strategy 15.

If security prices fully reflect all the relevant information that is available and usable, then a securities market is considered to be efficient.

Ans: T 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: 2.

How is the required rate of return utilized in stock analysis?

Answer:

Difficulty: Ref: 3.

The required rate of return is the minimum expected rate of return needed to attract investors to purchase it. The required return is critical information for the potential investor and the focus of the security analyst’s job.

Moderate The Impact of the Overall Market on Stocks

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.

Generally, 10-20 percent of the portfolio in international markets with no more than 5 percent in emerging markets.

Easy A Global Perspective

Many companies offer dividend reinvestment plans 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:

Difficulty:

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

Chapter Eleven Common Stocks: Analysis and Strategy

146

Ref: 5.

The Passive Strategy What are the major reasons investing in index funds works, according to Burton Malkiel?

Answer:

Difficulty: Ref: 6.

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

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 have 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:

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.

Chapter Eleven Common Stocks: Analysis and Strategy

147

Difficulty: Ref: 2.

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

Chapter Eleven Common Stocks: Analysis and Strategy

148

File: Ch.12, Chapter 12: Market Efficiency

Multiple Choice Questions 1.

We can expect that the U.S. stock markets will be efficient for all of the following reasons EXCEPT:

a.

A large number of rational, profit-maximizing investors exist who actively participate in the U.S. market by analyzing, valuing, and trading stocks.

The U.S. economy is the largest in the world, with the most sophisticated investors.

Information is costless and widely available to market participants at approximately the same time.

Investors react quickly and fully to the new information, causing stock prices to adjust accordingly.

b. c. d.

Ans: b Difficulty: Easy Ref: The Concept of an Efficient Market 2.

An efficient market is defined as one in which:

a. b. c. d.

all participants have the same opportunity to make the same returns. all participants have the same legal rights and transactions costs. securities prices quickly and fully reflect all available information. securities prices are completely in line with the intrinsic value.

Ans: c Difficulty: Easy Ref: The Concept of an Efficient Market 3.

All “known” information means:

a. b. c. d.

past information only. past and current information. past, current, and inferred information. past, current, inferred and relative information.

Ans: c Difficulty: Moderate Ref: The Concept of an Efficient Market 4.

What is the result of the widespread usage of the Internet with regards to efficient markets?

a.

It makes information cheaper and more accessible thus making markets more efficient.

Chapter Twelve Market Efficiency

148

b. c. d.

It is subject to new regulation thus marking markets less efficient.

It increases the volatility of security prices thus making markets less efficient.

It increases competition among brokers thus making markets more efficient.

Ans: a Difficulty: Moderate Ref: The Concept of an Efficient Market 5.

If a market is inefficient, as new information is received about a security:

a. b. c. d.

nothing will happen. the stock price will fall at first and then later rise. there will be a lag in the adjustment of the stock price there will be negative demand for the stock.

Ans: c Difficulty: Difficult Ref: The Concept of an Efficient Market 6.

All of the following conditions must occur for a market to be considered efficient except:

a.

Information is costless and widely available to market participants at approximately the same time.

Information is generated in a specific fashion such that announcements are basically dependent on each other.

There are a large number of rational, profit-maximizing investors who actively participate in the market.

Investors react quickly and fully to the new information, causing stock prices to adjust accordingly.

b. c. d.

Ans: b Difficulty: Difficult Ref: The Concept of an Efficient Market 7.

Tests of the semistrong EMH include:

a. b. c. d.

regression analysis. correlation tests that compare the security returns to the overall market return. tests of the speed of adjustment of stock prices to company announcements. queuing line theory tests.

Ans: c Difficulty: Difficult Ref: The Concept of an Efficient Market 8.

Which of the following markets is generally considered to be the most efficient:

a.

China.

Chapter Twelve Market Efficiency

149

b. c. d.

India.

Russia.

U.S.

Ans: d Difficulty: Easy Ref: The Concept of an Efficient Market 9.

Weak form market efficiency

a. b. c. d.

implies that the expected return on any security is zero. incorporates semi-strong form efficiency. involves price and volume information. is compatible with technical analysis.

Ans: c Difficulty: Easy Ref: The Concept of an Efficient Market 10.

The highest level of market efficiency is

a. b. c. d.

weak form efficiency. semi-strong form efficiency. random walk efficiency. strong form efficiency.

Ans: d Difficulty: Easy Ref: The Concept of an Efficient Market 11.

The weak form of the EMH is supported if successive price changes over time are

a. b. c. d.

independent of each other. negative. positive. lagged.

Ans: a Difficulty: Easy Ref: The Concept of an Efficient Market 12.

Select the FALSE statement concerning efficient markets.

a. b. c. d.

The current price of a stock reflects all known information.

Investors will use all relevant data in making their decisions.

A perfect adjustment in price follows any new information.

Following any adjustment, the new price does not have to be the new equilibrium price.

Chapter Twelve Market Efficiency

150

Ans: c Difficulty: Difficult Ref: The Concept of an Efficient Market 13.

Which of the following statements is true regarding the efficiency of foreign securities and foreign markets? a. b. c. d.

Foreign securities tend to be more analyzed than U.S. securities.

Foreign markets tend to be less efficient than U.S. markets.

Foreign markets often lag behind U.S. markets as much as 6 months.

Foreign markets tend to be as efficient as U.S. markets.

Ans: b Difficulty: Moderate Ref: The Concept of an Efficient Market 14.

The random walk hypothesis is most related to the:

a. b. c. d.

weak-form EMH semistrong-form EMH semiweak-form EMH strong-form EMH

Ans: a Difficulty: Moderate Ref: How to Test for Market Efficiency 15.

Debont and Thayler (1985)’s overreaction hypothesis tends to:

a. b. c. d.

support the weak form of the EMH. not support the weak form of the EMH. support the semistrong form of the EMH. not support the semistrong form of the EMH.

Ans: b Difficulty: Difficult Ref: How to Test for Market EfficiencyBehavioral Finance 16.

Stockholders that own more than ____% of a company's stock are considered insiders by the SEC. a. b. c. d.

10 20 30 40

Ans: a Difficulty: Moderate Ref: How to Test for Market Efficiency Chapter Twelve Market Efficiency

151

17.

Which of the following is NOT a test of semi-strong form efficiency?

a. b. c. d.

Insider transactions Stock splits Accounting changes Dividend announcements

Ans: a Difficulty: Moderate Ref: How to Test for Market Efficiency 18.

According to the weak form of the EMH,

a. b. c.

successive price changes are biased. successive price changes are dependent. specified trading rules can prove to be extremely useful in generating excess returns. successive price changes are independent.

d.

Ans: d Difficulty: Moderate Ref: How to Test for Market Efficiency 19.

With regard to market efficiency, identify the INCORRECT statement.

a. b. c.

Information is the central issue of the efficient markets concept.

The most stringent form of market efficiency is the strong form.

The efficient market concept does not require a perfect adjustment in price following new information.

Tests of the usefulness of price data are semi-strong form tests.

d.

Ans: d Difficulty: Difficult Ref: How to Test for Market Efficiency 20.

According to the semi-strong form of the EMH, investors who invest in a stock after a highly positive announcement concerning the stock can expect to earn

a. b.

normal return because the stock will be fairly priced when purchased. extraordinary return because the new information will not affect the price until later. extraordinary loss because insiders possess non-public information. zero return because the next price is expected to be the same as the last price.

c.

d.

Ans: a Difficulty: Moderate Ref: How to Test for Market Efficiency

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152

21.

A lady bought 100 shares of a leading diamond mining company with an expected return of 20 percent per year. The following day the company’s president announced a major new discovery in Arkansas. The stock price immediately doubled. This scenario probably best illustrates a. b. c. d.

weak form EMH is not valid. semi-strong form of EMH is not valid. market prices are random. the lady was lucky.

Ans: d Difficulty: Moderate Ref: How to Test for Market Efficiency 22.

According to the random walk hypothesis, price(s)

a. b. c. d.

over time are independent of one another. changes over time are independent. levels over time are independent. changes today are dependent on yesterday’s price changes.

Ans: b Difficulty: Moderate Ref: How to Test for Market Efficiency 23.

Studies cited in the text show technical trading rules based on price and volume data lead to investment timing decisions that a. b. c. d.

consistently outperform the buy-and-hold strategy. minimize brokerage costs. do not provide excess returns after all brokerage costs are deducted. do provide excess returns to most investors who follow the rules faithfully.

Ans: c Difficulty: Moderate Ref: How to Test for Market Efficiency 24.

According to the behavioral finance, markets are always

a. b. c. d.

informationally efficient. informationally inefficient. weak-form efficient. semi-strong form efficient.

Ans: b Difficulty: Difficult Ref: Behavioral Finance 25.

Evidence concerning the “overreaction hypothesis” indicates that

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a. b. c. d.

most overreactions occur within the first two days of an economic event. investors are consistently risk-averse value maximizers. the market is even more efficient than the weak-form EMH proposes. investors sometimes act rationally.

Ans: d Difficulty: Difficult Ref: Behavioral Finance 26.

Which of the following is frequently used to test the semistrong form of the EMH? a. b. c. d.

statistical tests of stock-price change independence. tests of specific trading rules that use past price data. event studies. insider returns.

Ans: c Difficulty: Moderate Ref: How to Test for Market Efficiency 27.

Based on the research related to market anomalies, investors should prefer

a. b. c. d.

low standardized unexpected earnings (SUE) and high P/E ratios. low SUE, low P/E stocks. high SUE, low P/E stocks. high SUE, high P/E stocks.

Ans: c Difficutly: Moderate Ref: Market Anomalies 28.

Which of the following is a market anomaly?

a. b. c. d.

A relationship between money supply growth and stock prices.

A relationship between P/E ratios and subsequent stock returns.

Independence of stock price changes.

Adjustment of stock prices due to accounting changes.

Ans: b Difficulty: Difficult Ref: Market Anomalies 29.

All of the following are considered market anomalies EXCEPT:

a. b. c.

size effect January effect earnings announcement anomaly

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d.

accounting changes effect

Ans: d Difficulty: Difficult Ref: Market Anomalies 30.

The January effect concerns:

a. b. c. d.

large cap stocks. mid-cap stocks. small cap stocks. foreign stocks.

Ans: c Difficulty: Easy Ref: Market Anomalies 31.

Which of the following announcements has NOT been involved in a direct test of the semi-strong form of the EMH? a. b. c. d.

Dividend announcements Accounting changes Stock splits Corporate insiders' actions

Ans: d Difficulty: Moderate Ref: Market Anomalies 32.

Value Line’s 1 to 5 stock ranking system of timeliness refers to:

a. b. c. d.

absolute return potential over a 10-year period probability of outperforming the market over a 3 to 5 year period probable total return including dividend yield probable relative price performance within the next 12 months

Ans: d Difficulty: Moderate Ref: Market Anomalies 33.

The disposition effect relates to the fact that:

a. b. c. d.

investors tend to overconfident regarding potential stock prices. investors often experience regrets about trading decisions. investors are more likely to sell winners than losers. investors tend to dispose of stocks at the end of the year.

Ans: c Difficulty: Difficult Chapter Twelve Market Efficiency

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Ref: Behavioral Finance 34.

Which of the following is true regarding the size anomaly?

a.

As much as 50% of small cap outperformance is associated with the January effect. b.

Small cap stocks underperform large cap stocks in recent years. c.

Small cap stock outperformance is a NASDAQ phenomenon, not NYSE. d.

Small cap stock outperformance is unaffected by micro-cap, commission, or liquidity (i.e., bid-ask spread) concerns.

Ans: a Difficulty: Difficult Ref: Market Anomalies 35.

The paradox of efficient markets is that

a.

even though markets are efficient overall, there are pockets of inefficiency. news about anomalies makes the market less efficient. investors attempting to uncover and use information about security prices help make the market more efficient (i.e., an “efficient amount of inefficiency”) investors make the market less efficient.

b. c. d.

Ans: c Difficulty: Moderate Ref: Some Conclusions about Market Efficiency 36.

If an investor searches for patterns in security returns by examining various techniques applied to a set of data and then applying the technique that works, this is known as: a. b. c. d.

fundamental analysis. technical analysis. random-walk theory. data mining.

Ans: d Difficulty: Moderate Ref: Some Conclusions about Market Efficiency

True-False Questions 1.

In a semistrong form efficient market, investors are not able to use publicly available financial statement data to earn abnormal returns.

Ans: T Difficulty: Moderate Chapter Twelve Market Efficiency

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Ref: The Concept of an Efficient Market 2.

Under the weak form of the EMH, technical analysis relying on the history of price information is of no value in trying to outperform the future market.

Ans: T Difficulty: Moderate Ref: The Concept of an Efficient Market 3.

The efficiency of markets is driven largely by the vast number of participants and their quick and Easy access to information.

Ans: T Difficulty: Moderate Ref: The Concept of an Efficient Market 4.

If there is less efficiency in emerging markets than in developed markets, there should be higher performance in emerging markets than in developed markets.

Ans: T Difficulty: Moderate Ref: The Concept of an Efficient Market 5.

An investor who believes in the strong form of the EMH should be an active investor.

Ans: F Difficulty: Moderate Ref: The Concept of an Efficient Market 6.

An earnings announcement effect would not be considered a good test of the weak form of the EMH.

Ans: T Difficulty: Moderate Ref: How to Test for Market Efficiency 7.

Calendar market anomalies include day-of-the-week, turn-of-the-month, day preceding a holiday effect.

Ans: T Difficulty: Moderate Ref: Market Anomalies 8.

Calendar market anomalies include the neglected firm effect, which means few analysts follow the stock, or few institutions own the stock.

Ans: F Difficulty: Difficult Chapter Twelve Market Efficiency

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Ref: Market Anomalies 9.

The evidence obtained on weak-form efficiency casts serious doubts on fundamental analysis.

Ans: F Difficulty: Moderate Ref: How to Test for Market Efficiency 10.

Tests of the strong-form EMH include studies of corporate insiders and event studies.

Ans: F Difficulty: Moderate Ref: How to Test for Market Efficiency 11.

Overall, the low P/E strategy should be viewed as a short run strategy.

Ans: F Difficulty: Easy Ref: Behavioral Finance and Market Anomalies 12.

A belief in the size-effect anomaly should encourage investors to buy large-firm stocks.

Ans: F Difficulty: Easy Ref: Behavioral Finance and Market Anomalies

13.

Value investing implies investors should always buy stocks with the lowest P/E ratios.

Ans: F Difficulty: Difficult Ref: Behavioral Finance and Market Anomalies

Short-Answer Questions 1.

What types of information are considered in each of the three forms of the EMH?

Weak form – past price and volume data Semi-strong form – all public information Strong form – all information, public and private Difficulty: Moderate Ref: The Concept of an Efficient Market Answer:

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2.

Insider trading is illegal in the U. S. How is this related to the strong form EMH?

Answer:

If the strong form EMH were valid, insider information would have no value to investors because the information would be reflected in current prices. There would be no need for laws against insider trading if the strong form EMH were valid Difficulty: Moderate Ref: The Concept of an Efficient Market 3.

Technical analysis involves the use of historic price and volume information to predict future price movements. What does the EMH say about technical analysis?

Answer:

The weak form EMH indicates that all information from past prices is reflected in current prices, so that abnormal profits cannot be earned by studying historical price patterns.

Difficulty: Moderate Ref: The Concept of an Efficient Market 4.

If securities are fairly priced, then the portfolio manager is unlikely to be able to identify undervalued stocks. What other activities could portfolio managers perform?

Answer:

Portfolio managers need to (a) diversify the portfolio, (b) set appropriate risk levels, (c) determine tax consequences for investors, and (d) reduce transactions costs consistent with trading requirements.

Difficulty: Moderate Ref: The Concept of an Efficient Market 5.

What forms of EMH are strongly supported by economic studies? What is some evidence?

Weak form – Price and volume data show little predictive power.

Semi-strong form – Announcements of information are reflected in security prices rapidly.

Difficulty: Moderate Ref: How to Test for Market Efficiency Answer:

6.

An oil company’s P/E ratio is 15; its projected EPS is $8; and its price is $120.

Expectations are that a new field will add $2 EPS the next year. If the P/E remains constant, what should happen to the price in an efficient market? How soon? Are investors that pay the price after adjustment paying a fair price and are they expected to earn a normal return?

Answer:

The price should jump to $150 [i.e., P/E * (EPS + change in EPS) = 15 * (8 + 2) = $135] immediately. Investors are paying a fair price and should earn a normal return.

Difficulty: Difficult Ref: How to Test for Market Efficiency

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7.

What is a market anomaly? Give examples of several market anomalies.

Answer:

An anomaly is an exception to a rule. Market anomalies are exceptions to the efficient market hypothesis. Several examples follow: (a) Standardized unexpected earnings (SUE) have a positive relationship with future returns.(b) Low P/E ratio stocks tend to outperform the market. (c) Size effect studies shows that small capitalization stocks tend to earn higher risk-adjusted returns than large companies. (d) January effect studies have found abnormal returns for small stocks in the month of January, especially during the first five days.

Difficulty: Difficult Ref: Market Anomalies

Fill-in-the-blank Questions 1.

An efficient market is defined as one in which prices of securities fully reflect all known ______________________ quickly and accurately.

Answer: information Difficulty: Easy Ref: The Concept of an Efficient Market 2.

According to the text, the most compelling evidence about relative market efficiency is: (1) __________% of large cap equity funds failed to perform as well as the S&P 500 index; and (2) the vast majority of __________________ fail to achieve top half performance rankings or outperform their index, especially on a consistent basis.

Answer: 90%; mutual funds Difficulty: Difficult Ref: Summary

Critical Thinking/Essay Questions 1.

Some market scholars talk about tiers of stocks in the markets. A top tier on the NYSE would be the largest, most widely held stocks. Second and third tiers would consist of stocks that are less widely held and followed by fewer analysts. Is it possible that the market might be more efficient for the top tier and progressively less efficient for the lower tiers?

Answer: Presumably the top tier stocks are more efficient because the more analysts that track a stock, the more quickly new information will be assessed and acted upon. The lower tiers are neglected and information will not be reflected in their prices as completely and quickly.

Difficulty: Difficult Ref: Behavioral Finance and Market Anomalies

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2.

If an astute (or lucky) market analyst were to find a “money machine” system that consistently beat the market, would the system eventually become self-defeating?

Answer: The money machine would eventually become self-defeating as the market became efficient in the anomaly that caused the money machine to work.

Difficulty: Moderate

Problems 1.

Nike Inc. reports first quarter earnings of $2.00 per share. As an investor using the SUE technique, you had estimated earnings to be $1.50 per share, with a standard error of estimate (SEE) of 0.15. (a) (b)

Calculate the SUE for Nike.

Would this stock be a good buy on the basis of this SUE?

Solution: (a) SUE = (actual EPS - predicted EPS)/SEE = ($2.00 - $1.50)/0.15 = 3.33 (b) This would be a good buy because stocks with SUEs greater than 3.0 are attractive.

Difficulty: Difficult 2.

Calculate the SUE for a stock with expected second quarter earnings of $1.00 and actual second quarter earnings of $0.75. The standardization variable is 0.20. Is this stock one of interest to investors using the SUE technique?

Solution: SUE = (actual EPS - predicted EPS)/SEE = ($0.75 - $1.00)/0.20 = -1.25 The SUE for this stock is too low to justify selling short.

Difficulty: Difficult 3.

Listed below are the actual returns on two stocks X and Y, and on the market (RM), along with their systematic risk measures (Betas) relative to the time period, t.

Stock X Y

(a) (b)

Ri,t % 12.2 9.7

RM,t % 15.5 6.0

ai 0 0

Beta 0.8 1.2

What is the abnormal return for stock X when you consider its systematic risk measure?

What is the abnormal return for stock Y when you consider its systematic risk measure?

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Solution: (a)

Expected Return(X) = =

Abnormal Return = Abnormal Return (X) = (b) Difficulty: 4.

Ai + Beta (RM,t) 0 + 0.8(15.5) = 12.4

Actual Return - Expected Return 12.2 - 12.4 = -0.20

Abnormal Return (Y) = Moderate

9.7 - [0 + 1.2(6)]

=

2.5 percent

In terms of Venn Diagrams in terms of states of the world, explain how weakform, semistrong form, and strong form market efficiency relate to one another.

Solution: In a universe of all possible states of the world (i.e., including inefficient as well as efficient markets), weak-form market efficiency would be the next biggest subset, then semistrong form market efficiency a subset of weak-form market efficiency, and strong form market efficiency a subset of semistrong form efficiency. In other words, you cannot have strong form market efficiency unless you have semistrong form market efficiency, and you cannont have semistrong form market efficiency unless you also have weak form market efficiency.

Difficulty: 5.

Moderate

The Auto Company (AC) had expected returns and realized returns for the periods shown below: Period 1 215% 3 415%

Expected Return 15% 13% 15% 15%

Actual Return 16% 17%

Calculate the cumulative abnormal return for the four periods.

Solution: ARit = Rit ARAC1 = 16 ARAC2 = ARAC3 = ARAC4 =

Difficulty:

CARi = = Moderate

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E(Rit) 15 = 15 15 15

ARit 1 + (-2) + 2 + 0

162

1 percent = -2 percent = 2 percent = 0 percent

=

1 percent

File: Ch. 13, Chapter 13: Economy Market Analysis

Multiple Choice Questions 1.

U.S. investors can buy equities from companies that comprise more than what fraction of the world’s market capitalization and what fraction of the world’s GDP.

a. b. c. d.

1/5th world market cap, 1/4th world GDP 1/4th world market cap, 1/3rd world GDP 1/3rd world market cap, 1/2 world GDP 1/2 world market cap, 2/3rds world GDP

Ans: d Difficulty: Easy Ref: Taking a Global Perspective 2.

Multinational companies often follow the U.S. lead in restructuring processes and adopting new technologies. As a consequence, a. foreign equities markets are driven by earnings growth and political considerations, like U.S. equities markets. b. foreign equities markets are driven by earnings growth and political considerations, unlike U.S. equities markets. c. foreign equities markets are driven by earnings growth and interest rate changes, like U.S. equities markets. d. foreign equities markets are driven by earnings growth and interest rate changes, unlike U.S. equities markets.

Ans: c Difficulty: Moderate Ref: Taking a Global Perspective 3.

Gross Domestic Product (GDP) is a basic measure of the economy, and is defined as the market value of what items produced by an economy for some time period (typically a year)? a. b. c. d.

final goods. final goods and services. final goods, services, and labor. final goods, services, labor, and capital.

Ans: b Difficulty: Easy Ref: Assessing the Economy

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4.

The Bureau of Economic Analysis of the U.S. Government releases advance estimates of quarterly GDP in the first month following quarter end. In the second month, it provides a preliminary estimate. In the third, it provides a “final” estimate (though even this estimate is subject to annual revisions). Over the past 30 years, the average revision of GDP growth rate from advance to final has been approximately what fraction of a percentage point? a. b. c. d.

1/4.

1/3.

1/2.

2/3.

Ans: c Difficulty: Moderate Ref: Assessing the Economy 5.

The advance estimate of GDP predicts direction of quarterly change in real GDP growth approximately what percent of the time? a. b. c. d.

10%.

25%.

75%.

90%.

Ans: d Difficulty: Moderate Ref: Assessing the Economy 6.

The period from a peak to a trough 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.

57.

66.

75.

84.

Ans: a Difficulty: Moderate Chapter Thirteen Economy/Market Analysis

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Ref: Assessing the Economy 8.

In the U.S. since the end of World War II, the typical business cycle contraction consists of how many months? a. b. c. d.

6.

10.

12.

15.

Ans: b Difficulty: Moderate Ref: Assessing the Economy 9.

The National Bureau of Economic Research that measures business cycles and officially decides when there are economic “turning points” 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” (really 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.

Ans: c Difficulty: Easy Ref: Assessing the Economy 12.

Indexes of general economic activity include all but:

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a. b. c. d.

lagging emerging leading coincident

Ans: b Difficulty: Moderate Ref: Assessing the Economy 13.

Which of the following is considered to a leading indicator of a country’s economy? a. b. c. d.

duration of unemployment stock prices money supply interest rate spread

Ans: b Difficulty: Moderate Ref: Assessing the Economy 14.

The federal agency most involved with the 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 16.

Stock investors pay attention to the bond market because:

a. b.

it is more stable than the stock market. it can provide daily signals whereas stock market data tends to trend weekly, monthly or quarterly.

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c. d.

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.

Generally, 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.

An inverted yield curve generally indicates:

a. b. c. d.

the economy is accelerating. economic activity is slowing down. a pending recession. rising inflation.

Ans: c Difficulty: Easy Ref: Assessing the Economy 19.

_______ 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 20.

In the early stages of a business cycle, yield tends to be:

a. b. c. d.

low and upward sloping. flat. high and downward sloping. inverted.

Ans: a Difficulty: Moderate Chapter Thirteen Economy/Market Analysis

167

Ref: Assessing the Economy 21.

Estrella and Mishkin (1996) developed a somewhat successful model to predict whether the economy is going into recession using what variable? a. b. c. d.

spread between the 10-year U.S. Treasury Inflation Protected Security and the 3month T-Bill. spread between the 5-year U.S. Treasury Note and the 3-month T-Bill. spread between the 10-year U.S. Treasury Note and the 3-month T-Bill. spread between the 30-year U.S. Treasury Note and the 3-month T-Bill.

Ans: c Difficulty: Moderate Ref: Assessing the Economy 22.

Stock prices often peak when?

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 24.

If someone was to tell you that "the market" was up by two percent, 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

Chapter Thirteen Economy/Market Analysis

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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, and between troughs and peaks (i.e., when the rates of decline in growth change from increasing to decreasing rates, and vice versa). ex post stock market returns.

Ans: b Difficulty: Difficult Ref: The Stock Market and the Economy 26.

During a typical contraction, stock prices decline 25 percent from peak. During recent recessions, however, the range of decline has been: a. b. c. d.

less than 20 percent. between 20 and 30 percent. between 30 and 40 percent. greater than 40 percent.

Ans: d Difficulty: Moderate Ref: The Stock Market and the Economy 27.

The ability of the market to predict economic recoveries is remarkably good.

Stock prices almost always turn up how many months before recovery? a. b. c. d.

3-5, with 4 typical.

3-7, with 5 typical.

4-8, with 6 typical.

5-9, with 7 typical.

Ans: a Difficulty: Moderate Ref: The Stock Market and the Economy 28.

Assume that the dividend payout ratio on the S&P 500 will be 40 percent when the rate on long-term government bonds falls to 9 percent. Investors being risk averse demand an equity risk premium of 8 percent. If the growth rate of dividends is expected to be 10 percent, what will be the price of the market index if the earnings expectation is $30? a. b. c. d.

$384.00 $213.44 $266.56 $171.43

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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 are _____ and inflation is ________. a. b. c. d.

high; low low; high high; high low: low

Ans: c Difficulty: Moderate Ref: The Stock Market and the Economy 28.

Many market participants believe that when the dividend yield on the Standard and Poor's 500 is ____, the market is in for a downward correction. a. b. c. d.

above 6 percent below 6 percent above 3 percent below 3 percent

Ans: d Difficulty: Difficult Ref: Making Market Forecasts 29.

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. all of the above

Ans: c Difficulty: Difficult Ref: Making Market Forecasts 30.

Which of the following types of yield curves is typically considered to be stimulative to the economy? a. b. c.

a steep, upward-sloping yield curve a flat yield curve an inverted yield curve

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d.

a skewed yield curve

Ans: a Difficulty: Moderate Ref: Making Market Forecasts 31.

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 realized corporate profits. interest rates and expected corporate profits interest rates, inflation, and unemployment interest rates, inflation, and growth in GDP

Ans: a Difficulty: Difficult Ref: Making Market Forecasts 32.

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 interest rates are higher.

P/E ratios are higher when inflation is higher.

P/E ratios are lower when unemployment is higher.

Ans: a Difficulty: Moderate Ref: Making Market Forecasts 33.

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

True-False Questions 1.

Despite political, cultural and economic differences, foreign markets are driven by the same factors that drive U.S. markets.

Ans: F Difficulty: Moderate Ref: A Global Perspective Chapter Thirteen Economy/Market Analysis

171

2.

The longest peacetime expansion ran from 1991 to 2000.

Ans: T Difficulty: Moderate Ref: Assessing the Economy 3.

To value the market, an investor must analyze both corporate earnings and multipliers.

Ans: T Difficulty: Moderate Ref: Assessing the Economy 4.

Most analysts today agree that using money as an indicator of future economic activity is accurate.

Ans: T Difficulty: Moderate Ref: Assessing the Economy 5.

The stock market is a leading indicator of the economy because investors discount future earnings.

Ans: T Difficulty: Moderate Ref: Assessing the Economy 6.

The typical business cycle in the United States seems to lead the stock market’s turning point by a few months.

Ans: F Difficulty: Moderate Ref: Assessing the Economy 7.

Most investors should keep a watch on the Federal Reserve because of the effect of the money supply on interest rates.

Ans: T Difficulty: Easy Ref: Assessing the Economy 8.

The Dow Jones Industrial Average provides the best representation of the performance of U.S. stocks.

Ans: F Difficulty: Moderate Chapter Thirteen Economy/Market Analysis

172

Ref: The Stock Market and the Economy

9.

P/E ratios are generally low when interest rates and inflation are high.

Ans: T Difficulty: Moderate Ref: The Stock Market and the Economy

10.

If interest rates rise, the risk free rate of return declines.

Ans: F Difficulty: Moderate Ref: The Stock Market and the Economy 11.

If the economy is prospering, investors expect corporate earnings to rise.

Ans: T 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: T 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: T 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: T Difficulty: Moderate Ref: Making Market Forecasts 15.

Stock prices have almost always risen as the business cycle is approaching a trough.

Ans: T Difficulty: Moderate Chapter Thirteen Economy/Market Analysis

173

Ref: Making Market Forecasts 16.

Over the past 30 years, the average P/E ratio for the S&P 500 has been 23.

Ans: F Difficulty: Moderate Ref: Making Market Forecasts 17.

During periods of restrictive Federal Reserve monetary policy, the stock market usually performs poorly.

Ans: T Difficulty: Moderate Ref: Making Market Forecasts

Short-Answer Questions 1.

Why is the stock market a leading indicator of the economy? Use the constantgrowth dividend discount model in your explanation.

Ans: 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.

Difficulty: Moderate Ref: Assessing the Economy 2.

Why do stock investors pay attention to the bond market?

Answer: The bond market provides daily information about the economy through interest rates. This information is useful to stock investors.

Difficulty: Easy Ref: Assessing the Economy 3.

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:

No. P/Es vary too much from year to year.

Easy The Stock Market and the Economy

4.

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:

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

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Difficulty: Ref:

levels, meaning that price declines are in store. Others would expect the exuberance to continue.

Moderate The Stock Market and the Economy

5.

Use the constant-growth dividend discount model to explain why stock prices have an inverse relationship to interest rates.

Answer: Difficulty: Ref: 6.

The stock price (P0) based on the model P0 = D1/(k – g) increases as the required rate of return (k) decreases.’

Moderate The Stock Market and the Economy

Why is there an inverse relationship between P/Es and dividend yield?

Answer:

Difficulty: Ref:

Price is in the numerator on P/Es 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

7.

Explain how dividend yield on the S&P 500 Index can be used to make market forecasts.

Answer:

Difficulty: Ref:

When dividend yield drops below three percent, the market is expected to fall in the near future. Investors will sell stocks and seek higher 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: E/P Difficulty: Moderate Ref: Making Market Forecasts 2.

According to Warren Buffett, the two critical economic variables are: _______________ and _________________.

Answer: interest rates, expected corporate profits.

Difficulty: Moderate Ref: Making Market Forecasts

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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:

2.

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 exercises more influence over the domestic economy.

Difficult Making Market Forecasts

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 $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

=

Difficulty:

Moderate

D1/(k – g)

=

20/(0.15 – 0.10)

=

$400

2.

Value Line's estimated dividends on its Industrial Composite for 199X are $2.00 while estimated earnings are $4.30. The expected spread between k and g is .04. (a) (b)

Solution:

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)

(11.63)(4.30)

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=

= Difficulty:

$50

Moderate

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)

=

Dividend Yield 0.04 $30.50

Expected price = 36.45(20) = 729 Difficulty: Moderate

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$1.22

File: Ch. 14, Chapter 14: Industry Analysis

Multiple Choice Questions 1.

The second step in the fundamental analysis of common stock, after the economy, is: a. company b. economy c. industry d. business cycle Ans: c Difficulty: Easy Ref: Introduction 2.

Standard & Poor's new Global Industry Classification system divides everything into _________economic sectors.

a. b. c. d.

10 24 68 154

Ans: a Difficulty: Moderate Ref: What is an Industry?

3.

Standard and Poor's new Global Industry Classification System already includes _______ companies. a. b. c. d.

10,000 + 25,000+ 50,000 + 75,000+

Ans: b Difficulty: Moderate Ref: What is an Industry?

4.

A well-known and widely used system that classified industries for more than 60 years was the:

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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. a. b. c. d.

Industry analysis is important because: 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 7.

If an industry is ranked number one, based on price performance of the S&P Industry Stock Indexes, an investor

a.

cannot necessarily expect that same industry to be ranked number one again next year. can usually depend on an industry to maintain its top ranking for five years or more. can expect that industry to do well over the next 10 to 20 years. can expect that industry to drop out of the top ten within five years.

b. c. d.

Ans: a Difficulty: Moderate Ref: The Importance of Sector/Industry Analysis

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8.

Which life cycle stage generally sees industries improving their products, lowering prices, and start to attract considerable investment funds? a. b. c. d.

pioneering stage expansion stage stabilization stage maturity stage

Ans: b Difficulty: Moderate Ref: Analyzing Sectors/Industries 9.

An investor at what stage of a company’s life cycle typically stands to earn the highest return? a. b. c. d.

pioneering stage. expansion stage. stabilization stage. maturity stage.

Ans: a Difficulty: Moderate Ref: Analyzing Sectors/Industries 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 factors 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

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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 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 ---------- society to an ----------- society.

a. b. c. d.

agricultural; industrial agricultural; information industrial; information industrial; international

Ans: c Difficulty: Moderate Ref: Analyzing Sectors/Industries 15.

When conducting industry analysis, investors should consider the historical record of all the following except:

a. b. c.

sales growth. earnings growth. interest rates.

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d.

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 very accurately into a specific phase.

The general framework may not apply to some industries.

This approach does not explicitly lead to a stock price determination.

Ans: b Difficulty: Moderate Ref: Analyzing Sectors/Industries 17.

The most important point of Michael Porter's analysis is that industry profitability is a function of

a. b. c. d.

economy. interest-rate level. industry structure. 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:

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a. b. c. d.

structural change. government effect. competitive effect. cyclical effect.

Ans: b Difficulty: Easy Ref: Analyzing Sectors/Industries 20.

The food industry would be considered:

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

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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 24.

Which of the following sectors was adversely affected by the recent 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.

Three industry analysis approaches are:

a. business cycle analysis, qualitative analysis of important factors affecting industries, sector rotation. b. business cycle analysis, quantitative analysis of important factors affecting industries, market timing. c. business cycle analysis, technical analysis of important factors affecting industries, fundamental sector analysis. d. business cycle analysis, fundamental analysis of important factors affecting industries, technical sector analysis.

Ans: a Difficulty: Difficult Ref: Summary

True-False Questions 1.

The Value Line Investment Survey covers approximately 60 industries.

Ans: F Difficulty: Moderate

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182

Ref: What is an Industry?

2.

The NAICS puts companies into industries based on the activity in which they are primarily engaged.

Ans: T Difficulty: Moderate Ref: The NAICS Classification System 3.

Standard & Poor’s industry analysis has been shown to be less accurate in predicting expected performance than the Value Line Investment Survey.

Ans: T Difficulty: Moderate Ref: What is an Industry?

4.

It is a relatively simple matter of finding industries that will perform well in the short run.

Ans: F Difficulty: Moderate Ref: The Importance of Sector/Industry Analysis 5.

In the expansion stage, products become more standardized.

Ans: F Difficulty: Difficult Ref: Analyzing Sectors/Industries 6.

One limitation of the life cycle approach is that all companies fall into a specific category.

Ans: F Difficulty: Easy Ref: Analyzing Sectors/Industries 7.

The expansion stage of the industry life cycle is probably of most interest to investors, in which growth is rapid and risk is tolerable.

Ans: T Difficulty: Moderate Ref: Analyzing Sectors/Industries 8.

Since performance is not always consistent, an industry's track record should not be of much concern to investors.

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183

Ans: F Difficulty: Moderate Ref: Analyzing Sectors/Industries 9.

A company’s founders, friends and family are typically the main investors in the pioneering stage of any company.

Ans: T Difficulty: Easy Ref: Analyzing Sectors/Industries 10.

The food industry is a good example of a countercyclical industry.

Ans: F Difficulty: Moderate Ref: Using Sector/Industry Analysis As an Investor 11.

Growth industries often perform well during economic setbacks.

Ans: T Difficulty: Moderate Ref: Using Sector/Industry Analysis As an Investor 12.

Countercyclical and defensive are different terms for the same industry type.

Ans: F Difficulty: Moderate Ref: Using Sector/Industry Analysis as an Investor 13.

Mature industries typically have much higher P/E ratios than growth industries, which are riskier.

Ans: F Difficulty: Moderate Ref: Using Sector/Industry Analysis as an Investor 14.

The North American Industry Classification System (NAICS) was developed using a production-oriented approach, with the result companies are classified into industries based on the activity in which they are primarily engated.

Ans: T Difficulty: Easy Ref: The NAICS Classification System

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184

15.

The NAICS uses a five digit hierarchical coding system to classify all economic activity into 20 industry sectors, providing greater flexibility relative to SIC codes. A total of 15 of these sectors are devoted to services-producing sectors, compared to only 5 that are mainly goods-producing sectors. NAICS allows for identification of 1,170 industries. It includes 9 new service sectors and 250 new service industries.

Ans: F Difficulty: Difficult Ref: The NAICS Classification System

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.

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

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:

Historical performance, competition, government effects, and structural changes.

Easy Analyzing Sectors/Industries

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185

4.

What are the five competitive factors identified in the Michael Porter model?

Answer:

Difficulty: Ref: 5.

Give several examples of government effects on industries.

Answer:

Difficulty: Ref: 6.

Difficulty: Ref:

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, which has led to increased federal taxes and law suits filed by state governments against tobacco companies.

Moderate Analyzing Sectors/Industries

When should companies in cyclical industries be bought?

Answer:

7.

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

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:

An analyst often looks for industries that are growing faster than the economy as a whole or gaining a increasing share of consumer dollars.

A relevant economic measure can be found for specific industries.

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186

Difficulty: Ref:

Moderate Using Sector/Industry Analysis as an Investor

Critical Thinking/Essay Questions 1.

What industries do you think will be the growth industries of the next decade?

Answer:

This one is certainly open-ended and open to debate. A few possibilities include computer Difficultware 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.

Difficulty: Moderate Ref: Using Sector/Industry Analysis as an Investor 2.

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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187

File: Ch. 15, Chapter 15: Company Analysis

Multiple Choice Questions 1. a. b. c. d.

The last step in top-down fundamental analysis is to analyze: individual industries individual companies 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 major variable of interest to a majority of investors is:

a. b. c. d.

sales. 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

187

5.

Which of the following are shown on the balance sheet on a lower of cost or market value basis? a. b. c. d.

cash stockholders’ equity marketable securities fixed assets

Ans: d 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. guarantees the quality of the earnings. attests that the statements are a fair presentation of financial position. all of the above are true

Ans: c Difficulty: Moderate Ref: The Accounting Aspects of Earnings 8.

On a company’s balance sheet, shareholder’s equity is nearly always described by its?

a. b. c. d.

Book value Market value Current value Stock value

Ans: a Difficulty: Moderate Ref: The Accounting Aspects of Earnings 9.

Fixed assets generally consist of?

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188

a. b. c. d.

Cash and marketable securities Property, plant and equipment, at cost Intangible assets, like goodwill Shareholders' Equity

Ans: b Difficulty: Easy Ref: The Accounting Aspects of Earnings 10.

How is EPS computed? After-tax net income divided 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 the 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. gross profit. operating expenses. after-tax net income.

Ans: d Difficulty: Moderate Ref: The Accounting Aspects of Earnings 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.

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189

Ans: a Difficulty: Moderate Ref: The Accounting Aspects of Earnings 14.

Which of the following is not one of the parts of the cashflow statement?

a. b. c. e.

cashflow from operating activities. cashflow from sales activities. cashflow from investing activities. cashflow from financing activities.

Ans: b Difficulty: Moderate Ref: The Accounting Aspects of Earnings 15.

Which of the following mandated that companies, 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 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 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

b. c. d.

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industry.

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 21.

ROA is the product of

a. b. c. d.

net income margin and turnover. book value and turnover. leverage and book value. net income margin and leverage.

Ans: a Difficulty: Moderate Ref: Analyzing a Company’s Profitability Chapter Fifteen Company Analysis

191

22.

Which of the following statements is true?

a. b. c. d.

Turnover is not related to ROA. Leverage affects EPS. ROA is a function of turnover and leverage.

EPS is solely a function of ROE

Ans: b Difficulty: difficult Ref: Analyzing a Company’s Profitability 23.

The sustainable growth rate of a firm can be calculated as the product of the

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 total sales.

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 25.

Which of the following is true regarding earnings estimates?

a. b. c. d.

management at most firms will update 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 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?

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a. b. c. d.

The evidence tends to support analysts' forecasts in terms of accuracy over statistical models.

The evidence tends to support statistical models' forecasts in terms of accuracy over statistical models.

The evidence tends to support both types of forecasts equally.

The evidence does 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 will ---------, other things the same. a. b. c. d.

increase stay the same decrease increase or decrease but not stay the same

Ans: a Difficulty: Moderate Ref: The P/E Ratio 29.

How would you explain P/E ratio differences among companies? By 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., the P/E will __________, other things the same.

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193

a. b. c. d.

increase stay the same decrease increase or decrease but not stay the same

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,

a. b. c. d.

the higher the expected growth rate, the lower the P/E ratio. if the risk-free rate rises, the required rate will decline. as the required rate rises, the P/E ratio declines. if the risk premium rises, the required rate will fall.

Ans: c Difficulty: difficult Ref: The P/E Ratio 33.

Low P/E stocks are generally associated with

a. b. c. d.

mature companies. cyclical companies. young fast-growing companies. defensive companies.

Ans: a Difficulty: Moderate Ref: The P/E Ratio 34.

In modern investment analysis, the market risk of a stock is measured byits:

a. b. c. d.

beta. standard deviation. leverage. coefficient of variation.

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194

Ans: a Difficulty: Moderate Ref: Fundamental Security Analysis in Practice 35.

The investment advisory service best known for evaluating mutual funds in the United States is: a. b. c. d.

Standard & Poor's Moody's Industrial Manuals Morningstar Value Line Investment Survey

Ans: c Difficulty: Easy Ref: Fundamental Security Analysis in Practice 36.

_______ use a computer program in an attempt to imitate the brain in analyzing securities.

a. b. c. d.

Decision trees Program trading Day traders Neural networks

Ans: d Difficulty: Moderate Ref: Fundamental Security Analysis in Practice 37.

The balance sheet shows:

a. the portfolio of assets for a corporation, as well as its liabilities, over an accounting period. b. the portfolio of assets for a corporation, as well as its labilities, over an accounting period. c. the portfolio of assets for a corporation, as well as its liabilities and owner’s equity, over an accounting period. d. the portfolio of assets for a corporation, as well as its liabilities and owner’s equity, at a moment in time.

Ans: c Difficulty: Moderate Ref: The Accounting Aspects of Earnings 38. to:

The income statement is more frequently used than the balance sheet by investors

a. b.

assess current management performance over an accounting period. as a guide to company future profitability at a moment in time.

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c. d.

assess current management performance and as a guide to company future profitability at a moment in time. assess current management performance and as a guide to company future profitability over an accounting period.

Ans: d Difficulty: hard Ref: The Accounting Aspects of Earnings 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: hard Ref: The Accounting Aspects of Earnings

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: F 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: F 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: F Difficulty: Moderate Ref: The Accounting Aspects of Earnings 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.

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Ans: T Difficulty: Moderate Ref: Fundamental Analysis 5.

EBITDA, sometimes called operating profit, is often emphasized by telecommunications companies because of their lack of real profitability.

Ans: T Difficulty: Moderate Ref: The Accounting Aspects of Earnings 6.

International Financial Reporting Standards (IFRS) are now used by most countries.

Ans: T 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: T 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: T Difficulty: Moderate Ref: Analyzing a Company's Profitability 9.

A company may maintain its ROA if the net income margin decreases by increasing its asset turnover.

Ans: T 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.

Ans: F Difficulty: difficult Ref: Earnings Estimates 11.

Some companies, for example Apple, tend to provide low guidance, contributing toward consistently positive earnings surprises.

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Ans: T 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: F Difficulty: Easy Ref: Earnings Estimates 13.

The P/E ratio can be expected to change as the expected dividend payout ratio changes.

Ans: T Difficulty: Moderate Ref: The P/E Ratio 14.

Other things being equal, as k rises, the P/E ratio will also rise.

Ans: F Difficulty: Moderate Ref: The P/E Ratio 15.

According to Peter Lynch, the P/E ratio of a company that is fairly valued will equal its expected growth rate.

Ans: T 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: T Difficulty: Easy Ref: The Accounting Aspects of Earnings

Short-Answer Questions 1.

What is the relationship of the Financial Accounting Standards Board and the Securities and Exchange Commission?

Answer:

The FASB and the SEC are separate organizations. The FASB is a selfregulatory body of the accounting profession that sets accounting

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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:

Difficulty: Ref:

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: 6.

The internal growth rate is the growth rate depending on earnings retention as the only source of new capital. It is calculated as g = br = (1 – payout rate)(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:

5.

The claim is represented by the entire 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.

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

Any new information that affects projected earnings creates an earnings surprise. The SUE model formalizes the surprise factor. Stock prices react up or down to the surprise.

Moderate Earnings Estimates

Can an investor that wants to use the approach of projected earnings and P/Es find help in Value Line?

Answer: Difficulty: Ref:

Yes. In fact Value Line projects EPS, dividends, dividend payout, growth rates and prices.

Easy The P/E Ratio

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7.

What three variables affect the P/E ratio? How does each affect it?

Answer:

Difficulty: Ref: 8.

Should an investor seek companies with low P/Es or high P/Es?

Answer:

Difficulty: Ref: 9.

Using the model P/E = (D1/E1)/(k – g), the variables are the dividend payout rate, D1/E1, the required rate of return, k, and the dividend growth rate, g. If the dividend payout rate 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

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

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:

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

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2.

In the model P/E = (D1/E1)/(k – g), the P/E should increase if the dividend payout rate increases, other things the same. If the payout rate 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 grow growth, and a reduced required return.

Moderate The P/E Ratio

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 0.1335 or 13.35 percent

(b)

ROE = ROA x Leverage = 0.1335 x 1.579 = 0.2101 or 21.01 percent

(c)

EPS = =

= ROE x book value per share $7.00 x .2101 $1.47

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 rate of return of 17 percent, determine the estimated price for High Tech, Inc., common stock.

Calculate the expected dollar dividend two periods from now.

(c)

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Solution: b = ROE = g =

(a) g = 1 - payout ratio ROA x Leverage .6 x .221

(b)

= =

P0

br

D1/(k - g) 2.00/(0.17 - .1326)

(c) D2 = $2.00 (1.1326) Difficulty: Moderate

= =

= = =

1 - .4 = .6 .13 x 1.7 = .221 .1326 or 13.26 percent

=

$53.48

D1(1 + g) $2.265

3.

The risk-free rate of return is 10 percent, and the expected return for the stock market is 16 percent. Evergreen Industries has a beta of 1.1, and investors expect dividends and earnings to grow at an 8 percent rate per year. The current dividend is $1.20, and the payout ratio is 50 percent.

(a) (b)

Calculate the P/E ratio for Evergreen Industries.

Estimate the price of the stock for the next year using the multiplier model.

Solution: (a) k = .10 + 1.1(.16 - .10) P/E =

=

= (D1/E1)/(k – g) ($1.30/$2.59)/(0.166 - .08)

(b) P1 = P/E x E1 = 5.81 x $2.59 Difficulty: Moderate 4.

RF + B(RM - RF) = 0.166

=

=

$15.05

Calculate the required rate of return on DCM Corporation'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

D1/(k – g) or D1/P0 + g = 2/35 + .054 Moderate

= =

Difficulty: 5.

5.81

= retention rate x ROE= (1 - dividend payout ratio) x ROE = (1 - 0.55) x 12 = .45 x 12 = .054

=

0.1111 or 11.11 percent

A company has sales of $220 million. These are expected to increase by 15 percent next year and 12 percent in the year after that. Over each of the next two years, the company expects to have a net profit margin of 8 percent, a payout ratio of 60 percent, and a constant 3 million shares of common stock outstanding. If the stock is expected to trade at a P/E ratio of 14 at the end of the second year and if the investor requires a 14 percent rate of return, what should the justified price of the stock be today?

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Solution: Current Year 1 Growth rate + 15 % Sales $253m Net Profit (8% of sales)$20.24m Number of shares out 3m EPS $6.75 DPS (60% of EPS) $4.05

Year 2 + 12% $283.36m $22.67m 3m $7.56 $4.54

Stock price in year 2 = EPS in year 2 x P/E at end of year 2 P2 = 7.56 x 14 = $105.84 Stock price today = Present value of D1 + Present value of D2 + Present value of P2 P0 = [$4.05/(1.14)] + [4.54/(1.14)2] + [105.84/(1.14)2] = $3.55 + $3.49 + $81.44 = $88.48 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 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: 7.

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

Given 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.

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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

br Retention rate x ROE 0.3(0.225) 0.0675 or 6.75 percent

Moderate

Find the P/E ratio of a stock with a ROE of 15 percent, a book value per share of $5.00, and a current stock price of $30.00.

Solution:

Difficulty:

EPS

= =

P/E = Moderate

Chapter Fifteen Company Analysis

ROE(Book value) 0.15($5) =

$0.75 per share

$30/$0.75

$22.50

=

204

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 ________ analysis.

a. b. c. d.

external. internal. stochastic. qualitative.

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.

All of the following are assumptions made by technical analysts except:

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 9.

A support level is a price range:

a.

at which a significant increase in demand for a stock is expected.

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205

b. c. d.

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. time period. 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. chart of stock price and volume.

Ans: d Difficulty: Moderate Ref: Stock Price and Volume Techniques 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.

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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 the relative strength has improved for at least ---------------months.

a. b. c. d.

1 2 3 4

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 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

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18.

Which of the following is a characteristic of the short interest ratio: It is:

a. b. c. d.

calculated daily as well as weekly. often interpreted without any additional information. between 2 and 3 in recent times. 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 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.

Relative strength ratio Investment advisory opinions Mutual fund liquidity positions

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208

d.

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 .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 25.

Technicians that utilize the CBOE put/call ratio generally believe:

a. b. c. d.

option investors are almost consistent losers. option investors are almost consistent 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 Chapter Sixteen Technical Analysis

209

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 all of the above would indicate a market peak to a contrarian

Ans: c Difficulty: Difficult Ref: Technical Indicators 28.

Which of the following is not one of the tests of a technical trading rule?

a. b. c. d.

Transaction and other costs Consistency Return Risk

Ans: c Difficulty: Moderate Ref: Testing Technical Analysis Strategies 29.

If an investor buys a stock when its price has increased 15 percent from its previous low, 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 tried 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

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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.

Small changes in the put/call ratio are considered unimportant, whereas extreme changes convey information. Two rules of thumb are that a ratio greater than _________ based on a 10-day moving average would be excessively bearish and thus a buy signal, and a ratio of less than _____________ would be excessively bullish, and therefore a sell signal. a. b. c. d.

0.70, 0.65 0.80, 0.45 0.90, 0.25 0.95, 0.05

Ans: b Difficulty: Moderate Ref: Technical Indicators 34.

Fama and Blume (1969) tested 24 filters ranging from 0.50% to 50% on each of the 30 DJIA stocks. Among the tested filters:

a. b. c. d.

several were profitable before commissions but not after. several were profitable before and after commissions. none were profitable even before commissions. all were profitable before commissions but not after.

Ans: a Difficulty: Difficult Ref: Testing Technical Analysis Strategies 35.

Some recent research shows technical analysis may have some value. For example, Brown and Jennings (1989) show investors can learn something about other investors by observing prices at which securities trade – i.e., prices reveal information and convey it. What other kinds of today’s models open up the possibility of profitable trading strategies using technical analysis?

a. b. c. d.

Arbitrage.

Trading Rules.

Short-interest.

Behavioral.

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211

Ans: d Difficulty: Difficult Ref: Some Conclusions about Technical Analysis True/False Questions 1.

Technical analysis utilizes a top-down, fundamental approach to common stocks.

Ans: F Difficulty: Moderate Ref: What Is Technical Analysis?

2.

Technical analysis focuses on timing and on the short run.

Ans: T Difficulty: Easy Ref: What Is Technical Analysis?

3.

Technical analysts agree with the fundamental analysts regarding the usefulness of accounting data.

Ans: F 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: T Difficulty: Easy Ref: Stock Price and Volume Techniques 5.

A bar chart is the simplest type of chart used in technical analysis.

Ans: T 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: T Difficulty: Easy Ref: Stock Price and Volume Techniques 7.

Relative strength analysis is popular because it is generally not subject to conflicting interpretations.

Ans: F Chapter Sixteen Technical Analysis

212

Difficulty: Moderate Ref: Stock Price and Volume Techniques 8.

If a trend exhibits support and resistance levels simultaneously that appear well defined, the trendlines are referred to as channel lines.

Ans: T Difficulty: Moderate Ref: Stock Price and Volume Techniques 9.

Secondary movements are often termed technical corrections.

Ans: T Difficulty: Moderate Ref: Stock Price and Volume Techniques 10.

The cash position of mutual funds is a contrarian indicator.

Ans: T 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: T Difficulty: Moderate Ref: Technical Indicators 12.

A filter rule specifies a breakpoint for a stock or average and trades are when the price is greater than the filter.

made

Ans: T Difficulty: Easy Ref: Testing Technical Analysis Strategies 13.

In the 1990s, many investment firms hired large numbers of fundamental analysts and very few technical analysts. Following the market downturns of 2000 and 2001, investment firms realized their mistake and hired far more technical analysts than fundamental analysts.

Ans: F Difficulty: Moderate Ref: The Ebb and Flow of Technical Analysis

Short-Answer Questions 1.

Explain how profit taking and support levels are related.

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213

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, if 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

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?

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214

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. Thus, if odd-lotters are selling, smart investors should buy. Similarly, the mutual fund liquidity technique asserts that mutual fund managers act like odd-lotters, buying when the 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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215

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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File ch17.rtf Chapter 17 Bond Yields

Type: Multiple Choice 1. How is the value of a bond determined? a) The present value of the bond’s future cash flows is discounted by one or more appropriate rate(s). b) The perpetuity model is used to determine the value of a bond. c) The present value of the company’s future cash flows is discounted by one or more appropriate rate(s). d) The constant growth dividend model is often used to value bonds.

Ans: A EASY Response: Section: Bond Prices.

2. Which of the following statements is most correct? a) The real risk-free rate of interest is the rate that is shown in the Wall Street Journal for the shortest term federal securities. b) The real risk-free rate of interest is the rate that is shown in the Wall Street Journal for the longest term federal securities. c) The real risk-free rate of interest is the rate that is shown in the Wall Street Journal for the shortest term federal securities, plus a forecast of the rate of inflation for the period of the securities. d) The real risk-free rate of interest is the rate that is shown in the Wall Street Journal for the longest term federal securities, plus a forecast of the rate of inflation for the period of the securities.

Ans: C MODERATE Response: Long-term treasury bonds typically yield more per year than short-term treasury bills.

Section: Bond Yields and Interest Rates.

3. What is meant by the real risk-free rate of interest? a) The opportunity cost of foregoing consumption, representing the rate that must be offered to individuals to persuade them to save rather than consume. b) The rate actually used in the market, not in textbooks. c) The rate quoted on short-term Treasury bills. d) The nominal risk-free interest rate, less the expected inflation.

Ans: A MODERATE Response: Section: Bond Yields and Interest Rates

4. For most long term bonds, when coupons are reinvested, what is the most important component of the bond’s total return? a) Coupon rate. b) Interest-on-interest. c) Yield to Maturity d) Interest-on-principal.

Ans: A MODERATE Response: Section: Measuring Bond Yields 5. What is meant by “Yield to Maturity”? a) The coupon interest rate paid each year, divided by the face value of the bond. b) The coupon interest rate paid each, divided by the current price of the bond. c) The periodic interest rate that equates the current price with the expected future flows. d) The periodic interest rate that equates the current price with the expected future flows, up to the time of the first call.

Ans: C MODERATE Response: Section: 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) The semi-annual coupon payments. b) The interest earned on reinvesting the coupon payments. c) The principal paid at maturity. d) The interest earned on reinvesting the last coupon and the principal.

Ans: D DIFFICULT Response: The total dollar return is calculated by adding the funds at the time of maturity, so the coupon and principal repayment cannot be reinvested. Section: 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 payment at the original yield to maturity. b) Interest rates do not change during the life of the bond. c) The issuer calls the bond prior to original maturity. d) The realized compound yield is equal to the promised yield to maturity.

Ans: C DIFFICULT Response: A call means the issuer is paying back the amount borrowed, plus a call premium, earlier than the original maturity date. The issuer will choose to do so only if interest rates have

fallen, so the investor will not be able to reinvest at the original Yield to Maturity. Section: Measuring Bond Yields.

8. Which of the following is the best definition of “realized compound yield”? a) The yield an investor realizes on the bond coupons. b) The total amount of the coupon and principal payments. c) The ending wealth divided by the starting wealth. d) The total amount of the coupon and principal payments, and the reinvestment of these flows.

Ans: D MODERATE Response: Section: Measuring Bond Yields.

9. What is the difference between the Yield-to-Maturity and the Realized Compound Yield? a) They are actually the same concept. b) The yield to maturity is the actual return, calculated at the end of the investment; the realized compound yield is the expected return at the beginning of the investment. c) The realized compound yield is the actual return, calculated at the end of the investment; the yield to maturity is the expected return at the beginning of the investment. d) The yield to maturity continues as far as the first call, the realized compound yield continues until final payment is made.

Ans: C MODERATE Response: Section: Measuring Bond Yields.

10. Which of the following typically contributes the greatest portion to the Total Dollar Return? a) The semi-annual coupon payments b) The interest earned on reinvesting the coupon payments. c) The principal paid at maturity. d) The interest earned on reinvesting the principal.

Ans: B EASY Response: As shown in Figure 17-3, the interest-on-interest is greater than either the principal or coupons. Section: Investments Intuition.

11. Assume an investor buys a newly issued 8 percent, semi-annual 10 year bond at par. He sells it two years later, when market interest rates have decreased to 6 percent. How much is the investor’s capital gain or loss? a) $1,000 gain b) $1,125.44 gain c) $125.44 gain d) $377.00 loss Ans: C

DIFFICULT Response: We use a present value table to look up the value of the $1000 principal to be paid 8 years or 16 semi-annual periods. Looking at the 3% row (rate per semi-annual period), we find the factor of .623. Multiplying by $1000, the investor is selling the value of the principal for $623.00. Using a present value of an annuity table, we also look up R=3% and N=16 to find the factor 12.561. Multiplying 12.561 times the $40 semi-annual coupon, we find our investor is selling the remaining stream of 16 coupon payments for $502.44. Thus the price of the bond is $623.00 + $502.44 = $1,125.44. But the bond originally cost our investor $1,000, so the capital gain is 125.44 (using financial calculator, the answer is $125.61). Section: Measuring Bond Yields.

12. Now let’s look from the view of the investor who buys an 8 percent semiannual bond with 8 years remaining to maturity, when market rates are 6%. If this investor pays $1,125.44 for the bond, what is his current yield? a) 3.55 percent b) 7.11 percent c) 8.00 percent d) 10.00 percent Ans: B DIFFICULT Response: Divide the $40 semi-annual coupon by the $1,125.44 to get 3.55%. Multiply by 2 to get the annual rate of 7.11% Section: Measuring Bond Yields.

13. What happens to the price of bonds, if interest rates go up? a) The price of bonds goes up. b) The price of bonds stays the same. c) The price of bonds goes down. d) The relationship between interest rates and bond prices cannot be determined.

Ans: C EASY Response: Section: Bond Price Changes.

14. Which of the following bonds will be most sensitive to changes in market interest rates? a) 8 percent semiannual coupon with 8 years to maturity. b) 6 percent semiannual coupon with 8 years to maturity. c) 8 percent semiannual coupon with 6 years to maturity. d) 6 percent semiannual coupon with 6 years to maturity.

Ans: B MODERATE Response: Changes in bond prices are directly related to time to maturity (8 years is more than 6 years), but changes in bond prices are inversely related to coupon rates (6 percent coupon means more of the bond’s value comes at maturity). Section: Bond Price Changes.

15. Examine Example 17-13. The basic data is repeated here, in financial calculator format: FV = 1000, N=30, PMT=50 I/Y At 10% At 8% At 12%

Price=PV $1,000.00 $1,172.93 $ 862.35

% change +17.29 % -13.77 %

Why are the % changes different? a) They are actually the same: the table includes an error. b) The prices shown are rounded to the nearest penny, slightly moving the % changes. c) The relationship between interest rates and price is not linear. d) Other factors, including duration and coupon rate, will also affect the relationship between interest rates and prices.

Ans: C DIFFICULT Response: Section: Measuring Bond Yields.

16. Which of the following is NOT one of the factors used in calculating duration? a) The final maturity of the bond. b) The coupon payment. c) The yield to maturity. d) The current price.

Ans: D EASY Response: Section: Bond Price Changes 17. Why is duration important for investing in bonds? a) Investors need to know the relationship between interest rates and prices. b) Investors need to know the “average” maturity of the bonds they are considering. c) Investors need to know the coupon rates of the bonds they are considering. d) Investors need to know the yield to maturity.

Ans: A MODERATE Response: Section: Bond Price Changes.

18. Which of the following is NOT a true statement? a) Duration measures the time until the principal is repaid. b) Duration is the weighted average of the timing of the bond’s payments. c) The weights in the calculation of duration are the present value of each payment, divided by the value of the bond. d) Modified duration measures the sensitivity of the bond’s price to interest rate changes.

Ans: A EASY Response: The time until the principal is repaid is time to maturity. Section: Bond Price Changes.

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 Section: 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 Response: A basis point is one hundredth of one percent.

Section: Bond Yields and Interest Rates.

3. The vast majority of corporate bonds pay floating rate interest on a quarterly basis.

Ans: False Difficulty: Easy Response: Most, but not all, bonds pay a fixed rate of interest semiannually.

Section: Measuring Bond Yields.

4. Reinvestment risk represents the possibility that future payments cannot be reinvested at the assumed rate.

Ans: True Difficulty: Easy Section: 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 Response: Litigation problems and excessive debt levels are also common reasons for a company’s bond spreads to widen.

Section: Bond Price Changes.

6. As interest rates increase, long bonds will decrease in price more slowly than shorter bonds.

Ans: False Difficulty: Moderate Response: An examination of Table 17-2 shows that a change of interest from 6% to 8 % results in a larger change to the longer maturity bonds.

Section: Bond Price Changes.

7.

If interest rates rise, then price risk and reinvestment risk decline.

Ans: F 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, and time to maturity.

Difficulty: Moderate Ref: Bond Yields and Interest Rates 2.

Three theories have been proposed to explain the term structure of interest rates. They 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 7 factors. Listing them, they are differences in: 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= t=1

n ct FV  ------------ + -----------(1 + ytm)t (1 + ytm)n

where P = the current market price of the bond n = the number of semiannual periods to maturity ytm = the semiannual yield to maturity to be solved for c = the semiannual coupon in dollars FV = the face value (or maturity value or par value) which in this always $1,000

discussion is

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. a. b. c. d.

Bond investors can avoid the risk that interest rates will rise and incur capital losses by: buying zero coupon bonds. buying Treasury bonds with maturities of one year or longer. holding bond funds till maturity. holding individual bonds till maturity.

Ans: d Difficulty: Easy Ref: Why Buy Bonds?

2. a. b. c. d.

Which of the following statements is true regarding investments in bonds? shorter maturities should return more than longer maturities, in general Treasury bonds should return more than corporate bonds of the same maturity longer maturities should return more than shorter maturities, in general lower-rated issues should return less than higher rated issues at maturity.

Ans: c Difficulty: Moderate Ref: Why Buy Bonds?

3. a. b. c. d.

The introduction of the Euro is expected to: increase the transactions cost of trading foreign bonds. decrease the transactions cost of trading foreign bonds. have no effect on the transactions cost of trading foreign bonds. have a minimal effect on the transactions cost of trading foreign bonds.

Ans: b Difficulty: Moderate Ref: Why Buy Bonds?

4. a. b. c. d.

Which of the following is considered to have the biggest impact on bond yields? economic growth business cycles inflation Federal Reserve actions

Ans: c Difficulty: Moderate Ref: Important Considerations in Managing a Bond Portfolios

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5. a. b. c. d.

The term structure of interest rates is also known as the: yield to maturity. probability distribution. yield differential. yield curve.

Ans: d Difficulty: Easy Ref: Important Considerations in Managing a Bond Portfolios 6. a. b. c. d.

Under the expectations theory, investors expecting interest rates to rise will: invest more now in short term bonds rather than in long term bonds. invest more now in long term bonds rather than in short term bonds. invest more now in Treasury bonds rather than in corporate bonds. invest more now in corporate bonds rather than in Treasury bonds.

Ans: a Difficulty: Difficult Ref: Important Considerations in Managing a Bond Portfolios 7.

Floating rate bonds often have yields tied to:

a. b. c. d.

London Interbank Offered Rate (LIBOR) plus some percentage yield amount.

London Interbank Offered Rate (LIBOR).

European Central Bank (ECB) borrowing rate.

Federal Funds overnight lending rate.

Ans: a Difficulty: Moderate Ref: Why Buy Bonds?

8. a. b. c. d.

Since the 1930s, the yield curve has most often been: upward sloping yield curve. downward sloping yield curve. flat yield curve. skewed yield curve.

Ans: a Difficulty: Easy Ref: Important Considerations in Managing a Bond Portfolios 9. a. b. c.

We can think of duration as the slope of a line that is tangent to the convex: price-yield curve at the expected future price and expected yield of the bond. price-yield curve at the current price and expected yield of the bond. price-yield curve at the current price of the bond.

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d.

price-yield curve at the current price and yield of the bond.

Ans: d Difficulty: Moderate Ref: Managing Price Volatility 10. a. b. c. d.

During periods of economic expansion, the spread between corporate bonds and U.S. Treasury generally: widens. narrows. stays the same. is always negative.

Ans: b Difficulty: Moderate Ref: Active Management Strategies 11. a. b. c. d.

Investors would expect a higher yield on a smaller, regional corporate bond than on a large, national corporate bond mainly due to: differences in coupon rates. differences in quality. differences in tax treatments. differences in marketability.

Ans: d Difficulty: Easy Ref: Important Considerations in Managing a Bond Portfolios 12. a. b. c. d.

Which of the following statements concerning yield spreads is not true?

Yield spreads may be positive or negative.

Yield spreads are often calculated by changing the maturity of the different bonds.

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 a Bond Portfolios 13. a. b. c. d.

Which of the following is NOT true regarding bond maturities?

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 Chapter Eighteen Bonds: Analysis and Strategy

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Ref: Important Considerations in Managing a Bond Portfolios 14. a. b. c. d.

The yield curve is normally plotted using Treasury securities because: 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 a Bond Portfolios 15. a. b. c. d.

One form of interest rate forecasting is: horizon analysis, which requires projections of bond performance over a planned investment period. yield-to-maturity analysis, which requires expectations about reinvestment rates and future market rates to be calculated in expected returns. yield curve analysis, which requires comparisons of different yield curves at different times to maturity. bond immunization analysis, which requires the use of barbells to protect against interest rate risk.

Ans: a Difficulty: Moderate Ref: Active Management Strategies 16. a. b. c. d.

Yield spreads between corporates and Treasuries will not widen as a result of: accounting scandals, such as those involving WorldCom, Enron, and Tyco in 2002. changes in maturity. financial crisis, such as occurred in 2008. litigation, such as that involving Halliburton and other companies with asbestos exposure.

Ans: b Difficulty: Moderate Ref: Active Management Strategies 17. a. b. c. d.

Active bond management strategies include: Forecasting changes in interest rates, identifying abnormal yield spreads between bond sectors, and identifying relative mispricing between fixed income securities.

Passive bond index investing.

Buy-and-hold bond investing.

Ladder investing.

Ans: a Difficulty: Easy Ref: Passive Management Strategies Chapter Eighteen Bonds: Analysis and Strategy

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18.

Under a laddering approach, investors can mitigate the effects of an increase in interest rates by: a. purchasing bonds with the same maturity dates and selling short bonds with other maturity dates. b. purchasing bonds with the same maturity date but different coupon rates. c. purchasing bonds with different maturity dates. d. purchasing bonds with different yield to maturity.

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 duration greater than: a.

3 years. b.

5 years. c.

10 years. d.

15 years.

Ans: c Difficulty: Difficult Ref: Managing Price Volatility 20. a. b. c. d.

Yield spreads tend to____ during recessions and ________ during times of economic prosperity. narrow . . . widen widen . . . narrow stay constant . . . widen widen . . . stay constant

Ans: b Difficulty: Moderate Ref: Important Considerations in Managing a Bond Portfolios 21.

Which of the following terms describes a change in investors’ preferences away from risky assets towards safer bonds? a. immunization b. flight to safety c. laddering d.

Convexity Ans: b Difficulty: Moderate Ref: Important Considerations in Managing a Bond Portfolios

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22. a. b. c. d.

Which of the following is not a passive bond strategy? an immunization strategy a bond swap strategy a buy and hold strategy an indexing strategy

Ans: b Difficulty: Difficult Ref: Bond Strategies 23.

A bond strategy attempting to immunize the portfolio from interest rate risk is based on the concept of: a. buy and hold. b. horizon. c. duration. d. indexing.

Ans: c Difficulty: Moderate Ref: Immunization 24. a. b. c. d.

A portfolio is said to be immunized if: the present value of the cashflows equals the principal. the duration of the portfolio is equal to the term. the present value of the cashflows is greater than the principal. the duration of the portfolio is equal to the investment horizon.

Ans: d Difficulty: Difficult Ref: Immunization 25.

a. b. c. d.

One form of interest rate forecasting has the investor evaluating bonds being considered for purchase over a selected holding period in order to determine which will perform the best and is known as: holding-period analysis. time-series analysis. horizon analysis. duration planning.

Ans: c Difficulty: Moderate Ref: Active Management Strategies 26. a. b.

Which of the following statements regarding classical immunization is false?

It is Easy to implement.

It requires frequent rebalancing.

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c. d.

It is not a passive bond strategy.

It faces real-world problems in its implementation.

Ans: a Difficulty: Moderate Ref: Immunization 27. a. b. c. d.

Immunization is a strategy in which bond investors: 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 28.

James wants to invest in bonds and has a 10 year investment horizon. To immunize his portfolio, he must buy bonds with durations of ________ 10 years. These bonds will have maturities ________ 10 years. a. greater than; less than b. equal to; less than c. less than; equal to d. equal to; greater than Ans: d Difficulty: Difficult Ref: Immunization 29. a. b. c. d.

Interest rate risk is composed of: market risk and default risk. price risk and credit risk. price risk and reinvestment risk. default risk and money risk.

Ans: c Difficulty: Moderate Ref: Immunization 30.

A bond investor has $100,000 to invest and has determined 10 years is his maximum term. He puts $10,000 in one-year bonds, $10,000 in two-year bonds, $10,000 in three-year bonds, etc. all the way to $10,000 in ten-year bonds. This is an example of: a. bond equality b. bond laddering c. bond blending d. bond term management Chapter Eighteen Bonds: Analysis and Strategy

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Ans: b Difficulty: Easy Ref: Passive Management Strategies 31. a. b. c. d.

Which of the following statements regarding duration is INCORRECT? Yield to Maturity is inversely related to duration, holding coupon and maturity constant.

Coupon is inversely related to duration, holding maturity and YTM constant.

For all coupon-paying bonds, duration equals time to maturity.

Duration expands with time to maturity at a decreasing rate, holding coupon and YTM constant.

Ans: c Difficulty: Moderate Ref: Managing Price Volatility 32. a. b. c. d.

A major advantage of bond index funds is their: higher performance than regular bond funds. ability to shelter income from taxes. relatively low expense ratios. all of the above are true.

Ans: c Difficulty: Moderate Ref: Passive Management Strategies 33.

An example of simultaneous buying of one bond (for example, with fixed rate coupon payments) and selling of another (for example, with variable rate interest payments) occurs when one participates in a: a. bond ladder strategy. b. bond swap. c. interest rate futures transaction. d. bond portfolio immunization strategy.

Ans: b Difficulty: Moderate Ref: Active Management Strategies 34. a. b. c. d.

Which of the following European countries experienced a debt crisis in recent years?

Germany.

Great Britain.

Greece.

France.

Ans: c Difficulty: Moderate Chapter Eighteen Bonds: Analysis and Strategy

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Ref: Important Considerations in Managing a Bond Portfolio 35. a b c d

Consider Example 18-11 and Table 18-1. What happens to the duration if the coupon rate was 6%, rather than the 5% shown?

No change – duration is based time to maturity The duration increases to 4.57, as the YTM increases The duration decreases to 4.38, as more payments come earlier The YTM is set by the market, so it will not change.

Ans: B Difficulty: EASY Response: Recalculate Table 18-1, using a $30 semi-annual payment. Section: Managing Price Volatility 36.

Consider Example 18-11 and Table 18-1. Let’s say the price is $950.00 rather $974.17 (so the YTM goes to 6.1% from 5.6%). What happens to duration? a.

It increases substantially. b.

It increases only a little amount. c.

It decreases substantially. d.

It decreases only a little amount Ans: D Difficulty: MODERATE Response: A recalculation of Table 18-1 show that duration decreases to 4.469 from 4.477.

Section: Managing Price Volatility

True-False Questions 1. If interest rates rise, reinvestment rates rise, whereas bond prices decline.

Ans: T Difficulty: Moderate Ref: Why Buy Bonds?

2. A weaker dollar increases the value of dollar-denominated assets to foreign investors.

Ans: F Difficulty: Difficult Ref: Why Buy Bonds?

3. An increase in expected inflation tends to decrease bond prices and bond yields.

Ans: T Difficulty: Easy Ref: Important Considerations in Managing a Bond Portfolio Chapter Eighteen Bonds: Analysis and Strategy

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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: F Difficulty: Moderate Ref: Important Considerations in Managing a Bond Portfolio 5. The term structure of interest rates consists of a set of forward rates and a current known rate.

Ans: T Difficulty: Difficult Ref: Important Considerations in Managing a Bond Portfolio 6. A commercial bank that always invested in short-term bonds in order to meet deposit withdrawals is a good example of the liquidity preference theory.

Ans: F 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: T Difficulty: Moderate Ref: Important Considerations in Managing a Bond Portfolio 8. A noncallable bond would be expected to have a higher yield to maturity than a comparable callable bond.

Ans: F Difficulty: Moderate Ref: Important Considerations in Managing a Bond Portfolio 9.

The size of yield spreads tends to remain constant over time.

Ans: F Difficulty: Moderate Ref: Important Considerations in Managing a Bond Portfolio 10. Yield spreads were at their widest during the Great Depression.

Ans: T Difficulty: Easy Ref: Important Considerations in Managing a Bond Portfolio

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11. One of the most cost-effective methods of passive bond investing is buying into a bond ETF. Ans: T 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: F Difficulty: Difficult Ref: Passive Management Strategies 13. For a zero coupon bond, duration is the same as time to maturity.

Ans: True Difficulty: Easy Response: A zero coupon bond has only one cash flow, the face value at maturity. Thus, Equation 18-1 reduces to (PV(Face value) / market price) x t. The fraction reduces to 1, so the Macaulay duration = t, the time to maturity.

Section: 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 Response: This is the basis for the concept of convexity.

Section: Managing Price Volatility.

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.

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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

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 increases 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 Chapter Eighteen Bonds: Analysis and Strategy

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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

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 lower transactions costs. 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 participate in options?

a. b. c. d.

Options eliminate leverage.

Options are a smaller investment than stock investments.

Options allow investors to trade on the 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 Chapter Nineteen Options

240

Ref: Introduction to Options 5.

To maximize his/her potential upside returns, ceteris paribus, an investor who was bullish on a particular stock would execute which of the following options strategies: a. b. c. d.

buy calls write calls buy puts write puts

Ans: a Difficulty: Easy Ref: Introduction to Options 6.

To maximize his/her expected returns, ceteris paribus, an investor who was bearish on a particular stock would execute which of the following options strategies: a. b. c. d.

buy calls write calls buy puts write puts

Ans: d Difficulty: Easy Ref: Introduction to Options 7.

A major difference between new shares sold by a corporation and shares sold under a call option is that: a. b. c. d.

there is no profit or loss under the shares sold under the call. there is no risk to the investor with the call. there is no increase in the shares outstanding with the call. there is no commission to the investor with the call.

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 often 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 13.

Options sold on exchanges are protected against

a. b.

stock dividends and splits. cash dividends.

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c. d.

interest rate movements. inflation.

Ans: a Difficulty: Easy Ref: Introduction to Options 14.

Other things equal, after an option first becomes available in the market,

a. b. c. d.

its time value approaches zero. its time value increases into maturity. the volatility of the stock is negatively related to the value of the call. if it is out of the money, it will have no time value.

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: Difficulty 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 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 Chapter Nineteen Options

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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.

The __________ is NOT a determinant of the value of a call option in the BlackScholes model?

a. b. c. d.

interest rate exercise price of the stock price of the underlying stock expected beta of the underlying stock

Ans: d Difficulty: Moderate Ref: Option Valuation 21.

If the price of the common stock exceeds the exercise price of a call for the holder 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 Chapter Nineteen Options

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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. the shorter the maturity of the option, the higher the premium.

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 Questions 24-26 are based on the following options data for XYZ Corporation: ------Call------ ------Put-----Option/Strike Exp. Vol. Last Vol. Last.

XYZ 38 5/8 25 Dec. ------- 100 1/8 38 5/8 30 Nov. 250 8¾ 464 1/16 38 5/8 30 Dec. ------- 572 5/16 38 5/8 35 Nov. 154 4 1/2 1748 5/16 38 5/8 35 Dec. 923 5 1/4 580 1 3/16 38 5/8 35 Mar. ------- 33 2 5/8 38 5/8 40 Nov. 2023 1 1/8 530 2 3/8 24.

Which of the following calls is not "in-the-money?"

a. b. c. d.

25 Dec 30 Nov 35 Dec 40 Nov

Ans: d Difficulty: Moderate Ref: Option Valuation 25.

Of the various combinations shown above, how many combinations of put contracts are currently trading "out-of-the-money?"

a.

6

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245

b. c. d.

5 4 1

Ans: a Difficulty: Moderate Ref: Option Valuation 26.

The closest quote for the Dec. 25 call, were it to trade, would be

a. b. c. d.

12.

4 7/8.

10 1/2.

13 5/8.

Solution:

Intrinsic value =38 5/8 - 25 =13 5/8

Ans: d Difficulty: Difficult Ref: Option Valuation 27.

A (an) ---------- seeks to earn a return without assuming risk by constructing riskless hedges.

a. b. c. d.

speculator call writer put writer arbitrageur

Ans: d Difficulty: Moderate Ref: Option Valuation 28.

Which of the following statements is FALSE?

a. b.

An in-the-money call occurs if the stock price exceeds the exercise price.

An out-of -the money call occurs if the stock price is less than the exercise price.

If a call is out of the money, the intrinsic value is zero.

If a call is in the money, the intrinsic value is zero.

c. d.

Ans: d Difficulty: Moderate Ref: Option Valuation 29.

Which of the following statements is true regarding equity options contracts?

a.

The majority of options contracts are standardized, including strike prices and time to maturity.

Investors typically create options contracts to trade amongst themselves.

Options contracts are typically customized to suit the needs of each investor.

b. c.

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d.

Options are available on all publicly traded U.S. stocks

Ans: a Difficulty: Moderate Ref: Option Valuation 30.

Which of the following statements is TRUE?

a. b. c. d.

An American option’s premium almost never declines below its intrinsic value.

If a call is in the money, its intrinsic value equals zero.

The speculative premium reflects the option’s immediate value.

If the exercise price of an put is less than the stock price, the put is "out of the money."

Ans: a Difficulty: Moderate Ref: Option Valuation 31.

A stock is at $68. A two-month put (strike price = $70) is available at a $6 premium.. The intrinsic value is ___ and the time value is ____.

a. b. c. d.

$0 . . . $4. $3 . . . $5. $2 . . . $4. $2 . . . $3.

Ans: c Difficulty: Difficult Ref: Option Valuation 32.

In the Black-Scholes model,

a. b. c. d.

all of the inputs except two are observable. all of the inputs except one are observable. the greater the stock price, the lower the price of the call option. there is an inverse relationship between the value of a call and interest rates in the market.

Ans: b Difficulty: Difficult Ref: Option Valuation 33.

Concerning 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 an index option receives the strike price.

Index options are settled in cash.

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Ans: c Difficulty: Difficult Ref: An Investor's Perspective on Puts and Calls 34.

The way to protect a stock portfolio most in 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.

Stock market index options are available on all of the following EXCEPT

a. b. c. d.

the Standard and Poor's 500 Index. the Major Market Index. the National OTC Index. the Shearson Lehman Hutton Index.

Ans: d Difficulty: Moderate Ref: An Investor's Perspective on Puts and Calls 36.

A combination of one put and one call on the same stock with the same exercise price and date is known as a:

a. b. c. d.

strip straddle strap spread

Ans: b Difficulty: Easy Ref: APPENDIX 19-A 37.

The two basic spreads are the:

a. b. c. d.

time spread and price spread put spread and call spread time spread and money spread money spread and rate spread

Ans: c Difficulty: Moderate Ref: APPENDIX 19-A

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38.

A combination of two calls and one put is called a:

a. b. c. d.

strip strap straddle spread

Ans: b Difficulty: Moderate Ref: APPENDIX 19-A 39.

Spreads are used to:

a. b. c. d.

increase the return potential circumvent option commissions reduce risk in an option position. all of the above are true.

Ans: c Difficulty: Moderate Ref: APPENDIX 19-A 40.

Three types of equity securities derivatives are:

a. b. c. d.

puts and calls created by corporations, and warrants created by investors. puts and calls created by investors, and warrants created by corporations. options, preferred stock, and commons stock created by corporations. options, stock, and warrants, created by corporations.

Ans: b Difficulty: Moderate Ref: Summary

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: T Difficulty: Moderate Ref: Understanding Options 2.

The Options Clearing Corporation does not ensure fulfillment of option obligations.

Ans: F Difficulty: Easy Chapter Nineteen Options

249

Ref: Understanding Options 3.

The writer of a call, like the buyer of a put, is bearish about the stock price.

Ans: T Difficulty: Easy Ref: Understanding Options 4.

Options traded on organized exchanges are protected against cash dividends.

Ans: F Difficulty: Moderate Ref: Understanding Options 5.

Options can be purchased on margin.

Ans: T 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: T 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: F 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: F Difficulty: Easy Ref: Option Valuation 9.

There is an positive relationship between the price of a put option and the volatility of the underlying common stock.

Ans: T Difficulty: Difficult Ref: Option Valuation 10.

Writing a naked call is potentially riskier than writing a naked put.

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250

Ans: T Difficulty: Difficult Ref: Option Valuation 11.

According to the Black Scholes (1973) 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: T 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 usually include options, futures and synthetic options.

Futures on indexes are commonly used to offset stock portfolio losses.

Moderate Understanding Options

A stock investor wants to hedge the Dell stock in his portfolio. How can he use a covered call to do this?

Answer:

Difficulty: Ref: 4.

All contracts are actually 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

A stock investor wants to hedge the Microsoft stock in his portfolio. How can he use a protective put to do this?

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251

Answer:

Difficulty: Ref: 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.

Difficulty: Ref:

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 earnings 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 the 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 and puts for the premium received. If the purchaser exercises the option, however, the writer will have to deliver the stock and may have to take capital losses.

Moderate Payoffs and Profits from Basic Option Strategies

What is a hedge ratio?

Answer:

7.

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.

Difficult Understanding Options

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: Chapter Nineteen Options

Warrants.

252

Difficulty: Ref:

Difficult Summary

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, higher the option price.

Volatility of underlying stock. The higher the volatility, the higher the option price.

Moderate

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

253

Problems 1.

AB Flex Inc. stock is currently trading at $38. The time left until expiration of a call and put trading on AB Flex Inc.'s 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, 199X, SCORP closed at $40 per share. Strike prices for SCORP are $35, $40, and $45. The following prices for the 9 call options (3 expiration dates and 3 strike prices) for this date were (in scrambled order): A. B. C. D. E.

5½ 4 2 1/16 6 3/8 3 1/8

F. G. H. I.

4 7/8 3/4 7 1/4 2 7/16

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 D $40 E B $45 G C Difficulty: Difficult 3.

December ________ ________ ________

September

December H F I

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 the price of XYZ rises to $60 within a week.

Solution:

Chapter Nineteen Options

Buying the stock gain = $10 per share x 100 shares = $1000

254

Buying 10 option contracts ($5000 to invest/$500 per option contract): gain

= 10 options contracts x assumed $10 gain 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:

Options/Strike ABC 140 151 150 151 160 (a) (b) (c)

Difficulty:

(d) (e)

(a) Intrinsic value = (b) Intrinsic value = (c) Minimum value= Moderate

151 - 150 151 - 140 156 - 150

= = =

$1.00 $11 $6

Listed below are the option quotes on JUP, Inc., in January of this year.

-------Calls------Options/Strike JUP 35 37 40 37 45 37 50 (a) (b) (c)

July 11 ¾ 3 1½

Calculate the intrinsic value of the April 150 call.

Calculate the intrinsic value of the April 140 call.

Should the price of ABC rise to $156, what is the minimum value that the April 150 call should trade at?

Answer:

5.

April 11 ¼ 1½ ¾

------------Calls------------October 13 4 2

--------Puts-------March June 3 1/2 4 1 1/2 2 1 1 1/2 1/2 r

March 1/2 4 1/2 8 3/8 r

June 1 1/8 5 s s

Which calls are in the money?

Which puts are in the money?

Why are investors willing to pay 3 1/2 for the MARCH 35 call but only 1/2 for the March 35 put?

Calculate the intrinsic value of the June 35 call.

Calculate the intrinsic value of the March 40 put.

Solution: (a) In-the-money calls are those whose EP<SP. Since the SP = 37 only the March 35 calls is in the money. (b)

In-the-money puts are those whose EP>SP. Hence the March 40, March 45 and June 40 puts are in-the-money.

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(c)

The investors are willing to pay 3 1/2 for the March 35 call option because it has an intrinsic value of 2 and the rest is speculative premium. Investors are probably expecting the stock to go up by March. On the other hand, the March 35 put is out-of-the money i.e. it's 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 1/2 on the put option.

(d) =

Intrinsic Value of June 35 Call 37 - 35 = $2

=

Stock Price - Exercise Price

(e) =

The Intrinsic Value of the March 40 put 40 - 37 = $3

=

Exercise Price - Stock Price

Difficulty: 6.

Difficult

Use the Black-Scholes model to calculate the theoretical value of a DBA December 45 call option. Assume that the risk free rate of return 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

$100

d1

(r + 0.52)t

=

ln(CMP/EP) + t1/2

91/365 =

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 = =

= 0.5512 - 0.6(0.5) 0.5512 - .3 0.2512

N(d1) = N(d2) =

+

0.25

0.36

[0.06 + 0.5(.36)](0.25) (0.36)1/2 (0.25)1/2

0.7088 (from standard normal table) 0.5987 (from standard normal table)

Value of the call = [$100(.7088)] - [$90/e(0.06)(0.25)][.5987] = 70.88 - [90(.9851)(.5987)] Chapter Nineteen Options

256

= =

$70.88 $17.80

- $53.08

Difficulty: Difficult

7.

You buy 1,000 shares of Sunbeam at 11 1/8 and write 10 calls at a premium of 4 3/8 with a strike price of 7 1/2. The stock goes to 20 in 6 months. You receive a 8 cent 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 = $7,500 bought stock at 11.125 x 1,000 = 11,125 (3,625) Dividends received = .08 x 1,000 = $80 Premium received on writing calls = 4.375 x 100 x 10 = $4,375 Total return = $830

Percentage return = $830/11,125 = 7.5% Difficulty: Moderate

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257

Ch.20, Chapter 20: FUTURES

Multiple Choice Questions

1. Spot markets are for immediate delivery. Forward prices are: a. b. c. d.

The price agreed upon today for an asset for deferred delivery in the future.

The price in the future for an asset delivered in the future.

The price today for a forward price in the future.

Based on current spot market prices.

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 does specify the selling price. 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.

a nonnegotiable, nonmarketable instrument. a security, like stocks and bonds. a standardized transferable agreement providing for the deferred delivery of a specified traded quantity of a commodity. not a legal contract, and therefore its terms can be changed .

d.

Ans: c

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257

Difficulty: Easy Ref: Understanding Futures Markets 5.

Futures contracts were first traded on

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 price delivery date specified grade

Ans: b Difficulty: Easy Ref: Understanding Futures Markets 7.

Futures trade on the:

a. b. c. d.

Spot market. b. 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 all controlled by commodity firms.

Ans: c Difficulty: Moderate Ref: The Structure of Futures Markets 9.

On the other side of every futures transaction is:

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258

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.

Which of the following exchanges claims that its 3,600 members trade 50 different futures and options products by open auction and electronically?: a. b. c. d.

Chicago Board Options Exchange.

Chicago Board of Trade.

Chicago Mercantile Exchange.

Globex.

Ans: b 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 is closed by offset before the contract expires: a. b. c. d.

25.

50 95.

75.

Ans: c Difficulty: Moderate Ref: The Mechanics of Trading 13.

When trading futures, margin

a. b. c.

is seldom used. indicates that credit is being extended. is a down payment.

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259

d.

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? They

a. b. c. d.

are marked to the market daily. can be sold short only on an uptick. are handled by specialists on futures exchanges. 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. can be put up by either party, whoever initiates the transaction. must be put up by both the buyer and the seller.

Ans: d Difficulty: Moderate Ref: The Mechanics of Trading 16.

Of the following statements about futures trading, which one 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 prices reach the daily limit.

The uptick rule applies to the shorting of futures contracts.

Ans: d Difficulty: Moderate Ref: The Mechanics of Trading 17.

How often are futures contracts marked to market?

a. b. c. d.

daily weekly monthly quarterly

Ans: c Difficulty: Moderate Ref: The Mechanics of Trading Chapter Twenty Futures

260

18.

The cumulative number of futures contracts that are not offset at any point in time is called: a. b. c. d.

margin. open interest. hedged position. marked to the 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 futures, the portfolio owner could execute a ____________ hedge. a. b. c. d.

long duration short maturity

Ans: c Difficulty: Moderate Ref: Using Futures Contracts 20.

An investor with a bond portfolio wishes to protect the value of his position by using futures contracts. This investor should use a a. b. c. d.

long hedge. short hedge. time spread. money spread.

Ans: b Difficulty: Moderate Ref: Using Futures Contracts 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

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261

22.

Speculators in the futures markets

a. b. c. d.

make the market more volatile. contribute liquidity to the market. engage mainly in short sales. 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 have 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 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 Treasury bonds

Ans: a Difficulty: Moderate Ref: Financial Futures 26.

Select the CORRECT statement regarding basis risk associated with futures.

a. b.

Basis risk can be completely eliminated.

Although the basis fluctuates over time, it can be precisely predicted.

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262

c. d.

The basis must be zero on the maturity date of the contract.

A hedge will reduce risk as long as basis fluctuations are positive.

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 Treasury bond futures contract is expecting to profit from

a. b. c. d.

an increase in the price of the treasury bond. an increase in the underlying level of interest rates. interest rates remaining unchanged. a decrease in the underlying level of interest rates.

Ans: b Difficulty: Difficult Ref: Financial Futures 29.

If an investor strongly believes that the stock market is going to have a sharp decline shortly, he or she could maximize profit by a. b. c. d.

short selling stock-index futures contracts. hedging current short positions. using stock-index futures to straddle the market. buying stock-index futures contracts.

Ans: a Difficulty: Moderate Ref: Single Stock Futures 30.

An attempt to exploit the differences between the prices of a stock index future and the prices of a stock index is known as: a. b. c. d.

index programming. arbitrage speculation. index arbitrage. program speculation.

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263

Ans: c Difficulty: Moderate Ref: Simple Stock Futures 31.

Basis =

a. b. c. d.

cash price futures price cash price + futures price cash price – futures price

Ans: d Difficulty: Moderate Ref: Using Futures Contracts

True/False Questions 1. Investors in futures can take either a long, short, or neutral position.

Ans: F Difficulty: Easy Ref: Understanding Futures Markets 2. Japan, which banned financial futures in 1985, is now very active in developing futures exchanges.

Ans: T Difficulty: Moderate Ref: Understanding Futures Markets 3. The National Futures Association is the federal agency which regulates the futures markets.

Ans: F Difficulty: Moderate Ref: Understanding Futures Markets 4. Futures are essentially standardized forward contracts.

Ans: T Difficulty: Easy Ref: Understanding Futures Markets 5. Futures contracts are handled by specialists on futures exchanges.

Ans: F Difficulty: Moderate Chapter Twenty Futures

264

Ref: The Mechanics of Trading 6. Most futures contracts are settled by delivery.

Ans: F 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: T Difficulty: Easy Ref: The Mechanics of Trading 8. Investors can speculate on interest rate declines by purchasing interest rate futures.

Ans: T Difficulty: Moderate Ref: The Mechanics of Trading 9. With futures, hedging requires one to simply take an opposite position.

Ans: T Difficulty: Moderate Ref: Using Futures Contracts 10. The DJIA is the most popular stock-index futures contract.

Ans: F Difficulty: Moderate Ref: Financial Futures 11. An anticipatory hedge is when an investor anticipates a falling market and liquidates his position.

Ans: F Difficulty: Difficult Ref: Financial Futures 12. A pension fund holds $10 million in Treasury bonds. In order to protect against a rise in interest rate, the pension fund should use a short hedge in T-bond futures.

Ans: T Difficulty: Difficult Ref: Financial Futures 13. Index arbitrage attempts to exploit the differences between the prices on two different stock indices.

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265

Ans: T Difficulty: Difficult Ref: Financial Futures 14. Program trading generally involves positions in both stocks and stock-index futures.

Ans: T Difficulty: Difficult Ref: Financial Futures 15. Stock-index futures may be settled either by cash or by delivery of securities.

Ans: F Difficulty: Easy Ref: Financial Futures 16. U.S. Futures trading occurs in futures exchanges’ trading pits.

Ans: T Difficulty: Easy Ref: Financial Futures 17. An organized futures exchange standardizes nonstandard forward contracts, establishing such features as contract size, delivery dates, and condition of items that can be delivered. Only the price and number of contracts are left for futures traders to negotiate.

Ans: T 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: T 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: T Difficulty: Moderate Ref: Financial Futures

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266

20. The initial margin requirement on an SSF contract is 15 percent.

Ans: F Difficulty: Moderate Ref: Single Stock Futures

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 is between the buyer and seller in every trade. Every trade is actually 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: 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 267

Ref: 5.

The Mechanics of Trading 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 the market. If an account has gains, the excess can be withdrawn. If the equity fall 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 two percent of the contracts.

Moderate The Mechanics of Trading

What is meant by the term "marked to the 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 10 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: 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 268

Ref:

Financial Futures

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:

Options on futures transfer risk just as futures contracts do. Thus, they do serve an economic purpose.

Easy Financial Futures

Problems 1.

Assume that 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)

Calculate the current equity on each of the next three days.

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269

(b) (c)

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 goes to 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 goes to 72.1) = (72.1 - 72.5 = -.4 or 8 ticks worth - $200) Equity after day two = -200 + 3750 = $3550 Increase in equity after day three (price goes to 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.

Assume a portfolio manager holds $2 million (par value) of 9 percent Treasury bonds due 1994-1999. 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. (a) 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? (b) What is the gain or loss on the cash position if the bonds are priced at 68 three months hence? (c) 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 =

$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: Ending: Chapter Twenty Futures

$770 x 2000 $680 x 2000

= =

$1,540,000 $1,360,000 270

Loss from long bonds (c)

=

$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: Difficult

=

$140,000 from part (a) 180,000 from part (b) $40,000

3.

An investor has 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 prices of the futures on the three days following the short sales were: 1.60, 1.66, and 1.68 calculate the current equity on each of the next three days. (c) 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?

Solution:

(a)

Position on Day 1 (purchase day) Market value of futures sold short $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 short 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 short 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 short sold (from part a) Gain (loss) Current equity (initial margin + gain)

=

$1.68 x 5000 x 7=

$14,000 – 1,400

(c) Final gain or loss Price at time of short sale Price at time of purchase to cover Gain (loss)

Chapter Twenty Futures

=

=

$1.60 x 5000 x 7 = $1.68 x 5000 x 7 =

271

$15,400

$58,100 $57,400 ($700) $13,300

$58,800 $57,400 ($1,400) $12,600

$57,400 58,800 ($1,400)

Rate of Return over the 4 days = (1,400)/14,000 = -10 percent Difficulty: Moderate

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=

272

Loss/Initial Deposit

Ch.21, Chapter 21: PORTFOLIO MANAGEMENT

Multiple Choice Questions

1. Which of the following is NOT part of the portfolio management process, as described by Maginn, Tuttle, McLeavy, and Pinto (2007)? a. b. c. d.

portfolio factors are monitored. portfolio is rebalanced. portfolio is rebalanced as required. strategies are developed and implemented.

Ans: b Difficulty: Easy Ref: Managing Your Financial Assets 2. The first step of portfolio management according to Maginn et al. (2007) is : a. b. c. d.

to assess market conditions. to determine objectives, constraints and preferences. to develop strategies and implement them. to adjust the portfolio as necessary.

Ans: b Difficulty: Moderate Ref: Managing Your Financial Assets 3. A financial plan should include decisions on: a.

Children. b.

Spouse. c.

Risk tolerance, purchase of a house, tax planning, life, health, disability, and protection of business and property insurance, and emergency reserve funds. d.

Career.

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.

1-month emergency fund.

2-month emergency fund.

6-month emergency fund.

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d.

9-month emergency fund

Ans: c Difficulty: Moderate Ref: What Issues do Investors Face in Financial Planning?

5. The stages of the life cycle for setting individual investment objectives are: a.

Accumulation Phase, Consolidation Phase, Retirement Phase, Estate Phase. b.

Accumulation Phase, Consolidation Phase, Retirement Phase, Gifting Phase. c.

Accumulation Phase, Consolidation Phase, Spending Phase, Retirement Phase, Gifting Phase. d.

Accumulation Phase, Consolidation Phase, Spending Phase, Gifting Phase.

Ans: d Difficulty: Difficult Ref: Investor Objectives 6.

Which of the following is not true regarding life-cycle approach?

a.

It is most appropriate for institutions. . b.

It automatically adjusts to a more conservative position as the investor nears retirement age. c.

It is suited to 401(k) plans. d.

It can be implemented using life-cycle (also known as target-date) funds.

Ans: a Difficulty: Moderate Ref: Managing Your Financial Assets 7.

The first step to establishing an investment policy is to state the

a. b. c. d.

minimum investment and maximum fees.

SEC guidelines for prudent man investing. objectives and 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 phase Consolidation phase Gifting phase Retirement phase

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Ans: d Difficulty: Moderate Ref: Investor Objectives 9.

Investors normally assume a Moderate trade-off between risk and return in the ____ phase of the life-cycle. a. b. c. d.

accumulation consolidation spending gifting

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? 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 __________ phase of the life cycle. a. b. c. d.

accumulation consolidation spending gifting

Ans: c Difficulty: Moderate Ref: Investor Objectives 12.

Portfolio objectives are always going to center on _______and_______, because these are the two aspects of most interest to investors. a. b. c. d.

accumulation; consolidation. return; taxes. return; risk. spending; gifting.

Ans:

c

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Difficulty: Moderate Ref: Investor Objectives 13.

_____ 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. capital gains are often taxed at a higher rate than income. b. current income is seldom a significant consideration for an investor in the spending phase of the life cycle. c. investors are exempt from taxes on capital gains once they reach age 65. d. 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. __________ is the most important investment decision because it determines the risk-return characteristics of the portfolio and determines as much as 98% of the performance of a portfolio. a. b. c. d.

Hedging Market timing Performance measurement 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 Chapter Twenty-one Portfolio Management

275

Ref: Implementing Investing Strategies 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.

An aggressive asset allocation would contain larger proportions of __________ than a conservative allocation. a. b. c. d.

cash and bonds bonds and large-cap stocks small-cap and international stocks bonds

Ans: c Difficulty: Moderate Ref: Implementing Investing Strategies 19.

Conservative retirees likely have ____ than they did early in their careers.

a. b. c. d.

more small-cap stocks more international stocks fewer bonds more bonds

Ans: d Difficulty: Moderate Ref: Implementing Investing Strategies 20. was:

The annual average compound rate of return for stocks from the period 1926-2007

a. b. c. d.

8.50% 9.55% 10.05% 12%

Ans: c Difficulty: Moderate Ref: Checking Your Understanding

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276

21.

The Markowitz model identifies the efficient set of portfolios, which offers the

a. highest return for any given level of risk or the lowest risk for any given level of return. b. least-risk portfolio for a conservative, middle-aged investor. c. long-run approach to wealth accumulation for a young investor. d. 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 be rising, and increases cash when the stock market is expected to be falling is a: a. b. c. d.

strategic asset allocation. tactical asset allocation. portfolio optimization. liquidity expectation timing.

Ans: b Difficulty: Easy Ref: Implementing Investing Strategies 23.

Strategic asset allocation is usually done:

a. once every few years, establishing a long-run or strategic asset mix. b. using Monte Carlo simulation to identify a range of outcomes for various asset mixes. c. the life-cycle concept. d. a market timing strategy.

Ans: a Difficulty: Easy Ref: Implementing Investing Strategies 24.

Which type of portfolio allocation is usually done routinely?

a. b. c. d.

integrated asset allocation strategic asset allocation tactical asset allocation command asset allocation

Ans: c Difficulty: Moderate Ref: Implementing Investing Strategies

Chapter Twenty-one Portfolio Management

277

25.

Investor expectations about expected returns from various asset classes should start with: a. historic rates of return of those asset classes, from sources such as Morningstar/Ibbotson & Associates. b. economic forecasts c. inflation. d. taxes.

Ans: a Difficulty: Moderate Ref: Investor Expectations as Part of Financial Planning 26.

Monitoring and rebalancing a portfolio over time involves all of the following costs EXCEPT a. b. c. d.

commissions. possible impact on market price. holding a portfolio that is no longer adequately diversified. time involved in decision making.

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:

a. problem that investors face in retirement accounts that cannot be liquidated prior to retirement. b. trust accounts that are not managed by the investor and cannot be traded without incurring administrative costs. c. taxable accounts subject to capital gains taxes if investments are traded. d. problem of fixed-income securities that have little liquidity and therefore, must be held till maturity.

Ans: c Difficulty: Difficult Ref: Rebalancing a Portfolio of Financial Assets

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: T Difficulty: Moderate

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278

Ref: Minimize Costs and Effort, and Improve Performance, When Managing a Portfolio of Financial Assets 2.

Monitoring and revision are part of the Maginn et al. (2007) portfolio management process.

Ans: T 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: F Difficulty: Moderate Ref: What Issues do Investors Face in Financial Planning?

4.

Retirement programs offer tax sheltering for individual U.S. investors.

Ans: T 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: F 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: F Difficulty: Moderate Ref: What Issues do Investors Face in Financial Planning 7.

The geometric mean for the S&P 500 for the period 1920-2005 was between 15 and 20 percent.

Ans: F Difficulty: Moderate Ref: Check Your Understanding 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: T Chapter Twenty-one Portfolio Management

279

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: T 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: F Difficulty: Moderate Ref: Investor Objectives 11.

An efficient set of portfolios offers maximum risk for any level of return.

Ans: F Difficulty: Moderate Ref: Implementing Investing Strategies 12.

The consolidation phase of the life cycle begins when the investor reaches retirement.

Ans: F 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: T Difficulty: Moderate Ref: Investor Objectives 14.

The spending phase of the life cycle is avoided by investors who follow the prudent man rule.

Ans: F Difficulty: Moderate Ref: Implementing Investing Strategies 15.

Rebalancing is Difficult for many investors because it represents a contrarian strategy.

Ans: T Difficulty: Difficult Chapter Twenty-one Portfolio Management

280

Ref:

Rebalancing a Portfolio of Financial Assets

16.

In today’s world, investor’s time horizons have lengthened.

Ans: F 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: T Difficulty: Easy Ref: Determining the Success of Your Financial Planning

Short-Answer Questions 1.

What is the portfolio management process outlined by Maginn and Tuttle.

Answer:

Difficulty: Ref:

(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) Portfolio is rebalanced as needed (6) Portfolio performance is measured Moderate Portfolio Management as a Process

2.

What are some of 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

3.

Give an example of how individual investors’ preferences are taken into account by institutional investors?

Answer:

Difficulty: Ref:

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

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4.

How does the prudent man rule affect asset allocation?

Answer:

Difficulty: Ref: 5.

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 individual investments rather than to the portfolio as a whole.

Moderate Formulate An Appropriate Investment Policy

What is difference between strategic asset allocation and tactical asset allocation?

Answer:

Difficulty: Ref:

Strategic asset allocation considers the range of outcomes for various asset mixes. This is accomplished with a simulation and repeated every few years. The preferred mix is chosen, based on the outcomes. Tactical asset allocation involves adjusting the proportions of assets among categories as expectations about the market change. For example, if a bull market is expected, the portfolio would be adjusted to have more stocks, fewer bonds, and less cash.

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 large 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

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:

Considering the client’s need for income, bonds are a good choice, but the

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Difficulty:

entire pension plan need 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.

The major question when evaluating the performance of a portfolio is:

a. b.

“Does the portfolio match the investor characteristics of the individual investor?”

“Does the expected return of the portfolio meet the needs of the individual investor?”

“Is the return on the portfolio adequate to compensate for the risk taken?”

“Is the risk on the portfolio in line with the personal characteristics of the investor?”

c. d.

Ans: c Difficulty: Difficult Ref: Performance Measurement Issues 2.

The --------------------- is the legitimate alternative to a portfolio that accurately reflects the objectives of the portfolio owners.

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 would be 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 4.

The __________ indicates the percentage of the variance in the portfolio's returns explained by the market's returns.

a.

standard deviation

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b. c. d.

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.

CFA Institute, the successor to AIMR. Russell/Mellon Financial, now Bank of New York Mellon Financial Morningstar.

MSCI.

Ans: a Difficulty: Moderate Ref: Performance Measurement Issues 7.

The reward-to-variability 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 the risk-free rate.

Ans: b Difficulty: easy Ref: Risk-Adjusted Measures of Performance 8.

Which one of the following statements is true?

Notation: RVAR: Sharpe’s reward-to-variability measure RVOL: Treynor’s reward-to-volatility measure

a. b. c. d.

RVOL is based on total risk while RVAR is based on systematic risk.

RVAR is based on total risk while RVOL is based on systematic risk.

RVAR is based on unsystematic risk while RVOL is based on systematic risk.

RVOL is based on systematic risk while RVAR is based on unsystematic risk.

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Ans: b Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 9.

Which is the better measure to estimate the performance of a well-diversified portfolio in relation to the market index?

a. b. c. d.

Sharpe’s RVAR Treynor’s RVOL Total return (alone) Portfolio beta (alone)

Ans: b 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 means of identifying superior or inferior portfolio performance The actual excess return on a portfolio during one period

Ans: c Difficulty: Difficult Ref: Risk-Adjusted Measures of Performance 11.

The return on a portfolio during a particular period was 13 percent, the risk-free rate was 6 percent, the return on the market was 12 percent, and the portfolio beta was 1.2. The performance of the portfolio (according to Jensen's measure) was __________ the market. a. b. c. d.

inferior to Solution: p = (Rp – RF) – [p(RM – RF)] superior to = (13 – 6) – [1.2(13 – 6)] the same as = -0.2 percent not compared to Negative alpha, if statistically significant, means inferior performance.

Ans: a Difficulty: Difficult Ref: Risk-Adjusted Measures of Performance 12.

Which of the following measures uses the standard deviation, and evaluates portfolio performance on the basis of both return and diversification.

a.

Jensen’s Alpha.

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b. c. d.

Treynor’s Reward to Volatility.

M2.

Sharpe Ratio.

Ans: d Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance The following information is to be used to answer questions 13-17.

R2 _ 0.95 0.80 0.90 0.65

SD_ Beta alpha Fund 1 1.97 1.0 1.3 Fund 2 2.94 0.8 0.6* Fund 3 3.82 1.2 -3.5 Fund 4 4.70 1.4 4.2 *Significant at the 5 percent level 13.

Which of the funds' returns are best explained by the market's returns?

a. b. c. d.

Fund 1 Fund 2 Fund 3 Fund 4

Solution:

Fund 1 has highest R2.

Ans: a Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 14.

Which of these four funds had the largest market risk?

a. b. c. d.

Fund 1 Fund 2 Fund 3 Fund 4

Solution:

Fund 4 has the highest beta.

Ans: d Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 15.

Which of these four funds had the largest total risk?

a. b. c. d.

Fund 1 Fund 2 Fund 3 Fund 4

Solution:

Fund 4 has the highest standard deviation

Ans: d Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance Chapter Twenty-Two Evaluation of Investment Performance

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16.

Which of these funds had the highest performance as determined by Jensen's performance measure?

a. b. c. d.

Fund 1 Fund 2 Fund 3 Fund 4

Solution: Fund 2 has the only positive and statistically significant alpha Ans: b Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 17.

Which of these funds was least well diversified?

a. b. c. d.

Fund 1 Fund 2 Fund 3 Fund 4

Solution: Fund 4 has the smallest R2.

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. the ability to time market turns. superior selectivity or timing performance. neither superior selection nor timing. The market is too efficient.

Ans: c Difficulty: easy Ref: Risk-Adjusted Measures of Performance 19.

Select the CORRECT statement about the reward-to-variability ratio (RVAR).

a. b. c. d.

RVAR is an absolute measure of performance.

RVAR measures the slope of the line from RF to the portfolio being evaluated.

The closer the RVAR to 0.0, the better is the performance.

RVAR does not take into account how well diversified a portfolio was.

Ans: b Difficulty: Difficult Ref: Risk-Adjusted Measures of Performance

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20.

The reward-to-volatility ratio measures the excess return per unit of

a. b. c. d.

total risk. systematic risk. market risk. systemic risk.

Ans: b Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 21.

Under Jensen's differential return approach to portfolio evaluation, superior market timing 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 Modigliani-squared?

a. b. c. d.

It compares Treasury bills to the S&P 500 Index.

It states its results in both percentage and graphical form.

It equates the volatility of a portfolio with the market.

It compares fixed income securities with equities securities.

Ans: c Difficulty: Difficult Ref: Risk-Adjusted Measures of Performance 23.

One approach to style analysis which uses the stocks in a portfolio to describe the fund's allocation among asset classes 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

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24.

One problem with style analysis is style:

a. b. c. d.

consistency. comparability. correctness. character.

Ans: a Difficulty: Moderate Ref: Style Analysis and Performance Attribution 25.

The --------------------- has issued minimum standards for investment performance.

a. b. c. d.

FINRA, formerly known as the National Association of Security Dealers Securities Exchange Commission (SEC) Association for Security Analysts and Portfolio Managers Chartered Financial Analyst Institute, formerly known as the Association for Investment Management and Research

Ans: d Difficulty: Difficult Ref: Money Managers and Performance Presentations 26.

GIPS presentation standards require

a.

a 5-year performance record, or since inception if the fund is less than 5-years old. b. inclusion of terminated portfolios. cash accounting. exclusion of cash and cash equivalents.

c. d.

Ans: a Difficulty: easy Ref: Money Managers and Performance Presentations

True/False Questions 1.

Standard deviation, beta and coefficient of determination are readily available for mutual funds from sources like Morningstar.

Ans: T Difficulty: easy Ref: Performance Measurement Issues 2.

The dollar-weighted rate of return is equivalent to the internal rate of return.

Ans: T Chapter Twenty-Two Evaluation of Investment Performance

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Difficulty: Moderate Ref: Performance Measurement Issues 3.

The time-weighted rate of return is affected by any cashflows to the portfolio.

Ans: F Difficulty: Moderate Ref: Performance Measurement Issues 4.

Total risk of a portfolio is measured by the beta coefficient.

Ans: F 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: F Difficulty: Moderate Ref: Performance Measurement Issues 6.

The higher the RVAR, the better the risk-adjusted portfolio performance.

Ans: T Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 7.

Sharpe's measure is a ratio of excess return to total risk.

Ans: T Difficulty: Difficult Ref: Risk-Adjusted Measures of Performance 8.

Treynor's measure is a ratio of excess return to systematic risk.

Ans: T Difficulty: Difficult Ref: Risk-Adjusted Measures of Performance 9.

The use of RVOL implies that total risk is the proper measure of risk in performance evaluation.

Ans: F Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 10.

Jensen's measure of performance is based on the CAPM.

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Ans: T Difficulty: easy Ref: Risk-Adjusted Measures of Performance 11.

Investors who have all their assets in one portfolio of securities should the Sharpe measure rather than the Treynor measure.

rely on

Ans: T Difficulty: easy Ref: Risk-Adjusted Measures of Performance 12.

Jensen's alpha measures the contribution of the portfolio manager.

Ans: T Difficulty: easy Ref: Risk-Adjusted Measures of Performance 13.

Modigliani-squared is a return adjusted for volatility that allows returns between portfolios to be compared.

Ans: T Difficulty: Moderate Ref: Risk-Adjusted Measures of Performance 14.

Performance attribution seeks to determine the detailed investment style adopted by a money manager.

Ans: F Difficulty: easy Ref: Style Analysis and Performance Attribution 15.

The purpose of performance attribution is to assess the risk of a portfolio.

Ans: F 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: F Difficulty: Moderate Ref: Money Managers and Performance Presentations 17.

GIPS® was created to obtain global acceptance of a standard for fair presentation.

Ans: T Difficulty: easy Ref: Money Managers and Performance Presentations

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18.

The coefficient of determination is also known as R-squared, is used to denote the degree of diversification.

Ans: T 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: T Difficulty: Moderate Ref: An Overview of Performance Evaluation 20.

Time-weighted as opposed to dollar-weighted return captures rate of return actually earned by the portfolio manager.

Ans: T Difficulty: Moderate Ref: Summary

Short-Answer Questions 1.

Discuss how constraints on portfolio managers affect the portfolio results.

Answer:

Difficulty: Ref: 2.

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

What is the major difference between the Sharpe and Treynor models?

Answer:

Difficulty: Ref:

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 volatility of the portfolio relative to the market.

Moderate Risk-Adjusted Measures of Performance

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3.

How is regression analysis used to measure portfolio diversification?

Answer:

Difficulty: Ref: 4.

What are the appropriate uses of the Sharpe and the Treynor performance measures?

Answer:

Difficulty: Ref: 5.

Difficulty: Ref:

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

Sharpe’s RVAR 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.

Sharpe’s RVAR 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

Explain the characteristic line in excess return form for the Jensen alpha measure.

Answer:

6.

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 is, the better the diversification.

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:

Performance attribution is an attempt to determine why a portfolio performed as it did. 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.

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Difficulty: Ref:

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 performance measure or the Treynor performance measure for the portfolio?

Answer:

Difficulty: 2.

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

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

Average Annual Return (%) 14 16 20 12 6

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Standard Deviation 21 24 28 20

294

Beta 1.15 1.00 1.25

R2 _ 0.70 0.98 0.90

a. b. c.

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) RVAR 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) RVOL 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 RVAR, all three funds outperformed the market. Using RVOL, only fund 3 outperformed the market, with fund 2 tying the market Difficulty: Difficult

2.

1 2 3 4 5 a. b c. d.

Consider the five funds shown below: Fund _a_ _b_ R2 _ 4.0 0.9 0.90 -1.6* 1.2 0.95 2.5 0.9 0.90 1.2 0.8 0.89 0.9* 1.3 0.90 * Significant at the 5 percent level 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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