Investment Analysis and Portfolio Management 10e Frank Reilly, Keith Brown (Test Bank All Chapters, 100% Original Verified, A+ Grade) CHAPTER 1—AN OVERVIEW OF THE INVESTMENT PROCESS TRUE/FALSE 1. The rate of exchange between certain future dollars and certain current dollars is known as the pure rate of interest. ANS: T
PTS: 1
2. An investment is the current commitment of dollars over time to derive future payments to compensate the investor for the time funds are committed, the expected rate of inflation and the uncertainty of future payments. ANS: T
PTS: 1
3. The holding period return (HPR) is equal to the holding period yield (HPY) stated as a percentage. ANS: F
PTS: 1
4. The geometric mean of a series of returns is always larger than the arithmetic mean and the difference increases with the volatility of the series. ANS: F
PTS: 1
5. The expected return is the average of all possible returns. ANS: F
PTS: 1
6. Two measures of the risk premium are the standard deviation and the variance. ANS: F
PTS: 1
7. The variance of expected returns is equal to the square root of the expected returns. ANS: F
PTS: 1
8. The coefficient of variation is the expected return divided by the standard deviation of the expected return. ANS: F
PTS: 1
9. Nominal rates are averages of all possible real rates. ANS: F
PTS: 1
10. The risk premium is a function of the volatility of operating earnings, sales volatility and inflation. ANS: F
PTS: 1
11. An individual who selects the investment that offers greater certainty when everything else is the same is known as a risk averse investor. ANS: T
PTS: 1
12. Investors are willing to forgo current consumption in order to increase future consumption for a nominal rate of interest. ANS: F
PTS: 1
13. The two most common calculations investors use to measure return performance are arithmetic means and geometric means. ANS: T
PTS: 1
14. The arithmetic mean is a superior measure of the long-term performance because it indicates the compound annual rate of return based on the ending value of the investment versus its beginning value. ANS: F
PTS: 1
MULTIPLE CHOICE 1. The basic trade-off in the investment process is a. between the anticipated rate of return for a given investment instrument and its degree of risk. b. between understanding the nature of a particular investment and having the opportunity to purchase it. c. between high returns available on single instruments and the diversification of instruments into a portfolio. d. between the desired level of investment and possessing the resources necessary to carry it out. e. None of the above. ANS: A
PTS: 1
OBJ: Multiple Choice
2. The rate of exchange between future consumption and current consumption is a. The nominal risk-free rate. b. The coefficient of investment exchange. c. The pure rate of interest. d. The consumption/investment paradigm. e. The expected rate of return. ANS: C
PTS: 1
OBJ: Multiple Choice
3. The ____ the variance of returns, everything else remaining constant, the ____ the dispersion of expectations and the ____ the risk. a. Larger, greater, lower b. Larger, smaller, higher c. Larger, greater, higher
d. Smaller, greater, lower e. Smaller, greater, greater ANS: C
PTS: 1
OBJ: Multiple Choice
4. The coefficient of variation is a measure of a. Central tendency. b. Absolute variability. c. Absolute dispersion. d. Relative variability. e. Relative return. ANS: D
PTS: 1
OBJ: Multiple Choice
5. The nominal risk free rate of interest is a function of a. The real risk free rate and the investment's variance. b. The prime rate and the rate of inflation. c. The T-bill rate plus the inflation rate. d. The tax free rate plus the rate of inflation. e. The real risk free rate and the rate of inflation. ANS: E
PTS: 1
OBJ: Multiple Choice
6. In the phrase "nominal risk free rate," nominal means a. Computed. b. Historical. c. Market. d. Average. e. Risk adverse. ANS: C
PTS: 1
OBJ: Multiple Choice
7. If a significant change is noted in the yield of a T-bill, the change is most likely attributable to a. A downturn in the economy. b. A static economy. c. A change in the expected rate of inflation. d. A change in the real rate of interest. e. A change in risk aversion. ANS: C
PTS: 1
OBJ: Multiple Choice
8. The real risk-free rate is affected by a two factors; a. The relative ease or tightness in capital markets and the expected rate of inflation. b. The expected rate of inflation and the set of investment opportunities available in the economy. c. The relative ease or tightness in capital markets and the set of investment opportunities available in the economy. d. Time preference for income consumption and the relative ease or tightness in capital markets. e. Time preference for income consumption and the set of investment opportunities available in the economy.
ANS: E
PTS: 1
OBJ: Multiple Choice
9. Which of the following is not a component of the risk premium? a. Business risk b. Financial risk c. Liquidity risk d. Exchange rate risk e. Unsystematic market risk ANS: E
PTS: 1
OBJ: Multiple Choice
10. The ability to sell an asset quickly at a fair price is associated with a. Business risk. b. Liquidity risk. c. Exchange rate risk. d. Financial risk. e. Market risk. ANS: B
PTS: 1
OBJ: Multiple Choice
11. The variability of operating earnings is associated with a. Business risk. b. Liquidity risk. c. Exchange rate risk. d. Financial risk. e. Market risk. ANS: A
PTS: 1
OBJ: Multiple Choice
12. The uncertainty of investment returns associated with how a firm finances its investments is known as a. Business risk. b. Liquidity risk. c. Exchange rate risk. d. Financial risk. e. Market risk. ANS: D
PTS: 1
OBJ: Multiple Choice
13. What will happen to the security market line (SML) if the following events occur, other things constant: (1) inflation expectations increase, and (2) investors become more risk averse? a. Shift up and keep the same slope b. Shift up and have less slope c. Shift up and have a steeper slope d. Shift down and keep the same slope e. Shift down and have less slope ANS: C
PTS: 1
OBJ: Multiple Choice
14. A decrease in the market risk premium, all other things constant, will cause the security market line to a. Shift up b. Shift down c. Have a steeper slope
d. Have a flatter slope e. Remain unchanged ANS: D
PTS: 1
OBJ: Multiple Choice
15. A decrease in the expected real growth in the economy, all other things constant, will cause the security market line to a. Shift up b. Shift down c. Have a steeper slope d. Have a flatter slope e. Remain unchanged ANS: B
PTS: 1
OBJ: Multiple Choice
16. Unsystematic risk refers to risk that is a. Undiversifiable b. Diversifiable c. Due to fundamental risk factors d. Due to market risk e. None of the above ANS: B
PTS: 1
OBJ: Multiple Choice
17. The security market line (SML) graphs the expected relationship between a. Business risk and financial risk b. Systematic risk and unsystematic risk c. Risk and return d. Systematic risk and unsystematic return e. None of the above ANS: C
PTS: 1
OBJ: Multiple Choice
18. Two factors that influence the nominal risk-free rate are; a. The relative ease or tightness in capital markets and the expected rate of inflation. b. The expected rate of inflation and the set of investment opportunities available in the economy. c. The relative ease or tightness in capital markets and the set of investment opportunities available in the economy. d. Time preference for income consumption and the relative ease or tightness in capital markets. e. Time preference for income consumption and the set of investment opportunities available in the economy. ANS: A
PTS: 1
OBJ: Multiple Choice
19. Measures of risk for an investment include a. Variance of returns and business risk b. Coefficient of variation of returns and financial risk c. Business risk and financial risk d. Variance of returns and coefficient of variation of returns e. All of the above
ANS: D
PTS: 1
OBJ: Multiple Choice
20. Sources of risk for an investment include a. Variance of returns and business risk b. Coefficient of variation of returns and financial risk c. Business risk and financial risk d. Variance of returns and coefficient of variation of returns e. All of the above ANS: C
PTS: 1
OBJ: Multiple Choice
21. Modern portfolio theory assumes that most investors are a. Risk averse b. Risk neutral c. Risk seekers d. Risk tolerant e. None of the above ANS: A
PTS: 1
OBJ: Multiple Choice
22. Which of the following is not a component of the required rate of return? a. Expected rate of inflation b. Time value of money c. Risk d. Holding period return e. All of the above are components of the required rate of return ANS: D
PTS: 1
OBJ: Multiple Choice
23. All of the following are major sources of uncertainty EXCEPT a. Business risk b. Financial risk c. Default risk d. Country risk e. Liquidity risk ANS: C
PTS: 1
OBJ: Multiple Choice
24. The total risk for a security can be measured by its a. Beta with the market portfolio b. Systematic risk c. Standard deviation of returns d. Unsystematic risk e. Alpha with the market portfolio ANS: C
PTS: 1
OBJ: Multiple Choice
25. The increase in yield spreads in late 2008 and early 2009 indicated that a. Credit risk premiums decreased b. Market risk premiums increased c. Investors are more confident of the future cash flows of bonds d. Non-investment grade bonds are less risky
e. Government bonds are no longer a risk free investment ANS: B
PTS: 1
OBJ: Multiple Choice
26. Which of the following is least likely to move a firm's position to the right on the Security Market Line (SML)? a. An increase in the firm's beta b. Adding more financial debt to the firm's balance sheet relative to equity c. Changing the business strategy to include new product lines with more volatile expected cash flows d. Investors perceive the stock as being more risky e. An increase in the risk-free required rate of return. ANS: E
PTS: 1
OBJ: Multiple Choice
Exhibit 1.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Assume you bought 100 shares of NewTech common stock on January 15, 2003 at $50.00 per share and sold it on January 15, 2004 for $40.00 per share. 27. Refer to Exhibit 1.1. What was your holding period return? a. −10% b. −0.8 c. 25% d. 0.8 e. −20% ANS: D HPR = Ending Value/Beginning Value = 40/50 = 0.8 PTS: 1
OBJ: Multiple Choice Problem
28. Refer to Exhibit 1.1. What was your holding period yield? a. −10% b. −0.8 c. 25% d. 0.8 e. −20% ANS: E HPY = HPR − 1 = (40/50) − 1 = 0.8 − 1 = −0.2 = −20% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 1.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Suppose you bought a GM corporate bond on January 25, 2001 for $750, on January 25, 2004 sold it for $650.00.
29. Refer to Exhibit 1.2. What was your annual holding period return? a. 0.8667 b. −0.1333 c. 0.0333 d. 0.9534 e. −0.0466 ANS: D HPR = Ending Value/Beginning Value = $650.00/$750 = 0.8667 Annual HPR = (HPR)1/n = (0.8667)1/3 = 0.9534 PTS: 1
OBJ: Multiple Choice Problem
30. Refer to Exhibit 1.2. What was your annual holding period yield? a. −0.0466 b. −0.1333 c. 0.0333 d. 0.3534 e. 0.8667 ANS: A HPR = Ending Value/Beginning Value = $650.00/$750 = 0.8667 Annual HPR = (HPR)1/n = (0.8667)1/3 = 0.9534 Annual HPY = Annual HPR − 1 = 0.9534 − 1 = −0.0466 = −4.66% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 1.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The common stock of XMen Inc. had the following historic prices. Time 3/01/1999 3/01/2000 3/01/2001 3/01/2002 3/01/2003 3/01/2004
Price of X-Tech 50.00 47.00 76.00 80.00 85.00 90.00
31. Refer to Exhibit 1.3. What was your holding period return for the time period 3/1/1999 to 3/1/2004? a. 0.1247 b. 1.8 c. 0.1462 d. 0.40 e. 0.25 ANS: B
HPR = Ending Value/Beginning Value = 90/50 = 1.8 PTS: 1
OBJ: Multiple Choice Problem
32. Refer to Exhibit 1.3. What was your annual holding period yield (Annual HPY)? a. 0.1462 b. 0.1247 c. 1.8 d. 0.40 e. 0.25 ANS: B Annual HPR = (HPR)1/n = (1.8)1/5 = 1.1247 Annual HPY = Annual HPR − 1 = 1.1247 − 1 = 0.1247 = 12.47% Time 3/01/1999 3/01/2000 3/01/2001 3/01/2002 3/01/2003 3/01/2004 PTS: 1
Price of X-Tech 50 47 76 80 85 90
Return
HPR
−0.0600 0.6170 0.0526 0.0625 0.0588
0.9400 1.6170 1.0526 1.0625 1.0588
OBJ: Multiple Choice Problem
33. Refer to Exhibit 1.3. What was your arithmetic mean annual yield for the investment in XMen Industries. a. 0.1462 b. 0.1247 c. 1.8 d. 0.40 e. 0.25 ANS: A Arithmetic Mean =
PTS: 1
OBJ: Multiple Choice Problem
34. Refer to Exhibit 1.3. What was your geometric mean annual yield for the investment in XMen? a. 0.25 b. 0.40 c. 1.8 d. 0.1247 e. 0.1462 ANS: D
PTS: 1
OBJ: Multiple Choice Problem
Exhibit 1.4 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You have concluded that next year the following relationships are possible: Economic Status Weak Economy Static Economy Strong Economy
Probability .15 .60 .25
Rate of Return −5% 5% 15%
35. Refer to Exhibit 1.4. What is your expected rate of return [E(Ri)] for next year? a. 4.25% b. 6.00% c. 6.25% d. 7.75% e. 8.00% ANS: B E(Ri) = (0.15)(−5) + (0.60)(5) + (0.25)(15) = 6% PTS: 1
OBJ: Multiple Choice Problem
36. Refer to Exhibit 1.4. Compute the standard deviation of the rate of return for the one year period. a. 0.65% b. 1.45% c. 4.0% d. 6.25% e. 6.4% ANS: D = [(0.15)(−5 − 6)2 + (0.60)(5 − 6)2 + (0.25)(15 − 6)2]1/2 = 6.25% PTS: 1
OBJ: Multiple Choice Problem
37. Refer to Exhibit 1.4. Compute the coefficient of variation for your portfolio. a. 0.043 b. 0.12 c. 1.40 d. 0.69 e. 1.04
ANS: E CV = Standard Deviation of Returns/Expected Rate of Return = 6.25/6 = 1.04 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 1.5 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Assume that during the past year the consumer price index increased by 1.5 percent and the securities listed below returned the following nominal rates of return. U.S. Government T-bills U.S. Long-term bonds
2.75% 4.75%
38. Refer to Exhibit 1.5. What are the real rates of return for each of these securities? a. 4.29% and 6.32% b. 1.23% and 4.29% c. 3.20% and 6.32% d. 1.23% and 3.20% e. 3.75% and 5.75% ANS: D Real rate on T-bills = (1.0275/1.015) − 1 = 0.0123 = 1.23% Real rate on bonds = (1.0475/1.015) − 1 = 0.032 = 3.2% PTS: 1
OBJ: Multiple Choice Problem
39. Refer to Exhibit 1.5. If next year the real rates all rise by 10 percent while inflation climbs from 1.5 percent to 2.5 percent, what will be the nominal rate of return on each security? a. 1.24% and 1.52% b. 1.35% and 3.52% c. 3.89% and 6.11% d. 3.52% and 3.89% e. 1.17% and 6.11% ANS: C The computations for the new real rates are: Real rate on T-bills = 1.23 1.10 = 1.353% Real rate on bonds = 3.2 1.10 = 3.52% Nominal rate on T-bills = (1.01353)(1.025) − 1 = .03886 = 3.89% Nominal rate on corporate bonds = (1.0352)(1.025) − 1 = .06108 = 6.11% PTS: 1
OBJ: Multiple Choice Problem
40. If over the past 20 years the annual returns on the S&P 500 market index averaged 12% with a standard deviation of 18%, what was the coefficient of variation? a. 0.6
b. c. d. e.
0.6% 1.5 1.5% 0.66%
ANS: C Coefficient of Variation
PTS: 1
= Standard Deviation of Returns/Expected Rate of Return = 18%/12% = 1.5
OBJ: Multiple Choice Problem
41. Given investments A and B with the following risk return characteristics, which one would you prefer and why?
Investment A B a. b. c. d. e.
Expected Return 12.2% 8.8%
Standard Deviation of Expected Returns 7% 5%
Investment A because it has the highest expected return. Investment A because it has the lowest relative risk. Investment B because it has the lowest absolute risk. Investment B because it has the lowest coefficient of variation. Investment A because it has the highest coefficient of variation.
ANS: D Coefficient of Variation = Standard Deviation of Returns/Expected Rate of Return CVA = 7%/12.2% = 0.573 CVB = 5%/8.8% = 0.568 Investment B has the lowest coefficient of variation and would be preferred. PTS: 1
OBJ: Multiple Choice Problem
Exhibit 1.6 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You are provided with the following information: Nominal return on risk-free asset = 4.5% Expected return for asset i = 12.75% Expected return on the market portfolio = 9.25% 42. Refer to Exhibit 1.6. Calculate the risk premium for asset i. a. 4.5% b. 8.25% c. 4.75% d. 3.5% e. None of the above
ANS: B Risk premium for asset i = 12.75 − 4.5 = 8.25% PTS: 1
OBJ: Multiple Choice Problem
43. Refer to Exhibit 1.6. Calculate the risk premium for the market portfolio. a. 4.5% b. 8.25% c. 4.75% d. 3.5% e. None of the above ANS: C Risk premium market portfolio = 9.25 − 4.5 = 4.75% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 1.7 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Consider the following information Nominal annual return on U.S. government T-bills for year 2009 = 3.5% Nominal annual return on U.S. government long-term bonds for year 2009 = 4.75% Nominal annual return on U.S. large-cap stocks for year 2009= 8.75% Consumer price index January 1, 2009 = 165 Consumer price index December 31, 2009 = 169 44. Refer to Exhibit 1.7. Compute the rate of inflation for the year 2009. a. 2.42% b. 4.0% c. 1.69% d. 1.24% e. None of the above ANS: A Rate of inflation = (169/165) − 1 = .0242 = 2.42% PTS: 1
OBJ: Multiple Choice Problem
45. Refer to Exhibit 1.7. Calculate the annual real rate of return for U.S. T-bills. a. 2.26% b. 1.81% c. −0.5% d. 1.05% e. None of the above ANS: D Real return on U.S. T-bills = (1.035/1.0242) − 1 = .0105 = 1.05% PTS: 1
OBJ: Multiple Choice Problem
46. Refer to Exhibit 1.7. Calculate the annual real rate of return for U.S. long-term bonds. a. 3.06% b. 2.27% c. 2.51% d. 3.5% e. None of the above ANS: B Real return on U.S. bonds = (1.0475/1.0242) − 1 = .0227 = 2.27% PTS: 1
OBJ: Multiple Choice Problem
47. Refer to Exhibit 1.7. Calculate the annual real rate of return for U.S. large-cap stocks. a. 7.06% b. 6.18% c. 4.75% d. 3.75% e. None of the above ANS: B Real return on U.S. stocks = (1.0875/1.0242) − 1 = .0618 = 6.18% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 1.8 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Assume that you hold a two stock portfolio. You are provided with the following information on your holdings: Stock 1 2
Shares 15 25
Price(t) 10 15
Price(t + 1) 12 16
48. Refer to Exhibit 1.8. Calculate the HPY for stock 1. a. 10% b. 20% c. 15% d. 12% e. 7% ANS: B Stock 1 2
Shares 15 25
Price(t) 10 15
MV (t) 150 375 525
Price (t+1) 12 16
HPY for stock 1 = (180/150) − 1 = .2 = 20%
MV (t+1) 180 400 580
HPR 1.2 1.07
HPY 0.2 0.07
Weight 0.29 0.71
Weighted HPY 0.058 0.048 0.106
PTS: 1
OBJ: Multiple Choice Problem
49. Refer to Exhibit 1.8. Calculate the HPY for stock 2. a. 5% b. 6% c. 7% d. 8% e. 10% ANS: C Stock 1 2
Shares 15 25
Price(t) 10 15
MV (t) 150 375 525
Price (t+1) 12 16
MV (t+1) 180 400 580
HPR 1.2 1.07
HPY 0.2 0.07
Weight 0.29 0.71
Weighted HPY 0.058 0.048 0.106
HPY for stock 2 = (400/375) − 1 = .07 = 7% PTS: 1
OBJ: Multiple Choice Problem
50. Refer to Exhibit 1.8. Calculate the market weights for stock 1 and 2 based on period t values. a. 39% for stock 1 and 61% for stock 2 b. 50% for stock 1 and 50% for stock 2 c. 71% for stock 1 and 29% for stock 2 d. 29% for stock 1 and 71% for stock 2 e. None of the above ANS: D Stock 1 2
Shares 15 25
Price(t) 10 15
MV (t) 150 375 525
Price (t+1) 12 16
MV (t+1) 180 400 580
Market weight for stock 1 = 150/525 = .29 = 29% Market weight for stock 2 = 375/525 = .71 = 71% PTS: 1
OBJ: Multiple Choice Problem
51. Refer to Exhibit 1.8. Calculate the HPY for the portfolio. a. 10.6% b. 6.95% c. 13.5% d. 10% e. 15.7% ANS: A
HPR 1.2 1.07
HPY 0.2 0.07
Weight 0.29 0.71
Weighted HPY 0.058 0.048 0.106
Stock 1 2
Shares 15 25
Price(t) 10 15
MV (t) 150 375 525
Price (t+1) 12 16
MV (t+1) 180 400 580
HPR 1.2 1.07
HPY 0.2 0.07
Weight 0.29 0.71
Weighted HPY 0.058 0.048 0.106
Portfolio HPY = .29(.20) + .71(.07) = .106 = 10.6% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 1.9 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You purchased 100 shares of GE common stock on January 1, for $29 a share. A year later you received $1.25 in dividends per share and you sold it for $28 a share. 52. Refer to Exhibit 1.9. Calculate your holding period return (HPR) for this investment in GE stock. a. 0.9655 b. 1.0086 c. 1.0357 d. 1.0804 e. 1.0973 ANS: B HPR = (28 + 1.25)/29 = 1.0086 PTS: 1
OBJ: Multiple Choice Problem
53. Refer to Exhibit 1.9. Calculate your holding period yield (HPY) for this investment in GE stock. a. −0.0345 b. −0.0090 c. 0.0086 d. 0.0643 e. 0.0804 ANS: C HPY = (28 + 1.25)/29 − 1 = 1.0086 − 1 = 0.0086 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 1.10 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The annual rates of return of Stock Z for the last four years are 0.10, 0.15, −0.05, and 0.20, respectively. 54. Refer to Exhibit 1.10. Compute the arithmetic mean annual rate of return for Stock Z. a. 0.03 b. 0.04 c. 0.06
d. 0.10 e. 0.40 ANS: D AM = (0.10 + 0.15 − 0.05 + 0.20)/4 = 0.10 PTS: 1
OBJ: Multiple Choice Problem
55. Refer to Exhibit 1.10. Compute the standard deviation of the annual rate of return for Stock Z. a. 0.0070 b. 0.0088 c. 0.0837 d. 0.0935 e. 0.1145 ANS: D
PTS: 1
OBJ: Multiple Choice Problem
56. Refer to Exhibit 1.10. Compute the coefficient of variation for Stock Z. a. 0.837 b. 0.935 c. 1.070 d. 1.145 e. 1.281 ANS: B The coefficient of variation is equal to the standard deviation divided by the expected return. .0935/10 = 0.935 PTS: 1
OBJ: Multiple Choice Problem
57. Refer to Exhibit 1.10. Compute the geometric mean rate of return for Stock Z. a. 0.051 b. 0.074 c. 0.096 d. 0.150 e. 1.090 ANS: C [(1.1)(1.15)(0.95)(1.2)]1/4 = 1.0958 − 1 = 0.0958 PTS: 1
OBJ: Multiple Choice Problem
58. Economists project the long-run real growth rate for the next five years to be 2.5 percent and the average annual rate of inflation over this five year period to be 3 percent. What is the expected nominal rate of return over the next five years? a. 0.500 percent b. 1.056 percent c. 2.750 percent d. 5.500 percent e. 5.575 percent ANS: E 1 − (1.025)(1.03) = 1 − 1.05575 = 5.575% PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 1 APPENDIX MULTIPLE CHOICE Exhibit 1A.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Your expectations from a one year investment in Wang Computers is as follows: Probability .15 .15 .35 .25 .10
Rate of Return −.10 −.20 .00 .15 .15
1. Refer to Exhibit 1A.1. The expected return from this investment is a. −0.0752 b. −0.0040 c. 0.00 d. 0.0075 e. 0.4545 ANS: D E(R) = (−0.10)(0.15) + (−0.20)(0.15) + (0.00)(0.35) + (0.15)(0.25) + (0.15)(0.10) = 0.0075 PTS: 1
OBJ: Multiple Choice Problem
2. Refer to Exhibit 1A.1. The standard deviation of your expected return from this investment is a. 0.001 b. 0.004 c. 0.124 d. 1.240 e. None of the above ANS: C 2 = (0.15)(−0.1 − 0.0075)2 + (0.15)(−0.2 − 0.0075)2 + (0.35)(.00 − 0.0075)2 + (0.25)(0.15 − 0.0075)2 + (0.10)(0.15 − 0.0075)2 = 0.015319 = 0.0153191/2 = 0.124 PTS: 1
OBJ: Multiple Choice Problem
3. Refer to Exhibit 1A.1. The coefficient of variation of this investment is a. −0.06 b. −0.65 c. 6.60 d. 16.53
e. 165.10 ANS: D The coefficient of variation (CV) equals 0.124/0.0075 = 16.53 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 1A.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You have an opportunity to invest in project X with the following expected rates of return: Probability .25 .25 .50
Rate of Return −.10 .00 .10
4. Refer to Exhibit 1A.2. The expected return for project X is a. 0.0 percent b. 0.5 percent c. 2.5 percent d. 5.0 percent e. 7.5 percent ANS: C E(R) = (.25)(−.10) + (.25)(.00) + (.50)(.10) = 0.025 or 2.5 percent PTS: 1
OBJ: Multiple Choice Problem
5. Refer to Exhibit 1A.2. The standard deviation for project X is a. −1.581 percent b. 0.000 percent c. 1.581 percent d. 2.738 percent e. 5.000 percent ANS: B
PTS: 1
OBJ: Multiple Choice Problem
6. An investment has a standard deviation of 12 percent and an expected return of 7 percent. What is the coefficient of variation for this investment? a. 1.714 b. 1.372 c. 0.714 d. 0.583 e. 0.500 ANS: A 0.121/0.07 = 1.714 PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 2—THE ASSET ALLOCATION DECISION TRUE/FALSE 1. Experts suggest life insurance coverage should be seven to ten times an individual's annual salary. ANS: T
PTS: 1
2. Term life insurance provides both a death benefit and a savings plan. ANS: F
PTS: 1
3. Most experts recommend a cash reserve of at least one year's worth of living expenses. ANS: F
PTS: 1
4. The spending phase occurs when investors are relatively young. ANS: F
PTS: 1
5. The gifting phase is similar to, and may be concurrent with, the spending phase. ANS: T
PTS: 1
6. Long-term, high-priority goals include some form of financial independence. ANS: T
PTS: 1
7. It is not a good idea to get too specific when constructing your policy statement. ANS: F
PTS: 1
8. Asset allocation is the process of dividing funds into different classes of assets. ANS: T
PTS: 1
9. The typical investor's goals rarely change during his/her lifetime. ANS: F
PTS: 1
10. Individual security selection is far more important than the asset allocation decision. ANS: F
PTS: 1
11. Return is the only important consideration when establishing investment objectives. ANS: F
PTS: 1
12. In constructing the portfolio, the manager should maximize the investor's risk level. ANS: F
PTS: 1
13. Risk tolerance is exclusively a function of an individual's psychological makeup. ANS: F
PTS: 1
14. An appropriate investment objective for a typical 25-year-old investor is a low-risk strategy, such as capital preservation or current income. ANS: F
PTS: 1
15. Investment planning is complicated by the tax code. ANS: T
PTS: 1
16. Average tax rate is defined as total tax payment divided by total income. ANS: T
PTS: 1
17. The portfolio mixes of institutional investors around the world are approximately the same. ANS: F
PTS: 1
18. The ability to retire at a certain age is a typical example of a long-term, lower-priority goal. ANS: F
PTS: 1
19. It is essential that both the client and the portfolio manager agree on an appropriate benchmark portfolio. ANS: T
PTS: 1
20. An example of a unique need in an investment policy statement is related to the legal responsibilities of a fiduciary or trustee. ANS: F
PTS: 1
21. Equity allocations of pension funds in Japan and Germany are similar to those in the United States. ANS: F
PTS: 1
22. Investing 30 to 40 percent of your retirement funds in the company you work for is reasonable when they match funds. ANS: F
PTS: 1
23. The majority of a pension fund's return is explained by asset allocation. ANS: T
PTS: 1
MULTIPLE CHOICE 1. The current outlay of money to guard against a potentially large future loss is commonly known as a. Asset management. b. Portfolio management.
c. Minimizing risk. d. Loss control. e. Insurance. ANS: E
PTS: 1
OBJ: Multiple Choice
2. In an investment policy statement the objectives of an investor are expressed in terms of a. risk and return b. risk c. return d. time horizon e. liquidity needs ANS: A
PTS: 1
OBJ: Multiple Choice
3. ____ phase is the stage when investors in their early-to-middle earning years attempt to accumulate assets to satisfy near-term needs, e.g., children's education or down payment on a home. a. Accumulation b. Spending c. Gifting d. Consolidation e. Divestiture ANS: A
PTS: 1
OBJ: Multiple Choice
4. Which of the following is not a life cycle phase? a. Discovery phase b. Accumulation phase c. Consolidation phase d. Spending phase e. Gifting phase ANS: A
PTS: 1
OBJ: Multiple Choice
5. Which of the following is not a step in the portfolio management process? a. Develop a policy statement. b. Study current financial and economic conditions. c. Construct the portfolio. d. Monitor investor's needs and market conditions. e. Sell all assets and reinvestment proceeds at least once a year. ANS: E
PTS: 1
OBJ: Multiple Choice
6. The first step in the investment process is the development of a(n) a. Objective statement. b. Policy statement. c. Financial statement. d. Statement of cash needs. e. Statement of cash flows. ANS: B
PTS: 1
OBJ: Multiple Choice
7. Which of the following is not considered to be an investment objective? a. Capital preservation b. Capital appreciation c. Current income
d. Total return e. None of the above (that is, all are considered investment objectives) ANS: E
PTS: 1
OBJ: Multiple Choice
8. ____ must be stated in terms of expected returns and risk. An investor's tolerance for risk must be established before returns objectives can be stated. a. Investment requirements b. Investment constraints c. Investment rewards d. Investment objectives e. Investment policy ANS: D
PTS: 1
OBJ: Multiple Choice
9. ____ is an appropriate objective for investors who want their portfolio to grow in real terms, i.e., exceed the rate of inflation. a. Capital preservation b. Capital appreciation c. Portfolio growth d. Value additivity e. Nominal preservation ANS: B
PTS: 1
OBJ: Multiple Choice
10. ____ refer(s) to the ability to convert assets to cash quickly and at a fair market price and often increase(s) as one approaches the later stages of the investment life cycle. a. Liquidity needs b. Time horizons c. Liquidation values d. Liquidation essentials e. Capital liquidations ANS: A
PTS: 1
OBJ: Multiple Choice
11. The policy statement may include a ____ against which a portfolio's or portfolio manager's performance can be measured. a. Milestone b. Benchmark c. Landmark d. Reference point e. Market pair ANS: B
PTS: 1
OBJ: Multiple Choice
12. Asset allocation is a. The process of dividing funds into asset classes. b. Concerned with returns variability. c. Concerned with the risk associated with different assets. d. Concerned with the relationship among investments' returns. e. All of the above. ANS: E
PTS: 1
OBJ: Multiple Choice
13. The asset allocation decision must involve a consideration of a. Cultural differences.
b. c. d. e.
The objectives stated in the investor's policy statement. The types of assets that are appropriate for the investor. The risk associated with different investments. All of the above.
ANS: E
PTS: 1
OBJ: Multiple Choice
14. Research has shown that the asset allocation decision explains ____% of the variation in fund returns across all funds, and ____% of the variation in returns for a particular fund over time. a. 90 and 100. b. 100 and 40. c. 90 and 40. d. 40 and 100. e. 40 and 90. ANS: E
PTS: 1
OBJ: Multiple Choice
15. Once the portfolio is constructed, it must be continuously a. Rebalanced. b. Recycled c. Reinvested d. Monitored. e. Manipulated. ANS: D
PTS: 1
OBJ: Multiple Choice
16. Which of the following statements is false? a. Unrealized capital gains are taxable. b. Realized capital gains are taxable. c. Tax-exempt investments are attractive to individuals with high tax liabilities. d. Returns comparisons should be made on an equivalent tax basis. e. Tax exempt investors prefer tax exempt investments. ANS: A
PTS: 1
OBJ: Multiple Choice
17. ____ gains are taxable and occur when an asset is sold for more than its basis (the value of the asset when it was purchased by the original owner, or inherited by the heirs of the original owner). a. Realized capital b. Income c. Portfolio d. Nominal e. Real ANS: A
PTS: 1
OBJ: Multiple Choice
18. Which of the following statements is true? a. Except for tax-exempt investors and tax-deferred accounts, annual tax payments increase investment returns. b. The only way to maintain purchasing power over time is to invest in bonds. c. After adjusting for taxes, long-term bonds consistently outperform stocks. d. An asset allocation decision for a taxable portfolio that does not include a substantial commitment to common stocks may make it difficult for the portfolio to maintain real value over time. e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
19. Important reasons for constructing a policy statement include: a. Helps investors decide on realistic investment goals b. Create a standard by which to judge the performance of the portfolio manager c. Develop an instrument to judge risk d. Choices a and b e. All of the above ANS: D
PTS: 1
OBJ: Multiple Choice
20. For an investor with a time horizon of 6 to 10 years and lower risk tolerance, an appropriate asset allocation strategy would be a. 100% stocks b. 100% cash c. 30% cash, 50% bonds, and 20% stocks d. 10% cash, 30% bonds, and 60% stocks e. 100% bonds ANS: C
PTS: 1
OBJ: Multiple Choice
21. For an investor with a time horizon of 8 years and higher risk tolerance, an appropriate asset allocation strategy would be a. 100% stocks b. 100% cash c. 30% cash, 50% bonds, and 20% stocks d. 10% cash, 30% bonds, and 60% stocks e. 100% bonds ANS: D
PTS: 1
OBJ: Multiple Choice
22. For an investor with a time horizon of 12 years and higher risk tolerance, an appropriate asset allocation strategy would be a. 100% stocks b. 30% cash, 50% bonds, and 20% stocks c. 10% cash, 30% bonds, and 60% stocks d. 50% bonds and 50% stocks e. 100% bonds ANS: A
PTS: 1
OBJ: Multiple Choice
23. For an investor with a time horizon of 15 years and moderate risk tolerance, an appropriate asset allocation strategy would be a. 100% stocks b. 40% cash and 60% stocks c. 30% cash, 50% bonds, and 20% stocks d. 50% bonds, and 50% stocks e. 20% bonds, and 80% stocks ANS: E
PTS: 1
OBJ: Multiple Choice
24. For an investor with a time horizon of 4 years and higher risk tolerance, an appropriate asset allocation strategy would be a. 100% cash b. 30% cash, 50% bonds, and 20% stocks c. 20% cash, 40% bonds, and 40% stocks
d. 10% cash, 40% bonds, and 50% stocks e. 100% bonds ANS: C
PTS: 1
OBJ: Multiple Choice
25. For an investor with a time horizon of 5 years and moderate risk tolerance, an appropriate asset allocation strategy would be a. 100% cash b. 30% cash, 50% bonds, and 20% stocks c. 20% cash, 40% bonds, and 40% stocks d. 10% cash, 30% bonds, and 60% stocks e. 100% bonds ANS: B
PTS: 1
OBJ: Multiple Choice
26. John is 55 years old has $55,000 outstanding on a mortgage and no other debt. John typically saves $5,000 in an IRA account and another $10,000 in a company pension. John is most likely in the: a. Discovery phase b. Accumulation phase c. Consolidation phase d. Spending phase e. Gifting phase ANS: C
PTS: 1
OBJ: Multiple Choice
27. Which of the following is not a typical portfolio constraint? a. Liquidity needs b. Risk tolerance c. Time horizon d. Tax concerns e. Legal factors ANS: B
PTS: 1
OBJ: Multiple Choice
28. Which of the following strategies seeks to increase the portfolio value by reinvesting current income in addition to capital gains? a. Capital appreciation b. Capital preservation c. Return preservation d. Current income e. Total return ANS: D
PTS: 1
OBJ: Multiple Choice
29. Research from the 1970s to the 1990s found that over 90 percent of a fund's returns over time is explained by: a. Market timing b. Stock selection c. Manager selection d. Asset allocation e. All of the above ANS: D
PTS: 1
OBJ: Multiple Choice
Exhibit 2.1 USE THE TAX TABLE PROVIDED BELOW FOR THE FOLLOWING PROBLEM(S)
Single
Married Filing Jointly
If Taxable Income Is Over But Not Over $0 $7,150 $7,150 $29,050 $29,050 $70,350 $70,350 $146,750 $146,750 $319,100 $319,100 $0 $14,300 $58,100 $117,250 $178,650 $319,100
Then
$14,300 $58,100 $117,250 $178,650 $319,100 -
The Tax is This Amount 0 715 $4,000 $14,325 $35,717 $92,592.50
Plus This % 10% 15% 25% 28% 33% 35%
Of The Excess Over 0 $7,150 $29,050 $70,350 $146,750 $319,100
0 1430 $8,000 $22,787.50 $39,979.50 $86,328
10% 15% 25% 28% 33% 35%
0 $14,300 $58,100 $117,250 $178,650 $319,100
30. Refer to Exhibit 2.1. What is the marginal tax rate for a single individual with taxable income of $85,000? a. 15% b. 25% c. 28% d. 33% e. 35% ANS: C Marginal tax rate = 28% PTS: 1
OBJ: Multiple Choice Problem
31. Refer to Exhibit 2.1. What is the tax liability for a single individual with taxable income of $85,000? a. $23,800 b. $18,427 c. $24,958 d. $16,867 e. $19,650 ANS: B $14,325 + 0.28($85,000 − $70,350) = $18,427 (tax bill) PTS: 1
OBJ: Multiple Choice Problem
32. Refer to Exhibit 2.1. What is the average tax for a single individual with taxable income of $85,000? a. 13.57% b. 15.68% c. 21.68% d. 25.74% e. 29.55% ANS: C $18,427/$85,000 = 21.68% (average tax rate) PTS: 1
OBJ: Multiple Choice Problem
33. Refer to Exhibit 2.1. What is the tax liability for a married couple filing jointly with taxable income of $125,000? a. $23,800 b. $18,427 c. $24,958 d. $16,867 e. $19,650 ANS: C $22,787.50 + 0.28($125,000 − $117,250) = $24,958 PTS: 1
OBJ: Multiple Choice Problem
34. What would the equivalent taxable yield be on an investment that offers a 6 percent tax exempt yield? Assume a marginal tax rate of 28%. a. 0.125% b. 7.20% c. 6.48% d. 8.33% e. 32.14% ANS: D Equivalent taxable yield = .06/(1 − .28) = .06/.72 = 8.33% PTS: 1
OBJ: Multiple Choice Problem
35. What would the after-tax yield be on an investment that offers a 6 percent fully taxable yield? Assume a marginal tax rate of 31%. a. 2.79% b. 6.48% c. 4.14% d. 7.20% e. 12.50% ANS: C After-tax yield = Before-tax yield (1 − Tax Rate) = 6%(1 − .31) = 4.14% PTS: 1
OBJ: Multiple Choice Problem
36. The future value of $50,000 invested today, at the end of 10 years assuming an interest rate of 7.5% per year, with semiannual compounding, is a. $104,407.60 b. $103,051.58 c. $123,510.52 d. $210,673.43 e. $105,117.46 ANS: A FV = 50,000(1 + .0375)20 = $104,407.60 PTS: 1
OBJ: Multiple Choice Problem
37. Assume that you invest $750 at the end of each quarter for the next 20 years in a mutual fund. The annual rate of interest that you expect to earn in this account is 5.25%. The amount in the account at the end of 20 years is
a. b. c. d. e.
$60,000.00 $105,039.84 $37,009.35 $123,510.52 $115,637.37
ANS: B
PTS: 1
OBJ: Multiple Choice Problem
38. Assume that you invest $1250 at the end of each of the next 15 years in a mutual fund. You currently have $10,000 in the mutual fund. The annual rate of interest that you expect to earn in this account is 4.35%. The amount in the account at the end of 15 years is a. $58,940.30 b. $28,750.00 c. $37,009.35 d. $44,630.81 e. $25,690.50 ANS: D
PTS: 1
OBJ: Multiple Choice Problem
39. Someone in the 15 percent tax bracket can earn 8 percent annually on his investments in a tax-exempt IRA account. What will be the value of a $10,000 investment after 5 years (assuming annual compounding)? a. $ 6,805 b. $14,693 c. $15,528 d. $20,114 e. $50,000 ANS: B FV = 10,000(1 + .08)5 = $14,693 PTS: 1
OBJ: Multiple Choice Problem
40. Suppose the 8 percent investment of the previous problem is taxable rather than tax-deferred. What will be the after-tax value of his $10,000 investment after 5 years (assuming annual compounding)? a. $10,680 b. $11,765 c. $13,895 d. $14,693 e. $15,528 ANS: C After-tax yield
= Before-tax yield (1 − Tax rate) = 8% (1 − .15) = 6.8%
$10,000(1 + 0.068)5 = $13,895 PTS: 1
OBJ: Multiple Choice Problem
41. An individual in the 36% tax bracket invests $5,000 in a tax-exempt IRA. If the investment earns 10% annually, what will be the value of the IRA after five years? a. $6,600 b. $6,818 c. $7,500 d. $8,053 e. $10,879 ANS: D The total amount is not adjusted for taxes or inflation. FV = $5,000(1 + 0.10)5 = $8,052.55 PTS: 1
OBJ: Multiple Choice Problem
42. An individual in the 15% tax bracket has $10,000 invested in a tax-exempt IRA account. If the individual earns 8% annually before taxes and inflation is 2.5% per year, what is the real value of the investment in 20 years? a. $23,211 b. $28,467 c. $29,178 d. $37,276 e. $46,610 ANS: B The annual real return adjusted for inflation is computed as follows: (1.08)/(1.025) −1 = 5.37%. FV = $10,000(1 + 0.0537)20 = $28,466.86 PTS: 1
OBJ: Multiple Choice Problem
43. An individual in the 36% tax bracket has $20,000 invested in a tax-exempt account. If the individual earns 10% annually before taxes and inflation is 3.0% per year, what is the real value of the investment in 10 years? a. $31,000 b. $33,200 c. $38,614 d. $39,343 e. $47,823 ANS: C The annual real return adjusted for inflation is computed as follows: (1.10)/(1.03) − 1 = 6.8%. FV = $20,000(1 + 0.068)10 = $38,613.80 PTS: 1
OBJ: Multiple Choice Problem
44. You currently have $150,000 in an IRA designated for retirement. If you save an additional $100 at the end of every month and expect to earn an annual return of 12%, how much do you expect to have in the IRA in 10 years? a. $467,632
b. c. d. e.
$518,062 $732,546 $949,328 $1,215,234
ANS: B
PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 2 APPENDIX TRUE/FALSE 1. Non-life insurance companies have somewhat unpredictable cash outflows and are therefore faced with different investment constraints than life insurance companies. ANS: T
PTS: 1
2. Many endowments are tax-exempt. ANS: T
PTS: 1
3. Cash flows for nonlife insurance companies, such as property and casualty, are similar to cash flows of life insurance companies. ANS: F
PTS: 1
4. Banks must compete for funds (savings deposits, CD's, etc.) in order to make loans and other types of investments. ANS: T
PTS: 1
5. Banks have high liquidity needs and therefore, have a short time horizon. ANS: T
PTS: 1
6. Banks face regulatory constraints at both the state and federal level. ANS: T
PTS: 1
7. Defined contribution pension plans promise to pay retirees a specific income stream after retirement. ANS: F
PTS: 1
MULTIPLE CHOICE 1. Which of the following is not true regarding defined contribution pension plans? a. Employees make regular contributions to the plan. b. Employers make regular contributions to the plan. c. The employer bears all of the investment risk. d. Benefits are directly related to the earnings of the funds investments. e. The number of defined contribution plans is increasing. ANS: C
PTS: 1
OBJ: Multiple Choice
2. In a defined contribution pension plan, a. The plan does not promise to pay the retiree a specific income stream after retirement. b. The plan does promise to pay the retiree a specific income stream after retirement. c. The employee's retirement income is not an obligation of the firm. d. The company carries the risk of paying future pension benefits to retirees. e. Choices a and c
ANS: E
PTS: 1
OBJ: Multiple Choice
3. The retirement plan that promises to pay a specific benefit to its beneficiaries is a. A defined contribution plan. b. A defined benefit pension plan. c. A non-contribution pension plan. d. An actuarial pension plan. e. Supplemental Retirement Account (SRA). ANS: B
PTS: 1
OBJ: Multiple Choice
4. Endowment funds a. Are formed from the contributions to charitable and educational institutions. b. Are attractive investments for individuals with low liquidity needs. c. Usually have very short investment horizons. d. Provide retirement benefits for public employees. e. Provide death benefits for its contributor's survivors. ANS: A
PTS: 1
OBJ: Multiple Choice
5. ____ are investment specialists that are responsible for managing the investments of others. There are often legal standards against which they must abide in the performance of their duties. a. Underwriters b. Investments bankers c. Fiduciaries d. Account executives e. Trust officers ANS: C
PTS: 1
OBJ: Multiple Choice
6. Banks typically a. Have low liquidity needs. b. Face very few federal and state regulatory constraints. c. Don't have to compete for funds. d. Have high liquidity needs and a short time horizons constraint. e. Low investment risk. ANS: D
PTS: 1
OBJ: Multiple Choice
7. Banks typically have short-term investment horizons because a. They have a strong need for liquidity. b. They offer short-term deposit accounts. c. They are required to by federal and state laws. d. Choices a and b. e. All of the above ANS: D
PTS: 1
OBJ: Multiple Choice
8. Which of the following statements concerning defined benefit plans is false? a. The company bears the risk of investments b. Employees are entitled to either a lump-sum payment or income stream at retirement c. Risk tolerance depends on funding status and its actuarial rate d. Defined benefit plans for young workers are typically more conservatively invested than defined contribution plans e. All of the above are true statements
ANS: D
PTS: 1
OBJ: Multiple Choice
CHAPTER 3—SELECTING INVESTMENTS IN A GLOBAL MARKET TRUE/FALSE 1. The U.S. equity and bond markets have grown in terms of their relative size of the world equity and bond market. ANS: F
PTS: 1
2. Diversification with foreign securities can help reduce portfolio risk. ANS: T
PTS: 1
3. The total domestic return on German bonds is the return that would be experienced by an U.S. investor who owned German bonds. ANS: F
PTS: 1
4. If the exchange rate effect for Japanese bonds is negative, it means that the domestic rate of return will be greater than the U.S. dollar return. ANS: T
PTS: 1
5. A U.S. investor who ignores foreign markets reduces overall number of investment choices. ANS: T
PTS: 1
6. Treasury bills are long-term investments that make regular interest and principal payments. ANS: F
PTS: 1
7. A debenture is an option issued by a corporation that gives the holder the right to acquire common stock from the issuing firm at a specified price within a designated period of time. ANS: F
PTS: 1
8. Income bonds are considered as safe as debentures because they pay higher rates of interest. ANS: F
PTS: 1
9. A Eurobond is an international bond denominated in a currency other than that of the United States. ANS: F
PTS: 1
10. Warrants are options often issued in connection with the sale of fixed income securities. ANS: T
PTS: 1
11. A call option is usually issued in conjunction with convertible bonds. ANS: F
PTS: 1
12. Yields on money market funds are often lower than yields available to individuals investing in CD's because of the fees involved. ANS: F
PTS: 1
13. Municipal bond nominal yields are generally below comparable taxable bond yields. ANS: T
PTS: 1
14. REITS are investment companies that invest in high-quality money market instruments such as Treasury bills, high-grade commercial paper, and large CD's. ANS: F
PTS: 1
15. It is very important when diversifying that the correlation between rates of return for various countries be high and very stable over time. ANS: F
PTS: 1
16. The decrease in the standard deviation of returns after adding 40 to 50 securities within a country is known as domestic diversification. ANS: T
PTS: 1
17. Government agency securities are issued by local government entities as either general obligation or revenue bonds. ANS: F
PTS: 1
18. Subordinated bondholders have claim to the assets of the firm only after the firm has satisfied the claims of all senior secured and debenture bondholders. ANS: T
PTS: 1
19. The relative size of U.S. financial markets to the total investable assets in the global capital markets has grown considerably over the last three decades. ANS: F
PTS: 1
20. The correlation of returns between a single pair of countries remains constant over time. ANS: F
PTS: 1
MULTIPLE CHOICE 1. An investor who purchases a put option: a. Has the right to buy a given stock at a specified price during a designated time period. b. Has the right to sell a given stock at a specified price during a designated time period. c. Has the obligation to buy a given stock at a specified price during a designated time period. d. Has the obligation to sell a given stock at a specified price during a designated time period. e. None of the above.
ANS: B
PTS: 1
OBJ: Multiple Choice
2. If you are considering investing in German stocks as a means to reduce the risk of your portfolio, the initial factor that you should examine is: a. The average rate of return of the portfolio when you combine U.S. and German stocks. b. The standard deviation of the German stocks. c. The standard deviation of the German stocks compared to the standard deviation of U.S. stocks. d. The correlation between the rates of return for German stocks and U.S. stocks. e. The coefficient of variation (CV) of rates of return for German stocks versus the CV of rates of return for U.S. stocks. ANS: D
PTS: 1
OBJ: Multiple Choice
3. All of the following are considered fixed income investments except a. Corporate bonds. b. Preferred stock. c. Treasury bills, notes, and bonds. d. Money market mutual funds. e. Certificates of deposit (CDs). ANS: D
PTS: 1
OBJ: Multiple Choice
4. Capital market instruments include all of the following except a. U.S. Treasury notes and bonds. b. U.S Treasury bills. c. U.S. government agency securities. d. Municipal bonds. e. Corporate bonds. ANS: B
PTS: 1
OBJ: Multiple Choice
5. The original maturity of a United States Treasury note is a. Zero years to five years. b. Six months to ten years. c. One year or less. d. One year to ten years. e. Over ten years. ANS: D
PTS: 1
OBJ: Multiple Choice
6. The original maturity of a United States Treasury bill is a. Zero years to five years. b. Six months to ten years. c. One year or less. d. One year to ten years. e. Over ten years. ANS: C
PTS: 1
OBJ: Multiple Choice
7. The original maturity of a United States Treasury bond is a. Zero years to five years. b. Six months to ten years. c. One year or less. d. One year to ten years.
e. Over ten years. ANS: E
PTS: 1
OBJ: Multiple Choice
8. Which of the following is not a U.S. government agency? a. Federal National Mortgage Association b. Federal Home Loan Bank c. Government National Mortgage Association d. Government Employees Insurance Company e. Federal Housing Administration ANS: D
PTS: 1
OBJ: Multiple Choice
9. The legal document setting forth the obligations of a bond's issuer is called a. A debenture. b. A warrant. c. An indenture. d. The preemptive right. e. A trustee deed. ANS: C
PTS: 1
OBJ: Multiple Choice
10. All of the following are considered fixed income securities except a. Debentures. b. Eurobonds. c. Preferred stock. d. Mutual funds. e. Yankee bonds. ANS: D
PTS: 1
OBJ: Multiple Choice
11. The purchase and sale of commodities for current delivery and consumption is known as dealing in the ____ market. a. Futures b. Spot c. Money d. Capital e. Options ANS: B
PTS: 1
OBJ: Multiple Choice
12. An investor who purchases a call option: a. Has the right to buy a given stock at a specified price during a designated time period. b. Has the right to sell a given stock at a specified price during a designated time period. c. Has the obligation to buy a given stock at a specified price during a designated time period. d. Has the obligation to sell a given stock at a specified price during a designated time period. e. None of the above. ANS: A
PTS: 1
OBJ: Multiple Choice
13. If this year is consistent with historical trends you would expect the return for small capitalization stocks to be a. Below common stocks and above long-term government bonds. b. Below common stocks and below long-term government bonds.
c. Above last year's return on the same stocks. d. Above common stock, long-term government, and corporate bonds. e. The least variable among long-term bonds and common stocks. ANS: D
PTS: 1
OBJ: Multiple Choice
14. The correlation between U.S. equities and U.S. government bonds is a. Strongly positive. b. Weakly Positive. c. Strongly Negative. d. Weakly Negative. e. Indeterminate. ANS: B
PTS: 1
OBJ: Multiple Choice
15. The best way to directly acquire the shares of a foreign company is through a. International mutual funds. b. Global mutual funds. c. American Depository Receipts. d. Investment in U.S. companies operating internationally. e. Eurobonds. ANS: C
PTS: 1
OBJ: Multiple Choice
16. Which of the following would be considered a low liquidity investment? a. Warrants b. Call options c. Zero coupon bonds d. Balanced mutual funds e. Diamonds ANS: E
PTS: 1
OBJ: Multiple Choice
17. An agreement that provides for the future delivery or receipt of an asset at a specified date for a specified price is a a. Eurobonds contract. b. Futures contract. c. Put option contract. d. Call option contract. e. Warrant contract. ANS: B
PTS: 1
OBJ: Multiple Choice
18. Which of the following is not a type of investment company? a. Money market funds b. Common stock funds c. Balanced funds d. Bond funds e. None of the above ANS: E
PTS: 1
OBJ: Multiple Choice
19. Antiques, art, coins, stamps, jewelry, etc., are not included in the investment portfolios of financial institutions because a. Prices vary substantially. b. Transaction costs are relatively high.
c. They are illiquid. d. All of the above. e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
20. Rank the following four investments in increasing order of historical risk. a. Art, T-bills, corporate bonds, and common stock b. T-bills, common stock, corporate bonds, art c. Corporate bonds, T-bills, common stock, art d. Common stock, corporate bonds, T-bills, art e. T-bills, corporate bonds, common stock, art ANS: E
PTS: 1
OBJ: Multiple Choice
21. An ETF (exchange traded fund): a. Is priced once a day at the opening of trading. b. Is priced once a day at the close of trading. c. Is priced continuously during the trading day. d. Is priced at the open and close of trading. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
22. A statistic that measures how two variables tend to move together is the a. Coefficient of variation b. Correlation coefficient c. Standard deviation d. Mean e. Variance ANS: B
PTS: 1
OBJ: Multiple Choice
23. Which of the following statements concerning historical investment risk and return is false? a. The geometric mean of the rates of return was always lower than the arithmetic mean of the rates of return. b. The rates of return on long-term U.S. government bonds were lower than on stocks. c. Real estate investments consistently provide higher rates of return than those provided by common stock. d. Stocks and bonds experienced results in the middle of the art and antiques series. e. none of the above (that is, all are true statements) ANS: C
PTS: 1
OBJ: Multiple Choice
24. Which of the following are reasons that U.S. investors should consider foreign markets when constructing global portfolios. a. Ignoring foreign markets reduced their choices of investment opportunities. b. Foreign markets have low correlations with U.S. markets. c. Returns on non-U.S. stocks can substantially exceed returns for U.S securities. d. All of the above. e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
25. A mutual fund: a. Is priced once a day at the opening of trading.
b. c. d. e.
Is priced once a day at the close of trading. Is priced continuously during the trading day. Is priced at the open and close of trading. None of the above.
ANS: B
PTS: 1
OBJ: Multiple Choice
26. For a U.S. based investor, a weaker dollar means that overall dollar based returns on overseas security investment will be higher because a. A weaker dollar means that exports will rise. b. A weaker dollar means that more foreign investors will by U.S. securities. c. A weaker dollar means that the foreign currency will convert to more dollars. d. A weaker dollar means that more investors will purchase the foreign security. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
27. In order to diversify risk an investor must have investments that have correlations with other investments in the portfolio that are a. low positive b. zero c. negative d. any of the above e. none of the above ANS: D
PTS: 1
OBJ: Multiple Choice
28. Correlations between bond markets in different countries have been changing over time because a. Countries are developing closer trade and economic links. b. Countries are becoming more segmented. c. There are fewer barriers to travel. d. U.S. investors are purchasing more foreign securities. e. Correlations between bond markets of different countries have been rising. ANS: A
PTS: 1
OBJ: Multiple Choice
29. Senior secured bonds are a. The most senior bonds in a firm's capital structure. b. Bonds with the lowest risk of default. c. Bonds that are not backed by specific assets. d. a and b. e. a and c. ANS: B
PTS: 1
OBJ: Multiple Choice
30. Convertible bonds are bonds a. That are convertible into more bonds. b. That are convertible from unsecured to secured status. c. That are convertible into company stock. d. That are convertible into specific assets. e. That have an option attached. ANS: C
PTS: 1
OBJ: Multiple Choice
31. A Eurobond is an international bond a. Sold by an issuer within its own country in that country's currency.
b. c. d. e.
Denominated in a currency not native to where it is issued. Also known as a Yankee Bond. Denominated in U.S. dollars but issued by a foreign company. That is sold only to European investors.
ANS: B
PTS: 1
OBJ: Multiple Choice
32. Foreign equities can be acquired by purchasing all of the following except a. American Depository Receipts (ADRs) b. American shares c. Foreign shares listed on a U.S. or foreign stock exchange d. Global Exchange-Traded Funds (GETFs) e. All of the above are ways to purchase foreign equities. ANS: E
PTS: 1
OBJ: Multiple Choice
33. Which of the following is not a characteristic of a warrant? a. The right to buy common stock in a corporation. b. Issued by the corporation or an individual. c. Typically valid for longer time periods than options. d. Similar to a call option with respect to a striking price. e. All of the above statements are characteristics of a warrant. ANS: B
PTS: 1
OBJ: Multiple Choice
34. Certificates of ownership issued by a U.S. bank that represent indirect ownership of a certain number of shares of a specific foreign firm on deposit in a bank in the firm's home country are known as: a. American Depository Receipts (ADRs) b. Exchange Traded Funds (ETFs) c. Warrants d. Options e. Futures ANS: A
PTS: 1
OBJ: Multiple Choice
35. All of the following are ways to invest in real estate except a. Real Estate Investment Trusts (REITs) b. Raw Land c. Land Development d. Rental Properties e. All of the above are ways to invest in real estate. ANS: E
PTS: 1
OBJ: Multiple Choice
36. Which of the following statements regarding real estate investments is false? a. The large number of transactions and national data sources provide accurate readily available estimates of historical returns. b. Real Estate Investment Trusts (REITs) had higher returns than common stocks from 1972 to 1987. c. Real Estate Investment Trusts (REITs) had lower volatility than common stocks from 1972 to 1987. d. All of the above statements are true. e. All of the above statements are false. ANS: A
PTS: 1
OBJ: Multiple Choice
37. A bond provision that specifies payments the issuer must make to redeem a given percentage of the outstanding issue prior to maturity is known as a. Call provision b. Indenture c. Collateralization d. Sinking fund e. Collateral trust bond ANS: D
PTS: 1
OBJ: Multiple Choice
38. Adding international investments to an all U.S. portfolio will most likely: a. Increase the overall risk of the portfolio b. Decrease the overall risk of the portfolio c. Increase the expected return of the portfolio d. Decrease the expected return of the portfolio e. None of the above ANS: B
PTS: 1
OBJ: Multiple Choice
39. Investments with predetermined contractual payments are known as: a. Fixed-income b. Real estate c. Real assets d. Equities e. Low liquidity investments ANS: A
PTS: 1
OBJ: Multiple Choice
40. Which of the following investments can be purchased with future contracts? a. Commodities b. T-bills c. Treasury bonds d. Eurobonds e. All of the above ANS: E
PTS: 1
OBJ: Multiple Choice
41. What type of mutual fund issues "redeemable securities" meaning that the fund stands ready to buy or sell the shares at their net asset value with a transaction fee? a. No-load, closed-end fund b. No-load, open-end fund c. Load, closed-end fund d. Load, open-end fund e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
42. An individual with only $10,000 to invest is most likely better off investing in: a. Mutual funds to increase the expected return b. ETFs to increase the diversification c. Individual equities to increase portfolio efficiency d. Individual bonds and individual equities to increase efficiency e. All of the above are rational choices ANS: B
PTS: 1
OBJ: Multiple Choice
Exhibit 3.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Security U.S. government T-bills Long-term government bonds Long-term corporate bonds Large capitalization common stocks Small capitalization common stocks
Annual Percentage Return 3.04 5.75 6.80 13.50 15.60
The annual rate of inflation is 2%. 43. Refer to Exhibit 3.1. What is the real return on long-term corporate bonds? a. 1.02% b. 3.68% c. 4.71% d. 11.27% e. 13.33% ANS: C Real return on long term corporate bonds = 4.71% = [(1.068)/(1.02)] − 1 PTS: 1
OBJ: Multiple Choice Problem
44. Refer to Exhibit 3.1. What is the real return on T-bills? a. 1.02% b. 3.68% c. 4.71% d. 11.27% e. 13.33% ANS: A Real return on T-bills = 1.02% = [(1.034)/(1.02)] − 1 PTS: 1
OBJ: Multiple Choice Problem
45. Refer to Exhibit 3.1. What is the real return on small capitalization stocks? a. 1.02% b. 3.68% c. 4.71% d. 11.27% e. 13.33% ANS: E Real return on small cap stocks = 13.33% = [(1.156)/(1.02)] − 1 PTS: 1
OBJ: Multiple Choice Problem
46. Refer to Exhibit 3.1. What is the real return on large capitalization stocks? a. 1.02% b. 3.68% c. 4.71% d. 11.27% e. 13.33%
ANS: D Real return on large cap stocks = 11.27% = [(1.135)/(1.02)] − 1 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 3.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Real Returns Investment Large company stock Small capitalization stock Long-term corporate bonds Long-term government bonds U.S. Treasury bills
Real Annual Return 6.50% 8.60% 3.60% 2.80% 1.03%
The annual rate of inflation is 2.5% 47. Refer to Exhibit 3.2. What is the large company stock nominal return? a. 3.56% b. 5.37% c. 6.19% d. 9.16% e. 11.32% ANS: D Nominal return on large cap stocks = 9.16% = [(1.065)(1.025)] − 1 PTS: 1
OBJ: Multiple Choice Problem
48. Refer to Exhibit 3.2. What is the T-bill nominal return? a. 3.56% b. 5.37% c. 6.19% d. 9.16% e. 11.32% ANS: A Nominal return on T-bills = 3.56% = [(1.0103)(1.025)] − 1 PTS: 1
OBJ: Multiple Choice Problem
49. Refer to Exhibit 3.2. What is the long term Treasury bond nominal return? a. 3.56% b. 5.37% c. 6.19% d. 9.16% e. 11.32% ANS: B Nominal return on long term government bonds = 5.37% = [(1.028)(1.025)] − 1 PTS: 1
OBJ: Multiple Choice Problem
50. Refer to Exhibit 3.2. What is the small capitalization stock nominal return? a. 3.56% b. 5.37% c. 6.19% d. 9.16% e. 11.32% ANS: E Nominal return on small cap stocks = 11.32% = [(1.086)(1.025)] − 1 PTS: 1
OBJ: Multiple Choice Problem
51. A return series has an arithmetic mean of 12.8% and standard deviation of 7.8%. Assuming the returns are normally distributed what is the range of returns that an investor would expect to receive 90% of the time? a. 12.8% to 20.6% b. −10.6% to 36.2% c. −2.8% to 28.4% d. −12.8% to 20.6% e. 10.6% to 36.2% ANS: C The range of returns is between 12.8 − 2(7.8) and 12.8 + 2(7.8) = −2.8 and 28.4 PTS: 1
OBJ: Multiple Choice Problem
52. A return series has an arithmetic mean of 12.8% and standard deviation of 7.8%. Assuming the returns are normally distributed what is the range of returns that an investor would expect to receive 95% of the time? a. 12.8% to 20.6% b. −10.6% to 36.2% c. −2.8% to 28.4% d. −12.8% to 20.6% e. 10.6% to 36.2% ANS: B The range of returns is between 12.8 − 3(7.8) and 12.8 + 3(7.8) = −10.6 and 36.2 PTS: 1
OBJ: Multiple Choice Problem
53. A return series has an arithmetic mean of 10.5% and standard deviation of 13%. Assuming the returns are normally distributed what is the range of returns that an investor would expect to receive 95% of the time? a. 10.5% to 13% b. −2.5% to 23.5% c. −28.5% to 49.5% d. −15.5% to 36.5% e. 0% to 36.5% ANS: C The range of returns is between 10.5 − 3(13) and 10.5 + 3(13) = −28.5 and 49.5 PTS: 1
OBJ: Multiple Choice Problem
54. A return series has an arithmetic mean of 10.5% and standard deviation of 13%. Assuming the returns are normally distributed what is the range of returns that an investor would expect to receive 90% of the time? a. 10.5% to 13% b. −2.5% to 23.5% c. −28.5 to 49.5% d. −15.5% to 36.5% e. 0% to 10.5% ANS: D The range of returns is between 10.5 − 2(13) and 10.5 + 2(13) = −15.5 and 36.5. PTS: 1
OBJ: Multiple Choice Problem
55. You are trying to decide between a par value corporate bond carrying a coupon rate of 6.25% per year and a par value municipal bond that pays an annual coupon rate of 4.75%. Assuming all other factors are the same and you are in the 28% tax bracket, which bond should you choose and why? a. Corporate bond because the after tax yield is 6.25%. b. Corporate bond because the after tax yield is 4.5%. c. Municipal bond because the equivalent taxable yield is 6.3%. d. Municipal bond because the equivalent taxable yield is 6.6%. e. You will be indifferent between the two because the after tax yields are the same. ANS: D The municipal bond has an equivalent taxable yield of 0.475/(1 − 0.28) = 0.066. This is higher than the bond yield of .0625. PTS: 1
OBJ: Multiple Choice Problem
56. What range of returns would an investor expect to achieve 99% of the time on an investment with an expected return of 11% and a standard deviation of 16%? a. 5% to 27% b. −5% to 27% c. −21% to 43% d. −37% to 59% e. 5% to 21% ANS: D Assuming the returns are normally distributed a 99% confidence interval is constructed by 11% plus or minus three times the standard deviation. 11% − 3(16%) to 11% + 3(16%) = −37% to 59% PTS: 1
OBJ: Multiple Choice Problem
57. If the nominal return on an investment of common stocks was 11% and inflation was 2.5% annually, what was the real return on common stock? a. 8.3% b. 8.5% c. 9.7% d. 11.0% e. 12.6% ANS: A (1.11)/(1.025) − 1 = 0.0829 or 8.3%
PTS: 1
OBJ: Multiple Choice Problem
58. If the real return for corporate bonds was 4% and the inflation rate was 2%, what is the nominal return for corporate bonds? a. 1.96% b. 2.00% c. 4.00% d. 6.08% e. 6.42% ANS: D (1.04)(1.02) − 1 = 0.068 or 6.08% PTS: 1
OBJ: Multiple Choice Problem
59. What is the 95 percent confidence interval for an investment with an expected return of 9 percent and a standard deviation of 15%? a. 9% to 15% b. −6% to 24% c. −15% to 32% d. −21% to 39% e. −36% to 56% ANS: D 95% confidence interval is 2 standard deviations from the mean 9% − 2(15%) to 9% + 2(15%) −21% to 39% PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 3 APPENDIX MULTIPLE CHOICE Exhibit 3A.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Given the following annual returns for both Alpine Corporation and Tauber Industries:
Year 1995 1996 1997 1998 1999
Alpine's Rate of Return 5 9 11 −10 12
Tauber's Rate of Return 9 16 −16 12 9
1. Refer to Exhibit 3A.1. Calculate the covariance. a. −32.20 b. −23.32 c. 1.00 d. 23.32 e. 32.20 ANS: A Alpine's average return equals (5 + 9 + 11 − 10 + 12) 5 = 27 5 = 5.4 Tauber's average return equals (9 + 16 − 16 + 12 + 9) 5 = 30 5 = 6.0 Alpine (A − Amean) 5 − 5.4 = −0.4 3.6 9 − 5.4 = 5.6 11 − 5.4 = −10 − 5.4 = −15.4 6.6 12 − 5.4 =
Tauber (T − Tmean) 3 9−6 = 16 − 6 = 10 −16 − 6 = −22 6 12 − 6 = 3 9−6 =
[A − Amean] [T − Tmean] (−0.4) (3.0) = −1.2 = 36.0 (3.6) (10) (5.6) (−22) = −123.2 (−15.4) (6) = −92.4 19.8 (6.6) (3) = −161.00 COVAT = −161.00 5 = −32.20 PTS: 1
OBJ: Multiple Choice Problem
2. Refer to Exhibit 3A.1. Calculate the coefficient of correlation. a. −0.456 b. −0.354 c. 0.000 d. 0.456 e. 3.538 ANS: B Alpine (A − Amean)2 0.16 (5 − 5.4)2 = 2 (9 − 5.4) = 12.96 (11 − 5.4)2 = 31.36 (−10 − 5.4)2 = 237.16 (12 − 5.4)2 = 43.56 Sum 325.2
Tauber (T − Tmean)2 9 (9 − 6)2 = 2 (16 − 6) = 100 (−16 − 6)2 = 484 (12 − 6)2 = 36 9 (9 − 6)2 = Sum 638
A2 = 325.2 5 = 65.04
2T = 638 5 = 127.6
A = 8.06
T = 11.30
rA,Y = COVA,T A T = −32.20 (8.06)(11.30) = −0.354 PTS: 1
OBJ: Multiple Choice Problem
3. What is the correlation coefficient for two assets with a covariance of .0032, if asset 1 has a standard deviation of 12 percent and asset 2 has a standard deviation of 9 percent? a. 0.2963 b. 0.3456 c. 0.8721 d. 1.5980 ANS: A Correlation coefficient is equal to the Covariance divided by the product of the two individual standard deviations. .0032/(.12)(.09) = .0032/.0108 = 0.2963 PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 4—ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS TRUE/FALSE 1. A market is a means through which buyers and sellers are brought together to aid in the transfer of goods and/or services. ANS: T
PTS: 1
2. It is required by law that a stock market must have a physical location. ANS: F
PTS: 1
3. If transaction prices are volatile, but long-term prices are stable, this is referred to as price continuity. ANS: F
PTS: 1
4. A continuous market that has price continuity requires depth of buyers and sellers. ANS: T
PTS: 1
5. A market where prices adjust rapidly to new information is considered to be internally efficient. ANS: F
PTS: 1
6. Informational efficiency is where the cost of acquiring information is very cheap. ANS: F
PTS: 1
7. The primary market is where issues are traded between current and potential owners. ANS: F
PTS: 1
8. Negotiation, competitive bids, and best efforts are three forms of underwriting arrangements. ANS: T
PTS: 1
9. A corporation wishing to raise funds will normally want the investment banker to use a "best efforts" arrangement rather than a negotiated basis. ANS: F
PTS: 1
10. Rule 415, shelf registration, allows large firms to register ten years worth of financing needs all at one time. ANS: F
PTS: 1
11. Only the stocks of large companies are traded in the primary market. ANS: F
PTS: 1
12. A good secondary market is important to the efficiency of the primary market. ANS: T
PTS: 1
13. The NYSE has dominated the other U.S. exchanges in trading volume. ANS: T
PTS: 1
14. In recent years there has been a trend toward the consolidation of existing exchanges in developed markets, such as London, Frankfurt and Paris. ANS: T
PTS: 1
15. Listed stocks traded on the over-the-counter market are being traded in the third market. ANS: T
PTS: 1
16. The over-the-counter market includes all stocks not listed on one of the major exchanges but constitutes a lesser of a dollar value than the New York and American Exchanges combined. ANS: T
PTS: 1
17. The over-the-counter market lists more stocks than the New York Stock Exchange and the American Stock Exchange combined. ANS: T
PTS: 1
18. The value of the stocks traded in the over-the-counter market is greater than the combined values of the stocks traded on the New York Stock Exchange and the American Stock Exchange combined. ANS: F
PTS: 1
19. The Nasdaq National Market System is an order driven market. ANS: F
PTS: 1
20. Margin transaction involves borrowing part of the cost of an investment. ANS: T
PTS: 1
21. Short selling is practiced when an investor borrows part of the cost of the investment, e.g., they are "short" on cash. ANS: F
PTS: 1
22. The NYSE is a dealer market. ANS: F
PTS: 1
23. A block house is a brokerage firm that buys and sells blocks of stock for institutions. ANS: T
PTS: 1
24. Super DOT is an electronic order-routing system through which member firms can transmit market and limit orders directly to the posts where the securities are traded. ANS: T
PTS: 1
25. Global trading has eroded the NYSE's share of the market for NYSE-listed stocks. ANS: T
PTS: 1
26. Rule 415 allows corporations to place securities privately with large, sophisticated institutional investors without extensive registration documents. ANS: F
PTS: 1
27. Secondary equity issues are new shares offered by firms that already have stock outstanding. ANS: F
PTS: 1
28. In a pure auction market buyers and sellers submit bid-and-ask prices for a given stock to a central location. ANS: T
PTS: 1
29. In a dealer market trading system shares of stock are sold to the investor with the highest bid price and bought from the seller with the lowest offering price. ANS: F
PTS: 1
30. Specialists provide added liquidity in the Nasdaq market. ANS: F
PTS: 1
31. Initial public offerings (IPOs) involve selling of bonds to the public for the first time. ANS: F
PTS: 1
32. Rule 144A reduced registration documentation requirements for placing securities privately with large institutional investors. ANS: T
PTS: 1
33. A pure auction market is also referred to as a quote-driven market. ANS: F
PTS: 1
MULTIPLE CHOICE 1. Which of the following statements about a market is true? a. It is not necessary for the market to have a physical location. b. The market does not necessarily own the goods or services involved. c. A market can deal in any variety of goods and services. d. All of the above e. None of the above
ANS: D
PTS: 1
OBJ: Multiple Choice
2. Which of the following is not a characteristic of a good market for goods and services? a. Timely and accurate information b. Liquidity c. Low transaction costs d. External efficiency e. All of the above are characteristics of a good market. ANS: E
PTS: 1
OBJ: Multiple Choice
3. Which of the following is not a secondary equity market? a. Treasury market b. National exchanges c. Regional exchanges d. Over-the-counter market e. All of the above are secondary equity markets. ANS: A
PTS: 1
OBJ: Multiple Choice
4. Regional exchanges exist because a. They provide trading facilities for local companies b. They allow local brokers to trade dual listed stocks c. They allow for trading of local bonds d. a and b. e. b and c. ANS: D
PTS: 1
OBJ: Multiple Choice
5. An order that specifies the highest buy or lowest sell price is a a. Limit order. b. Short sale. c. Market order. d. Margin call. e. Stop loss. ANS: A
PTS: 1
OBJ: Multiple Choice
6. When an investor borrows part of the investment cost it is known as a. A short sale. b. A fill or kill order. c. A margin transaction. d. A limit order. e. Going long. ANS: C
PTS: 1
OBJ: Multiple Choice
7. Which of the following is not a function of the specialist? a. Assists the Federal Reserve in controlling the money supply b. Acts as a broker who handles the limit orders or special orders placed with member brokers c. Buys and sells securities in order to stabilize the market d. Acts as a dealer in assigned stocks to maintain a fair and orderly market e. All of the above are functions of a specialist
ANS: A
PTS: 1
OBJ: Multiple Choice
8. The member of the New York Stock Exchange who acts as a dealer on assigned stocks is known as a a. Registered trader. b. Commission broker. c. Registered broker. d. Floor broker. e. Specialist. ANS: E
PTS: 1
OBJ: Multiple Choice
9. Floor brokers on the New York Stock Exchange a. Use their membership to buy and sell for their own account. b. Are employees of a member firm and buy and sell for customers of the firm. c. Handle limit and other orders placed by other brokers. d. Act as brokers for other members. e. Maintain a fair and orderly market. ANS: D
PTS: 1
OBJ: Multiple Choice
10. A block trade is one which involves a minimum of a. 1,000 shares. b. 5,000 shares. c. 10,000 shares. d. 100,000 shares. e. 1,000,000 shares. ANS: C
PTS: 1
OBJ: Multiple Choice
11. In a call market, trading for individual stocks a. Occurs anytime the market is open. b. Takes place at specific times. c. Takes place at the open and close of the trading day. d. All of the above. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
12. A pure auction market is one in which a. Dealers provide liquidity by buying and selling shares of stock for themselves. b. Dealers compete against each other to provide the highest bid and lowest asking prices. c. Buyers submit bid prices to sellers. d. Sellers submit ask prices to buyers. e. Buyers and sellers submit bid and ask prices to a central location to be matched. ANS: E
PTS: 1
OBJ: Multiple Choice
13. In a negotiated bid, the underwriter carries out the following service(s) a. Origination, risk-bearing, and distribution. b. Origination and risk-bearing. c. Risk-bearing and distribution. d. Origination and distribution. e. Risk-bearing and distribution. ANS: A
PTS: 1
OBJ: Multiple Choice
14. Municipal bonds are sold using the following method or methods: a. Competitive bid b. Negotiated sale c. Private placement d. All of the above e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
15. When a market is externally efficient, it means that a. Timely and accurate information is available b. The market is liquid c. Transaction costs are low d. Prices adjust rapidly to new information e. The number of buyers and sellers are the same ANS: D
PTS: 1
OBJ: Multiple Choice
16. When a market is internally efficient, it means that a. The market has price continuity. b. The market has minimal transactions costs c. The market has good depth d. The market has more buyers than sellers e. The market has more sellers than buyers ANS: B
PTS: 1
OBJ: Multiple Choice
17. Trading in the secondary markets for U.S. Government and municipal bonds a. Takes place through a network of primary dealers b. Takes place over the counter by dealers who buy and sell on their own account c. Takes place on the NYSE bond annex d. All of the above e. None of the above ANS: A
PTS: 1
OBJ: Multiple Choice
18. Which of the following is an underwriting function? a. Origination b. Risk-bearing c. Distribution d. Choices b and c e. All of the above ANS: E
PTS: 1
OBJ: Multiple Choice
19. With a best effort offering, the investment banker performs all of the following roles except: a. determines the fee paid to themselves for handling the issue. b. manages the selling group for the new issue. c. evaluates market conditions and determines the characteristics of the security. d. guarantees the selling price for the entire issue to the firm issuing the securities. e. All of the above are true. ANS: D
PTS: 1
OBJ: Multiple Choice
20. The basic distinction between a primary and a secondary market is a. proceeds from sales in the primary market go to the current owner of a security; proceeds
in secondary market go to the original owner. b. primary markets involve direct dealings within regional exchanges. c. only new securities are sold in the primary market; only outstanding securities are bought and sold in the secondary market. d. primary markets deal exclusively in bonds; secondary markets deal primarily in common stock. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
21. Trading in the secondary markets for Corporate bonds a. Takes place through a network of primary dealers b. Takes place over the counter by dealers who buy and sell on their own account c. Takes place on the NYSE bond annex d. All of the above e. None of the above ANS: B
PTS: 1
OBJ: Multiple Choice
22. Secondary markets are important because a. The prevailing market price of securities is determined in the secondary market b. It has an impact on price stability c. It has an impact on price continuity d. All of the above e. None of the above ANS: A
PTS: 1
OBJ: Multiple Choice
23. Which of the following is not a characteristic of shelf registrations? Shelf registrations: a. Were introduced by Rule 415. b. Allow large firms to register security issues and sell them piecemeal during the following six years. c. Provide flexibility and reduce registration fees and expenses. d. Are typically used for the sale of straight debentures rather than common stock or convertible issues. e. All of the above are characteristics of shelf registrations. ANS: B
PTS: 1
OBJ: Multiple Choice
24. All of the following are advantages of secondary markets except a. Provide liquidity to individuals holding the securities. b. Support the primary market by reducing the required rate of return due to the lower liquidity risk for securities. c. Provide price discovery for corporations selling seasoned securities. d. Impact market efficiency and price volatility. e. All of the above are advantages of secondary markets. ANS: E
PTS: 1
OBJ: Multiple Choice
25. Which of the following is not a major category of membership in stock exchanges? a. Specialist b. Commission broker c. Floor broker d. Financial analyst e. Registered trader
ANS: D
PTS: 1
OBJ: Multiple Choice
26. Investors can leverage their stock transactions with the use of a. Margin orders b. Stop loss orders c. Limit orders d. Market orders e. Specialists ANS: A
PTS: 1
OBJ: Multiple Choice
27. All of the following are characteristics of a dealer market except: a. Also referred to as a quote-driven market b. NASDAQ market is a dealer market c. Individual dealers buy and sell shares for themselves d. Centralized trading location e. All of the above are characteristics of a dealer market ANS: D
PTS: 1
OBJ: Multiple Choice
28. The US secondary market with the largest number of issues traded is the: a. AMEX b. NASDAQ c. NYSE d. LSE e. Both a and c ANS: B
PTS: 1
OBJ: Multiple Choice
29. A 1994 study concluded dealers were colluding to maintain wide bid/ask spreads by concentrating market quotes in quarters instead of eighths. This study eventually led to new order handling rules that required quotes to be available to the public through: a. NASDAQ market b. Electronic communications networks (ECN) c. High frequency trading (HFT) d. Algorithmic trading (AT) e. Intermarket trading system (ITS) ANS: B
PTS: 1
OBJ: Multiple Choice
Exhibit 4.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Jackie has a margin account with a balance of $150,000. The initial margin deposit is 60 percent and Turtle Industries is currently selling at $50 per share. 30. Refer to Exhibit 4.1. How many shares of Turtle can Jackie purchase? a. 5,000 b. 3,000 c. 1,800 d. 1,200 e. None of the above ANS: A Letting X = total investment, Jackie's share will represent 60 percent.
Thus .60X = $150,000 and X = $150,000 .60 = $250,000. At $50 per share, she can purchase ($250,000 $50) = 5000 shares. PTS: 1
OBJ: Multiple Choice Problem
31. Refer to Exhibit 4.1. What is Jackie's profit/loss if Turtle's price after one year is $40? a. $50,000 b. −$50,000 c. $100,000 d. −$100,000 e. None of the above ANS: B Profit = (40 − 50)(5000) = −$50,000 PTS: 1
OBJ: Multiple Choice Problem
32. Refer to Exhibit 4.1. If the maintenance margin is 25 percent, to what price can Turtle Industries fall before Jackie receives a margin call? a. $14.56 b. $23.17 c. $32.42 d. $26.67 e. None of the above ANS: D Margin = (Market Value − Debit Balance) Market Value, where Debit Balance = initial loan value = ($250,000 − $150,000) = $100,000 Market Value = Price Number of Shares = 5000P Thus 0.30 = (5000P − $100,000) (5000P) P = $26.67 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 4.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Heidi Talbott has a margin account with a balance of $50,000. The initial margin deposit is 50 percent, and RC Industries is currently selling at $50 per share. 33. Refer to Exhibit 4.2. How many shares of RC can Heidi buy? a. 2,500 b. 2,000 c. 1,000 d. 500 e. None of the above ANS: B Letting P = price and Q = quantity of shares, Heidi's share of the investment will = 50% of PQ. Thus 0.50PQ = $50,000 and PQ = $50,000/0.50 = $100,000 At $50 per share, she can purchase ($100,000 $50) = 2000 shares.
PTS: 1
OBJ: Multiple Choice Problem
34. Refer to Exhibit 4.2. What is Heidi's profit if RC's price rises to $80? a. $55,000 b. $50,000 c. $60,000 d. $68,270 e. $28,570 ANS: C Profit = (80 − 50)(2000) = $60,000 PTS: 1
OBJ: Multiple Choice Problem
35. Refer to Exhibit 4.2. If the maintenance margin is 25 percent, to what price can RC Industries stock price fall before Heidi receives a margin call? a. $21.75 b. $23.33 c. $32.00 d. $33.33 e. None of the above ANS: D Margin = (Market Value − Debit Balance) Market Value, where Debit Balance = initial loan value = ($100,000 − $50,000) = $50,000 Market Value = Price Number of Shares = 2000P Thus 0.25 = (2000P − $60,000) (2000P) P = $33.33 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 4.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Kathy Smith has a margin account with a balance of $60,000. Initial margin requirements are 80 percent, and Jackson Industries is currently selling at $40 per share. 36. Refer to Exhibit 4.3. How many shares of Jackson can Kathy buy? a. 1875 b. 1500 c. 1750 d. 1200 e. None of the above ANS: A Letting P = price and Q = quantity of shares, Kathy's share will represent 80% of PQ. Thus 0.80X = $60,000 and X = $60,000 .80 = $75,000. At $40 per share, she can purchase ($75,000 $40) = 1875 shares. PTS: 1
OBJ: Multiple Choice Problem
37. Refer to Exhibit 4.3. What is Kathy's profit if Jackson's price rises to $50? a. $18,750 b. $15,750 c. $55,000 d. $37,750 e. $28,570 ANS: A Profit = (50 − 40)(1875) = $18,750 PTS: 1
OBJ: Multiple Choice Problem
38. Refer to Exhibit 4.3. If the maintenance margin is 25 percent, to what price can Jackson Industries fall before Kathy receives a margin call? a. $21.75 b. $23.00 c. $10.67 d. $15.93 e. None of the above ANS: C Margin = (Market Value − Debit Balance) Market Value, where Debit Balance = initial loan value = ($75,000 − $60,000) = $15,000 Market Value = Price Number of Shares = 1875P Thus 0.25 = (1875P − $15,000) 1875P P = $10.67 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 4.4 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You decide to sell 100 shares of Davis Industries short when it is selling at its yearly high of $35. Your broker tells you that your margin requirement is 55 percent and that the commission on the sale is $15. While you are short, Davis pays a $0.75 per share dividend. At the end of one year you buy your Davis shares (cover your short sale) at $30 and are charged a commission of $15 and a 6 percent interest rate. 39. Refer to Exhibit 4.4. What is your dollar return on the investment? a. $130.50 b. $300.50 c. $100.00 d. $1,773.75 e. $3,500.00 ANS: B Profit = $3500 − $3000 − $75 − $15 − $15 − (1 − 0.55)(3500)(0.06) = $300.50 PTS: 1
OBJ: Multiple Choice Problem
40. Refer to Exhibit 4.4. What is your rate of return on the investment? a. 10.48% b. 12.87%
c. 13.98% d. 15.49% e. 18.87% ANS: D Rate of Return = Profit Initial Investment Initial investment = (.55 $3500) + $15 = $1,940 Rate of Return = $300.50/$1,940 = 15.49% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 4.5 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You decide to sell 100 shares of Topgun Enterprises Inc. short when it is selling at its yearly high of $42.25. Your broker tells you that your margin requirement is 60 percent and that the commission on the sale is $20. While you are short, Topgun pays a $0.85 per share dividend. At the end of one year you buy your Topgun shares (cover your short sale) at $44 and are charged a commission of $20 and a 5 percent interest rate. 41. Refer to Exhibit 4.5. What is your dollar return on the investment? a. $384.50 b. $432.88 c. −$432.88 d. −$384.50 e. −$950.55 ANS: D Profit = $4225 − $4400 − $85 − $20 − $20 − (1 − 0.60)(4225)(0.05) = −$384.50 PTS: 1
OBJ: Multiple Choice Problem
42. Refer to Exhibit 4.5. What is your rate of return on the investment? a. 10.48% b. 12.87% c. −13.98% d. −24.49% e. −15.05% ANS: E Rate of Return = Profit Initial investment Initial investment = (0.60 $4225) + 20 = $2,555 Rate of Return = −$384.50/$2,555.00 = −15.05% PTS: 1
OBJ: Multiple Choice Problem
43. Suppose you buy a round lot of DG Solutions stock on 60% margin when it is selling at $55 a share. The broker charges a 10 percent annual interest rate and commissions are 3 percent of the total stock value on both the purchase and the sale. If at year end you receive a $1.10 per share dividend and sell the stock for 55 5/8, what is your rate of return on the investment? a. −10.38% b. −12.84%
c. −10.95% d. 21.84% e. 28.38% ANS: C Rate of Return = Profit Initial investment Profit = Total Return − Initial Stock Value − Transaction Costs − Interest Total Return = Ending Market Value + Dividend Value = $5,562.50 + $110.00 = $5,672.50 Initial Stock Value = 100($55) = $5,500.00 Transaction Costs = (0.03)(5,500) + (0.03)(5,562.50) = $331.86 Interest = (0.10)(0.40)($5,500) = $220.00 Profit = $5,672.50 − $5,500.00 − $331.86 − $220.00 = −$379.36 Initial investment
= Margin deposit + Commission = (0.60)($5,500.00) + (0.03)($5,500.00) = $3,465
Rate of Return = −$379.36/$3,465 = −.10948 = −10.95% PTS: 1
OBJ: Multiple Choice Problem
44. Suppose you buy a round lot of HS Inc. stock on 55% margin when it is selling at $40 a share. The broker charges a 10 percent annual interest rate and commissions are 4 percent of the total stock value on both the purchase and the sale. If at year end you receive a $0.90 per share dividend and sell the stock for 35 5/8, what is your rate of return on the investment? a. −35.17% b. −21.84% c. 14.74% d. 21.84% e. 35.17% ANS: A Rate of Return = Profit Initial investment Profit = Total Return − Initial Stock Value − Transaction Costs − Interest Total Return = Ending Market Value + Dividend Value = $3562.50 + $90= $3652.50 Initial Stock Value = 100($40) = $4000 Transaction Costs = (0.04)(4000) + (0.04)(3562.50) = $302.50 Interest = (0.10)(0.45)($4000) = $180.00 Profit = $3652.50 − $4000 − $302.50 − $180.00 = −$830.00 Initial investment
= Margin deposit + Commission = (0.55)($4,000) + (0.04)($4,000) = $2,360
Rate of Return = −$830.00/$2360 = −0.3517 = −35.17% PTS: 1
OBJ: Multiple Choice Problem
45. Suppose you buy a round lot of Altman Industries stock on 50% margin when it is selling at $35 a share. The broker charges a 10 percent annual interest rate and commissions are 5 percent of the total stock value on both the purchase and the sale. If at year end you receive a $1.00 per share dividend and sell the stock for $42.63, what is your rate of return on the investment? a. 15.58% b. 11.84% c. 14.74% d. 21.84% e. 28.38% ANS: A Rate of Return = Profit Initial Investment Profit = Total Return − Initial Stock Value − Transaction Costs − Interest Total Return = Ending Market Value + Dividend = $4263 + $100 = $4363 Initial Stock Value = 35(100) = $3,500.00 Transaction Costs = .05 3,500 + (0.05)(4,263) = $388.15 Interest = (0.10)(0.50)($3,500) = $175.00 Profit = $4,363 − $3,500 − $175.00 − $388.15 = $299.85 Initial investment
= Margin deposit + Initial investment = .50 $3,500 + .05 $3,500 = $1,925
Rate of Return = $299.85/$1,925 = 15.58% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 4.6 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You decide to sell short 200 shares of XCorp stock at a price of $75. Your margin deposit is 65 percent. Commission on the sale is 1.25%. While you are short, the stock pays a $1.75 per share dividend. Interest on margin debt is 5.25% per year. 46. Refer to Exhibit 4.6. At the end of one year you close out your short position by purchasing share of XCorp at $45 per share. The commission is 1.25%. What is your rate of return on the investment? a. −55.92% b. 10.31% c. 51.06% d. 23.1% e. −33.05% ANS: C Rate of return = [75 − 45 − 0.9375 − 0.5625 − 1.75 − (1 − .65)(75)(.0525)]/[(.65)(75) + 0.9375] = 51.06% PTS: 1
OBJ: Multiple Choice Problem
47. Refer to Exhibit 4.6. Suppose at the end of one year XCorp is selling at $90 per share and you cover your short position at this price. What is your rate of return on the investment? (Assume a 1.25% commission on the purchase.) a. −40.64% b. −25.53%
c. 5.21% d. 72.7% e. −71.2% ANS: A Rate of return = [75 − 90 − 0.9375 − 1.125 − 1.75 − (1 − .65)(75)(.0525)]/[(.65)(75) + 0.9375] = −40.64% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 4.7 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Shares of RossCorp stock are selling for $45 per share. Brokerage commissions are 2% for purchases and 2% for sales. The interest rate on margin debt is 6.25% per year. The maintenance margin is 30%. 48. Refer to Exhibit 4.7. At the end of one year shares of RossCorp stock are selling for $55 per share and the company paid dividends of $0.85 per share. Assuming that you paid the full cost of the purchase, what is your rate of return if you sell RossCorp stock? a. 18.08% b. 23.51% c. 22.32% d. 14.96% e. 19.28% ANS: E Rate of return = [55 − 45 + 0.85 − 1.10 − 0.90]/[45 + 0.90] = 19.28% PTS: 1
OBJ: Multiple Choice Problem
49. Refer to Exhibit 4.7. At the end of one year shares of RossCorp stock are selling for $35 per share and the company paid dividends of $0.85 per share. Assuming that you paid the full cost of the purchase, what is your rate of return if you sell RossCorp stock? a. −33.05% b. −23.42% c. 23.42% d. 33.05% e. −25.35% ANS: B Rate of return = [35 − 45 + 0.85 − 0.70 − 0.90]/[45 + 0.90] = −23.42% PTS: 1
OBJ: Multiple Choice Problem
50. Refer to Exhibit 4.7. At the end of one year shares of RossCorp stock are selling for $55 per share and the company paid dividends of $0.85 per share. Assuming that you borrowed 25% of cost of the purchase, what is your rate of return? a. −23.51% b. 29.35% c. 23.51% d. 5.21% e. 10.06% ANS: C
Rate of return = [55 − 45 + 0.85 − 1.10 − 0.90 − (1 − .75)(45)(.0625)]/[(0.75)(45) + 0.90] = 23.51% PTS: 1
OBJ: Multiple Choice Problem
51. Refer to Exhibit 4.7. At the end of one year shares of RossCorp stock are selling for $35 per share and the company paid dividends of $0.85 per share. Assuming that you borrowed 25% of cost of the purchase, what is your rate of return? a. 33.05% b. −33.05% c. −23.51% d. −25.35% e. −40.64% ANS: B Rate of return = [35 − 45 + 0.85 − 0.70 − 0.90 − (1 − .75)(45)(.0625)]/[(0.75)(45) + 0.90] = −33.05% PTS: 1
OBJ: Multiple Choice Problem
52. Refer to Exhibit 4.7. Assume that you purchase 150 shares of RossCorp stock at $45 each by making a margin deposit of 55%. At what price would you receive a margin call? a. $29.39 b. $26.48 c. $50.39 d. $28.93 e. $50.10 ANS: D 0.30 = [(150)(P) − (0.45)(150)(45)]/[(150)(P)] 0.30 = [(150)(P) − 3,037.50]/[(150)(P)] 45P = 150P − 3037.50 −105P = −3037.50 P = $28.93 PTS: 1
OBJ: Multiple Choice Problem
53. You own 50 shares of Auto Corporation that you purchased for $30 a share. The stock is currently selling for $50 a share and you placed a stop loss order at $45. If the stock price drops to $35 a share what is your return on this investment? a. −30.0% b. 16.7% c. 50.0% d. 66.7% e. 150.0% ANS: C ($45 − $30)/$30 = $15/$30 = 0.50 or 50% PTS: 1
OBJ: Multiple Choice Problem
54. You purchased 100 shares of Highlight Company for $20 a share one year ago with a margin of 50%. The stock is currently selling for $28 a share and no dividends were ever paid. The broker charges an annual interest rate of 8% and a $100 commission on both the purchase and sale of these shares. What is your annual rate of return on this investment? a. 21% b. 47% c. 52% d. 60% e. 72% ANS: B Annual Rate of Return = Profit/Initial Investment Profit = Ending Market Value − Initial Stock Value − Commissions − Interest = (100*$28) − (100*$20) − (2*$100) − (0.08*0.5*100*$20) = $2,800 − $2,000 − $200 − $80 = $520 Annual Rate of Return = $520/(.50*100*$20) = 520/(1,000 + 100) = 0.47 or 47% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 4.8 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You sell 100 shares short of AMF Corporation when it is selling at $45 per share. Your margin requirement is 60% and the commission on the sale is $50 and the broker charges 10% annual interest. AMF Corporation paid a $0.50 per share dividend while you were short the stock. After one year you cover your short sale at $35 per share with a $50 commission for the purchase. 55. Refer to Exhibit 4.8. What is your total dollar return on this investment? a. $1,000 b. $900 c. $850 d. $670 e. $520 ANS: D Profit = $4,500 short sale − $3,500 cover − $50 for dividends − $100 for commissions − (1 − .60)($4,500)(0.10) interest expense = $850 − $180 = $670 PTS: 1
OBJ: Multiple Choice Problem
56. Refer to Exhibit 4.8. What is your annual rate of return on this investment? a. 18% b. 24% c. 25% d. 36% e. 37% ANS: B Return = Profit/Initial Investment = $670/(.6*$4,500 + $50) = $670/$2750 = 0.244 PTS: 1
OBJ: Multiple Choice Problem
57. Suppose you purchase 200 shares of Best Hat Corporation at $52 a share by making a margin deposit of 50%. If the maintenance margin is 30%, at what price will you receive a margin call?
a. b. c. d. e.
$37.14 $37.95 $38.23 $38.76 $39.42
ANS: A 0.30 = [(200)(P) − (0.50)(200)(52)]/[(200)(P)] 0.30 = [(200)(P) − 5,200]/[(200)(P)] 60P = 200P − 5,200 −140P = −5,200 P = $37.14 PTS: 1
OBJ: Multiple Choice Problem
58. You purchased 75 shares of Basket Company for $42 a share. One share of the stock is currently trading between $52 and $53 and you placed a stop loss order at $47. If the stock price drops to $40 a share, what is your return on this investment? a. 8.7% b. 9.2% c. 10.3% d. 11.9% e. 12.8% ANS: D ($47 − $42)/$42 = $5/$42 = 0.11905 or 11.9% PTS: 1
OBJ: Multiple Choice Problem
59. You sell short 100 shares of Hi-Light Corporation when it is trading at $70. Your margin requirement is 50%. Assuming there was no commission and the maintenance margin is 25%, at what stock price would you receive a margin call? a. $76 b. $80 c. $84 d. $88 e. $92 ANS: C (your equity)/(value of stock owned) = 0.25 [(100)($70) + (0.50)(100)($70) − 100P]/100P = 0.25 [$7,000 + $3,500 − 100P]/100P = 0.25 $10,500 − 100P = 25P $10,500 = 125P P = $84 PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 5—SECURITY-MARKET INDEXES TRUE/FALSE 1. The general purpose of a market indicator series is to provide an overall indication of aggregate market changes or movements. ANS: T
PTS: 1
2. An aggregate market index can be used as a benchmark to judge the performance of professional money managers. ANS: T
PTS: 1
3. A price weighted series is disproportionately influenced by larger capitalization companies. ANS: F
PTS: 1
4. The Dow Jones Industrial Average is a value weighted average. ANS: F
PTS: 1
5. A two for one stock split causes the divisor in a price-weighted series to decline. ANS: T
PTS: 1
6. The Dow Jones Industrial Average has been criticized for being blue-chip biased. ANS: T
PTS: 1
7. Unlike the Dow Jones Industrial Average, the Nikkei-Dow Jones Average is price weighted. ANS: F
PTS: 1
8. A value weighted index automatically adjusts for stock splits. ANS: T
PTS: 1
9. The New York Stock Exchange Index is based on a sample of all of the New York Stock Exchange stocks. ANS: F
PTS: 1
10. An equally weighted indicator series is also known as an unweighted indicator series. ANS: T
PTS: 1
11. Bond-market indicator series have been around much longer than stock-market indicator series. ANS: F
PTS: 1
12. It is easier to construct an indicator series for bonds because of their relatively stable returns pattern.
ANS: F
PTS: 1
13. The major U.S. stock indexes are highly correlated. ANS: T
PTS: 1
14. To solve comparability problems across countries, global equity indexes with consistent sample selection, weighting and computational procedure have been developed. ANS: T
PTS: 1
15. There are no composite series currently available that will measure the performance of all securities (i.e. stocks and bonds) in a given country. ANS: F
PTS: 1
16. The NYSE series should have higher rates of return and risk measures than the AMEX and OTC series. ANS: F
PTS: 1
17. There is a high correlation between the Wilshire 5000 index and the alternative NYSE series (S&P 500 and the NYSE), representing the substantial influence of large NYSE stocks on the Wilshire 5000 index. ANS: T
PTS: 1
18. The low correlations between the U.S. and Japan confirm the benefit of global diversification. ANS: T
PTS: 1
19. The correlations among the U.S. investment-grade-bond series were very high because all rates of return for investment-grade bonds over time are impacted by common macroeconomic variables. ANS: T
PTS: 1
20. A bond market index is easier to create than a stock market index because the universe of bonds is much broader than that of stocks. ANS: F
PTS: 1
21. The Standard & Poor's 500 index is an example of a value weighted index. ANS: T
PTS: 1
22. The Standard & Poor's International Index consists of 3 international, 19 national, and 38 international industry indexes. ANS: F
PTS: 1
23. The most common way to test a portfolio manager's performance is to compare the portfolio return to a benchmark.
ANS: T
PTS: 1
24. A price-weighted index such as the DJIA is a geometric mean of current stock prices. ANS: F
PTS: 1
25. The Morgan Stanley group index for Europe, Australia, and the Far East (EAFE) is a price weighted index. ANS: F
PTS: 1
MULTIPLE CHOICE 1. Which of the following is not a use of security market indicator series? a. To use as a benchmark of individual portfolio performance b. To develop an index portfolio c. To determine factors influencing aggregate security price movements d. To use in the measurement of systematic risk e. To use in the measurement of diversifiable risk ANS: E
PTS: 1
OBJ: Multiple Choice
2. A properly selected sample for use in constructing a market indicator series will consider the sample's source, size and a. Breadth. b. Average beta. c. Value. d. Variability. e. Dividend record. ANS: A
PTS: 1
OBJ: Multiple Choice
3. In a price weighted average stock market indicator series, the following type of stock has the greatest influence a. The stock with the highest price b. The stock with the lowest price c. The stock with the highest market capitalization d. The stock with the lowest market capitalization e. The stock with the highest P/E ratio ANS: A
PTS: 1
OBJ: Multiple Choice
4. What effect does a stock substitution or stock split have on a price-weighted series? a. Index remains the same, divisor will increase/decrease. b. Divisor remains the same, index will increase/decrease. c. Index and divisor will both remain the same. d. Index and divisor will both reflect the changes (immediately). e. Not enough information is provided. ANS: A
PTS: 1
OBJ: Multiple Choice
5. Which of the following is not a value-weighted series? a. NASDAQ Industrial Index b. Dow Jones Industrial Average
c. Wilshire 5000 Equity Index d. American Stock Exchange Series e. NASDAQ Composite Index ANS: B
PTS: 1
OBJ: Multiple Choice
6. An example of a value weighted stock market indicator series is the a. Dow Jones Industrial Average. b. Nikkei Dow Jones Average. c. S & P 500 Index. d. Value Line Index. e. Shearson Lehman Hutton Index. ANS: C
PTS: 1
OBJ: Multiple Choice
7. In a value weighted index a. Exchange rate fluctuations have a large impact. b. Exchange rate fluctuations have a small impact. c. Large companies have a disproportionate influence on the index. d. Small companies have an exaggerated effect on the index. e. None of the above ANS: C
PTS: 1
OBJ: Multiple Choice
8. Of the following indices, which includes the most comprehensive list of stocks? a. New York Exchange Index b. Standard and Poor's Index c. American Stock Exchange Index d. NASDAQ Series Index e. Wilshire Equity Index ANS: E
PTS: 1
OBJ: Multiple Choice
9. The Value Line Composite Average is calculated using the ____ of percentage price changes. a. arithmetic average b. harmonic average c. expected value d. geometric average e. logarithmic average ANS: D
PTS: 1
OBJ: Multiple Choice
10. Which of the following is not a global equity indicator series? a. Morgan Stanley Capital International Indexes b. Dow Jones World Stock Index c. FT/S & P-Actuaries World Indexes d. Merrill Lynch-Wilshire World Indexes e. None of the above (that is, each is a global equity indicator series) ANS: D
PTS: 1
11. The Ryan Treasury Index is an example of a a. Bond market indicator series. b. Stock market indicator series. c. Composite security market series. d. World market series.
OBJ: Multiple Choice
e. Commodity market series. ANS: A
PTS: 1
OBJ: Multiple Choice
12. Studies of correlations among monthly equity price index returns have found: a. Low correlations between various U.S. equity indexes b. High correlations between various U.S. equity indexes c. High correlations between U.S. and non-U.S. equity indexes d. Negative correlations between various U.S. equity indexes e. None of the above ANS: B
PTS: 1
OBJ: Multiple Choice
13. Which of the following is true of the various market index series? a. A low correlation exists between the U.S. indexes and those of Japan. b. The NYSE series have higher rates of return and risk measures than the AMEX and OTC series. c. A low correlation exists between alternative series that include almost all NYSE stocks. d. A low correlation exists between alternative bond series. e. None of the above ANS: A
PTS: 1
OBJ: Multiple Choice
14. Which of the following are factors that make it difficult to create and maintain a bond index? a. The universe of bonds is broader than stocks. b. The universe of bonds is constantly changing due to new issues, bond maturities, calls, and bond sinking funds. c. It is difficult to derive value, up-to-date prices. d. Choices a and c e. All of the above ANS: E
PTS: 1
OBJ: Multiple Choice
15. Which of the following is not a U.S. investment-grade bond index? a. Merrill Lynch b. Ryan Treasury c. Salomon Brothers d. Lehman Brothers e. None of the above (that is, all are U.S. investment-grade bond indexes) ANS: E
PTS: 1
OBJ: Multiple Choice
16. The following are examples of Style Indexes a. Small-cap growth b. Mid-cap value c. Small-cap value d. All of the above e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
17. Studies of correlations among monthly U.S. bond price index returns have found: a. Low correlations between investment grade bonds and high yield bonds b. High correlations between investment grade bonds and high yield bonds c. Low correlations between various investment grade bond indexes d. Negative correlations between investment grade bonds and high yield bonds
e. None of the above ANS: A
PTS: 1
OBJ: Multiple Choice
18. Index movements are influenced by differential prices of the components in a(n) a. Equally-weighted index. b. Price-weighted index. c. Unweighted index. d. Value-weighted index. e. All of the above ANS: B
PTS: 1
OBJ: Multiple Choice
19. A style index created to track ethical funds is known as: a. Green index b. SRI index c. EAFE index d. Freedom index e. Ethical index ANS: B
PTS: 1
OBJ: Multiple Choice
20. Which index is created by first deriving the initial total market value of all stocks used in the index? a. Equally-weighted index. b. Price-weighted index. c. Unweighted index. d. Value-weighted index. e. All of the above ANS: D
PTS: 1
OBJ: Multiple Choice
21. The actual index movements are typically based on the arithmetic mean of the percent changes in price or value for the stocks in the a. Price-weighted index. b. Unweighted index. c. Value-weighted index. d. All of the above e. None of the above ANS: B
PTS: 1
OBJ: Multiple Choice
22. Which of the fundamental factors was not used in the Fundamental Index created by Research Affiliates, Inc.? a. Sales b. Profits (cash flow) c. Leverage (debt/equity) d. Net assets (book value) e. Dividends ANS: C
PTS: 1
OBJ: Multiple Choice
Exhibit 5.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Companies
Number of shares outstanding
Closing Prices Day T
(per share) Day T + 1
1 2 3 4
2,000 7,000 5,000 4,000
$30.00 55.00 20.00 40.00
$25.00 60.00 25.00 45.00
23. Refer to Exhibit 5.1. Assume that a stock price-weighted indicator consisted of the four issues with their prices. What are the values of the stock indicator for Day T and T + 1 and what is the percentage change? a. 36.25, 38.75, 6.9% b. 38.75, 36.25, −6.9% c. 100, 106.9, 6.9% d. 107.48, 106.33, 1.15% e. None of the above ANS: A Companies 1 2 3 4
Closing Prices Day T 30.00 55.00 20.00 40.00
(per share) Day T + 1 25.00 60.00 25.00 45.00
36.25
38.75
Therefore the index closed up 38.75/36.25 − 1 = 6.9% PTS: 1
OBJ: Multiple Choice Problem
24. Refer to Exhibit 5.1. For a value-weighted series, assume that Day T is the base period and the base value is 100. What is the new index value for Day T + 1 and what is the percentage change in the index from Day T? a. 106.33, 6.33% b. 107.48, 7.48% c. 109.93, 9.93% d. 108.7, 8.7% e. None of the above ANS: C Companies 1 2 3 4
Number of shares outstanding 2,000 7,000 5,000 4,000
Price Day T 30.00 55.00 20.00 40.00
Market value 60,000 385,000 100,000 160,000 705,000
Price Day T + 1 25.00 60.00 25.00 45.00
Market value 70,000 420,000 125,000 180,000
Base value equal to an index of 100
Companies 1 2 3 4
Number of shares outstanding 2,000 7,000 5,000 4,000
775,000 Therefore the index closed up 9.93%
PTS: 1
OBJ: Multiple Choice Problem
25. Refer to Exhibit 5.1. Compute an unweighted price indicator series, using geometric means. What is the percentage change in the index from Day T to Day T+1? Assume a base index value of 100 on Day T. a. 5.35% b. 7.48% c. 9.93% d. 6.33% e. None of the above ANS: D Companies 1 2 3 4
Price Day T 30 55 20 40
Price Day T + 1 25 60 25 45
(1 + return) 0.83 1.09 1.25 1.125
Index value day T + 1 = [(0.83)(1.09)(1.25)(1.125)]1/4 (100) = 106.33 Percentage change in index = 6.33% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 5.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Jan. 13, 2005 Jan. 14, 2005 Jan. 15, 2005 Jan. 16, 2005
X 20 25 27 20
Stock Price Y 40 42 45 40
Z 30 18 8 10
X 1000 1000 1000** 3000
# Shares Y 2000 2000 2000 2000
*2:1 Split on Stock Z after Close on Jan. 13, 2005 **3:1 Split on Stock X after Close on Jan. 15, 2005 The base date for index calculations is January 13, 2005 26. Refer to Exhibit 5.2. Calculate a price weighted average for January 13th. a. 32 b. 30 c. 36.13 d. 34 e. None of the above ANS: B
Z 1000* 2000 2000 2000
January 13 index = (20 + 40 + 30) 3 = 30 PTS: 1
OBJ: Multiple Choice Problem
27. Refer to Exhibit 5.2. What is the divisor at the beginning of January 14th? a. 3.0 b. 2.5 c. 2.2734 d. 1.9375 e. None of the above ANS: B January 14 adjusted divisor = (20 + 40 + 15) X = 30 X = 2.5 PTS: 1
OBJ: Multiple Choice Problem
28. Refer to Exhibit 5.2. Calculate a price weighted average for January 14th. a. 32 b. 30 c. 36.13 d. 34 e. None of the above ANS: D January 14 index = (25 + 42 + 18) 2.5 = 34 PTS: 1
OBJ: Multiple Choice Problem
29. Refer to Exhibit 5.2. Calculate a price weighed average for January 15th. a. 30 b. 36.13 c. 32 d. 34 e. None of the above ANS: C January 15 index = (27 + 45 + 8) 2.5 = 32 PTS: 1
OBJ: Multiple Choice Problem
30. Refer to Exhibit 5.2. What is the divisor at the beginning of January 16th? a. 1.9375 b. 3.0 c. 2.5 d. 2.2734 e. None of the above ANS: A January 16 divisor = (9 + 45 + 8) X = 32 X = 1.9375 PTS: 1
OBJ: Multiple Choice Problem
31. Refer to Exhibit 5.2. Calculate a price weighted average for January 16th.
a. b. c. d. e.
30 32 34 36.13 None of the above
ANS: D January 16 index = (20 + 40 + 10) 1.9375 = 36.13 PTS: 1
OBJ: Multiple Choice Problem
32. Refer to Exhibit 5.2. Calculate a value weighted index for Jan. 13th if the initial index value is 100. a. 111.54 b. 100 c. 102.31 d. 123.07 e. None of the above ANS: B January 13 index = 100 by definition PTS: 1
OBJ: Multiple Choice Problem
33. Refer to Exhibit 5.2. Calculate a value weighted index for Jan. 14th if the initial index value is 100. a. 100 b. 102.31 c. 123.07 d. 111.54 e. None of the above ANS: D Base Value = (20)(1000) + (40)(2000) + (30)(1000) = $130,000 January 14 Value = (25)(1000) + (42)(2000) + (18)(2000) = 145,000 Index = (145,000 130,000) 100= 111.5385 PTS: 1
OBJ: Multiple Choice Problem
34. Refer to Exhibit 5.2. Calculate a value weighted index for January 15th if the initial index value is 100. a. 102.31 b. 100 c. 123.07 d. 111.54 e. None of the above ANS: A January 15 Value = (27)(1000) + (45)(2000) + (8)(2000) = 133,000 Index = (133,000 130,000) 100 = 102.3077 PTS: 1
OBJ: Multiple Choice Problem
35. Refer to Exhibit 5.2. Calculate a value weighted index for January 16th if the initial index value is 100. a. 123.07
b. c. d. e.
100.00 102.31 111.54 None of the above
ANS: A January 16 Value = (20)(2000) + (40)(2000) + (10)(2000) = 160,000 Index = (160,000 130,000) 100 = 123.0769 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 5.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Year 2000 2001 2002 2003 2004
% Price Change for GB Industries 10.0% 12.0% 10.0% 11.0% 6.0%
36. Refer to Exhibit 5.3. Calculate the average annual rate of change for GB Industries for the 5 year period using the arithmetic mean. a. 0.098% b. 9.80% c. 8.50% d. 8.00% e. 89.00% ANS: B The Arithmetic Average is: (10 + 12 + 10 + 11 + 6) 5 = 9.8% PTS: 1
OBJ: Multiple Choice Problem
37. Refer to Exhibit 5.3. Calculate the average annual rate of change for GB Industries for the 5 year period using the geometric mean. a. 9.7800% b. 0.0978% c. 9.0700% d. 0.0970% e. 3.6400% ANS: A The Geometric Average is: [(1.10)(1.12)(1.10)(1.11)(1.06)]1/5 − 1 = 9.78% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 5.4 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Year 2000 2001
% Price Change for Stock Index 8.0% 10.0%
−14.0% 20.0% −10.0%
2002 2003 2004
38. Refer to Exhibit 5.4. Calculate the average annual rate of change for this index for the 5 year period using the arithmetic mean. a. 0.28% b. 1.28% c. 2.80% d. 3.58% e. 6.38% ANS: C The Arithmetic Average is: (8 + 10 − 14 + 20 − 10) 5 = 2.8% PTS: 1
OBJ: Multiple Choice Problem
39. Refer to Exhibit 5.4. Calculate the average annual rate of change for this index for the 5 year period using the geometric mean. a. 0.09% b. 1.99% c. 3.99% d. 4.50% e. 4.67% ANS: B The Geometric Average is: [(1.08)(1.10)(.86)(1.20)(.9)]1/5 − 1 = 1.99% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 5.5 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Stock W X Y Z
31-Dec-03 Price $ 75.00 $150.00 $ 25.00 $ 40.00
31-Dec-03 Shares 10000 5000 20000 25000
31-Dec-04 Price $50.00 $65.00 $35.00 $50.00
31-Dec-04 Shares 20000 10000 20000 25000
Stocks W and X had 2 for 1 splits after the close on Dec 31, 2003. 40. Refer to Exhibit 5.5. Calculate the price weighted series for Dec 31, 2003, prior to the splits. a. 81.69 b. 100.0 c. 72.5 d. 121.25 e. 119.25 ANS: C Price weighted series Dec 2003 = (75 + 150 + 25 + 40)/4 = 72.5 PTS: 1
OBJ: Multiple Choice Problem
41. Refer to Exhibit 5.5. Calculate the price weighted series for Dec 31, 2003, after the splits. a. 72.5 b. 100.0 c. 119.25 d. 121.25 e. 81.69 ANS: A Post split series = 72.5 = (37.5 + 75 + 25 + 40)/X The new divisor, X = 2.4483. PTS: 1
OBJ: Multiple Choice Problem
42. Refer to Exhibit 5.5. Calculate the price weighted series for Dec 31, 2004. a. 121.25 b. 119.25 c. 100.0 d. 72.5 e. 81.69 ANS: E Price weighted series Dec 2004 = (50 + 65 + 35 + 50)/2.4483 = 81.69 PTS: 1
OBJ: Multiple Choice Problem
43. Refer to Exhibit 5.5. Calculate the percentage return in the price weighted series for the period Dec 31, 2000 to Dec 31, 2004. a. 12.68% b. 20.00% c. 21.76% d. 33.33% e. 40.00% ANS: A Return on series = (81.69 − 72.5)/72.5 = 12.68% PTS: 1
OBJ: Multiple Choice Problem
44. Refer to Exhibit 5.5. Calculate the value weighted index for Dec 31, 2003, prior to the splits. Assume a base index value of 100. The base year is Dec 31, 2003. a. 120.0 b. 81.69 c. 72.5 d. 100.0 e. 121.25 ANS: D Value weighted series Dec 2003 =
PTS: 1
OBJ: Multiple Choice Problem
45. Refer to Exhibit 5.5. Calculate the value weighted index for Dec 31, 2003, after the splits. Assume a base index value of 100. The base year is Dec 31, 2003. a. 72.5 b. 81.69 c. 100.0 d. 120.0 e. 121.25 ANS: C Value weighted post split = 100. Not affected by splits. PTS: 1
OBJ: Multiple Choice Problem
46. Refer to Exhibit 5.5. Calculate the value weighted index for Dec 31, 2004. Assume a base index value of 100. The base year is Dec 31, 2003. a. 121.25 b. 100.0 c. 81.69 d. 72.5 e. 120.0 ANS: E Value weighted series Dec 2004 =
PTS: 1
OBJ: Multiple Choice Problem
47. Refer to Exhibit 5.5. Calculate the percentage return in the value weighted index for the period Dec 31, 2003 to Dec 31, 2004. a. 12.68% b. 20.00% c. 21.76% d. 33.33% e. 40.00% ANS: B Since the base value is 100 and the current index value is 120, the percentage return is 20%. PTS: 1
OBJ: Multiple Choice Problem
48. Refer to Exhibit 5.5. Calculate the unweighted index for Dec 31, 2003, prior to the splits. Assume a base index value of 100. The base year is Dec 31, 2003. a. 100.0 b. 200.0 c. 150.0 d. 120.0 e. 175.0 ANS: A The index value Dec 2003 is 100 PTS: 1
OBJ: Multiple Choice Problem
49. Refer to Exhibit 5.5. Calculate the unweighted index for Dec 31, 2003, after the splits. Assume a base index value of 100. The base year is Dec 31, 2003. a. 110.0 b. 200.0 c. 100.0 d. 120.0 e. 150.0 ANS: C Post split the index value is 100 PTS: 1
OBJ: Multiple Choice Problem
50. Refer to Exhibit 5.5. Calculate the unweighted index (geometric mean) for Dec 31, 2004. Assume a base index value of 100. The base year is Dec 31, 2003. a. 119.25 b. 121.25 c. 151.25 d. 95.25 e. 100.25 ANS: A Index Dec 2004 = (1.33 + 0.87 + 1.40 + 1.25)1/4 (100) = 119.25 PTS: 1
OBJ: Multiple Choice Problem
51. Refer to Exhibit 5.5. Calculate the percentage return in the unweighted index (geometric mean) for the period Dec 31, 2003 to Dec 31, 2004. Assume a base index value of 100. Base year is Dec 31, 2003. a. 19.25% b. 21.25% c. 51.25% d. 5.25% e. 100.25% ANS: A The return on the index is 19.25% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 5.6 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Price Stock Q R S
Number of Shares 5,000,000 8,000,000 15,000,000
Day T 80 60 20
Day T + 1 95 55 24
52. Refer to Exhibit 5.6. Calculate a price weighted average for Day T. a. 46.20 b. 53.33 c. 54.12 d. 92.39 e. 108.23
ANS: B (80 + 60 + 20)/3 = 53.33 PTS: 1
OBJ: Multiple Choice Problem
53. Refer to Exhibit 5.6. Calculate a value weighted average for Day T + 1. Assume a base index value of 100 on Day T. a. 46.20 b. 53.33 c. 54.12 d. 92.39 e. 108.23 ANS: D Base Value = $80(5,000,000) + $60(8,000,000) + $20(15,000,000) = 1,380,000,000 Day T + 1 Value = $95(5,000,000) + $55(8,000,000) + $24(15,000,000) = 1,275,000,000 Value Index = (1,275,000,000/1,380,000,000)*100 = 92.39 PTS: 1
OBJ: Multiple Choice Problem
54. Refer to Exhibit 5.6. If an equal-weighted index is constructed on Day T with $10,000 in each stock, what is the percentage change in wealth for this index on Day T + 1? Assume a base index value of 100 on Day T. a. 8.65% b. 10.14% c. 15.69% d. 30.42% e. 47.08% ANS: B Q%: (95 − 80)/80 = 18.75% R%: (55 − 60)/60 = −8.33% S%: (24 − 20)/20 = 20.00% Index on Day T + 1: [(18.75% − 8.33% + 20.00%)/3]*100 + 100 = 110.14 Percentage change: (110.14 − 100)/100 = 10.14% PTS: 1
OBJ: Multiple Choice Problem
55. Refer to Exhibit 5.6. Compute the arithmetic mean of the price change of Stocks Q, R, and S from days T to T + 1. a. 8.65% b. 10.14% c. 15.69% d. 30.42% e. 47.08% ANS: B Q%: (95 − 80)/80 = 18.75% R%: (55 − 60)/60 = −8.33% S%: (24 − 20)/20 = 20.00%
(18.75% − 8.33% + 20.00%)/3 = 10.14% PTS: 1
OBJ: Multiple Choice Problem
56. Refer to Exhibit 5.6. Compute the geometric mean of the price change of Stocks Q, R, and S from days T to T + 1. a. 9.32% b. 10.14% c. 15.57% d. 30.63% e. 54.37% ANS: A Q%: (95 − 80)/80 = 18.75% R%: (55 − 60)/60 = −8.33% S%: (24 − 20)/20 = 20.00% Geometric Average = [(1.1875)(0.9167)(1.2000)]1/3 − 1 = 0.0932 or 9.32% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 5.7 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Stock A B C
Number of Shares 5,000 8,000 15,000
December 31, 2011 Price Value $20 $100,000 $40 $320,000 $10 $150,000
December 31, 2012 Price Value $25 $125,000 $42 $304,000 $15 $225,000
57. Refer to Exhibit 5.7. What would be the total percentage change in an equally weighted portfolio of ABC? a. 13.33% b. 18.67% c. 23.41% d. 26.67% e. 36.83% ANS: D Stock A B C
Number of Shares 5,000 8,000 15,000
December 31, 2011 Price Value $20 $100,000 $40 $320,000 $10 $150,000
Price $25 $42 $15
December 31, 2012 Value % Change $125,000 25.0 $304,000 5.0 $225,000 50.0
Total percent change for equally weighted ABC = (25 + 5 + 50)/3 = 26.67% PTS: 1
OBJ: Multiple Choice Problem
58. Refer to Exhibit 5.7. If the December 31, 2011 equal weighted index for ABC was 100, what is the equal weighted index for ABC on December 31, 2012? a. 108.35 b. 114.74
c. 120.19 d. 126.67 e. 131.54 ANS: D Equal Weighted Index = 100(1.2667) = 126.67 PTS: 1
OBJ: Multiple Choice Problem
59. Refer to Exhibit 5.7. If the December 31, 2011 value weighted index for ABC was 100, what is the value weighted index for ABC on December 31, 2012? a. 108.35 b. 114.74 c. 120.19 d. 126.67 e. 131.54 ANS: B Stock A B C
Number of Shares 5,000 8,000 15,000
December 31, 2011 Price Value $20 $100,000 $40 $320,000 $10 $150,000 $570,000
December 31, 2012 Price Value $25 $125,000 $42 $304,000 $15 $225,000 $654,000
Market Value Weighted Index = (100)($654,000/$570,000) = 114.74 PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 6—EFFICIENT CAPITAL MARKETS TRUE/FALSE 1. Prices in efficient capital markets fully reflect all available information and rapidly adjust to new information. ANS: T
PTS: 1
2. An efficient market requires a large number of profit-maximizing investors. ANS: T
PTS: 1
3. If the efficient market hypothesis is true price changes are independent and biased. ANS: F
PTS: 1
4. The random walk hypothesis contends that stock prices occur randomly. ANS: T
PTS: 1
5. In his original article, Fama divided the efficient market hypothesis into two subhypotheses. ANS: F
PTS: 1
6. The weak form of the efficient market hypothesis contends that stock prices fully reflect all public and private information. ANS: F
PTS: 1
7. The weak form of the efficient market hypothesis contends that technical trading rules are of little value. ANS: T
PTS: 1
8. Tests have shown that if small filters are used in simulating trading rules, these trading rules have produced above average returns after transactions costs are factored in. ANS: F
PTS: 1
9. In tests of the semistrong-form EMH, it is not necessary to use risk-adjusted rates of return. ANS: F
PTS: 1
10. Results of initial public offering (IPOs) studies tend to support the semi-strong EMH, because it appears that prices adjusted rapidly after initial underpricing. ANS: T
PTS: 1
11. Results from studies on the effects of unexpected world events have consistently indicated that the price change is so rapid, that it takes place between the close of one day and the opening of the next day.
ANS: T
PTS: 1
12. Studies concerning quarterly earnings reports indicate that information in quarterly statements is of value and can provide an above-average risk-adjusted return. ANS: T
PTS: 1
13. Results of studies concerning corporate insider trading indicate that corporate insiders generally enjoy above-average returns. ANS: T
PTS: 1
14. The strong form of the efficient market hypothesis contends that only insiders can earn abnormal returns. ANS: F
PTS: 1
15. Technical analysis and the efficient market hypothesis have a consistent set of assumptions concerning stock market behavior. ANS: F
PTS: 1
16. Even when fees and costs are considered most mutual fund managers outperform the aggregate market. ANS: F
PTS: 1
17. When considering markets in Europe, it is inappropriate to assume a level of efficiency similar to that for U.S. markets. ANS: F
PTS: 1
18. The weak-form efficient market hypothesis assumes all publicly available information is reflected in current stock prices. ANS: F
PTS: 1
19. Studies examining stock splits support the semistrong form efficient market hypothesis. ANS: T
PTS: 1
20. There is little evidence from studies examining initial public offerings (IPOs) that suggest markets are semistrong form efficient. ANS: F
PTS: 1
21. Recent studies indicate that due to lower transaction costs intraday patterns of returns and volume persisted and result in profitable momentum trading strategies. ANS: T
PTS: 1
22. There is empirical evidence that low P/E stocks have outperformed high P/E stocks for some historical time periods.
ANS: T
PTS: 1
MULTIPLE CHOICE 1. Which of the following would be inconsistent with an efficient market? a. Information arrives randomly and independently. b. Stock prices adjust rapidly to new information. c. Price changes are independent. d. Price changes are random. e. Price adjustments are biased. ANS: E
PTS: 1
OBJ: Multiple Choice Concept
2. Fusion investing is the integration of the following elements of investment valuation: a. Fundamental value and investor sentiment. b. Fads and fashions. c. Technical analysis and investor sentiment. d. Historical prices and returns. e. Transaction costs and fundamental value. ANS: A
PTS: 1
OBJ: Multiple Choice Concept
3. The weak form of the efficient market hypothesis states that a. Successive price changes are dependent. b. Successive price changes are independent. c. Successive price changes are biased. d. Successive price changes depend on trading volume. e. Properly specified trading rules are of value. ANS: B
PTS: 1
OBJ: Multiple Choice Concept
4. Which statement is true concerning alternative efficient market hypothesis? a. The weak hypothesis encompasses the semi-strong hypothesis. b. The weak hypothesis encompasses the strong hypothesis. c. The semi-strong hypothesis encompasses the weak hypothesis. d. The strong hypothesis relates only to public information. e. None of the above (all statements are false) ANS: C
PTS: 1
OBJ: Multiple Choice Concept
5. If statistical tests of stock returns over time support the efficient market hypothesis the resulting correlations should be a. Positive. b. Negative. c. Zero. d. Lagged. e. Skewed. ANS: C
PTS: 1
OBJ: Multiple Choice Concept
6. A "runs test" on successive stock price changes which supports the efficient market hypothesis would show the actual number of runs a. Falls into the range expected of a random series. b. Falls into the range expected of a dependent series.
c. Is small. d. Is large. e. Would approximate N/2. ANS: A
PTS: 1
OBJ: Multiple Choice Concept
7. A trading rule which signals purchase of a stock if it rises X percent and sale of a stock if it falls X percent is known as a a. Breakout. b. Short sale. c. Sieve. d. Filter. e. Relative strength. ANS: D
PTS: 1
OBJ: Multiple Choice Concept
8. Which of the following has not been involved in a direct test of the semi-strong form of the efficient market hypothesis? a. Stock splits b. New Issues c. Exchange listing d. Accounting changes e. NYSE Specialists' returns ANS: E
PTS: 1
OBJ: Multiple Choice Concept
9. Examples of anomalies providing contrary evidence to the semi-strong efficient market hypothesis include studies of all of the following except a. Quarterly earnings reports. b. Price earnings ratios. c. Total market value. d. Stocks ranked by Standard & Poor's. e. The January effect. ANS: D
PTS: 1
OBJ: Multiple Choice Concept
10. The opportunity to take advantage of the downward pressure on stock prices that result from end-of-the-year tax selling is known as a. The End-of-the-Year Effect. b. The December Anomaly. c. The End-of-the-Year Anomaly. d. The January Anomaly. e. The New Years Anomaly. ANS: D
PTS: 1
OBJ: Multiple Choice Concept
11. Banz and Reinganum found that small firms consistently outperformed large firms. This anomaly is referred to as the a. Large firm effect. b. Size effect. c. Small firm effect. d. PIE effect. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice Concept
12. The performance of four major groups of investors has been studied in connection with tests of the strong-form of the efficient market hypothesis. These include all of the following except a. Professional money managers. b. Stock exchange specialists. c. Securities Exchange officers. d. Security analysts. e. Corporate insiders. ANS: C
PTS: 1
OBJ: Multiple Choice Concept
13. Abnormal returns associated with rankings by a major advisory service are associated with a. The PIE effect. b. The Value-Line Enigma. c. The Value-Line Effect. d. The Standard and Poor's Anomaly. e. The rankings anomaly. ANS: B
PTS: 1
OBJ: Multiple Choice Concept
14. The implication of efficient capital markets and a lack of superior analysts have led to the introduction of a. Balanced funds. b. Naive funds. c. January funds. d. Index funds. e. Futures options. ANS: D
PTS: 1
OBJ: Multiple Choice Concept
15. Superior analysts are encouraged to concentrate their efforts in "middle tier" stocks. This is recommended because a. it works to minimize taxes for the client. b. only individuals deal in the middle tier stocks. c. prices may not adjust quite as rapidly for middle tier stocks as they do in the top tier; therefore, the chances of temporarily undervalued securities are greater. d. it includes companies too small to be considered by institutions. e. technical analysts never look at "middle tier" stocks. ANS: C
PTS: 1
OBJ: Multiple Choice Concept
16. A portfolio manager without superior analytical skills should a. Determine and quantify the risk preferences of a client. b. Minimize transaction costs. c. Maintain the specified risk level. d. Ensure that the portfolio is completely diversified. e. All of the above. ANS: E
PTS: 1
OBJ: Multiple Choice Concept
17. Some studies have attempted to determine whether it is possible to predict future returns for a stock based on publicly available quarterly earnings reports. The results of these studies indicate a. Stock prices adjust to reflect quarterly earnings reports. b. Stock prices do not adjust to reflect quarterly earnings reports. c. Support for the semistrong EMH. d. Stock prices adjust if earnings reports are released in January.
e. Stock prices do not adjust if earnings reports are released in January. ANS: B
PTS: 1
OBJ: Multiple Choice Concept
18. Which is not an implication of the EMH? a. To do superior industry or company analysis you must understand the variables that affect returns and do a superior job of estimating these variables. b. Aggregate market analysis that involves very detailed analysis of reliable historical economic data should outperform a simple buy-and-hold policy. c. A superior analyst is one who can consistently select stocks that provide positive abnormal returns on a risk-adjusted basis. d. If a portfolio manager does not have any superior analysts, he/she should consider investing funds in an index fund. e. If a portfolio manager has some superior analytical skills, they should be encouraged to concentrate in second tier stocks which have liquidity, but may be neglected. ANS: B
PTS: 1
OBJ: Multiple Choice Concept
19. The results of studies that have looked at the relationship between PEG ratios and subsequent stock returns a. Find an inverse relationship, with annual rebalancing. b. Find no relationship, with monthly or quarterly rebalancing. c. Find an inverse relationship, with monthly or quarterly rebalancing. d. Find a direct relationship, with monthly or quarterly rebalancing. e. Find a direct relationship with annual rebalancing ANS: C
PTS: 1
OBJ: Multiple Choice Concept
20. The strongest explanations for the size anomaly are a. risk measurements b. higher transaction costs c. P/E ratio d. a and b. e. b and c. ANS: D
PTS: 1
OBJ: Multiple Choice Concept
21. Fama and French examined the relationship between the Book Value to Market Value ratio and average stock returns and found a. No evidence of a relationship for U.S. stocks. b. Evidence of a negative relationship in U.S. stocks only. c. Evidence of a positive relationship for Japanese stocks only. d. Evidence of a negative relationship for U.S. and Japanese stocks. e. Evidence of a positive relationship for U.S. and Japanese stocks. ANS: E
PTS: 1
OBJ: Multiple Choice Concept
22. Investigators have tested the strong form EMH by examining the performance of the following type of investor: a. Corporate insiders. b. Stock exchange specialists. c. Security analysts. d. Professional money managers. e. All of the above. ANS: E
PTS: 1
OBJ: Multiple Choice Concept
23. Escalation bias refers to the situation where a. Investors have a propensity to sell winners too soon and hang on to losers too long. b. Investors ignore bad news and overemphasize good news. c. Investors tend to follow the herd. d. Investors put more money into a failure rather than into a success. e. Investors are all noise traders. ANS: D
PTS: 1
OBJ: Multiple Choice Concept
24. Confirmation bias refers to the situation where a. Investors have a propensity to sell winners too soon and hang on to losers too long. b. Investors ignore bad news and overemphasize good news. c. Investors tend to follow the herd. d. Investors put more money into a failure rather than into a success. e. Investors are all noise traders. ANS: B
PTS: 1
OBJ: Multiple Choice Concept
25. According to prospect theory a. Investors have a propensity to sell winners too soon and hang on to losers too long. b. Investors ignore bad news and overemphasize good news. c. Investors tend to follow the herd. d. Investors put more money into a failure rather than into a success. e. Investors are all noise traders. ANS: A
PTS: 1
OBJ: Multiple Choice Concept
26. Behavioral finance differs from the standard model of finance because behavioral finance a. Precludes the impact of investor psychology. b. Includes the impact of investor psychology. c. Accepts the Efficient Markets Hypothesis. d. Rejects the idea of market anomalies. e. none of the above. ANS: B
PTS: 1
OBJ: Multiple Choice Concept
27. Studies of the relationship between P/E ratios and stock returns have found that a. Low P/E stocks of large cap stocks outperformed low P/E stocks of small cap stocks. b. Low P/E stocks of small cap stocks outperformed high P/E stocks of large cap stocks. c. High P/E stocks of large cap stocks outperformed low P/E stocks of small cap stocks. d. High P/E stocks of large cap stocks outperformed high P/E stocks of small cap stocks. e. none of the above. ANS: B
PTS: 1
OBJ: Multiple Choice Concept
28. The January anomaly refers to the phenomenon where stock prices a. Decline in December. b. Decline in January. c. Rise in January. d. Decline in December and rise in January. e. Rise in December and decline in January. ANS: D
PTS: 1
OBJ: Multiple Choice Concept
29. Researchers have found a positive relationship between default spread and stock returns in the long run because a large default spread implies a. a high risk premium and higher expected returns. b. a high risk premium and lower expected returns. c. a low risk premium and higher expected returns. d. a low risk premium and lower expected returns. e. none of the above. ANS: A
PTS: 1
OBJ: Multiple Choice Concept
30. The results of return prediction studies have found a. Limited success predicting short-horizon returns. b. Limited success predicting long-horizon returns. c. Good success predicting long-horizon returns. d. a and b. e. a and c. ANS: E
PTS: 1
OBJ: Multiple Choice Concept
31. In tests of the semistrong-form efficient market hypothesis, an adjustment for market effects is carried out by a. Calculating the historical return. b. Calculating the market rate of return. c. Calculating the abnormal rate of return. d. Calculating the cross-sectional return. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice Concept
32. In an event study the objective is to a. Determine whether it is possible to predict stock prices. b. Determine how fast stock prices adjust to news. c. Examine the cross-sectional distributions of returns. d. Conduct a time series analysis of returns. e. Determine normal P/E ratios. ANS: B
PTS: 1
OBJ: Multiple Choice Concept
33. In order to confirm the weak-form efficient market hypothesis you could develop trading rules that consider a. Advance-decline ratios. b. Short sales. c. Specialist activities. d. Any of the above. e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice Concept
34. In order to confirm the weak-form efficient market hypothesis, an examination of stock price runs over time would reveal that stock price changes over time were a. Highly positively correlated. b. Moderately positively correlated. c. Highly negatively correlated. d. Moderately negatively correlated. e. None of the above.
ANS: E
PTS: 1
OBJ: Multiple Choice Concept
35. According to the strong-form efficient market hypothesis, stock prices fully reflect a. All security market information only. b. All public information only. c. All public and private information only. d. All of the above. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice Concept
36. According to the semistrong-form efficient market hypothesis, which of the following types of information are fully reflected in stock prices? a. Rates of return, trading volume, and news about the economy. b. Dividend and earnings announcements. c. Rates of return, trading volume, and block trades. d. Earnings announcements and rates of return. e. All of the above. ANS: E
PTS: 1
OBJ: Multiple Choice Concept
37. According to the weak-form efficient market hypothesis, which of the following types of information are fully reflected in stock prices? a. Rates of return, trading volume, and news about the economy. b. Dividend and earnings announcements. c. Rates of return, trading volume, and block trades. d. Earnings announcements and rates of return. e. All of the above. ANS: C
PTS: 1
OBJ: Multiple Choice Concept
38. Which of the following assumptions imply capital markets will be efficient? a. A large number of independent profit-maximizing participants analyze securities. b. New information regarding securities comes to the market in a random fashion. c. Investors adjust security prices rapidly to reflect the effect of new information. d. Both b and c only. e. All of the above are assumptions that imply a market will be efficient. ANS: E
PTS: 1
OBJ: Multiple Choice Concept
39. Autocorrelation and runs tests are used to test the a. Weak-form efficient market hypothesis (EMH). b. Semistrong-form efficient market hypothesis (EMH). c. Strong-form efficient market hypothesis (EMH). d. Both a and b. e. All of the above. ANS: A
PTS: 1
OBJ: Multiple Choice Concept
40. Event studies are used to test the a. Weak-form efficient market hypothesis (EMH). b. Semistrong-form efficient market hypothesis (EMH). c. Strong-form efficient market hypothesis (EMH). d. Both b and c. e. All of the above.
ANS: B
PTS: 1
OBJ: Multiple Choice Concept
41. Evidence supporting the strong-form efficient market hypothesis (EMH) resulted from examining a. Value Line rankings. b. Corporate insiders. c. Stock exchange specialists. d. Both b and c only. e. All of the above. ANS: A
PTS: 1
OBJ: Multiple Choice Concept
42. Which of the following behaviors is consistent with escalation bias? a. Buying more of a stock as it increases in value. b. Buying more of a stock as it decreases in value. c. Selling a stock as it decreases in value. d. Selling a stock as it increases in value. e. Buying or selling a stock as it increases in value. ANS: B
PTS: 1
OBJ: Multiple Choice Concept
43. Fusion investing refers to the combination of a. Technical analysis and fundamental analysis. b. Behavioral analysis and technical analysis. c. Fundamental analysis and investor sentiment. d. Technical analysis and investor sentiment. e. All of the above ANS: C
PTS: 1
OBJ: Multiple Choice Concept
44. All of the following are underlying assumptions of the capital asset pricing model (CAPM) except: a. A large number of profit-maximizing participants analyze and value securities. b. New information enters the market in a random fashion c. Security prices adjust rapidly to reflect the effect of new information d. Expected returns implicit in the current price of the security reflect its risk e. All of the above are assumptions of the CAPM ANS: E
PTS: 1
OBJ: Multiple Choice Concept
45. Tests of the efficient market hypothesis (EMH) are sometimes based on examining its abnormal rate of return. The abnormal rate of return is calculated by: a. Subtracting the expected rate of return from the actual return, where the expected return is based on the stock's beta and the CAPM. b. Subtracting the actual rate of return from the expected return, where the expected return is based on the stock's beta and the CAPM. c. Subtracting the expected rate of return from the actual return, where the expected return is based on the stock's projected dividend yields. d. Subtracting the expected rate of return from the actual return, where the expected return is based on the stock's projected dividend yields. e. None of the above ANS: A
PTS: 1
OBJ: Multiple Choice Concept
46. In an efficient market all securities should have: a. Equal returns for the same time period b. Equal risk-adjusted returns
c. Equal inflation-adjusted returns d. All of the above e. None of the above ANS: B
PTS: 1
OBJ: Multiple Choice Concept
47. Which of the following ratios is the most commonly used ratio for predicting the performance of a growth company? a. PE ratio b. PG ratio c. PEG ratio d. MV/BV ratio e. BV/MV ratio ANS: C
PTS: 1
OBJ: Multiple Choice Concept
Exhibit 6.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Stock C E
Rit 12 10
Rmt 10 8.0
ai 0 0
Beta 0.8 1.1
Rit = return for stock i during period t Rmt = return for the aggregate market during period t 48. Refer to Exhibit 6.1. What is the abnormal rate of return for Stock C during period t using only the aggregate market return (ignore differential systematic risk)? a. 4.0% b. 1.2% c. −1.05% d. 2.0% e. −8.50 ANS: D Abnormal Returnit = Rit − Rmt Abnormal Returnct = 12 − 10 = 2.0 PTS: 1
OBJ: Multiple Choice Problem
49. Refer to Exhibit 6.1. What is the abnormal rate of return for Stock E during period t using only the aggregate market return (ignore differential systematic risk)? a. 4.0% b. 2.0% c. 1.2% d. −1.05% e. −8.5% ANS: B Abnormal Returnit = Rit − Rmt Abnormal Returnet = 10 − 8.0 = 2.0
PTS: 1
OBJ: Multiple Choice Problem
50. Refer to Exhibit 6.1. What is the abnormal rate of return for Stock C when you consider its systematic risk measure (beta)? a. 4.0% b. 1.2% c. 2.0% d. −1.05% e. −8.5% ANS: A Abnormal Returnit = Rit − (Beta Rmt) Abnormal Returnct = 12 − (.8 10) = 4% PTS: 1
OBJ: Multiple Choice Problem
51. Refer to Exhibit 6.1. What is the abnormal rate of return for Stock E when you consider its systematic risk measure (beta)? a. 2.0% b. 1.2% c. 4.0% d. −1.05% e. −8.5% ANS: B Abnormal Returnit = Rit − (Beta Rmt) Abnormal Returnit = 10 − (1.1 8.0) = 1.2% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 6.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Stock ABC XYZ
Rit 11.5 9.0
Rmt 13.0 7.0
ai 0 0
Beta 0.7 1.1
Rit = return for stock i during period t Rmt = return for the aggregate market during period t 52. Refer to Exhibit 6.2. What is the abnormal rate of return for Stock ABC during period t using only the aggregate market return (ignore differential systematic risk)? a. 3.2% b. 2.4% c. 1.3% d. −1.5% e. 2.0% ANS: D Abnormal Returnit = Rit − Rmt Abnormal Returnct = 11.5 − 13.0 = −1.5
PTS: 1
OBJ: Multiple Choice Problem
53. Refer to Exhibit 6.2. What is the abnormal rate of return for Stock XYZ during period t using only the aggregate market return (ignore differential systematic risk)? a. −3.2% b. 2.4% c. 2.0% d. 1.3% e. −1.5% ANS: C Abnormal Returnit = Rit − Rmt Abnormal Returnet = 9.0 − 7.0 = 2.0 PTS: 1
OBJ: Multiple Choice Problem
54. Refer to Exhibit 6.2. What is the abnormal rate of return for Stock ABC when you consider its systematic risk measure (beta)? a. 2.4% b. 1.5% c. −1.5% d. 2.0% e. −3.2% ANS: A Abnormal Returnit = Rit − (Beta Rmt) Abnormal Returnct = 11.5 − (0.7 13.0) = 2.4% PTS: 1
OBJ: Multiple Choice Problem
55. Refer to Exhibit 6.2. What is the abnormal rate of return for Stock XYZ when you consider its systematic risk measure (beta)? a. 2.0% b. −1.5% c. 2.4% d. 1.3% e. −3.2% ANS: D Abnormal Returnit = Rit − (Beta Rmt) Abnormal Returnit = 9.0 − (1.1 7.0) = 1.3% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 6.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Stock Elliot Hemlick
Rit 9.9 9.1
Rmt 15.0 8.0
ai 0 0
Beta 0.8 1.1
Rit = return for stock i during period t Rmt = return for the aggregate market during period t 56. Refer to Exhibit 6.3. What is the abnormal rate of return for Elliot during period t using only the aggregate market return (ignore differential systematic risk)? a. 1.50 b. 1.10 c. −1.50 d. −5.10 e. −8.00 ANS: D Abnormal Returnit = Rit − Rmt Abnormal Returnct = 9.9 − 15.0 = −5.1 PTS: 1
OBJ: Multiple Choice Problem
57. Refer to Exhibit 6.3. What is the abnormal rate of return for Hemlick during period t using only the aggregate market return (ignore differential systematic risk)? a. 0.11 b. 1.10 c. −1.80 d. −1.80 e. −4.60 ANS: B Abnormal Returnit = Rit − Rmt Abnormal Returnet = 9.1 − 8.0 = 1.1 PTS: 1
OBJ: Multiple Choice Problem
58. Refer to Exhibit 6.3. What is the abnormal rate of return for Elliot when you consider its systematic risk measure (beta)? a. −2.10% b. −2.00% c. 5.20% d. 14.10% e. None of the above ANS: A Abnormal Returnit = Rit − (Beta Rmt) Abnormal Returnct = 9.9 − (0.8 15.0) = 9.9 − 12.0 = −2.1% PTS: 1
OBJ: Multiple Choice Problem
59. Refer to Exhibit 6.3. What is the abnormal rate of return for Hemlick when you consider its systematic risk measure (beta)? a. 0.1% b. 0.3% c. 0.5%
d. 1.5% e. 3.0% ANS: B Abnormal Returnit = Rit − (Beta Rmt) Abnormal Returnit = 9.1 − (1.1 8.0) = 9.1 − 8.8 = 0.3% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 6.4 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Stock A B
Rit 10.3 9.4
Rmt 12 9.0
ai 0 0
Beta 0.6 1.2
Rit = return for stock i during period t Rmt = return for the aggregate market during period t 60. Refer to Exhibit 6.4. What is the abnormal rate of return for Stock A during period t using only the aggregate market return (ignore differential systematic risk)? a. 3.34 b. 1.75 c. −1.75 d. −3.70 e. −1.70 ANS: E Abnormal Returnit = Rit − Rmt Abnormal Returnct = 10.3 − 12.0 = −1.7 PTS: 1
OBJ: Multiple Choice Problem
61. Refer to Exhibit 6.4. What is the abnormal rate of return for Stock B during period t using only the aggregate market return (ignore differential systematic risk)? a. 0.40 b. 1.40 c. −1.10 d. −4.40 e. −6.40 ANS: A Abnormal Returnit = Rit − Rmt Abnormal Returnet = 9.4 − 9.0 = 0.4 PTS: 1
OBJ: Multiple Choice Problem
62. Refer to Exhibit 6.4. What is the abnormal rate of return for Stock A when you consider its systematic risk measure (beta)? a. 2.30% b. 2.10%
c. 3.10% d. 12.40% e. None of the above ANS: C Abnormal Returnit = Rit − (Beta Rmt) Abnormal Returnct = 10.3 − (0.6 12.0) = 10.3 − 7.20 = 3.1% PTS: 1
OBJ: Multiple Choice Problem
63. Refer to Exhibit 6.4. What is the abnormal rate of return for Stock B when you consider its systematic risk measure (beta)? a. 0.1% b. −1.4% c. 0.5% d. 1.5% e. 2.0% ANS: B Abnormal Returnit = Rit − (Beta Rmt) Abnormal Returnit = 9.4 − (1.2 9.0) = 9.4 − 10.8 = −1.4% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 6.5 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Stock A Z
Rit 10.6 9.8
Rmt 15 8.0
ai 0 0
Beta 0.8 1.1
Rit = return for stock i during period t Rmt = return for the aggregate market during period t 64. Refer to Exhibit 6.5. What is the abnormal rate of return for Stock A during period t using only the aggregate market return (ignore differential systematic risk)? a. 3.40 b. 4.40 c. −1.86 d. −4.40 e. −1.70 ANS: D Abnormal Returnit = Rit − Rmt Abnormal Returnct = 10.6 − 15.0 = −4.4 PTS: 1
OBJ: Multiple Choice Problem
65. Refer to Exhibit 6.5. What is the abnormal rate of return for Stock Z during period t using only the aggregate market return (ignore differential systematic risk)? a. 1.80
b. c. d. e.
1.40 −1.80 −4.80 −8.80
ANS: A Abnormal Returnit = Rit − Rmt Abnormal Returnet = 9.8 − 8.0 = 1.8 PTS: 1
OBJ: Multiple Choice Problem
66. Refer to Exhibit 6.5. What is the abnormal rate of return for Stock A when you consider its systematic risk measure (beta)? a. 1.40% b. −1.40% c. 2.80% d. −2.80% e. None of the above ANS: B Abnormal Returnit = Rit − (Beta Rmt) Abnormal Returnct = 10.6 − (0.8 15.0) = 10.6 − 12.0 = −1.4% PTS: 1
OBJ: Multiple Choice Problem
67. Refer to Exhibit 6.5. What is the abnormal rate of return for Stock Z when you consider its systematic risk measure (beta)? a. 0.1% b. 1.0% c. 0.5% d. −1.0% e. −2.0% ANS: B Abnormal Returnit = Rit − (Beta Rmt) Abnormal Returnit = 9.8 − (1.1 8.0) = 9.8 − 8.8 = 1.0% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 6.6 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Stock A B
Rit 9.7 10.4
Rmt 10.0 8.0
ai 0 0
Beta 0.7 1.4
Rit = return for stock i during period t Rmt = return for the aggregate market during period t 68. Refer to Exhibit 6.6. What is the abnormal rate of return for Stock A during period t using only the aggregate market return (ignore differential systematic risk)?
a. b. c. d. e.
−2.3% −0.3% 0.3% 2.3% 3.0%
ANS: B Abnormal Returnit = Rit − Rmt Abnormal Returnct = 9.7 − 10.0 = −0.3 PTS: 1
OBJ: Multiple Choice Problem
69. Refer to Exhibit 6.6. What is the abnormal rate of return for Stock A when you consider its systematic risk measure (beta)? a. −2.3% b. −0.3% c. 0.3% d. 2.3% e. 3.0% ANS: D Abnormal Returnit = Rit − (Beta Rmt) Abnormal Returnct = 9.7 − (0.7 10.0) = 9.7 − 7.0 = 2.3% PTS: 1
OBJ: Multiple Choice Problem
70. Refer to Exhibit 6.6. What is the abnormal rate of return for Stock B when you consider its systematic risk measure (beta)? a. −0.8% b. −1.2% c. 1.3% d. 2.4% e. 6.6% ANS: A Abnormal Returnit = Rit − (Beta Rmt) Abnormal Returnit = 10.4 − (1.4 8.0) = 10.4 − 11.2 = −0.8% PTS: 1
OBJ: Multiple Choice Problem
71. Refer to Exhibit 6.6. Stock X had an actual return of 14% and Stock X's normal return based on the market's return for the same period was 13.6%. What is Stock X's abnormal rate of return? a. −0.4% b. 0.1% c. 0.4% d. 4.0% e. 6.4% ANS: C Abnormal Returnit = actual return − market based return
Abnormal Returnit = 14.0% − 13.6% = 0.4% PTS: 1
OBJ: Multiple Choice Problem
72. Based on Stock Z's beta of 0.9 the normal return is 9%. However, the actual return for Stock Z was 8%. What is Stock Z's abnormal rate of return? a. −1.0% b. −0.1% c. 0.1% d. 1.0% e. 1.1% ANS: A Abnormal Returnit = actual return − market based return Abnormal Returnit = 8.0% − 9.0% = −1.0% PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 7—AN INTRODUCTION TO PORTFOLIO MANAGEMENT TRUE/FALSE 1. A good portfolio is a collection of individually good assets. ANS: F
PTS: 1
2. Risk is defined as the uncertainty of future outcomes. ANS: T
PTS: 1
3. Prior to the work of Markowitz in the late 1950's and early 1960's, portfolio managers did not have a well-developed, quantitative means of measuring risk. ANS: T
PTS: 1
4. A basic assumption of the Markowitz model is that investors base decisions solely on expected return and risk. ANS: T
PTS: 1
5. Markowitz assumed that, given an expected return, investors prefer to minimize risk. ANS: T
PTS: 1
6. The correlation coefficient and the covariance are measures of the extent to which two random variables move together. ANS: T
PTS: 1
7. For a two stock portfolio containing Stocks i and j, the correlation coefficient of returns (rij) is equal to the square root of the covariance (covij). ANS: F
PTS: 1
8. If the covariance of two stocks is positive, these stocks tend to move together over time. ANS: T
PTS: 1
9. The expected return and standard deviation of a portfolio of risky assets is equal to the weighted average of the individual asset's expected returns and standard deviation. ANS: F
PTS: 1
10. The combination of two assets that are completely negatively correlated provides maximum returns. ANS: F
PTS: 1
11. Increasing the correlation among assets in a portfolio results in an increase in the standard deviation of the portfolio.
ANS: T
PTS: 1
12. Combining assets that are not perfectly correlated does affect both the expected return of the portfolio as well as the risk of the portfolio. ANS: F
PTS: 1
13. In a three asset portfolio the standard deviation of the portfolio is one third of the square root of the sum of the individual standard deviations. ANS: F
PTS: 1
14. As the number of risky assets in a portfolio increases, the total risk of the portfolio decreases. ANS: T
PTS: 1
15. Assuming that everyone agrees on the efficient frontier (given a set of costs), there would be consensus that the optimal portfolio on the frontier would be where the ratio of return per unit of risk was greatest. ANS: F
PTS: 1
16. An investor is risk neutral if she chooses the asset with lower risk given a choice of several assets with equal returns. ANS: F
PTS: 1
17. A portfolio is efficient if no other asset or portfolios offer higher expected return with the same (or lower) risk or lower risk with the same (or higher) expected return. ANS: T
PTS: 1
18. A measure that only considers deviations above the mean is semi-variance. ANS: F
PTS: 1
19. The set of portfolios with the maximum rate of return for every given risk level is known as the optimal frontier. ANS: F
PTS: 1
20. Investors choose a portfolio on the efficient frontier based on their utility functions that reflect their attitudes towards risk. ANS: T
PTS: 1
MULTIPLE CHOICE 1. When individuals evaluate their portfolios they should evaluate a. All the U.S. and non-U.S. stocks. b. All marketable securities. c. All marketable securities and other liquid assets. d. All assets.
e. All assets and liabilities. ANS: E
PTS: 1
OBJ: Multiple Choice Concept
2. The probability of an adverse outcome is a definition of a. Statistics. b. Variance. c. Random. d. Risk. e. Semi-variance above the mean. ANS: D
PTS: 1
OBJ: Multiple Choice Concept
3. The Markowitz model is based on several assumptions regarding investor behavior. Which of the following is not such any assumption? a. Investors consider each investment alternative as being represented by a probability distribution of expected returns over some holding period. b. Investors maximize one-period expected utility. c. Investors estimate the risk of the portfolio on the basis of the variability of expected returns. d. Investors base decisions solely on expected return and risk. e. None of the above (that is, all are assumptions of the Markowitz model) ANS: E
PTS: 1
OBJ: Multiple Choice Concept
4. Markowitz believes that any asset or portfolio of assets can be described by ____ parameter(s). a. One b. Two c. Three d. Four e. Five ANS: B
PTS: 1
OBJ: Multiple Choice Concept
5. Semivariance, when applied to portfolio theory, is concerned with a. The square root of deviations from the mean. b. All deviations below the mean. c. All deviations above the mean. d. All deviations. e. The summation of the squared deviations from the mean. ANS: B
PTS: 1
OBJ: Multiple Choice Concept
6. The purpose of calculating the covariance between two stocks is to provide a(n) ____ measure of their movement together. a. Absolute b. Relative c. Indexed d. Loglinear e. Squared ANS: A
PTS: 1
OBJ: Multiple Choice Concept
7. In a two stock portfolio, if the correlation coefficient between two stocks were to decrease over time, everything else remaining constant, the portfolio's risk would a. Decrease.
b. c. d. e.
Remain constant. Increase. Fluctuate positively and negatively. Be a negative value.
ANS: A
PTS: 1
OBJ: Multiple Choice Concept
8. Which of the following statements about the correlation coefficient is false? a. The values range between −1 to +1. b. A value of +1 implies that the returns for the two stocks move together in a completely linear manner. c. A value of −1 implies that the returns move in a completely opposite direction. d. A value of zero means that the returns are independent. e. None of the above (that is, all statements are true) ANS: D
PTS: 1
OBJ: Multiple Choice Concept
9. You are given a two asset portfolio with a fixed correlation coefficient. If the weights of the two assets are varied the expected portfolio return would be ____ and the expected portfolio standard deviation would be ____. a. Nonlinear, elliptical b. Nonlinear, circular c. Linear, elliptical d. Linear, circular e. Circular, elliptical ANS: C
PTS: 1
OBJ: Multiple Choice Concept
10. Given a portfolio of stocks, the envelope curve containing the set of best possible combinations is known as the a. Efficient portfolio. b. Utility curve. c. Efficient frontier. d. Last frontier. e. Capital asset pricing model. ANS: C
PTS: 1
OBJ: Multiple Choice Concept
11. If equal risk is added moving along the envelope curve containing the best possible combinations the return will a. Decrease at an increasing rate. b. Decrease at a decreasing rate. c. Increase at an increasing rate. d. Increase at a decreasing rate. e. Remain constant. ANS: D
PTS: 1
OBJ: Multiple Choice Concept
12. A portfolio is considered to be efficient if: a. No other portfolio offers higher expected returns with the same risk. b. No other portfolio offers lower risk with the same expected return. c. There is no portfolio with a higher return. d. Choices a and b e. All of the above ANS: D
PTS: 1
OBJ: Multiple Choice Concept
13. The optimal portfolio is identified at the point of tangency between the efficient frontier and the a. highest possible utility curve. b. lowest possible utility curve. c. middle range utility curve. d. steepest utility curve. e. flattest utility curve. ANS: A
PTS: 1
OBJ: Multiple Choice Concept
14. An individual investor's utility curves specify the tradeoffs he or she is willing to make between a. high risk and low risk assets. b. high return and low return assets. c. covariance and correlation. d. return and risk. e. efficient portfolios. ANS: D
PTS: 1
OBJ: Multiple Choice Concept
15. As the correlation coefficient between two assets decreases, the shape of the efficient frontier a. approaches a horizontal straight line. b. bends out. c. bends in. d. approaches a vertical straight line. e. none of the above. ANS: C
PTS: 1
OBJ: Multiple Choice Concept
16. A portfolio manager is considering adding another security to his portfolio. The correlations of the 5 alternatives available are listed below. Which security would enable the highest level of risk diversification? a. 0.0 b. 0.25 c. −0.25 d. −0.75 e. 1.0 ANS: D
PTS: 1
OBJ: Multiple Choice Concept
17. A positive covariance between two variables indicates that a. the two variables move in different directions. b. the two variables move in the same direction. c. the two variables are low risk. d. the two variables are high risk. e. the two variables are risk free. ANS: B
PTS: 1
OBJ: Multiple Choice Concept
18. A positive relationship between expected return and expected risk is consistent with a. investors being risk seekers. b. investors being risk avoiders. c. investors being risk averse. d. all of the above. e. none of the above. ANS: C
PTS: 1
OBJ: Multiple Choice Concept
19. The slope of the efficient frontier is calculated as follows a. E(Rportfolio)/E(portfolio) b. E(portfolio)/ E(Rportfolio) c. E(Rportfolio)/E(portfolio) d. E(portfolio)/E(Rportfolio) e. None of the above ANS: C
PTS: 1
OBJ: Multiple Choice Concept
20. The slope of the utility curves for a strongly risk-averse investor, relative to the slope of the utility curves for a less risk-averse investor, will a. Be steeper. b. Be flatter. c. Be vertical. d. Be horizontal. e. None of the above. ANS: A
PTS: 1
OBJ: Multiple Choice Concept
21. All of the following are assumptions of the Markowitz model except a. Risk is measured based on the variability of returns. b. Investors maximize one-period expected utility. c. Investors' utility curves demonstrate properties of diminishing marginal utility of wealth. d. Investors base decisions solely on expected return and time. e. All of the above ANS: D
PTS: 1
OBJ: Multiple Choice Concept
22. The most important criteria when adding new investments to a portfolio is the a. Expected return of the new investment. b. Standard deviation of the new investment. c. Correlation of the new investment with the portfolio. d. Both a and b e. All of the above are equally important ANS: C
PTS: 1
OBJ: Multiple Choice Concept
23. A portfolio of two securities that are perfectly positively correlated has a. A standard deviation that is the weighted average of the individual securities standard deviations. b. An expected return that is the weighted average of the individual securities expected returns. c. No diversification benefit over holding either of the securities independently. d. Both b and c e. All of the above ANS: E
PTS: 1
OBJ: Multiple Choice Concept
24. All of the following are common risk measurements except a. Standard deviation b. Variance c. Semivariance d. Covariance e. Range of returns
ANS: D
PTS: 1
OBJ: Multiple Choice Concept
25. When assessing the risk impact of adding a new security to a portfolio, it is necessary to consider the a. New securities variance b. Variance of every security in the portfolio c. Weight of every security in the portfolio d. Average covariance of the new security with every security in the portfolio e. All of the above ANS: E
PTS: 1
OBJ: Multiple Choice Concept
26. Between 1990 and 2000, the standard deviation of the returns for the NIKKEI and the DJIA indexes were 0.18 and 0.16, respectively, and the covariance of these index returns was 0.003. What was the correlation coefficient between the two market indicators? a. 9.6 b. 0.0187 c. 0.1042 d. 0.0166 e. 0.343 ANS: C rA,B = (A,B) [(A)( B)] = (0.003) (0.18)(0.16) = .1042 PTS: 1
OBJ: Multiple Choice Problem
27. Between 1994 and 2004, the standard deviation of the returns for the S&P 500 and the NYSE indexes were 0.27 and 0.14, respectively, and the covariance of these index returns was 0.03. What was the correlation coefficient between the two market indicators? a. 1.26 b. 0.7937 c. 0.2142 d. 0.1111 e. 0.44 ANS: B rA,B = (A,B) [(A)( B)] = (0.03) (0.27)(0.14) = .7937 PTS: 1
OBJ: Multiple Choice Problem
28. Between 1980 and 1990, the standard deviation of the returns for the NIKKEI and the DJIA indexes were 0.19 and 0.06, respectively, and the covariance of these index returns was 0.0014. What was the correlation coefficient between the two market indicators? a. 8.1428 b. 0.0233 c. 0.0073 d. 0.2514 e. 0.1228 ANS: E rA,B = (A,B) [(A)( B)] = (0.0014) (0.19)(0.06) = .1228 PTS: 1
OBJ: Multiple Choice Problem
29. Between 1975 and 1985, the standard deviation of the returns for the NYSE and the S&P 500 indexes were 0.06 and 0.07, respectively, and the covariance of these index returns was 0.0008. What was the correlation coefficient between the two market indicators? a. .1525 b. .1388 c. .1458 d. .1622 e. .1064 ANS: C rA,B = (A,B) [(A)( B)] = (0.0008) (0.06)(0.07) = .1458 PTS: 1
OBJ: Multiple Choice Problem
30. Between 1986 and 1996, the standard deviation of the returns for the NYSE and the DJIA indexes were 0.10 and 0.09, respectively, and the covariance of these index returns was 0.0009. What was the correlation coefficient between the two market indicators? a. .1000 b. .1100 c. .1258 d. .1322 e. .1164 ANS: A rA,B = (A,B) [(A)( B)] = (0.0009) (0.10)(0.09) = .1000 PTS: 1
OBJ: Multiple Choice Problem
31. Between 1980 and 2000, the standard deviation of the returns for the NIKKEI and the DJIA indexes were 0.08 and 0.10, respectively, and the covariance of these index returns was 0.0007. What was the correlation coefficient between the two market indicators? a. .0906 b. .0985 c. .0796 d. .0875 e. .0654 ANS: D rA,B = (A,B) [(A)( B)] = (0.0007) (0.08)(0.10) = .0875 PTS: 1
OBJ: Multiple Choice Problem
32. What is the expected return of the three stock portfolio described below? Common Stock Ando Inc. Bee Co. Cool Inc. a. b. c. d. e.
18.45% 12.82% 13.38% 15.27% 16.67%
Market Value 95,000 32,000 65,000
Expected Return 12.0% 8.75% 17.7%
ANS: C WA = 95,000 192,000 = 0.4947 WB = 32,000 192,000 = 0.1667 WC = 65,000 192,000 = 0.3385 0.1338 = (0.4947)(0.12) + (0.1667)(0.0875) + (0.3385)(0.177) PTS: 1
OBJ: Multiple Choice Problem
33. What is the expected return of the three stock portfolio described below? Common Stock Xerox Yelcon Zwiebal a. b. c. d. e.
Market Value 125,000 250,000 175,000
Expected Return 8% 25% 16%
18.27% 14.33% 16.33% 12.72% 16.45%
ANS: A WX = 125,000 550,000 = 0.2273 WY = 250,000 550,000 = 0.4545 WZ = 175,000 550,000 = 0.3182 0.1827 = (0.2273)(0.08) + (0.4545)(0.25) + (0.3182)(0.16) PTS: 1
OBJ: Multiple Choice Problem
34. What is the expected return of the three stock portfolio described below? Common Stock Alko Inc. Belmont Co. Cardo Inc. a. b. c. d. e.
Market Value 25,000 100,000 75,000
21.33% 12.50% 32.00% 15.75% 16.80%
ANS: D WA = 25,000 200,000 = 0.125 WB = 100,000 200,000 = 0.50 WC = 75,000 200,000 = 0.375
Expected Return 38% 10% 16%
0.1575 = (0.125)(0.38) + (0.5)(0.1) + (0.375)(0.16) PTS: 1
OBJ: Multiple Choice Problem
35. What is the expected return of the three stock portfolio described below? Common Stock Delton Inc. Efley Co. Grippon Inc. a. b. c. d. e.
Market Value 50,000 40,000 60,000
Expected Return 10% 11% 16%
14.89% 16.22% 12.66% 13.85% 16.99%
ANS: C WD = 50,000 150,000 = 0.33 (0.33)(10) = 3.33 WE = 40,000 150,000 = 0.27 (0.27)(11) = 2.93 WG = 60,000 150,000 = 0.40 (0.40)(16) = 6.40 3.33 + 2.93 + 6.4 = 12.66% PTS: 1
OBJ: Multiple Choice Problem
36. What is the expected return of the three stock portfolio described below? Common Stock Lupko Inc. Mackey Co. Nippon Inc. a. b. c. d. e.
Market Value 50,000 25,000 75,000
12.04% 12.83% 13.07% 15.89% 17.91%
ANS: B WL = 50,000 150,000 = 0.33 (0.33)(13) = 4.33 WM = 25,000 150,000 = 0.167 (0.167)(9) = 1.50 WN = 75,000 150,000 = 0.50 (0.50)(14) = 7.0
Expected Return 13% 9% 14%
4.33 + 1.50 + 7.0 = 12.83% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 7.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Asset (A) Asset (B) E(RA) = 10% E(RB) = 15% (A) = 8% (B) = 9.5% WA = 0.25 WB = 0.75 CovA,B = 0.006 37. Refer to Exhibit 7.1. What is the expected return of a portfolio of two risky assets if the expected return E(Ri), standard deviation (i), covariance (COVi,j), and asset weight (Wi) are as shown above? a. 8.79% b. 12.5% c. 13.75% d. 7.72% e. 12% ANS: C E(Rp) = WAE(RA) + WBE(RB) = (0.25)(10) + (0.75)(15) = 13.75% PTS: 1
OBJ: Multiple Choice Problem
38. Refer to Exhibit 7.1. What is the standard deviation of this portfolio? a. 8.79% b. 13.75% c. 12.5% d. 7.72% e. 5.64% ANS: A p = [(WA)2 (A)2 + (WB)2 (B)2 + (2)(WA)(WB)(COVA,B)]1/2 = [(0.25)2(0.08)2 + (0.75)2(0.095)2 + (2)(0.25)(0.75)(0.006)]1/2 = 8.79% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 7.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Asset (A) Asset (B) E(RA) = 25% E(RB) = 15% (A) = 18% (B) = 11% WA = 0.75 WB = 0.25 COVA,B = −0.0009 39. Refer to Exhibit 7.2. What is the expected return of a portfolio of two risky assets if the expected return E(Ri), standard deviation (i), covariance (COVi,j), and asset weight (Wi) are as shown above?
a. b. c. d. e.
18.64% 20.0% 22.5% 13.65% 11%
ANS: C E(Rp) = WAE(RA) + WBE(RB) = (0.75)(25) + (0.25)(15) = 22.5% PTS: 1
OBJ: Multiple Choice Problem
40. Refer to Exhibit 7.2. What is the standard deviation of this portfolio? a. 5.45% b. 18.64% c. 20.0% d. 22.5% e. 13.65% ANS: E p = [(WA)2 (A)2 + (WB)2 (B)2 + (2)(WA)(WB)(COVA,B)]1/2 = [(0.75)2(0.18)2 + (0.25)2(0.11)2 + (2)(0.75)(0.25)(−0.0009]1/2 = 13.65% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 7.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Asset (A) Asset (B) E(RA) = 9% E(RB) = 11% (A) = 4% (B) = 6% WA = 0.4 WB = 0.6 COVA,B = 0.0011 41. Refer to Exhibit 7.3. What is the expected return of a portfolio of two risky assets if the expected return E(Ri), standard deviation (i), covariance (COVi,j), and asset weight (Wi) are as shown above? a. 8.95% b. 9.30% c. 9.95% d. 10.20% e. 10.70% ANS: D E(Rp) = WAE(RA) + WBE(RB) = (0.4)(9) + (0.6)(11) = 10.20% PTS: 1
OBJ: Multiple Choice Problem
42. Refer to Exhibit 7.3. What is the standard deviation of this portfolio? a. 3.68% b. 4.56% c. 4.99% d. 5.16%
e. 6.02% ANS: B p = [(WA)2 (A)2 + (WB)2 (B)2 + (2)(WA)(WB)(COVA,B)]1/2 = [(0.4)2 (0.04)2 + (0.6)2(0.06)2 + (2)(0.4)(0.6)(0.0011)]1/2 = (0.002080)1/2 = 4.56% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 7.4 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Asset (A) Asset (B) E(RA) = 10% E(RB) = 8% (A) = 6% (B) = 5% WA = 0.3 WB = 0.7 COVA,B = 0.0008 43. Refer to Exhibit 7.4. What is the expected return of a portfolio of two risky assets if the expected return E(Ri), standard deviation (i), covariance (COVi,j), and asset weight (Wi) are as shown above? a. 8.6% b. 8.1% c. 9.3% d. 10.2% e. 11.6% ANS: A E(Rp) = WAE(RA) + WBE(RB) = (0.3)(10) + (0.7)(8) = 8.6% PTS: 1
OBJ: Multiple Choice Problem
44. Refer to Exhibit 7.4. What is the standard deviation of this portfolio? a. 5.02% b. 3.88% c. 6.21% d. 4.04% e. 4.34% ANS: E p = [(WA)2 (A)2 + (WB)2 (B)2 + (2)(WA)(WB)(COVA,B)]1/2 = [(0.3)2(0.06)2 + (0.7)2(0.05)2 + (2)(0.3)(0.7)(0.0008)]1/2 = (0.001885)1/2 = 4.34% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 7.5 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Asset (A) Asset (B) E(RA) = 8% E(RB) = 15% (A) = 7% (B) = 10% WA = 0.4 WB = 0.6 COVA,B = 0.0006
45. Refer to Exhibit 7.5. What is the expected return of a portfolio of two risky assets if the expected return E(Ri), standard deviation (i), covariance (COVi,j), and asset weight (Wi) are as shown above? a. 8.0% b. 12.2% c. 7.4% d. 9.1% e. 11.6% ANS: B E(Rp) = WAE(RA) + WBE(RB) = (0.4)(8) + (0.6)(15) = 12.2% PTS: 1
OBJ: Multiple Choice Problem
46. Refer to Exhibit 7.5. What is the standard deviation of this portfolio? a. 3.89% b. 4.61% c. 5.02% d. 6.83% e. 6.09% ANS: D p = [(WA)2 (A)2 + (WB)2 (B)2+ (2)(WA)(WB)(COVA,B)]1/2 = [(0.4)2(0.07)2 + (0.6)2(0.10)2 + (2)(0.6)(0.4)(0.0006)]1/2 = (0.004672)1/2 = 6.83% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 7.6 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Asset (A) Asset (B) E(RA) = 16% E(RB) = 10% (A) = 9% (B) = 7% WA = 0.5 WB = 0.5 COVA,B = 0.0009 47. Refer to Exhibit 7.6. What is the expected return of a portfolio of two risky assets if the expected return E(Ri), standard deviation (i), covariance (COVi,j), and asset weight (Wi) are as shown above? a. 10.6 % b. 10.2% c. 13.0% d. 11.9% e. 14.0% ANS: C E(Rp) = WAE(RA) + WBE(RB) = (0.5)(16) + (0.5)(10) = 13% PTS: 1
OBJ: Multiple Choice Problem
48. Refer to Exhibit 7.6. What is the standard deviation of this portfolio? a. 6.08%
b. c. d. e.
5.89% 7.06% 6.54% 7.26%
ANS: A p = [(WA)2 (A)2 + (WB)2 (B)2 + (2)(WA)(WB)(COVA,B)]1/2 = [(0.5)2(0.09)2 + (0.5)2(0.07)2 + (2)(0.5)(0.5)(0.0009)]1/2 = (0.0037)1/2 = 6.08% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 7.7 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Asset (A) Asset (B) E(RA) = 7% E(RB) = 9% (A) = 6% (B) = 5% WA = 0.6 WB = 0.4 COVA,B = 0.0014 49. Refer to Exhibit 7.7. What is the expected return of a portfolio of two risky assets if the expected return E(Ri), standard deviation (i), covariance (COVi,j), and asset weight (Wi) are as shown above? a. 5.8% b. 6.1% c. 6.9% d. 7.8% e. 8.9% ANS: D E(Rp) = WAE(RA) + WBE(RB) = (0.6)(7) + (0.4)(9) = 7.8% PTS: 1
OBJ: Multiple Choice Problem
50. Refer to Exhibit 7.7. What is the standard deviation of this portfolio? a. 4.87% b. 3.62% c. 4.13% d. 5.76% e. 6.02% ANS: A p = [(WA)2 (A)2 + (WB)2(B)2 + (2)(WA)(WB)(COVA,B)]1/2 = [(0.6)2(0.06)2 + (0.4)2(0.05)2 + (2)(0.6)(0.4)(0.0014)]1/2 = (0.002368)1/2 = 4.87% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 7.8 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Asset (A) E(RA) = 10%
Asset (B) E(RB) = 14%
(A) = 7% (B) = 8% WA = 0.7 WB = 0.3 COVA,B = 0.0013 51. Refer to Exhibit 7.8. What is the expected return of a portfolio of two risky assets if the expected return E(Ri), standard deviation (i), covariance (COVi,j), and asset weight (Wi) are as shown above? a. 6.4% b. 9.1% c. 10.2% d. 10.8% e. 11.2% ANS: E E(Rp) = WAE(RA) + WBE(RB) = (0.7)(10) + (0.3)(14) = 11.2% PTS: 1
OBJ: Multiple Choice Problem
52. Refer to Exhibit 7.8. What is the standard deviation of this portfolio? a. 4.51% b. 5.94% c. 6.75% d. 7.09% e. 8.62% ANS: B p = [(WA)2 (A)2 + (WB)2 (B)2 + (2)(WA)(WB)(COVA,B)]1/2 = [(0.7)2(0.07)2 + (0.3)2(0.08)2 + (2)(0.7)(0.3)(0.0013)]1/2 = (0.003523)1/2 = 5.94% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 7.9 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Asset (A) Asset (B) E(RA) = 18% E(RB) = 13% (A) = 7% (B) = 6% WA = 0.3 WB = 0.7 COVA,B = 0.0011 53. Refer to Exhibit 7.9. What is the expected return of a portfolio of two risky assets if the expected return E(Ri), standard deviation (i), covariance (COVi,j), and asset weight (Wi) are as shown above? a. 10.10% b. 11.60% c. 13.88% d. 14.50% e. 15.37% ANS: D E(Rp) = WAE(RA) + WBE(RB) = (0.3)(18) + (0.7)(13) = 14.5% PTS: 1
OBJ: Multiple Choice Problem
54. Refer to Exhibit 7.9. What is the standard deviation of this portfolio? a. 5.16% b. 5.89% c. 6.11% d. 6.57% e. 7.02% ANS: A p = [(WA)2 (A)2 + (WB)2 (B)2 + (2)(WA)(WB)(COVA,B)]1/2 = [(0.3)2(0.07)2 + (0.7)2(0.06)2 + (2)(0.3)(0.7)(0.0011)]1/2 = (0.002667)1/2 = 5.16% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 7.10 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Asset (A) Asset (B) E(RA) = 16% E(RB) = 14% (A) = 3% (B) = 8% WA = 0.5 WB = 0.5 COVA,B = 0.0014 55. Refer to Exhibit 7.10. What is the expected return of a portfolio of two risky assets if the expected return E(Ri), standard deviation (i), covariance (COVi,j), and asset weight (Wi) are as shown above? a. 11% b. 12% c. 13% d. 14% e. 15% ANS: E E(Rp) = WAE(RA) + WBE(RB) = (0.5)(16) + (0.5)(14) = 15% PTS: 1
OBJ: Multiple Choice Problem
56. Refer to Exhibit 7.10. What is the standard deviation of this portfolio? a. 3.02% b. 4.88% c. 5.24% d. 5.98% e. 6.52% ANS: C p = [(WA)2 (A)2 + (WB)2 (B)2 + (2)(WA)(WB)(COVA,B)]1/2 = [(0.5)2(0.03)2 + (0.5)2(0.08)2 + (2)(0.5)(0.5)(0.0014)]1/2 = (0.002750)1/2 = 5.24% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 7.11 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Asset 1 E(R1) = 0.28 E(1) = 0.15 W1 = 0.42
Asset 2 E(R2) = 0.12 E(2) = 0.11 W2 = 0.58 r1,2 = 0.7
57. Refer to Exhibit 7.11. Calculate the expected return of the two stock portfolio. a. 0.107 b. 0.1367 c. 0.1169 d. 0.1872 e. 0.20 ANS: D Rp = (0.42)(0.28) + (0.58)(0.12) = 0.1872 PTS: 1
OBJ: Multiple Choice Problem
58. Refer to Exhibit 7.11. Calculate the expected standard deviation of the two stock portfolio. a. 0.1367 b. 0.1872 c. 0.1169 d. 0.20 e. 0.3950 ANS: C = [(0.42)2 (0.15)2 + (0.58)2 (0.11)2 + (2)(0.42)(0.58)(0.15)(0.11)(0.7)]1/2 p = 0.1169 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 7.12 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Asset 1 E(R1) = .12 E(1) = .04
Asset 2 E(R2) = .16 E(2) = .06
59. Refer to Exhibit 7.12. Calculate the expected return and expected standard deviation of a two stock portfolio when r1,2 = −.60 and w1 = .75. a. .13 and .0024 b. .13 and .0455 c. .12 and .0585 d. .12 and .5585 e. .13 and .6758 ANS: A Rp = (0.75)(0.12) + (0.25)(0.16) = 0.13 p
= [(0.75)2 (0.04)2 + (0.25)2(0.06)2 + (2)(0.75)(0.25)(0.04)(0.06) − 0.6]1/2 = [0.0009 + 0.000225 − 0.00054]1/2 = [0.000585]1/2 = 0.024
PTS: 1
OBJ: Multiple Choice Problem
60. Refer to Exhibit 7.12. Calculate the expected returns and expected standard deviations of a two stock portfolio when r1,2 = .80 and w1 = .60. a. .144 and .0002 b. .144 and .0018 c. .136 and .0045 d. .136 and .0455 e. .136 and .4554 ANS: D Rp = (0.60)(0.12) + (0.40)(0.16) = 0.136 p
= [(0.60)2 (0.04)2 + (0.40)2(0.06)2 + (2)(0.60)(0.40)(0.04)(0.06)(0.8)]1/2 = [0.000576 + 0.000576 + 0.000922]1/2 = [0.002074]1/2 = 0.0455
PTS: 1
OBJ: Multiple Choice Problem
61. Consider two securities, A and B. Security A and B have a correlation coefficient of 0.65. Security A has standard deviation of 12, and security B has standard deviation of 25. Calculate the covariance between these two securities. a. 300 b. 461.54 c. 261.54 d. 195 e. 200 ANS: D Cov(A, B) = (0.65)(12)(25) = 195 PTS: 1
OBJ: Multiple Choice Problem
62. Calculate the expected return for a three asset portfolio with the following Asset A B C a. b. c. d. e.
Exp. Ret. 0.0675 0.1235 0.1425
Std. Dev 0.12 0.1675 0.1835
Weight 0.25 0.35 0.40
11.71% 11.12% 15.70% 14.25% 6.75%.
ANS: A Expected Return = 11.71% = (0.25)(0.0675) + (0.35)(0.1235) + (0.40)(0.1425) PTS: 1
OBJ: Multiple Choice Problem
63. Given the following weights and expected security returns, calculate the expected return for the portfolio. Weight .20
Expected Return .06
.25 .30 .25 a. b. c. d. e.
.08 .10 .12
0.085 0.090 0.092 0.097 None of the above
ANS: C Weight .20 .25 .30 .25
PTS: 1
Expected Return .06 .08 .10 .12
WiRi .012 .020 .030 .030 .092
OBJ: Multiple Choice Problem
Exhibit 7.13 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) A financial analyst covering Magnum Oil has determined the following four possible returns given four different states of the economy over the next period. Probability 0.10 0.25 0.40 0.25
Return −.20 −.05 0.15 0.30
64. Refer to Exhibit 7.13. Calculate the expected return for Magnum Oil. a. 5.0 b. 10.3% c. 13.7% d. 17.5% e. 20.0% ANS: B Expected Return for Magnum Oil
PTS: 1
= 0.1(−0.20) + 0.25(−0.05) + 0.40(0.15) + (0.25)(0.30) = −0.02 − 0.0125 + 0.06 + 0.075 = 0.1025
OBJ: Multiple Choice Problem
65. Refer to Exhibit 7.13. Calculate the standard deviation for Magnum Oil. a. 0% b. 11% c. 16% d. 20% e. 26% ANS: C
PTS: 1
OBJ: Multiple Choice Problem
Exhibit 7.14 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Stocks A and B have a correlation coefficient of −0.8. The stocks' expected returns and standard deviations are in the table below. A portfolio consisting of 40% of stock A and 60% of stock B is constructed. Stock A B
Expected Return 20% 15%
Standard Deviation 25% 19%
66. Refer to Exhibit 7.14. What is the expected return of the stock A and B portfolio? a. 17.0% b. 17.5% c. 18.0% d. 18.5% e. 19.0% ANS: A Expected return = 0.40(0.20) + 0.60(0.15) = 0.08 + 0.09 = 0.17 PTS: 1
OBJ: Multiple Choice Problem
67. Refer to Exhibit 7.14. What is the standard deviation of the stock A and B portfolio? a. 0.0% b. 0.5% c. 4.1% d. 6.9% e. 20.3% ANS: D The portfolio of stocks A and B has a standard deviation of
PTS: 1
OBJ: Multiple Choice Problem
68. Refer to Exhibit 7.14. What percentage of stock A should be invested to obtain the minimum risk portfolio that contains stock A and B? a. 35% b. 42%
c. 58% d. 65% e. 72% ANS: B
PTS: 1
OBJ: Multiple Choice Problem
69. What is the standard deviation of an equally weighted portfolio of two stocks with a covariance of 0.009, if the standard deviation of the first stock is 15% and the standard deviation of the second stock is 20%? a. 2.0% b. 2.1% c. 7.8% d. 14.2% e. 14.7% ANS: D The correlation coefficient is 0.3 calculated as follows .009/(.15)(.2). The portfolio s.d. =
PTS: 1
OBJ: Multiple Choice Problem
Exhibit 7.15 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Asset (A) Asset (B) E(RA) = 14% E(RB) = 16% (A) = 13% (B) = 18% WA = 0.4 WB = 0.6 COVA,B = 0.0024 70. Refer to Exhibit 7.15. What is the expected return of a portfolio of two risky assets if the expected return E(Ri), standard deviation (i), covariance (COVi,j), and asset weight (Wi) are as shown above? a. 13.8% b. 14.6% c. 15.0% d. 15.2% e. 16.8% ANS: D E(Rp) = WAE(RA) + WBE(RB) = (0.4)(14%) + (0.6)(16%) = 5.6% + 9.6% = 15.2% PTS: 1
OBJ: Multiple Choice Problem
71. Refer to Exhibit 7.15. What is the standard deviation of this portfolio? a. 10.0%
b. c. d. e.
12.5% 14.4% 15.5% 16.0%
ANS: B p = [(WA)2 (A)2 + (WB)2 (B)2 + (2)(WA)(WB)(COVA,B)]1/2 = [(0.4)2(0.13)2 + (0.6)2(0.18)2 + (2)(0.4)(0.6)(0.0024)]1/2 = [0.00270 + 0.01167 + 0.00115]1/2 = [0.01552]1/2 = 0.12459 or 12.5% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 7.16 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Based on the economic outlook for the industry a financial analyst covering Top Choice Corporation has determined the following three possible returns given three different states of the economy over the next period. Probability 0.25 0.50 0.25
Return 0.02 0.14 0.30
72. Refer to Exhibit 7.16. What is the expected return for Top Choice Corporation? a. 5.2% b. 10.4% c. 13.7% d. 15.0% e. 17.6% ANS: D Expected Return for Top Choice Corporation
PTS: 1
= 0.25(0.02) + 0.5(0.14) + (0.25)(0.30) = 0.005 + 0.07 + 0.075 = 0.15
OBJ: Multiple Choice Problem
73. Refer to Exhibit 7.16. What is the standard deviation for Top Choice Corporation? a. 0.1% b. 6.3% c. 7.9% d. 9.4% e. 12.1% ANS: C
PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 7 APPENDIX A MULTIPLE CHOICE Exhibit 7A.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The general equation for the weight of the first security to achieve the minimum variance (in a two stock portfolio) is given by: W1 = [E(2)2 − r1.2 E(1)E(2)] [E(1)2 + E(2)2 − 2 r1.2E(1)E(2)] 1. Refer to Exhibit 7A.1. What weight of security 1 gives the minimum portfolio variance when r1.2 = .60, E(1) = .10 and E(2) = .16? a. .0244 b. .3679 c. .5697 d. .6309 e. .9756 ANS: E W1 = [(.16)2 − .60 .10 .16(.016)] [.102 + .162 − 2(.60)(.10)(.16)] = .016 .0164 = .9756 PTS: 1
OBJ: Multiple Choice Problem
2. Refer to Exhibit 7A.1. Show the minimum portfolio variance for a two stock portfolio when r1.2 = 1. a. E(2) [E(1) − E(2)] b. E(2) [E(1) + E(2)] c. E(1) [E(1) − E(2)] d. E(1) [E(1) + E(2)] e. None of the above ANS: A Substitute 1 for r1.2 in the general equation. W1 = [E(2)2 − (1) E(1)E(2)] [E(1)2 + E(2)2 − 2(1)E(1)E(2)] W1 = [E(2)2 − E(1)E(2)] [E(1)2 + E(2)2 − 2E(1)E(2)] W1 = E(2) [E(2) −E(1)] [E(1) − E(2)]2 = E(2) [E(1) − E(2)] PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 7 APPENDIX B MULTIPLE CHOICE Exhibit 7B.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The general equation for the weight of the first security to achieve the minimum variance (in a two stock portfolio) is given by: W1 = [E(1)2 − r1.2 E(1) E(2)] [E(1)2 + E(2)2 − 2 r1.2 E(1) E(2)] 1. Refer to Exhibit 7B.1. Show the minimum portfolio variance for a portfolio of two risky assets when r1.2 = −1. a. E(1) [E(1) + E(2)] b. E(1) [E(1) − E(2)] c. E(2) [E(1) + E(2)] d. E(2) [E(1) − E(2)] e. None of the above ANS: C Substitute −1 for r1.2 in the general equation W1 = [E(2)2 − (−1)E(1) E(2)] [E(1)2 + E(2)2 − 2(−1)E(1)E(2)] W1 = [E(2)2 + E(1)E(2)] [E(1)2 + E(2)2 + 2(1)E(1)E(2)] W1
= E(2) [E(2) + E(1)] [E(1) + E(2)]2 = E(2) [E(1) + E(2)]
PTS: 1
OBJ: Multiple Choice Problem
2. Refer to Exhibit 7B.1. What is the value of W1 when r1.2 = −1 and E(1) = .10 and E(2) = .12? a. 45.46% b. 50.00% c. 59.45% d. 54.55% e. 74.55% ANS: D W1 = 12/(.12 + .10) = .5455 = 54.55% PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 8—AN INTRODUCTION TO ASSET PRICING MODELS TRUE/FALSE 1. One of the assumptions of capital market theory is that investors can borrow or lend at the risk free rate. ANS: T
PTS: 1
2. Since many of the assumptions made by the capital market theory are unrealistic, the theory is not applicable in the real world. ANS: F
PTS: 1
3. A risk-free asset is one in which the return is completely guaranteed; there is no uncertainty. ANS: T
PTS: 1
4. The market portfolio consists of all risky assets. ANS: T
PTS: 1
5. The introduction of lending and borrowing severely limits the available risk/return opportunities. ANS: F
PTS: 1
6. The capital market line is the tangent line between the risk free rate of return and the efficient frontier. ANS: T
PTS: 1
7. The portfolios on the capital market line are combinations of the risk-free asset and the market portfolio. ANS: T
PTS: 1
8. If you borrow money at the RFR and invest the money in the market portfolio, the rate of return on your portfolio will be higher than the market rate of return. ANS: T
PTS: 1
9. Studies have shown that a well-diversified investor needs as few as five stocks. ANS: F
PTS: 1
10. Beta is a measure of unsystematic risk. ANS: F
PTS: 1
11. The betas of those companies compiled by Value Line Investment Services tend to be almost identical to those compiled by Merrill Lynch. ANS: F
PTS: 1
12. Securities with returns that lie above the security market line are undervalued. ANS: T
PTS: 1
13. Securities with returns that lie below the security market line are undervalued. ANS: F
PTS: 1
14. Under the CAPM framework, the introduction of lending and borrowing at differential rates leads to a non-linear capital market line. ANS: T
PTS: 1
15. Correlation of the market portfolio and the zero-beta portfolio will be linear. ANS: T
PTS: 1
16. There can be only one zero-beta portfolio. ANS: F
PTS: 1
17. The existence of transaction costs indicates that at some point the additional cost of diversification relative to its benefit would be excessive for most investors. ANS: T
PTS: 1
18. Studies have shown the beta is more stable for portfolios than for individual securities. ANS: T
PTS: 1
19. If the market portfolio is mean-variance efficient it has the lowest risk for a given level of return among the attainable set of portfolios. ANS: T
PTS: 1
20. Using the S&P index as the proxy market portfolio when evaluating a portfolio manager relative to the SML will tend to underestimate the manager's performance. ANS: F
PTS: 1
21. If an incorrect proxy market portfolio such as the S&P index is used when developing the security market line, the slope of the line will tend to be underestimated. ANS: T
PTS: 1
22. Since the market portfolio is reasonable in theory, it is easy to implement when testing or using the CAPM. ANS: F
PTS: 1
23. The planning period for the CAPM is the same length of time for every investor. ANS: F
PTS: 1
24. The only way to estimate a beta for a security is to calculate the covariance of the security with the market. ANS: F
PTS: 1
25. The "true" market portfolio is unknown. ANS: T
PTS: 1
26. More recent studies done in 2001 suggest more securities are needed than historically to create a well-diversified portfolio. ANS: T
PTS: 1
27. Tobin's separation theory states that the market is a separate investment from the risk-free security. ANS: F
PTS: 1
28. The standard deviation for the risk-free security is equal to zero. ANS: T
PTS: 1
29. The Capital Market Line (CML) can be thought of as the new Efficient Frontier. ANS: T
PTS: 1
30. The usefulness of CAPM theory is limited in practice due to benchmark error. ANS: T
PTS: 1
31. Overall the correlation coefficients of industries to the market portfolio vary widely, which is expected due to the wide variance of industry Betas. ANS: F
PTS: 1
32. The Capital Market Line (CML) refers only to those portfolios that lie on the line segment that extends from the risk-free asset to the point of tangency on the efficient frontier known as the market portfolio. ANS: F
PTS: 1
MULTIPLE CHOICE 1. Which of the following is not an assumption of the Capital Market Theory? a. All investors are Markowitz efficient investors. b. All investors have homogeneous expectations. c. There are no taxes or transaction costs in buying or selling assets. d. All investments are indivisible so it is impossible to buy or sell fractional shares. e. All investors have the same one period time horizon. ANS: D
PTS: 1
OBJ: Multiple Choice
2. The rate of return on a risk free asset should equal the
a. b. c. d. e.
Long run real growth rate of the economy. Long run nominal growth rate of the economy. Short run real growth rate of the economy. Short run nominal growth rate of the economy. Prime rate of interest.
ANS: A
PTS: 1
OBJ: Multiple Choice
3. Which of the following statements about the risk-free asset is correct? a. The risk-free asset is defined as an asset for which there is uncertainty regarding the expected rate of return. b. The standard deviation of return for the risk-free asset is equal to zero. c. The standard deviation of return for the risk-free asset cannot be zero, since division by zero is undefined. d. Choices a and b. e. Choices a and c. ANS: B
PTS: 1
OBJ: Multiple Choice
4. What does WRF = −0.50 mean? a. The investor can borrow money at the risk-free rate. b. The investor can lend money at the current market rate. c. The investor can borrow money at the current market rate. d. The investor can borrow money at the prime rate of interest. e. The investor can lend money at the prime rate of interest. ANS: A
PTS: 1
OBJ: Multiple Choice
5. The market portfolio consists of all a. New York Stock Exchange stocks. b. High grade stocks and bonds. c. Stocks and bonds. d. U.S. and non-U.S. stocks and bonds. e. Risky assets. ANS: E
PTS: 1
OBJ: Multiple Choice
6. The separation theorem divides decisions on ____ from decisions on ____. a. Lending, borrowing b. Risk, return c. Investing, financing d. Risky assets, risk free assets e. Buying stocks, buying bonds ANS: C
PTS: 1
OBJ: Multiple Choice
7. When identifying undervalued and overvalued assets, which of the following statements is false? a. An asset is properly valued if its estimated rate of return is equal to its required rate of return. b. An asset is considered overvalued if its estimated rate of return is below its required rate of return. c. An asset is considered undervalued if its estimated rate of return is above its required rate of return. d. An asset is considered overvalued if its required rate of return is below its estimated rate of return.
e. None of the above (that is, all are true statements) ANS: D
PTS: 1
OBJ: Multiple Choice
8. The line of best fit for a scatter diagram showing the rates of return of an individual risky asset and the market portfolio of risky assets over time is called the a. Security market line. b. Capital asset pricing model. c. Characteristic line. d. Line of least resistance. e. Market line. ANS: C
PTS: 1
OBJ: Multiple Choice
9. Utilizing the security market line an investor owning a stock with a beta of −2 would expect the stock's return to ____ in a market that was expected to decline 15 percent. a. Rise or fall an indeterminate amount b. Fall by 3% c. Fall by 30% d. Rise by 13% e. Rise by 30% ANS: E
PTS: 1
OBJ: Multiple Choice
10. All of the following questions remain to be answered in the real world except a. What is a good proxy for the market portfolio? b. What happens when you cannot borrow or lend at the risk free rate? c. How good is the capital asset model as a predictor? d. What is the beta of the market portfolio of risky assets? e. What is the stability of beta for individual stocks? ANS: D
PTS: 1
OBJ: Multiple Choice
11. The correlation coefficient between the market return and a risk-free asset would a. be +. b. be −. c. be +1. d. be −1. e. be Zero. ANS: E
PTS: 1
OBJ: Multiple Choice
12. As the number of securities in a portfolio increases, the amount of systematic risk a. Remains constant. b. Decreases. c. Increases. d. Changes. e. None of the above ANS: A
PTS: 1
OBJ: Multiple Choice
13. Theoretically, the correlation coefficient between a completely diversified portfolio and the market portfolio should be a. −1.0. b. +1.0.
c. 0.0. d. −0.5. e. +0.5. ANS: B
PTS: 1
OBJ: Multiple Choice
14. All portfolios on the capital market line are a. Perfectly positively correlated. b. Perfectly negatively correlated. c. Unique from each other. d. Weakly correlated. e. Unrelated except that they contain the risk free asset. ANS: A
PTS: 1
OBJ: Multiple Choice
15. The fact that tests have shown the CAPM intercept to be greater than the RFR is consistent with a(n) a. Zero beta model. b. unstable beta or a higher borrowing rate. c. Zero beta model or a higher borrowing rate. d. higher borrowing rate. e. unstable beta. ANS: C
PTS: 1
OBJ: Multiple Choice
16. If the assumption that there are no transaction costs is relaxed, the SML will be a a. Straight line. b. Band of securities. c. Convex curve. d. Concave curve. e. Parabolic curve. ANS: B
PTS: 1
OBJ: Multiple Choice
17. Which of the following is not a relaxation of the assumptions for the CAPM? a. Differential lending and borrowing rates b. A zero beta model c. Transaction costs d. Taxes e. Homogeneous expectations and fixed planning periods ANS: E
PTS: 1
OBJ: Multiple Choice
18. Which of the following variables were found to be important in explaining return based upon a study of Fama and French (covering the period 1963 to 1990)? a. Size b. Book-to-market value c. Beta d. Choices a and b only e. All of the above ANS: D
PTS: 1
OBJ: Multiple Choice
19. Which of the following would most closely resemble the true market portfolio? a. Stocks b. Stocks and bonds c. Stocks, bonds and foreign securities
d. Stocks, bonds, foreign securities and options e. Stocks, bonds, foreign securities options and coins ANS: E
PTS: 1
OBJ: Multiple Choice
20. The error caused by not using the true market portfolio has become known as the a. Portfolio deviation. b. CAPM shift. c. Benchmark error. d. Market error. e. Beta error. ANS: C
PTS: 1
OBJ: Multiple Choice
21. The ____ the number of stocks in a portfolio and the ____ the time period the ____ the portfolio beta. a. Larger, longer, less stable b. Larger, longer, more stable c. Larger, shorter, less stable d. Larger, shorter, more stable e. Smaller, longer, more stable ANS: B
PTS: 1
OBJ: Multiple Choice
22. A completely diversified portfolio would have a correlation with the market portfolio that is a. Equal to zero because it has only unsystematic risk. b. Equal to one because it has only systematic risk. c. Less than zero because it has only systematic risk. d. Less than one because it has only unsystematic risk. e. Less than one because it has only systematic risk. ANS: B
PTS: 1
OBJ: Multiple Choice
23. In the presence of transactions costs, the SML will be a. A single straight line. b. A kinked line. c. A set of lines rather than a single straight line. d. A curve rather than a single straight line. e. Impossible to determine. ANS: C
PTS: 1
OBJ: Multiple Choice
24. If the wrong benchmark (or market portfolio) is selected then a. Computed betas would be wrong. b. The SML would be wrong. c. Computed betas would be correct. d. a and b. e. b and c. ANS: D
PTS: 1
OBJ: Multiple Choice
25. All of the following are assumptions of the Capital Asset Pricing Model (CAPM) except a. Investors can borrow and lend any amount at the risk-free rate. b. Investors all have homogeneous expectations regarding expected returns. c. Investors can have different time horizons, daily, weekly, annual, or some other period. d. All investments are infinitely divisible. e. Capital markets are in equilibrium.
ANS: C
PTS: 1
OBJ: Multiple Choice
26. Beta is a measure of: a. Company specific risk b. Industry risk c. Diversifiable risk d. Systematic risk e. Unique risk ANS: C
PTS: 1
OBJ: Multiple Choice
27. The Efficient Frontier refers to a set of portfolios that a. Have the highest expected return for a given level of risk. b. Have the lowest risk for a given level of return. c. Are dominant to all other portfolios. d. a, b, and c above are correct. e. None of the answers above are correct. ANS: D
PTS: 1
OBJ: Multiple Choice
28. If an individual owns only one security the most appropriate measure of risk is: a. Standard deviation b. Correlation c. Beta d. Covariance e. All of the above are equally important ANS: A
PTS: 1
OBJ: Multiple Choice
29. The betas for the market portfolio and risk-free security are:
a. b. c. d. e.
Market 0 1 −1 1 2
ANS: B
Risk-free 1 0 1 −1 1 PTS: 1
OBJ: Multiple Choice
30. A portfolio manager uses two different proxies for the market portfolio, the S&P 500 index and the MSCI World index. Differences in the manager's portfolio performance resulting from the different market portfolios is referred to as a. The size effect b. The market effect c. Measurement error d. Benchmark error e. Manager's performance error ANS: D
PTS: 1
OBJ: Multiple Choice
31. The capital market line (CML) uses ____ as a risk measurement, whereas the capital asset pricing model (CAPM) uses ____. a. Beta; total risk b. Standard deviation; total risk
c. Standard deviation; systematic risk d. Unsystematic risk; total risk e. Systematic risk; beta ANS: C
PTS: 1
OBJ: Multiple Choice
32. Which of the following is not a major difference between the capital market line (CML) and the capital asset pricing model (CAPM)? a. Definitions of portfolio risk are based on systematic and total risk b. One is related to the market portfolio, the other does not c. The number of calculations to determine risk is significantly greater for one method d. One requires a tangency point on the efficient frontier, the other does not e. All of the above ANS: B
PTS: 1
OBJ: Multiple Choice
33. Calculate the expected return for A Industries which has a beta of 1.75 when the risk free rate is 0.03 and you expect the market return to be 0.11. a. 11.13% b. 14.97% c. 16.25% d. 22.25% e. 17.0% ANS: E k = 0.03 + 1.75 (0.11 − 0.03) = 0.17 PTS: 1
OBJ: Multiple Choice Problem
34. Calculate the expected return for B Services which has a beta of 0.83 when the risk free rate is 0.05 and you expect the market return to be 0.12. a. 14.96% b. 16.15% c. 10.81% d. 17.00% e. 15.25% ANS: C k = 0.05 + 0.83 (0.12 − 0.05) = 0.1081 PTS: 1
OBJ: Multiple Choice Problem
35. Calculate the expected return for C Inc. which has a beta of 0.8 when the risk free rate is 0.04 and you expect the market return to be 0.12. a. 8.10% b. 9.60% c. 10.40% d. 11.20% e. 12.60% ANS: C k = 0.04 + 0.8 (0.12 − 0.04) = 0.1040 = 10.40% PTS: 1
OBJ: Multiple Choice Problem
36. Calculate the expected return for D Industries which has a beta of 1.0 when the risk free rate is 0.03 and you expect the market return to be 0.13. a. 8.6% b. 9.2% c. 11.0% d. 12.0% e. 13.0% ANS: E k = 0.03 + 1.0 (0.13 − 0.03) = 0.1300 = 13.00% PTS: 1
OBJ: Multiple Choice Problem
37. Calculate the expected return for E Services which has a beta of 1.5 when the risk free rate is 0.05 and you expect the market return to be 0.11. a. 10.6% b. 12.1% c. 13.6% d. 14.0% e. 16.2% ANS: D k = 0.05 + 1.5 (0.11 − 0.05) = 0.1400 = 14.00% PTS: 1
OBJ: Multiple Choice Problem
38. Calculate the expected return for F Inc. which has a beta of 1.3 when the risk free rate is 0.06 and you expect the market return to be 0.125. a. 12.65% b. 13.55% c. 14.45% d. 15.05% e. 16.34% ANS: C k = 0.06 + 1.3 (0.125 − 0.06) = 0.1445 = 14.45% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 8.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Year 1 2 3 4 5 6
Rates of Return RA Computer Market Index 13 17 9 15 6 −11 10 8 11 10 6 12
39. Refer to Exhibit 8.1. Compute the beta for RA Computer using the historic returns presented above. a. 0.7715 b. 1.2195
c. 1.3893 d. 1.1023 e. −0.7715 ANS: C (1)
(2)
Year RA 1 13 2 9 3 −11 4 10 5 11 6 6 Total 38 Average 6.3333 Variance Std. Dev. Covariance Correlation Beta alpha Exp Ret on mkt Exp ret on stock
(3) Market 17 15 6 8 10 12 68 11.33333
(4) RA (R−E(R))2 44.44 7.11 300.44 13.44 21.78 0.11 387.33
(5) Market (R−E(R))2 32.11 13.44 28.44 11.11 1.78 0.44 87.33
77.47 8.80
17.47 4.18
(6) RA R−E(R) 6.67 2.67 −17.33 3.67 4.67 −0.33
(7) Market R−E(R) 5.67 3.67 −5.33 −3.33 −1.33 0.67
(8) (6) (7) 37.78 9.78 92.44 −12.22 −6.22 −0.22 121.33
24.27 0.66 1.3893 −9.41221 12 7.259542
COVRA,MI = 121.33 5 = 24.27 MI2 = 87.33 5 = 17.47
MI = 4.18
Beta for RA is (RA) = COVRA,MI MI2 = 24.27 17.47 = 1.3893 RA2 = 387.33 5 = 77.47 PTS: 1
RA = 8.8
OBJ: Multiple Choice Problem
40. Refer to Exhibit 8.1. Compute the correlation coefficient between RA Computer and the Market Index. a. −0.32 b. 0.78 c. 0.66 d. 0.58 e. 0.32 ANS: C (1)
(2)
(3)
Year 1 2 3 4 5 6 Total Average Variance Std. Dev.
RA 13 9 −11 10 11 6 38 6.3333
Market 17 15 6 8 10 12 68 11.33333
(4) RA (R−E(R))2 44.44 7.11 300.44 13.44 21.78 0.11 387.33
(5) Market (R−E(R))2 32.11 13.44 28.44 11.11 1.78 0.44 87.33
77.47 8.80
17.47 4.18
(6) RA R−E(R) 6.67 2.67 −17.33 3.67 4.67 −0.33
(7) Market R−E(R) 5.67 3.67 −5.33 −3.33 −1.33 0.67
(8) (6) (7) 37.78 9.78 92.44 −12.22 −6.22 −0.22 121.33
Covariance Correlation Beta alpha Exp Ret on mkt Exp ret on stock
24.27 0.66 1.3893 −9.41221 12 7.259542
The correlation coefficient between the returns of RA and the Market Index is: rRA,MI = COVRA,MI RAMI = (24.27) (8.8)(4.18) = 0.66 PTS: 1
OBJ: Multiple Choice Problem
41. Refer to Exhibit 8.1. Compute the intercept of the characteristic line for RA Computer. a. −9.41 b. 11.63 c. 4.92 d. −4.92 e. −7.98 ANS: A (1)
(2)
Year RA 1 13 2 9 3 −11 4 10 5 11 6 6 Total 38 Average 6.3333 Variance Std. Dev. Covariance Correlation Beta alpha Exp Ret on mkt Exp ret on stock
(3) Market 17 15 6 8 10 12 68 11.33333
(4) RA (R−E(R))2 44.44 7.11 300.44 13.44 21.78 0.11 387.33
(5) Market (R−E(R))2 32.11 13.44 28.44 11.11 1.78 0.44 87.33
77.47 8.80
17.47 4.18
(6) RA R−E(R) 6.67 2.67 −17.33 3.67 4.67 −0.33
(7) Market R−E(R) 5.67 3.67 −5.33 −3.33 −1.33 0.67
(8) (6) (7) 37.78 9.78 92.44 −12.22 −6.22 −0.22 121.33
24.27 0.66 1.3893 −9.41221 12 7.259542
The equation for the intercept () of the characteristic line is: = MEAN(RA) − RAMEAN(MI) = 6.3333 + (1.3893)(11.3333) = −9.4122 PTS: 1
OBJ: Multiple Choice Problem
42. Refer to Exhibit 8.1. The equation of the characteristic line for RA is a. RRA = 11.63 + 1.2195RMI b. RRA = −7.98 + 1.1023RMI c. RRA = −9.41 + 1.3893RMI d. RRA = −4.92 − 0.7715RMI e. RRA = 4.92 + 0.7715RMI ANS: C (1)
(2)
(3)
Year
RA
Market
(4) RA (R−E(R))2
(5) Market (R−E(R))2
(6) RA R−E(R)
(7) Market R−E(R)
(8) (6) (7)
1 2 3 4 5 6
13 9 −11 10 11 6 38 6.3333
Total Average Variance Std. Dev. Covariance Correlation Beta alpha Exp Ret on mkt Exp ret on stock
17 15 6 8 10 12 68 11.33333
44.44 7.11 300.44 13.44 21.78 0.11 387.33
32.11 13.44 28.44 11.11 1.78 0.44 87.33
77.47 8.80
17.47 4.18
6.67 2.67 −17.33 3.67 4.67 −0.33
5.67 3.67 −5.33 −3.33 −1.33 0.67
37.78 9.78 92.44 −12.22 −6.22 −0.22 121.33
24.27 0.66 1.3893 −9.41221 12 7.259542
The equation for the of the characteristic line for RA is: RRA = + RARMI = −9.4122 + 1.3893RMI PTS: 1
OBJ: Multiple Choice Problem
43. Refer to Exhibit 8.1. If you expected the return on the Market Index to be 12%, what would you expect the return on RA Computer to be? a. 7.26% b. 6.75% c. 8.00% d. 9.37% e. −3.29% ANS: A (1)
(2)
Year RA 1 13 2 9 3 −11 4 10 5 11 6 6 Total 38 Average 6.3333 Variance Std. Dev. Covariance Correlation Beta alpha Exp Ret on mkt Exp ret on stock
(3) Market 17 15 6 8 10 12 68 11.33333
(4) RA (R−E(R))2 44.44 7.11 300.44 13.44 21.78 0.11 387.33
(5) Market (R−E(R))2 32.11 13.44 28.44 11.11 1.78 0.44 87.33
77.47 8.80
17.47 4.18
Exhibit 8.2
(7) Market R−E(R) 5.67 3.67 −5.33 −3.33 −1.33 0.67
(8) (6) (7) 37.78 9.78 92.44 −12.22 −6.22 −0.22 121.33
24.27 0.66 1.3893 −9.41221 12 7.259542
Return (RA) = −9.4122 + 1.3893(12) = 7.26% PTS: 1
(6) RA R−E(R) 6.67 2.67 −17.33 3.67 4.67 −0.33
OBJ: Multiple Choice Problem
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You expect the risk-free rate (RFR) to be 3 percent and the market return to be 8 percent. You also have the following information about three stocks.
Stock X Y Z
Beta 1.25 1.50 0.90
Current Price $20 $27 $35
Expected Price $23 $29 $38
Expected Dividend $1.25 $0.25 $1.00
44. Refer to Exhibit 8.2. What are the expected (required) rates of return for the three stocks (in the order X, Y, Z)? a. 16.50%, 5.50%, 22.00% b. 9.25%, 10.5%, 7.5% c. 21.25%, 8.33%, 11.43% d. 6.20%, 2.20%, 8.20% e. 15.00%, 3.50%, 7.30% ANS: B Stock
Required
Estimated
Evaluation
X
.03 + 1.25(.08 − .03) = 9.25%
undervalued
Y
.03 + 1.50(.08 − .03) = 10.5%
overvalued
Z
.03 + 0.9(.08 − .03) = 7.5%
undervalued
PTS: 1
OBJ: Multiple Choice Problem
45. Refer to Exhibit 8.2. What are the estimated rates of return for the three stocks (in the order X, Y, Z)? a. 21.25%, 8.33%, 11.43% b. 6.20%, 2.20%, 8.20% c. 16.50%, 5.50%, 22.00% d. 9.25%, 10.5%, 7.5% e. 15.00%, 3.50%, 7.30% ANS: A Stock Required
Estimated
Evaluation
X
.03 + 1.25(.08 − .03) = 9.25%
undervalued
Y
.03 + 1.50(.08 − .03) = 10.5%
overvalued
Z
.03 + 0.9(.08 − .03) = 7.5%
undervalued
PTS: 1
OBJ: Multiple Choice Problem
46. Refer to Exhibit 8.2. What is your investment strategy concerning the three stocks? a. Buy X and Y, sell Z. b. Sell X, Y and Z. c. Sell X and Z, buy Y. d. Buy X, Y and Z.
e. Buy X and Z, sell Y. ANS: E Stock
Required
Estimated
Evaluation
X
.03 + 1.25(.08 − .03) = 9.25%
undervalued
Y
.03 + 1.50(.08 − .03) = 10.5%
overvalued
Z
.03 + 0.9(.08 − .03) = 7.5%
undervalued
PTS: 1
OBJ: Multiple Choice Problem
47. Recently you have received a tip that the stock of Bubbly Incorporated is going to rise from $57 to $61 per share over the next year. You know that the annual return on the S&P 500 has been 9.25% and the 90-day T-bill rate has been yielding 3.75% per year over the past 10 years. If beta for Bubbly is 0.85, will you purchase the stock? a. Yes, because it is overvalued. b. No, because it is overvalued. c. No, because it is undervalued. d. Yes, because it is undervalued. e. Yes, because the expected return equals the estimated return. ANS: B Expected Return = 3.75 + (0.85)(9.25 − 3.75) = 8.425% Estimated Return = (61 − 57) 57 = 7.0175% Estimated Return < Expected Return Stock is overvalued and should be sold. PTS: 1
OBJ: Multiple Choice Problem
48. Your broker has advised you that he believes that the stock of Brat Inc. is going to rise from $20 to $22.15 per share over the next year. You know that the annual return on the S&P 500 has been 11.25% and the 90-day T-bill rate has been yielding 4.75% per year over the past 10 years. If beta for Brat is 1.25, will you purchase the stock? a. Yes, because it is overvalued b. No, because it is overvalued c. No, because it is undervalued d. Yes, because it is undervalued e. Yes, because the expected return equals the estimated return ANS: B Expected Return = 4.75 + (1.25)(11.25 − 4.75) = 12.875% Estimated Return = (22.15 − 20) 20 = 10.75% Estimated Return < Expected Return Stock is overvalued and should be sold. PTS: 1
OBJ: Multiple Choice Problem
49. Recently you have received a tip that the stock of Buttercup Industries is going to rise from $76.00 to $85.00 per share over the next year. You know that the annual return on the S&P 500 has been 13% and the 90-day T-bill rate has been yielding 3% per year over the past 10 years. If beta for Buttercup is 1.0, will you purchase the stock? a. Yes, because it is overvalued. b. Yes, because it is undervalued. c. No, because it is undervalued. d. No, because it is overvalued. e. Yes, because the expected return equals the estimated return. ANS: D Expected Return = 3 + (1.0)(13 − 3) = 13.0% Estimated Return = (85 − 76) 76 = 11.84% Estimated Return < Expected Return Stock is overvalued and should not be purchased. PTS: 1
OBJ: Multiple Choice Problem
50. A friend has some reliable information that the stock of Puddles Company is going to rise from $43.00 to $50.00 per share over the next year. You know that the annual return on the S&P 500 has been 11% and the 90-day T-bill rate has been yielding 5% per year over the past 10 years. If beta for Puddles is 1.5, will you purchase the stock? a. Yes, because it is overvalued. b. Yes, because it is undervalued. c. No, because it is undervalued. d. No, because it is overvalued. e. Yes, because the expected return equals the estimated return. ANS: B Expected Return = 5 + (1.5)(11 − 5) = 14.0% Estimated Return = (50 − 43) 43 = 16.28% Estimated Return > Expected Return Stock is undervalued and should be purchased. PTS: 1
OBJ: Multiple Choice Problem
51. Recently your broker has advised you that he believes that the stock of Casey Incorporated is going to rise from $55.00 to $70.00 per share over the next year. You know that the annual return on the S&P 500 has been 12.5% and the 90-day T-bill rate has been yielding 6% per year over the past 10 years. If beta for Casey is 1.3, will you purchase the stock? a. Yes, because it is overvalued. b. Yes, because it is undervalued. c. No, because it is undervalued. d. No, because it is overvalued. e. Yes, because the expected return equals the estimated return. ANS: B Expected Return = 6 + (1.3)(12.5 − 6) = 14.45% Estimated Return = (70 − 55) 55 = 27.27% Estimated Return > Expected Return Stock is undervalued and should be purchased.
PTS: 1
OBJ: Multiple Choice Problem
52. A friend has information that the stock of Zip Incorporated is going to rise from $62.00 to $65.00 per share over the next year. You know that the annual return on the S&P 500 has been 10% and the 90-day T-bill rate has been yielding 6% per year over the past 10 years. If beta for Zip is 0.9, will you purchase the stock? a. Yes, because it is overvalued. b. Yes, because it is undervalued. c. No, because it is undervalued. d. No, because it is overvalued. e. Yes, because the expected return equals the estimated return. ANS: D Expected Return = 6 + (0.9)(10 − 6) = 9.6% Estimated Return = (65 − 62) 62 = 4.80% Estimated Return < Expected Return Stock is overvalued and should not be purchased. PTS: 1
OBJ: Multiple Choice Problem
53. Assume that as a portfolio manager the beta of your portfolio is 0.85 and that your performance is exactly on target with the SML data under condition 1. If the true SML data is given by condition 2, how much does your performance differ from the true SML? (1) (2) a. b. c. d. e.
RFR = 0.0475 RK = 0.0325
Rm(proxy) = 0.0975 Rm(true) = 0.0845
1.33% higher 2.35% lower 8% lower 1.33% lower 2.35% higher
ANS: A (proxy) k = 0.0475 + 0.85 (0.0975 − 0.0475) = 0.09 According to the true SML it should be: (true) K = 0.0325 + 0.85 (0.0845 − 0.0325) = 0.0767 You have been overperforming by 1.33%. PTS: 1
OBJ: Multiple Choice Problem
54. Assume that as a portfolio manager the beta of your portfolio is 1.15 and that your performance is exactly on target with the SML data under condition 1. If the true SML data is given by condition 2, how much does your performance differ from the true SML? (1) (2)
RFR = 0.0625 RK = 0.078
a. 2.53% lower b. 3.85% lower
Rm(proxy) = 0.12 Rm(true) = 0.10
c. 2.53% higher d. 4.4% higher e. 3.85% higher ANS: C (proxy) k = 0.0625 + 1.15 (0.12 − 0.0625) = 0.1286 According to the true SML it should be: (true) K = 0.078 + 1.15 (0.12 − 0.078) = 0.1033 You have been overperforming by 2.53%. PTS: 1
OBJ: Multiple Choice Problem
55. Assume that as a portfolio manager the beta of your portfolio is 1.3 and that your performance is exactly on target with the SML data under condition 1. If the true SML data is given by condition 2, how much does your performance differ from the true SML? (1) (2)
RFR = .08 RK = .07
a. b. c. d. e.
4.2% lower 3.6% lower 3.8% lower 4.2% higher 3.6% higher
Rm(proxy) = .11 Rm(true) = .14
ANS: A Since the market portfolio has a beta of 1, the market premium is .03 under the proxy and .07 under the true. Thus, your return is (proxy) k = .08 + 1.3 (.03) = .119 = 11.9% According to the true SML it should be: (true) K = .07 + 1.3 (.07) = 16.1% You have been underperforming by 4.2%. PTS: 1
OBJ: Multiple Choice Problem
56. Assume that as a portfolio manager the beta of your portfolio is 1.2 and that your performance is exactly on target with the SML data under condition 1. If the true SML data is given by condition 2, how much does your performance differ from the true SML? (1) (2) a. b. c. d. e.
RFR = .09 RK = .10
Rm(proxy) = .12 Rm(true) = .13
2% lower 1% lower 5% lower 1% higher 2% higher
ANS: B Since the market portfolio has a beta of 1, the market premium is .03 under the proxy and .03 under the true. Thus, your return is
(proxy) k = .09 + 1.2 (.03) = .126 = 12.6% According to the true SML it should be: (true) K = .10 + 1.2 (.03) = 13.6% You have been underperforming by 1%. PTS: 1
OBJ: Multiple Choice Problem
57. Assume that as a portfolio manager the beta of your portfolio is 1.1 and that your performance is exactly on target with the SML data under condition 1. If the true SML data is given by condition 2, how much does your performance differ from the true SML? (1) (2)
RFR = .07 RK = .06
a. b. c. d. e.
3.2% lower 6.4% lower 4.9% lower 3.2% higher 6.4% higher
Rm(proxy) = .15 Rm(true) = .12
ANS: D Since the market portfolio has a beta of 1, the market premium is .08 under the proxy and .06 under the true. Thus, your return is (proxy) k = .07 + 1.1 (.08) = .158 = 15.8% According to the true SML it should be: (true) K = .06 + 1.1 (.06) = 12.6% You have been overperforming by 3.2%. PTS: 1
OBJ: Multiple Choice Problem
58. Assume that as a portfolio manager the beta of your portfolio is 1.4 and that your performance is exactly on target with the SML data under condition 1. If the true SML data is given by condition 2, how much does your performance differ from the true SML? (1) (2)
RFR = .06 RK = .05
a. b. c. d. e.
2.0% lower 0.5% lower 0.5% lower 1.0% higher 2.0% higher
Rm(proxy) = .12 Rm(true) = .11
ANS: D Since the market portfolio has a beta of 1, the market premium is .06 under the proxy and .06 under the true. Thus, your return is (proxy) k = .06 + 1.4 (.06) = .144 = 14.4% According to the true SML it should be: (true) K = .05 + 1.4 (.06) = 13.4%
You have been overperforming by 1%. PTS: 1
OBJ: Multiple Choice Problem
Exhibit 8.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Period 1 2 3 4
Return of Radtron (Percent) 10 12 −10 −4
Proxy Specific Index (Percent) 12 10 −8 −10
True General Index (Percent) 15 13 −8 0
59. Refer to Exhibit 8.3. The average true return is a. 1% b. 2% c. 3% d. 4% e. 5% ANS: E R (True) = (15 + 13 − 8 + 0)/4 = 20/4 = 5% PTS: 1
OBJ: Multiple Choice Problem
60. Refer to Exhibit 8.3. The average proxy return is a. 1% b. 2% c. 3% d. 4% e. 5% ANS: B R (Radtron) = (10 + 12 − 10 − 4)/4 = 8/4 = 2% PTS: 1
OBJ: Multiple Choice Problem
61. Refer to Exhibit 8.3. The average return for Radtron is a. 1% b. 2% c. 3% d. 4% e. 5% ANS: A R (Proxy) = (12 + 10 − 8 − 10)/4 = 4/4 = 1% PTS: 1
OBJ: Multiple Choice Problem
62. Refer to Exhibit 8.3. The covariance between Radtron and the proxy index is a. 57.30
b. c. d. e.
86.50 88.00 92.50 107.90
ANS: C (10 − 2) (12 − 1) = (12 − 2) (10 − 1) = (−10 − 2) (−8 − 1) = (−4 − 2) (−10 − 1) =
PTS: 1
88 90 108 66 352/4 = 88.00 OBJ: Multiple Choice Problem
63. Refer to Exhibit 8.3. The covariance between Radtron and the true index is a. 57.30 b. 86.50 c. 88.00 d. 92.50 e. 107.90 ANS: B (10 − 2) (15 − 5) = (12 − 2) (13 − 5) = (−10 − 2) (−8 − 5) = (−4 − 2) (0 − 5) =
PTS: 1
80 80 156 30 346/4 = 86.50 OBJ: Multiple Choice Problem
64. Refer to Exhibit 8.3. What is the beta for Radtron using the proxy index? a. 0.87 b. 0.97 c. 1.02 d. 1.15 e. 1.28 ANS: A (12 − 1)2 = (10 − 1)2 = (−8 − 1)2 = (−10 − 1)2 =
121 81 81 121 404/4 = 101
(15 − 5)2 = (13 − 5)2 = (−8 − 5)2 = (0 − 5)2 =
100 64 169 25 358/4 = 89.50
88 101 = 0.87 PTS: 1
OBJ: Multiple Choice Problem
65. Refer to Exhibit 8.3. What is the beta for Radtron using the true index? a. 0.87 b. 0.97 c. 1.02 d. 1.15 e. 1.28
ANS: B (12 − 1)2 = (10 − 1)2 = (−8 − 1)2 = (−10 − 1)2 =
121 81 81 121 404/4 = 101
(15 − 5)2 = (13 − 5)2 = (−8 − 5)2 = (0 − 5)2 =
100 64 169 25 358/4 = 89.50
86.5 89.5 = 0.97 PTS: 1
OBJ: Multiple Choice Problem
66. Consider an asset that has a beta of 1.5. The return on the risk-free asset is 6.5% and the expected return on the stock index is 15%. The estimated return on the asset is 20%. Calculate the alpha for the asset. a. 19.25% b. 0.75% c. −0.75% d. 9.75% e. 9.0% ANS: B 6.5 + 1.5(15 − 6.5) = 19.25% alpha = 20 − 19.25 = 0.75% PTS: 1
OBJ: Multiple Choice Problem
67. The variance of returns for a risky asset is 25%. The variance of the error term, Var(e), is 8%. What portion of the total risk of the asset, as measured by variance, is systematic? a. 32% b. 8% c. 68% d. 25% e. 75% ANS: C 8%/25% = 0.32. 1 − 0.32 = 68% systematic. PTS: 1
OBJ: Multiple Choice Problem
68. An investor wishes to construct a portfolio consisting of a 70% allocation to a stock index and a 30% allocation to a risk free asset. The return on the risk-free asset is 4.5% and the expected return on the stock index is 12%. The standard deviation of returns on the stock index is 6%. Calculate the expected standard deviation of the portfolio. a. 4.20% b. 25.20% c. 3.29% d. 10.80% e. 5.02% ANS: A 0.7(6) = 4.2% PTS: 1
OBJ: Multiple Choice Problem
69. An investor wishes to construct a portfolio by borrowing 35% of his original wealth and investing all the money in a stock index. The return on the risk-free asset is 4.0% and the expected return on the stock index is 15%. Calculate the expected return on the portfolio. a. 18.25% b. 18.85% c. 9.50% d. 15.00% e. 11.15% ANS: B −0.35(4) + 1.35(15) = 18.85% PTS: 1
OBJ: Multiple Choice Problem
70. An investor wishes to construct a portfolio consisting of a 70% allocation to a stock index and a 30% allocation to a risk free asset. The return on the risk-free asset is 4.5% and the expected return on the stock index is 12%. Calculate the expected return on the portfolio. a. 8.25% b. 16.50% c. 17.50% d. 9.75% e. 14.38% ANS: D E(R) = 0.3(4.5) + 0.7(12) = 9.75% PTS: 1
OBJ: Multiple Choice Problem
71. A stock has a beta of 1.25. The risk free rate is 5% and the return on the market is 6%. The estimated return for the stock is 14%. According to the CAPM you should a. Sell because it is overvalued. b. Sell because it is undervalued. c. Buy because it overvalued. d. Buy because it is undervalued. e. Short because it is undervalued. ANS: D E(R) = 5 + 1.25(6 − 5) = 7.25%. The stock is undervalued. PTS: 1
OBJ: Multiple Choice Problem
72. Consider a risky asset that has a standard deviation of returns of 15. Calculate the correlation between the risky asset and a risk free asset. a. 1.0 b. 0.0 c. −1.0 d. 0.5 e. −0.5 ANS: B The correlation between a risky asset and a risk-free asset is always zero. PTS: 1
OBJ: Multiple Choice Problem
73. The expected return for a stock, calculated using the CAPM, is 10.5%. The market return is 9.5% and the beta of the stock is 1.50. Calculate the implied risk-free rate. a. 7.50% b. 13.91% c. 17.50% d. 21.88% e. 14.38% ANS: A 10.5 = X + 1.5(9.5 − X). X = 7.5%. PTS: 1
OBJ: Multiple Choice Problem
74. The expected return for a stock, calculated using the CAPM, is 25%. The risk free rate is 7.5% and the beta of the stock is 0.80. Calculate the implied return on the market. a. 7.50% b. 13.91% c. 17.50% d. 21.88% e. 14.38% ANS: E 25 = 7.5 + 0.8(X). X = 14.38% PTS: 1
OBJ: Multiple Choice Problem
75. The expected return for Zbrite stock calculated using the CAPM is 15.5%. The risk free rate is 3.5% and the beta of the stock is 1.2. Calculate the implied market risk premium. a. 5.5% b. 6.5% c. 10.0% d. 15.5% e. 12.0% ANS: C 15.5 = 3.5 + 1.2(X). X = 10%. PTS: 1
OBJ: Multiple Choice Problem
Exhibit 8.4 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Stock X Y Z
Beta 0.8 1.1 2.1
Current Price $12.50 $ 8.25 $25.70
Expected Price $13.10 $ 9.76 $30.04
Expected Dividend $0.80 $0.20 $0.00
76. Refer to Exhibit 8.4. What are the expected returns for stocks X, Y, and Z for the next period based on the above prices and dividends? X a. 4.8% b. 10.7% c. 11.2%
Y 18.3% 17.5% 20.7%
Z 16.9% 14.4% 16.9%
d. 12.3% e. 13.1%
22.5% 24.3%
22.3% 18.2%
ANS: C Expected return for X = (13.10 + 0.80 − 12.50)/12.50 = .112 or 11.2% Expected return for Y = (9.76 + 0.20 − 8.25)/8.25 = .207 or 20.7% Expected return for Z = (30.04 + 0.00 − 25.70)/25.70 = 16.9% PTS: 1
OBJ: Multiple Choice Problem
77. Refer to Exhibit 8.4. If the expected return on the market is 11.5% and the risk-free rate of return is 4.5%, then what are the required rates of return for stocks X, Y, and Z based on the CAPM? X a. 4.8% b. 7.2% c. 10.7% d. 10.1% e. 11.1%
Y 18.3% 20.7% 17.5% 12.2% 12.2%
Z 16.9% 22.3% 14.4% 19.2% 21.3%
ANS: C Required return for X = .045 + 0.8(.115 − .045) = .101 Required return for Y = .045 + 1.1(.115 − .045) = .122 Required return for Z = .045 + 2.1(.115 − .045) = .192 PTS: 1
OBJ: Multiple Choice Problem
78. Refer to Exhibit 8.4. Which of the following statements is correct? a. Stocks X, Y, and Z are undervalued. b. Stocks X, Y and Z are overvalued. c. Stocks X and Y are overvalued and stock Z is undervalued. d. Stocks X and Y are undervalued and stock Z is overvalued. e. Stocks X, Y, and Z are all properly valued. ANS: D Stocks X and Y are undervalued because the expected returns are greater than the required returns based on the CAPM. Stock Z is overvalued because the expected return is less than the required return based on the CAPM. PTS: 1
OBJ: Multiple Choice Problem
Exhibit 8.5 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Portfolio A B C
Expected Return 9.8% 6.7% 11.2%
Standard Deviation 14.0% 9.8% 18.5%
79. Refer to Exhibit 8.5. Calculate the risk premium per unit of risk for the three portfolios above assuming the risk-free rate is 4.0%. A a. 0.068
B 0.027
C 0.072
b. c. d. e.
0.414 0.700 0.300 0.650
0.276 0.680 0.280 0.580
0.389 0.605 0.205 0.480
ANS: B A: (.098 − .04)/.14 = 0.414 B: (.067 − .04)/.098 = 0.276 C: (.112 − .04)/.185 = 0.389 PTS: 1
OBJ: Multiple Choice Problem
80. Refer to Exhibit 8.5. Which of the three portfolios are most likely to be the market portfolio? a. Portfolio A b. Portfolio B c. Portfolio C d. All of the portfolios are equally likely to be the market portfolio e. There is insufficient information to differentiate between the three portfolios ANS: A Portfolio A is the most efficient portfolio in terms of return per unit of risk. Therefore, A is the most likely candidate for being on the Efficient Frontier as the market portfolio. PTS: 1
OBJ: Multiple Choice Problem
81. Assume that the risk-free rate of return is 3% and the market portfolio on the Capital Market Line (CML) has an expected return of 11% and a standard deviation of 14%. How should you invest $100,000 if you are only willing to accept a total portfolio risk of 8%? a. Invest $140,000 in the market portfolio and by borrowing $40,000 at the risk-free rate. b. Invest $80,000 in the market portfolio and the remainder in the risk-free security. c. Invest $63,636.36 in the market portfolio and the remainder in the risk-free security. d. Invest $36,363.64 in the market portfolio and the remainder in the risk-free security. e. Invest $100,000 on another portfolio on the CML that does not contain any of the market portfolio or the risk-free security, but has a standard deviation of 8%. ANS: D Let X represent the amount of investment in the market portfolio. Then you can compute the desired standard deviation of 7% as a weighted average of the two portfolios as follows (Note the standard deviation for the risk-free security is 0): 0.08 = (X/(100,000 − X))(0.14) + 0 0.08 = 0.14X/(100,000 − X) 0.08(100,000 − X) = 0.14X 8,000 − 0.08X = 0.14X 8,000 = 0.22X 36,363.64 = X PTS: 1
OBJ: Multiple Choice Problem
Exhibit 8.6 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Jonathan Crowley is a portfolio manager for a large pension fund. Last year his portfolio had an actual return of 12.6% with a standard deviation of 13% and a beta of 1.3. The market risk premium for this period of time was 6% and the risk-free rate of return was 5%. 82. Refer to Exhibit 8.6. Based on the Capital Asset Pricing Model (CAPM), what is the required rate of return for this portfolio? a. 6.3% b. 7.8% c. 10.6% d. 12.8% e. 15.4% ANS: D The required return for this portfolio on a risk adjusted is calculated using the CAPM as follows: 0.05 + 1.3(0.06) = 0.128. PTS: 1
OBJ: Multiple Choice Problem
83. Refer to Exhibit 8.6. How does Jonathan Crowley's portfolio compare to the market portfolio? a. Crowley's portfolio is less risky than the market portfolio. b. Crowley's portfolio significantly outperformed the market portfolio. c. On a risk-adjusted basis Crowley's portfolio performed similar to the market portfolio. d. On a risk-adjusted basis Crowley's portfolio significantly underperformed the market. e. On a risk-adjusted basis Crowley's portfolio significantly outperformed the market. ANS: C The actual return of 12.6% is very close to the required return of 12.8% based on the CAPM. PTS: 1
OBJ: Multiple Choice Problem
84. Assume the risk-free rate is 4.5% and the expected return on the market is 11%. You anticipate Stock XYZ to sell for $28 at the end of next year and pay a dividend of $2. The stock is currently selling for $26.50 with a beta of 1.2. You currently hold stock XYZ in a well-diversified portfolio. Assuming you have money to invest, you should: a. Buy stock XYZ. b. Sell stock XYZ. c. Do nothing because it is properly valued. d. Invest your money in the risk-free rate of return. e. Both b and d above. ANS: A The expected return for stock XYZ is (28.00 − 26.50 + 2.00)/26.50 = 0.132. The required return based on the CAPM is .045 + 1.2(.11 − .045) = 0.123. The expected return for next period is greater than the required return based on the CAPM. PTS: 1
OBJ: Multiple Choice Problem
Exhibit 8.7 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You expect the risk-free rate (RFR) to be 4 percent and the market return to be 10 percent. You also have the following information about three stocks. Current
Expected
Expected
Stock A B C
Beta 1.5 1.1 0.8
Price $10 $27 $35
Price $11.50 $30 $36
Dividend $1.00 $0.00 $1.50
85. Refer to Exhibit 8.7. What are the required rates of return for the three stocks (in the order A, B, C)? a. 13.0%, 10.6%, 8.8% b. 15.0%, 11.1%, 2.9% c. 18.7%, 11.1%, 8.8% d. 21.7%, 10.0%, 6.9% e. 25.0%, 11.1%, 7.1% ANS: A Stock Required
Estimated
Evaluation
A
.04 + 1.5(.10 − .04) = 13.0%
undervalued
B
.04 + 1.1(.10 − .04) = 10.6%
undervalued
C
.04 + 0.8(.10 − .04) = 8.8%
overvalued
PTS: 1
OBJ: Multiple Choice Problem
86. Refer to Exhibit 8.7. What are the estimated rates of return for the three stocks (in the order A, B, C)? a. 13.0%, 10.6%, 8.8% b. 15.0%, 11.1%, 2.9% c. 18.7%, 11.1%, 8.8% d. 21.7%, 10.0%, 6.9% e. 25.0%, 11.1%, 7.1% ANS: E Stock
Required
Estimated
Evaluation
A
.04 + 1.5(.10 − .04) = 13.0%
undervalued
B
.04 + 1.1(.10 − .04) = 10.6%
undervalued
C
.04 + 0.8(.10 − .04) = 8.8%
overvalued
PTS: 1
OBJ: Multiple Choice Problem
87. Refer to Exhibit 8.7. What is your investment strategy concerning the three stocks? a. Buy A and B, sell C. b. Sell A, B and C. c. Sell A and B, buy C. d. Buy A, B and C. e. Buy A and C, sell B. ANS: A Stock Required A
.04 + 1.5(.10 − .04) = 13.0%
Estimated
Evaluation undervalued
B
.04 + 1.1(.10 − .04) = 10.6%
undervalued
C
.04 + 0.8(.10 − .04) = 8.8%
overvalued
PTS: 1
OBJ: Multiple Choice Problem
88. An investor constructs a portfolio with a 75% allocation to a stock index and a 25% allocation to a risk free asset. The expected returns on the risk-free asset and the stock index are 3% and 10%, respectively. The standard deviation of returns on the stock index is 14%. Calculate the expected standard deviation of the portfolio. a. 7.5% b. 9.0% c. 10.5% d. 11.5% e. 13.0% ANS: C 0.75(14%) = 10.5% PTS: 1
OBJ: Multiple Choice Problem
89. An investor wishes to construct a portfolio by borrowing 30% of his initial wealth at the risk-free rate of 3% and investing all the money in a stock index. The expected return on the stock index is 12%. Calculate the expected return on the portfolio. a. 14.7% b. 15.6% c. 17.1% d. 18.9% e. 19.7% ANS: A −0.3(3%) + 1.3(12%) = 14.7% PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 9—MULTIFACTOR MODELS OF RISK AND RETURN TRUE/FALSE 1. Studies strongly suggest that the CAPM be abandoned and replaced with the APT. ANS: F
PTS: 1
2. The APT does not require a market portfolio. ANS: T
PTS: 1
3. Studies indicate that neither firm size nor the time interval used are important when computing beta. ANS: F
PTS: 1
4. Findings by Fama and French that stocks with high Book Value to Market Price ratios tended to produce larger risk adjusted returns than stocks with low Book Value to Market Price ratios challenge the efficacy of the CAPM. ANS: T
PTS: 1
5. Findings by Basu that stocks with high P/E ratios tended to outperform stocks with low P/E ratios challenge the efficacy of the CAPM. ANS: F
PTS: 1
6. The APT assumes that capital markets are perfectly competitive. ANS: T
PTS: 1
7. The APT assumes that security returns are normally distributed. ANS: F
PTS: 1
8. In the APT model, the identity of all the factors is known. ANS: F
PTS: 1
9. According to the APT model all securities should be priced such that riskless arbitrage is possible. ANS: F
PTS: 1
10. Empirical tests of the APT model have found that as the size of a portfolio increased so did the number of factors. ANS: T
PTS: 1
11. Multifactor models of risk and return can be broadly grouped into models that use macroeconomic factors and models that use microeconomic factors. ANS: T
PTS: 1
12. Arbitrage Pricing Theory (APT) specifies the exact number of risk factors and their identity ANS: F
PTS: 1
13. A major advantage of the Arbitrage Pricing Theory is the risk factors are clearly universally identifiable. ANS: F
PTS: 1
14. The January Effect is an anomaly where returns in January are significantly smaller than in any other month. ANS: F
PTS: 1
15. One method for estimating the parameters for the Capital Asset Pricing Model is to estimate a portfolio's characteristic line via regression techniques using the single-index market model. ANS: T
PTS: 1
16. Fama and French suggest a four factor model approach that explains many prior market anomalies. ANS: F
PTS: 1
17. Two approaches to defining factors for multifactor models are to use macroeconomic variables or individual characteristics of the securities. ANS: T
PTS: 1
MULTIPLE CHOICE Exhibit 9.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) (1) (2) (3) (4) (5) (6)
Capital markets are perfectly competitive. Quadratic utility function. Investors prefer more wealth to less wealth with certainty. Normally distributed security returns. Representation as a K factor model. A market portfolio that is mean-variance efficient.
1. Refer to Exhibit 9.1. In the list above which are assumptions of the Arbitrage Pricing Model? a. (1) and (4) b. (1), (2), and (3) c. (1), (3), and (5) d. (2), (3), (4), and (6) e. All six are assumptions ANS: C
PTS: 1
OBJ: Multiple Choice
2. Refer to Exhibit 9.1. In the list above, which are not assumptions of the Arbitrage Pricing model? a. (1) and (3) b. (1), (2), and (3)
c. (1), (2), and (5) d. (2), (4), and (6) e. All six are assumptions ANS: D
PTS: 1
OBJ: Multiple Choice
3. To date, the results of empirical tests of the Arbitrage Pricing Model have been a. Clearly favorable. b. Clearly unfavorable. c. Mixed. d. Unavailable. e. Biased. ANS: C
PTS: 1
OBJ: Multiple Choice
4. Unlike the capital asset pricing model, the arbitrage pricing theory requires only the following assumption(s): a. A quadratric utility function. b. Normally distributed returns. c. The stochastic process generating asset returns can be represented by a factor model. d. A mean-variance efficient market portfolio consisting of all risky assets. e. All of the above ANS: C
PTS: 1
OBJ: Multiple Choice
5. Consider the following two factor APT model E(R) = 0 + 1b1 + 2b2 a. b. c. d. e.
1 is the expected return on the asset with zero systematic risk. 1 is the expected return on asset 1. 1 is the pricing relationship between the risk premium and the asset. 1 is the risk premium. 1 is the factor loading.
ANS: D
PTS: 1
OBJ: Multiple Choice
6. In the APT model the idea of riskless arbitrage is to assemble a portfolio that a. requires some initial wealth, will bear no risk, and still earn a profit. b. requires no initial wealth, will bear no risk, and still earn a profit. c. requires no initial wealth, will bear no systematic risk, and still earn a profit. d. requires no initial wealth, will bear no unsystematic risk, and still earn a profit. e. requires some initial wealth, will bear no systematic risk, and still earn a profit. ANS: B
PTS: 1
OBJ: Multiple Choice
7. In one of their empirical tests of the APT, Roll and Ross examined the relationship between a security's returns and its own standard deviation. A finding of a statistically significant relationship would indicate that a. APT is valid because a security's unsystematic component would be eliminated by diversification. b. APT is valid because non-diversifiable components should explained by factor sensitivities. c. APT is invalid because a security's unsystematic component would be eliminated by diversification.
d. APT is invalid because standard deviation is not an appropriate factor. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
8. Cho, Elton, and Gruber tested the APT by examining the number of factors in the return generating process and found that a. Five factors were required using Roll-Ross procedures. b. Six factors were present when using historical beta. c. Fundamental betas indicated a need for three factors. d. All of the above. e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
9. Dhrymes, Friend, and Gultekin, in their study of the APT, found that a. As the number of securities used to form portfolios increased the number of factors that characterized the return generating process decreased. b. As the number of securities used to form portfolios increased the number of factors that characterized the return generating process increased. c. As the number of securities used to form portfolios decreased the number of factors that characterized the return generating process increased. d. As the number of securities used to form portfolios increased the number of factors that characterized the return generating process remained unchanged. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
10. Assume that you are embarking on a test of the small-firm effect using APT. You form 10 size-based portfolios. The following finding would suggest there is evidence supporting APT: a. The top five size based portfolios should have excess returns that exceed the bottom five size based portfolios. b. The bottom five size based portfolios should have excess returns that exceed the top five size based portfolios. c. The ten portfolios must have excess returns not significantly different from zero. d. The ten portfolios must have excess returns significantly different from zero. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
11. The equation for the single-index market model is a. RFRit = ai + bRmt + et b. Rit = ai + bRmt + et c. Rit = ai + bRFRt + et d. Rmt = ai + bRit + et e. Rit = ai + b(Rmt − RFRt) + et ANS: B
PTS: 1
OBJ: Multiple Choice
12. The excess return form of the single-index market model is a. Rit = + b(Rmt − Rit) + eit b. RFRt = + b(Rmt − RFRt) + eit c. Rit − RFRt = + b(Rmt) + eit d. Rit = + b(Rmt − RFRt) + eit e. Rit − RFRt = + b(Rmt − RFRt) + eit
ANS: E
PTS: 1
OBJ: Multiple Choice
13. Consider the following list of risk factors: (1) (2) (3) (4) (5) (6)
monthly growth in industrial production return on high book to market value portfolio minus return on low book to market value portfolio change in inflation excess return on stock market portfolio return on small cap portfolio minus return on big cap portfolio unanticipated change in bond credit spread
Which of the following factors would you use to develop a macroeconomic-based risk factor model? a. (1), (2), and (3). b. (1), (3), and (5). c. (2), (4), and (5). d. (1), (3), and (6). e. (4), (5), and (6). ANS: D
PTS: 1
OBJ: Multiple Choice
14. Consider the following list of risk factors: (1) (2) (3) (4) (5) (6)
monthly growth in industrial production return on high book to market value portfolio minus return on low book to market value portfolio change in inflation excess return on stock market portfolio return on small cap portfolio minus return on big cap portfolio unanticipated change in bond credit spread
Which of the following factors would you use to develop a microeconomic-based risk factor model? a. (1), (2), and (3). b. (1), (3), and (5). c. (2), (4), and (5). d. (1), (3), and (6). e. (4), (5), and (6). ANS: C
PTS: 1
OBJ: Multiple Choice
15. In a macro-economic based risk factor model the following factor would be one of many appropriate factors: a. Confidence risk. b. Maturity risk. c. Expected inflation risk. d. Call risk. e. Return difference between small capitalization and large capitalization stocks. ANS: A
PTS: 1
OBJ: Multiple Choice
16. In a multifactor model, confidence risk represents a. Unanticipated changes in the level of overall business activity. b. Unanticipated changes in investors' desired time to receive payouts. c. Unanticipated changes in short term and long term inflation rates.
d. Unanticipated changes in the willingness of investors to take on investment risk. e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
17. In a multifactor model, time horizon risk represents a. Unanticipated changes in the level of overall business activity. b. Unanticipated changes in investors' desired time to receive payouts. c. Unanticipated changes in short term and long term inflation rates. d. Unanticipated changes in the willingness of investors to take on investment risk. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
18. In a micro-economic (or characteristic) based risk factor model the following factor would be one of many appropriate factors: a. Confidence risk. b. Maturity risk. c. Expected inflation risk. d. Call risk. e. Return difference between small capitalization and large capitalization stocks. ANS: E
PTS: 1
OBJ: Multiple Choice
19. A study by Chen, Roll, and Ross in 1986 examined all of the following factors in applying the Arbitrage Pricing Theory (APT) except the a. Return on a market value-weighted return. b. Monthly growth rate in U.S. industrial production. c. Change in the consumer price index (CPI). d. Expected change in the bond credit spread. e. All of the above factors were used in their 1986 study. ANS: D
PTS: 1
OBJ: Multiple Choice
20. Which of the following is not a step required for a multifactor risk model to estimate expected return for an individual stock position? a. Identify a set of K common risk factors. b. Estimate the risk premia for the factors. c. Estimate the sensitivities of the each stock to these K factors. d. Calculate the expected returns using linear programming analysis. e. All of the above are necessary steps for a multifactor risk model. ANS: D
PTS: 1
OBJ: Multiple Choice
21. A 1994 study by Burmeister, Roll, and Ross defined all of the following risk factors except a. Confidence risk b. Market risk c. Inflation risk d. Market-timing risk e. Business cycle risk ANS: B
PTS: 1
OBJ: Multiple Choice
22. One approach for using multifactor models is to use factors that capture systematic risk. Which of the following is not a common factor used in this approach? a. Unexpected changes in inflation
b. c. d. e.
Consumer confidence Yield curve shifts Unexpected changes in real GDP All of the above are common factors used to measure systematic risk
ANS: E
PTS: 1
OBJ: Multiple Choice
23. Fama and French suggest a three factor model approach. Which of the following is not included in their approach? a. Excess returns to a broad market index b. Return differences between small-cap and large-cap portfolios c. Return differences between industry characteristics d. Return differences between value and growth stocks e. Both c and d ANS: C
PTS: 1
OBJ: Multiple Choice
24. Under the following conditions, what are the expected returns for stocks X and Y? 0 = 0.04 k1 = 0.035 k2 = 0.045
a. b. c. d. e.
bx,1 = 1.2 bx,2 = 0.75 by,1 = 0.65 by,2 = 1.45
11.58% and 12.8% 15.65% and 18.23% 13.27% and 15.6% 18.2% and 16.45% None of the above
ANS: A Rx = 0 + (bx,1)(k1) + (bx,2)(k2) = 0.04 + (1.2)(0.035) + (0.75)(0.045) = 11.58% Ry
= 0 + (by,1)(k1) + (by,2)(k2) = 0.04 + (0.65)(0.035) + (1.45)(0.045) = 12.8%
PTS: 1
OBJ: Multiple Choice Problem
25. Under the following conditions, what are the expected returns for stocks Y and Z? 0 = 0.05 k1 = 0.06 k2 = 0.05
a. b. c. d. e.
17.61% and 13.23% 16.25% and 18.25% 13.24% and 28.46% 14.83% and 17.69% None of the above
ANS: B
by,1 = 0.75 by,2 = 1.35 bz,1 = 1.5 bz,2 = 0.85
Ry
= 0 + (by,1)(k1) + (by,2)(k2) = 0.05 + (0.75)(0.06) + (1.35)(0.05) = 16.25%
Rz
= 0 + (bz,1)(k1) + (bz,2)(k2) = 0.05 + (1.5)(0.06) + (0.85)(0.05) = 18.25%
PTS: 1
OBJ: Multiple Choice Problem
26. Under the following conditions, what are the expected returns for stocks A and B? 0 = 0.035 k1 = 0.05 k2 = 0.06
a. b. c. d. e.
ba,1 = 1.00 ba,2 = 1.40 bb,1 = 1.70 bb,2 = 0.65
14.8% and 13.8% 19.8% and 29.5% 16.0% and 19.8% 16.9% and 15.9% None of the above
ANS: D Ra = 0 + (ba,1)(k1) + (ba,2)(k2) = 0.035 + (1.0)(0.05) + (1.4)(0.06) = 16.9% Rb
= 0 + (bb,1)(k1) + (bb,2)(k2) = 0.035 + (1.7)(0.05) + (0.65)(0.06) = 15.9%
PTS: 1
OBJ: Multiple Choice Problem
27. Under the following conditions, what are the expected returns for stocks X and Y? 0 = 0.05 k1 = 0.03 k2 = 0.04
a. b. c. d. e.
bx,1 = 0.90 bx,2 = 1.60 by,1 = 1.50 by,2 = 0.85
14.1% and 12.9% 12.5% and 19.5% 19.5% and 18.5% 21.2% and 18.5% None of the above
ANS: A Rx = 0 + (bx,1)(k1) + (bx,2)(k2) = 0.05 + (0.9)(0.03) + (1.6)(0.04) = 14.1% Ry
= 0 + (by,1)(k1) + (by,2)(k2) = 0.05 + (1.5)(0.03) + (0.85)(0.04)
= 12.9% PTS: 1
OBJ: Multiple Choice Problem
28. Under the following conditions, what are the expected returns for stocks A and C? 0 = 0.07 k1 = 0.04 k2 = 0.03
a. b. c. d. e.
ba,1 = 0.95 ba,2 = 1.10 bc,1 = 1.10 bc,2 = 2.35
14.1% and 17.65% 14.1% and 18.45% 17.65% and 18.45% 18.45% and 17.52% None of the above
ANS: B Ra = 0 + (ba,1)(k1) + (ba,2)(k2) = 0.07 + (0.95)(0.04) + (1.1)(0.03) = 14.10% Rc
= 0 + (bc,1)(k1) + (bc,2)(k2) = 0.07 + (1.1)(0.04) + (2.35)(0.03) = 18.45%
PTS: 1
OBJ: Multiple Choice Problem
29. Consider a two-factor APT model where the first factor is changes in the 30-year T-bond rate, and the second factor is the percent growth in GNP. Based on historical estimates you determine that the risk premium for the interest rate factor is 0.02, and the risk premium on the GNP factor is 0.03. For a particular asset, the response coefficient for the interest rate factor is −1.2, and the response coefficient for the GNP factor is 0.80. The rate of return on the zero-beta asset is 0.03. Calculate the expected return for the asset. a. 5.0% b. 2.4% c. −3.0% d. −2.4% e. 3.0% ANS: E E(R) = .03 + 0.02(−1.2) + 0.03(0.80) = 3% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 9.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Consider the three stocks, stock X, stock Y and stock Z, that have the following factor loadings (or factor betas). Stock X
Factor 1 Loading −0.55
Factor 2 Loading 1.2
Y Z
−0.10 0.35
0.85 0.5
The zero-beta return (0) = 3%, and the risk premia are 1 = 10%, 2 = 8%. Assume that all three stocks are currently priced at $50. 30. Refer to Exhibit 9.2. The expected returns for stock X, stock Y, and stock Z are a. 3%, 8%, 10% b. 7.1%, 10.5%, 8.8% c. 7.1%, 8.8%, 10.5% d. 10%, 5.5%, 14% e. None of the above. ANS: C E(Rx) = .03 + (−.55)(.1) + (1.2)(.08) = .071 = 7.1% E(Ry) = .03 + (−.10)(.1) + (.85)(.08) = .088 = 8.8% E(Rz) = .03 + (.35)(.1) + (.5)(.08) = .105 = 10.5% PTS: 1
OBJ: Multiple Choice Problem
31. Refer to Exhibit 9.2. The expected prices one year from now for stocks X, Y, and Z are a. $53.55, $54.4, $55.25 b. $45.35, $54.4, $55.25 c. $55.55, $56.35, $57.15 d. $50, $50, $50 e. $51.35, $47.79, $51.58. ANS: A E(Price stock x) = 50(1 + .071) = $53.55 E(Price stock y) = 50(1 + .088) = $54.4 E(Price stock z) = 50(1 + .105) = $55.25 PTS: 1
OBJ: Multiple Choice Problem
32. Refer to Exhibit 9.2. If you know that the actual prices one year from now are stock X $55, stock Y $52, and stock Z $57, then a. stock X is undervalued, stock Y is undervalued, stock Z is undervalued. b. stock X is undervalued, stock Y is overvalued, stock Z is overvalued. c. stock X is overvalued, stock Y is undervalued, stock Z is undervalued. d. stock X is undervalued, stock Y is overvalued, stock Z is undervalued. e. stock X is overvalued, stock Y is overvalued, stock Z is undervalued. ANS: D Stock X is undervalued, 53.55 < 55 Stock Y is overvalued, 54.4 > 52 Stock Z is undervalued, 55.25 < 57 PTS: 1
OBJ: Multiple Choice Problem
33. Refer to Exhibit 9.2. Assume that you wish to create a portfolio with no net wealth invested. The portfolio that achieves this has 50% in stock X, −100% in stock Y, and 50% in stock Z. The weighted exposure to risk factor 1 for stocks X, Y, and Z are a. 0.50, −1.0, 0.50 b. −0.50, 1.0, −0.50
c. 0.60, −0.85, 0.25 d. −0.275, 0.10, 0.175 e. None of the above. ANS: D Wx = .5 Wy = −1 Wz = .5 That is for every two shares of Y that you sell short you purchase one share of X and one share of Z. Exposure to risk factor 1 Stock X = (.5)(−.55) = −0.275 Stock Y = (−1)(−.1) = 0.1 Stock Z = (.5)(.35) = 0.175 PTS: 1
OBJ: Multiple Choice Problem
34. Refer to Exhibit 9.2. Assume that you wish to create a portfolio with no net wealth invested. The portfolio that achieves this has 50% in stock X, −100% in stock Y, and 50% in stock Z. The weighted exposure to risk factor 2 for stocks X, Y, and Z are a. 0.50, −1.0, 0.50 b. −0.50, 1.0, −0.50 c. 0.60, −0.85, 0.25 d. −0.275, 0.10, 0.175 e. None of the above. ANS: C Wx = .5 Wy = −1 Wz = .5 That is for every two shares of Y that you sell short you purchase one share of X and one share of Z. Exposure to risk factor 2 Stock X = (.5)(1.2) = 0.6 Stock Y = (−1)(.85) = −0.85 Stock Z = (.5)(.5) = 0.25 PTS: 1
OBJ: Multiple Choice Problem
35. Refer to Exhibit 9.2. Assume that you wish to create a portfolio with no net wealth invested and the portfolio that achieves this has 50% in stock X, −100% in stock Y, and 50% in stock Z. The net arbitrage profit is a. $8 b. $5 c. $7 d. $12 e. $15 ANS: A Wx = .5 Wy = −1 Wz = .5
That is for every two shares of Y that you sell short you purchase one share of X and one share of Z. The net arbitrage profit = (55 − 50) + 2(50 −52) + (57 − 50) = $8 PTS: 1
OBJ: Multiple Choice Problem
36. Refer to Exhibit 9.2. The new prices now for stocks X, Y, and Z that will not allow for arbitrage profits are a. $53.55, $54.4, $55.25 b. $45.35, $54.4, $55.25 c. $55.55, $56.35, $57.15 d. $50, $50, $50 e. $51.35, $47.79, $51.58. ANS: E The prices now that will prevent an arbitrage profit are Stock X = 55/(1 + .071) = $51.35 Stock Y = 52/(1 + .088) = $47.79 Stock Z = 57/(1 + .105) = $51.58 PTS: 1
OBJ: Multiple Choice Problem
37. The table below provides factor risk sensitivities and factor risk premia for a three factor model for a particular asset where factor 1 is MP the growth rate in U.S. industrial production, factor 2 is UI the difference between actual and expected inflation, and factor 3 is UPR the unanticipated change in bond credit spread. Risk Factor MP UI UPR
Factor Sensitivity() 1.76 −0.8 0.87
Risk Premium() 0.0259 −0.0432 0.0149
Calculate the expected excess return for the asset. a. 12.32% b. 9.32% c. 4.56% d. 6.32% e. 8.02% ANS: A The table below shows the relevant calculations Risk Factor MP UI UPR Expected return PTS: 1
Factor Sensitivity() 1.76 −0.8 0.87
Risk Premium() 0.0259 −0.0432 0.0149
() () 0.0456 0.0346 0.013 0.1232
OBJ: Multiple Choice Problem
Exhibit 9.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Stocks A, B, and C have two risk factors with the following beta coefficients. The zero-beta return (0) = .025 and the risk premiums for the two factors are (1) = .12 and (0) = .10. Stock A B C
Factor 1 bi1 −0.25 −0.05 0.01
Factor 2 bi2 1.1 0.9 0.6
38. Refer to Exhibit 9.3. Calculate the expected returns for stocks A, B, C. A a. b. c. d. e.
0.082 0.105 0.132 0.165 0.850
B 0.033 0.032 0.033 0.032 0.610
0.091 0.109 0.128 0.121 0.850
C
ANS: B E(RA) = 0.025 − 0.25(.12) + 1.1(.10) = 0.105 E(RB) = 0.025 − 0.05(.12) + 0.9(.10) = 0.109 E(RC) = 0.025 + 0.01(.12) + 0.6(.10) = 0.032 PTS: 1
OBJ: Multiple Choice Problem
39. Refer to Exhibit 9.3. Assume that stocks A, B, and C never pay dividends and stocks A, B, and C are currently trading at $10, $20, and $30, respectively. What is the expected price next year for each stock? A a. b. c. d. e.
$10.82 $11.05 $11.32 $11.65 $18.50
$21.82 $22.18 $22.56 $22.42 $37.00
B $30.99 $30.96 $30.99 $30.96 $48.30
C
ANS: B Price of A = $10*1.105 = $11.05 Price of B = $20*1.109 = $22.18 Price of C = $30*1.032 = $30.96 PTS: 1
OBJ: Multiple Choice Problem
40. Refer to Exhibit 9.3. Suppose that you know that the prices of stocks A, B, and C will be $10.95, 22.18, and $30.89, respectively. Based on this information a. All three stocks are overvalued. b. All three stocks are undervalued. c. Stock a is undervalued, stock b is properly valued, stock c is undervalued. d. Stock a is undervalued, stock b is properly valued, stock c is overvalued. e. Stock a is overvalued, stock b is overvalued, stock c is undervalued. ANS: C Stock A is undervalued $10.95 < $11.05 Stock B is properly valued $22.18 = $22.18
Stock C is undervalued $30.89 < $30.96 PTS: 1
OBJ: Multiple Choice Problem
41. Under the following conditions, what are the expected returns for stocks Y and Z? 0 = 0.04 k1 = 0.07 k2 = 0.05
a. b. c. d. e.
by,1 = 0.5 by,2 = 1.3 bz,1 = 1.2 bz,2 = 0.9
12.0% and 13.3% 13.5% and 14.2% 13.9% and 15.6% 14.0% and 16.9% 15.8% and 17.3%
ANS: D Ry = 0 + (by,1)(k1) + (by,2)(k2) = 0.04 + (0.5)(0.07) + (1.3)(0.05) = 0.04 + 0.035 + 0.065 = 14.0% Rz
= 0 + (bz,1)(k1) + (bz,2)(k2) = 0.04 + (1.2)(0.07) + (0.9)(0.05) = 0.04 + 0.084 + 0.045 = 16.9%
PTS: 1
OBJ: Multiple Choice Problem
42. Under the following conditions, what are the expected returns for stocks A and B? 0 = 0.03 k1 = 0.09 k2 = 0.07
a. b. c. d. e.
ba,1 = 1.5 ba,2 = 0.8 bb,1 = 1.20 bb,2 = 0.6
24.8% and 19.7% 22.1% and 18.0% 20.3% and 17.8% 19.9% and 16.9% 18.7% and 15.3%
ANS: B Ra = 0 + (ba,1)(k1) + (ba,2)(k2) = 0.03 + (1.5)(0.09) + (0.8)(0.07) = 0.03 + 0.135 + 0.056 = 22.1% Rb
= 0 + (bb,1)(k1) + (bb,2)(k2) = 0.03 + (1.2)(0.09) + (0.6)(0.07) = 0.03 + 0.108 + 0.042 = 18.0%
PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 10—ANALYSIS OF FINANCIAL STATEMENTS TRUE/FALSE 1. Financial Accounting Standards Board (FASB) recognizes that it would be improper for all companies to use identical and restrictive accounting principles. ANS: T
PTS: 1
2. The balance sheet shows what assets the firm controls at a point in time and how it financed the assets. ANS: T
PTS: 1
3. The income statement indicates the flow of sales, expenses, and earnings during a period of time. ANS: T
PTS: 1
4. The statement of cash flows shows the effect on the firm's cash flows of earnings and changes in the assets, current liabilities, long-term liabilities and net worth. ANS: T
PTS: 1
5. Cash flow from operations = Net Income + Non cash revenue and expenses − Changes in net working capital. ANS: F
PTS: 1
6. Free cash flow = Cash flow from operations − Capital expenditures + Disposition of property and equipment. ANS: T
PTS: 1
7. Traditional cash flow and Free cash flow are equivalent concepts. ANS: F
PTS: 1
8. It is important to compare a firm's performance relative to: the aggregate economy, its industry, its major competitors and its past performance. ANS: T
PTS: 1
9. The current ratio, receivables turnover and total asset turnover are measures of internal liquidity. ANS: F
PTS: 1
10. Inventory turnover, net fixed asst turnover and equity turnover are measures of operating efficiency. ANS: F
PTS: 1
11. According to the DuPont system ROE (return on equity) can be decomposed into the profit margin ratio and the total asset turnover ratio.
ANS: F
PTS: 1
12. Some factors that determine business risk include sales variability and debt to equity ratio. ANS: F
PTS: 1
13. Some factors that determine financial risk include interest coverage and cash flow coverage. ANS: T
PTS: 1
14. The growth of business depends on the percentage of earnings reinvested and the return on equity. ANS: T
PTS: 1
15. Financial ratios are used in stock and bond valuation models. ANS: F
PTS: 1
16. Financial ratios can be used to estimate systematic risk. ANS: T
PTS: 1
17. Bond rating agencies include the analysis of financial ratios in arriving at corporate bond ratings. ANS: T
PTS: 1
18. Financial ratios can be used to identify firms that might default on a loan or declare bankruptcy. ANS: T
PTS: 1
19. A cross-sectional analysis compares a firm to a subset of industry firms comparable in size or characteristics. ANS: T
PTS: 1
20. In common size analysis all assets and liabilities on the balance sheet are divided by total sales. ANS: F
PTS: 1
21. Financial risk is the uncertainty of operating income caused by the firm's industry. ANS: F
PTS: 1
22. Cross-sectional analysis is a useful technique for estimating future performance that involves examining a firm's relative performance over time. ANS: F
PTS: 1
23. The DuPont equation breaks down a firm's return on equity into three components, which are profit margin, total asset turnover, and financial leverage. ANS: T
PTS: 1
MULTIPLE CHOICE 1. The comparisons with which ratios should be made include the following, except a. The firm's own past performance. b. The firm's major competitor within the industry. c. The firm's suppliers and customers. d. The firm's industry or industries. e. The aggregate economy. ANS: C
PTS: 1
OBJ: Multiple Choice
2. The five major classes of ratios include the following, except a. Internal liquidity. b. Risk analysis. c. Growth analysis. d. Market performance. e. Operating performance. ANS: D
PTS: 1
OBJ: Multiple Choice
3. Which of the following is not a flow ratio? a. Interest coverage b. Fixed charge coverage c. Debt/equity d. Cash flow/long term debt e. Cash flow/total debt ANS: C
PTS: 1
OBJ: Multiple Choice
4. Which ratio is considered an internal liquidity ratio? a. Total asset turnover b. Net fixed asset turnover c. Receivables turnover d. Equity turnover e. Inventory turnover ANS: C
PTS: 1
OBJ: Multiple Choice
5. Operating performance is divided into which two subcategories of ratios? a. Efficiency and profitability b. Efficiency and debt c. Profitability and growth d. Debt and equity e. Liquidity and leverage ANS: A
PTS: 1
OBJ: Multiple Choice
6. Which of the following is not a component of return on equity (ROE)? a. Net income/sales b. Total assets/equity c. Equity/sales d. Sales/total assets e. Net Profit Margin ANS: C
PTS: 1
OBJ: Multiple Choice
7. Which equation is valid? a. g = Percent of earnings retained Return on equity b. g = Return on equity Percent of earnings retained c. g = Return on equity Return on total assets d. g = Percent of earnings retained Return on equity e. g = Total assets Return on total assets ANS: D
PTS: 1
OBJ: Multiple Choice
8. Determinants of market liquidity include all except the a. Number of shares traded. b. Dollar value of shares traded. c. Bid-ask spread. d. Number of security owners. e. Market price per share. ANS: E
PTS: 1
OBJ: Multiple Choice
9. Which of the following is not a use of financial ratios? a. Stock valuation b. Assigning credit quality ratings on bonds c. Predicting insolvency d. Identification of internal corporate variables that affect a stock's systematic risk e. None of the above (that is, all are uses of financial ratios) ANS: E
PTS: 1
OBJ: Multiple Choice
10. Limitations on the use of ratios include a. Accounting comparability. b. Company homogeneity. c. Consistent results. d. A reasonable range within the industry. e. All of the above ANS: E
PTS: 1
OBJ: Multiple Choice
11. Business risk is a function of a. Sales variability. b. Operating leverage. c. Financial leverage. d. a and b. e. b and c. ANS: D
PTS: 1
OBJ: Multiple Choice
12. A common-size balance sheet expresses all balance sheet items a. As a percentage of Current Assets. b. As a percentage of Fixed Assets. c. As a percentage of Total Assets. d. As a percentage of Net Income. e. As a percentage of Sales. ANS: C
PTS: 1
OBJ: Multiple Choice
13. A common-size income statement expresses all income statement items
a. b. c. d. e.
As a percentage of Current Assets. As a percentage of Fixed Assets. As a percentage of Total Assets. As a percentage of Net Income. As a percentage of Sales
ANS: E
PTS: 1
OBJ: Multiple Choice
14. An estimate of the discounted value of future lease payments can be obtained by: a. Discounting future lease payments at the firm's cost of debt. b. Discounting future lease payments at the firm's cost of capital. c. Applying a multiple to forthcoming minimum lease payments. d. a or b. e. a or c. ANS: E
PTS: 1
OBJ: Multiple Choice
15. Financial risk is the additional uncertainty of returns to equity holders due to a. The firm's use of fixed financial obligations b. The firm's level of fixed productions costs c. Business risk d. a and b. e. b and c. ANS: A
PTS: 1
OBJ: Multiple Choice
16. The market liquidity of a security can be measured using a. Trading turnover. b. Bid-Ask spread. c. Price of the security. d. a and b. e. b and c. ANS: D
PTS: 1
OBJ: Multiple Choice
17. Which of the following factors would be an indication of high quality earnings? a. Earnings are close to cash. b. Earnings are the result of repeat business. c. Revenue recognition is based on the installment principle. d. All of the above. e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
18. Which of the following factors would be indicative of a high quality balance sheet? a. Book value is greater than market value. b. The presence of off-balance sheet liabilities c. Market value is greater than book value. d. Very little unused borrowing capacity. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
19. Which of the following ratios is not a measurement of the firm's liquidity? a. Current ratio b. Cash ratio
c. Receivables turnover d. Inventory turnover e. Total asset turnover ANS: E
PTS: 1
OBJ: Multiple Choice
20. DuPont Analysis breaks down return on equity into major areas that can be used to identify a firm's strengths or weaknesses with respect to a. Profitability b. Leverage c. Liquidity d. Efficiency e. All of the above are broken out in the basic DuPont equation. ANS: C
PTS: 1
OBJ: Multiple Choice
21. Which of the following statements regarding financial risk and business risk is true? a. The acceptable level of financial risk for a firm depends on its business risk. b. A firm with a greater degree of business risk has the ability to take on more debt. c. A firm with a greater degree of financial risk typically takes on less business risk. d. Financial risk and business risk are both important but they are not related in any way. e. Financial risk is more important for small firms and business risk is more important for large firms. ANS: A
PTS: 1
OBJ: Multiple Choice
22. Financial ratios are only useful when they are compared to other ratios. All of the following are useful means of examining relative performance except a. Aggregate economy b. Industries c. Competitors d. Historical performance e. All of the above are relevant comparison measures for financial ratios ANS: E
PTS: 1
OBJ: Multiple Choice
23. The practice of comparing the firm to a subset of industry firms comparable in size or characteristics is referred to as a. Common size analysis b. Cross-sectional analysis c. DuPont analysis d. Proforma analysis e. Time-series analysis ANS: B
PTS: 1
OBJ: Multiple Choice
Exhibit 10.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) BMC CORPORATION INCOME STATEMENT FISCAL YEAR ENDING 12/31/2004 (DOLLARS IN THOUSANDS) Net Sales Cost of Goods Sold
$1025 682
Gross Profit Margin Depreciation Operating Expense Administrative Expense Operating Profit Interest Profit Before Tax Taxes Net Income
$
343 31 103 127 82 27 55 17 38
BMC CORPORATION BALANCE SHEET FISCAL YEAR ENDING 12/31/2004 (DOLLARS IN THOUSANDS) Assets Cash Accts rec Inventory Ttl cur assts Net fixed assets
Total assets
$
61 286 354 701 802
$1503
Liabilities Notes payable Accounts payable Accruals Total current liabilities Long term debt Common stock ($1.50 par) Paid in surplus Retained earnings Total liabilities and Stockholders' equity
24. Refer to Exhibit 10.1. What was BMC'S return on equity in 2004? a. 4.8% b. 5.9% c. 6.7% d. 8.3% e. 11.6% ANS: A ROE = 38 790 = 0.048= 4.8% Where equity = 102 + 226 + 462 = $790 PTS: 1
OBJ: Multiple Choice Problem
25. Refer to Exhibit 10.1. What was BMC'S quick ratio for 2004? a. 1.72 b. 1.37 c. 1.02 d. 0.85 e. 0.55 ANS: D Quick Ratio = (701 − 354) 407 = 0.85 PTS: 1
OBJ: Multiple Choice Problem
26. Refer to Exhibit 10.1. What was BMC'S interest coverage for 2004? a. 6.82 b. 3.04
$ 223 152 32 407 306 102 226 462 $1503
c. 2.74 d. 2.04 e. 1.41 ANS: B Interest Coverage = 82 27 = 3.04 PTS: 1
OBJ: Multiple Choice Problem
27. Refer to Exhibit 10.1. What was BMC'S total asset turnover for 2004? a. 0.23 b. 1.28 c. 1.46 d. 0.87 e. 0.68 ANS: E Total asset turnover = 1025 1503 = 0.68 PTS: 1
OBJ: Multiple Choice Problem
28. Refer to Exhibit 10.1. What was BMC'S current ratio at year-end 2004? a. 0.852 b. 1.000 c. 1.368 d. 1.722 e. 1.943 ANS: D Current ratio = 701 407 = 1.722 PTS: 1
OBJ: Multiple Choice Problem
29. Refer to Exhibit 10.1. What was BMC'S net profit margin? a. 0.058 b. 0.037 c. 0.125 d. 0.015 e. 0.165 ANS: B Net profit margin = 38 1025 = 0.037 PTS: 1
OBJ: Multiple Choice Problem
30. Refer to Exhibit 10.1. What was BMC'S fixed asset turnover ratio? a. 0.680 b. 0.780 c. 1.278 d. 1.874 e. 8.220 ANS: C Fixed asset turnover ratio = 1025 802 = 1.278
PTS: 1
OBJ: Multiple Choice Problem
31. Refer to Exhibit 10.1. What was the financial leverage multiplier used in the BMC system? a. 2.058 b. 2.289 c. 3.014 d. 1.903 e. 0.904 ANS: D Financial leverage multiplier = 1503 790 = 1.903 1503 − 306 − 407 = 790 PTS: 1
OBJ: Multiple Choice Problem
32. Refer to Exhibit 10.1. What is BMC'S traditional cash flow? a. 69 b. 86 c. 38 d. 55 e. 701 ANS: A Traditional Cash Flow = 38 + 31 = 69 PTS: 1
OBJ: Multiple Choice Problem
33. Refer to Exhibit 10.1. What is BMC'S operating profit margin? a. 0.800 b. 0.054 c. 0.080 d. 0.540 e. 5.480 ANS: C Operating profit margin = 82 1025 = 0.080 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 10.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) STAR CORPORATION INCOME STATEMENT FISCAL YEAR ENDING 12/31/2004 (DOLLARS IN THOUSANDS) Net Sales Cost of Goods Sold Gross Profit Margin Depreciation Operating Expense Administrative Expense Operating Profit Interest
$1075 706 369 30 109 129 101 29
Profit Before Tax Taxes Net Income
$
72 21 51
STAR CORPORATION BALANCE SHEET FISCAL YEAR ENDING 12/31/2004 (DOLLARS IN THOUSANDS) Assets Cash Accounts receivable Inventory Total current assets Net fixed assets
$
Total assets
69 233 348 650 886
$1536
Liabilities Notes payable Accounts payable Accruals Total current liabilities Long term debt Common stock ($1.50 par) Paid in surplus Retained earnings Total liabilities and Stockholders' equity
34. Refer to Exhibit 10.2. What was Star's return on equity in 2004? a. 5.8% b. 6.3% c. 6.8% d. 7.2% e. 8.1% ANS: B ROE = 51 810 = 6.30% Where equity = 111 + 190 + 509 = $810 PTS: 1
OBJ: Multiple Choice Problem
35. Refer to Exhibit 10.2. What was Star's quick ratio for 2004? a. 0.11 b. 0.44 c. 0.38 d. 0.74 e. 0.98 ANS: D Quick Ratio = (650 − 348) 408 = 0.74 PTS: 1
OBJ: Multiple Choice Problem
36. Refer to Exhibit 10.2. What was Star's interest coverage for 2004? a. 4.99 b. 2.58 c. 3.48 d. 5.16 e. 6.02 ANS: C Interest Coverage = 101 29 = 3.48
$ 231 146 31 408 318 111 190 509 $1536
PTS: 1
OBJ: Multiple Choice Problem
37. Refer to Exhibit 10.2. What was Star's total asset turnover for 2004? a. 1.65 b. 1.21 c. 0.92 d. 0.033 e. 0.70 ANS: E Total Asset Turnover = 1075 1536 = 0.70 PTS: 1
OBJ: Multiple Choice Problem
38. Refer to Exhibit 10.2. What was Star's current ratio at year-end 2004? a. 1.59 b. 1.00 c. 0.82 d. 0.74 e. 0.33 ANS: A Current Ratio = 650 408 = 1.59 PTS: 1
OBJ: Multiple Choice Problem
39. Refer to Exhibit 10.2. What was Star's net profit margin? a. 2.4% b. 3.8% c. 4.2% d. 4.7% e. 5.2% ANS: D Net profit margin = 51 1075 = 4.7% PTS: 1
OBJ: Multiple Choice Problem
40. Refer to Exhibit 10.2. What was Star's fixed asset turnover ratio? a. 1.65 b. 1.21 c. 1.01 d. 0.82 e. 0.42 ANS: B Fixed asset turnover ratio = 1075 886 = 1.21 PTS: 1
OBJ: Multiple Choice Problem
41. Refer to Exhibit 10.2. What was the financial leverage multiplier used in the Star system? a. 0.852 b. 1.896 c. 1.996
d. 2.054 e. 2.998 ANS: B Financial Leverage Multiplier = 1536 810 = 1.896 1536 − 318 − 408 = 810 PTS: 1
OBJ: Multiple Choice Problem
42. Refer to Exhibit 10.2. What is Star's traditional cash flow? a. 81 b. 72 c. 51 d. 102 e. 131 ANS: A Traditional Cash Flow = 51 + 30 = 81 PTS: 1
OBJ: Multiple Choice Problem
43. Refer to Exhibit 10.2. What is Star's operating profit margin? a. 0.104 b. 0.094 c. 0.084 d. 0.067 e. 0.047 ANS: B Operating profit margin = 101 1075 = 0.094 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 10.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You are provided with the following information for a company. Net Annual Sales Average Receivables COGS Average Inventory Average Trade Payables
60000 1200 35000 3000 1500
44. Refer to Exhibit 10.3. Calculate the receivables turnover ratio. a. 50 b. 25 c. 55 d. 36 e. 27 ANS: A Receivable T/O = 60000/1200 = 50 PTS: 1
OBJ: Multiple Choice Problem
45. Refer to Exhibit 10.3. Calculate the inventory turnover ratio. a. 27.23 b. 23.3 c. 55.43 d. 8.67 e. 11.67 ANS: E Inventory T/O = 35000/3000 = 11.67 PTS: 1
OBJ: Multiple Choice Problem
46. Refer to Exhibit 10.3. Calculate the payables turnover ratio. a. 30.3 b. 23.3 c. 55.4 d. 11.6 e. 56.6 ANS: B Payables T/O = 35000/1500 = 23.3 PTS: 1
OBJ: Multiple Choice Problem
47. Refer to Exhibit 10.3. Calculate the cash conversion cycle. a. 27 b. 46 c. 27 d. 55 e. 22 ANS: E Cash conversion cycle = (365/50 + 365/11.67 + 365/23.3) = 22 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 10.4 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You are provided with the following information about MaxCorp. Net sales Total Assets Depreciation Net Income Long term Debt Equity Dividends
5000 3000 260 600 2000 2160 160
48. Refer to Exhibit 10.4. Calculate the return on equity (ROE). a. 20.4% b. 17.8% c. 22.4% d. 27.8%
e. 30.4% ANS: D ROE = 600/2160 = 27.8% PTS: 1
OBJ: Multiple Choice Problem
49. Refer to Exhibit 10.4. Calculate the sustainable growth rate. a. 27.8% b. 30.4% c. 20.4% d. 27.8% e. 17.8% ANS: C g = 0.278(1 − 160/600) = 20.4% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 10.5 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You are provided with the following information about Albermarle Corp. Income Statement Data Sales Operating Income Depreciation Interest Expense Pretax Income Income Taxes Net Income after tax
542 38 3 3 32 13 19
Balance Sheet Data Fixed Assets Total Assets Working Capital Total Debt Equity
41 245 123 16 159
50. Refer to Exhibit 10.5. Calculate the operating margin. a. 15.5% b. 5.6% c. 8.6% d. 10.6% e. 6.5% ANS: E Operating margin = (38 − 3)/542 = 6.5% PTS: 1
OBJ: Multiple Choice Problem
51. Refer to Exhibit 10.5. Calculate the asset turnover ratio. a. 2.2
b. c. d. e.
5.6 4.2 2.9 3.9
ANS: A Asset turnover = 542/245 = 2.2 PTS: 1
OBJ: Multiple Choice Problem
52. Refer to Exhibit 10.5. Calculate the interest expense rate. a. 7% b. 0.5% c. 1.2% d. 5% e. 2.3% ANS: C Interest expense rate = 3/245 = 1.2% PTS: 1
OBJ: Multiple Choice Problem
53. Refer to Exhibit 10.5. Calculate the financial leverage. a. 1.05 b. 5.32 c. 2.15 d. 1.54 e. 2.31 ANS: D Financial leverage = 245/159 = 1.54 PTS: 1
OBJ: Multiple Choice Problem
54. Refer to Exhibit 10.5. Calculate the income tax rate. a. 40.6% b. 25.6% c. 16.8% d. 28.9% e. 44.9% ANS: A Income tax rate = 13/32 = 40.6% PTS: 1
OBJ: Multiple Choice Problem
55. Refer to Exhibit 10.5. Calculate the return on equity (ROE). a. 15% b. 12% c. 32% d. 9% e. 7% ANS: B ROE = [(6.5)(2.2) − 1.2](1.54)(1 − .406) = 12%
PTS: 1
OBJ: Multiple Choice Problem
Exhibit 10.6 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You are provided with the following information for the Klandy Corporation.
Net Income Depreciation Total Current Assets Total Current Liabilities
2003 $1200 $ 200 $ 700 $ 500
2004 $1500 $ 300 $ 900 $ 800
During 2004 Klandy Corp. made capital expenditures totaling $500 and disposed property worth $400. 56. Refer to Exhibit 10.6. The firm's cash flow from operating activities for the year 2004 is a. $2100 b. $1900 c. $1800 d. $1700 e. $1600 ANS: B Cash flow from operations = 1500 + 300 + 100 = $1900 PTS: 1
OBJ: Multiple Choice Problem
57. Refer to Exhibit 10.6. The firm's free cash flow is a. $2100 b. $1900 c. $1800 d. $1700 e. $1600 ANS: C Free cash flow = 1900 − 500 + 400 = $1800 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 10.7 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You are provided with the following information for the Nelson Corporation.
Net Income Depreciation Total Current Assets Total Current Liabilities
2003 $1500 $ 200 $ 700 $ 500
2004 $2000 $ 475 $ 900 $ 800
During 2004 Nelson Corp. made capital expenditures totaling $500 and disposed property worth $800. 58. Refer to Exhibit 10.7. The firm's cash flow from operating activities for the year 2004 is
a. b. c. d. e.
$2200 $2575 $2325 $2875 $1900
ANS: B Cash flow from operations = 2000 + 475 + 100 = $2575 PTS: 1
OBJ: Multiple Choice Problem
59. Refer to Exhibit 10.7. The firm's free cash flow is a. $2200 b. $1900 c. $2875 d. $2325 e. $2575 ANS: C Free cash flow = 2575 − 500 + 800 = $2875 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 10.8 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Zeco Company has the following financial statements for year ending 12/31/2008. Sales Cost of Goods Sold Gross Profit Depreciation Operating Expenses Administration Exp. Operating Profit 15,000 Interest Expense Profit Before Taxes Taxes Net Income Dividends Assets Cash Accounts Receivable Inventory Total Current Assets Net Fixed Assets Total Assets
1,000,000 750,000 250,000 100,000 70,000 65,000 8,000 7,000 2,800 4,200 3,200
50,000 250,000 325,000 825,000 450,000 1,275,000
Liabilities Notes Payable Accounts Payable Total Current Liab. Long Term Debt Common Stock Retained Earnings Total Liab. & Earnings
The Zeco Company's industry averages are as follows: Net Profit Margin = 4.5%; Total Asset Turnover = 0.8; Total Assets/Equity = 1.5 60. Refer to Exhibit 10.8. Calculate Zeco Company's Net Profit Margin.
250,000 350,000 800,000 225,000 200,000 50,000 1,275,000
a. b. c. d. e.
0.42% 0.97% 1.50% 19.60% 25.00%
ANS: A NI/Sales = 4,200/1,000,000 = 0.0042 or 0.42% PTS: 1
OBJ: Multiple Choice Problem
61. Refer to Exhibit 10.8. Calculate Zeco Company's Total Asset Turnover. a. 0.59 b. 0.78 c. 1.28 d. 1.70 e. 1.97 ANS: B Sales/Total Assets = 1,000,000/1,275,000 = 0.7843 PTS: 1
OBJ: Multiple Choice Problem
62. Refer to Exhibit 10.8. Calculate Zeco Company's Total Assets/Equity ratio. a. 5.1 b. 6.1 c. 6.4 d. 8.7 e. 25.5 ANS: A Total Assets/Equity = 1,275,000/(200,000 + 50,000) = 5.1 PTS: 1
OBJ: Multiple Choice Problem
63. Refer to Exhibit 10.8. Calculate the return on equity (ROE) for Zeco Company and the Industry.
a. b. c. d. e.
Zeco 1.52% 1.68% 2.10% 6.00% 8.40%
Industry Average 0.55% 5.40% 1.80% 5.40% 9.32%
ANS: B Zeco's ROE = NI/Sales Or Zeco's ROE Industry Average ROE PTS: 1
= 4,200/(200,000 + 50,000) = .0168 = 0.0042 * 0.7843 * 5.1 = 0.0168 = 0.045 * 0.8 * 1.5 = 0.054
OBJ: Multiple Choice Problem
64. Refer to Exhibit 10.8. Calculate the sustainable growth rate for Zeco Company. a. 0.4% b. 0.7% c. 1.3%
d. 2.1% e. 4.1% ANS: A Sustainable growth = ROE(1 − Div Payout Ratio) = 0.0168(1 − 3,200/4,200) = 0.004 PTS: 1
OBJ: Multiple Choice Problem
65. Refer to Exhibit 10.8. Based on this information what are the strengths and concerns of Zeco Company? a. Zeco needs to lower its leverage and improve profitability and efficiency. b. Zeco needs to increase its leverage and improve efficiency. c. Zeco needs to lower its leverage and improve efficiency. d. Zeco needs to lower its leverage and improve profitability. e. Zeco needs to increase its leverage and improve profitability. ANS: D Comparing the DuPont relationship for Zeco and the industry reveals that Zeco is less profitable, efficiency is relatively equal to the industry average, and Zeco has much higher leverage. Zeco's ROE Industry Average ROE PTS: 1
= 0.0042 * 0.7843 * 5.1 = 0.0168 = 0.045 * 0.8 * 1.5 = 0.054
OBJ: Multiple Choice Problem
Exhibit 10.9 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You are provided with the following year end information for All Systems Corporation. Income Statement Data Sales Operating Income Depreciation Interest Expense Pretax Income Income Taxes Net Income after tax
800 280 85 48 147 52 95
Balance Sheet Data Fixed Assets Total Assets Net Working Capital Total Debt Equity
810 1050 85 640 410
66. Refer to Exhibit 10.9. Calculate the profit margin for the firm. a. 22.5% b. 18.4% c. 17.6% d. 15.3% e. 11.9% ANS: E
Profit margin = NI/Sales = 95/800 = 0.1188 or 11.9% PTS: 1
OBJ: Multiple Choice Problem
67. Refer to Exhibit 10.9. Calculate the total asset turnover ratio for the firm. a. 0.76 b. 1.31 c. 1.64 d. 2.81 e. 3.24 ANS: A Total asset turnover = Sales/Total Assets = 800/1050 = 0.76 PTS: 1
OBJ: Multiple Choice Problem
68. Refer to Exhibit 10.9. Calculate the financial leverage ratio used in DuPont analysis. a. 0.61 b. 1.56 c. 1.77 d. 1.98 e. 2.56 ANS: E Financial leverage = 1050/410 = 2.56 PTS: 1
OBJ: Multiple Choice Problem
69. Refer to Exhibit 10.9. Calculate the return on equity (ROE). a. 31.3% b. 23.2% c. 18.4% d. 13.2% e. 7.5% ANS: B ROE = NI/Equity = 95/410 = 0.232 or 23.2% PTS: 1
OBJ: Multiple Choice Problem
70. Refer to Exhibit 10.9. The industry norms for profit margin (PM), total asset turnover (TAT), and financial leverage are 10.9%, 1.2, and 1.0, respectively. Based on this information it appears that All Systems Corporation is a. Better than the industry in terms of PM, but worse in terms of TAT b. Better than the industry for all three ratios c. Better than the industry for TAT and leverage, but worse for PM d. Worse than the industry for all three measures e. None of the above ANS: A DuPont ratio comparisons
Industry All Systems
PM 10.9% 11.9%
TAT 1.20 0.76
Leverage 1.00 2.56
All Systems Corporation is more highly leveraged than the industry and has a lower TAT indicating they are less efficient. All Systems Corporation is better than the industry in terms of PM, but worse than the industry in terms of TAT. Leverage for All Systems Corporation is higher, which increases ROE, but is much riskier in terms of bankruptcy risk. PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 11—INTRODUCTION TO SECURITY VALUATION TRUE/FALSE 1. Fundamentalists typically use the "Bottom-Up Approach" whereas technicians use the "Top-Down Approach" to the valuation process. ANS: F
PTS: 1
2. Empirical studies have shown that the market factor has increased over time and now accounts for the majority of an individual stock's price variance. ANS: F
PTS: 1
3. The general economic influences would include inflation, political upheavals, monetary policy, and fiscal policy initiatives. ANS: T
PTS: 1
4. Given an optimistic economic and stock-market outlook for a country, the investor should underweight the allocation to this country in his/her portfolio. ANS: F
PTS: 1
5. The importance of an industry's performance on an individual stock's performance varies across industries. ANS: T
PTS: 1
6. If the estimated value of an asset is greater than the market price, you would want to buy the investment. ANS: T
PTS: 1
7. The most difficult part of valuing a bond is determining the required rate of return on this investment. ANS: T
PTS: 1
8. A preferred stock is a perpetuity. ANS: T
PTS: 1
9. Growth companies are those firms that consistently earn higher rates of return by assuming greater amounts of risk. ANS: F
PTS: 1
10. The growth rate of dividends and profit margin are the main determinants of the P/E ratio. ANS: F
PTS: 1
11. The dividend growth models are only meaningful for companies that have a required rate of return that exceeds their dividend growth rate. ANS: T
PTS: 1
12. The three step valuation process consists of (1) analysis of alternative economies and markets, (2) analysis of alternative industries and (3) analysis of industry influences. ANS: F
PTS: 1
13. The two components that are required in order to carry out asset valuation are (1) the stream of expected cash flows and (2) the required rate of return. ANS: T
PTS: 1
14. The importance of an industry's performance on an individual stock's performance varies across industries. ANS: T
PTS: 1
15. If the intrinsic value of an asset is greater than the market price, you would want to buy the investment. ANS: T
PTS: 1
16. The required rate of return is determined by (1) the real risk free rate, (2) the expected rate of inflation and (3) liquidity risk. ANS: F
PTS: 1
17. The price of a bond can be calculated by discounting future coupons over the bonds life by the yield to maturity. ANS: F
PTS: 1
18. An example of a relative valuation technique is the Price/Cash Flow ratio. ANS: T
PTS: 1
19. Discounted cash flow techniques for equity valuation may use one of the following: (1) dividends, (2) Free cash flow or (3) coupons. ANS: F
PTS: 1
20. In dividend discount models (DDM) with supernormal growth, supernormal growth may continue indefinitely. ANS: F
PTS: 1
21. The real risk free rate depends on the real growth in the economy and can be affected for short time periods by temporary tightness or ease in the capital markets. ANS: T
PTS: 1
22. The risk premium is impacted by business risk, financial risk, and liquidity risk.
ANS: T
PTS: 1
23. A bond typically pays interest payments every six months equal to the coupon rate times the face value of the bond. ANS: F
PTS: 1
24. The value of preferred stock can be calculated by dividing its dividend by the required rate of return. ANS: T
PTS: 1
25. A relative valuation technique is appropriate to consider when you have a good set of comparable entities. ANS: T
PTS: 1
26. The infinite period dividend discount model (DDM) can be used to value a supernormal growth company. ANS: F
PTS: 1
27. The growth rate in equity without any external financing is determined by multiplying the payout ratio times the return on equity (ROE). ANS: F
PTS: 1
28. The dividend discount model (DDM) can be used to value preferred stock by simply using a growth rate of zero in the DDM model. ANS: T
PTS: 1
29. An equity investor's required rate of return is influenced by the economy's real risk-free rate, the expected rate of inflation, and a risk premium. ANS: T
PTS: 1
MULTIPLE CHOICE 1. Which of the following is not a consideration in the three-step valuation process? a. Analysis of alternative economies b. Analysis of security markets c. Analysis of alternative industries d. Analysis of individual companies e. None of the above (that is, all are considerations in the three-step valuation process) ANS: E
PTS: 1
OBJ: Multiple Choice
2. Which of the following is not considered a basic economic force? a. Fiscal policy b. Monetary policy c. Inflation d. P/E ratio
e. None of the above (that is, all are basic economic forces) ANS: D
PTS: 1
OBJ: Multiple Choice
3. The process of fundamental valuation requires estimates of all the following factors, except a. The time pattern of returns. b. The economy's real risk-free rate. c. The risk premium for the asset. d. The times series of stock prices. e. The expected rate of inflation. ANS: D
PTS: 1
OBJ: Multiple Choice
4. Which of the following is correct? a. If estimated value > Market price, you should buy. b. If estimated value > Market price, you should sell. c. If estimated value < Market price, you should sell. d. If estimated value < Market price, you should buy. e. Choices a and c. ANS: E
PTS: 1
OBJ: Multiple Choice
5. The value of a corporate bond can be derived by calculating the present value of the interest payments and the present value of the face value at the bond's a. Current yield. b. Coupon rate. c. Required rate of return. d. Effective rate. e. Prime rate. ANS: C
PTS: 1
OBJ: Multiple Choice
6. Which securities can be valued by dividing the annual dividend by the required rate of return? a. Low coupon bonds b. Junk bonds c. Common stocks d. Preferred stocks e. Constant growth common stocks ANS: D
PTS: 1
OBJ: Multiple Choice
7. According to the dividend growth model, if a company were to declare that it would never pay dividends, its value would be a. Based on earnings. b. Based on expectations regarding. c. Higher than similar firms since it could reinvest a greater amount in new projects. d. Zero. e. Based on the capital asset pricing model. ANS: D
PTS: 1
8. Dividend growth is a function of a. Return on equity. b. The retention rate. c. The payout ratio. d. All of the above.
OBJ: Multiple Choice
e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
9. Growth rates of the (1) labor force, (2) average number of hours worked and (3) labor productivity are the main determinants of a foreign country's a. Dividend payout ratio. b. Beta. c. Real risk free rate. d. Nominal risk free rate. e. Risk premium. ANS: C
PTS: 1
OBJ: Multiple Choice
10. The growth rate of equity earnings without external financing is equal to a. Retention rate plus return on equity. b. Retention rate minus return on equity. c. Retention rate divided by return on equity. d. Retention rate times return on equity. e. Return on equity divided by retention rate. ANS: D
PTS: 1
OBJ: Multiple Choice
11. Which of the following factors influence an investor's required rate of return? a. The economy's real risk-free rate (RFR) b. The expected rate of inflation (I) c. A risk premium d. All of the above e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
12. The P/E ratio is determined by a. The required rate of return. b. The expected dividend payout ratio. c. The expected growth rate of dividends. d. Choices a and b e. All of the above ANS: E
PTS: 1
OBJ: Multiple Choice
13. Which of the following statements regarding fundamental and relative valuation techniques is true? a. Both techniques require an appropriate estimate of the required rate of return and the growth rate. b. Both techniques require an estimate of future cash flows and a discount rate. c. Both techniques require an estimate of future cash flows and a growth rate. d. Both techniques require an estimate of future cash flows, the required rate of return and a growth estimate. e. All of the above are true. ANS: A
PTS: 1
OBJ: Multiple Choice
14. Which of the following is an underlying assumption of the constant growth dividend discount model (DDM)? a. Dividends have a constant growth rate b. The constant growth rate of dividends will continue for an infinite time period
c. The required rate of return is greater than the expected growth rate d. All of the above e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
15. All of the following are ways in which a firm can increase its growth rate of equity earnings without any external financing except a. Decreasing its dividend payments b. Increasing its retention ratio c. Increasing its return on equity (ROE) d. Increasing its return on assets (ROA) e. All of the above will increase the firm's growth rate without external financing ANS: E
PTS: 1
OBJ: Multiple Choice
16. The most appropriate discount rate to use when applying the Operating Free Cash Flows model is the firm's a. Required rate of return based on the capital asset pricing model (CAPM) b. Required rate of return based on the dividend discount model (DDM) c. Weighted average cost of capital (WACC) d. Historical cost of debt and equity e. All of the above are appropriate depending on the situation ANS: C
PTS: 1
OBJ: Multiple Choice
Exhibit 11.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) A major retailer is reevaluating its bonds since it is planning to issue a new bond in the current market. The firm's outstanding bond issue has 8 years remaining until maturity. The bonds were issued with a 6.5 percent coupon rate (paid quarterly) and a par value of $1,000. The required rate of return is 4.25 percent. 17. Refer to Exhibit 11.1. What is the current value of these securities? a. $1149.94 b. $433.15 c. $1151.92 d. $860.50 e. $863.35 ANS: C
PTS: 1
OBJ: Multiple Choice Problem
18. Refer to Exhibit 11.1. What will be the value of these securities in one year if the required return is 7 percent? a. $970.14 b. $388.13
c. $1031.15 d. $1035.81 e. $972.52 ANS: E
PTS: 1
OBJ: Multiple Choice Problem
Exhibit 11.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) A major manufacturer is reevaluating its bonds since it is planning to issue a new bond in the current market. The firm's outstanding bond issue has 7 years remaining till maturity. The bonds were issued with an 8 percent coupon rate (paid quarterly) and a par value of $1,000. The required rate of return is 10 percent. 19. Refer to Exhibit 11.2. What is the current value of these securities? a. $900.18 b. $1151.92 c. $972.52 d. $1113.63 e. $904.00 ANS: A
PTS: 1
OBJ: Multiple Choice Problem
20. Refer to Exhibit 11.2. What will be the value of these securities in one year if the required return is 6 percent? a. $1151.92 b. $972.52 c. $1100.15 d. $900.18 e. $936.72 ANS: C
PTS: 1
OBJ: Multiple Choice Problem
Exhibit 11.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) A large grocery chain is reevaluating its bonds since it is planning to issue a new bond in the current market. The firm's outstanding bond issue has 6 years remaining until maturity. The bonds were issued with a 6 percent coupon rate (paid semiannually) and a par value of $1,000. Because of increased risk the required rate has risen to 10 percent. 21. Refer to Exhibit 11.3. What is the current value of these securities? a. $656.40 b. $899.00 c. $822.70 d. $569.50 e. $962.00 ANS: C P = 30(PVIFA5%,12) + 1000(PVIF5%,12) P = 30(8.8633) + 1000(.5568) = $822.70 PTS: 1
OBJ: Multiple Choice Problem
22. Refer to Exhibit 11.3. What will be the value of these securities in one year if the required return declines to 8 percent? a. $899.43 b. $862.50 c. $869.88 d. $918.93 e. $946.98 ANS: D P = 30(PVIFA4%,10) + 1000(PVIF4%,10) P = 30(8.1109) + 1000(.6756) = $918.93 PTS: 1
OBJ: Multiple Choice Problem
23. In 2004, Montpelier Inc. issued a $100 par value preferred stock that pays a 9 percent annual dividend. Due to changes in the overall economy and in the company's financial condition investors are now requiring a 10 percent return. What price would you be willing to pay for a share of the preferred if you receive your first dividend one year from now? a. $100 b. $110 c. $75 d. $90 e. $85 ANS: D Dividend = .09 $100 = $9 PTS: 1
Price = 9 0.1 = $90
OBJ: Multiple Choice Problem
24. In 2004, Smiths Corp. issued a $50 par value preferred stock that pays a 6 percent annual dividend. Due to changes in the overall economy and in the company's financial condition investors are now requiring an 7 percent return. What price would you be willing to pay for a share of the preferred if you receive your first dividend one year from now? a. $42.86 b. $30.00 c. $31.54 d. $33.38 e. $38.37 ANS: A Dividend = .06 $50 = $3 PTS: 1
Price = 3 0.07 = $42.85
OBJ: Multiple Choice Problem
25. In 2004, Venus Fly Co. issued a $75 par value preferred stock which pays a 7 percent annual dividend. Due to changes in the overall economy and in the company's financial condition investors are now requiring a 5 percent return. What price would you be willing to pay for a share of the preferred if you receive your first dividend one year from now? a. $125 b. $84 c. $91 d. $145 e. $105 ANS: E Dividend = .07 $75 = $5.25 PTS: 1
Price = 5.25 0.05 = $105
OBJ: Multiple Choice Problem
26. In 2004, Swisten Inc. issued a $150 par value preferred stock that pays an 8 percent annual dividend. Due to changes in the overall economy and in the company's financial condition investors are now requiring an 15 percent return. What price would you be willing to pay for a share of the preferred if you receive your first dividend one year from now? a. $80 b. $75 c. $59 d. $95 e. $110 ANS: A Dividend = .08 $150 = $12 PTS: 1
Price = 12 0.15 = $80
OBJ: Multiple Choice Problem
27. Using the constant growth model, a decrease in the required rate of return from 15 to 13 percent combined with an increase in the growth rate from 5 to 6 percent would cause the price to a. Rise more than 50%. b. Rise less than 50%. c. Remain constant. d. Fall more than 50%. e. Fall less than 50%. ANS: B
% = P2/P1
PTS: 1
= [(D0)(1 + g2)/(k2 − g2)] [(D0)(1 + g1)/(k1 − g1)] − 1 = [(D0)(1 + 0.06)/(0.13 − 0.06)] [(D0)(1 + 0.05)/(0.15 − 0.05)] − 1 = (15.14 10.5) − 1 = 44.22% < 50% OBJ: Multiple Choice Problem
28. Using the constant growth model, an increase in the required rate of return from 19 to 17 percent combined with an increase in the growth rate from 11 to 9 percent would cause the price to a. Fall more than 2% b. Fall less than 2%. c. Remain constant. d. Rise more than 2%. e. Rise less than 3%. ANS: B % = P2/P1
PTS: 1
= [(D0)(1 + g2)/(k2 − g2)] [(D0)(1 + g1)/(k1 − g1)] − 1 = [(D0)(1 + 0.09)/(0.17 − 0.09)] [(D0)(1 + 0.11)/(0.19 − 0.11)] − 1 = (13.625 13.875) − 1 = −1.8% > −2% OBJ: Multiple Choice Problem
29. Using the constant growth model, an increase in the required rate of return from 14 to 15 percent combined with an increase in the growth rate from 6 to 7 percent would cause the price to a. Rise more than 1% b. Rise less than 1%. c. Remain constant. d. Fall more than 1%. e. Fall less than 1%. ANS: B % = P2/P1
PTS: 1
= [(D0)(1 + g2)/(k2 − g2)] [(D0)(1 + g1)/(k1 − g1)] − 1 = [(D0)(1 + 0.07)/(0.15 − 0.07)] [(D0)(1 + 0.06)/(0.14 − 0.06)] − 1 = (13.375 13.25) − 1 = 0.94% < 1% OBJ: Multiple Choice Problem
30. Using the constant growth model, an increase in the required rate of return from 17 to 20 percent combined with an increase in the growth rate from 8 to 11 percent would cause the price to a. Rise more than 3% b. Rise less than 3%. c. Remain constant. d. Fall more than 3%. e. Fall less than 3%. ANS: B % = P2/P1
PTS: 1
= [(D0)(1 + g2)/(k2 − g2)] [(D0)(1 + g1)/(k1 − g1)] − 1 = [(D0)(1 + 0.11)/(0.20 − 0.11)] [(D0)(1 + 0.08)/(0.17 − 0.08)] − 1 = (12.33 12.00) − 1 = 2.75% < 3% OBJ: Multiple Choice Problem
31. Using the constant growth model, an increase in the required rate of return from 14 to 18 percent combined with an increase in the growth rate from 8 to 12 percent would cause the price to
a. b. c. d. e.
Fall more than 4% Fall less than 4%. Rise more than 4% Rise less than 4%. Remain constant.
ANS: D % = P2/P1
PTS: 1
= [(D0)(1 + g2)/(k2 − g2)] [(D0)(1 + g1)/(k1 − g1)] − 1 = [(D0)(1 + 0.12)/(0.18 − 0.12)] [(D0)(1 + 0.08)/(0.14 − 0.08)] − 1 = (18.66 18.00) − 1 = 3.77% < 4% OBJ: Multiple Choice Problem
Exhibit 11.4 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Davenport Corporation's last dividend was $2.70 and the directors expect to maintain the historic 3 percent annual rate of growth. You plan to purchase the stock today because you feel that the growth rate will increase to 5 percent for the next three years and the stock will then reach $25 per share. 32. Refer to Exhibit 11.4. How much should you be willing to pay for the stock if you require a 17 percent return? a. $16.97 b. $22.16 c. $21.32 d. $32.63 e. $23.63 ANS: B
PTS: 1
OBJ: Multiple Choice Problem
33. Refer to Exhibit 11.4. How much should you be willing to pay for the stock if you feel that the 5 percent growth rate can be maintained indefinitely and you require a 17 percent return? a. $22.16 b. $19.28 c. $21.32 d. $23.63 e. $25.46 ANS: D P = (2.70 1.05) (0.17 − 0.05) = $23.63 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 11.5 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
The National Motor Company's last dividend was $1.25 and the directors expect to maintain the historic 4 percent annual rate of growth. You plan to purchase the stock today because you feel that the growth rate will increase to 7 percent for the next three years and the stock will then reach $25.00 per share. 34. Refer to Exhibit 11.5. How much should you be willing to pay for the stock if you require a 16 percent return? a. $17.34 b. $18.90 c. $19.09 d. $19.21 e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice Problem
35. Refer to Exhibit 11.5. How much should you be willing to pay for the stock if you feel that the 7 percent growth rate can be maintained indefinitely and you require a 16 percent return? a. $11.15 b. $14.44 c. $14.86 d. $18.90 e. $19.24 ANS: C P = (1.25 1.07) (0.16 − 0.07) = $14.86 PTS: 1
OBJ: Multiple Choice Problem
36. Ross Corporation paid dividends per share of $1.20 at the end of 1990. At the end of 2000 it paid dividends per share of $3.50. Calculate the compound annual growth rate in dividends. a. 52.17% b. 34.28% c. 23% d. 19.17% e. 11.29% ANS: E g = (3.50/1.20)1/10 − 1 = 11.29% PTS: 1
OBJ: Multiple Choice Problem
37. Hunter Corporation had a dividend payout ratio of 63% in 1999. The retention rate in 1999 was a. 37% b. 63% c. 50% d. 0% e. 100%
ANS: A retention rate = 1 − .63 = 37% PTS: 1
OBJ: Multiple Choice Problem
38. The beta for the DAK Corporation is 1.25. If the yield on 30 year T-bonds is 5.65%, and the long term average return on the S&P 500 is 11%. Calculate the required rate of return for DAK Corporation. a. 12.34% b. 7.06% c. 13.74% d. 5.35% e. 5.65% ANS: A required return = .0565 + 1.25(.11 − .0565) = 12.34% PTS: 1
OBJ: Multiple Choice Problem
39. Micro Corp. just paid dividends of $2 per share. Assume that over the next three years dividends will grow as follows, 5% next year, 15% in year two, and 25% in year 3. After that growth is expected to level off to a constant growth rate of 10% per year. The required rate of return is 15%. Calculate the intrinsic value using the multistage model. a. $5.56 b. $66.4 c. $49.31 d. $43.66 e. none of the above ANS: C
PTS: 1
OBJ: Multiple Choice Problem
40. The P/E ratio for BMI Corporation is 21, and the P/S ratio is 5.2. The industry P/E ratio is 35 and the industry P/S ratio is 7.5. Based on relative valuation, BMI is a. undervalued on the basis of relative P/E and relative P/S. b. overvalued on the basis of relative P/E and undervalued on the basis of relative P/S. c. undervalued on the basis of relative P/E and overvalued on the basis of relative P/S. d. overvalued on the basis of relative P/E and relative P/S. e. none of the above. ANS: A Relative P/E = 21/35 = undervalued Relative P/S = 5.2/7.5 = undervalued PTS: 1
OBJ: Multiple Choice Problem
Exhibit 11.6 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Consider a firm that has just paid a dividend of $2. An analyst expects dividends to grow at a rate of 8% per year for the next five years. After that dividends are expected to grow at a normal rate of 5% per year. Assume that the appropriate discount rate is 7%. 41. Refer to Exhibit 11.6. The dividends for years 1, 2, and 3 are a. $2, $2.08, $2.16 b. $2, $2.05, $2.10 c. $2.16, $2.24, $2.32 d. $2.16, $2.33, $2.52 e. $2.07, $2.14, $2.21 ANS: D Year 1 Dividends = 2(1 + .08) = $2.16 Year 2 Dividends = 2(1 + .08)2 = $2.33 Year 3 Dividends = 2(1 + .08)3 = $2.52 PTS: 1
OBJ: Multiple Choice Problem
42. Refer to Exhibit 11.6. The future price of the stock in year 5 is a. $113.40 b. $122.47 c. $132.27 d. $142.85 e. $154.35 ANS: E Future price of stock in year 5 = P5 = D6/(k − g) where g is the normal growth rate = 5% D6 = 2(1 + .08)5(1 + .05) = $3.087 P5 = 3.087/(.07 − .05) = $154.35 PTS: 1
OBJ: Multiple Choice Problem
43. Refer to Exhibit 11.6. The present value today of dividends for years 1 to 5 is a. $4.06 b. $10.28 c. $12.40 d. $14.52 e. $10.0 ANS: B The present value today of dividends from years 1 to 5 = 2.16/(1.07) + 2.33/(1.07)2 + 2.52/(1.07)3 + 2.72/(1.07)4 + 2.94/(1.07)5 = $10.28 PTS: 1
OBJ: Multiple Choice Problem
44. Refer to Exhibit 11.6. The price of the stock today (P0) is a. $136.29 b. $133.03 c. $120.33 d. $123.43 e. $126.60 ANS: C
P0
= PV of dividends yr1 to yr5 + PV of P5 = 10.28 + 154.35/(1.07)5 = $120.33
PTS: 1
OBJ: Multiple Choice Problem
Exhibit 11.7 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Consider a firm that has just paid a dividend of $1.5. An analyst expects dividends to grow at a rate of 9% per year for the next three years. After that dividends are expected to grow at a normal rate of 5% per year. Assume that the appropriate discount rate is 7%. 45. Refer to Exhibit 11.7. The dividends for years 1, 2, and 3 are a. $1.5, $2.0, $2.05 b. $1.64, $1.78, $1.94 c. $1.64, $1.94, $2.24 d. $1.5, $2.40, $3.30 e. $2.07, $2.14, $2.21 ANS: B Year 1 Dividends = 1.5(1 + .09) = $1.64 Year 2 Dividends = 1.5(1 + .09)2 = $1.78 Year 3 Dividends = 1.5(1 + .09)3 = $1.94 PTS: 1
OBJ: Multiple Choice Problem
46. Refer to Exhibit 11.7. The future price of the stock in year 3 is a. $81.75 b. $84.81 c. $92.56 d. $101.85 e. $111.16 ANS: D Future price of stock in year 3 = P3 = D4/(k − g) where g is the normal growth rate = 5% D4 = 1.5(1 + .09)3(1 + .05) = $2.037 P3 = 2.037/(.07 − .05) = $101.85 PTS: 1
OBJ: Multiple Choice Problem
47. Refer to Exhibit 11.7. The present value today of dividends for years 1 to 3 is a. $4.67 b. $3.08 c. $5.67 d. $4.5 e. $1.53 ANS: A The present value today of dividends from years 1 to 3 = 1.64/(1.07) +1.78/(1.07)2 + 1.94/(1.07)3 = $4.67 PTS: 1
OBJ: Multiple Choice Problem
48. Refer to Exhibit 11.7. The price of the stock today (P0) is a. $84.81 b. $87.81 c. $91.09 d. $94.32 e. $97.61 ANS: B P0 = PV of dividends yr1 to yr5 + PV of P3 = 4.67 + 101.85/(1.07)3 = $87.81 PTS: 1
OBJ: Multiple Choice Problem
49. Tayco Corporation has just paid dividends of $3 per share. The earnings per share for the company was $4. If you believe that the appropriate discount rate is 15% and the long term growth rate in dividends is 6%, and earnings is 6%, the firm's P/E ratio is a. 8.33 b. 33.33 c. 44.44 d. 11.11 e. None of the above ANS: A
PTS: 1
OBJ: Multiple Choice Problem
50. What is the value of a 10% semi-annual coupon bond with a par value of $1,000 that matures in 5 years and has a required rate of return of 9%? a. $1,021.95 b. $1,038.90 c. $1,039.56 d. $1,064.18 e. $1,078.23 ANS: C
PTS: 1
OBJ: Multiple Choice Problem
51. What is the value of a preferred stock that has a par value of $100, a required rate of return of 11%, and pays a 7 percent annual dividend? a. $63.64 b. $157.14 c. $909.09 d. $1,428.57
e. $2,500.00 ANS: A Dividend = .07*$100 = $7. Value of a perpetuity = D/k = $7/.11 = $63.64 PTS: 1
OBJ: Multiple Choice Problem
52. XCEL Corporation paid a dividend yesterday for $1.50. They expect to pay dividends annually at a constant 6% annual growth rate indefinitely. If the required rate of return on this investment is 12%, what is the current value of this common stock? a. $1.50 b. $12.50 c. $13.25 d. $25.00 e. $26.50 ANS: E Using the DDM: P = $1.50(1.06)/(.12 − .06) = $1.59/.06 = $26.50 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 11.8 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Fast Grow Corporation is expecting dividends to grow at a 20% rate for the next two years. The corporation just paid a $2 dividend and the next dividend will be paid one year from now. After two years of rapid growth dividends are expected to grow at a constant rate of 9% forever. 53. Refer to Exhibit 11.8. If the required return is 14%, what is the value of Fast Grow Corporation common stock today? a. $40.26 b. $42.38 c. $46.70 d. $52.63 e. $62.78 ANS: D
PTS: 1
OBJ: Multiple Choice Problem
54. Refer to Exhibit 11.8. Assume that the annual dividend grows at a constant rate of 9% indefinitely instead of the supernormal growth. How much is the stock worth if dividends grow annually at 9%? a. $40.00 b. $43.60 c. $45.60 d. $47.80 e. $52.40 ANS: B P = $2(1.09)/(.14 − .09) = 2.18/.05 = $43.60
PTS: 1
OBJ: Multiple Choice Problem
55. What is the value to you of a 10 percent coupon bond with semi-annual coupon payments and a par value of $10,000 that matures in 20 years if you require an 8 percent return? a. $9,652.89 b. $10,356.65 c. $11,359.03 d. $11,979.28 e. $12,385.62 ANS: D
Using the calculator TVM functions PMT = Coupon payments = .10($10,000)/2 = $1,000/2 = $500 N = number of 6-month periods = 20*2 = 40 I/Y = required rate of return/2 = 8%/2 = 4% FV = Par Value = $10,000 Compute for PV = value today = $11,979.28 PTS: 1
OBJ: Multiple Choice Problem
56. The Absolute Finance Company (AFC) earned $5 a share last year and paid a dividend of $2 per share. Next year, you expect AFC to earn $6 a share next year and continue its payout ratio. Assume that you expect to sell the stock for $45 a year from now. If you require a 13 percent return on this stock, how much would you be willing to pay for it? a. $41.95 b. $43.21 c. $45.13 d. $46.72 e. $47.40 ANS: A Expected dividend in one year = (2/5)(6) = $2.40 Value today = ($45 + $2.40)/(1.13) = $41.95 PTS: 1
OBJ: Multiple Choice Problem
57. A company has a dividend payout ratio of 35 percent. If the company's return on equity is 15 percent, what is the expected growth rate if no new outside financing is used? a. 4.50% b. 5.25% c. 7.75% d. 8.25% e. 9.75% ANS: E g = RR(ROE) = (1 − .35)(.15) = 0.0975 or 9.75% PTS: 1
OBJ: Multiple Choice Problem
58. A company's dividend last year was $3.00. Dividends are expected to grow indefinitely at 7% and the required rate of return for the stock is 13%. What is the value of the stock today? a. $2.83 b. $23.08 c. $24.69 d. $50.00 e. $53.50 ANS: E Value of stock today = $3.00(1.07)/(.13 − .07) = $3.21/0.06 = $53.50 PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 12—MACROANALYSIS AND MICROVALUATION OF THE STOCK MARKET TRUE/FALSE 1. A main limitation of the NBER indicator series is false signals. ANS: T
PTS: 1
2. Stock prices move coincidentally with the economy. ANS: F
PTS: 1
3. The cyclical indicator approach to market analysis is based on the belief that the economy expands and contracts in a random manner. ANS: F
PTS: 1
4. Leading indicators of the business cycle include economic series that reach peaks or troughs before the peaks and troughs of the overall economy. ANS: T
PTS: 1
5. Coincident indicators include economic time series that have peaks and troughs that roughly occur at the same time as the peaks and troughs of overall economic activity. ANS: T
PTS: 1
6. The economy and the stock market have a strong, consistent relationship, but the stock market generally turns before the economy does. ANS: T
PTS: 1
7. Diffusion indexes indicate the spread in interest rates between major economies. ANS: F
PTS: 1
8. The economic factor assumed to be closely related to stock prices is productivity. ANS: F
PTS: 1
9. The best known monetary variable is the level of taxes. ANS: F
PTS: 1
10. Recent studies show that money supply changes have an important impact on stock price movements. ANS: T
PTS: 1
11. Recent studies indicate that one can earn excess returns in the stock market by forecasting unanticipated changes in the money supply.
ANS: T
PTS: 1
12. The first step in the Goldman Sachs analysis of world markets examines a country's aggregate economy and its components that relate to the valuation of securities. ANS: T
PTS: 1
13. The Goldman Sach analysis recommends an allocation of equity investments among countries in comparison to the country's normal weighting based on its relative market value. ANS: T
PTS: 1
14. It is important to analyze the economies and security markets before analyzing alternative industries or companies. ANS: F
PTS: 1
15. Over the last 20 years, increases in the return on equity for the S&P Index has been associated with decreases in return of assets. ANS: F
PTS: 1
16. It is more important to estimate future earnings than the future earnings multiplier. ANS: F
PTS: 1
17. An analysis of U.S. equity markets using the cash flow techniques concludes that the market is not fully valued. ANS: F
PTS: 1
18. There is a negative relationship between the capacity utilization rate and the profit margin. ANS: F
PTS: 1
19. Estimating net profit margin directly is difficult because it is so volatile. ANS: T
PTS: 1
20. An increase in the required rate of return k will increase the P/E ratio. ANS: F
PTS: 1
21. Future tax rates are difficult to estimate because they are politically influenced. ANS: T
PTS: 1
22. As the market's return on equity increases so will the P/E ratio. ANS: T
PTS: 1
23. It is reasonable to expect corporate sales to be closely related to GNP. ANS: T
PTS: 1
24. Dividend growth is positively related to the return on equity. ANS: T
PTS: 1
25. Changes in the dividend payout ratio are positively related to changes in the retention rate. ANS: F
PTS: 1
26. In well developed economies, markets are not affected by changes in expected inflation. ANS: F
PTS: 1
27. The valuation techniques presented in the chapter can only be applied to the stock market in the United States, since the U.S. stock market is inefficient. ANS: F
PTS: 1
28. One of the economic series included in the National Bureau of Economic Research (NBER) coincident indicator is the index of industrial production. ANS: T
PTS: 1
29. A major advantage of the cyclical indicator approach is that it spans all important major economic sectors including the service sector and import-exports. ANS: F
PTS: 1
30. The University of Michigan Consumer Sentiment Index is an example of a leading indicator. ANS: T
PTS: 1
31. When estimating a major stock market value using the earnings multiplier approach near-term estimates of the required rate of return and growth rate are essential due to the impact of near-term events on cash flows. ANS: F
PTS: 1
32. The authors of the text prefer forward valuation ratios as opposed to historical valuation variables in relative valuation methods. ANS: T
PTS: 1
33. Interest rate spread, 10-year Treasury bonds less federal funds, is listed as a lagging indicator in the National Bureau of Economic Research (NBER). ANS: F
PTS: 1
34. Building permits for new private housing units are listed as a leading indicator by the National Bureau of Economic Research (NBER). ANS: T
PTS: 1
35. An increase in the retention ratio will cause a decrease in the growth rate.
ANS: F
PTS: 1
MULTIPLE CHOICE 1. The index of leading indicators includes all of the following, except: a. M2 money supply. b. S & P 500 index. c. Orders for plant and equipment. d. Changes in the sensitive materials price. e. Index of industrial production. ANS: D
PTS: 1
OBJ: Multiple Choice
2. Which of the following are not cyclical indicators? a. Selected series b. Coincident indicators c. Diffusion indicators d. Leading indicators e. Lagging indicators ANS: C
PTS: 1
OBJ: Multiple Choice
3. The U.S. balance of payments, the federal deficit and military contract awards are ____ of aggregate economic activity. a. Leading indicators b. Coincident indicators c. Lagging indicators d. Not categorized indicators e. Not indicators ANS: D
PTS: 1
OBJ: Multiple Choice
4. Which of the following series does not include the long-leading index? a. Dow Jones Industrial Average b. Dow Jones Bond Prices, Percent Face Value c. Price to Unit Labor Cost d. M2 Money Supply, Deflated e. New Building Permits ANS: A
PTS: 1
OBJ: Multiple Choice
5. Which of the following variables was considered not significant in explaining stock returns? a. Industrial production b. Changes in the risk premium c. Consumption d. Twists in the yield curve e. Inflation ANS: C
PTS: 1
OBJ: Multiple Choice
6. If a diffusion index for new orders went from 87 to 74 and then to 68, it would indicate ____ receipt of new orders and indicate a ____ in breadth and the possibility of a future ____ in the series. a. Limited, strengthening, decline b. Limited, weakening, increase
c. Widespread, strengthening, increase d. Widespread, weakening, decline e. Widespread, weakening, increase ANS: D
PTS: 1
OBJ: Multiple Choice
7. The correlation of stock market returns between the U.S. and Japan is ____ and ____. a. High, increasing. b. High, decreasing. c. Low, increasing. d. Low, decreasing. e. Low, remaining constant. ANS: C
PTS: 1
OBJ: Multiple Choice
8. Which of the following is not an analytical measure used by the NBER to examine behavior within a series? a. Diffusion indexes b. Rates of change c. Direction of change d. Ratios among series e. Comparison with previous cycles ANS: D
PTS: 1
OBJ: Multiple Choice
9. Excess liquidity is defined as a. The year-to year percentage change in the M2 money supply less the year-to-year percentage change in the nominal GNP. b. The growth rate in M2 money supply less the growth rate in M1 money supply. c. The year-to-year percentage change in the M1 money supply less the year-to-year percentage. d. The year-to-year percentage change in the "real" GNP less the year-to-year percentage change in the nominal GNP. e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
10. Which of the following is not normally associated with cyclical indicators? a. The Securities and Exchange Commission (SEC) b. The National Bureau of Economic Research (NBER) c. Business Week d. Center for International Business Cycle Research (CIBCR) e. All of the above ANS: C
PTS: 1
OBJ: Multiple Choice
11. Which of the following is not a reason given for why forecaster are so often incorrect? a. There is a temptation for economic forecasters to stay fairly close to the "norm," that is, "group think." b. Many analysts are simply too short-sighted. c. Economists and economic forecaster often suffer from information overload. d. Some economic forecasters are too broad-minded, trying to include a number of ideas in their forecasts. e. None of the above (that is, all are reasons cited for why forecasters are often incorrect) ANS: D
PTS: 1
OBJ: Multiple Choice
12. Which of the following statements concerning asset allocation is false? a. Diversification across international boundaries can improve risk-adjusted portfolio returns. b. Economies expected to grow at an above-average rate with above-average profit growth should be considered as candidates to overweight in a global portfolio. c. Severe currency blockages should not impact global diversification selections. d. Portfolio allocation among asset classes may provide higher portfolio returns while lowering portfolio risk levels. e. None of the above (that is, all statements are true). ANS: C
PTS: 1
OBJ: Multiple Choice
13. The National Bureau of Economic Research (NBER) has derived the following indicator series in order to monitor business cycles. a. M2, leading, and lagging. b. Leading, coincident, and consumer expectations. c. Leading, coincident, and lagging. d. Leading, coincident, and M2. e. Consumer expectations, leading, and lagging. ANS: C
PTS: 1
OBJ: Multiple Choice
14. An examination of the relationship between stock prices and the economy has shown that the relationship is a. Weak, and that stock prices turn after the economy does. b. Nonexistent. c. Strong, and that stock prices turn after the economy does. d. Strong, and that stock prices turn before the economy does. e. Weak, and that stock prices turn before the economy does. ANS: D
PTS: 1
OBJ: Multiple Choice
15. Which of the following economic series are included in the NBER leading indicator group? a. Average weekly hour of production workers. b. Average weekly initial claims for unemployment insurance. c. Index of bond prices. d. a and b. e. b and c. ANS: D
PTS: 1
OBJ: Multiple Choice
16. Which of the following economic series are included in the NBER coincident indicator group? a. Employees on nonagricultural payrolls. b. Change in consumer price index for services. c. Index of consumer expectations. d. Spread of 10-year Treasury yield less fed funds. e. Index of stock prices. ANS: A
PTS: 1
OBJ: Multiple Choice
17. Which of the following economic series are included in the NBER lagging indicator series? a. Vendor Performance. b. Index of industrial production. c. Manufacturing and trade sales data in 1992 dollars. d. Manufacturers' new orders, non-defense capital goods.
e. Average duration of unemployment in weeks. ANS: E
PTS: 1
OBJ: Multiple Choice
18. The initial effect of a change in monetary policy appears in ____ and only later in ____. a. The aggregate economy, financial markets. b. Financial markets, the aggregate economy. c. Bond markets, stock markets, d. Stock markets, bond markets. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
19. Jensen, Johnson, and Mercer showed that the relationship between stock returns and size and price-to-book ratio holds in periods when monetary policy is a. Neutral. b. Tight. c. Easy. d. All of the above. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
20. If interest rates increase due to inflation, but expected cash flows to a firm do not change, then you would expect stock prices to a. Rise. b. Rise and then decline. c. Remain unchanged. d. Decline. e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
21. If interest rates rise due to inflation, and expected cash flows to a firm rise, then you would expect stock prices to a. Rise. b. Rise and then decline. c. Remain unchanged. d. Decline. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
22. There are three techniques available to help an investor make a market decision. Which of the following is not such an analysis technique? a. Macro techniques that are based on the strong relationship between the economy and security markets. b. Micro techniques that estimate future market values by applying one of several basic valuation models to equity markets. c. Technical analysis where an investor analyzes past and recent market movements for indications of future performance. d. Fundamental analysis that considers the effect of market on the entire portfolio. e. None of the above (that is, all are techniques available to make market decisions) ANS: D
PTS: 1
OBJ: Multiple Choice
23. Which of the following is not a factor under the Free Cash Flow to Equity (FCFE) Model? a. Depreciation expense b. Capital expenditure c. Change in working capital d. Principal debt repayment e. Earnings multiplier ANS: D
PTS: 1
OBJ: Multiple Choice
24. Expected earnings per share estimates requires all of the following except a. A sales per share estimate. b. A GDP estimate. c. An aggregate operating profit margin estimate d. An estimate of the real risk-free rate. e. A tax rate estimate. ANS: D
PTS: 1
OBJ: Multiple Choice
25. The dividend payout ratio, the required rate of return on common equity, and the expected growth rate of stock dividends are the major variables that affect a. The profit margin for the S&P Industrials Index. b. The earnings multiplier for common stock. c. Aggregate tax revenues. d. Capital gains tax revenues. e. Aggregate GDP. ANS: B
PTS: 1
OBJ: Multiple Choice
26. Aggregate return on equity increases as a. Profit margins increase. b. Total asset turnover increases. c. Financial leverage increases. d. Equity turnover decreases. e. All of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
27. All of the following factors affect the required rate of return except a. The economy's risk free rate. b. Corporate business risk. c. Return on equity. d. Country risk. e. Expected rate of inflation. ANS: C
PTS: 1
OBJ: Multiple Choice
28. The growth rate (g) of dividends is affected by all of the following except a. Required return b. Retention rate c. Total asset turnover d. Financial leverage e. Net profit margin ANS: A
PTS: 1
OBJ: Multiple Choice
29. Unit labor costs, the rate of inflation, the level of foreign competition, and the capacity utilization rate were variables tested by Finkel and Tuttle as determinants of the a. Balance of payments. b. The exchange rate. c. Aggregate operating profit margin. d. Aggregate profit margin. e. Aggregate cost margin. ANS: D
PTS: 1
OBJ: Multiple Choice
30. Which of the following is not a determinant of the aggregate gross profit margin? a. Unit labor costs of production b. Rate of inflation c. Unemployment rate d. Level of foreign competition e. Growth rate of M2 money supply ANS: E
PTS: 1
OBJ: Multiple Choice
31. A microeconomic estimate of the market earnings multiple requires an estimate for which of the following variables? a. Dividend payout ratio b. Return on equity c. Real RFR d. All of the above e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
32. Which of the following economic series is not included in the National Bureau of Economic Research (NBER) leading indicator group? a. Average weekly initial claims for unemployment b. Index of 500 consumer stock prices c. Real money supply, M2 d. Index of industrial production e. All of the above are included in the NBER leading indicator group ANS: D
PTS: 1
OBJ: Multiple Choice
33. Which of the following economic series is not included in the National Bureau of Economic Research (NBER) lagging indicator group? a. Average duration of unemployment b. Ratio of manufacturing and trade inventories to sales c. Number of employees on nonagricultural payrolls d. Percentage change in the labor cost per unit of output in manufacturing e. All of the above are included in the NBER lagging indicator group ANS: C
PTS: 1
OBJ: Multiple Choice
34. The multiplier approach for estimating the intrinsic market value of a major stock market series requires the following step(s): a. Estimating the future earnings per share for the stock market series b. Estimating the appropriate earnings multiplier for the stock market series c. Estimating long-run required rates of return and growth rates d. Both a and b
e. All of the above ANS: E
PTS: 1
OBJ: Multiple Choice
35. You are attempting to estimate expected earnings per share for a major stock market series. You have determined an appropriate estimate for sales per share. Which of the following methods can be used to estimate the profit margin? a. Base the estimate on recent trends of net profit margins. b. Estimate the net before tax (NBT) profit margin along with a tax estimate. c. Incorporate an estimate an operating profit margin, defined as earnings before interest, taxes, and depreciation. d. All of the above methods are appropriate. e. None of the above methods are appropriate. ANS: D
PTS: 1
OBJ: Multiple Choice
36. A 1971 study by Finkel and Tuttle hypothesizes that all of the following variables affect the aggregate profit margin except a. Capacity utilization rate b. Unit labor costs c. Variable labor costs d. Rate of inflation e. Foreign competition ANS: C
PTS: 1
OBJ: Multiple Choice
37. Which of the following economic series is not included in the National Bureau of Economic Research (NBER) coincident economic indicator group? a. Total value of commercial loans b. Employees on nonagricultural payrolls c. Personal income less transfer payments d. Industrial production e. Manufacturing and trade sales ANS: A
PTS: 1
OBJ: Multiple Choice
38. Which of the following is not a major variable that affects the aggregate stock market earning multiplier in a country? a. Required rate of return on common stock in the country b. Expected growth rate of dividends for the stocks in the country c. Composite dividend-payout ratio for common stocks in country d. Composite debt to equity ratio for firms in the country e. All of the above are major variables for a country's aggregate stock market earnings multiplier ANS: D
PTS: 1
OBJ: Multiple Choice
39. The growth rate will most likely increase if the: a. Retention ratio decreases b. Payout ratio decreases c. Return on equity decreases d. Net income increases e. Both a and c ANS: B
PTS: 1
OBJ: Multiple Choice
40. When applying the earnings multiplier model all of the following will cause the required rate of return, k, to change except a. Changes in the real risk free rate b. Changes in the retention rate c. Changes in the rate of inflation d. Changes in the risk premium for common stock e. All of the above changes will cause a change in the required rate of return ANS: B
PTS: 1
OBJ: Multiple Choice
41. If, for the S&P Industrials Index, the profit margin was 0.35 and the equity turnover ratio was 10, the ROE would be: a. 0.035% b. 2.857% c. 3.500% d. 28.57% e. 35.00% ANS: C ROE = (Profit Margin) (Equity Turnover) = (0.35)(10) = 3.5 PTS: 1
OBJ: Multiple Choice Problem
42. If, for the S&P Industrials Index, the profit margin was 0.30 and the equity turnover ratio was 11, the ROE would be: a. 0.033% b. 3.300% c. 33.00% d. 36.70% e. 333.00% ANS: B ROE = (Profit Margin) (Equity Turnover) = (0.30)(11) = 3.3 PTS: 1
OBJ: Multiple Choice Problem
43. If, for the S&P Industrials Index, the profit margin was .25 and the equity turnover ratio was 12, the ROE would be: a. 0.83% b. 0.48% c. 3.00% d. 30.00% e. 48.00% ANS: C ROE = (Profit Margin) (Equity Turnover) = (0.25)(12) = 3.0 PTS: 1
OBJ: Multiple Choice Problem
44. If, for the S&P Industrials Index, the profit margin was 0.20 and the equity turnover ratio was 13, the ROE would be: a. 0.026% b. 2.600% c. 6.500% d. 26.00%
e. 65.00% ANS: B ROE = (Profit Margin) (Equity Turnover) = (0.20)(13) = 2.6 PTS: 1
OBJ: Multiple Choice Problem
45. The dividend payout ratio for the aggregate market is 55 percent, the required rate of return is 15 percent, and the expected growth rate for dividends is 7 percent. Compute the current earnings multiple. a. 3.93 b. 78.6 c. 6.88 d. 39.3 e. None of the above ANS: C P/E = Payout (k − g) = .55 (.15 − .07) = 6.88 PTS: 1
OBJ: Multiple Choice Problem
46. The dividend payout ratio for the aggregate market is 65 percent, the required rate of return is 13 percent, and the expected growth rate for dividends is 8 percent. Compute the current earnings multiple. a. 7 b. 13 c. 4.61 d. 14.61 e. None of the above ANS: B P/E = Payout (k − g) = .65 (.13 − .08) = 13 PTS: 1
OBJ: Multiple Choice Problem
47. The dividend payout ratio for the aggregate market is 65 percent, the required rate of return is 12 percent, and the expected growth rate for dividends is 6 percent. Compute the current earnings multiple. a. 5.41 b. 16.25 c. 6.25 d. 10.83 e. None of the above ANS: D P/E = Payout (k − g) = .65 (0.12 − .06) = 10.83 PTS: 1
OBJ: Multiple Choice Problem
48. The dividend payout ratio for the aggregate market is 50 percent, the required rate of return is 16 percent, and the expected growth rate for dividends is 6 percent. Compute the current earnings multiple. a. 5 b. 2.81 c. 7.5
d. 4 e. None of the above ANS: A P/E = Payout (k − g) = .50 (.16 − .06) = 5 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 12.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Assume that the dividend payout ratio will be 65 percent when the rate on long-term government bonds falls to 8 percent. Since investors are becoming more risk averse, the equity risk premium will rise to 7 percent and investors will require a 15 percent return. The return on equity will be 12 percent. 49. Refer to Exhibit 12.1. What is the expected sustainable growth rate? a. 2.80% b. 4.20% c. 5.25% d. 7.80% e. 9.75% ANS: B g = (1 − Payout) (ROE) = 0.35 12 = 4.2% PTS: 1
OBJ: Multiple Choice Problem
50. Refer to Exhibit 12.1. What is your expectation of the market P/E ratio? a. 8.33 b. 5.33 c. 9.03 d. 6.02 e. 3.24 ANS: D P/E = Payout (k − g) = .65 (0.15 − .042) = 6.02 PTS: 1
OBJ: Multiple Choice Problem
51. Refer to Exhibit 12.1. To what price will the market rise if the earnings expectation is $22.00 per share? a. $183.26 b. $132.41 c. $198.66 d. $71.28 e. $14.30 ANS: B P = P/E EPS = 6.02 22.00 = $132.41 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 12.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Assume that the dividend payout ratio will be 75 percent when the rate on long-term government bonds falls to 8 percent. Since investors are becoming more risk averse, the equity risk premium will rise to 7 percent and investors will require a 15 percent return. The return on equity will be 12 percent. 52. Refer to Exhibit 12.2. What is the expected sustainable growth rate? a. 9.0% b. 7.2% c. 6.0% d. 3.0% e. 3.6% ANS: D g = (1 − Payout) (ROE) = 0.25 .12 = 3% PTS: 1
OBJ: Multiple Choice Problem
53. Refer to Exhibit 12.2. What is your expectation of the market P/E ratio? a. 3.92 b. 6.25 c. 6.67 d. 8.33 e. 12.00 ANS: B P/E = Payout (k − g) = .75 (0.15 − .048) = 6.25 PTS: 1
OBJ: Multiple Choice Problem
54. Refer to Exhibit 12.2. To what price will the market rise if the earnings expectation is $32.00? a. $384.00 b. $266.56 c. $213.44 d. $200.00 e. $125.44 ANS: D P = P/E EPS = 6.25 32.00 = $200 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 12.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Assume that the dividend payout ratio will be 55 percent when the rate on long-term government bonds falls to 9 percent. Since investors are becoming more risk averse, the equity risk premium will rise to 8 percent and investors will require a 7 percent return. The return on equity will be 13 percent. 55. Refer to Exhibit 12.3. What is the expected sustainable growth rate? a. 5.85 b. 7.15 c. 4.05 d. 6.75 e. 8.25 ANS: A
g = (1 − Payout) (ROE) = 0.45 13 = 5.85% PTS: 1
OBJ: Multiple Choice Problem
56. Refer to Exhibit 12.3. What is your expectation of the market P/E ratio? a. 37.69 b. 24.92 c. 58.15 d. 55.02 e. 47.82 ANS: E P/E = Payout (k − g) = .55 (0.07 − .0585) = 47.82 PTS: 1
OBJ: Multiple Choice Problem
57. Refer to Exhibit 12.3. To what price will the market rise if the earnings expectation is $1.5? a. $138.42 b. $90.36 c. $71.74 d. $105.30 e. $85.14 ANS: C P = P/E EPS = 47.82 1.5 = $71.74 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 12.4 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Assume that the dividend payout ratio will be 45 percent when the rate on long term government bonds falls to 9 percent. Since investors are becoming more risk averse, the equity risk premium will rise to 7 percent and investors will require a 16 percent return. The return on equity will be 14 percent. 58. Refer to Exhibit 12.4. What is the expected sustainable growth rate? a. 4.95 b. 7.2 c. 8.8 d. 6.3 e. 7.7 ANS: E g = (1 − Payout) (ROE) = 0.55 14 = 7.7% PTS: 1
OBJ: Multiple Choice Problem
59. Refer to Exhibit 12.4. What is your expectation of the market P/E ratio? a. 5.42 b. 7.14 c. 6.63 d. 6.25 e. 5.11 ANS: A
P/E = Payout (k − g) = .45 (0.16 − .077) = 5.42 PTS: 1
OBJ: Multiple Choice Problem
60. Refer to Exhibit 12.4. To what price will the market rise if the earnings expectation is $10.00? a. $71.40 b. $66.30 c. $54.20 d. $77.00 e. $51.10 ANS: C P = P/E Earnings = 5.42 10.00 = $54.20 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 12.5 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) An analyst wishes to estimate the share price for Ashley Corporation. The following information is made available: Estimated profit margin = 15% Total asset turnover = 2 Financial leverage = 1.2 Estimated dividend payout ratio = 75% Required rate of return = 14% Estimated EPS = $2.50 61. Refer to Exhibit 12.5. Calculate the firm's ROE. a. 36% b. 25% c. 15% d. 10% e. 8% ANS: A ROE = (0.15)(2)(1.2) = 0.36 = 36% PTS: 1
OBJ: Multiple Choice Problem
62. Refer to Exhibit 12.5. The firm's sustainable growth rate is a. 15% b. 10% c. 9% d. 8% e. 7% ANS: C g = (1 − 0.75)(0.36) = 0.09 = 9% PTS: 1
OBJ: Multiple Choice Problem
63. Refer to Exhibit 12.5. Calculate the P/E multiple.
a. b. c. d. e.
35 30 25 20 15
ANS: E P/E = 0.75/(0.14 − .09) = 15 PTS: 1
OBJ: Multiple Choice Problem
64. Refer to Exhibit 12.5. Calculate the firm's estimated share price. a. 57.5 b. 37.5 c. 45 d. 32.75 e. 75 ANS: B P = (2.5)(15) = $37.5 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 12.6 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Consider the following information that you propose to use to obtain an estimate of year 2004 EPS for the MacLog Company.
GDP GDP growth Sales per share Operating profit margin Depreciation/Fixed Assets Fixed asset turnover Interest rate Total asset turnover Debt/Total assets Tax rate
Year 2003 11,000 Billion
Estimated Year 2004 3.5%
$800 12% 14% 2 3.5% 0.7 45% 36%
In addition a regression analysis indicates the following relationship between growth in sales per share for MacLog and GDP growth is % Sales per share = 0.015 + 0.75(% GDP) 65. Refer to Exhibit 12.6. Calculate GDP for the year 2004. a. $10,500 billion b. $11,000 billion c. $11,385 billion d. $10,550 billion e. $11,025 billion
ANS: C GDP year 2004 = (11000)(1 + .035) = $11,385 PTS: 1
OBJ: Multiple Choice Problem
66. Refer to Exhibit 12.6. Estimate the firm's growth rate in sales per share. a. 1.5% b. 2% c. 2.16% d. 4.13% e. 3.73% ANS: D growth rate sales per share = .015 + (.75)(.035) = 4.13% PTS: 1
OBJ: Multiple Choice Problem
67. Refer to Exhibit 12.6. Estimate the firm's sales per share for the year 2004. a. $833.04 b. $900.08 c. $885.03 d. $925.56 e. $850.75 ANS: A Sales per share year 2004 = 800(1 + .0413) = $833.04 PTS: 1
OBJ: Multiple Choice Problem
68. Refer to Exhibit 12.6. Calculate the firm's year 2004 EBITDA per share. a. $95.05 b. $87.15 c. $112.56 d. $104.73 e. $99.96 ANS: E EBITDA per share = (0.12)(833.04) = $99.96 PTS: 1
OBJ: Multiple Choice Problem
69. Refer to Exhibit 12.6. Obtain an estimate of the per share depreciation charge for the year 2004. a. $58.31 b. $102.35 c. $53.68 d. $75.93 e. $65.78 ANS: A FA t/o = 2, Dep/FA = 0.14. Sales = $833.04 FA = 833.04/2 = 416.52 Depreciation = (.14)(416.52) = $58.31
PTS: 1
OBJ: Multiple Choice Problem
70. Refer to Exhibit 12.6. Calculate the per share EBIT for the year 2004. a. $35.53 b. $41.65 c. $55.89 d. $65.14 e. $75.10 ANS: B EBIT per share = 99.96 − 58.31 = $41.65 PTS: 1
OBJ: Multiple Choice Problem
71. Refer to Exhibit 12.6. Calculate the firm's level of Total Assets per share for the year 2004. a. $1050.65 b. $1065.67 c. $1113.58 d. $1190.06 e. $1385.77 ANS: D TA t/o = 0.7, Sales per share = 833.04 TA = 833.04/0.7 = $1190.06 PTS: 1
OBJ: Multiple Choice Problem
72. Refer to Exhibit 12.6. Calculate the firm's level of debt for the year 2004. a. $535.53 b. $600.75 c. $637.67 d. $485.98 e. $393.72 ANS: A Debt/TA = .45 Debt = (1190.06)(.45) = $535.53 PTS: 1
OBJ: Multiple Choice Problem
73. Refer to Exhibit 12.6. Calculate the per share interest rate charge for the year 2004. a. $18.74 b. $14.72 c. $30.07 d. $13.76 e. $28.59 ANS: A Interest charge = (.035)(535.53) = $18.74 PTS: 1
OBJ: Multiple Choice Problem
74. Refer to Exhibit 12.6. Calculate the firm's EBT per share for the year 2004.
a. b. c. d. e.
$13.29 $27.89 $18.75 $19.63 $22.91
ANS: E EBT = 41.65 − 18.74 = $22.91 PTS: 1
OBJ: Multiple Choice Problem
75. Refer to Exhibit 12.6. Calculate the firm's EPS for the year 2004. a. $15.25 b. $14.66 c. $17.25 d. $12.56 e. $18.57 ANS: B Taxes per share = (22.91)(.36) = $8.25 EPS = 22.91 − 8.25 = $14.66 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 12.7 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You are using the free cash flow to equity (FCFE) technique to analyze U.S. equity market. The beginning FCFE is $90 and the required rate of return is 10%. Free cash flows are expected to grow at a 10% rate for the next two years and then grow at a constant rate of 7% forever. 76. Refer to Exhibit 12.7. What will FCFE be three years from now? a. 108.90 b. 116.52 c. 117.00 d. 119.79 e. 120.21 ANS: B FCFE3 = 90(1.10)2 (1.07) = 116.52 PTS: 1
OBJ: Multiple Choice Problem
77. Refer to Exhibit 12.7. What is the estimated value of the U.S. market today using the FCFE approach? a. 2,852 b. 2,918 c. 3,210 d. 3,390 e. 3,884 ANS: D
PTS: 1
OBJ: Multiple Choice Problem
78. Refer to Exhibit 12.7. What would the estimated value of the U.S. market be today using the FCFE approach, if the growth rate was expected to be a constant 8% indefinitely, instead of the 10% and 7% estimates? a. 4,500 b. 4,728 c. 4,860 d. 4,923 e. 5,042 ANS: C
PTS: 1
OBJ: Multiple Choice Problem
79. Compute the current earnings multiple if the dividend payout ratio for the aggregate market is 60 percent, the required rate of return is 11%, and the dividend growth rate is 8%. a. 15 b. 20 c. 25 d. 30 e. 35 ANS: B P/E = .60/(.11 − .08) = 20 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 12.8 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) As an economist for a research firm you are forecasting the market P/E ratio using the dividend discount model. Because the economy has been slow for 5 years, you expect the dividend-payout ratio to be 55%. Long-term government bond rates are at 6% and the equity risk premium is estimated to be 3%. Return on equity (ROE) is estimated to be 11%. 80. Refer to Exhibit 12.8. What is the expected growth rate? a. 3.00% b. 3.92% c. 4.95% d. 5.27% e. 6.05% ANS: C
g = ROE(1 − payout ratio) = 0.11(1 − .55) = .0495 PTS: 1
OBJ: Multiple Choice Problem
81. Refer to Exhibit 12.8. What is your expectation of the market P/E ratio? a. 9.17 b. 11.11 c. 13.58 d. 18.33 e. 21.42 ANS: C P/E = payout ratio/(k − g) = .55/(.06 + .03 − .0495) = .55/.0405 = 13.58 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 12.9 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The aggregate market currently has a retention ratio of 60 percent, a required rate of return of 12 percent, and an expected growth rate for dividends of 4 percent. 82. Refer to Exhibit 12.9. What is the current earnings multiplier? a. 2.5 b. 5.0 c. 7.5 d. 10.0 e. 12.5 ANS: B payout ratio = 1 − retention ratio = 1 − .60 = .40 P/E = payout ratio/(k − g) = 0.40/(0.12 − 0.04) = 0.40/0.08 = 5.0 PTS: 1
OBJ: Multiple Choice Problem
83. Refer to Exhibit 12.9. If the payout ratio changes to 50 percent, but there are no other changes, what will be the new P/E? a. 3.25 b. 4.16 c. 5.75 d. 6.25 e. 7.67 ANS: D P/E = payout ratio/(k − g) = 0.50/(0.12 − 0.04) = 0.50/0.08 = 6.25 PTS: 1
OBJ: Multiple Choice Problem
84. Refer to Exhibit 12.9. Starting with the initial conditions, you expect the retention ratio to be constant, the rate of inflation to decline by 2 percent, and the growth rate to decline by 1 percent. What is the expected P/E? a. 8.57 b. 8.00
c. 6.67 d. 5.71 e. 5.00 ANS: D payout ratio = 1 − retention ratio = 1 − .60 = .40 P/E = payout ratio/(k − g) = 0.40/(0.10 − 0.03) = 0.40/0.07 = 5.71 PTS: 1
OBJ: Multiple Choice Problem
85. Refer to Exhibit 12.9. Starting with the initial conditions, you expect the retention ratio to be constant, the rate of inflation to increase by 2 percent, and the growth rate to increase by 1 percent. What is the expected P/E? a. 4.44 b. 5.00 c. 5.71 d. 6.67 e. 8.00 ANS: A payout ratio = 1 − retention ratio = 1 − .60 = .40 P/E = payout ratio/(k − g) = 0.40/(0.14 − 0.05) = 0.40/0.09 = 4.44 PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 13—INDUSTRY ANALYSIS TRUE/FALSE 1. Complete consistency over time for different industries would indicate that industry analysis is not necessary after market analysis. ANS: T
PTS: 1
2. Studies of industries indicate that their past performance can be useful in predicting future performance. ANS: F
PTS: 1
3. While there is substantial dispersion in industry risk over periods of time, there is consistency in the industry risk during a period of time. ANS: F
PTS: 1
4. The fact that all firms in an industry do not move together negates the value of industry analysis. ANS: F
PTS: 1
5. The micro approach to estimating the industry multiple would entail examining specific variables such as: dividend payout ratios, required rates of return, and expected growth rates of dividends and earnings. ANS: T
PTS: 1
6. Structural changes occur when the economy undergoes a major organizational change or how it functions. ANS: T
PTS: 1
7. "Downsizing" of corporate America in the 1990s is an example of structural change. ANS: T
PTS: 1
8. Switching from one industry group to another over the course of a business cycle is known as a rotation strategy. ANS: T
PTS: 1
9. Assuming the U.S. dollar is strong relative to the Euro, it will be easier for the U.S. paper industry to export to Germany. ANS: F
PTS: 1
10. When considering inputs, you would evaluate an industry's prospects based on those of its raw material suppliers, labor force, etc. ANS: T
PTS: 1
11. The relationship between an economic series such as disposable personal income and industry sales is usually stronger in an industry that is more specialized. ANS: F
PTS: 1
12. Input-output analysis would be useful to indicate the long run relationship between industries. ANS: T
PTS: 1
13. The industry life cycle can be rejuvenated at any stage by product innovations that attract new customers or convince existing customers to buy the new product. ANS: T
PTS: 1
14. The relationship between an economic series such as disposable personal income and retail sales is usually stronger in an industry that has become more specialized. ANS: F
PTS: 1
15. Global industry analysis must evaluate the effects not only of world supply, demand and cost components for an industry, but also different valuation levels due to accounting conventions and the impact of exchange rates. ANS: T
PTS: 1
16. The way to reduce the rivalry between existing competitors in an industry is to reduce the barrier to entry to the industry. ANS: F
PTS: 1
17. When the government introduces a licensing requirement for an industry, it reduces the barriers to entry for the industry. ANS: F
PTS: 1
18. In the rapid accelerating growth stage, profit margins are typically very high. ANS: T
PTS: 1
19. Because all firms in an industry do not move together there is little value in industry analysis. ANS: F
PTS: 1
20. The rates of returns for firms within an industry vary which indicates that company analysis is necessary after industry analysis. ANS: T
PTS: 1
21. Risk measures for different industries remain fairly constant over time so historical risk analysis can be useful when estimating future risk. ANS: T
PTS: 1
22. Structural changes do have a cyclical pattern. ANS: F
PTS: 1
23. Switching industry groups over the course of a business cycle is known as a cyclical strategy. ANS: F
PTS: 1
24. Cyclical industries are attractive investments during the early stages of an economic recovery. ANS: T
PTS: 1
25. The capital goods industry typically outperforms other sectors during a recession. ANS: F
PTS: 1
26. Country risk is the uncertainty of earning due to changes in exchange rates faced by firms in this industry that sell outside the United States. ANS: F
PTS: 1
27. Risk measures for different industries remain fairly constant over time, so the historical risk analysis is useful for estimating future risk. ANS: T
PTS: 1
28. Consumer staples tend to outperform other industries the most at the peak of a business cycle. ANS: F
PTS: 1
29. An example of a barrier to entry is high prices relative to costs. ANS: F
PTS: 1
MULTIPLE CHOICE 1. In analyzing risk levels among industries, studies have found that a. risk levels vary among different industries. b. risk levels remained fairly constant across industries. c. risk levels for the same industry varied over time. d. risk levels for the same industry remain fairly constant over time. e. Choices a and d ANS: E
PTS: 1
OBJ: Multiple Choice
2. Which of the following statements about the business cycle is false? a. Toward the end of a recession, financial stocks typically increase in value as investment and borrowing activities accelerate. b. Once the economy hits a trough and begins to recover, consumer durable stocks become attractive investments. c. Once the economy has recovered and current levels of consumption are sustainable, businesses may consider modernizing or expanding, thus stocks of capital goods industries become attractive investments.
d. As the business cycle reaches a peak, inflation rates decrease. e. None of the above (that is, all are true statements) ANS: D
PTS: 1
OBJ: Multiple Choice
3. A number of economic variables affect both the economy and industries. Which of the following statements is false? a. Industries with high levels of operating and financial leverage should benefit from lower inflation rates. b. Banks generally benefit from volatile interest rates, while stable interest rates reduce margins. c. Consumers who are optimistic about the economy will spend money on high-priced items, such as autos and houses. d. The abundance or scarcity of input components can affect the perceived attractiveness of an industry. e. None of the above (that is, all are true statements) ANS: A
PTS: 1
OBJ: Multiple Choice
4. Which of the following is not considered a structural influence on the economy and industry? a. Demographics b. Life-styles c. International economics d. Social values e. Technology ANS: C
PTS: 1
OBJ: Multiple Choice
5. What might cause an industry's sales to decline? a. Changes in consumer tastes b. Product obsolescence c. Growth of substitute products d. Sluggish economic growth e. All of the above ANS: E
PTS: 1
OBJ: Multiple Choice
6. All of the following are industries with a strong, consistent industry component except a. Gold. b. Steel. c. Railroads. d. Tobacco. e. Paper. ANS: E
PTS: 1
OBJ: Multiple Choice
7. Which of the following is not a stage in the industrial life cycle? a. Early pioneering development b. Rapid accelerating growth c. Acquisition and consolidation d. Mature growth e. Stabilization and market maturity ANS: C
PTS: 1
OBJ: Multiple Choice
8. In which industrial life cycle stage do sales correlate highly with an economic series or the economy in general? a. Pioneering development b. Rapidly accelerating growth c. Mature growth d. Stabilization and market maturity e. Deceleration of growth and decline ANS: D
PTS: 1
OBJ: Multiple Choice
9. During which stage of the industrial life cycle is the product or service recognized as viable and the demand substantial? a. Early pioneering development b. Rapid accelerating growth c. Acquisition and consolidation d. Mature growth e. Stabilization and market maturity ANS: B
PTS: 1
OBJ: Multiple Choice
10. At what stage in the industrial life cycle is there an influx of competition? a. Early pioneering development b. Rapid accelerating growth c. Acquisition and consolidation d. Mature growth e. Stabilization and market maturity ANS: D
PTS: 1
OBJ: Multiple Choice
11. Which of the following is not a competitive force suggested by Porter? a. Rivalry among existing competitors b. Threat of new entrants c. Threat of substitute products d. Government and regulatory influences e. None of the above (that is, all are competitive forces) ANS: D
PTS: 1
OBJ: Multiple Choice
12. Which of the following statements concerning the competitive environment is true? a. High fixed costs encourage firms to produce at a low level of capacity, in order to minimize fixed cost per unit produced. b. Low current prices relative to costs in an industry indicate low barriers to entry. c. Substantial economies of scale do not give a current industry member an advantage over a new firm. d. The ability to substitute another product limits the industry's profit potential. e. Buyers and suppliers do not influence the profitability of an industry. ANS: D
PTS: 1
OBJ: Multiple Choice
13. The financial risk for the retail store industry is difficult to judge because of a. Convertible debt. b. Numerous building leases. c. Warrants. d. Variable operating profits. e. Extensive use of preferred stock.
ANS: B
PTS: 1
OBJ: Multiple Choice
14. When compared to the overall market P/E, the retail store P/E was estimated to be ____ and near the ____ of the range. a. More volatile, low end b. More volatile, high end c. Less volatile, low end d. Less volatile, high end e. Equally volatile, middle ANS: C
PTS: 1
OBJ: Multiple Choice
15. When forecasting industry sales it can be useful to a. Utilize the industry life cycle. b. Use input-output analysis. c. Use the relationship between an industry and the aggregate economy. d. All of the above. e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
16. The ____ of an industry is a function of retention rate and return on equity. a. Expected return b. Expected business risk c. Expected financial risk d. Expected growth rate e. Expected sales volatility ANS: D
PTS: 1
OBJ: Multiple Choice
17. Toward the end of a recession, a. Financial stocks rise on expectations of increases in loan demand, housing constructions and security offerings. b. Consumer durable stocks rise on expectations of rising consumer confidence and personal income. c. Capital goods stocks rise on expectation of increases in business capital spending. d. Basic materials stocks rise on expectation of rising profit margins. e. Consumer staple stocks rise on expectations that consumers will continue to spend on necessities. ANS: A
PTS: 1
OBJ: Multiple Choice
18. At the initial stage of an economic recovery, a. Financial stocks rise on expectations of increases in loan demand, housing constructions and security offerings. b. Consumer durable stocks rise on expectations of rising consumer confidence and personal income. c. Capital goods stocks rise on expectation of increases in business capital spending. d. Basic materials stocks rise on expectation of rising profit margins. e. Consumer staple stocks rise on expectations that consumers will continue to spend on necessities. ANS: B
PTS: 1
OBJ: Multiple Choice
19. Once it becomes clear the economy is recovering,
a. Financial stocks rise on expectations of increases in loan demand, housing constructions and security offerings. b. Consumer durable stocks rise on expectations of rising consumer confidence and personal income. c. Capital goods stocks rise on expectation of increases in business capital spending. d. Basic materials stocks rise on expectation of rising profit margins. e. Consumer staple stocks rise on expectations that consumers will continue to spend on necessities. ANS: C
PTS: 1
OBJ: Multiple Choice
20. Toward the business cycle peak a. Financial stocks rise on expectations of increases in loan demand, housing constructions and security offerings. b. Consumer durable stocks rise on expectations of rising consumer confidence and personal income. c. Capital goods stocks rise on expectation of increases in business capital spending. d. Basic materials stocks rise on expectation of rising profit margins. e. Consumer staple stocks rise on expectations that consumers will continue to spend on necessities. ANS: D
PTS: 1
OBJ: Multiple Choice
21. Which of the following statements is false? a. Returns for different industries vary within a wide range b. Rates of return for individual industries vary over time c. Rates of return of firms within industries vary over time d. Different industries' risk levels vary within a wide range e. Risk measures for different industries vary within a wide range over time ANS: E
PTS: 1
OBJ: Multiple Choice
22. During a recession, a. Financial stocks rise on expectations of increases in loan demand, housing constructions and security offerings. b. Consumer durable stocks rise on expectations of rising consumer confidence and personal income. c. Capital goods stocks rise on expectation of increases in business capital spending. d. Basic materials stocks rise on expectation of rising profit margins. e. Consumer staple stocks rise on expectations that consumers will continue to spend on necessities. ANS: E
PTS: 1
OBJ: Multiple Choice
23. Which of the following statements is not true? a. During a specific time period, rates of return across industry do not vary substantially. b. The rates of return for individual industries do vary substantially over time. c. During a specific time period, rates of return within industries do vary substantially. d. Risk measures for individual industries remain relatively constant over time. e. None of the above (that is, all are true statements) ANS: A
PTS: 1
OBJ: Multiple Choice
24. Which of the following statements about industry analysis is true? a. During any time period, rates of return of firms within industries do vary within a wide
range. b. Aggregate market performance accurately reflects the performance of alternative industries. c. Risk of return for individual industries have not varied over time, so one can simply extrapolate past performance into the future. d. All of the above are true. e. None of the above are true. ANS: A
PTS: 1
OBJ: Multiple Choice
25. If the economic outlook was such that you expected corporate earnings to decline, consumers have excessive levels of debt, and there is significant overcapacity in the technology sector, then an appropriate asset allocation policy would be to: a. Overweight equity especially technology stocks and underweight bonds b. Underweight equity especially technology stocks and overweight bonds c. Overweight equity especially technology stocks and overweight bonds d. Underweight equity especially technology stocks and underweight bonds e. None of the above ANS: B
PTS: 1
OBJ: Multiple Choice
26. Which of the following economic variables does not have an impact on industry analysis? a. Inflation b. Interest rates c. International economics d. Consumer sentiment e. None of the above (that is, all of the above economic variables have at least some impact on industry analysis) ANS: E
PTS: 1
OBJ: Multiple Choice
27. A number of factors affect the cash flow and risk prospects of different industries. Which of the following is not such a factor? a. Demographics b. Life-styles c. Technology d. Politics e. None of the above (that is, all are factors to be considered) ANS: E
PTS: 1
OBJ: Multiple Choice
28. Analysts should identify and monitor a. The current and emerging trends and patterns affecting an industry. b. The indicators of trends and patterns in structural factors. c. The momentum toward change in trends and patterns in structural factors. d. Choices a and b e. All of the above ANS: E
PTS: 1
OBJ: Multiple Choice
29. Which of the following is not considered a basic competitive force? a. Rivalry among existing competitors b. Threat of new entrants c. Threat of substitute products d. Threat of government interference
e. Bargaining power of buyers and suppliers ANS: D
PTS: 1
OBJ: Multiple Choice
30. Which of the following is not characteristic of the "growth" phase in the industry life cycle? a. Consumer will accept uneven quality b. Products have technical and performance differentiation c. High advertising costs d. Low profits e. Many competitors ANS: D
PTS: 1
OBJ: Multiple Choice
31. Which of the following is not characteristic of the "decline" phase of the industry life cycle? a. Little product differentiation b. Substantial manufacturing overcapacity c. Many competitors d. Falling prices e. None of the above (this is, all are characteristics of the "decline" phase) ANS: C
PTS: 1
OBJ: Multiple Choice
32. Which of the following statements regarding cyclical industries is true? a. Cyclical industries are affected by changes in consumer sentiment. b. Cyclical industries are not affected by the consumer's willingness to borrow and spend money. c. Cyclical industries often outperform other sectors during a recession. d. All of the above statements are true. e. None of the above statements are true. ANS: A
PTS: 1
OBJ: Multiple Choice
33. During which industry life cycle stage do firms experience low rates of return on capital and investors begin to seek alternative uses of capital? a. Pioneering and development b. Mature growth c. Stabilization and market maturity d. Deceleration of growth and decline e. Disassembly and restructure ANS: D
PTS: 1
OBJ: Multiple Choice
34. Which of the following are not typically considered a threat of new entrants to an industry? a. Low current prices relative to costs b. Large capital requirements c. Extensive distribution channels with exclusive distribution contracts d. Government policy restricting access to raw materials e. Large volume purchases relative to the sales of a supplier ANS: E
PTS: 1
OBJ: Multiple Choice
35. Which of the following statements regarding global industry analysis is true? a. Cavaglia, Brightman, and Aked (2000) found that country factors dominated industry factors in terms of explaining equity returns. b. Cavaglia, Brightman, and Aked (2000) found that industry factors have been declining in importance.
c. Cavaglia, Brightman, and Aked (2000) found that industry factors dominate country factors. d. Both a and b are true e. All of the above are true ANS: C
PTS: 1
OBJ: Multiple Choice
36. Which of the following statements is false? a. Financial institutions are typically adversely impacted by higher rates of interest. b. Industries with high operating leverage typically benefit with inflation when their costs are fixed in nominal terms. c. Industries with low financial leverage typically outperform firms with higher leverage when inflation increases. d. A weaker U.S. dollar typically helps U.S. industries. e. Consumer cyclical industries are affected by increasing interest rates. ANS: C
PTS: 1
OBJ: Multiple Choice
37. Towards the end of the recession which industry is most likely to excel? a. Consumer staples b. Consumer durables c. Basic industries d. Financial stocks e. Capital goods ANS: D
PTS: 1
OBJ: Multiple Choice
38. During a recession which industry is most likely to excel? a. Consumer staples b. Consumer durables c. Basic industries d. Financial stocks e. Capital goods ANS: B
PTS: 1
OBJ: Multiple Choice
39. An increase in any of the following will cause the expected dividend growth rate to increase for an industry except a. Profit margin b. Total asset turnover c. Return on equity d. Dividend payout ratio e. Financial leverage ANS: D
PTS: 1
OBJ: Multiple Choice
40. To estimate earnings per share an analyst will start by estimating a. Profits b. Free cash flows c. Sales d. Number of shares outstanding e. All of the above ANS: C Exhibit 13.1
PTS: 1
OBJ: Multiple Choice
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Assume that you are an analyst for the U.S. Autoparts Industry. Consider the following information that you propose to use to obtain an estimate of year 2002 EPS for the U.S. Autoparts Industry:
Personal consumption expenditures Personal consumption expenditures growth Industry Sales per share Industry Operating profit margin Industry Depreciation/Fixed Assets Industry Fixed asset turnover Interest rate Industry Total asset turnover Industry Debt/Total assets Industry Tax rate
Year 2003 $6,800 billion
Estimated Year 2004 1.5%
$525 15% 8.25% 3 6% 1.2 45% 36%
In addition a regression analysis indicates the following relationship between growth in industry sales per share and personal consumption expenditures (PCE) growth is % Sales per share = 0.02 + 1.5(%PCE) 41. Refer to Exhibit 13.1. Calculate personal consumption expenditures for the year 2004. a. $7,500 billion b. $7,000 billion c. $7140 billion d. $7,550.5 billion e. $6,825.75 billion ANS: C GDP year 2002 = (6800)(1 + .05) = $7,140 PTS: 1
OBJ: Multiple Choice Problem
42. Refer to Exhibit 13.1. Estimate the industry growth rate in sales per share. a. 10.5% b. 11% c. 12.16% d. 9.5% e. 8.73% ANS: D Growth rate sales per share = .02 + (1.5)(.05) = .095 = 9.5% PTS: 1
OBJ: Multiple Choice Problem
43. Refer to Exhibit 13.1. Estimate the industry sales per share for the year 2004. a. $574.9 b. $600.0 c. $585.03 d. $625 e. $550
ANS: A Sales per share year 2002 = 525(1 + .095) = $574.88 PTS: 1
OBJ: Multiple Choice Problem
44. Refer to Exhibit 13.1. Calculate the industry year 2004 EBITDA per share. a. $95.05 b. $89.15 c. $92.56 d. $94.73 e. $86.23 ANS: E EBITDA per share = (0.15)(574.88) = $86.23 PTS: 1
OBJ: Multiple Choice Problem
45. Refer to Exhibit 13.1. Obtain an estimate of the per share depreciation charge for the year 2004. a. $15.81 b. $12.35 c. $23.68 d. $25.93 e. $35 ANS: A FA t/o = 3, Dep/FA = 0.0825. Sales = $574.88 FA = 574.88/3 = 191.63 Depreciation = (.0825)(191.63) = $15.81 PTS: 1
OBJ: Multiple Choice Problem
46. Refer to Exhibit 13.1. Calculate the per share EBIT for the year 2004. a. $95.33 b. $70.42 c. $85.56 d. $95.89 e. $75.32 ANS: B EBIT per share = 86.23 − 15.81 = $70.42 PTS: 1
OBJ: Multiple Choice Problem
47. Refer to Exhibit 13.1. Calculate industry total assets per share for the year 2004. a. $450 b. $565.67 c. $513.58 d. $479.07 e. $385.77 ANS: D TA t/o = 1.2, Sales per share = 574.88
TA = 574.88/1.2 = $479.07 PTS: 1
OBJ: Multiple Choice Problem
48. Refer to Exhibit 13.1. Calculate industry level of debt for the year 2004. a. $215.58 b. $300.75 c. $237.67 d. $285.98 e. $193.72 ANS: A Debt/TA = .45 Debt = (479.07)(.45) = $215.58 PTS: 1
OBJ: Multiple Choice Problem
49. Refer to Exhibit 13.1. Calculate the per share interest rate charge for the year 2004. a. $12.93 b. $17.72 c. $10.07 d. $13.76 e. $18.59 ANS: A Interest charge = (.06)(215.58) = $12.93 PTS: 1
OBJ: Multiple Choice Problem
50. Refer to Exhibit 13.1. Calculate the industry EBT per share for the year 2004. a. $53.29 b. $67.89 c. $68.75 d. $59.63 e. $57.49 ANS: E EBT = 70.42 − 12.93 = $57.49 PTS: 1
OBJ: Multiple Choice Problem
51. Refer to Exhibit 13.1. Calculate industry EPS for the year 2004. a. $45.25 b. $36.79 c. $57.25 d. $32.56 e. $48.57 ANS: B Taxes per share = (57.49)(.36) = $20.7 EPS = 57.49 − 20.7 = $36.79 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 13.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) At the end of the year 2004 the Office Equipment Industry had free cash flow to equity (FCFE) of $2.50 per share. The following annual growth rates in FCFE are projected: Year 2005 2006 2007 2008 2009 2010 2011 2012
Growth Rate 10% 15% 20% 25% 20% 15% 10% 7%
From year 2013 onward growth in FCFE is expected to remain constant at 5% per year. The industry has a beta of 0.90 and the current industry price is $105. Currently the yield on 10-year Treasury notes is 5% and the equity risk premium is 4% 52. Refer to Exhibit 13.2. Calculate the required rate of return on equity. a. 5% b. 9.2% c. 8.6% d. 10% e. 4.3% ANS: C k = 0.05 + 0.9(0.04) = 0.086 PTS: 1
OBJ: Multiple Choice Problem
53. Refer to Exhibit 13.2. Calculate the present value now (Year 2004) of FCFE during the period of increasing growth (that is for years 2005 to 2008). a. $17.19 b. $14.15 c. $11.59 d. $15.78 e. $18.09 ANS: C The table below shows the relevant calculations (note that these calculations were carried out using Excel and there may be some rounding differences).
T 0 1 2 3 4 5 6
Year 2004 2005 2006 2007 2008 2009 2010
g 0.1 0.15 0.2 0.25 0.2 0.15
FCFE $2.50 $2.75 $3.16 $3.80 $4.74 $5.69 $6.55
k 0.086 0.086 0.086 0.086 0.086 0.086 0.086
PV yr 2014
PV yr 2006 $2.53 $2.68 $2.96 $3.41 $3.77 $3.99
$11.59
7 2011 8 2012 9 2013 PV constant growth Intrinsic Value
0.1 0.07 0.05
$7.20 $7.71 $8.09
0.086 0.086 0.086
$224.73
$4.04 $3.98
$15.78 $116.15
$143.52
The future FCFE are calculated by applying the appropriate growth rates. For example FCFE for the year 2005 is calculated as 2.5(1.1) = 2.75 The present value = 2.75/(1.086) = 2.53 Summing up the present value of the cash flows for years 2005 to 2008 = $11.59 PTS: 1
OBJ: Multiple Choice Problem
54. Refer to Exhibit 13.2. Calculate the present value now (Year 2004) of FCFE during the period of declining growth (that is for years 2009 to 2012). a. $17.19 b. $14.15 c. $11.59 d. $15.78 e. $18.09 ANS: D Present value of cash flows for the years 2009 to 2012 = $15.78 PTS: 1
OBJ: Multiple Choice Problem
55. Refer to Exhibit 13.2. Calculate the present value now (Year 2004) of FCFE during the period of constant growth (that is for years 2013 onwards). a. $116.15 b. $97.03 c. $155.58 d. $89.86 e. $67.89 ANS: A The present value of the cash flows during the constant growth period is calculated as follows: PV year 2012 = 8.09/(0.086 − 0.05) = $224.73 Present value now = 224.73/(1.086)8 = $116.15 PTS: 1
OBJ: Multiple Choice Problem
56. Refer to Exhibit 13.2. Calculate the intrinsic value of the industry now (Year 2004). a. $155 b. $143.52 c. $177.79 d. $135.77 e. $162.34 ANS: B Intrinsic value per share = 11.59 + 15.78 + 116.15 = $143.52 PTS: 1 Exhibit 13.3
OBJ: Multiple Choice Problem
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The Home Appliance Industry had free cash flow to equity (FCFE) of $87 for the most recent year ending reported yesterday. The industry anticipates a growth rate of 8% for the next three years due to favorable economic conditions. However, the growth rate is expected to decline to 4% after three years and remain at that level indefinitely. The required rate of return is 12% for this industry. 57. Refer to Exhibit 13.3. Calculate the FCFE at the end of the 8% growth period three years from now. a. $78.00 b. $107.88 c. $109.59 d. $111.64 e. $113.52 ANS: C FCFE3 = $87(1.08)3 = $109.59 PTS: 1
OBJ: Multiple Choice Problem
58. Refer to Exhibit 13.3. Calculate the intrinsic value of the Home Appliance Industry at the end of the 8% growth period three years from now. a. $109.59 b. $113.98 c. $949.83 d. $1,369.94 e. $1,424.73 ANS: E
PTS: 1
OBJ: Multiple Choice Problem
59. Refer to Exhibit 13.3. Calculate the intrinsic value of the Home Appliance Industry today. a. $605.03 b. $1,014.09 c. $1,256.88 d. $1,424.73 e. $1,729.76 ANS: C
PTS: 1
OBJ: Multiple Choice Problem
Exhibit 13.4 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
The Furniture Manufacturing Industry had free cash flow to equity (FCFE) of $63 for the most recent year ending reported yesterday. The industry is in the mature stage and anticipates a growth rate of 4% indefinitely. The required rate of return is 11% for this industry. 60. Refer to Exhibit 13.4. Calculate the intrinsic value of the Furniture Manufacturing Industry today. a. $573 b. $596 c. $900 d. $936 e. $989 ANS: D Value Today = $63(1.04)/(0.11 − 0.04) = $65.52/0.07 = $936.00 PTS: 1
OBJ: Multiple Choice Problem
61. Refer to Exhibit 13.4. Suppose unexpected inflation suddenly increases by 2 percent and there are no other changes in expectations. What will be the new intrinsic value of the Furniture Manufacturing Industry today? a. $700 b. $728 c. $989 d. $1,260 e. $1,310 ANS: B Value Today = $63(1.04)/(0.13 − 0.04) = $65.52/0.09 = $728.00 PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 14—COMPANY ANALYSIS AND STOCK VALUATION TRUE/FALSE 1. A growth company is one whose stock is undervalued by the market. ANS: F
PTS: 1
2. A cyclical company's sales and earnings are heavily influenced by aggregate business activity. ANS: T
PTS: 1
3. A stock with low systematic risk is considered to be a defensive stock. ANS: T
PTS: 1
4. A growth company is a firm that has the opportunities and ability to invest capital in projects that generate rates of return greater than the firm's cost of debt. ANS: F
PTS: 1
5. With a differentiation strategy, a firm seeks to identify itself as unique in its industry in an area that is important to buyers. ANS: T
PTS: 1
6. By definition growth companies have growth stocks. ANS: F
PTS: 1
7. Turnarounds are firms with valuable assets that are hidden on the balance sheet. ANS: F
PTS: 1
8. Present value of free cash flow to equity resembles the present value of earnings concept except that it includes the capital expenditures required to maintain and grow the firm and the change in working capital required for a growing firm. ANS: T
PTS: 1
9. In the present value of operating free cash flow technique, the firm's operating free cash flow to the firm is discounted at the firm's weighted average cost of capital (WACC). ANS: T
PTS: 1
10. The best known measure of relative value for common stock is the P/E ratio. ANS: T
PTS: 1
11. Price-to-book value ratio cannot be used to estimate the value of firms with negative earnings or negative cash flows.
ANS: F
PTS: 1
12. The price/cash flow ratio has grown in prominence and use for valuing firms because many analysts contend that a firm's cash flow is less subject to manipulation than the firm's earnings per share. ANS: T
PTS: 1
13. Price-to-sales ratio is still considered the predominant firm valuation technique. ANS: F
PTS: 1
14. The constant growth dividend growth model is not appropriate for the valuation of growth companies. ANS: T
PTS: 1
15. A negative EVA (Economic Value Added) for the year implies that the firm has not earned enough during the year to cover its total cost of capital and the value of the firm has declined. ANS: T
PTS: 1
16. While EVA is considered an internal performance measure, MVA is considered to be an external performance measure. ANS: T
PTS: 1
17. A defensive company is one whose sales, earnings and cash flows are strongly correlated with the business cycle. ANS: F
PTS: 1
18. An undervalued stock is a growth stock. ANS: T
PTS: 1
19. An overvalued stock is a non-growth stock. ANS: T
PTS: 1
20. A firm's competitive strategy can be either defensive or offensive. ANS: T
PTS: 1
21. To benefit from cost leadership a firm must command prices near the industry average. ANS: T
PTS: 1
22. Two major competitive strategies are low-cost leadership and low-price leadership. ANS: F
PTS: 1
23. According to Peter Lynch a favorable attribute of a firm that may result in favorable stock performance is when a firm's product is the latest craze. ANS: F
PTS: 1
24. According to Peter Lynch a favorable attribute of a firm that may result in favorable stock performance is when a firm buys back its shares. ANS: T
PTS: 1
25. Underpriced stocks can be ranked using the excess return ratio which is calculated as the Market price/Risk free rate. ANS: F
PTS: 1
26. Operating free cash flow and Free cash flow to equity are equivalent cash flow concepts. ANS: F
PTS: 1
27. One way to measure a company's intrinsic value is to divide the company's current dividends by the required return less the dividend growth rate. ANS: F
PTS: 1
28. The sustainable growth rate can be calculated by taking the dividend payout ratio time return on equity (ROE). ANS: F
PTS: 1
29. Based on the annual reports of Walgreens it has pursued both a low-cost strategy and a differentiation strategy for different business segments. ANS: T
PTS: 1
30. A cyclical stock's rate of return is not expected to decline during an overall market decline. ANS: F
PTS: 1
31. An offensive competitive strategy involves positioning the firm to deflect the effect of the competitive forces in the industry. ANS: F
PTS: 1
32. Low-cost leadership and differentiation are two major competitive strategies suggested by Porter. ANS: T
PTS: 1
MULTIPLE CHOICE 1. A speculative stock possesses a ____ probability of ____ return and is currently ____. a. High, negative, underpriced. b. High, negative, overpriced. c. High, positive, overpriced. d. Low, negative, overpriced. e. Low, positive, underpriced. ANS: B
PTS: 1
OBJ: Multiple Choice
2. A ____ stock possesses a high probability of low or negative rates of return and a low probability of normal or high rates of return. a. Growth b. Defensive c. Cyclical d. Speculative e. Value ANS: D
PTS: 1
OBJ: Multiple Choice
3. A growth company is one that has the ability to a. Acquire capital at a low cost and is able to invest in projects that yield an average return. b. Acquire capital at a low cost and is able to invest in projects that yield a below average return. c. Acquire capital at an average cost and is able to invest in projects that yield an above average return. d. Acquire capital at an average cost and is able to invest in projects that yield an average return. e. Acquire capital at an above average cost and is able to invest in projects that yield an average return. ANS: C
PTS: 1
OBJ: Multiple Choice
4. Porter contends that ____ and ____ are two important competitive strategies. a. Low cost leadership, barrier to entry b. New entrant deterrent, differentiation c. Low cost leadership, differentiation d. Differentiation, monopolistic e. Monopolistic simulation, differentiation ANS: C
PTS: 1
OBJ: Multiple Choice
5. In a(n) ____ strategy, a firm seeks to identify itself as unique within its industry. a. Defensive b. Offensive c. Low-cost d. Differentiation e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
6. In SWOT analysis, one examines all of the following factors, except a. Strengths. b. Weaknesses. c. Opportunities. d. Threats. e. Turnarounds. ANS: E
PTS: 1
OBJ: Multiple Choice
7. Which of the following statements concerning SWOT analysis is false? a. Strengths are the factors that give the firm a comparative advantage in the marketplace. b. Weaknesses result when the company has potentially exploitable advantages over other firms.
c. Opportunities are environmental factors that favor the firm. d. Threats are environmental factors that can hinder the firm in achieving its goals. e. None of the above (that is, all statements are true) ANS: B
PTS: 1
OBJ: Multiple Choice
8. Peter Lynch identified a number of attributes of firms that may result in favorable stock market performances, including a. Products that are faddish, people like change. b. Firms that have competitive advantages over their rivals. c. Firms that can benefit from cost reductions. d. Choices b and c only e. All of the above ANS: D
PTS: 1
OBJ: Multiple Choice
9. In Berkshire Hathoway annual reports Warren Buffet highlights business tenets that he believes are important. Which of the following is not a business tenet of Warren Buffet? a. Is the business unique and technologically advanced? b. Does the business have a consistent operating history? c. Does the business have favorable long-term prospects? d. a and b above. e. All of the above are business tenets of Warren Buffet. ANS: A
PTS: 1
OBJ: Multiple Choice
10. In Berkshire Hathoway annual reports Warren Buffet highlights financial tenets that he believes are important. Which of the following is not a financial tenet of Warren Buffet? a. Focus on return on equity (ROE) not earnings per share (EPS). b. Calculate owner earnings similar to free cash flow after capital expenditures. c. High profit margins relative to the industry. d. Company should create at least one dollar of market value for every dollar retained. e. All of the above are financial tenets of Warren Buffet. ANS: E
PTS: 1
OBJ: Multiple Choice
11. Which of the following is not a technique for valuing a firm's common stock? a. Present value of free cash flow to equity b. Present value of dividends c. Price-earnings ratio d. Price-book value ratios e. Price-cost of goods sold ratio ANS: E
PTS: 1
OBJ: Multiple Choice
12. Which of the following is not considered when looking at free cash flow to equity technique? a. Depreciation expense b. Change in working capital c. Principal debt repayments d. Change in competitive environment e. Net income ANS: D
PTS: 1
OBJ: Multiple Choice
13. Under the present value of operating free cash flow technique, the firm's operating free cash flow to the firm is discounted at the firm's
a. b. c. d. e.
Weighted average cost of capital. Cost of debt. Internal rate of return. External cost of new equity. Net present value.
ANS: A
PTS: 1
OBJ: Multiple Choice
14. Which of the following is not considered a relative valuation technique? a. Price-earnings ratio b. Price/cash flow ratio c. Price/book value ratio d. Price/cost of goods sold ratio e. Price/sales ratio ANS: D
PTS: 1
OBJ: Multiple Choice
15. Which of the following is not considered in the price-earnings ratio technique? a. Firm's required rate of return on equity (k) b. Firm's dividend payout ratio (D/E) c. Firm's expected growth rate of dividends (g) d. All of the above are components of P/E ratio e. None of the above are components of P/E ratio ANS: D
PTS: 1
OBJ: Multiple Choice
16. Evidence that a firm has high business risk would be provided by its volatile ____. a. Fixed costs. b. Profit after taxes. c. Operating profit. d. Sales. e. Employee turnover. ANS: C
PTS: 1
OBJ: Multiple Choice
17. Which of the following factors does not indicate market liquidity? a. Number of shareholders b. High price volatility c. Number of shares outstanding d. Number of shares traded e. Institutional interest ANS: B
PTS: 1
OBJ: Multiple Choice
18. A growth company can invest in projects that generate a return greater than the firm's a. Return on equity. b. Cost of debt. c. Cost of equity. d. Cost of capital. e. Return on assets. ANS: D
PTS: 1
OBJ: Multiple Choice
Exhibit 14.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
(1) (2) (3) (4) (5) (6)
The firm's expected rate of growth of earning per share The amount of capital invested in growth investments The rate of return earned on the funds relative to the required rate of return The required rate of return on the security based on its systematic risk The firm's dividend payout ratio The time horizon when these growth investments will be available
19. Refer to Exhibit 14.1. In the listing above, which three factors influence the capital gain component of a growth company? a. 1, 3, and 5 b. 2, 3, and 4 c. 2, 3, and 6 d. 3, 4, and 5 e. 3, 4, and 6 ANS: C
PTS: 1
OBJ: Multiple Choice
20. Refer to Exhibit 14.1. In the listing above, which three factors influence the earnings multiple for a stock? a. 1, 4, and 5 b. 1, 4, and 6 c. 2, 4, and 6 d. 2, 5, and 6 e. 4, 5, and 6 ANS: A
PTS: 1
OBJ: Multiple Choice
21. An inconsistency between a stock's P/E ratio and growth rate can be attributed to all of the following, except a. A major difference in the risk involved. b. Inaccurate growth estimates. c. An undervaluation of the stock. d. An overvaluation of the stock. e. Competition. ANS: E
PTS: 1
OBJ: Multiple Choice
22. A set of performance measures called ____ are directly related to the capital budgeting techniques used in corporate finance. a. Dividend discount model b. Aggressive growth indexes c. Growth indexes d. Value added e. Profit sensitization ANS: D
PTS: 1
OBJ: Multiple Choice
23. "Economic profit" is analogous to ____ in capital budgeting. a. Weighted average cost of capital b. Internal rate of return c. Composite discount rates d. Discounted cashflows e. Net present value ANS: E
PTS: 1
OBJ: Multiple Choice
24. Which of the following is not a value added performance measure? a. Economic Value Added (EVA) b. Market Value Added (MVA) c. Franchise Factor d. Company Value Added (CVA) e. None of the above (that is, all are value added performance measures) ANS: D
PTS: 1
OBJ: Multiple Choice
25. Market value-added is a measure of ____ performance. a. External b. Internal c. Competitive d. Economic e. None of the above ANS: A
PTS: 1
OBJ: Multiple Choice
26. Which of the following statements concerning global company analysis is false? a. Analysis of companies within industries should be extended to include foreign companies. b. There is a problem in obtaining data that is required for a thorough company analysis of foreign companies. c. Foreign companies' financial risk should be evaluated over time. d. Differences in relative measures can be explained by the variations in accounting procedures among countries and investors attitudes within each country. e. None of the above (that is, all statements are true) ANS: E
PTS: 1
OBJ: Multiple Choice
27. The following are tenets of Warren Buffett: a. Business tenets. b. Financial tenets. c. Management tenets. d. All of the above. e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
28. Which of the following is a business tenet of Warren Buffett? a. Long term prospects. b. Resistance to institutional imperative. c. Creation of one dollar of market value for every dollar retained. d. Purchase at discount to intrinsic value. e. Product is not faddish ANS: A
PTS: 1
OBJ: Multiple Choice
29. Which of the following is a management tenet of Warren Buffett? a. Long term prospects. b. Resistance to institutional imperative. c. Creation of one dollar of market value for every dollar retained. d. Purchase at discount to intrinsic value. e. Product is not faddish ANS: B
PTS: 1
OBJ: Multiple Choice
30. Which of the following is a financial tenet of Warren Buffett? a. Long term prospects. b. Resistance to institutional imperative. c. Creation of one dollar of market value for every dollar retained. d. Purchase at discount to intrinsic value. e. Product is not faddish. ANS: C
PTS: 1
OBJ: Multiple Choice
31. Which of the following is a market tenet of Warren Buffett? a. Long term prospects. b. Resistance to institutional imperative. c. Creation of one dollar of market value for every dollar retained. d. Purchase at discount to intrinsic value. e. Product is not faddish ANS: D
PTS: 1
OBJ: Multiple Choice
32. Studies that have examined the relationship between EVA and MVA have found a. An inverse relationship. b. A positive relationship. c. A poor relationship. d. EVA always exceeded MVA. e. MVA always exceeded EVA. ANS: C
PTS: 1
OBJ: Multiple Choice
33. The franchise P/E is a function of a. Relative rate of return on new business opportunities b. Size of superior return opportunities. c. Duration of earnings growth. d. a and b e. a, b and c ANS: D
PTS: 1
OBJ: Multiple Choice
34. Cyclical companies are firms where a. Sales, earnings and cash flows are extremely uncertain and not necessarily related to the economy. b. Sales, earnings and cash flows are likely to withstand changes caused by the economic environment. c. Sales, earnings and cash flows are heavily influenced by aggregate business activity. d. Sales, earnings and cash flows are growing exponentially. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
35. Defensive companies are firms where a. Sales, earnings and cash flows are extremely uncertain and not necessarily related to the economy. b. Sales, earnings and cash flows are likely to withstand changes caused by the economic environment. c. Sales, earnings and cash flows are heavily influenced by aggregate business activity. d. Sales, earnings and cash flows are growing exponentially.
e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
36. Speculative companies are firms where a. Sales, earnings and cash flows are extremely uncertain and not necessarily related to the economy. b. Sales, earnings and cash flows are likely to withstand changes caused by the economic environment. c. Sales, earnings and cash flows are heavily influenced by aggregate business activity. d. Sales, earnings and cash flows are growing exponentially. e. None of the above. ANS: A
PTS: 1
OBJ: Multiple Choice
37. A firm that follows a defensive competitive strategy could a. Lower production costs. b. Create a strong brand image. c. Use its buying power to obtain price concessions. d. a and b. e. b and c ANS: D
PTS: 1
OBJ: Multiple Choice
38. A firm that follows a low cost leadership strategy a. Must heavily discount its prices. b. Must command prices near the industry average. c. Must focus on providing exceptional quality and service. d. All of the above. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
39. A firm that follows a differentiation strategy a. Must heavily discount its prices. b. Must command prices near the industry average. c. Must focus on providing exceptional quality and service. d. All of the above. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
40. When a firm seeks to identify itself as unique in its industry in an area that is important to buyers it is known as a a. Defensive strategy b. Differentiation strategy c. Low-cost strategy d. Focused strategy e. Value strategy ANS: B
PTS: 1
OBJ: Multiple Choice
41. What variables impact the Price/Sales ratio? a. Sales growth rate, volatility of sales growth, profit margin b. Earnings growth rate, volatility of sales growth, profit margin c. Earnings growth rate, volatility of sales growth, operating margin
d. Sales growth rate, volatility of sales growth, operating margin e. Sales growth rate, volatility of profit margin, profit margin ANS: A
PTS: 1
OBJ: Multiple Choice
42. A growth company may exist for all of the following reasons except a. The company holds patents. b. The company possess unique distribution or marketing strategies. c. The company is in a competitive environment. d. Significant barriers to entry exist. e. All of the above are reasons a growth company may exist. ANS: C
PTS: 1
OBJ: Multiple Choice
43. Which of the following is not a determinant of the capital gain component? a. The percentage of earnings retained for reinvestment. b. The relative rate of return earned on the funds retained. c. The time period for these growth investments. d. The amount of capital invested in growth investments. e. All of the above are determinants of the capital gain component. ANS: E
PTS: 1
OBJ: Multiple Choice
44. Which of the following is not considered a favorable attribute of firms by Peter Lynch? a. Firm's product is not faddish b. Firm has a sustainable comparative competitive advantage over its rivals c. Firm's industry or product has market stability d. Firm can benefit from cost reductions e. All of the above are considered favorable attributes by Peter Lynch ANS: E
PTS: 1
OBJ: Multiple Choice
45. When using the Present Value of Operating Free Cash Flow model, the firm's operating free cash flow to the firm is discounted by the firm's: a. Cost of equity b. Cost of debt c. Required rate of return d. Weighted Average Cost of Capital e. Beta-adjusted cost of equity ANS: D
PTS: 1
OBJ: Multiple Choice
46. Walgreen's higher P/BV ratio than the market or industry is most likely attributed to Walgreen's a. Consistently higher ROE b. Difference in WACC c. Marketing strategy d. Lower cost of assets e. None of the above ANS: A
PTS: 1
OBJ: Multiple Choice
47. Which of the following ratios is least likely to be impacted by accounting manipulation? a. P/E b. ROE c. ROI d. P/S
e. PM ANS: D
PTS: 1
OBJ: Multiple Choice
48. What is the implied growth duration of Bowe Industries given the following:
P/E Ratios Average Growth (%) Dividend Yield a. b. c. d. e.
S&P Industrials 15 5.0 .06
Bowe Industries 25 15.0 .02
3.2 years 6.6 years 8.6 years 9.7 years 10.6 years
ANS: D ln (25/15) = T ln [1 + .15 + .02)/(1 + .05 + .06)] T = 9.7 years PTS: 1
OBJ: Multiple Choice Problem
49. What is the implied growth duration of Casey Industries given the following:
P/E Ratios Average Growth (%) Dividend Yield a. b. c. d. e.
S&P Industrials 15 5.0 .04
Casey Industries 20 15.0 .06
3.2 years 2.8 years 4.8 years 9.6 years 13.2 years
ANS: B ln (20/15) = T ln [1 + .15 + .06)/(1 + .05 + .04)] T = 2.8 years PTS: 1
OBJ: Multiple Choice Problem
50. What is the implied growth duration of Jones Industries given the following:
P/E Ratios Average Growth (%) Dividend Yield a. b. c. d. e.
7.2 years 10.9 years 12.5 years 13.9 years 15.2 years
S&P Industrials 12 6.0 .05
Jones Industries 15 10.0 .03
ANS: C ln (15/12) = T ln [1 + .10 + .03)/(1 + .06 + .05)] T = 12.5 years PTS: 1
OBJ: Multiple Choice Problem
51. What is the implied growth duration of Freed Industries given the following:
P/E Ratios Average Growth (%) Dividend Yield a. b. c. d. e.
S&P Industrials 19 11.0 .033
Freed Industries 22 16.0 .08
1.8 years 1.3 years 5.0 years 4.5 years 3.5 years
ANS: A ln (22/19) = T ln [1 + .16 + .08)/(1 + .11 + .033)] T = 1.8 years PTS: 1
OBJ: Multiple Choice Problem
52. What is the implied growth duration of Howard Industries given the following:
P/E Ratios Average Growth (%) Dividend Yield a. b. c. d. e.
S&P Industrials 14 6.0 .07
Howard Industries 24 12.0 .04
11.5 years 16.8 years 22.6 years 18.4 years 20.6 years
ANS: E ln (24/14) = T ln [1 + .12 + .04)/(1 + .06 + .07)] T = 20.6 years PTS: 1
OBJ: Multiple Choice Problem
Exhibit 14.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Modular Industries currently has a 16% annual growth rate while the market average is 6 percent. The market multiple is 10. 53. Refer to Exhibit 14.2. Determine the justified P/E ratio for Modular Industries assuming Modular can maintain its superior growth rate for the next 5 years. a. 6.4 b. 13.1
c. 16.5 d. 23.8 e. 15.7 ANS: E ln (X) = 5 ln (1.16/1.06) ln (X) = 5 ln (1.094) ln (X) = 5 (.090) = 0.45 X = 1.57 Thus, the P/E ratio would be 1.57 10 = 15.7 PTS: 1
OBJ: Multiple Choice Problem
54. Refer to Exhibit 14.2. Determine the P/E ratio for Modular Industries assuming Modular can maintain its superior growth rate for the next 8 years. a. 6.4 b. 20.5 c. 16.5 d. 23.8 e. 29.5 ANS: B ln (X) = 8 ln (1.16/1.06) ln (X) = 8 ln (1.094) ln (X) = 8 (.090) = 0.72 X = 2.05 The P/E would be 10 2.05 = 20.5 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 14.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Harcourt Industries currently has an 18% annual growth rate while the market average is 8 percent. The market multiple is 12. 55. Refer to Exhibit 14.3. Determine the justified P/E ratio for Harcourt Industries assuming Harcourt can maintain its superior growth rate for the next 9 years. a. 5.98 b. 13.13 c. 21.20 d. 58.68 e. 26.65 ANS: E ln (X) = 9 ln (1.18/1.08) ln (X) = 9 ln (1.093) ln (X) = 9 (.089) = .801 X = 2.22 The P/E would be 2.22 12 = 26.65 PTS: 1
OBJ: Multiple Choice Problem
56. Refer to Exhibit 14.3. Determine the P/E ratio for Harcourt Industries assuming Harcourt can maintain its superior growth rate for the next 3 years. a. 4.25 b. 12.50 c. 15.67 d. 30.10 e. 42.80 ANS: C ln (X) = 3 ln (1.18/1.08) ln (X) = 3 ln (1.093) ln (X) = 3 (.089) = .269 X = 1.306 The P/E would be 12 1.306 = 15.67 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 14.4 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The Valentine Company currently has a 14% annual growth rate while the market average is 4 percent. The market multiple is 15. 57. Refer to Exhibit 14.4. Determine the justified P/E ratio for the Valentine Company assuming Valentine can maintain its superior growth rate for the next 10 years. a. 3.0 b. 9.2 c. 16.6 d. 28.6 e. 37.6 ANS: E ln (X) = 10 ln (1.14/1.04) ln (X) = 10 ln (1.096) ln (X) = 10 (.092) = .92 X = 2.51 Thus, the P/E ratio would be 2.51 15 = 37.6 PTS: 1
OBJ: Multiple Choice Problem
58. Refer to Exhibit 14.4. Determine the P/E ratio for the Valentine Company assuming Valentine can maintain its superior growth rate for the next 5 years. a. 23.7 b. 16.4 c. 15.3 d. 8.3 e. 3.8 ANS: A ln (X) = 5 ln (1.14/1.04) ln (X) = 5 ln (1.096) ln (X) = 5 (.092) = .46 X = 1.584 The P/E would be 15 1.584 = 23.7
PTS: 1
OBJ: Multiple Choice Problem
59. Given Gitech's beta of 1.55 and a risk free rate of 8 percent, what is the expected rate of return assuming a 14 percent market return? a. 12.4% b. 14.3% c. 17.3% d. 20.4% e. 29.7% ANS: C K1 = 8 + 1.55 (14 − 08) = 17.3% PTS: 1
OBJ: Multiple Choice Problem
60. The expected rate of return on Research Industries is twice the 12 percent expected rate of return from the market. What is Research's beta if the risk free rate is 6 percent? a. 2 b. 3 c. 4 d. 5 e. 6 ANS: B 24 = 6 + (12 − 6) 18 = (6)
=3
PTS: 1
OBJ: Multiple Choice Problem
61. Given Birdchip's beta of 1.25 and a risk free rate of 6 percent, what is the expected rate of return assuming a 12 percent market return? a. 1% b. 10% c. 11% d. 12% e. 31% ANS: C K1 = 6 + 1.25 (12 − 8) = 11.0% PTS: 1
OBJ: Multiple Choice Problem
62. The expected rate of return on Rewind Industries is 2.5 times the 12 percent expected rate of return from the market. What is Rewind's beta if the risk free rate is 6 percent? a. 2 b. 3 c. 4 d. 5 e. 6 ANS: C 30 = 6 + (12 − 6) 24 = (6)
=4
PTS: 1
OBJ: Multiple Choice Problem
63. Given Gilbert's beta of 1.10 and a risk free rate of 5 percent, what is the expected rate of return assuming a 10 percent market return? a. 21.5% b. 10.5% c. 5.5% d. 15.5% e. 16.5% ANS: B K1 = 5 + 1.10 (10 − 5) = 10.5% PTS: 1
OBJ: Multiple Choice Problem
64. The expected rate of return on Rooter Industries is 1.5 times the 16 percent expected rate of return from the market. What is Research's beta if the risk free rate is 8 percent? a. 2 b. 3 c. 4 d. 5 e. 6 ANS: A 24 = 8 + (16 − 8) 16 = (8)
=2
PTS: 1
OBJ: Multiple Choice Problem
65. ABC Co. has paid annual dividends in the past five years of $.20, $.25, $.28, $.33, and $.36. Calculate the average growth rate of its dividends. a. 1.16% b. 1.80% c. 12.47% d. 15.83% e. None of the above ANS: D Average dividend growth rate
PTS: 1
= [Dn/D0]1/n − 1 = [$.36/$.20]1/4 − 1 = [1.80]1/4 − 1 = 1.1583 − 1 = .1583 or 15.83%
OBJ: Multiple Choice Problem
Exhibit 14.5 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
DPS Total Asset Turnover Net Profit Margin EPS Total Assets/Equity
Wal-Blue 1.00 3.20 3.50% 4.00 3.00
Industry 1.50 2.50 3.00% 3.00 4.00
66. Refer to Exhibit 14.5. What are the ROE's for Wal-Blue and its industry? a. 24.3% and 27.0% b. 29.7% and 27.0% c. 29.7% and 30.0% d. 33.6% and 30.0% e. 34.5% and 31.5% ANS: D ROE = Total asset turnover Net profit margin Total assets/equity ROE (Wal-Blue) = 3.20 .035 3.00 = .336 or 33.6% ROE (Industry) = 2.50 .03 4.00 = .300 or 30.0% PTS: 1
OBJ: Multiple Choice Problem
67. Refer to Exhibit 14.5. What are the expected sustainable growth rates for Wal-Blue and its industry? a. 25.2% and 15.0% b. 30.0% and 17.5% c. 25.2% and 17.5% d. 27.5% and 12.5% e. 30.0% and 15.0% ANS: A g = ROE RR = ROE (1 − dividend payout) g (Wal-Blue) = .336 (1 − 1.00/4.00) = .336 .75 = .252 or 25.2% g (Industry) = .300 (1 − 1.50/3.00) = .300 .50 = .150 or 15.0% PTS: 1
OBJ: Multiple Choice Problem
68. A firm has a current price of $40 a share, an expected growth rate of 11 percent and expected dividend per share (D1) of $2. Given its risk you have a required rate of return for it of 12 percent. Your expected rate of return and investment decision is as follows: a. 10% − do not buy b. 12% − do not buy c. 14% − buy d. 16% − buy e. 18% − buy ANS: D Expected rate of return
= Di/P0 + g = $2.00/$40.00 + 11% = 5% + 11% = 16%
Buy, expected return (16%) exceeds required return (12%). PTS: 1
OBJ: Multiple Choice Problem
69. A firm has a current price of $40 a share, an expected growth rate of 11 percent and expected dividend per share (D1) of $2. Given its risk you have a required rate of return for it of 12 percent. Assuming that you expect the stock price to increase to $42 during the investment period, your expected rate of return and decision would be: a. 10% − do not buy b. 12% − do not buy c. 14% − buy d. 16% − buy e. 18% − buy ANS: A
Do not buy, expected return (10%) does not exceed the required return (12%). PTS: 1
OBJ: Multiple Choice Problem
70. Based on the information provided, calculate the intrinsic value in 2010 of a share of INV Corp. using the FCFF (free cash flow to the firm) model. For 2010 the FCFF was $30,000, total debt was $20,000, and there were 12000 shares outstanding. The required rate of return is 9% and the estimated growth rate in FCFF is 6.5%. a. $104.83 b. $153.25 c. $112.50 d. $94.92 e. $80.45 ANS: A
PTS: 1
OBJ: Multiple Choice Problem
71. Based on the information provided, calculate the intrinsic value in 2010 of a share of INV Corp. using the Present Value of Earnings Model (infinite holding period). For 2010 net income was $250,000, total debt was $50,000, and there were 206,263 shares outstanding. The required rate of return is 12% and the estimated growth rate in earnings is 5.5%. a. $19.43 b. $23.98 c. $28.52 d. $22.73 e. $15.50 ANS: A
PTS: 1
OBJ: Multiple Choice Problem
72. You are provided with the following information about Javier Corporation. Sales for the year 2010 were $500,000, the Net Profit Margin (NPM) was 15%. Analysts project sales to grow by 12% next year (that is 2011). However, because of more competition, the NPM is expected to decline by 10% for the year 2010. The expected P/E multiple for the year 2011 is 22. The total number of shares outstanding is 20,000. Use the earnings multiplier model to calculate the expected price for Javier Corporation in the year 2011. a. $74.25 b. $61.6 c. $82.5 d. $83.16 e. $101.64 ANS: D The price is calculated as follows Sales for 2005 = 500,000(1.12) = 560,000 New NPM = .15(1 − .1) = .135 2005 NPM = 560,000(.135) = 75,600 EPS = 75,600/20,000 = $3.78 Price = 3.78(22) = $83.16 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 14.6 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You are provided with the following information on Kayray Corporation. Your ultimate objective is to calculate the EVA for the firm. LIFO reserve Net plant, property, and equipment Other assets Goodwill Accumulated Goodwill amortized PV of Operating leases Tax benefit from interest on expenses Tax benefit from interest on leases Taxes on non-operating income Implied interest on op. lease Increase in LIFO reserve Goodwill amortization Operating profit Income tax expense Net working capital WACC
60 1325 30 325 65 140 10 5 2 9.5 12 15 550 215 440 0.12
73. Refer to Exhibit 14.6. Calculate the adjusted operating profits before taxes. a. $586.5 b. $225.64 c. $825.23
d. $831.56 e. $692.5 ANS: A Operating profit + implied interest on op. lease + an increase in LIFO reserve + goodwill amortization = Adjusted Operating profits before taxes PTS: 1
550 9.5 12 15 586.5
OBJ: Multiple Choice Problem
74. Refer to Exhibit 14.6. Calculate the cash operating expenses for the firm. a. 225 b. 228 c. 232 d. 242 e. 252 ANS: B Income tax expense + tax benefit from interest on expenses + tax benefit from interest on leases − taxes on non-operating income = Cash Operating expenses PTS: 1
215 10 5 2 228
OBJ: Multiple Choice Problem
75. Refer to Exhibit 14.6. Calculate the capital for the firm. a. 1725 b. 1953 c. 2524 d. 2385 e. 1987 ANS: D Net working capital + LIFO reserve + Net plant, property, and equipment + Other assets + Goodwill + Accumulated Goodwill amortized + PV of Operating leases = Capital PTS: 1
OBJ: Multiple Choice Problem
76. Refer to Exhibit 14.6. Calculate the dollar cost of capital. a. 286.2 b. 207 c. 234.36 d. 238.44 e. 302.9 ANS: A
440 60 1325 30 325 65 140 2385
WACC
0.12
Dollar cost of capital = Capital WACC
286.2
PTS: 1
OBJ: Multiple Choice Problem
77. Refer to Exhibit 14.6. Calculate the firm's EVA. a. 85.2 b. 72.3 c. 65.8 d. 89.5 e. 78.2 ANS: B EVA = 586.5 − 228 − 286.2 = 72.3 PTS: 1
OBJ: Multiple Choice Problem
78. The Peterson Company has FCFF of $1000. FCFF is expected to grow by 12% next year. The cost of capital is 12% and the level of debt is $5000. The number of shares outstanding is 500. Calculate the firm's share price. a. $44 b. $55 c. $34.19 d. $47.23 e. $50 ANS: A
PTS: 1
OBJ: Multiple Choice Problem
79. The Pekay Company has FCFE of $800. FCFE is expected to grow by 7% next year. The cost of capital is 7% and the level of debt is $4000. The number of shares outstanding is 700. Calculate the firm's share price. a. $44.25 b. $65.12 c. $38.19 d. $40.76 e. $50.56 ANS: D
PTS: 1
OBJ: Multiple Choice Problem
Exhibit 14.7 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) At the end of the year 2010 the BRK Corporation had free cash flow to equity (FCFE) of $250,000 and shares outstanding of 200,000. The company projects the following annual growth rates in FCFE:
Year 2011 2012 2013 2014 2015 2016 2017 2018
Growth Rate 10% 15% 20% 25% 20% 15% 10% 7%
From year 2019 onward growth in FCFE is expected to remain constant at 5% per year. The stock has a beta of 1.3 and the current market price is $55. Currently the yield on 10-year Treasury notes is 5% and the equity risk premium is 4%. 80. Refer to Exhibit 14.7. Calculate the required rate of return on equity. a. 5% b. 9.2% c. 10.2% d. 10% e. 4.3% ANS: C k = 0.05 + 1.3(0.04) = 0.102 PTS: 1
OBJ: Multiple Choice Problem
81. Refer to Exhibit 14.7. Calculate the present value now (Year 2010) of FCFE during the period of increasing growth (that is for years 2011 to 2014). a. $1,719,119 b. $1,715,784 c. $1,115,195 d. $1,434,903 e. $1,809,171 ANS: C The table below shows the relevant calculations (note that these calculations were carried out using Excel and there may be some rounding differences). T Year g 0 2004 1 2005 0.1 2 2006 0.15 3 2007 0.2 4 2008 0.25 5 2009 0.2 6 2010 0.15 7 2011 0.1 8 2012 0.07 9 2013 0.05 PV constant growth Intrinsic Value Intrinsic price per share
FCFE $250,000 $275,000 $316,250 $379,500 $474,375 $569,250 $654,638 $720,101 $770,508 $809,034
k 0.102 0.102 0.102 0.102 0.102 0.102 0.102 0.102 0.102 0.102
PV yr 2014
PV yr 2006
$15,558,341
$249,546 $260,416 $283,574 $321,659 $350,264 $365,520 $364,857 $354,262
$1,115,195
$1,434,903 $7,153,368
$9,703,465 $48.52
The future FCFE are calculated by applying the appropriate growth rates. For example FCFE for the year 2005 is calculated as 250,000(1.1) = 275,000 The present value = 275,000/(1.102) = 249,546 Summing up the present value of the cash flows for years 2005 to 2008 = $1,115,195 PTS: 1
OBJ: Multiple Choice Problem
82. Refer to Exhibit 14.7. Calculate the present value now (Year 2010) of FCFE during the period of declining growth (that is for years 2015 to 2018). a. $1,719,119 b. $1,715,784 c. $1,115,195 d. $1,434,903 e. $1,809,171 ANS: D Present value of cash flows for the years 2009 to 2012 = $1,434,903 PTS: 1
OBJ: Multiple Choice Problem
83. Refer to Exhibit 14.7. Calculate the present value now (Year 2010) of FCFE during the period of constant growth (that is for years 2019 onwards). a. $7,153,368 b. $9,703,476 c. $15,558,341 d. $8,986,012 e. $6,789,125 ANS: A The present value of the cash flows during the constant growth period is calculated as follows: PV year 2012 = 809,034/(0.102 − 0.05) = $15,558,341 Present value now = 15,558,341/(1.102)8 = $7,153,368 PTS: 1
OBJ: Multiple Choice Problem
84. Refer to Exhibit 14.7. Calculate the intrinsic value of the stock now (Year 2010). a. $55 b. $48.52 c. $77.79 d. $35.77 e. $62.34 ANS: B Intrinsic value per share = (1,115,195 + 1,434,903 + 7,153,368)/200,000 = $48.52 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 14.8 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) At the end of the year 2010 the CKL Corporation had operating free cash flow (OFCF) of $300,000 and shares outstanding of 100,000. Total debt is currently $10,000,000. The company projects the following annual growth rates in OFCF
Year 2011 2012 2013 2014 2015 2016 2017 2018
Growth Rate 25% 20% 15% 10% 12% 14% 16% 18%
From year 2019 onward growth in OFCF is expected to remain constant at 5% per year. The stock has a beta of 1.1 and the current market price is $80. Currently the yield on 10-year Treasury notes is 5% and the equity risk premium is 4%. The firm can raise debt at a pre-tax cost of 9%. The tax rate is 25%. The proportion of equity is 55% and the proportion of debt is 45%. 85. Refer to Exhibit 14.8. Calculate the required rate of return on equity. a. 8.2% b. 9.4% c. 9.0% d. 10.3% e. 7.3% ANS: B Required return on equity = k = 0.05 + 1.1(0.04) = 0.094 PTS: 1
OBJ: Multiple Choice Problem
86. Refer to Exhibit 14.8. Calculate the weighted average cost of capital (WACC). a. 8.2% b. 9.4% c. 9.0% d. 10.3% e. 7.3% ANS: A WACC = (0.55)(0.094) + (0.45)(0.09)(1 − 0.25) = 0.082 PTS: 1
OBJ: Multiple Choice Problem
87. Refer to Exhibit 14.8. Calculate the present value now (Year 2010) of OFCF during the period of declining growth (that is for years 2011 to 2014). a. $1,044,612 b. $1,554,823 c. $1,898,096 d. $1,327,547 e. $1,579,326 ANS: B The table below shows the relevant calculations (note that these calculations were carried using Excel and there may be some rounding differences) T 0 1 2
Year 2004 2005 2006
g 0.25 0.2
OFCF $300,000 $375,000 $450,000
WACC 0.082 0.082 0.082
PV yr 2014
PV yr 2006 $346,580 $384,378
3 2007 0.15 4 2008 0.1 5 2009 0.12 6 2010 0.14 7 2011 0.16 8 2012 0.18 9 2013 0.05 PV of constant growth Intrinsic Value less debt Equity value Intrinsic price per share
$517,500 $569,250 $637,560 $726,818 $843,109 $994,869 $1,044,612
0.082 0.082 0.082 0.082 0.082 0.082 0.082
$32,644,140
$408,534 $415,331 $429,917 $452,963 $485,616 $529,600
$1,554,823
$1,898,096 $17,377,494
$20,830,412 $10,000,000 $10,830,412 $108.30
The future OFCF are calculated by applying the appropriate growth rates. For example OFCF for the year 2005 is calculated as 300,000(1.25) = 375,000 The present value = 375,000/(1.082) = 346,580 Summing up the present value of the cash flows for years 2005 to 2008 = $1,554,823 PTS: 1
OBJ: Multiple Choice Problem
88. Refer to Exhibit 14.8. Calculate the present value now (Year 2010) of OFCF during the period of declining growth (that is for years 2015 to 2018). a. $1,044,612 b. $1,554,823 c. $1,898,096 d. $1,327,547 e. $1,579,326 ANS: C Present value of cash flows for the years 2009 to 2012 = $1,898,096 PTS: 1
OBJ: Multiple Choice Problem
89. Refer to Exhibit 14.8. Calculate the present value now (Year 2010) of OFCF during the period of constant growth (that is for years 2019 onwards). a. $19,644,612 b. $15,558,546 c. $17,377,494 d. $20,779,025 e. $10,779,025 ANS: C The present value of the cash flows during the constant growth period is calculated as follows: PV year 2012 = 1,044,612/(0.082 − 0.05) = $32,644,140 Present value now = 32,644,140/(1.082)8 = $17,377,494 PTS: 1
OBJ: Multiple Choice Problem
90. Refer to Exhibit 14.8. Calculate the total intrinsic value of the firm. a. $19,644,612 b. $15,558,546 c. $17,327,250 d. $20,830,412 e. $10,779,025
ANS: D Intrinsic value = (1,554,823 + 1,898,096 + 17,377,494) = $20,830,412 PTS: 1
OBJ: Multiple Choice Problem
91. Refer to Exhibit 14.8. Calculate the intrinsic value of the stock now (Year 2010). a. $155.55 b. $173.27 c. $196.44 d. $207.79 e. $108.30 ANS: E Intrinsic value per share = (20,830,412 − 10,000,000)/100,000 = $108.30 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 14.9 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The Rollerball Corporation's industry averages are as follows: Net Profit Margin = 7.5%; Total Asset Turnover = 2.2; Total Assets/Equity = 2.0 Rollerball Corporation has the following financial statements for year ending 12/31/2008. (000's omitted) Sales Cost of Goods Sold Gross Profit Depreciation Operating Expenses Administration Exp. Operating Profit 795 Interest Expense Profit Before Taxes Taxes Net Income Dividends Assets Cash Accounts Receivable Inventory Total Current Assets Net Fixed Assets Total Assets
5,450 3,250 2,200 820 470 115 88 707 247 460 250
100 1,250 1,125 2,475 1,450 3,925
Liabilities Notes Payable Accounts Payable Total Current Liab. Long Term Debt Common Stock Retained Earnings Total Liab. & Earnings
92. Refer to Exhibit 14.9. Calculate Rollerball Corporation's Net Profit Margin. a. 3.9% b. 8.4% c. 14.6% d. 40.4% e. 41.8%
850 1,550 2,400 425 400 700 3,925
ANS: B NI/Sales = 460/5,450 = 0.084 PTS: 1
OBJ: Multiple Choice Problem
93. Refer to Exhibit 14.9. Calculate Rollerball Corporation's Total Asset Turnover. a. 0.72 b. 0.85 c. 1.39 d. 1.65 e. 2.31 ANS: C Sales/Total Assets = 5,450/3,925 = 1.39 PTS: 1
OBJ: Multiple Choice Problem
94. Refer to Exhibit 14.9. Calculate Rollerball Corporation's Total Assets/Equity ratio. a. 3.57 b. 4.28 c. 5.61 d. 7.35 e. 9.81 ANS: A TA/Equity = 3,925/(400 + 700) = 3.57 PTS: 1
OBJ: Multiple Choice Problem
95. Refer to Exhibit 14.9. Calculate the return on equity (ROE) for Rollerball Corporation and the Industry. Rollerball a. 115.0% b. 65.7% c. 41.8% d. 19.1% e. 8.7%
Industry Average 67.5% 33.0% 33.0% 15.7% 15.7%
ANS: C Rollerball = NI/Equity = 460/1,100 = 0.418; Industry = .075*2.2*2.0 = 0.33 PTS: 1
OBJ: Multiple Choice Problem
96. Refer to Exhibit 14.9. Calculate the sustainable growth rate for Rollerball Corporation. a. 19.1% b. 22.7% c. 27.5% d. 52.5% e. 62.5% ANS: A (1 − 250/460)*0.418 = 0.191
PTS: 1
OBJ: Multiple Choice Problem
97. Johnson Company just paid an annual dividend of $1.75. The next dividend will be paid one year from today. Johnson Company expects a constant growth of 5% in dividends forever. The required rate of return for this company's common stock is 13%. What is the value of one share of common stock? a. $1.55 b. $13.46 c. $14.13 d. $21.88 e. $22.97 ANS: E Using DDM: PTS: 1
OBJ: Multiple Choice Problem
Exhibit 14.10 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Left-Aid Corporation $2.45 3.80 6.50% $3.50 1.60
DPS Total Asset Turnover Net Profit Margin EPS Total Assets/Equity
98. Refer to Exhibit 14.10. What is the Left-Aid Corporation's return on equity (ROE)? a. 25.5% b. 27.4% c. 29.7% d. 35.6% e. 39.5% ANS: E ROE = Total asset turnover Net profit margin Total assets/equity ROE = 3.80 .065 1.60 = .3952 or 39.52% PTS: 1
OBJ: Multiple Choice Problem
99. Refer to Exhibit 14.10. What is Left-Aid Corporation's expected sustainable growth rate? a. 11.9% b. 18.7% c. 22.1% d. 27.7% e. 30.0% ANS: A g = ROE RR = ROE (1 − dividend payout) g = .3952 (1 − 2.50/3.50) = .3952 .3 = .1186 or 11.86% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 14.11 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Investment Stock X Stock Y Market Portfolio Risk-free rate
Beta 2.3 1.2 1.0
Analyst's Estimated Return 15.5% 13.6% 11.5% 4.0%
100. Refer to Exhibit 14.11. What is the required rate of return for Stock X based on the capital asset pricing model (CAPM)? a. 15.5% b. 17.3% c. 21.3% d. 26.5% e. 30.5% ANS: C Required return = 0.04 + 2.3(0.115 − 0.04) = 0.04 + 2.3(0.075) = 0.2125 or 21.3% PTS: 1
OBJ: Multiple Choice Problem
101. Refer to Exhibit 14.11. What is the required rate of return for Stock Y based on the capital asset pricing model (CAPM)? a. 11.5% b. 13.0% c. 13.6% d. 14.8% e. 15.5% ANS: B Required return = 0.04 + 1.2(0.115 − 0.04) = 0.04 + 1.2(0.075) = 0.13 or 13.0% PTS: 1
OBJ: Multiple Choice Problem
102. Refer to Exhibit 14.11. Based on the analyst's estimated return and the stocks' betas the analyst should a. Sell both Stock X and Stock Y b. Sell Stock X and Buy Stock Y c. Buy Stock X and Sell Stock Y d. Buy both Stock X and Stock Y e. None of the above ANS: B Stock X's required return, 21.3%, is greater than estimated return, 15.5%, so Sell X. Stock Y's required return, 13.0%, is less than estimated return, 13.6%, so Buy Y. PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 15—TECHNICAL ANALYSIS TRUE/FALSE 1. Fundamentalists contend that past price movements will indicate future price movements. ANS: F
PTS: 1
2. Technical analysts believe that security prices do not adjust rapidly. ANS: T
PTS: 1
3. One of the potential disadvantages of technical analysis is that it can lead to investing too early, even before fundamental analysts do. ANS: F
PTS: 1
4. The use of trading rules requires a great deal of subjective judgment. ANS: T
PTS: 1
5. Most technicians feel that since price patterns repeat themselves, a single trading rule is sufficient. ANS: F
PTS: 1
6. If a technical trading rule is successful, more traders use it, causing the rule to become even more successful. ANS: F
PTS: 1
7. For technical trading rules to consistently generate superior returns, the market would have to be inefficient. ANS: T
PTS: 1
8. The majority of technicians follows many trading rules and attempt to arrive at a consensus among their rules. ANS: T
PTS: 1
9. Two major classes of technicians include the contrarians and those who "follow the smart money". ANS: T
PTS: 1
10. Contrary trading rules assert that investors tend to be wrong except at market peaks and troughs. ANS: F
PTS: 1
11. The confidence index increases as the yield on lower grade bonds decreases, everything else being constant. ANS: T
PTS: 1
12. The T-Bill-Eurodollar yield spread widens during periods of international crisis. ANS: T
PTS: 1
13. An increase in debit balances in brokerage accounts is viewed by technicians as a bullish sign. ANS: T
PTS: 1
14. Technicians consider a high short interest ratio to be bearish. ANS: F
PTS: 1
15. The Dow theory contends that stock price movements are similar to the movement of tides, waves, and ripples. ANS: T
PTS: 1
16. A resistance level is the price range at which the technician would expect an increase in the demand of stock and a price reversal. ANS: F
PTS: 1
17. A high put/call ratio indicates a pervasive bearish attitude by sophisticated investors so it is a bearish indicator. ANS: F
PTS: 1
18. The Confidence Index increases as the yield on lower grade bonds decreases, everything else being constant. ANS: T
PTS: 1
19. An increase in debit balances means more investing by naive investors and would be a bearish indicator. ANS: F
PTS: 1
20. If the aggregate market is rising, but the breadth index is declining, it is a bearish signal. ANS: T
PTS: 1
21. If the 50-day moving average line crosses the 200-day moving average line from below on good volume, this would be a bullish signal. ANS: T
PTS: 1
22. The relative strength ratio for a stock can be computed by dividing the value of the S&P 500 stock index by the price of a stock. ANS: F
PTS: 1
23. A rise in the Confidence Index published by Barron's is an indication investors will purchase more lower-quality bonds.
ANS: T
PTS: 1
24. The breadth of the market measures the daily volume for a particular market. ANS: F
PTS: 1
25. A support level is the price range at which the technician would expect an increase in the supply of stock and a price reversal. ANS: F
PTS: 1
26. Candlestick charts indicate the price change from open to close by shading whether the market went down or up for the day. ANS: T
PTS: 1
27. When the 50 day MA line crosses the 200 day MA line from above it is considered a buy signal. ANS: F
PTS: 1
28. If 10 percent of the stocks are selling above their 200 day moving average, the market is considered to be oversold. ANS: T
PTS: 1
29. Empirical analysis suggests that trigger points for trading rules are relatively stable over time. ANS: F
PTS: 1
MULTIPLE CHOICE 1. Technical analysis differs from fundamental analysis in that a. Technical analysts contend that in-depth assessments of basic aggregate market, industry, and company performance is necessary; past price movements indicate future price movements. b. Technical analysts believe the market value of common stocks is determined by the interaction of supply and demand. c. Technical analysts argue that the market constantly weighs rational and irrational factors and that both of these affect price. d. Technical analysts depend far more heavily on objective, data-based approaches than the fundamentalists do. e. Technical analysts hold that the price of a security is determined by an expected return risk. ANS: B
PTS: 1
OBJ: Multiple Choice
2. Which of the following is not considered an assumption of technical analysis? a. Market value is determined solely by supply and demand. b. Supply and demand are governed by both rational and irrational factors. c. Security prices tend to move in trends that persist for an appreciable length of time. d. Stock prices follow a random walk. e. Changes in trend are caused by the shifts in supply and demand relationships.
ANS: D
PTS: 1
OBJ: Multiple Choice
3. For technical trading rules to generate returns that are superior to a buy-and-hold strategy, net of transaction costs, the market would have to be a. Rising. b. Falling. c. Inefficient. d. Overvalued. e. Undervalued. ANS: C
PTS: 1
OBJ: Multiple Choice
4. Technical analysts feel that financial accounting statements lack information, or report it in a way that makes comparisons difficult. Which of the following does not constitute a problem? a. Detailed information concerning sales and expenses by product line. b. Statements of change in financial position. c. Alternative ways of reporting expenses. d. Alternative ways of reporting assets and liabilities. e. The availability of psychological and nonquantitative variables. ANS: B
PTS: 1
OBJ: Multiple Choice
5. The following are classified as contrary trading rules, except the a. Odd lot short sales. b. Investment advisory opinions. c. Relative OTC volume. d. CBOE put/call ratio. e. Confidence index. ANS: E
PTS: 1
OBJ: Multiple Choice
6. According to contrary opinion technicians, the ratio of mutual funds cash to total assets ____ near troughs in the market cycle and ____ near peaks. a. Level out, spikes b. Remains low, remains high c. Is published near, is not published d. Increases, decreases e. Decreases, increases ANS: D
PTS: 1
OBJ: Multiple Choice
7. Analysts following what the smart, sophisticated investor is doing would examine a. Mutual fund cash positions. b. Debit balances in brokerage houses. c. Investment advisory opinions. d. Breadth of market. e. Stocks above their 200 day moving average. ANS: B
PTS: 1
OBJ: Multiple Choice
8. Indicators that tell what smart investors are doing include a. The put/call ratio. b. Mutual fund cash position. c. The Dow theory. d. Short sales by specialists.
e. Head and tail indicator. ANS: D
PTS: 1
OBJ: Multiple Choice
9. The confidence index published by Barron's is the ratio of the average yield on 10 top grade corporate bonds to the a. Average yield on 30 blue chip corporate stocks. b. Average yield on 40 convertible corporate bonds. c. Yield on U.S. Treasury bills. d. Yield on the Dow Jones average of 40 bonds. e. Yield on the Shearson Lehman Hutton Corporate Bond Index ANS: D
PTS: 1
OBJ: Multiple Choice
10. The cumulative number of shares that have been sold short by investors and not covered is called a. Margin interest. b. Short interest. c. Short ratio. d. Short/long ratio. e. Naked short ratio. ANS: B
PTS: 1
OBJ: Multiple Choice
11. The short interest ratio is the ratio between the number of shares sold short and not covered, and the a. Average number of stocks reaching new highs. b. Average daily number of stocks that increased in value. c. Average daily volume of trading on the exchange. d. Average monthly volume of trading on the exchange. e. Average number of shares outstanding in those stocks. ANS: C
PTS: 1
OBJ: Multiple Choice
12. Technicians believe that an industry or stock that is outperforming the market will tend to a. Continue to outperform the market. b. Return to normal. c. Reverse trend. d. Meet a resistance level. e. Form head and shoulder patterns. ANS: A
PTS: 1
OBJ: Multiple Choice
13. The ratio of the price of a stock or an industry group to the value of the market index is called the a. Company to market ratio. b. Composite stock ratio. c. Relational proportion ratio. d. Stock to market ratio. e. Relative strength ratio. ANS: E
PTS: 1
OBJ: Multiple Choice
14. ____ charts show time series of price while ____ charts only reflect change regardless of time. a. Relative strength, bar b. Relative strength, advance/decline c. Point and bar, figure d. Bar, point and figure e. Bar, multiple indicator
ANS: D
PTS: 1
OBJ: Multiple Choice
15. A type of charting which normally disregards both time and volume is the a. Bar chart. b. Point and figure chart. c. Pie chart. d. Histogram. e. A linear regression graph. ANS: B
PTS: 1
OBJ: Multiple Choice
16. A price range at which technicians would expect a substantial increase in the demand for a stock is called a. Demand threshold. b. Resistance level. c. Support level. d. Resistance limit. e. Technical restraint. ANS: C
PTS: 1
OBJ: Multiple Choice
17. A price range at which technicians feel that a significant increase in the price of the stock will be resisted is referred to as a. Supply threshold. b. Support level. c. Short interest level. d. Advancement level. e. Resistance level. ANS: E
PTS: 1
OBJ: Multiple Choice
18. Advances and declines are associated with market a. Efficiency. b. Position. c. Diffusion. d. Depth. e. Breadth. ANS: E
PTS: 1
OBJ: Multiple Choice
19. In examining the properties of world market currencies or the spreads between currencies, an analyst is most likely to use time series properties to determine all the following, except a. Volatility. b. Overbought condition. c. Resistance-support levels. d. Trend. e. An oversold condition. ANS: A
PTS: 1
OBJ: Multiple Choice
20. Technicians believe, when the relative strength index is stable or ____, during a ____ market, the stock should do well during a ____ market. a. Decreases, bull, bear. b. Increases, bear, bull. c. Decreases, bear, bull.
d. Increases, bull, bear. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
21. When the 50 day moving average crosses the 200 day moving average from ____ on ____ volume, this would be a ____ signal. a. Above, low, bullish. b. below, high, bearish. c. below, low, bullish. d. above, high, bullish. e. below, high, bullish. ANS: E
PTS: 1
OBJ: Multiple Choice
22. When ____ of stocks are trading above the 200-day moving average, the market is considered ____, and subject to a ____. a. 20%, oversold, negative correction b. 80%, overbought, negative correction c. 80%, oversold, positive correction d. 20%, overbought, positive correction e. None of the above ANS: B
PTS: 1
OBJ: Multiple Choice
23. A divergence between an increase in a stock market series and the rest of the stock market can be detected using a. Debit balances in brokerage accounts b. Short interest c. The advance-decline line d. Confidence index e. None of the above ANS: C
PTS: 1
OBJ: Multiple Choice
24. A narrowing of the T-bill-Eurodollar and ____ signal, because ____. a. Bearish, it signals falling investor confidence b. Bullish, it signal rising investor confidence c. Bearish, it signals a flight to quality d. Bullish, it signals a flight to quality e. b and d ANS: B
PTS: 1
OBJ: Multiple Choice
25. A technical analyst might consider the following as a bearish signal a. Investment advisory opinion is bearish b. Investment advisory opinion is bullish c. CBOE put-call ratio above 0.60 d. CBOE put-call ratio below 0.40 e. b and d ANS: E
PTS: 1
OBJ: Multiple Choice
26. A technical analyst might use credit balances in brokerage accounts as follows: a. Sell stock when credit balances rise b. Buy stock when credit balances rise
c. Sell stock when credit balances decline d. b and c e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
27. A technical analyst might use mutual fund cash positions as follows: a. Sell stock when cash levels are low b. Buy stock when cash levels are low c. Sell stock when cash levels are high d. b and c e. a and b ANS: A
PTS: 1
OBJ: Multiple Choice
28. The ratio of OTC volume versus NYSE volume is a measure of ____. This ratio typically ____ at a market ____. a. Speculative activity, bottoms, peak. b. Hedging activity, bottoms, peak. c. Speculative activity, peaks, peak d. Speculative activity, bottoms, bottoms. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
29. A technical analyst might consider the following a bearish signal. a. The percentage of speculators in stock index futures exceeds 70%. b. The percentage of speculators in stock index futures exceeds 30%. c. The percentage of speculators in stock index futures falls to 30%. d. The percentage of speculators in stock index futures remains flat. e. None of the above. ANS: A
PTS: 1
OBJ: Multiple Choice
30. To a technician that believed in the importance of volume, a bullish signal would occur when a. Prices increase on light volume. b. Prices decrease on light volume. c. Prices increase on heavy volume. d. Prices decrease on heavy volume. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
31. Which of the following is not a technical trading rule category? a. Contrary-opinion rules b. Follow the smart money rules c. Anti-fundamental and anti-portfolio approaches d. Stock price and volume techniques e. Other market environment indicators ANS: C
PTS: 1
OBJ: Multiple Choice
32. Which of the following is not considered a contrary trading rules? a. Futures traders bullish on stock index futures b. Investment advisory opinions c. Credit balance in brokerage accounts
d. CBOE put/call ratio e. Confidence index ANS: E
PTS: 1
OBJ: Multiple Choice
33. According to technical analysts using mutual fund cash positions to guide investment decisions a. A low cash ratio position is a bullish indicator. b. A high cash position is a bullish indicator. c. A high cash position is a bearish indicator. d. A low cash position is neither bearish nor bullish. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
34. Technicians using the confidence index published by Barrons to make investment decisions a. Believe the ratio is a bullish indicator because during periods of high confidence investors will invest in higher quality bonds. b. Believe the ratio is a bearish indicator because during periods of high confidence investors will invest in higher quality bonds. c. Believe the ration is a bearish indicator because during periods of high confidence investors will invest in lower quality bonds. d. Believe the ration is a bullish indicator because during periods of high confidence investors will invest in lower quality bonds. e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
35. When the 50-day moving average crosses the 200-day moving average from below on good volume a. This would be a bearish indicator because it signals a change to a negative trend. b. This would be a bullish indicator because it signals a change to a negative trend. c. This would be a bullish indicator because it signals a change to a positive trend. d. This would be a bearish indicator because it signals a change to a positive trend. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
36. The Dow Theory describes stock prices as moving in trends analogous to the movement of water. Which of the following statements is not true? a. Major trends resemble tides. b. Intermediate trends resemble waves. c. Short-run movements are like ripples. d. Waves are the most important. e. None of the above (that is, all are true statements) ANS: D
PTS: 1
OBJ: Multiple Choice
37. Which of the following statements is true? a. At a support level, the technician would expect an increase in the demand for a stock. b. At a resistance level, the technician would expect an increase in the demand for a stock. c. At a resistance level, the technician would expect any price increase to reverse abruptly. d. Choices a and c e. All of the above ANS: D
PTS: 1
OBJ: Multiple Choice
38. A resistance level differs from a support level in that
a. at a resistance level most investors would hold stock until the price improves; at a support level a stock becomes overvalued and investor interest is likely to decrease. b. at a resistance level the analyst would expect a substantial increase in the demand for a stock; at a support level the analyst would expect a substantial decrease in the demand for a stock. c. at a resistance level most investors would sell a stock; at a support level most investors would be willing to purchase a stock. d. Choices a and b. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
39. Which of the following assumptions regarding price movements summarized by Levy (1966) are controversial? a. Supply and demand determine the market value of any good or service. b. Supply and demand are governed by numerous rational and irrational factors. c. The prices for individual securities and the overall value of the market tend to move in trends. d. All of the above assumptions are controversial. e. None of the above assumptions are controversial. ANS: C
PTS: 1
OBJ: Multiple Choice
40. Which of the following is not an advantage of technical analysis identified by technicians? a. Fundamental analysis depends heavily on financial accounting statements. b. The majority of investors cannot consistently process new information correctly. c. Fundamental analysis may not time the investment properly when trading under- or over-valued securities. d. The majority of investors cannot process new information quickly enough. e. All of the above are advantages identified by technicians. ANS: E
PTS: 1
OBJ: Multiple Choice
41. According to Dow Theory, a major market a. Advance has few price fluctuations indicate a new upward trend. b. Advance does not go straight up, because some investors will take profits. c. Decline is easier to predict than an advance. d. Decline typically has a higher level of volume than a major market advance. e. Both a and d. ANS: B
PTS: 1
OBJ: Multiple Choice
42. The relative strength index for a stock is equal to the price of the stock a. Divided by the value of a stock-market index. b. Multiplied by the value of a stock-market index. c. Divided by the value of a group of industry stocks. d. Multiplied by an industry peer group and divided by a market index. e. Divided by the 30 day moving average of prior stock movements. ANS: A
PTS: 1
OBJ: Multiple Choice
43. A chart used to show only significant price changes, regardless of their timing, is the a. Candlestick chart b. Multiple indicator chart c. Bar chart
d. Point-and-figure chart e. Point-and-click chart ANS: D
PTS: 1
OBJ: Multiple Choice
44. The market is considered to be overbought and subject to a negative correction when more than a. 60% of the stocks are selling above their 90 day average. b. 70% of the stocks are selling above their 100 day average. c. 80% of the stocks are selling above their 200 day average. d. 70% of the stocks are selling above their 150 day average. e. 90% of the stocks are selling above their 150 day average. ANS: C
PTS: 1
OBJ: Multiple Choice
45. An advantage of technical analysis over fundamental analysis is technical analysis a. Has an increased amount of data that allows the analyst to process the information b. Can more thoroughly investigate accounting information c. Adjusts for differences in GAAP accounting procedures across the industry d. Can capture non-quantifiable variables such as psychological factors e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
46. A technical analyst would consider the following a strong buy signal: a. A graph of declining prices ends in a trough followed by an upward trend that breaks through the declining trend channel. b. A graph of increasing prices ends in a peak followed by a downward trend that breaks through the rising trend channel. c. A graph begins to trade in a flat trend after it breaks out of its rising trend channel d. A graph begins to trade in a declining trend after it breaks out of its flat trend channel e. None of the above ANS: A
PTS: 1
OBJ: Multiple Choice
47. A contrary opinion technician would buy stock when mutual funds a. Are at the market peak b. Are fully invested c. Have a cash ratio approaching 4 percent d. Have a cash ratio approaching 11 percent e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
48. A technical analyst would consider a put call ratio of ____ as a bearish indicator. a. 30 percent b. 40 percent c. 50 percent d. 60 percent e. 70 percent ANS: A
PTS: 1
OBJ: Multiple Choice
49. Based on the daily closings for the Dow Jones Industrial Average given in the table below, calculate a four-day moving average for Day 4. Day
Price
1 2 3 4 a. b. c. d. e.
10500 10025 10125 10210
10,500 10,210 10,215 10,000 11,000
ANS: C Day 4 = (10500 + 10025 + 10125 + 10210)/4 = 10215 PTS: 1
OBJ: Multiple Choice Problem
50. Given the following three days of data, compute the daily net advance-decline line and cumulative advance-decline line for each day. What is the final value at the end of the third day?
Day 1 2 3 a. b. c. d. e.
Issues Traded 8540 7535 6545
Advances 6500 5500 4554
Declines 1500 1230 1324
Unchanged 540 805 667
Advances 6500 5500 4554
Declines 1500 1230 1324
Unchanged 540 805 667
5,000 9,270 12,500 13,250 11,667
ANS: C Day 1 2 3 PTS: 1
Issues Traded 8540 7535 6545
AdvanceDecline 5000 4270 3230
OBJ: Multiple Choice Problem
Exhibit 15.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Daily closings for the Dow Jones Industrial Average are given in the table below. Day 1 2 3 4 5 6
Price 9867 10025 10524 10210 10104 9925
51. Refer to Exhibit 15.1. Calculate a 5-day moving average for day 6.
Cum 5000 9270 12500
a. b. c. d. e.
10,102.3 9905.6 9875.4 10,215.7 10,157.6
ANS: E Day 6 = (10025 + 10524 + 10210 + 10104 + 9925)/6 = 10157.6 PTS: 1
OBJ: Multiple Choice Problem
52. Refer to Exhibit 15.1. Calculate a 4-day moving average for day 5. a. 10,102.3 b. 9905.6 c. 9875.4 d. 10,215.7 e. 10,157.6 ANS: D Day 5 = (10025 + 10524 + 10210 + 10104)/4 = 10215.75 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 15.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The table below provides five days of trade data.
Day 1 2 3 4 5
Issues Traded 22456 23013 23124 22678 21897
Advances 15698 14560 10324 9867 8678
Declines 6158 8210 12678 11567 12561
Unchanged 600 243 122 1244 658
53. Refer to Exhibit 15.2. Calculate the net advance-decline for day 5. a. −3,883 b. 9,540 c. −2,354 d. 13,356 e. 7,953 ANS: A Day 1 2 3 4 5
Issues Traded 22456 23013 23124 22678 21897
Advances 15698 14560 10324 9867 8678
Advance decline line for day 5 = −3883
Declines 6158 8210 12678 11567 12561
Unchanged 600 243 122 1244 658
Ad-decl 9540 6350 −2354 −1700 −3883
Cum 9540 15890 13536 11836 7953
PTS: 1
OBJ: Multiple Choice Problem
54. Refer to Exhibit 15.2. Calculate the final value of the cumulative advance-decline line at the end of the fifth day. a. −3,883 b. 9,540 c. −2,354 d. 13,356 e. 7,953 ANS: E Final value of cumulative advance-decline line on day 5 = 7953 PTS: 1
OBJ: Multiple Choice Problem
55. Daily closing for the Dow Jones Industrial Average are provided in the table below. Day 1 2 3 4 5 6
DJIA 13,500 13,395 13,505 13,750 13,820 13,910
Calculate a 5-day moving average for day 6. a. 11,397 b. 13,565 c. 13,594 d. 13,647 e. 13,676 ANS: E Day 6 5-day MA = (13,395 + 13,505 + 13,750 + 13,820 + 13,910)/5 = 13,676 PTS: 1
OBJ: Multiple Choice Problem
56. Calculate the net advance-decline for day 5 using the trade data in the table below.
Day 1 2 3 4 5 a. b. c. d. e.
−5,459 941 5,459 6,400 7,853
ANS: D
Issues Traded 32456 43013 33124 32678 31897
Advances 25698 24560 20324 19867 18678
Declines 6058 17210 12378 11367 12278
Unchanged 700 1243 422 1444 941
Advance-decline line for day 5 = 18,678 − 12,278 = 6,400 PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 16—EQUITY PORTFOLIO MANAGEMENT STRATEGIES TRUE/FALSE 1. Active equity portfolio management is a long-term buy-and-hold strategy. ANS: F
PTS: 1
2. A benchmark portfolio is defined as a passive portfolio whose average characteristics match the client's risk-return objectives. ANS: T
PTS: 1
3. The goal of a passive portfolio is to track the index as closely as possible. ANS: T
PTS: 1
4. An advantage of sampling is that portfolio returns will not track the index as closely as with full replication. ANS: F
PTS: 1
5. An advantage of quadratic programming is that it relies on historical correlations. ANS: F
PTS: 1
6. Tracking error is defined as the degree to which the portfolio's returns deviate from those of the actual index. ANS: T
PTS: 1
7. Completeness funds are portfolios designed to complement active portfolios that do not cover the entire market. ANS: T
PTS: 1
8. Following an earnings momentum strategy, an investor acquires stocks that have enjoyed above-market stock price increases. ANS: F
PTS: 1
9. In backtesting, computers are used to examine the composition and returns of portfolios based on historical data in order to determine if the investment strategy would have worked in the past. ANS: T
PTS: 1
10. Growth stocks consistently outperform value stocks. ANS: F
PTS: 1
11. Style investing involves constructing portfolios in such a way as to capture one or more of the characteristics of equity securities.
ANS: T
PTS: 1
12. It does not make economic sense for portfolio managers to try to "time" between different investment styles. ANS: F
PTS: 1
13. The three basic techniques for constructing a passive index are: full replication, sampling and linear programming. ANS: F
PTS: 1
14. With dollar-cost averaging a manager purchases fewer shares when stock prices are low and more shares when stock prices are high. ANS: F
PTS: 1
15. Style identification allows an investor to select investment managers that allow his overall portfolio to be properly diversified. ANS: T
PTS: 1
16. Style investing allows control of the total portfolio to be shared between investment managers and pension fund managers. ANS: T
PTS: 1
17. Growth oriented investors focus on the price component of the Price/Earnings ratio. ANS: F
PTS: 1
18. Sharpe's (1991) study reveals that active managers typically outperform passive managers even after transaction costs and fees. ANS: F
PTS: 1
19. There is a direct relationship between a passive portfolio's tracking error relative to its index and the time and expense necessary to create and maintain the portfolio. ANS: F
PTS: 1
20. Exchange-Traded Funds (ETF) are depository receipts that give investors a pro rata claim on the capital gains and cash flows of securities held by financial institutions. ANS: T
PTS: 1
21. Insured asset allocation is a strategy to limit investment losses by shifting funds between an existing equity portfolio and a risk-free security. ANS: T
PTS: 1
22. A portfolio manager who uses tactical asset allocation is attempting to create alpha.
ANS: T
PTS: 1
MULTIPLE CHOICE 1. Which of the following is not a technique for constructing a passive index portfolio? a. Full replication b. Sampling c. Quadratic programming d. Linear programming e. None of the above (that is, all are techniques for constructing a passive index portfolio) ANS: D
PTS: 1
OBJ: Multiple Choice
2. Which of the following statements concerning active equity portfolio management strategies is true? a. The goal of active equity portfolio management is to earn a portfolio return that exceeds the return of a passive benchmark portfolio (net of transaction costs) on a risk-adjusted basis. b. An actively managed equity portfolio has lower total transaction costs. c. An actively managed equity portfolio has lower risk than the passive benchmark. d. A key to success for an actively managed equity portfolio is to maximize trading activity. e. All of the above ANS: A
PTS: 1
OBJ: Multiple Choice
3. In ____ strategy, certain economic sectors or industries are overweighted relative to the benchmark in anticipation of the next phase of the business cycle. a. Sector rotation b. Price momentum c. Earnings momentum d. Return rotation e. None of the above ANS: A
PTS: 1
OBJ: Multiple Choice
4. Which of the following is not considered an active management strategy? a. Sector rotation b. Use of factor models c. Quantitative screens d. Full replication e. Linear programming ANS: D
PTS: 1
OBJ: Multiple Choice
5. Which of the following is not considered a mainstream investment style? a. Value b. Growth c. Market-oriented d. Benchmark e. Small-cap ANS: D
PTS: 1
OBJ: Multiple Choice
6. Which of the following statements about investment style is false? a. Growth stocks generally have smaller capitalizations than value stocks. b. Value stocks have P/E and P/B ratios significantly lower than those of growth stocks.
c. Value stocks dividend yields are much higher than those of growth stocks. d. Growth and levels of earnings is higher in growth stocks. e. Value stocks have a higher risk premium. ANS: A
PTS: 1
OBJ: Multiple Choice
7. Which of the following is considered a strategy for timing the market and adding value to actively managed portfolios? a. Time the markets by shifting between different types of securities based on market forecasts and estimated risk premiums. b. Shift funds between the various equity sectors, industries, investment styles, etc., in order to take advantage of the "hot" concept before the remainder of the market does. c. Individual stockpicking in order to buy low and sell high. d. Choices a and b only e. All of the above ANS: E
PTS: 1
OBJ: Multiple Choice
8. Which of the following statements is false? a. A manager's choice to align with an investment style communicates information to clients about the investor's focus, area of expertise, and stock evaluation methods. b. An investment manager's style cannot be used as a basis for measuring the manager's performance relative to a benchmark. c. Style identification allows an investor to select investment managers that allow his overall portfolio to be properly diversified. d. Style investing allows control of the total portfolio to be shared between the investment managers and a knowledgeable sponsor. e. None of the above (all are true statements) ANS: B
PTS: 1
OBJ: Multiple Choice
9. Which of the following is not considered an asset allocation strategy? a. Integrated asset allocation b. Strategic asset allocation c. Tactical asset allocation d. Insured asset allocation e. None of the above (that is, all are asset allocation strategies) ANS: E
PTS: 1
OBJ: Multiple Choice
10. In ____ asset allocation, the investor's risk tolerance and constraints are assumed to be constant over time. However, changes in capital market conditions result in changes in the portfolio's stock-bond mix. a. Integrated b. Strategic c. Tactical d. Insured e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
11. ____ is a strategy used because the market seems to reward companies that have steady, above average earnings growth, or whose prices are rising because of market optimism. a. Relative strength b. Asset momentum
c. Rotational attribution d. All of the above. e. None of the above. ANS: E
PTS: 1
OBJ: Multiple Choice
12. The asset allocation strategy that separately examines capital market conditions and the investor's objectives and constraints is called a. Integrated asset allocation. b. Tactical asset allocation. c. Sector rotation. d. Strategic asset allocation. e. Insured asset allocation. ANS: A
PTS: 1
OBJ: Multiple Choice
13. In equity portfolio management, tracking error occurs when a. The managed portfolio outperforms the benchmark portfolio. b. The managed portfolio under performs the benchmark portfolio. c. The return volatility of the managed portfolio is positively correlated with the return volatility of the benchmark portfolio. d. The return volatility of the managed portfolio is negatively correlated with the return volatility of the benchmark portfolio. e. The return volatility of the managed portfolio is not correlated with the return volatility of the benchmark portfolio. ANS: E
PTS: 1
OBJ: Multiple Choice
14. The following are ways to implement index portfolio investing a. Buying shares in index mutual funds b. Buying hedge funds. c. Buying exchange traded funds d. a and b. e. a and c. ANS: E
PTS: 1
OBJ: Multiple Choice
15. Exchange traded funds a. Are exactly the same as index mutual funds. b. Can be bought and sold like common stocks. c. Can be sold short. d. a and b. e. b and c. ANS: E
PTS: 1
OBJ: Multiple Choice
16. A portfolio management strategy that overweights a particular industry, relative to the benchmark portfolio, based on the next expected phase of the business cycle is called a. Tactical asset allocation. b. Indexing. c. Sector rotation. d. Contrarian investing. e. Bottom up investing. ANS: C
PTS: 1
OBJ: Multiple Choice
17. The following is an example of a fundamental active equity portfolio management strategy. a. Contrarian investing. b. Earnings momentum investing. c. Low P/E and low P/BV investing. d. Bottom up investing. e. Investing on the basis of calendar effects. ANS: D
PTS: 1
OBJ: Multiple Choice
18. A fundamental tenet of the contrarian investment strategy is the notion that a. All stock returns are mean reverting. b. Certain stocks outperform others during different stages of the business cycle. c. Value stock investing is superior to growth stock investing. d. Growth stock investing is superior to value stock investing. e. None of the above. ANS: A
PTS: 1
OBJ: Multiple Choice
19. Value stocks would have the following characteristics: a. Low price/book, high price/earnings. b. Low price/book, low price/earnings. c. High EPS growth, high profitability. d. Low EPS growth, high profitability. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
20. Growth stocks would have the following characteristics: a. Low price/book, high price/earnings. b. Low price/book, low price/earnings. c. High EPS growth, high profitability. d. Low EPS growth, high profitability. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
21. In returns-based style analysis a coefficient of determination of 95% would suggest that a. The portfolio manager outperformed 95% of his peers. b. The portfolio manager was outperformed by 95% of his peers. c. 95% of the portfolio return variability could be attributed to portfolio style. d. 95% of the portfolio return variability could be attributed to stock selection skills. e. 5% of the portfolio return variability could be attributed to portfolio style. ANS: C
PTS: 1
OBJ: Multiple Choice
22. A Long futures positions in the S&P500 has the effect of ____ portfolio exposure to equities, while short futures positions in the S&P500 has the effect of ____ portfolio exposure to equities. a. Increasing, decreasing. b. Decreasing, increasing, c. Increasing, increasing. d. Decreasing, decreasing. e. None of the above. ANS: A
PTS: 1
OBJ: Multiple Choice
23. A contrarian investment strategy is based on the belief that
a. b. c. d. e.
Stock returns are mean reverting. The best time to buy is when other investors are bullish. Rising stocks will continue to rise. Passive management is preferred to active management. A long/short portfolio will outperform a long only portfolio.
ANS: A
PTS: 1
OBJ: Multiple Choice
24. Which of the following statements regarding 130/30 strategies is false? a. Analyst can make full use of their knowledge of undervalued and overvalued stocks. b. Long positions up to 130% of the value of the portfolio cab be made. c. Short positions up to 30% of the value of the portfolio can be made. d. 130/30 strategies are not very popular due to the increased risk of hedging. e. The use of short positions creates leverage. ANS: D
PTS: 1
OBJ: Multiple Choice
25. Which of the following statements regarding momentum strategies is true? a. Price momentum is a fundamental strategy. b. Earnings momentum is a technical strategy. c. Price momentum and earnings momentum strategies will often result in identical portfolio strategies and holdings. d. The earnings momentum investor will most likely acquire stocks for companies that have positive earnings surprises. e. All of the above statements are true ANS: D
PTS: 1
OBJ: Multiple Choice
26. An investor focusing on a growth strategy does all of the following except a. Focuses on the earnings per share (EPS) component on the P/E ratio. b. Seek out investments with higher expected growth in earnings. c. Implicitly assume that the P/E ratio will grow over the near term. d. Focuses on the current and future economic "story" of a company. e. All of the above statements are true. ANS: C
PTS: 1
OBJ: Multiple Choice
27. A portfolio manager who is trying to generate alpha could use a. Hedge funds b. Mutual funds c. Insured asset allocation d. ETFs e. None of the above ANS: A
PTS: 1
OBJ: Multiple Choice
28. The goal of the passive portfolio manager is to minimize a. Alpha b. Beta c. Standard error d. Tracking error e. Portfolio risk ANS: D
PTS: 1
OBJ: Multiple Choice
29. All of the following are advantages of ETFs over mutual funds except
a. b. c. d. e.
Ability for continuous trading while markets are open Ability to time capital gain tax realizations Smaller management fee Can be bought and sold like common stock Smaller brokerage commission
ANS: E
PTS: 1
OBJ: Multiple Choice
30. If you have a portfolio with a market value of $100 million and a beta (measured against the S&P 500) of 1.5, then if the market rises by 10 percent, what value would you expect your portfolio to have? a. $100 million b. $110 million c. $150 million d. $165 million e. $1.65 billion ANS: D Portfolio value = $100 million 1.5 1.10 = $165 million PTS: 1
OBJ: Multiple Choice Problem
31. If the annual geometric mean for the equity risk premium is 8.4 percent, what percentage of the equity risk premium is consumed by trading costs of 1.2 percent? a. 7.20% b. 9.60% c. 9.70% d. 10.08% e. 14.29% ANS: E Trading costs of 1.2 percent is equal to 14.29% (1.2/8.4) of the equity risk premium. PTS: 1
OBJ: Multiple Choice Problem
32. The table below provides returns on a portfolio along with returns for the corresponding benchmark index for the past eight quarters. The table also provides the difference between portfolio returns and the benchmark index, the average of these differences over the past eight quarters and the standard deviation of these differences. Period 1 2 3 4 5 6 7 8
Portfolio 0.05 −0.036 0.022 0.012 −0.003 −0.023 0.089 −0.008
Index 0.027 −0.046 0.019 0.022 −0.001 −0.03 0.081 0.006
Average SD The annualized tracking error for this period is a. 2.36%
Difference 0.023 0.010 0.003 −0.010 −0.002 0.007 0.008 −0.014 0.003 0.011789
b. c. d. e.
4.08% 2.89% 3.33% 1.18%
ANS: A Annualized Tracking Error = 0.011789 PTS: 1
= 0.0236
OBJ: Multiple Choice Problem
Exhibit 16.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) A portfolio manager is trying to establish a strategic asset allocation for two different clients, Bob Bowman and Tom Luck. Bob Bowman has a risk tolerance factor of 22 and Tom Luck has a risk tolerance factor of 6. The characteristics of the three model portfolios under consideration are provided in the table below.
Portfolio A B C
Asset Mix Stock Bond 0.75 0.25 0.4 0.6 0.3 0.7
Expected Return 0.12 0.08 0.05
Variance 0.45 0.16 0.06
33. Refer to Exhibit 16.1. The expected utilities of Portfolios A, B and C for Bob Bowman are a. Portfolio A = 9.95, Portfolio B = 7.27, Portfolio C = 4.73 b. Portfolio A = 4.5, Portfolio B = 5.33, Portfolio C = 4.0 c. Portfolio A = 7.95, Portfolio B = 5.33, Portfolio C = 4.73 d. Portfolio A = 3.5, Portfolio B = 7.27, Portfolio C = 4.73 e. Portfolio A = 5.33, Portfolio B = 7.27, Portfolio C = 4.73 ANS: A Expected Utilities for Bob Bowman are provided below:
Investor Bowman PTS: 1
A 0.099545
Portfolio B 0.072727
C 0.047273
OBJ: Multiple Choice Problem
34. Refer to Exhibit 16.1. The expected utilities of Portfolios A, B and C for Tom Luck are a. Portfolio A = 9.95, Portfolio B = 7.27, Portfolio C = 4.73 b. Portfolio A = 4.5, Portfolio B = 5.33, Portfolio C = 4.0 c. Portfolio A = 7.95, Portfolio B = 5.33, Portfolio C = 4.73 d. Portfolio A = 3.5, Portfolio B = 7.27, Portfolio C = 4.73 e. Portfolio A = 5.33, Portfolio B = 7.27, Portfolio C = 6.75 ANS: B Expected Utilities for Tom Luck are provided below:
Investor Luck
A 0.045
Portfolio B 0.053333
C 0.04
PTS: 1
OBJ: Multiple Choice Problem
35. Refer to Exhibit 16.1. The recommended portfolio for Bob Bowman is a. Portfolio A because it has expected utility of 9.95 b. Portfolio A because it has expected utility of 4.5 c. Portfolio B because it has expected utility of 5.33 d. Portfolio B because it has expected utility of 7.27 e. Portfolio C because it has expected utility of 6.75 ANS: A The appropriate portfolio for Bob Bowman is portfolio A with expected utility of 9.95. PTS: 1
OBJ: Multiple Choice Problem
36. Refer to Exhibit 16.1. The recommended portfolio for Tom Luck is a. Portfolio A because it has expected utility of 9.95 b. Portfolio A because it has expected utility of 4.5 c. Portfolio B because it has expected utility of 5.33 d. Portfolio B because it has expected utility of 7.27 e. Portfolio C because it has expected utility of 6.75 ANS: C The appropriate portfolio for Tom Luck is portfolio B with expected utility of 5.33. PTS: 1
OBJ: Multiple Choice Problem
37. An active portfolio manager sold $90 million of stocks in a year. If the portfolio had an average value of $110 million in assets under management what is the portfolio turnover ratio? a. 22.2% b. 81.8% c. 90.0% d. 110.0% e. 122.2% ANS: B Portfolio Turnover
PTS: 1
= (Dollar value of securities sold)/(Average dollar value of assets managed) = $90 million/$110 million = 81.8% OBJ: Multiple Choice Problem
38. Fund XYZ had a pretax return of 10.2% and a tax-adjusted return of 9.5%. Calculate Fund XYZ's tax cost ratio. a. 0.006 b. 0.106 c. 0.116 d. 0.342 e. 0.635 ANS: E Tax Cost Ratio = [1 − {(1 + 0.095)/(1 + 0.102)}](100) = [1 − 0.99365](100) = 0.635 PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 17—BOND FUNDAMENTALS TRUE/FALSE 1. Public bonds differ from other debt because they are sold to the public rather than to a single investor. ANS: T
PTS: 1
2. A nonrefunding provision prohibits a call and premature retirement of an issue from the proceeds of a lower-coupon refunding bond. ANS: T
PTS: 1
3. In the case of a bond, the only contractual factor is the amount of interest payments, since beginning and ending bond prices are determined by market forces. ANS: T
PTS: 1
4. In Germany, the government sector is the largest bond market segment. ANS: F
PTS: 1
5. Wealthy individual investors typically account for 90 to 95 percent of investors in the bond market. ANS: F
PTS: 1
6. High-yield bonds are considered "investment" grade. ANS: F
PTS: 1
7. Government bond issues require an annual sinking fund payment of not less than one percent of the outstanding issue. ANS: F
PTS: 1
8. Most U.S. municipal bonds are serial issues which are subject to state and local taxes when they are issued in the investor's home state. ANS: F
PTS: 1
9. The secondary bond market is significantly more active than the stock market. ANS: F
PTS: 1
10. High-yield bonds are considered "investment" grade. ANS: F
PTS: 1
11. A bond's price is determined by the issue's coupon rate, length to maturity, and the prevailing yield in the market. ANS: T
PTS: 1
12. Bonds can have different types of collateral and can be either secured, unsecured or registered bonds. ANS: F
PTS: 1
13. A bond's maturity is affected by: call features, non-refunding provisions, and sinking fund provisions. ANS: T
PTS: 1
14. Treasury Inflation Protected Securities (TIPS) ensures that investors will received the promised yield in real terms by indexing bond principal and interest payments to the stock market. ANS: T
PTS: 1
15. The coupon of a bond indicates the income that the bond investor will receive over the life of the bond. ANS: T
PTS: 1
16. Bonds rated BB or above are considered to be investment grade bonds. ANS: F
PTS: 1
17. As of 2008, approximately 80% of all new municipal bond issues are insured. ANS: F
PTS: 1
18. The yield to maturity is normally equal to the coupon rate. ANS: F
PTS: 1
19. Samurai bonds are yen-denominated bonds sold in markets outside Japan by international syndicates. ANS: F
PTS: 1
MULTIPLE CHOICE 1. The bond market segments that tend to be highly correlated and move together include a. Short and long term bonds. b. Short and intermediate term bonds. c. Intermediate and long term bonds. d. Short, intermediate and long term bonds. e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
2. Of the following provisions that might be found in a bond indenture, which would tend to reduce the coupon interest rate? a. A call provision b. No restrictive covenants c. A sinking fund provision d. Change in bond rating from Aaa to Aa e. None of the above (that is, all will increase the coupon rate) ANS: C
PTS: 1
OBJ: Multiple Choice
3. The refunding provision of an indenture allows bonds to be retired unless a. They are replaced with a lower coupon bond issue. b. The remaining time to maturity is less than five years. c. The remaining time to maturity is greater than five years. d. The stated time period in the indenture has not passed. e. The stated time period in the indenture has passed. ANS: A
PTS: 1
OBJ: Multiple Choice
4. Serial bonds a. Can be callable. b. Can have sinking funds. c. Have different maturity dates. d. All of the above. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
5. Which of the following statements is not true regarding bond ratings? a. The ratings assigned are meant to indicate the probability of default for the bond issuer. b. The bonds assigned one of the top four rating classes are considered investment grade bonds. c. Once a rating is assigned to an issue it cannot be changed for the first two years after which it is reviewed on a regular basis. d. Bonds rated BB and below are referred to as high yield or "junk" bonds. e. The rating agencies modify the ratings with + and − signs or numbers after the letters. ANS: C
PTS: 1
OBJ: Multiple Choice
6. When a fixed income security is being traded but the issuer is not meeting interest payments it is trading a. Stamped. b. Registered. c. Flat. d. Round. e. No accrual. ANS: C
PTS: 1
OBJ: Multiple Choice
7. Which type of bond is backed by the full faith and credit of the issuer and its entire taxing power? a. Fannie Mae b. Freddie Mac c. GSEs d. General obligation e. Revenue ANS: D
PTS: 1
OBJ: Multiple Choice
8. The bonds issued by the Bank of England are known as a. Gilts. b. Bunds. c. Limies. d. Treasuries. e. Benchmarks.
ANS: A
PTS: 1
OBJ: Multiple Choice
9. When a bond issue is secured by a legal claim on equipment it is known as a(n) a. Junior bond. b. Income bond. c. Bearer bond. d. Trust certificate. e. Perpetuity. ANS: D
PTS: 1
OBJ: Multiple Choice
10. Which set of conditions will result in a bond with the greatest volatility? a. A high coupon and a short maturity b. A high coupon and a long maturity c. A low coupon and a short maturity d. A low coupon and a long maturity e. A deferred call feature and a sinking fund. ANS: D
PTS: 1
OBJ: Multiple Choice
11. The annual interest paid on a bond relative to its prevailing market price is called its a. Promised yield. b. Yield to maturity. c. Coupon rate. d. Effective yield. e. Current yield. ANS: E
PTS: 1
OBJ: Multiple Choice
12. The institutions which invest most heavily in corporate bond issues are a. Life insurance companies and commercial banks. b. Life insurance companies and property and liability insurance companies. c. Life insurance companies and pension funds. d. Commercial banks and property and liability insurance companies. e. Commercial banks and pension funds. ANS: C
PTS: 1
OBJ: Multiple Choice
13. Which of the following is not a major rating agency for bonds? a. Moody's b. Standard & Poor's c. Fitch Investor Services d. Value Line e. Duff and Phelps ANS: D
PTS: 1
OBJ: Multiple Choice
14. Treasury bonds which can be purchased at a discount to be used at par to pay estate taxes are called a. Estate bonds. b. Flower bonds. c. Municipal bonds. d. Probate bonds. e. Survivor bonds. ANS: B
PTS: 1
OBJ: Multiple Choice
15. The major owners of high-yield bonds have been a. Commercial banks. b. Savings and loans. c. Mutual funds. d. California Credit Unions (CCU's). e. European banks. ANS: C
PTS: 1
OBJ: Multiple Choice
16. When a fixed income security is being traded at the price above its face value it is trading a. At a discount. b. At par. c. At a premium. d. Flat. e. No accrual. ANS: C
PTS: 1
OBJ: Multiple Choice
17. A security that has a coupon that is periodically adjusted is a(n) a. Variable note. b. Variation note. c. Adjustable coupon note. d. Money market certificate. e. Deep discount bond. ANS: A
PTS: 1
OBJ: Multiple Choice
18. The following are participating issuers in bond markets: a. Governments. b. School districts. c. Corporations d. a and c. e. a, b and c. ANS: E
PTS: 1
OBJ: Multiple Choice
19. The following are participating investors in bond markets: a. U.S. Treasury. b. Life insurance companies. c. Commercial banks. d. a and b. e. b and c. ANS: E
PTS: 1
OBJ: Multiple Choice
20. Institutional investors typically account for about a. 90 to 95 percent of bond market trading. b. 40 to 50 percent of bond market trading. c. 10 to 15 percent of bond market trading. d. Less than 5% of bond market trading. e. None of the above. ANS: A
PTS: 1
OBJ: Multiple Choice
21. Alternative institutions favor different sectors of the bond market based on a. The level of interest rates.
b. c. d. e.
The tax code applicable to the institution. The nature of the institution's asset structure a and b. b and c.
ANS: B
PTS: 1
OBJ: Multiple Choice
22. Bond ratings are positively related to a. Leverage. b. Size. c. Type of business. d. All of the above. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
23. Bond ratings are negatively related to a. Profitability. b. Cash flow coverage. c. Earnings instability. d. All of the above. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
24. TIPS are U.S Treasury securities where the coupon rate is a. Zero b. Indexed to the rate of inflation. c. Indexed to the discount rate. d. Indexed to the prime rate. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
25. If the yield to maturity for a par value TIPS bond with 8 years to maturity is 3%, and the yield to maturity of a U.S Treasury note with 8 years is 4.25%, this implies that a. The expected annual rate of inflation over the next 8 years is −1.25%. b. The expected annual rate of inflation over the next 8 years is 1.25%. c. The expected annual rate of inflation over the next 8 years is −2.25% d. The expected annual rate of inflation over the next 8 years is 2.25% e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
26. The face value of a U.S. government agency security a. Is always $1000. b. Ranges from $1000 to $5000. c. Ranges from $1000 to $100,000. d. Ranges from $1000 to $50,000. e. Is always $10,000. ANS: C
PTS: 1
OBJ: Multiple Choice
27. A major source of risk faced by GNMA issues is a. Default risk. b. Prepayment risk.
c. Counterparty risk. d. a and b. e. a, b and c. ANS: B
PTS: 1
OBJ: Multiple Choice
28. When homeowners pay off mortgages when they sell their homes, or when homeowners refinance home mortgages, they effectively a. Make the maturities of GNMA securities longer. b. Make the maturities of GNMA securities shorter. c. Make the maturities of U.S. Treasury securities longer. d. Make the maturities of U.S. Treasury securities shorter. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
29. General obligation bonds are a. U.S. Treasury bonds backed by the full faith and credit of the issuer. b. U.S. Treasury bonds backed by income generated form specific projects. c. Municipal bonds backed by the full faith and credit of the issuer. d. Municipal bonds backed by income generated from specific projects. e. A type of U.S. agency security. ANS: C
PTS: 1
OBJ: Multiple Choice
30. Revenue bonds are a. U.S. Treasury bonds backed by the full faith and credit of the issuer. b. U.S. Treasury bonds backed by income generated form specific projects. c. Municipal bonds backed by the full faith and credit of the issuer. d. Municipal bonds backed by income generated from specific projects. e. A type of U.S. agency security. ANS: D
PTS: 1
OBJ: Multiple Choice
31. Collateralized Mortgage obligations are a. Mortgage pass-through securities. b. Mortgage pass-through securities with varying maturities. c. Mortgage pass-through securities with no default risk. d. Mortgage pass-through securities with variable coupon rates. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
32. A bond denominated in U.S. dollars and sold in Japan to Japanese investors is called a a. Samurai bond. b. Eurobond. c. Yankee bond. d. Euroyen bond e. Foreign bond. ANS: B
PTS: 1
OBJ: Multiple Choice
33. The legal document setting forth the obligations of a bond's issuer is called a. A debenture. b. A warrant. c. An indenture.
d. A rights certificate. e. A trustee deed. ANS: C
PTS: 1
OBJ: Multiple Choice
34. Collateralized mortgage obligations (CMOs) offset some of the problems associated with traditional mortgage pass-throughs because a. They are overcollateralized. b. They have variable rates. c. Collateralized by auto-loans. d. They are deep discount instruments. e. Collateralized by credit card debt. ANS: A
PTS: 1
OBJ: Multiple Choice
35. A bond that only pays a principal payment at maturity date is known as a(n): a. Blank bond. b. Maturity bond. c. Interest free bond. d. Mini-coupon bond. e. Zero coupon bond. ANS: E
PTS: 1
OBJ: Multiple Choice
36. What was developed in the early 1980s to offset some of the problems with traditional mortgage pass-throughs? a. Variable rate mortgages. b. Collateralized mortgage obligations (CMOs) c. Leveraged buyouts (LBOs) d. Deep discount bonds (DDBs) e. High yield bonds. ANS: B
PTS: 1
OBJ: Multiple Choice
37. Which of the following statements regarding Collateralized Debt Obligations (CDOs) is false? a. CDOs experienced rapid growth since the year 2000. b. The assets used to back the CDOs are substantially diverse. c. The credit quality within a CDO at the time of issue is diverse. d. CDOs have generated significant credit and liquidity problems. e. All of the above statements are true. ANS: E
PTS: 1
OBJ: Multiple Choice
38. A U.S. dollar-denominated bond sold in the United States by a Japanese-firm is called a(n): a. Yankee bond. b. Homeland bond. c. International bond. d. U.S. Domestic bond. e. Japanese U.S. Regional bond. ANS: A
PTS: 1
OBJ: Multiple Choice
39. Which of the following entities acquire mortgages and create mortgage backed securities? a. Federal National Mortgage Association (Fannie Mae) b. Government National Mortgage Association (Ginnie Mae) c. Federal Home Loan Mortgage Corporation (Freddie Mac)
d. All of the above. e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
40. When a borrower pledges financial assets as collateral for a bond it is called a(n) a. Mortgage bond. b. Equipment trust certificate. c. Mortgage pass-through security. d. Collateral trust bond. e. Collateralized mortgage obligation (CMO). ANS: D
PTS: 1
OBJ: Multiple Choice
41. Issues that provide funds to retire another issue early are known as a. Bearer bonds b. Secured debentures c. Unsecured debentures d. Revenue bonds e. Refunding bonds ANS: E
PTS: 1
OBJ: Multiple Choice
42. Which bond provision would be considered the most risky for an investor who is concerned that market interest rates will drop dramatically over the life of the bond? a. Sinking fund b. Deferred call c. Freely callable d. Non-callable e. None of the above ANS: C
PTS: 1
OBJ: Multiple Choice
43. Which type of bond market is the largest sector in both Japan and the United States? a. Corporate b. High Yield/Emerging Market c. Securitized/Collaterallized d. Sovereign e. Quasi & Foreign Governments ANS: D
PTS: 1
OBJ: Multiple Choice
44. A 4.75 percent coupon bond issued by the State of Washington sells for $1,000. What coupon rate on a corporate bond selling at $1,000 par value would produce the same after tax return to the investor as the municipal bond if the investor is in the 28 percent marginal tax bracket? a. 1.1% b. 5.8% c. 6.6% d. 7.3% e. 9.7% ANS: C 4.75 (1.0 − 0.28) = 6.597% PTS: 1
OBJ: Multiple Choice Problem
45. A 6.5 percent coupon bond issued by the State of California sells for $1,000. What coupon rate on a corporate bond selling at $1,000 par value would produce the same after tax return to the investor as the municipal bond if the investor is in the 26 percent marginal tax bracket? a. 1.69% b. 11.25% c. 8.78% d. 14.63% e. 25% ANS: C 6.5 (1.0 − 0.26) = 8.78% PTS: 1
OBJ: Multiple Choice Problem
46. An 8.5 percent coupon bond issued by the State of Ohio sells for $1,000. What coupon rate on a corporate bond selling at $1,000 par value would produce the same after tax return to the investor as the municipal bond if the investor is in the 25 percent marginal tax bracket? a. 2.13% b. 12.25% c. 11.33% d. 13.53% e. 34.71% ANS: C 8.5 (1.0 − 0.25) = 11.33% PTS: 1
OBJ: Multiple Choice Problem
47. A 7.0 percent coupon bond issued by the State of Tennessee sells for $1,000. What coupon rate on a corporate bond selling at $1,000 par value would produce the same after tax return to the investor as the municipal bond if the investor is in the 29 percent marginal tax bracket? a. 7.59% b. 12.25% c. 9.86% d. 14.63% e. 30.71% ANS: C 7 (1.0 − 0.29) = 9.86% PTS: 1
OBJ: Multiple Choice Problem
48. At what point would an investor be indifferent between a Drifton corporate bond yielding 12.5 percent and a tax-free municipal bond of equal financial strength if the investor's marginal tax rate is 25 percent? a. 6.05% b. 7.10% c. 8.15% d. 9.38% e. 16.27% ANS: D (12.5)(1.0 − 0.25) = 9.38% PTS: 1
OBJ: Multiple Choice Problem
49. At what point would an investor be indifferent between a Compco corporate bond yielding 8.5 percent and a tax-free municipal bond of equal financial strength if the investor's marginal tax rate is 25 percent? a. 6.05% b. 7.10% c. 8.15% d. 6.38% e. 2.34% ANS: D (8.5)(1.0 − 0.25) = 6.38% PTS: 1
OBJ: Multiple Choice Problem
50. At what point would an investor be indifferent between a Trifton corporate bond yielding 12.0 percent and a tax-free municipal bond of equal financial strength if the investor's marginal tax rate is 25 percent? a. 6.00% b. 7.10% c. 9.00% d. 9.15% e. 14.00% ANS: C (12)(1.0 − 0.25) = 9% PTS: 1
OBJ: Multiple Choice Problem
51. At what point would an investor be indifferent between a Bridgford corporate bond yielding 8.0 percent and a tax-free municipal bond of equal financial strength if the investor's marginal tax rate is 25 percent? a. 5.00% b. 7.10% c. 8.00% d. 9.15% e. 6.00% ANS: E (8)(1.0 − 0.25) = 6% PTS: 1
OBJ: Multiple Choice Problem
52. You purchase a 10 3/8s February $10,000 par Treasury Note at 103:11 and hold it for exactly one year at which time you sell it. What is your rate of return if your selling price is 101:13? a. 8.14% b. 8.16% c. 8.22% d. 8.32% e. 8.47% ANS: B Purchase Price = [(103 + 11/32) 100] 10,000 = $10,334.375 Selling Price = [(101 + 13/32) 100] 10,000 = $10,140.625
Interest = 10 3/8% of 10,000 = $1,037.50 Return
= (Pend − Pbeg + Interest) Pbeg = (10,140.625 − 10,334.375 + 1,037.50) 10,334.375 = 8.16%
PTS: 1
OBJ: Multiple Choice Problem
53. You purchase a 9 3/4s February $10,000 par Treasury Note at 101:11 and hold it for exactly one year at which time you sell it. What is your rate of return if your selling price is 101:17? a. 8.14% b. 8.75% c. 9.75% d. 9.81% e. 10.47% ANS: D Purchase Price = [(101 + 11/32) 100] 10,000 = $10,134.375 Selling Price = [(101 + 17/32) 100] 10,000 = $10,153.125 Interest = 9 3/4% of 10,000 = $975.00 Return
= (Pend − Pbeg + Interest) Pbeg = (10,153.125 − 10,134.375 + 975.00) 10,134.375 = 9.81%
PTS: 1
OBJ: Multiple Choice Problem
54. You purchase a 8 1/2s February $10,000 par Treasury Note at 105:16 and hold it for exactly one year at which time you sell it. What is your rate of return if your selling price is 105:16? a. 8.00% b. 8.06% c. 8.22% d. 8.50% e. 8.47% ANS: B Purchase Price = [(105 + 16/32) 100] 10,000 = $10,550.00 Selling Price = [(105 + 16/32) 100] 10,000 = $10,550.00 Interest = 8 1/2% of 10,000 = $850.00 Return
PTS: 1
= (Pend − Pbeg + Interest) Pbeg = (10,550.00 − 10,550.00 + 850.00) 10,550.00 = 8.06% OBJ: Multiple Choice Problem
55. You purchase a 11 3/8s February $10,000 par Treasury Note at 103:11 and hold it for exactly one year at which time you sell it. What is your rate of return if your selling price is 100:13?
a. b. c. d. e.
10.14% 11.75% 8.22% 8.32% 8.16%
ANS: E Purchase Price = [(103 + 11/32) 100] 10,000 = $10,334.375 Selling Price = [(100 + 13/32) 100] 10,000 = $10,040.625 Interest = 11 3/8% of 10,000 = $1,137.50 Return
= (Pend − Pbeg + Interest) Pbeg = (10,040.625 − 10,334.375 + 1,137.50) 10,334.375 = 8.16%
PTS: 1
OBJ: Multiple Choice Problem
56. You purchase a 10 1/4s February $10,000 par Treasury Note at 102:15 and hold it for exactly one year at which time you sell it. What is your rate of return if your selling price is 104:14? a. 11.92% b. 8.16% c. 8.55% d. 8.61% e. 10.25% ANS: A Purchase Price = [(102 + 15/32) 100] 10,000 = $10,246.875 Selling Price = [(104 + 14/32) 100] 10,000 = $10,443.75 Interest = 10 1/4% of 10,000 = $1,025.00 Return
= (Pend − Pbeg + Interest) Pbeg = (10,443.75 − 10,246.875 + 1,025.00) 10,246.875 = 11.92%
PTS: 1
OBJ: Multiple Choice Problem
Exhibit 17.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Company Gen Elec
Ticker GE
Coupon 4.75
Maturity 9/15/2019
Last Price 99.544
Last Yield 4.808
EST Spread 62
UST 10
57. Refer to Exhibit 17.1. What annual dollar coupon amount will investors receive? a. $4.75 b. $47.50 c. $4.808 d. $48.08 e. $62
Est $ Vol (000's) 158736
ANS: B Annual dollar coupon amount = (1000)(0.0475) = $47.50. PTS: 1
OBJ: Multiple Choice Problem
58. Refer to Exhibit 17.1. What price would you pay in dollars to purchase this bond? a. $62 b. $9.954 c. $48.08 d. $99.544 e. $995.44 ANS: E Price = $995.44. Or 99.544% of face value of $1000. PTS: 1
OBJ: Multiple Choice Problem
59. Refer to Exhibit 17.1. What is the estimated yield on Treasury securities? a. 4.188% b. 5.428% c. 5.371% d. 4.132% e. 4.753% ANS: A Estimated yield on 10 year Treasury = 4.808% − 0.62% = 4.188%. PTS: 1
OBJ: Multiple Choice Problem
60. Refer to Exhibit 17.1. What is the current yield for this bond? a. 4.18% b. 5.88% c. 4.77% d. 8.125% e. 4.063% ANS: C Current yield = 47.50/995.44 = 0.0477 or 4.77%. PTS: 1
OBJ: Multiple Choice Problem
61. Refer to Exhibit 17.1. What is the capital gains/loss yield on this bond? a. −0.038% b. 0.456% c. 0.038% d. −0.456% e. None of the above ANS: C Capital gains yield = 4.808% − 4.77% = 0.038% PTS: 1
OBJ: Multiple Choice Problem
62. How much would you expect to pay for a $10,000 Treasury note quoted at 96:27? a. $9,627.00
b. c. d. e.
$10,000.00 $968.44 $9,684.38 None of the above
ANS: D [(96 + 27/32) 100] 10,000 = $9,684.38 PTS: 1
OBJ: Multiple Choice Problem
63. How much would you expect to pay for a $10,000 stripped Treasury bond quoted at 101:16? a. $10,150.00 b. $10,000.00 c. $101.16 d. $10,160.00 e. None of the above ANS: A [(101 + 16/32) 100] 10,000 = $10,150.00 PTS: 1
OBJ: Multiple Choice Problem
64. For bonds A and B below find the values of X and Y assuming each is a zero coupon bond with a $1,000 face value (semiannual compounding).
Bond A B a. b. c. d. e.
Maturity (Years) X 9
Yield (Percent) 10 Y
Price ($$) 458.10 212.00
8 years and 4 percent 10 years and 8 percent 12 years and 10 percent 14 years and 12 percent 8 years and 18 percent
ANS: E Bond A $458.10 = 1,000 (Present Value Factor at 5% and 2t periods) 0.4581 = Present Value Factor The value 0.4581 for 5% is found at 16 periods Then 2t = 16, and t = 8 years Bond B $212.00 = $1,000 (Present Value Factor at i/2 and 18 periods) 0.2120 = Present Value Factor The value 0.2120 for 18 periods is found at 9%
Then i/2 = 9%, and i = 18% PTS: 1
OBJ: Multiple Choice Problem
65. Calculate the yield to maturity of a zero coupon bond with a face value of $1000, maturing in 10 years and selling for a price of $529.30. a. 6.57% b. 8.45% c. 4.16% d. 10.23% e. 12.17% ANS: A Solve for i 1000 = 529.3(1 + i)10 i = (1000/529.3) 1/10 −1 = .0657 PTS: 1
OBJ: Multiple Choice Problem
66. Calculate the yield to maturity of a zero coupon bond with a face value of $1000, maturing in 15 years and selling for a price of $525.75. a. 5.62% b. 4.38% c. 8.74% d. 15.26% e. 16.27% ANS: B Solve for i 1000 = 525.75(1 + i)15 i = (1000/525.75) 1/15 −1 = .0438 PTS: 1
OBJ: Multiple Choice Problem
67. Calculate the price of a zero coupon bond with yield to maturity of 8.75%, a face value of $1000, and maturing in 5 years. a. $1000 b. $756.43 c. $675.44 d. $435.12 e. $875.14 ANS: C Solve for P P = 1000/(1 + .0875)5 P = $657.44 PTS: 1
OBJ: Multiple Choice Problem
68. What is the value of a zero coupon bond with a yield to maturity of 9%, a par value of $1,000, and 10 years to maturity? (Assume semi-annual compounding) a. $208.29 b. $414.64 c. $422.41 d. $643.93 e. $910.00 ANS: B
PTS: 1
OBJ: Multiple Choice Problem
Exhibit 17.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) XLR Corporation just issued a $1,000 par value bond with a 7% yield to maturity, twenty years to maturity, with an 8% semi-annual coupon rate. 69. Refer to Exhibit 17.2. What is the price of the XLR Corporate bond? a. $901.04 b. $932.04 c. $1,102.62 d. $1,105.94 e. $1,106.78 ANS: E
PTS: 1
OBJ: Multiple Choice Problem
70. Refer to Exhibit 17.2. If market interest rates are constant, what will the price of the XLR Corporate bond be in three years? a. $904.29 b. $1,097.63 c. $1,098.50 d. $1,102.85 e. $1,105.62 ANS: C
PTS: 1
OBJ: Multiple Choice Problem
71. Refer to Exhibit 17.2. If market interest rates rise to 10%, what will the price of the XLR Corporate bond be in three years? a. $832.89 b. $838.07 c. $1097.63 d. $1,102.85 e. $1,191.43 ANS: B
PTS: 1
OBJ: Multiple Choice Problem
72. A 9.0 percent coupon bond issued by the State of Iowa sells for $1,000. What coupon rate on a corporate bond selling at $1,000 par value would produce the same after tax return to the investor as the municipal bond if the investor is in the 30 percent marginal tax bracket? a. 6.30% b. 6.92% c. 11.70% d. 12.86% e. 15.25% ANS: D 9 (1.0 − 0.3) = 12.86% PTS: 1
OBJ: Multiple Choice Problem
73. At what point would an investor be indifferent between a GM corporate bond yielding 9.5 percent and a tax-free municipal bond of equal financial strength if the investor's marginal tax rate is 25 percent? a. 7.13% b. 7.60% c. 11.87% d. 12.67% e. 14.27% ANS: A (9.5)(1.0 − 0.25) = 7.13% PTS: 1
OBJ: Multiple Choice Problem
74. Calculate the yield to maturity of a zero coupon bond with a face value of $1000, maturing in 10 years and selling for a price of $628.72. a. 4.18% b. 4.75% c. 6.29% d. 8.23% e. 9.54% ANS: B Solve for i
1000 = 628.72(1 + i)10 i = (1000/628.72) 1/10 −1 = .0475 PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 18—THE ANALYSIS AND VALUATION OF BONDS TRUE/FALSE 1. For a bond the present value model incorporates both the coupon receipts and the capital gain or loss. ANS: T
PTS: 1
2. The major problem facing a bond analyst is the ability to forecast the basic interest rate level since yield spreads are generally inconsequential. ANS: F
PTS: 1
3. Yield to maturity and current yield are equal when the bond is selling for exactly par value. ANS: T
PTS: 1
4. An interest rate is the price of loanable funds. ANS: T
PTS: 1
5. The internal rate of return is that discount rate that sets the present value of cash flows from an investment equal to its par value. ANS: F
PTS: 1
6. If an investor buys a high coupon bond, and rates then fall, the investor has "locked up" that high yield as a realized yield. ANS: F
PTS: 1
7. The three major theories explaining the term structure of interest rates are the expectations hypothesis, the liquidity differential hypothesis, and the segmented quality hypothesis. ANS: F
PTS: 1
8. The expectations hypothesis is also known as both the institutional theory and the hedging pressure theory. ANS: F
PTS: 1
9. Bond price volatility varies directly with the term to maturity and directly with the coupon. ANS: F
PTS: 1
10. The longer the time to maturity, the greater the percentage change in a bond's price. ANS: T
PTS: 1
11. There is an inverse relationship between duration and coupon. ANS: T
PTS: 1
12. The lower a bond's yield to maturity, the greater its duration. ANS: T
PTS: 1
13. The fundamental determinants of interest rates are the real risk free rate, inflation, and the risk premium. ANS: T
PTS: 1
14. Because you expect market interest rates to decline during the next four months, if you were offered two bonds with equal duration, you would select the one with the higher measure of convexity. ANS: T
PTS: 1
15. According to the expectations hypothesis, a rising yield curve indicates that investors' demand for long maturity bonds is expected to rise. ANS: F
PTS: 1
16. According to the segmented market hypothesis, yields for a particular maturity segment depend on supply and demand within the maturity segment. ANS: T
PTS: 1
17. For a given change in yield bond price volatility is inversely related to term to maturity. ANS: F
PTS: 1
18. For a given change in yield bond price volatility is inversely related to coupon. ANS: T
PTS: 1
19. For a given change in yield bond price volatility is directly related to duration. ANS: T
PTS: 1
20. Convexity is a measure of how much a bond's price-yield curve deviates from the linear approximation of that curve. ANS: T
PTS: 1
21. The price-yield curve is a concave curve representing the relationship of bond prices and yields. ANS: F
PTS: 1
22. The realized yield measures the expected rate of return of a bond that you expect to sell prior to its maturity. ANS: T
PTS: 1
23. The term structure of interest rates is a dynamic function that relates the term to maturity to the yield to maturity of bonds.
ANS: F
PTS: 1
24. Modified duration is determined by making small adjustments to Macaulay duration. ANS: T
PTS: 1
25. There is a direct relationship between coupon and price. ANS: T
PTS: 1
MULTIPLE CHOICE 1. The annual interest paid on a bond relative to its prevailing market price is called its ____. a. Promised yield b. Yield to maturity c. Coupon rate d. Effective yield e. Current yield ANS: E
PTS: 1
OBJ: Multiple Choice
2. If the holding period is equal to the term to maturity for a corporate bond the rate of discount represents the a. Coupon yield. b. Effective yield. c. Yield to call. d. Yield to maturity. e. Reinvestment rate. ANS: D
PTS: 1
OBJ: Multiple Choice
3. The nominal yield of a bond is the a. Annual coupon as a percent of the current price. b. Annual rate earned including the capital gain or loss. c. Rate earned giving consideration to coupon reinvestment. d. Coupon rate. e. Promised yield to maturity. ANS: D
PTS: 1
OBJ: Multiple Choice
4. If the coupon payments are not reinvested during the life of the issue then the a. Promised yield is greater than the realized yield. b. Promised yield is less than the realized yield. c. Nominal yield declines. d. Nominal yield is greater than the promised yield. e. Current yield equals the yield to maturity. ANS: A
PTS: 1
OBJ: Multiple Choice
5. The importance of the reinvestment assumption increases with a ____ coupon and a ____ term to maturity. a. Low, short b. Low, long c. High, short
d. High, long e. Zero, very long ANS: D
PTS: 1
OBJ: Multiple Choice
6. The best way for an investor to "lock in" to high interest rates would be to purchase a bond that has a ____ coupon and a ____ term to maturity. a. Low, short b. Low, long c. High, short d. High, long e. Zero, very long ANS: E
PTS: 1
OBJ: Multiple Choice
7. The term structure of interest rates is a static function that relates the a. Term to call and the yield to maturity. b. Term to maturity and the yield to maturity. c. Term to call and the yield to call. d. Term to maturity and the coupon rate. e. Term to maturity and the current yield. ANS: B
PTS: 1
OBJ: Multiple Choice
8. The yield to call is a more conservative yield measure whenever the price of a callable bond is quoted at a value a. Equal to or greater than par plus one year's interest. b. Equal to par. c. Equal to par less one year's interest. d. Less than par. e. Five percent over par. ANS: A
PTS: 1
OBJ: Multiple Choice
9. Which of the following is not a major risk premium component for bond investors? a. Quality differentials. b. Term to maturity. c. Indenture provisions. d. Yield to maturity. e. Exchange rate risk differences. ANS: D
PTS: 1
OBJ: Multiple Choice
10. There are four major factors accounting for the existence of yield differentials. Which of the following is not a factor? a. Segments b. Sectors c. Indentures d. Coupons e. Maturities ANS: C
PTS: 1
OBJ: Multiple Choice
11. The convexity of a bond is affected as follows: a. Positively with maturity. b. Positively with yield.
c. Inversely with coupon. d. Choices a and b e. Choices a and c ANS: E
PTS: 1
OBJ: Multiple Choice
12. Which of the following statements is true? a. An inverse relationship exists between coupon and convexity. b. A direct relationship exists between maturity and convexity. c. An inverse relationship exists between yield and convexity. d. Choices a and c only e. All of the above statements are true ANS: E
PTS: 1
OBJ: Multiple Choice
13. If you expected interest rates to fall, you would prefer to own bonds with a. long durations and high convexity. b. long durations and low convexity. c. short durations and high convexity. d. short durations and low convexity. e. none of the above. ANS: A
PTS: 1
OBJ: Multiple Choice
14. If you expected interest rates to fall, you would prefer to own bonds with a. short maturities and low coupons. b. long maturities and high coupons . c. long maturities and low coupons. d. short maturities and high coupons. e. none of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
15. If you expected interest rates to rise, you would prefer to own bonds with a. short maturities and low coupons. b. long maturities and high coupons . c. long maturities and low coupons. d. short maturities and high coupons. e. none of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
16. According to the liquidity preference hypothesis yield curves generally slope upward because a. investors prefer short maturity obligations to long maturity obligations. b. investors prefer long maturity obligations to short maturity obligations. c. investors prefer less volatile long maturity obligations. d. investors prefer more volatile short maturity obligations. e. none of the above. ANS: A
PTS: 1
OBJ: Multiple Choice
17. According to the segmented-market hypothesis a downward sloping yield curve indicates that a. demand for long term bonds has fallen and demand for short term bonds has fallen. b. demand for long term bonds has risen and demand for short term bonds has fallen. c. demand for long term bonds has fallen and demand for short term bonds has risen. d. demand for long term bonds has risen and demand for short term bonds has risen.
e. none of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
18. According to the segmented-market hypothesis a rising yield curve indicates that a. demand for long term bonds has fallen and demand for short term bonds has fallen. b. demand for long term bonds has risen and demand for short term bonds has fallen. c. demand for long term bonds has fallen and demand for short term bonds has risen. d. demand for long term bonds has risen and demand for short term bonds has risen. e. none of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
19. According to the expectations hypothesis a rising yield curve indicates that investors expect a. future short term rates to fall b. future short term rates to rise c. future long term rates to rise d. future long term rates to fall e. none of the above ANS: B
PTS: 1
OBJ: Multiple Choice
20. The price-yield relationship for a bond will become more convex a. For a low coupon bond. b. For a high coupon bond. c. For a long maturity bond. d. b and c. e. a and c. ANS: E
PTS: 1
OBJ: Multiple Choice
21. Convexity is a desirable feature of bonds because. a. As interest rates decline, the price of a low convexity bond decreases at a decreasing rate. b. As interest rates decline, the price of a high convexity bond decreases at an increasing rate. c. As interest rates decline, the price of a low convexity bond increases at a decreasing rate. d. As interest rates decline, the price of a high convexity bond increases at an increasing rate. e. As interest rates decline, the price of a high convexity bond decreases at a decreasing rate. ANS: D
PTS: 1
OBJ: Multiple Choice
22. The position of a bondholder that is long a callable bond is equal to being a. Long a noncallable bond + long a call option on the bond. b. Long a noncallable bond + short a call option on the bond. c. Short a noncallable bond + long a call option on the bond. d. Short a noncallable bond + short a call option on the bond. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
23. Option adjusted duration can be calculated as a. Duration of noncallable bond − duration of call option on the bond. b. Duration of noncallable bond + duration of call option on the bond. c. Duration of callable bond − duration of call option on the bond. d. Duration of callable bond + duration of call option on the bond. e. None of the above.
ANS: A
PTS: 1
OBJ: Multiple Choice
24. The option adjusted duration will approach the duration to maturity, when a. Interest rates are significantly above the coupon rate because the option has very little chance of being called, and the call option will have very little value. b. Interest rates are significantly below the coupon rate because the option has very little chance of being called, and the call option will have very little value. c. Interest rates are significantly above the coupon rate because the option has a high chance of being called, and the call option will have significant value. d. Interest rates are significantly below the coupon rate because the option has a high chance of being called, and the call option will have significant value. e. None of the above. ANS: A
PTS: 1
OBJ: Multiple Choice
25. The promised yield to maturity calculation assumes that a. All coupon interest payments are reinvested at the current market interest rate for the bond. b. All coupon interest payments are reinvested at the coupon interest rate for the bond. c. All coupon interest payments are reinvested at short term money market interest rates. d. All coupon interest payments are not reinvested. e. None of the above ANS: A
PTS: 1
OBJ: Multiple Choice
26. If the coupon payments are not reinvested during the life of the issue then the a. Promised yield is greater than realized yield. b. Promised yield is less than realized yield. c. Nominal yield declines. d. Nominal yield is greater than promised yield. e. Current yield equals the yield to maturity. ANS: A
PTS: 1
OBJ: Multiple Choice
27. Consider a bond portfolio manager who expects interest rates to decline and has to choose between the following two bonds. Bond A: 10 years to maturity, 5% coupon, 5% yield to maturity Bond B: 10 years to maturity, 3% coupon, 4% yield to maturity a. b. c. d. e.
Bond A because it has a higher coupon rate. Bond A because it has a higher yield to maturity. Bond B because it has a lower coupon rate. Bond A or Bond B because the maturities are the same. None of the above.
ANS: C
PTS: 1
OBJ: Multiple Choice
28. ____ measures the expected rate of return of a bond assuming that you sell it prior to its maturity. a. Yield to maturity b. Current yield c. Realized yield d. Coupon rate e. None of the above
ANS: C
PTS: 1
OBJ: Multiple Choice
29. The yield to call is a more conservative yield measure whenever the price of a callable bond is quoted at a value a. Equal to or greater than par plus one year's interest. b. Equal to par. c. Equal to par less one year's interest. d. Less than par. e. Five percent over par. ANS: A
PTS: 1
OBJ: Multiple Choice
30. Which of the following is not a risk premium component of bonds? a. Bond quality b. Term to maturity of the bond c. Indenture provisions d. Foreign bond risk e. All of the above are risk premium components of bonds. ANS: E
PTS: 1
OBJ: Multiple Choice
31. Which term-structure hypothesis suggests that any long-term interest rate simply represents the geometric mean of current and future on-year interest rates expected to prevail over the maturity of the issue? a. Expectations hypothesis b. Liquidity preference hypothesis c. Segmented market hypothesis d. Preferred habitat hypothesis e. Hedging pressure hypothesis ANS: A
PTS: 1
OBJ: Multiple Choice
32. Which of the four major yield spreads defines the difference in yields between pure government agency bonds and corporate bonds? a. Segments b. Sectors c. Coupons d. Seasoning e. Maturity ANS: A
PTS: 1
OBJ: Multiple Choice
33. All of the following are one of Malkiel's stated relationships between yield changes and bond prices except a. Bond prices move inversely to bond yields. b. Longer-maturity bonds experience larger price changes than shorter-maturity bonds. c. Bond price volatility increases at a diminishing rate as term to maturity increases. d. Bond price movements resulting from equal absolute increases or decreases in yield are symmetrical. e. Bond price volatility is inversely related to the coupon rate. ANS: D
PTS: 1
OBJ: Multiple Choice
34. Which duration is computed by discounting flows using the yield to maturity of the bond? a. Effective
b. c. d. e.
Macaulay Duration Modified Duration Present Value Duration Cash Flow Duration
ANS: B
PTS: 1
OBJ: Multiple Choice
35. A graph of a bond's Price-Yield curve reveals all of the following except a. Price moves inverse to yield b. The bond sells at a premium when the yield is below the coupon rate c. The bond sells at a discount when the yield is above the coupon rate d. The Price-Yield curve in concave e. All of the above are characteristics of the Price-Yield curve ANS: D
PTS: 1
OBJ: Multiple Choice
36. Reinvestment risk is greatest for bonds that have a. Short maturities and low coupon rates b. Long maturities and high coupon rates c. Short maturities and high coupon rates d. Long maturities and low coupon rates e. None of the above ANS: B
PTS: 1
OBJ: Multiple Choice
37. Estimating forward rates from the spot rate curve is based on the assumption that the ____ hypothesis accurately describes the shape of the yield curve. a. Expectations b. Liquidity preference c. Segmented market d. Efficient market e. None of the above ANS: A
PTS: 1
OBJ: Multiple Choice
38. When there are no embedded options, ____ duration can be used to provide an approximation of the interest rate sensitivity of the bond. a. Macaulay b. Modified c. Effective d. Empirical e. None of the above ANS: B
PTS: 1
OBJ: Multiple Choice
39. Consider a 12%, 15 year bond that pays interest semiannually, and its current price is $675. What is the promised yield to maturity? a. 10.23% b. 18.45% c. 17.77% d. 2.31% e. 9.26% ANS: B
i = .09227. Annualized i = .09227 2 = .1845 PTS: 1
OBJ: Multiple Choice Problem
40. Consider a 15%, 20 year bond that pays interest annually, and its current price is $850. What is the promised yield to maturity? a. 10.23% b. 18.45% c. 2.31% d. 17.77% e. 9.26% ANS: D
i = .1777. Annualized i = .1777 1 = .1777 PTS: 1
OBJ: Multiple Choice Problem
41. Consider a 10%, 15 year bond that pays interest annually quarterly, and its current price is $1060. What is the promised yield to maturity? a. 10.23% b. 18.45% c. 2.31% d. 17.77% e. 9.26% ANS: E
i = .02314. Annualized i = .02134 4 = .0926 PTS: 1
OBJ: Multiple Choice Problem
42. Consider a zero coupon bond that has a current price of $436.19 and matures in 10 years. What is its yield to maturity? a. 0.86% b. 8.65% c. 8.00% d. 58.80% e. 6.564%
ANS: B Price = Par/(1 + YTM)n YTM = (Price/Par)1/n − 1 YTM = (1000/436.19)1/10 − 1 = 8.65% PTS: 1
OBJ: Multiple Choice Problem
43. What is the current price of a zero coupon bond with a 6% yield to maturity that matures in 15 years? a. $4.17 b. $41.27 c. $417.27 d. $4,172.00 e. None of the above ANS: C Price = Par/(1 + YTM)n = 1000/(1.06)15 = $417.27 PTS: 1
OBJ: Multiple Choice Problem
44. What is the current price of a zero coupon bond with a 7% yield to maturity that matures in 20 years? a. $1,000 b. $2,582 c. $25.82 d. $258.42 e. $100.00 ANS: D Price = Par/(1 + YTM)n = 1000/(1.07)20 = $258.42 PTS: 1
OBJ: Multiple Choice Problem
45. Consider a bond with a 9% coupon and a current yield of 8 1/2%. What is this bond's price? a. $1058.82 b. $1009.00 c. $1085.00 d. $1062.44 e. $1077.96 ANS: A 90 x = 0.085. x = $1,058.82 PTS: 1
OBJ: Multiple Choice Problem
46. Consider a bond with a current yield of 8% and a price of $1,250. What is this bond's coupon? a. 8.0% b. 10.0% c. 11.0% d. 8.5% e. 9.6% ANS: B Coupon $1,250 = 0.08. Therefore, coupon = $100.00 or 10% PTS: 1
OBJ: Multiple Choice Problem
47. Consider a bond with a price of $944.44 and a coupon of 8 1/2%. What is the current yield? a. 9.4% b. 6.8% c. 8.6% d. 9.0% e. 11.0% ANS: D 85 $944.44 = 9% PTS: 1
OBJ: Multiple Choice Problem
48. Suppose you have a 12%, 20 year bond traded at $850. If it is callable in 5 years at $1,100, what is the bond's yield to call? Interest is paid semiannually. a. 8% b. 9.0% c. 18.0% d. 9.4% e. 16.5% ANS: C
i = .09. Annualized i = .09 2 = .18. PTS: 1
OBJ: Multiple Choice Problem
49. Suppose you have a 15%, 25 year bond traded at $975. If it is callable in 5 years at $1050, what is the bond's yield to call? Interest is paid annually. a. 15% b. 16.5% c. 7.65% d. 8.52% e. 9.64% ANS: B
i = .165. PTS: 1
OBJ: Multiple Choice Problem
50. Suppose you have a 10%, 20 year bond traded at $1,120. If it is callable in 5 years at $1,150, what is the bond's approximate yield to call? Interest is paid quarterly. a. 7.78% b. 8.00% c. 9.40%
d. 9.36% e. 9.72% ANS: C
i = .0234. Annualized i = .0234 4 = .094 PTS: 1
OBJ: Multiple Choice Problem
51. Calculate the duration of a 6 percent, $1,000 par bond maturing in three years if the yield to maturity is 10 percent and interest is paid semiannually. a. 1.35 years b. 1.78 years c. 2.50 years d. 2.78 years e. 2.95 years ANS: D (1) Period 1 2 3 4 5 6
(2) Cash Flow $ 30 30 30 30 30 1030
(3)
(4)
PV @ 5% .9524 .9070 .8638 .8227 .7835 .7462
PV of Flow $ 28.57 27.21 25.91 24.68 23.51 768.59 $898.47
(5) PV as % of Price .03180 .03028 .02884 .02747 .02617 .85544 1.00000
(6) (1) (5) .03180 .06056 .08652 .10988 .13085 5.13264 5.55225
The duration equals 5.55225 semiannual periods or 2.77613 years. PTS: 1
OBJ: Multiple Choice Problem
52. Calculate the modified duration for a 10-year, 12 percent bond with a yield to maturity of 10 percent and a Macaulay duration of 7.2 years. a. 6.43 years b. 6.55 years c. 6.79 years d. 6.86 years e. 7.01 years ANS: D Dmod = 7.2/(1 + .10/2) = 7.2/1.05 = 6.86 years PTS: 1
OBJ: Multiple Choice Problem
53. A 12-year, 8 percent bond with a YTM of 12 percent has a Macaulay duration of 9.5 years. If interest rates decline by 50 basis points, what will be the percent change in price for this bond? a. +4.48% b. +4.61%
c. +8.48% d. +8.96% e. +17.92% ANS: A Dmod = 9.5/(1 + .12/2) = 9.5/1.06 = 8.96 years %P = −Dmod i = −(8.96) (−50/100) = 4.48% (increase) PTS: 1
OBJ: Multiple Choice Problem
54. Consider a bond with a duration of 6 years having a yield to maturity of 8% and interest rates are expected to rise by 50 basis points. What is the percentage change in the price of the bond? a. 2.88% b. 3.45% c. −3.89% d. −3.45% e. −2.88% ANS: E 6 [1 + (0.08/2)] = 5.77 −5.77 (50/100) = −2.88% PTS: 1
OBJ: Multiple Choice Problem
55. If the price before yields changed was $950, what is the resulting price? a. $922.64 b. $918.66 c. $1000.00 d. $968.50 e. $1012.45 ANS: A (1 − 0.0288)(950) = $922.64 PTS: 1
OBJ: Multiple Choice Problem
56. Consider a bond with a duration of 7 years having a yield to maturity of 7% and interest rates are expected to rise by 50 basis points. What is the percentage change in the price of the bond? a. 3.62% b. 3.45% c. −3.38% d. 3.38% e. −3.62% ANS: C 7 [1 + (0.07/2)] = 6.76 −6.76 (50/100) = −3.38% PTS: 1
OBJ: Multiple Choice Problem
57. If the price before yields changed was $925, what is the resulting price?
a. b. c. d. e.
$865.22 $918.66 $889.11 $1000.00 $1012.45
ANS: C (1 − 0.0338)(925) = $889.11 PTS: 1
OBJ: Multiple Choice Problem
58. Consider a bond with a duration of 8 years having a yield to maturity of 8% and interest rates are expected to rise by 50 basis points. What is the percentage change in the price of the bond? a. 3.85% b. 3.45% c. −4.02% d. −3.45% e. −3.85% ANS: E 8 [1 + (0.08/2)] = 7.69 −7.69 (50 100) = −3.85% PTS: 1
OBJ: Multiple Choice Problem
59. If the price before yields changed was $975, what is the resulting price? a. $937.46 b. $918.66 c. $965.55 d. $898.62 e. $1012.45 ANS: A (1 − 0.0385)(975) = $937.46 PTS: 1
OBJ: Multiple Choice Problem
60. Suppose the current 6 year spot rate is 8% and the current 5 year spot rate is 7%. What is the one year forward rate in five years? a. 12.62% b. 11.58% c. 13.14% d. 14.65% e. 15.14% ANS: C (1 + 0.08)6 (1 + 0.07)5 = 13.14% PTS: 1
OBJ: Multiple Choice Problem
61. Suppose the current 6 year rate is 9% and the current 5 year rate is 7%. What is the one year forward rate for five years? a. 19.57%
b. c. d. e.
18.62% 15.80% 14.65% 12.67%
ANS: A (1 + 0.09)6 (1 + 0.07)5 = 19.57% PTS: 1
OBJ: Multiple Choice Problem
62. Assume that you purchase a 3-year $1,000 par value bond, with a 8% coupon, and a yield of 10%. After you purchase the bond, one-year interest rates are as follow, year 1 = 10%, year 2 = 8%, year 3 = 6% (these are the reinvestment rates). Calculate the realized horizon yield if you hold the bond to maturity. Interest is paid annually. a. 8.37% b. 7.28% c. 9.76% d. 10.67% e. 14.0% ANS: C The purchase price is = $950.26 =
The terminal value of cash flows
= $1256.38 = 80(1.08)(1.06) + 80(1.06) + 80 + 1000
The realized horizon yield = 9.76% =
PTS: 1
OBJ: Multiple Choice Problem
63. Assume that you purchase a 10-year $1,000 par value bond, with a 12% coupon, and a yield of 9%. Immediately after you purchase the bond, yields fall to 8% and remain at that level to maturity. Calculate the realized horizon yield, if you hold the bond for 5 years and then sell. Interest is paid annually. a. 16.25% b. 12.15% c. 7.75% d. 10.05% e. 9.34% ANS: E The purchase price is = $1192.53 =
The selling price after 5 years is = $1159.71 =
The terminal value of cash flows at year 5 = $1863.70 =
The realized horizon yield = 9.34% =
PTS: 1
OBJ: Multiple Choice Problem
64. Suppose the current 7 year rate is 8% and the current 6 year rate is 6%. What is the one year forward rate for six years? a. 16.33% b. 18.22% c. 20.82% d. 14.65% e. 15.14% ANS: C (1 + 0.08)7 (1 + 0.06)6 = 20.82% PTS: 1
OBJ: Multiple Choice Problem
65. Assume that you purchase a 5-year $1,000 par value bond, with a 6% coupon, and a yield of 7%. Immediately after you purchase the bond, yields rise to 8% and remain at that level to maturity. Calculate the realized horizon yield if you hold the bond to maturity. Interest is paid annually. a. 6.0% b. 7.11% c. 8.0% d. 15.25% e. 8.18% ANS: B The purchase price is = $959 =
The terminal value of cash flows at year 5 = $1352 =
The realized horizon yield = 7.11% =
PTS: 1
OBJ: Multiple Choice Problem
66. Estimate the percentage price change for a 5-year $1,000 par value bond, with a 6% coupon, if the yield rises from 8% to 8.5%. Interest is paid semiannually. a. 2.1% b. −2.1% c. 4.4% d. −4.4% e. None of the above ANS: B The price of the bond = $918.89 =
The present value of the weighted cash flows = $8015.41 = 30/(1.04) + 60/(1.04)2 + 90/(1.04)3 + 120/(1.04)4+150/(1.04)5 + 180/(1.04)6 + 210/(1.04)7 + 240/(1.04)8 + 270/(1.04)9 + 10300/(1.04)10 Macaulay duration = 8015.41/918.89 = 8.72 Or 8.72/2 = 4.36 years Modified duration = 4.36/(1 + .04) = 4.19 years. %price change = −(4.19 0.5) = −2.1% PTS: 1
OBJ: Multiple Choice Problem
67. Calculate the Macaulay duration for a 5-year $1,000 par value bond, with a 6% coupon and a yield to maturity of 8%. Interest is paid annually. a. 6.44 years b. 5.25 years c. 4.44 years d. 2.50 years e. None of the above ANS: C The price of the bond = $920.15 =
The present value of the weighted cash flows = $4084.82 = 60/(1.08) + 120/(1.08)2 + 180/(1.08)3 + 240/(1.08)4 + 5300/(1.08)5 Macaulay duration = 4084.41/920.15 = 4.44 years PTS: 1
OBJ: Multiple Choice Problem
68. A 15-year bond has a $1,000 par value bond, a 4% coupon and a yield to maturity of 3.3%. Interest is paid annually. The bond's current yield is a. 3.7% b. 4.0% c. 3.3% d. 7.3% e. None of the above ANS: A The price of the bond = $1081.78 =
Current yield = 40/1081.78 = 3.7% PTS: 1
OBJ: Multiple Choice Problem
69. A 5-year bond has a $1,000 par value bond, a 12% coupon and a yield to maturity of 8%. Interest is paid semiannually. The bond's price is a. $864.65 b. $1081.78 c. $852.80 d. $1162.22 e. None of the above ANS: D The price of the bond = $1162.22 =
PTS: 1
OBJ: Multiple Choice Problem
70. A 15-year bond, purchased 5 years ago, has a $1,000 par value bond, a 10 percent coupon and a yield to maturity of 12%. Interest is paid annually. The bond's price is
a. b. c. d. e.
$864 $887 $1152 $1123 None of the above
ANS: B The price of the bond = $887 =
PTS: 1
OBJ: Multiple Choice Problem
Exhibit 18.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) A $1000 par value bond with 5 years to maturity and a 6% coupon has a yield to maturity of 8%. Interest is paid semiannually. 71. Refer to Exhibit 18.1. Calculate the current price of the bond. a. $1579.46 b. $918.89 c. $789.29 d. $1000 e. $743.29 ANS: B The price of the bond = $918.89 =
PTS: 1
OBJ: Multiple Choice Problem
72. Refer to Exhibit 18.1. Calculate the Macaulay duration for the bond. a. 4.19 years b. 4.36 years c. 8.72 years d. 8.38 years e. 9.52 years ANS: B The present value of the weighted cash flows = $8015.41 = 30/(1.04) + 60/(1.04)2 + 90/(1.04)3 + 120/(1.04)4+150/(1.04)5 + 180/(1.04)6 + 210/(1.04)7 + 240/(1.04)8 + 270/(1.04)9 + 10300/(1.04)10 Macaulay duration = 8015.41/918.89 = 8.72 Or 8.72/2 = 4.36 years
PTS: 1
OBJ: Multiple Choice Problem
73. Refer to Exhibit 18.1. Calculate the modified duration for the bond. a. 4.19 years b. 4.36 years c. 8.72 years d. 8.38 years e. 9.52 years ANS: A Modified duration = 4.36/(1 + .04) = 4.19 years. PTS: 1
OBJ: Multiple Choice Problem
74. Refer to Exhibit 18.1. Estimate the percentage price change for this 5-year $1,000 par value bond, with a 6% coupon, if the yield rises from 8% to 8.5%. Interest is paid semiannually. a. 2.1% b. −2.1% c. 4.4% d. −4.4% e. None of the above ANS: A %price change = −(4.19 0.5) = −2.1% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 18.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Talmart Corporation bonds have a $1,000 face value and will mature in 4 years. The bonds have a 7% coupon rate. Interest is paid annually and the required rate of return is 6 percent for these bonds. 75. Refer to Exhibit 18.2. What is the price of the Talmart corporate bonds? a. $965.63 b. $966.13 c. $1,034.65 d. $1,135.10 e. $1,051.97 ANS: C
PTS: 1
OBJ: Multiple Choice Problem
76. Refer to Exhibit 18.2. What is the Macaulay duration of the Talmart corporate bonds? a. 3.43 b. 3.64 c. 3.76
d. 3.85 e. 4.11 ANS: B
PTS: 1
OBJ: Multiple Choice Problem
77. Refer to Exhibit 18.2. What is the Modified duration of the Talmart corporate bonds? a. 3.43 b. 3.64 c. 3.76 d. 3.85 e. 4.11 ANS: A Modified duration = 3.64/(1.06) = 3.43 PTS: 1
OBJ: Multiple Choice Problem
78. Refer to Exhibit 18.2. If interest rates increase 50 basis points, what will be the approximate price change for the Talmart bond? a. −17.0% b. −1.7% c. 1.7% d. 1.8% e. 17.0% ANS: B −MD(.005) = −3.43(.005) = −0.01715 PTS: 1
OBJ: Multiple Choice Problem
79. Calculate the modified duration of a bond that has a Macaulay duration of 7.6 and the bond pays interest semi-annually with a coupon rate of 6% and a required rate of return of 8%. a. 7.04 b. 7.17 c. 7.31 d. 7.38 e. 8.12 ANS: D MD = 7.6/(1.03) = 7.38 PTS: 1
OBJ: Multiple Choice Problem
80. Zappo Corporation just issued $1,000 face value bonds that will mature in 20 years and have a 7% coupon rate. Interest is paid semi-annually and the required rate of return is 9 percent for these bonds. The bonds have a 5 year call provision that will pay a call premium of $1,050 if they are called in. What is the price of the Zappo Corporation bond? a. $815.98 b. $817.43 c. $826.35 d. $920.87 e. $953.07 ANS: E
PTS: 1
OBJ: Multiple Choice Problem
Exhibit 18.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) A $1000 par value bond with 4 years to maturity and a 5% coupon has a yield to maturity of 6%. Interest is paid annually. 81. Refer to Exhibit 18.3. Calculate the current price of the bond. a. $964.90 b. $965.35 c. $981.41 d. $1035.45 e. $1035.85 ANS: B The price of the bond = $965.35 =
PTS: 1
OBJ: Multiple Choice Problem
82. Refer to Exhibit 18.3. Calculate the Macaulay duration for the bond. a. 3.19 years b. 3.36 years c. 3.57 years d. 3.72 years e. 3.84 years ANS: D The present value of the weighted cash flows = $3588.91 = 50/(1.06) + 100/(1.06)2 + 150/(1.06)3 + 4200/(1.06)4 Macaulay duration = 3588.91/965.35 = 3.718
PTS: 1
OBJ: Multiple Choice Problem
83. Refer to Exhibit 18.3. Calculate the modified duration for the bond. a. 3.51 years b. 3.61 years c. 3.72 years d. 4.38 years e. 7.44 years ANS: A Modified duration = 3.718/(1 + .06) = 3.507 years. PTS: 1
OBJ: Multiple Choice Problem
84. Refer to Exhibit 18.3. Estimate the percentage price change for this 4-year $1,000 par value bond, with annual 5% coupon, if the yield falls from 6% to 5.5%. a. −3.50% b. −1.75% c. 1.75% d. 3.50% e. None of the above ANS: C %price change = −(3.507) (−0.5) = 1.75% PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 19—BOND PORTFOLIO MANAGEMENT STRATEGIES TRUE/FALSE 1. A bond portfolio is immunized from interest rate risk if the modified duration of the portfolio is always equal to the desired investment horizon. ANS: T
PTS: 1
2. Interest rate anticipation is the most conservative management strategy. ANS: F
PTS: 1
3. In valuation analysis, undervalued bonds are bonds where the expected YTMs are lower than the prevailing YTM. ANS: T
PTS: 1
4. A bond swap involves liquidating a current bond position, and later investing in a similar issue under more favorable conditions. ANS: F
PTS: 1
5. A pure yield pickup swap involves a switch from a low-coupon bond to a higher-coupon bond of similar quality and maturity. ANS: T
PTS: 1
6. A substitution swap relies heavily on interest rate expectations. ANS: T
PTS: 1
7. When applying active management techniques to a global portfolio the additional concern is expectations regarding exchange rates between countries. ANS: T
PTS: 1
8. The bond management strategy intended to eliminate interest rate risk is immunization. ANS: T
PTS: 1
9. A portfolio of bonds is immunized from interest rate risk if the duration of the portfolio is always equal to the desired investment horizon. ANS: T
PTS: 1
10. The duration of a perpetual bond is always equal to its term to maturity. ANS: F
PTS: 1
11. In a buy-and-hold strategy, bonds are purchased in light of the investor's objectives and constraints and then held until maturity.
ANS: T
PTS: 1
12. Indexing is an active portfolio management strategy that seeks to copy the composition and performance of a selected market index. ANS: F
PTS: 1
13. Interest rate anticipation is one of the matched funding techniques that matches anticipated interest rates with the required rates on a portfolio. ANS: F
PTS: 1
14. In a ladder strategy, funds are invested equally among a wide range of maturities. ANS: T
PTS: 1
15. Credit analysis and core-plus management are examples of active bond portfolio management. ANS: T
PTS: 1
16. A manager following an interest rate anticipation strategy would shorten portfolio duration if interest rates were expected to increase. ANS: T
PTS: 1
17. When applying active management techniques to a global portfolio the additional concern is expectations regarding exchange rates between countries. ANS: T
PTS: 1
18. With a matched funding technique portfolio managers try to match specific liability obligations due at specific times to a portfolio of bonds that minimize the portfolio's interest rate risk. ANS: T
PTS: 1
19. Investment horizon is the future time when an investor must begin an investment program to generate the required funds for a future liability. ANS: F
PTS: 1
20. The components of interest rate risk are: price risk and maturity risk. ANS: F
PTS: 1
21. Altman-Nammacher (1987) create a modified Z-score model using a multiple regression analysis technique. ANS: F
PTS: 1
22. The substitution swap is generally long term and relies heavily on interest rate expectations. ANS: F
PTS: 1
23. An investor in a pure yield pickup swap is most concerned about changes in interest rates. ANS: F
PTS: 1
24. Historically the correlation between stocks and bonds has consistently remained between 0.20 and 0.45. ANS: F
PTS: 1
MULTIPLE CHOICE 1. Which of the following is a passive bond portfolio strategy? a. Indexing b. Buy-and-Hold c. Classical immunization d. Choices a and b e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
2. The active strategies for bond management include all of the following, except a. Interest rate anticipation. b. Credit analysis. c. Spread analysis. d. Classical immunization. e. Bond swaps. ANS: D
PTS: 1
OBJ: Multiple Choice
3. Which of the following is a matched funding technique? a. Classical immunization b. Contingent immunization c. Bond swaps d. Valuation analysis e. Interest rate anticipation ANS: A
PTS: 1
OBJ: Multiple Choice
4. For a bond investor selecting a buy-and-hold strategy, which of the following would be the least important consideration? a. Term to maturity b. Indenture provisions c. Coupon levels d. Liquidity e. Quality ANS: D
PTS: 1
OBJ: Multiple Choice
5. Junk bonds are high yield bond bonds rated below a. BBB. b. BB. c. B. d. CCC. e. CC.
ANS: A
PTS: 1
OBJ: Multiple Choice
6. Contingent immunization strategies a. Provide the bond portfolio manager to engage in various active portfolio strategies if the client is willing to accept a floor value. b. Insure that the modified duration of the portfolio is always equal to the desired investment horizon. c. Guarantee that the end of the holding period wealth will not be impacted by interest rate changes. d. All of the above statements are true. e. None of the above statements are true. ANS: A
PTS: 1
OBJ: Multiple Choice
7. Which of the following would not normally be a reason for a bond swap? a. Increasing current yield b. Improving the quality of the portfolio c. Taking advantage of interest rate shifts d. Tax savings e. Realigning the portfolio's duration ANS: E
PTS: 1
OBJ: Multiple Choice
8. If an investor swaps identical issues to establish a loss, the loss is disallowed and the transaction is known as a a. Switch sale. b. Wash sale. c. Green shoe. d. Flashback. e. White knight. ANS: B
PTS: 1
OBJ: Multiple Choice
9. The term dedication, used to describe portfolio management techniques, is referring to servicing a prescribed set of a. Interest payments. b. Assets. c. Liabilities. d. Pensioners. e. Sinking fund payments. ANS: C
PTS: 1
OBJ: Multiple Choice
10. Coupon reinvestment risk arises because the yield to maturity computation implicitly assumes that all coupon flows will be reinvested at the a. Coupon rate. b. Effective rate of interest. c. Realized yield to maturity. d. Promised yield to maturity. e. Existing yield as the coupons are paid. ANS: D
PTS: 1
OBJ: Multiple Choice
11. Assuming no change in interest rates, the duration of a coupon bond a. Stays constant.
b. c. d. e.
Declines more slowly than the term to maturity. Declines more quickly than the term to maturity Increases at a slower rate than the term to maturity. Changes in line with the term to maturity.
ANS: B
PTS: 1
OBJ: Multiple Choice
12. In core-plus bond management a. Seventy five percent of the portfolio is allocated to an equity index, and the balance to a bond index. b. Seventy five percent of the portfolio is allocated to a bond index, and the balance to an equity index. c. Seventy five percent of the portfolio is allocated to a bond index, and the balance to actively managed bond sectors. d. Seventy five percent of the portfolio is allocated to actively managed bond sectors, and the balance to a bond index. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
13. A tax swap involves swapping out of a a. Bond to realize capital losses, into a comparable bond. b. Low coupon bond, into a comparable high coupon bond. c. High coupon bond, into a comparable low coupon bond. d. Bond that is underpriced, into a comparable bond that is overpriced. e. Bond that is overpriced, into a comparable bond that is underpriced. ANS: A
PTS: 1
OBJ: Multiple Choice
14. A substitution pickup swap involves swapping out of a a. Bond to realize capital losses, into a comparable bond. b. Low coupon bond, into a comparable high coupon bond. c. High coupon bond, into a comparable low coupon bond. d. Bond that is underpriced, into a comparable bond that is overpriced. e. Bond that is overpriced, into a comparable bond that is underpriced. ANS: E
PTS: 1
OBJ: Multiple Choice
15. A pure yield pickup swap involves swapping out of a a. Bond to realize capital losses, into a comparable bond. b. Low coupon bond, into a comparable high coupon bond. c. High coupon bond, into a comparable low coupon bond. d. Bond that is underpriced, into a comparable bond that is overpriced. e. Bond that is overpriced, into a comparable bond that is underpriced. ANS: B
PTS: 1
OBJ: Multiple Choice
16. In a barbell strategy a. One half of funds are invested in short duration bonds and the test in long duration bonds. b. Seventy five percent of funds are invested in short duration bonds and the test in long duration bonds. c. Twenty five percent of funds are invested in short duration bonds and the test in long duration bonds. d. An equal amount of funds are invested in a wide range of maturities. e. None of the above.
ANS: A
PTS: 1
OBJ: Multiple Choice
17. In a ladder strategy a. One half of funds are invested in short duration bonds and the test in long duration bonds. b. Seventy five percent of funds are invested in short duration bonds and the test in long duration bonds. c. Twenty five percent of funds are invested in short duration bonds and the test in long duration bonds. d. An equal amount of funds are invested in a wide range of maturities. e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
18. An example of an active strategy for bond management would be a. Buy and hold. b. Credit analysis. c. Indexing. d. Classical immunization. e. Horizon matching. ANS: B
PTS: 1
OBJ: Multiple Choice
19. A portfolio manager that attempts to select bonds based on their intrinsic value would be carrying out a. Credit analysis b. Valuation analysis c. Yield-spread analysis d. Horizon-matching analysis e. Interest-rate analysis ANS: B
PTS: 1
OBJ: Multiple Choice
20. Which factors indicate that in-depth credit analysis of high-yield bonds is important? a. The large number of high-yield issues. b. The overall decline in quality of these bonds. c. The wide range of quality among these bonds. d. The growing complexity of these bonds. e. All of the above. ANS: E
PTS: 1
OBJ: Multiple Choice
21. In classical immunization the effect of a change in interest rates is effectively neutralized because a. Price risk and reinvestment risk offset each other. b. Price risk and maturity risk offset each other. c. Reinvestment risk and credit risk offset each other. d. Reinvestment risk and maturity risk offset each other. e. None of the above. ANS: A
PTS: 1
22. Horizon matching is a combination of a. Immunization and valuation. b. Cash matching and immunization. c. Valuation and cash matching. d. All of the above. e. None of the above.
OBJ: Multiple Choice
ANS: B
PTS: 1
OBJ: Multiple Choice
23. Interest rate risk is comprised of which of the following risks? a. Price risk. b. Coupon reinvestment risk. c. Default risk. d. Both a and b only. e. All of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
24. Which of the following statements is true? a. If Duration > Investment Horizon, the investor faces Net Reinvestment Risk. b. If Duration < Investment Horizon, the investor faces Net Price Risk. c. If Duration = Investment Horizon, the investor is immunized. d. All of the above statements are true. e. None of the above statements are true. ANS: C
PTS: 1
OBJ: Multiple Choice
25. Horizon matching is a combination of a. Cash-matching dedication and interest rates swaps. b. Cash-matching dedication and immunization. c. Interest rate swaps and immunization. d. Enhanced indexing and immunization. e. Enhanced indexing and interest rate swaps. ANS: B
PTS: 1
OBJ: Multiple Choice
26. Investment style for a bond portfolio is best characterized by a. Beta and credit quality b. Credit quality and duration c. Interest rate risk and yield to maturity d. Yield to maturity and beta e. None of the above ANS: B
PTS: 1
OBJ: Multiple Choice
27. Two common methods for constructing a bond index are a. Full replication and stratified sampling b. Partial replication and overall market approach c. ETFs and High Yield sampling d. Multiple discriminant analysis and bond swaps e. None of the above ANS: A
PTS: 1
OBJ: Multiple Choice
28. Studies by Reilly and Wright (1994, 2001) and Fabozzi (2005) suggest analysis of high-yield bonds should be expanded to include all of the following except a. The firm's competitive position with respect to cost and pricing b. The firm's cash flow relative to interest expense, research expenses, and growth needs c. The firm's market share and growth in sales d. The quality of the total management team e. All of the above were suggested as important areas of expanded analysis by these studies ANS: C
PTS: 1
OBJ: Multiple Choice
Exhibit 19.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The following information is given concerning a pure yield pick-up swap: You currently hold a 10 year, 7 percent coupon bond priced to yield 8 percent. As a swap candidate you are considering a 10 year, 8 percent coupon bond priced to yield 9 percent. Assume a reinvestment at 9 percent, semiannual compounding, and a one-year workout period. Current Bond $932.05 $70.00 $1.575 $936.70 $1008.28 8.018%
Dollar Investment Coupon i on One Coupon Principal Value at Year End Total Accrued Realized Compound Yield
Candidate Bond $934.96 $80.00 ? ? ? ?
29. Refer to Exhibit 19.1. The interest on one coupon for the candidate bond is a. $2.97 b. $2.03 c. $1.80 d. $1.37 e. $3.49 ANS: C Current Periods Price yield Par Value Sell price sell after Coupon reinvest maturity FV Total value % gain realiz yld Value of swap Current prices:
2 $932.05 0.08 1000 $936.70 1 0.07 0.09 10 $71.575 $1,008.28 8.179% 8.018%
yrs $70
$1.575
0.982%
Candidate Periods Price yield Par Value Sell price sell after Coupon reinvest maturity FV Total value % gain realiz yld
2 $934.96 0.09 1000 $939.20 1 0.08 0.09 10 $81.800 $1,021.00 9.202% 9.000%
yrs $80
$1.8
Year-end prices:
Interest = ($80.00/2) (0.09/2) = $1.8 PTS: 1
OBJ: Multiple Choice Problem
30. Refer to Exhibit 19.1. The realized compound yield on the candidate bond is a. 7.0% b. 11.0% c. 10.0% d. 9.0% e. 12.0% ANS: D Current Periods Price yield Par Value Sell price sell after Coupon reinvest maturity FV Total value % gain realiz yld Value of swap Current prices:
Year-end prices:
2 $932.05 0.08 1000 $936.70 1 0.07 0.09 10 $71.575 $1,008.28 8.179% 8.018%
yrs $70
$1.575
0.982%
Candidate Periods Price yield Par Value Sell price sell after Coupon reinvest maturity FV Total value % gain realiz yld
2 $934.96 0.09 1000 $939.20 1 0.08 0.09 10 $81.800 $1,021.00 9.202% 9.000%
yrs $80
$1.8
Current Bond Percentage gain = ($1008.28 − $932.05)/$932.05 = 0.08179 Realized compound yield = 2[(1 + 0.08179)1/2 − 1] = 0.08018 Candidate Bond Percentage Gain = ($1021 − $934.96)/$934.96 = 0.09202 Realized compound yield = 2[(1 + 0.09202)1/2 − 1] = .09 PTS: 1
OBJ: Multiple Choice Problem
31. Refer to Exhibit 19.1. The value of the swap is ____ basis points in one year. a. 32.3 b. 48.7 c. 75.8 d. 98.2 e. 104.3 ANS: D Current Periods Price yield Par Value Sell price sell after Coupon reinvest maturity FV Total value % gain realiz yld Value of swap Current prices:
2 $932.05 0.08 1000 $936.70 1 0.07 0.09 10 $71.575 $1,008.28 8.179% 8.018%
yrs $70
$1.575
0.982%
Candidate Periods Price yield Par Value Sell price sell after Coupon reinvest maturity FV Total value % gain realiz yld
2 $934.96 0.09 1000 $939.20 1 0.08 0.09 10 $81.800 $1,021.00 9.202% 9.000%
yrs $80
$1.8
Year-end prices:
Swap value = 9 − 8.018 = 0.982 = 98.2 basis points PTS: 1
OBJ: Multiple Choice Problem
Exhibit 19.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The following information is given concerning a substitution swap. You currently hold a 15 year, 7 percent coupon bond priced to yield 8 percent. As a swap candidate you are considering a 15 year, 7 percent coupon bond priced to yield 8.5 percent. Assume a reinvestment rate of 8.5 percent, semiannual compounding, and a one-year workout period.
Dollar Investment Coupon i on One Coupon Principal Value at Year End Total Accrued Total Gain Gain per Invested Dollar Realized Compound Yield
Current Bond $913.54 70.00 1.487 916.68 988.17 74.63 ? ?
Candidate Bond ? 70.00 1.487 878.55 950.04 ? ? ?
32. Refer to Exhibit 19.2. The dollar investment in the candidate bond is a. $812.57 b. $803.22 c. $874.16 d. $746.83 e. $700.01 ANS: C Current Periods Price yield Par Value
2 $913.54 0.08 1000
Candidate Periods Price yield Par Value
2 $874.16 0.085 1000
Sell price sell after Coupon Reinvest maturity FV Total value % gain realiz yld Value of swap
$916.68 1 0.07 0.085 15 $71.488 $988.17 8.17% 8.01%
yrs $70
$1.487 $74.63
Sell price sell after Coupon Reinvest maturity FV Total value % gain realiz yld
$878.55 1 0.07 0.085 15 $71.488 $950.04 8.68% 8.50%
0.491%
Current prices:
Year-end prices:
PTS: 1
OBJ: Multiple Choice Problem
33. Refer to Exhibit 19.2. The realized compound yield on the current bond is a. 15.50% b. 11.03% c. 10.30% d. 8.01% e. 9.00% ANS: D Current Periods Price
2 $913.54
Candidate Periods Price
2 $874.16
yrs $70
$1.487 $75.88
yield Par Value Sell price sell after Coupon Reinvest maturity FV Total value % gain realiz yld Value of swap
0.08 1000 $916.68 1 0.07 0.085 15 $71.488 $988.17 8.17% 8.01%
yrs $70
$1.487 $74.63
yield Par Value Sell price sell after Coupon Reinvest maturity FV Total value % gain realiz yld
0.085 1000 $878.55 1 0.07 0.085 15 $71.488 $950.04 8.68% 8.50%
0.491%
Current prices:
Year-end prices:
Current Bond Percentage gain = ($988.17 − $913.54)/$913.54 = 0.0817 Realized compound yield = 2[(1 + 0.08179)1/2 − 1] = 0.0801 Candidate Bond Percentage gain = ($950.04 − $874.16)/$874.16 = 0.0868 Realized compound yield = 2[(1 + 0.0868)1/2 − 1] =.085 PTS: 1
OBJ: Multiple Choice Problem
34. Refer to Exhibit 19.2. The value of the swap is ____ basis points in one year. a. 18.4 b. 23.3
yrs $70
$1.487 $75.88
c. 49.1 d. 46.5 e. 46.8 ANS: C Current Periods Price yield Par Value Sell price sell after Coupon Reinvest maturity FV Total value % gain realiz yld Value of swap
2 $913.54 0.08 1000 $916.68 1 0.07 0.085 15 $71.488 $988.17 8.17% 8.01%
yrs $70
$1.487 $74.63
Candidate Periods Price yield Par Value Sell price sell after Coupon Reinvest maturity FV Total value % gain realiz yld
2 $874.16 0.085 1000 $878.55 1 0.07 0.085 15 $71.488 $950.04 8.68% 8.50%
0.491%
Current prices:
Year-end prices:
Swap value = 8.5 − 8.01 = .491 = 49.1 basis points PTS: 1
OBJ: Multiple Choice Problem
Exhibit 19.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
yrs $70
$1.487 $75.88
The following information is given concerning a pure yield pick-up swap: You currently hold a 20 year, Aa 8 percent coupon bond priced to yield 10 percent. As a swap candidate you are considering a 20 year, Aa 10 percent coupon bond priced to yield 10.75 percent. Assume a reinvestment rate of 12.00 percent, semiannual compounding, and a one-year workout period.
Dollar Investment Coupon i on One Coupon Principal Value at Year End Total Accrued Realized Compound Yield
Current Bond $828.41 80.00 2.4 831.32 913.72 10.5547
Candidate Bond $938.83 100.00 ? ? ? ?
35. Refer to Exhibit 19.3. The interest on one coupon for the candidate bond is a. $2.40 b. $2.75 c. $9.60 d. $11.00 e. $50.00 ANS: B Dollar Investment Coupon i on One Coupon Principal Value at Year End Total Accrued Realized Compound Yield
Current Bond $824.41 80.00 2.4 831.32 913.72 10.5547
Candidate Bond $938.83 100.00 2.75 939.81 1042.56 10.7554
Current prices: Pcurrent = 40(PVIFA5%,40) + 1000(PVIF5.,40) = 40(17.1591) + 1000(0.1420) = $824.41 Pcandidate
= 50(PVIFA5.375%,40) + 1000(PVIF5.375%,40) = 50(16.3132) + 1000(0.1323) = $938.83
Year-end prices: Pcurrent = 40(PVIFA5%,38) + 1000(PVIF5%,38) = 40(16.8679) + 1000(0.1566) = $831.32 Pcandidate
= 50(PVIFA5.375%,38) + 1000(PVIF5.375%,38) = 50(16.0602) + 1000(0.1368) = $939.81
Interest = ($100.00/2) (0.12/2) = $2.75 PTS: 1
OBJ: Multiple Choice Problem
36. Refer to Exhibit 19.3. The value of the swap is ____ basis points in one year. a. 40.4 b. 60.6 c. 80.8 d. 20.5 e. 100.1
ANS: D Dollar Investment Coupon i on One Coupon Principal Value at Year End Total Accrued Realized Compound Yield
Current Bond $824.41 80.00 2.4 831.32 913.72 10.5547
Candidate Bond $938.83 100.00 2.75 939.81 1042.56 10.7554
Current prices: Pcurrent = 40(PVIFA5%,40) + 1000(PVIF5.,40) = 40(17.1591) + 1000(0.1420) = $824.41 Pcandidate
= 50(PVIFA5.375%,40) + 1000(PVIF5.375%,40) = 50(16.3132) + 1000(0.1323) = $938.83
Year-end prices: Pcurrent = 40(PVIFA5%,38) + 1000(PVIF5%,38) = 40(16.8679) + 1000(0.1566) = $831.32 Pcandidate
= 50(PVIFA5.375%,38) + 1000(PVIF5.375%,38) = 50(16.0602) + 1000(0.1368) = $939.81
Current Bond Percentage gain = ($913.72 − $824.41)/$824.41 = 0.108332 Realized yield per period = (1 + 0.108332)1/2 − 1 = 0.0527773 Realized compound yield = 2(0.02773) = 0.105547 = 10.5547% Candidate Bond Percentage gain = ($1042.56 − $938.83)/$938.83 = 0.110446 Realized yield per period = (1 + 0.110446)1/2 − 1 = 0.053797 Realized compound yield = 2(0.053797) = 0.107594 = 10.7594% Swap value = 10.7594 − 10.5547 = 0.2047 = 20.47 basis points PTS: 1
OBJ: Multiple Choice Problem
Exhibit 19.4 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The following information is given concerning a substitution swap. You currently hold a 25 year, Aa 8 percent coupon bond priced to yield 10 percent. As a swap candidate you are considering a 25 year, Aa 8 percent coupon bond priced to yield 10.50 percent. Assume a reinvestment rate of 10 percent, semiannual compounding, and a one-year workout period.
Dollar Investment Coupon i on One Coupon
Current Bond $817.44 80.00 2.00
Candidate Bond ? 80.00 2.20
Principal Value at Year End Total Accrued Total Gain Gain per Invested Dollar Realized Compound Yield
819.23 901.23 83.79 ? ?
782.33 864.53 ? ? ?
37. Refer to Exhibit 19.4. The dollar investment in the candidate bond is a. $780.34 b. $1483.25 c. $1361.54 d. $1413.95 e. $1000.00 ANS: A Dollar Investment Coupon i on One Coupon Principal Value at Year End Total Accrued Total Gain Gain per Invested Dollar Realized Compound Yield
Current Bond $817.44 80.00 2.00 819.23 901.23 83.79
Candidate Bond $780.34 80.00 2.20 782.36 864.53 84.19
0.102503 10.003%
0.107889 10.5126
Current prices: Pcurrent = 40(PVIFA5%,50) + 1000(PVIF5%,50) = 40(18.2559) + 1000(0.0872) = $817.44 Pcandidate
= 40(PVIFA5.25%,50) + 1000(PVIF5.25%,50) = 40(18.5728) + 1000(0.0774) = $780.34
Year-end prices: Pcurrent = 40(PVIFA5%,48) + 1000(PVIF5%,48) = 40(18.0772) + 1000(0.0961) = $819.23 Pcandidate
PTS: 1
= 40(PVIFA5.25%,48) + 1000(PVIF5.25%,48) = 40(17.4139) + 1000(0.0858) = $782.36 OBJ: Multiple Choice Problem
38. Refer to Exhibit 19.4. The realized compound yield on the current bond is a. 6.00% b. 7.00% c. 8.00% d. 10.00% e. 12.00% ANS: D Dollar Investment Coupon i on One Coupon Principal Value at Year End
Current Bond $817.44 80.00 2.00 819.23
Candidate Bond $780.34 80.00 2.20 782.36
Total Accrued Total Gain Gain per Invested Dollar Realized Compound Yield
901.23 83.79
864.53 84.19
0.102503 10.003%
0.107889 10.5126
Current prices: Pcurrent = 40(PVIFA5%,50) + 1000(PVIF5%,50) = 40(18.2559) + 1000(0.0872) = $817.44 Current Bond Percentage gain = ($901.23 − $817.44)/$817.44 = 0.102503 Realized yield per period = (1 + 0.102503)1/2 − 1 = .050001 Realized compound yield = 2(05001) = 0.10001 = 10.00% Candidate Bond Percentage gain = ($864.53 − $780.34)/$780.34. = 0.107889 Realized yield per period = (1 + 0.107889)1/2 − 1 =.052563 Realized compound yield = 2(052563) = 0.105126 = 10.5126% PTS: 1
OBJ: Multiple Choice Problem
39. Refer to Exhibit 19.4. The value of the swap is ____ basis points in one year. a. 26.91 b. 26.25 c. 31.25 d. 41.25 e. 51.25 ANS: E Dollar Investment Coupon i on One Coupon Principal Value at Year End Total Accrued Total Gain Gain per Invested Dollar Realized Compound Yield
Current Bond $817.44 80.00 2.00 819.23 901.23 83.79
Candidate Bond $780.34 80.00 2.20 782.36 864.53 84.19
0.102503 10.003%
0.107889 10.5126
Current prices: Pcurrent = 40(PVIFA5%,50) + 1000(PVIF5%,50) = 40(18.2559) + 1000(0.0872) = $817.44 Swap value = 10.5126 − 10.0001 = 0.5125 = 51.25 basis points PTS: 1 Exhibit 19.5
OBJ: Multiple Choice Problem
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The following information is given concerning a pure yield pick-up swap: You currently hold a 20 year, Aa 2 percent coupon bond priced to yield 9.5 percent. As a swap candidate you are considering a 20 year, Aa 14 percent coupon bond priced to yield 10.00. Assume a reinvestment rate of 11 percent, semiannual compounding, and a one-year workout period.
Dollar Investment Coupon i on One Coupon Principal Value at Year End Total Accrued Realized Compound Yield 9.5351%
Current Bond $1222.04 110.00 3.3 1218.04 1341.34 ?
Candidate Bond $1343.18 140.00 ? ? ?
40. Refer to Exhibit 19.5. The interest on one coupon for the candidate bond is a. $70.00 b. $3.58 c. $3.85 d. $8.35 e. $5.38 ANS: C Dollar Investment Coupon i on One Coupon Principal Value at Year End Total Accrued Realized Compound Yield
Current Bond $1222.0377 120.00 3.3 1218.04 1341.34 9.5351
Candidate Bond $1343.18 140.00 3.85 1337.36 1481.24 10.0272
Current prices: Pcurrent = 60(PVIFA4.75%,40) + 1000(PVIF4.75%,40) = 60(17.7630) + 1000(0.1563) = $1222.0377 Pcandidate
= 70(PVIFA5%,40) + 1000(PVIF5%,40) = 70(17.1591) + 1000(0.1420) = $1343.18
Year-end prices: Pcurrent = 60(PVIFA4.75%,38) + 1000(PVIF4.75%,38) = 60(17.4431) + 1000(0.1715) = $1218.04 Pcandidate
= 70(PVIFA5%,38) + 1000(PVIF5%,38) = 70(16.8679) + 1000(0.1566) = $1337.36
Interest on candidate bond = ($110.00/2) (0.11/2) = $3.85 PTS: 1
OBJ: Multiple Choice Problem
41. Refer to Exhibit 19.5. The value of the swap is ____ basis points in one year. a. 0.004921 b. 0.4921 c. 4.921 d. 49.21
e. 492.1 ANS: D Dollar Investment Coupon i on One Coupon Principal Value at Year End Total Accrued Realized Compound Yield
Current Bond $1222.0377 120.00 3.3 1218.04 1341.34 9.5351
Candidate Bond $1343.18 140.00 3.85 1337.36 1481.24 10.0272
Current prices: Pcurrent = 60(PVIFA4.75%,40) + 1000(PVIF4.75%,40) = 60(17.7630) + 1000(0.1563) = $1222.0377 Pcandidate
= 70(PVIFA5%,40) + 1000(PVIF5%,40) = 70(17.1591) + 1000(0.1420) = $1343.18
Year-end prices: Pcurrent = 60(PVIFA4.75%,38) + 1000(PVIF4.75%,38) = 60(17.4431) + 1000(0.1715) = $1218.04 Pcandidate
= 70(PVIFA5%,38) + 1000(PVIF5%,38) = 70(16.8679) + 1000(0.1566) = $1337.36
Current Bond Percentage gain = ($1341.34 − $1222.04)/$1222.04 = 0.097624 Realized yield per period = (1 + 0.097624)1/2 − 1 = 0.047675 Realized compound yield = 2(0.047675) = 0.095351 = 9.5351% Candidate Bond Percentage gain = ($1481.24 − $1343.18)/$1343.18 = 0.102786 Realized yield per period = (1 + 0.102786)1/2 − 1 = 0.050130 Realized compound yield = 2(0.050130) = 0.100272 = 10.0272% Swap value = 10.0272 − 9.5351 = 0.4921 = 49.21 basis points PTS: 1
OBJ: Multiple Choice Problem
Exhibit 19.6 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The following information is given concerning a substitution swap. You currently hold a 25 year, Aa 10 percent coupon bond priced to yield 12 percent. As a swap candidate you are considering a 25 year, Aa 10 percent coupon bond priced to yield 13 percent. Assume a reinvestment rate of 12 percent, semiannual compounding, and a one-year workout period.
Dollar Investment
Current Bond $842.38
Candidate Bond ?
Coupon i on One Coupon Principal Value at Year End Total Accrued Total Gain Gain per Invested Dollar Realized Compound Yield
100.00 3.0 843.50 946.50 104.12 ? ?
100.00 2.75 780.46 883.21 ? ? ?
42. Refer to Exhibit 19.6. The dollar investment in the candidate bond is a. $1515.36 b. $853.50 c. $780.46 d. $779.13 e. $877.53 ANS: D Dollar Investment Coupon i on One Coupon Principal Value at Year End Total Accrued Total Gain Gain per Invested Dollar
Current Bond $842.38 100.00 3.00 843.50 946.50 104.12 0.123585
Realized Compound Yield
Candidate Bond $779.13 100.00 2.75 780.46 883.21 104.08 0.133585 12.9399
11.9985% Current prices: Pcurrent = 50(PVIFA6%,50) + 1000(PVIF6%,50) = 50(15.7619) + 1000(0.0543) = $842.38 Pcandidate
= 50(PVIFA6.5%,50) + 1000(0.PVIF6.5%,50) = 50(14.7245) + 1000(0.0429) = $779.13
Year-end prices: Pcurrent = 50(PVIFA6%,48) + 1000(PVIF6%,48) = 50(15.6500) + 1000(0.0610) = $843.50 Pcandidate
= 50(PVIFA6.5%,48) + 1000(PVIF6.5%,48) = 50(14.6359) + 1000(0.0487) = $780.46
PTS: 1
OBJ: Multiple Choice Problem
43. Refer to Exhibit 19.6. The realized compound yield on the current bond is a. 10.00% b. 11.9985% c. 12.9397% d. 13.9399% e. 12.3585% ANS: B Dollar Investment
Current Bond $842.38
Candidate Bond $779.13
Coupon i on One Coupon Principal Value at Year End Total Accrued Total Gain Gain per Invested Dollar
100.00 3.00 843.50 946.50 104.12
100.00 2.75 780.46 883.21 104.08
0.123585
0.133585 12.9399
Realized Compound Yield 11.9985% Current prices: Pcurrent = 50(PVIFA6%,50) + 1000(PVIF6%,50) = 50(15.7619) + 1000(0.0543) = $842.38 Current Bond Percentage gain = ($946.50 − $842.38)/$842.38 = 0.123585 Realized yield per period = (1 + 0.123585)1/2 − 1 = .059993 Realized compound yield = 2(059993) = 0.119985 = 11.9985% Candidate Bond Percentage gain = ($883.21 − $779.13)/$779.13 = 0.133585 Realized yield per period = (1 + 0.133585)1/2 − 1 = .064699 Realized compound yield = 2(0.064699) = 0.129399 = 12.9399% PTS: 1
OBJ: Multiple Choice Problem
44. Refer to Exhibit 19.6. The value of the swap is ____ basis points in one year. a. 94.14 b. 0.9414 c. 9.414 d. 941.4 e. 0.09414 ANS: A Dollar Investment Coupon i on One Coupon Principal Value at Year End Total Accrued Total Gain Gain per Invested Dollar
Current Bond $842.38 100.00 3.00 843.50 946.50 104.12 0.123585
Realized Compound Yield 11.9985% Current prices: Pcurrent = 50(PVIFA6%,50) + 1000(PVIF6%,50) = 50(15.7619) + 1000(0.0543) = $842.38
Candidate Bond $779.13 100.00 2.75 780.46 883.21 104.08 0.133585 12.9399
Swap value = 12.9399 − 11.9985 = 0.9414 = 94.14 basis points PTS: 1
OBJ: Multiple Choice Problem
Exhibit 19.7 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Consider two bonds, both pay semiannual interest. Bond A has a coupon of 8% per year, maturity of 30 years, yield to maturity of 9% per year, and a face value of $1000. Bond B has a coupon of 8% per year, maturity of 30 years, yield to maturity of 9.5% per year, and a face value of $1000. 45. Refer to Exhibit 19.7. Calculate the percentage gain per invested dollar for Bond A assuming a one year horizon, and a reinvestment rate of 9% per year. a. 9.73% b. 9.93% c. 9.20% d. 8.20% e. 9.50% ANS: C The purchase price is = $896.81 =
The selling price after 1 year is = $897.54 =
The terminal value of cash flows at year 1 = $979.34 =
The percentage gain per invested dollar = 9.2% =
PTS: 1
OBJ: Multiple Choice Problem
46. Refer to Exhibit 19.7. Calculate the percentage gain per invested dollar for Bond B assuming a one year horizon, and a reinvestment rate of 9.5% per year. a. 9.73% b. 9.93% c. 9.20% d. 8.20% e. 9.50%
ANS: A The purchase price is = $851.86 =
The selling price after 1 year is = $852.81 =
The terminal value of cash flows at year 1 = $934.71 =
The percentage gain per invested dollar = 9.73% =
PTS: 1
OBJ: Multiple Choice Problem
47. Refer to Exhibit 19.7. Calculate the value of swap out of Bond A into Bond B. a. 0.41% b. 1.73% c. 0.23% d. 0.00% e. 0.51% ANS: E Realized yield for Bond A = ((1 + 0.092)1/2 − 1)(2) = .08997 Realized yield for Bond B = ((1 + 0.0973)1/2 − 1)(2) = .09504 The value of the swap = 9.504 − 8.997 = 0.507% = 0.51% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 19.8 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Consider two bonds, both pay annual interest. Bond C has a coupon of 6% per year, maturity of 5 years, yield to maturity of 6% per year, and a face value of $1000. Bond D has a coupon of 8% per year, maturity of 15 years, yield to maturity of 6% per year, and a face value of $1000. 48. Refer to Exhibit 19.8. Calculate the modified duration for Bond C. a. 4.47 b. 4.22 c. 4.34
d. 5 e. None of the above ANS: B The price of the bond = $1000 The present value of the weighted cash flows = $4465.11 = 60/(1.06) + 120/(1.06)2 + 180/(1.06)3 + 240/(1.06)4 + 5300/(1.06)5 Macaulay duration = 4465.11/1000 = 4.465 Or = 4.47 years Modified duration = 4.47/(1 + .06) = 4.22 years. PTS: 1
OBJ: Multiple Choice Problem
49. Refer to Exhibit 19.8. Calculate the modified duration for Bond D. a. 9.5 b. 9.8 c. 9.2 d. 15 e. None of the above ANS: C The price of the bond = $1194.24 =
The present value of the weighted cash flows = $11640.32 = 80/(1.06) + 160/(1.06)2 + 240/(1.06)3 + 320/(1.06)4 + 400/(1.06)5 + 480/(1.06)6 + 560/(1.06)7 + 640/(1.06)8 + 720/(1.06)9 + 800/(1.06)10 + 880/(1.06)11 + 960/(1.06)12 + 1040/(1.06)13 + 1120/(1.06)14 + 16200/(1.06)15 Macaulay duration = 11640.32/1194.24 = 9.75 Or 9.8 years Modified duration = 9.8/(1 + .06) = 9.2 years. PTS: 1
OBJ: Multiple Choice Problem
50. Refer to Exhibit 19.8. Assume that your investment horizon is 6 years and your portfolio consists only of Bond C and Bond D. Indicate the proportions invested in each bond, so that the portfolio is immunized. a. 50% in Bond C and 50% in Bond D b. 64% in Bond C and 36% in Bond D c. 36% in Bond C and 64% in Bond D d. 100% in Bond D e. None of the above ANS: B 6 = X(4.22) + (1 − X)(9.2)
X = 64.25% or 64% in Bond C 36% in Bond D PTS: 1
OBJ: Multiple Choice Problem
Exhibit 19.9 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Consider two bonds, both pay annual interest. Bond Y has a coupon of 6% per year, maturity of 5 years, yield to maturity of 6% per year, and a face value of $1000. Bond X has a coupon of 7% per year, maturity of 10 years, yield to maturity of 4% per year, and a face value of $1000. 51. Refer to Exhibit 19.9. Calculate the modified duration for Bond Y. a. 7.8 b. 4.22 c. 4.34 d. 7.5 e. 9.8 ANS: B The price of the bond = $1000 The present value of the weighted cash flows = $4465.11 = 60/(1.06) + 120/(1.06)2 + 180/(1.06)3 + 240/(1.06)4 + 5300/(1.06)5 Macaulay duration = 4465.11/1000 = 4.465 Or = 4.47 years Modified duration = 4.47/(1 + .06) = 4.22 years. PTS: 1
OBJ: Multiple Choice Problem
52. Refer to Exhibit 19.9. Calculate the modified duration for Bond X. a. 4.22 b. 7.8 c. 7.5 d. 9.2 e. 4.34 ANS: C The price of the bond = $1243.33 =
The present value of the weighted cash flows = $9,695.10 = 70/(1.06) + 140/(1.06)2 + 210/(1.06)3 + 280/(1.06)4 + 350/(1.06)5 + 420/(1.06)6 + 490/(1.06)7 + 560/(1.06)8 + 630/(1.06)9 + 10700/(1.06)10 Macaulay duration = 9695.10/12543.33 = Or 7.8 years
Modified duration = 7.8/(1 + .04) = 7.5 years. PTS: 1
OBJ: Multiple Choice Problem
53. Refer to Exhibit 19.9. Assume that your investment horizon is 5 years and your portfolio consists only of Bond Y and Bond X. Indicate the proportions invested in each bond, so that the portfolio is immunized. a. 50% in Bond Y and 50% in Bond X b. 76% in Bond Y and 24% in Bond X c. 36% in Bond Y and 64% in Bond X d. 100% in Bond X e. 100% in Bond Y ANS: B 5 = X(4.22) + (1 − X)(7.5) X = 76.14% or 76% in Bond Y 24% in Bond X PTS: 1
OBJ: Multiple Choice Problem
Exhibit 19.10 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) You are creating a portfolio that consists of the following two bonds. Bond A pays an annual 7% coupon, matures in two years, has a yield to maturity of 8%, and a face value of $1,000. Bond B pays an annual 8% coupon, matures in three years, has a yield to maturity of 9%, and a face value of $1,000. 54. Refer to Exhibit 19.10. Calculate the price of Bond A. a. $975.62 b. $982.17 c. $990.57 d. $1,009.50 e. $1,018.08 ANS: B
PTS: 1
OBJ: Multiple Choice Problem
55. Refer to Exhibit 19.10. Calculate the price of Bond B. a. $974.69 b. $990.64 c. $995.22 d. $1,013.88 e. $1,025.77 ANS: A
PTS: 1
OBJ: Multiple Choice Problem
56. Refer to Exhibit 19.10. Calculate the Macaulay Duration for Bond A. a. 0.98 b. 1.79 c. 1.90 d. 1.93 e. 2.31 ANS: D
PTS: 1
OBJ: Multiple Choice Problem
57. Refer to Exhibit 19.10. Calculate the Macaulay Duration for Bond B. a. 1.44 b. 2.47 c. 2.55 d. 2.70 e. 2.78 ANS: E
PTS: 1
OBJ: Multiple Choice Problem
58. Refer to Exhibit 19.10. Calculate the Modified Duration for Bond A. a. 0.98 b. 1.79 c. 1.90 d. 1.93 e. 2.31 ANS: B Modified Duration of A = 1.93/(1.08) = 1.79 PTS: 1
OBJ: Multiple Choice Problem
59. Refer to Exhibit 19.10. Calculate the Modified Duration for Bond B. a. 1.44
b. c. d. e.
2.47 2.55 2.70 2.78
ANS: C Modified Duration of B = 2.78/(1.09) = 2.55 PTS: 1
OBJ: Multiple Choice Problem
60. Refer to Exhibit 19.10. Assume that your investment horizon is 2 years and your portfolio consists only of bonds A and B. What proportion should be invested in each bond to immunize the portfolio? a. Invest 72.4% in bond A and 27.6% in bond B. b. Invest 68.3% in bond A and 31.7% in bond B. c. Invest 58.5% in bond A and 41.5% in bond B. d. Invest 31.7% in bond A and 68.3% in bond B. e. Invest 27.6% in bond A and 72.4% in bond B. ANS: A Let X be the proportion to invest in bond A and (1 − X) be the proportion to invest in bond B. 2 = X(1.79) + (1 − X)(2.55) 2 = 2.55 − 0.76X −.55/−.76 = X 0.724 = X Therefore, invest 72.4% in bond A and 27.6% in bond B. PTS: 1
OBJ: Multiple Choice Problem
Exhibit 19.11 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Consider two bonds, both pay semiannual interest. Bond X has a coupon of 7% per year, maturity of 20 years, yield to maturity of 8% per year, and a face value of $1000. Bond Y has a coupon of 7% per year, maturity of 20 years, yield to maturity of 8.5% per year, and a face value of $1000. 61. Refer to Exhibit 19.11. Calculate the percentage gain per invested dollar for Bond X assuming a one year horizon, and a reinvestment rate of 8% per year. a. 2.35% b. 4.08% c. 7.92% d. 8.16% e. 8.32% ANS: D The purchase price is = $901.04 =
The selling price after 1 year is = $903.16 =
The terminal value of cash flows at year 1 = $974.56 =
The percentage gain per invested dollar = 8.16% =
PTS: 1
OBJ: Multiple Choice Problem
62. Refer to Exhibit 19.11. Calculate the percentage gain per invested dollar for Bond Y assuming a one year horizon, and a reinvestment rate of 8.5% per year. a. 7.84% b. 7.97% c. 8.18% d. 8.34% e. 8.56% ANS: E The purchase price is = $856.92 =
The selling price after 1 year is = $859.82 =
The terminal value of cash flows at year 1 = $930.31 =
The percentage gain per invested dollar = 8.56% =
PTS: 1
OBJ: Multiple Choice Problem
63. Refer to Exhibit 19.11. Calculate the value of swap out of Bond X into Bond Y.
a. b. c. d. e.
0.38% 0.81% 1.94% 3.76% 4.12%
ANS: A Realized yield for Bond X = ((1 + 0.0816)1/2 − 1)(2) = .08000 Realized yield for Bond Y = ((1 + 0.0856)1/2 − 1)(2) = .08384 The value of the swap = .08384 − .08000 = .00384 = 0.38% PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 20—AN INTRODUCTION TO DERIVATIVE MARKETS AND SECURITIES TRUE/FALSE 1. A cash or spot contract is an agreement for the immediate delivery of an asset such as the purchase of stock on the NYSE. ANS: T
PTS: 1
2. Forward and future contracts, as well as options, are types of derivative securities. ANS: T
PTS: 1
3. All features of a forward contract are standardized, except for price and number of contracts. ANS: F
PTS: 1
4. Forward contracts are traded over-the-counter and are generally not standardized. ANS: T
PTS: 1
5. The forward market has low liquidity relative to the futures market. ANS: T
PTS: 1
6. A futures contract is an agreement between a trader and the clearinghouse of the exchange for delivery of an asset in the future. ANS: F
PTS: 1
7. A primary function of futures markets is to allow investors to transfer risk. ANS: T
PTS: 1
8. The futures market is a dealer market where all the details of the transactions are negotiated. ANS: F
PTS: 1
9. Futures contracts are slower to absorb new information than forward contracts. ANS: F
PTS: 1
10. The initial value of a future contract is the price agreed upon in the contract. ANS: F
PTS: 1
11. A futures contract eliminates uncertainty about the future spot price that an individual can expect to pay for an asset at the time of delivery. ANS: T
PTS: 1
12. Investment costs are generally higher in the derivative markets than in the corresponding cash markets. ANS: F
PTS: 1
13. An option buyer must exercise the option on or before the expiration date. ANS: F
PTS: 1
14. The minimum value of an option is zero. ANS: T
PTS: 1
15. An option to sell an asset is referred to as a call, whereas an option to buy an asset is called a put. ANS: F
PTS: 1
16. If an investor wants to acquire the right to buy or sell an asset, but not the obligation to do it, the best instrument is an option rather than a futures contract. ANS: T
PTS: 1
17. Investors buy call options because they expect the price of the underlying stock to increase before the expiration of the option. ANS: T
PTS: 1
18. A call option is in the money if the current market price is above the strike price. ANS: T
PTS: 1
19. A put option is in the money if the current market price is above the strike price. ANS: F
PTS: 1
20. The price at which the stock can be acquired or sold is the exercise price. ANS: T
PTS: 1
21. The minimum amount that must be maintained in an account is called the maintenance margin. ANS: T
PTS: 1
22. A forward contract gives its holder the option to conduct a transaction involving another security or commodity. ANS: F
PTS: 1
23. In the forward market both parties are required to post collateral or margin. ANS: F
PTS: 1
24. The option premium is the price the call buyer will pay to the option seller if the option is exercised. ANS: F
PTS: 1
25. The payoffs to both long and short position in the forward contact are symmetric around the contract price. ANS: T
PTS: 1
26. Forward contracts are much easier to unwind than futures contracts due to the standardization of the contracts. ANS: F
PTS: 1
27. Forward contracts do not require an upfront premium. ANS: T
PTS: 1
28. The payoffs diagrams to both long and short positions in a forward contract are asymmetrical around the contract price. ANS: F
PTS: 1
MULTIPLE CHOICE 1. Which of the following statements is false? a. Derivatives help shift risk from risk-adverse investors to risk-takers. b. Derivatives assist in forming cash prices. c. Derivatives provide additional information to the market. d. In many cases, the investment in derivatives (both commissions and required investment) is more than in the cash market. e. None of the above (that is, all are reasons) ANS: D
PTS: 1
OBJ: Multiple Choice
2. Derivative instruments exist because a. They help shift risk from risk-averse investors to risk-takers. b. They help in forming prices. c. They have lower investment costs. d. Choices a and b e. All of the above ANS: E
PTS: 1
OBJ: Multiple Choice
3. There are a number of differences between forward and futures contracts. Which of the following statements is false? a. Futures have less liquidity risk than forward contracts. b. Futures have less credit risk than forward contracts. c. Futures have more default risk than forward contracts. d. In futures, the exchange becomes the counterparty to all transactions. e. None of the above (that is, all statements are true) ANS: C
PTS: 1
OBJ: Multiple Choice
4. Futures differ from forward contracts because a. Futures have more liquidity risk. b. Futures have more credit risk.
c. Futures have more maturity risk. d. All of the above e. None of the above ANS: E
PTS: 1
OBJ: Multiple Choice
5. The price at which a futures contract is set at the end of the day is the a. Stock price. b. Strike price. c. Maintenance price. d. Settlement price. e. Parity price. ANS: D
PTS: 1
OBJ: Multiple Choice
6. Which of the following statements is true? a. The buyer of a futures contract is said to be long futures. b. The seller of a futures contract is said to be short futures. c. The seller of a futures contract is said to be long futures. d. The buyer of a futures contract is said to be short futures. e. Choices a and b ANS: E
PTS: 1
OBJ: Multiple Choice
7. The CBOE brought numerous innovations to the option market, which of the following is not such an innovation? a. Creation of a central marketplace b. Creation of a non-liquid secondary option market c. Introduction of a Clearing Corporation d. Standardization of all expiration dates e. Standardization of all exercise prices ANS: B
PTS: 1
OBJ: Multiple Choice
8. Which of the following factors is not considered in the valuation of call and put options? a. Current stock price b. Exercise price c. Market interest rate d. Volatility of underlying stock price e. none of the above (that is, all are factors which should be considered in the valuation of call and put options) ANS: E
PTS: 1
OBJ: Multiple Choice
9. Which of the following statements is a true definition of an in-the-money option? a. A call option in which the stock price exceeds the exercise price. b. A call option in which the exercise price exceeds the stock price. c. A put option in which the stock price exceeds the exercise price. d. An index option in which the exercise price exceeds the stock price. e. A call option in which the call premium exceeds the stock price. ANS: A
PTS: 1
OBJ: Multiple Choice
10. The value of a call option just prior to expiration is (where V is the underlying asset's market price and X is the option's exercise price) a. Max [0, V − X]
b. c. d. e.
Max [0, X − V] Min [0, V − X] Min [0, X − V] Max [0, V > X]
ANS: A
PTS: 1
OBJ: Multiple Choice
11. Which of the following is not a factor needed to calculate the value of an American call option? a. The price of the underlying stock. b. The exercise price. c. The price of an equivalent put option. d. The volatility of the underlying stock. e. The interest rate. ANS: C
PTS: 1
OBJ: Multiple Choice
12. In the valuation of an option contract, the following statements apply except a. The value of an option increases with its maturity. b. There is a negative relationship between the market interest rate and the value of a call option. c. The value of a call option is negatively related to its exercise price. d. The value of a call option is positively related to the volatility of the underlying asset. e. The value of a call option is positively related to the price of the underlying stock. ANS: B
PTS: 1
OBJ: Multiple Choice
13. You own a stock that has risen from $10 per share to $32 per share. You wish to delay taking the profit but you are troubled about the short run behavior of the stock market. An effective action on your part would be to a. Buy a put option on the stock. b. Write a call option on the stock. c. Purchase an index option. d. Utilize a bearish spread. e. Utilize a bullish spread. ANS: A
PTS: 1
OBJ: Multiple Choice
14. A vertical spread involves buying and selling call options in the same stock with a. The same time period and exercise price. b. The same time period but different exercise price. c. A different time period but same exercise price. d. A different time period and different price. e. Quotes in different options markets. ANS: B
PTS: 1
OBJ: Multiple Choice
15. The value of a put option at expiration is a. Max [0, S(T) − X] b. Max [0, X − S(T)] c. Min [0, S(T) − X] d. Min [0, X − S(T)] e. X ANS: B
PTS: 1
OBJ: Multiple Choice
16. In the two state option pricing model, which of the following does not influence the option price? a. Past stock price b. Up and down factors u and d c. The risk free rate d. The exercise price e. Current stock price ANS: A
PTS: 1
OBJ: Multiple Choice
17. The cost of carry includes all of the following except a. Storage costs. b. Insurance. c. Current price. d. Financing costs. e. Risk free rate. ANS: C
PTS: 1
OBJ: Multiple Choice
18. A call option in which the stock price is higher than the exercise price is said to be a. At-the-money. b. In-the-money. c. Before-the-money. d. Out-of-the-money. e. Above-the-money. ANS: B
PTS: 1
OBJ: Multiple Choice
19. The price paid for the option contract is referred to as the a. Forward price. b. Exercise price. c. Striking price. d. Option premium. e. Call price. ANS: D
PTS: 1
OBJ: Multiple Choice
20. A stock currently sells for $75 per share. A call option on the stock with an exercise price $70 currently sells for $5.50. The call option is a. At-the-money. b. In-the-money. c. Out-of-the-money. d. At breakeven. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
21. A stock currently sells for $150 per share. A call option on the stock with an exercise price $155 currently sells for $2.50. The call option is a. At-the-money. b. In-the-money. c. Out-of-the-money. d. At breakeven. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
22. A stock currently sells for $75 per share. A put option on the stock with an exercise price $70 currently sells for $0.50. The put option is a. At-the-money. b. In-the-money. c. Out-of-the-money. d. At breakeven. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
23. A stock currently sells for $15 per share. A put option on the stock with an exercise price $15 currently sells for $1.50. The put option is a. At-the-money. b. In-the-money. c. Out-of-the-money. d. At breakeven. e. None of the above. ANS: A
PTS: 1
OBJ: Multiple Choice
24. A stock currently sells for $15 per share. A put option on the stock with an exercise price $20 currently sells for $6.50. The put option is a. At-the-money. b. In-the-money. c. Out-of-the-money. d. At breakeven. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
25. An equity portfolio manager can neutralize the risk of falling stock prices by entering into a hedge position where the payoffs are a. Not correlated with the existing exposure. b. Positively correlated with the existing exposure. c. Negatively correlated with the existing exposure. d. Any of the above. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
26. The derivative based strategy known as portfolio insurance involves a. The sale of a put option on the underlying security position. b. The purchase of a put on the underlying security position. c. The sale of a call on the underlying security position. d. The purchase of a call on the underlying security position. e. b and d. ANS: B
PTS: 1
OBJ: Multiple Choice
27. A hedge strategy known as a collar agreement involves the simultaneous a. Purchase of an in-the money put and purchase of an out-of-the-money call on the same underlying asset with same expiration date and market price. b. Sale of an out-of-the money put and sale of an out-of-the-money call on the same underlying asset with same expiration date and market price. c. Purchase of an in-the money put and purchase of an in-the-money call on the same
underlying asset with same expiration date and market price. d. Purchase of an out-of-the money put and sale of an out-of-the-money call on the same underlying asset with same expiration date and market price. e. Sale of an in-the money put and purchase of an in-the-money call on the same underlying asset with same expiration date and market price. ANS: D
PTS: 1
OBJ: Multiple Choice
28. A call option differs from a put option in that a. a call option obliges the investor to purchase a given number of shares in a specific common stock at a set price; a put obliges the investor to sell a certain number of shares in a common stock at a set price. b. both give the investor the opportunity to participate in stock market dealings without the risk of actual stock ownership. c. a call option gives the investor the right to purchase a given number of shares of a specified stock at a set price; a put option gives the investor the right to sell a given number of shares of a stock at a set price. d. a put option has risk, since leverage is not as great as with a call. e. none of the above ANS: C
PTS: 1
OBJ: Multiple Choice
29. Which of the following statements is a true definition of an out-of-the-money option? a. A call option in which the stock price exceeds the exercise price. b. A call option in which the exercise price exceeds the stock price. c. A call option in which the exercise price exceeds the stock price. d. A put option in which the exercise price exceeds the stock price. e. A call option in which the call premium exceeds the stock price. ANS: B
PTS: 1
OBJ: Multiple Choice
30. According to put/call parity a. Stock price + Call Price = Put Price + Risk Free Bond Price b. Stock price + Put Price = Call Price + Risk Free Bond Price c. Put price + Call Price = Stock Price + Risk Free Bond Price d. Stock price − Put Price = Call Price + Risk Free Bond Price e. Stock price + Call Price = Put Price − Risk Free Bond Price ANS: B
PTS: 1
OBJ: Multiple Choice
31. Futures contracts are similar to forward contracts in that they both a. Have volatile price movements and strong interest from buyers and sellers. b. Give the holder the option to make a transaction in the future. c. Have similar liquidity. d. Have similar credit risk. e. None of the above. ANS: A
PTS: 1
OBJ: Multiple Choice
32. Which of the following statements are true? a. Futures contracts have less liquidity risk and credit risk than forward contracts. b. Futures contract prices are strongly linked to the prevailing level of the underlying spot index. c. Futures contract decrease in price, the further forward in time the delivery date is set. d. All of the above.
e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
33. A buyer of the call option is speculating on the a. Direction of the price movement of the underlying investment. b. Timing of the price movement of the underlying investment. c. Leverage that a call option creates with respect to the underlying investment. d. All of the above. e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
34. Which of the following is consistent with put-call-spot parity? a. S + C = P + X/(1 + RFR) b. S + P = C + X/(1 + RFR) c. S − C = P + X/(1 + RFR) d. S − P = C + X/(1 + RFR) e. S = P − C + X/(1 + RFR) ANS: B
PTS: 1
OBJ: Multiple Choice
35. Holding a put option and the underlying security at the same time is an example of a. Collar b. Straddle c. Income generation d. Portfolio insurance e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
36. Derivative securities can be used a. By investors in the same way as the underlying security b. To modify the risk and expected return characteristics of existing investment portfolios c. To duplicate cash flow patterns for arbitrage opportunities d. All of the above e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
37. An advantage of a forward contract over a futures contract is that a. The terms of the contract are flexible b. It is more liquid c. It trades through a centralized market exchange d. It is easier to unwind due to contract homogeneity e. None of the above ANS: A
PTS: 1
OBJ: Multiple Choice
38. A forward contract is similar to an option contract because they both a. Can provide insurance against the price of the underlying stock b. Are paid for up front in the form of premiums c. Are paid for at the end of the contract in the form of premiums d. Require a future settlement payment e. None of the above
ANS: A
PTS: 1
OBJ: Multiple Choice
39. An expiration date payoff and profit diagram for forward positions illustrates a. Gains and losses are usually small b. The payoffs to both long and short positions in the forward contract are asymmetrical around the contract price c. Forward contracts are zero-sum games d. Long positions benefit from falling prices e. None of the above ANS: C
PTS: 1
OBJ: Multiple Choice
40. A one year call option has a strike price of 50, expires in 6 months, and has a price of $5.04. If the risk free rate is 5%, and the current stock price is $50, what should the corresponding put be worth? a. $3.04 b. $4.64 c. $6.08 d. $3.83 e. $0 ANS: D p(t) = $5.04 − $50+ $50(1 + .05)−1/2 = $3.83 PTS: 1
OBJ: Multiple Choice Problem
41. A one year call option has a strike price of 50, expires in 6 months, and has a price of $4.74. If the risk free rate is 3%, and the current stock price is $45, what should the corresponding put be worth? a. $12.74 b. $10.48 c. $5.00 d. $9.00 e. $8.30 ANS: D p(t) = $4.74 − $45+ $50(1 + .03) −1/2 = $9.0 PTS: 1
OBJ: Multiple Choice Problem
42. A one year call option has a strike price of 60, expires in 6 months, and has a price of $2.5. If the risk free rate is 7%, and the current stock price is $55, what should the corresponding put be worth? a. $5.00 b. $4.56 c. $5.50 d. $7.08 e. $7.54 ANS: C p(t) = $2.5 − $55+ $60(1 + .07) −1/2 = $5.50 PTS: 1
OBJ: Multiple Choice Problem
43. A one year call option has a strike price of 70, expires in 3 months, and has a price of $7.34. If the risk free rate is 6%, and the current stock price is $62, what should the corresponding put be worth? a. $5.34 b. $8.00
c. $10.68 d. $14.33 e. $13.33 ANS: D p(t) = $7.34 − $62 + $70(1 + .06) −1/4 = $14.33 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 20.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) December futures on the S&P 500 stock index trade at 250 times the index value of 1187.70. Your broker requires an initial margin of 10% percent on futures contracts. The current value of the S&P 500 stock index is 1178. 44. Refer to Exhibit 20.1. How much must you deposit in a margin account if you wish to purchase one contract? a. $267,232.5 b. $29,450 c. $29,692.50 d. $30,000 e. $265,050 ANS: C Margin = 0.10 250 1187.70 = $29,692.50 PTS: 1
OBJ: Multiple Choice Problem
45. Refer to Exhibit 20.1. Suppose at expiration the futures contract price is 250 times the index value of 1170. Disregarding transaction costs, what is your percentage return? a. 1.87% b. −0.68% c. −14.90% d. 10.36% e. None of the above ANS: C Purchase December contract 250 1187.7 = $296,925 Sell December contract 250 1170 = $292,500 Loss in futures = $292,500 − $296,925 = −$4425 Rate of return = −$4425/29,692.50 = −.1490 or −14.9% PTS: 1
OBJ: Multiple Choice Problem
46. Refer to Exhibit 20.1. Calculate the return on a cash investment in the S&P 500 stock index if the ending index value is 1170 over the same time period. a. 1.87% b. −0.68%
c. −14.90% d. 10.36% e. None of the above ANS: B Return on cash investment in the index = (1170 − 1178)/1178 = −0.0068 or −0.68% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 20.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) A futures contract on Treasury bond futures with a December expiration date currently trade at 103:06. The face value of a Treasury bond futures contract is $100,000. Your broker requires an initial margin of 10%. 47. Refer to Exhibit 20.2. Calculate the current value of one contract. a. $100,000 b. $103,600.5 c. $103,187.5 d. $102,306.3 e. $104,293.5 ANS: C Current price is 103 6/32 percent of face value of $100,000 = 1.031875 100,000 = $103,187.50 PTS: 1
OBJ: Multiple Choice Problem
48. Refer to Exhibit 20.2. Calculate the initial margin deposit. a. $10,000 b. $10,360.50 c. $10,318.75 d. $10,230.63 e. $10,429.35 ANS: C Margin deposit = 0.10 103,187.5 = $10,318.75 PTS: 1
OBJ: Multiple Choice Problem
49. Refer to Exhibit 20.2. If the futures contract is quoted at 105:08 at expiration calculate the percentage return. a. 1.99% b. 19.99% c. 20.62% d. 25.37% e. −13.65% ANS: B Purchase December contract 103 6/32 percent of 100,000 = $103,187.50 Sell December contract 105 8/32 percent of $100,000 = $105,250
Gain in futures = $105,250 − $103,187.50 = $2,062.50 Rate of return = 2062.5/10318.75 = 0.1999 or 19.9% PTS: 1
OBJ: Multiple Choice Problem
Exhibit 20.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) On the last day of October, Bruce Springsteen is considering the purchase of 100 shares of Olivia Corporation common stock selling at $37 1/2 per share and also considering an Olivia option. Calls Price 35 40
December 3 3/4 2 1/2
Puts March 5 3 1/2
December 1 1/4 4 1/2
March 2 4 3/4
50. Refer to Exhibit 20.3. If Bruce decides to buy a March call option with an exercise price of 35, what is his dollar gain (loss) if he closes his position when the stock is selling at 43 1/2? a. $225.00 loss b. $350.00 loss c. $225.00 gain d. $350.00 gain e. $850.00 gain ANS: D 43 1/2 − 35 = 8.5 8.5 − 5 = 3.5. $3.5/share 100 shares/contract = $350.00 PTS: 1
OBJ: Multiple Choice Problem
51. Refer to Exhibit 20.3. If Bruce buys a March put option with an exercise price of 40, what is his dollar gain (loss) if he closes his position when the stock is selling at 43 1/2? a. $825.00 loss b. $475.00 loss c. $350.00 loss d. $25.00 loss e. He has a gain ANS: B The option is worthless so he loses the $475 he paid for the contract. PTS: 1
OBJ: Multiple Choice Problem
Exhibit 20.4 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Rick Thompson is considering the following alternatives for investing in Davis Industries which is now selling for $44 per share: (1) (2)
Buy 500 shares, and Buy six month call options with an exercise price of 45 for $3.25 premium.
52. Refer to Exhibit 20.4. Assuming no commissions or taxes what is the annualized percentage gain if the stock reaches $50 in four months and a call was purchased? a. 161.54% gain b. 53.85% gain c. 161.54% loss d. 11.11% gain e. 53.85% loss ANS: A [(50 − 45 − 3.25) 3.25] 3 = 161.54% gain PTS: 1
OBJ: Multiple Choice Problem
53. Refer to Exhibit 20.4. Assuming no commissions or taxes, what is the annualized percentage gain if the stock is at $30 in four months and the stock was purchased? a. 9.54% loss b. 95.45% loss c. 0.9545% gain d. 95.45% gain e. 9.54% gain ANS: B [(30 − 44) 44] 3 = 95.45% loss PTS: 1
OBJ: Multiple Choice Problem
54. Tom Gettback buys 100 shares of Johnson Walker stock for $87.00 per share and a 3-month Johnson Walker put option with an exercise price of $105.00 for $20.00. What is his dollar gain if at expiration the stock is selling for $80.00 per share? a. $200 loss b. $700 loss c. $200 gain d. $700 gain e. None of the above ANS: A Profit on put = 105 − 80 − 20 = 5 5 100 = $500.00 Loss on stock = $700.00 Net loss = $700.00 − 500.00 = $200.00 (loss) PTS: 1
OBJ: Multiple Choice Problem
55. Tom Gettback buys 100 shares of Johnson Walker stock for $87.00 per share and a 3-month Johnson Walker put option with an exercise price of $105.00 for $20.00. What is Tom's dollar gain/loss if at expiration the stock is selling for $105.00 per share? a. $1000 gain b. $200 loss c. $1000 loss d. $200 gain e. None of the above ANS: B
Put value = 0, therefore, loss = $2,000.00 Stock (105 − 87)(100) = $1,800.00 Net loss = $2,000 − 1,800 = $200.00 (loss) PTS: 1
OBJ: Multiple Choice Problem
Exhibit 20.5 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Sarah Kling bought a 6-month Peppy Cola put option with an exercise price of $55 for a premium of $8.25 when Peppy was selling for $48.00 per share. 56. Refer to Exhibit 20.5. If at expiration Peppy is selling for $42.00, what is Sarah's dollar gain or loss? a. $420 gain b. $420 loss c. $475 loss d. $475 gain e. None of the above ANS: D [(55 − 42 − 8.25) 100] = $475 gain PTS: 1
OBJ: Multiple Choice Problem
57. Refer to Exhibit 20.5. What is Sarah's annualized gain/loss? a. 11.51% gain b. 115.15% gain c. 11.51% loss d. 115.15% loss e. None of the above ANS: B [(55 − 42 − 8.25) 8.25] 2 = 115.15% gain PTS: 1
OBJ: Multiple Choice Problem
58. Refer to Exhibit 20.5. If at expiration Peppy is selling for $47.00, what is Sarah's dollar gain or loss? a. $25 loss b. $250 loss c. $25 gain d. $250 gain e. None of the above ANS: A [(55 − 47 − 8.25) 100] = $25 loss PTS: 1
OBJ: Multiple Choice Problem
59. Refer to Exhibit 20.5. What is Sarah's annualized gain/loss? a. 60.60% gain b. 6.06% loss c. 60.60% loss
d. 6.06% gain e. None of the above ANS: B [(55 − 47 − 8.25) 8.25] 2 = 6.06% loss PTS: 1
OBJ: Multiple Choice Problem
60. A stock currently trades for $25. January call options with a strike price of $30 sell for $6. The appropriate risk free bond has a price of $30. Calculate the price of the January put option. a. $11 b. $24 c. $19 d. $30 e. $25 ANS: A P = 6 + 30 − 25 = $11 PTS: 1
OBJ: Multiple Choice Problem
61. A stock currently trades for $115. January call options with a strike price of $100 sell for $16, and January put options a strike price of $100 sell for $5. Estimate the price of a risk free bond. a. $120 b. $15 c. $105 d. $116 e. $104 ANS: E Bond price = 115 + 5 − 16 = $104 PTS: 1
OBJ: Multiple Choice Problem
62. Assume that you have purchased a call option with a strike price $60 for $5. At the same time you purchase a put option on the same stock with a strike price of $60 for $4. If the stock is currently selling for $75 per share, calculate the dollar return on this option strategy. a. $10 b. −$4 c. $5 d. $6 e. $15 ANS: D Profit on call = (75 − 60) − 5 = 10 Profit on put = −4 Total = $6 PTS: 1
OBJ: Multiple Choice Problem
63. Assume that you purchased shares of a stock at a price of $35 per share. At this time you purchased a put option with a $35 strike price of $3. The stock currently trades at $40. Calculate the dollar return on this option strategy. a. $3 b. −$2
c. $2 d. −$3 e. $0 ANS: C Profit on stock = 40 − 35 = 5 Profit on put = −3 Total = $2 PTS: 1
OBJ: Multiple Choice Problem
64. Assume that you purchased shares of a stock at a price of $35 per share. At this time you wrote a call option with a $35 strike and received a call price of $2. The stock currently trades at $70. Calculate the dollar return on this option strategy. a. $25 b. −$2 c. $2 d. −$25 e. $0 ANS: C Profit on stock = 70 − 35 = 35 Profit on call = 35 − 70 + 2 = −23 Total = $2 PTS: 1
OBJ: Multiple Choice Problem
65. A stock currently trades at $110. June call options on the stock with a strike price of $105 are priced at $4. Calculate the arbitrage profit that you can earn. a. $0 b. $1 c. $5 d. $4 e. None of the above ANS: B Arbitrage profit = 110 − 105 − 4 = $1 PTS: 1
OBJ: Multiple Choice Problem
66. Datacorp stock currently trades at $50. August call options on the stock with a strike price of $55 are priced at $5.75. October call options with a strike price of $55 are priced at $6.25. Calculate the value of the time premium between the August and October options. a. −$0.50 b. $0 c. $0.50 d. $5 e. −$5 ANS: C Time premium = 6.25 − 5.75 = $0.50 PTS: 1
OBJ: Multiple Choice Problem
67. A stock currently trades at $110. June put options on the stock with a strike price of $100 are priced at $5.25. Calculate the dollar return on one put contract. a. −$525 b. $1000 c. $0 d. −$1000 e. $525 ANS: A Dollar return = (100 − 110 − 5.25)(100) = −$525 PTS: 1
OBJ: Multiple Choice Problem
68. A stock currently trades at $110. June call options on the stock with a strike price of $120 are priced at $5.75. Calculate the dollar return on one call contract. a. −$1000 b. $1000 c. $575 d. −$575 e. $0 ANS: D Dollar return = (110 − 120 − 5.75)(100) = −$575 PTS: 1
OBJ: Multiple Choice Problem
69. Consider a stock that is currently trading at $65. Calculate the intrinsic value for a put option that has an exercise price of $55. a. $10 b. $50 c. $55 d. −$10 e. $0 ANS: E Put = Max[55 − 65, 0] = $0 PTS: 1
OBJ: Multiple Choice Problem
70. Consider a stock that is currently trading at $20. Calculate the intrinsic value for a put option that has an exercise price of $35. a. $15 b. $55 c. $35 d. −$15 e. $0 ANS: A Put = Max[35 − 20, 0] = $15 PTS: 1
OBJ: Multiple Choice Problem
71. Consider a stock that is currently trading at $45. Calculate the intrinsic value for a call option that has an exercise price of $35.
a. b. c. d. e.
$25 $35 $0 −$10 $10
ANS: E Call = Max[45 − 35, 0] = $10 PTS: 1
OBJ: Multiple Choice Problem
72. Consider a stock that is currently trading at $10. Calculate the intrinsic value for a call option that has an exercise price of $15. a. $25 b. −$5 c. $0 d. $20 e. $5 ANS: C Call = Max[10 − 15, 0] = $0 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 20.6 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The current stock price of ABC Corporation is $53.50. ABC Corporation has the following put and call option prices that expire 6 months from today. The risk-free rate of return is 5% and the expected return on the market is 11%. Exercise Price 50 55
Put Price $1.50 $3.25
Call Price $5.75 ---
73. Refer to Exhibit 20.6. What should the price be of a call option that expires 6 month from today with an exercise price of $55? a. $1.33 b. $3.08 c. $4.58 d. $6.07 e. $6.33 ANS: B C = P + S − X/(1 + RFR)t = 3.25 + 53.50 − $55/(1.05)0.5 = 56.75 − 53.67 = 3.08 PTS: 1
OBJ: Multiple Choice Problem
74. Refer to Exhibit 20.6. What is the value of a synthetic stock created with put and call options that expire in 6 months with an expiration price of $50? a. $53.04 b. $53.53 c. $54.54 d. $55.03
e. $56.23 ANS: A S = C − P + X/(1 + RFR)t = 5.75 − 1.50 + $50/(1.05)0.5 = 4.25 + 48.79 = 53.04 PTS: 1
OBJ: Multiple Choice Problem
75. Refer to Exhibit 20.6. How could an investor create arbitrage profits? a. Sell the stock short, write a put, buy a call and invest the proceeds at the risk-free rate. b. Buy the stock, write a put, buy a call and invest the proceeds at the risk-free rate. c. Sell the stock short, buy a put, write a call and invest the proceeds at the risk-free rate. d. Buy the stock, write a put, buy a call and borrow the strike price at the risk-free rate. e. Sell the stock short, write a put, buy a call and borrow the strike price at the risk-free rate. ANS: A The stock price is $53.50 and the synthetic stock price is $53.04. The synthetic stock price is created by combining a long call, short put, and the present value of the strike price. The synthetic stock and stock price must converge. So shorting the stock (−S) and going long the synthetic stock (C − P + PV(X)) will create an arbitrage profit. PTS: 1
OBJ: Multiple Choice Problem
76. A stock currently trades for $63. Call options with a strike price of $62 sell for $4.00 and expire in 6 months. If the risk-free rate is 4% what should the price of a put option with an exercise price of $62 be worth? a. $0.62 b. $0.98 c. $1.80 d. $3.00 e. $5.80 ANS: C P = C + X/(1 + RFR)t − S = $4 + $62/(1.04)0.5 − $63 = $4 + $60.80 − $63 = $1.80 PTS: 1
OBJ: Multiple Choice Problem
77. You own a call option and put option that both have the same exercise price of $50 and their respective prices are $4 and $3. The stock is currently trading at $60. Calculate the dollar return on this strategy. a. $1.00 b. $2.00 c. $3.00 d. $4.00 e. $5.00 ANS: C $60 − $50 − $7 = $3 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 20.7 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The current stock price of Zanco Corporation is $50. Zanco Corporation has the following put and call option prices with exercise prices at $45 and $50.
Exercise Price $45 $50
Put Price $1.50 $3.75
Call Price $6.75 $4.25
78. Refer to Exhibit 20.7. The time premium for the put option with a $45 exercise price is a. $0.00 b. $1.50 c. $2.75 d. $5.25 e. $6.50 ANS: B The time premium for the put option with a $45 exercise price is $1.50. The put option is out of the money so the market price is purely a time premium. PTS: 1
OBJ: Multiple Choice Problem
79. Refer to Exhibit 20.7. The intrinsic value for the put option with a $50 exercise price is a. $0.00 b. $1.50 c. $2.25 d. $3.75 e. $8.75 ANS: A The intrinsic value for the put option with a $50 exercise price is $0.00. The put option is out of the money so there is no intrinsic value. PTS: 1
OBJ: Multiple Choice Problem
80. Refer to Exhibit 20.7. The intrinsic value for the call option with a $45 exercise price is a. $0.00 b. $1.50 c. $5.00 d. $5.25 e. $6.75 ANS: C The intrinsic value for the call option with a $45 exercise price is $5.00. The call option is in the money so the difference between the current stock price of $50 and the strike price equals the intrinsic value. PTS: 1
OBJ: Multiple Choice Problem
81. Refer to Exhibit 20.7. The time premium for the call option with a $50 exercise price is a. $0.00 b. $1.50 c. $1.75 d. $4.25 e. $9.25 ANS: D The time premium for the call option with a $50 exercise price is $4.25. The call option is out of the money so the market price is purely a time premium.
PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 21—FORWARD AND FUTURES CONTRACTS TRUE/FALSE 1. Forward contracts are individually designed agreements, and can be tailored to the specific needs of the ultimate end-user. ANS: T
PTS: 1
2. Like future contracts, all forward contracts are processed by a clearing corporation. ANS: F
PTS: 1
3. Since futures contracts are "marked-to-market" daily, the gains and losses are settled daily. ANS: T
PTS: 1
4. Some forward contracts, particularly in the foreign exchange market, are quite standard and liquid. ANS: T
PTS: 1
5. The goal of a hedge transaction is to increase expected returns of a fundamental holding. ANS: F
PTS: 1
6. The basis is the spot price minus the future price. ANS: T
PTS: 1
7. The number of future contracts needed to hedge a unit of the spot assets is solely a function of the variance of the spot prices. ANS: F
PTS: 1
8. In the absence of arbitrage opportunities, the forward price should be equal to the spot price plus the cost of carry. ANS: T
PTS: 1
9. Stock index futures are useful in providing a hedge against movements in an underlying financial asset. ANS: T
PTS: 1
10. The cost-of-carry model is useful for pricing future contracts. ANS: T
PTS: 1
11. If you were bearish on the near term outlook for the stock market but did not want to sell your portfolio, you could hedge against the decline by selling stock index futures. ANS: T
PTS: 1
12. If you have entered into a currency futures hedge for the Japanese yen in connection with buying Japanese equipment, if the yen goes from 110 yen/$1 to 100 yen/$1, you will lose in the spot market but have an offsetting gain in the futures market. ANS: T
PTS: 1
13. Like hedging, arbitrage results in increased returns with a disproportional increase in risk. ANS: F
PTS: 1
14. Interest rate parity is a key concept in managing risk in the commodities market. ANS: F
PTS: 1
15. According to the cost of carry model the futures price is the present value of the spot price discounted at the risk free rate. ANS: F
PTS: 1
16. In the cost of carry model the inclusion of storage costs will increase the futures price. ANS: T
PTS: 1
17. The inclusion of dividends in the cost of carry model will increase the futures price. ANS: F
PTS: 1
18. The basis (Bt,T) at time t between the spot price (St) and a futures contract expiring at time T (Ft,T) is: St − Ft,T. ANS: T
PTS: 1
19. A riskless stock index arbitrage profit is possible if the following condition holds: F0,T = S0(1 + rf − d)T, where spot price now is S0, value now of a futures contract expiring at time T is (F0,T), rf is the risk free rate and d is the dividend. ANS: F
PTS: 1
20. The pure expectations hypothesis suggests futures prices serve as unbiased forecasts of future spot prices. ANS: T
PTS: 1
21. The Chicago Board of Trade (CBT) uses conversion factors to correct for differences in deliverable bonds. ANS: T
PTS: 1
22. The Eurodollar futures contract is a popular hedging vehicle because it is based on the three-month LIBOR. ANS: T
PTS: 1
23. An investor in a hedge position is no longer exposed to the absolute price movement of the underlying asset, but the investor is still exposed to basis risk. ANS: T
PTS: 1
24. In the absence of arbitrage opportunities, the forward contract price should be equal to the current spot price plus interest. ANS: F
PTS: 1
MULTIPLE CHOICE 1. The main tradeoff between forward and future contracts is a. Design flexibility. b. Credit risk. c. Liquidity risk. d. All of the above. e. Choices a and b only ANS: D
PTS: 1
OBJ: Multiple Choice Concept
2. The process by which invest on margin accounts are credited or debited to reflect daily trading gains or losses is referred to as the ____ process. a. Hedge rationing b. Daily settlement c. Marked-to-market d. Book-to-market e. Account realization ANS: C
PTS: 1
OBJ: Multiple Choice Concept
3. As a contract approaches maturity, the spot price and forward price a. Increase. b. Diverge. c. Maintain a fixed price differential. d. Have a random relationship. e. Converge. ANS: E
PTS: 1
OBJ: Multiple Choice Concept
4. Which of the following statements is true? a. The buyer of a forward contract is said to be long forward. b. The seller of a forward contract is said to be short forward. c. The seller of a forward contract is said to be long forward. d. The buyer of a forward contract is said to be short forward. e. Choices a and b ANS: E
PTS: 1
OBJ: Multiple Choice Concept
5. The optimal hedge ratio is a function of all of the following except a. The standard deviation of changes in spot prices. b. The variance deviation of changes in forward prices. c. The covariance between changes in spot and forward prices.
d. Choices a and b only e. All of the above ANS: D
PTS: 1
OBJ: Multiple Choice Concept
6. The major difference between valuing futures versus forward contracts stems from the fact that future contracts are a. Traded on exchange. b. Backed by a clearinghouse. c. Marked-to-market daily. d. Less risky. e. Relatively inflexible. ANS: C
PTS: 1
OBJ: Multiple Choice Concept
7. In the absence of arbitrage opportunities, the forward contract price should be equal to the current price plus a. Contract price. b. The cost of carry. c. Margin requirement. d. The price discovery rate. e. The convenience return. ANS: B
PTS: 1
OBJ: Multiple Choice Concept
8. Which of the following is not considered a "cost of carry"? a. Commissions for physical storage b. An opportunity cost for the net amount of invested capital c. A premium for the convenience of consuming the asset now d. A risk premium for uncertainty e. All of the above are considered costs of carry. ANS: D
PTS: 1
OBJ: Multiple Choice Concept
9. Financial futures have become an increasingly attractive investment alternative since the Chicago Board of Trade (CBOT) began trading them in 1977, and their hedging function partly accounts for the growth in trading. Which of the following statements concerning financial futures is true? a. Financial futures protect the investment portfolio against inflation in the economy. b. Investors seek protection against the increasing volatility of interest rates. c. Unlike commodity futures, factors that influence price shifts are not supply and demand of the commodity but buyer psychology. d. A reason for their popularity is that trading is restricted to government obligations, which reduces risks. e. All of the above are true statements ANS: B
PTS: 1
OBJ: Multiple Choice Concept
10. The most popular financial futures in terms of average daily volume is the a. OEX contracts. b. S&P 500 contracts. c. LIBOR contracts. d. T-bill contracts. e. T-bond contracts. ANS: E
PTS: 1
OBJ: Multiple Choice Concept
11. The bond that maximizes the difference between the invoice price and the delivery price is referred to as the a. Cheapest-to-deliver. b. Conversion bond. c. Delivery bond. d. Cheapest to substitute. e. Cost-of-carry. ANS: A
PTS: 1
OBJ: Multiple Choice Concept
12. According to the cost of carry model the relationship between the spot (S0) and futures price (F0,T) is a. S0 = F0,T/(1 + rf)T b. S0 = F0,T(1 + rf)T c. S0 + F0,T = (1 + rf)T d. S0 = F0,T + (1 + rf)T e. S0 − F0,T = (1 + rf)T ANS: A
PTS: 1
OBJ: Multiple Choice Concept
13. The inclusion of the following in the cost of carry model will increase the futures price a. Dividends b. Storage costs c. Interest rate d. a and b e. None of the above ANS: B
PTS: 1
OBJ: Multiple Choice Concept
14. The basis (Bt,T) at time t between the spot price (St) and a futures contract expiring at time T (Ft,T) is a. Bt,T = St + Ft,T b. Bt,T = St − Ft,T c. Bt,T = St Ft,T d. Bt,T = St/Ft,T e. None of the above ANS: B
PTS: 1
OBJ: Multiple Choice Concept
15. A riskless stock index arbitrage profit is possible if the following condition holds: a. F0,T = S0(1 + rf − d)T b. F0,T > S0(1 + rf − d)T c. F0,T < S0(1 + rf − d)T d. a and b e. b and c ANS: D
PTS: 1
OBJ: Multiple Choice Concept
16. A backwardated futures market occurs when a. F0,T < S0 b. F0,T = S0 c. F0,T > S0 d. F0,T > E( ST) e. F0,T > ST ANS: A
PTS: 1
OBJ: Multiple Choice Concept
17. Which of the following is true when F0,T < E(ST)? a. Occurs when long hedgers outnumber short hedgers. b. Occurs when short hedgers outnumber long hedgers. c. The market is said to be in contango. d. The market is said to be in normal contango. e. The pure expectations hypothesis holds. ANS: B
PTS: 1
OBJ: Multiple Choice Concept
18. When F0,T > E(ST) it is known as a. Backwardation. b. Normal backwardation. c. Normal contango. d. Inverted spread. e. Pure expectations equilibrium. ANS: C
PTS: 1
OBJ: Multiple Choice Concept
19. Financial futures include all of the following underlying securities except a. Stock indexes b. Treasury bonds c. Bank deposits d. Foreign currencies e. All of the above are examples of underlying securities for financial futures ANS: E
PTS: 1
OBJ: Multiple Choice Concept
20. An investor who wants a long position in a ____ must first place the order with a broker, who then passes it on to the trading pit or electronic network. Details of the order are then passed on to the exchange clearinghouse. a. Call option b. Put option c. Forward contract d. Futures contract e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice Concept
21. In your portfolio you have $1 million of 20 year, 8 5/8 percent bonds which are selling at 83.15 (or 83 15/32) against this position. Because you feel interest rates will rise you sell 10 bond futures at 81.15 (or 81 15/32) against this position. Two months later you decide to close your position. The bonds have fallen to 78 and the futures contracts are at 75.16 (75 16/32). Disregarding margin and transaction costs, what is your gain or loss? a. $5,000 loss b. $500 loss c. Breakeven d. $500 gain e. $5,000 gain ANS: E Bonds Value of portfolio (now) Value of portfolio (2 mo.) Loss in value
$834,687.50 780,000.00 $ 54,687.50
Futures Sell 10 bond futures (now) Buy 10 bond futures (2 mo.) Gain in futures Net gain
PTS: 1
$814,687.50 755,000.00 $ 59,687.50
= Gain in futures − loss in bond value = $59,687.50 − $54,687.50 = $5,000 OBJ: Multiple Choice Problem
Exhibit 21.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) In late January 2004, The Union Cosmos Company is considering the sale of $100 million in 10-year debentures that will probably be rated AAA like the firm's other bond issues. The firm is anxious to proceed at today's rate of 10.5 percent. As treasurer, you know that it will take until sometime in April to get the issue registered and sold. Therefore, you suggest that the firm hedge the pending issue using Treasury bond futures contracts each representing $100,000. Current Value − January 2004 Bond Rate June 2004 Treasury Bonds Estimated Values − April 2004 Bond Rate June 2004 Treasury Bonds
Case 1
Case 2
10.5% 78.875
10.5% 78.875
11.0% 75.93
10.0% 81.84
22. Refer to Exhibit 21.1. Explain how you would go about hedging the bond issue? a. Sell 1,000 contracts b. Buy 1,000 contracts c. Sell 100 contracts d. Sell 10,000 contracts e. None of the above ANS: A A short hedge is appropriate in this case. So, assuming a 1:1 hedge ratio, sell 1,000 $100,000 contracts. PTS: 1
OBJ: Multiple Choice Problem
23. Refer to Exhibit 21.1. What is the dollar gain or loss assuming that future conditions described in Case 1 actually occur? (Ignore commissions and margin costs, and assume a naive hedge ratio.) a. $2,945,000.00 gain b. $65,500.00 gain c. $2,945,000.00 loss d. $65,500.00 loss e. None of the above ANS: D Payoff on futures position: $100,000(.78875 − .7593) = $2,945 per contract Times 1,000 contracts = $2,945,000 gain Annual interest increase = (11.00 − 10.50) = .5%
Or $100,000,000(0.005) = $500,000 per year Present value of increased interest at 10.5% for 10 years = $3,010,500 Net loss = $2,945,000 − $3,010,500 = ($65,500) PTS: 1
OBJ: Multiple Choice Problem
24. Refer to Exhibit 21.1. What is the dollar gain or loss assuming that future conditions described in Case 2 actually occur? (Ignore commissions and margin costs, and assume a naive hedge ratio.) a. $2,965,000.00 gain b. $45,500.00 gain c. $2,965,000.00 loss d. $45,500.00 loss e. None of the above ANS: B Payoff on futures position: $100,000(0.78875 − 0.8184) = $2,965 per contract Times 1,000 contracts = $2,965,000 loss Additional annual interest savings = 11.00 − 10.50 = .5% per year Or (0.005)(100,000,000) = $500,000 per year Present value of interest savings at 10.5% for 10 years = $3,000,500 Net gain = (2,965,000) + 3,010,500 = $45,500 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 21.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Assume you are the Treasurer for the Johnson Pharmaceutical Company and in late July 2004, the company is considering the sale of $500 million in 20-year debentures that will most likely be rated the same as the firm's other debt issues. The firm would like to proceed at the current rate of 8.5%, but you know that it will probably take until November to bring the issue to market. Therefore, you suggest that the firm hedge the pending issue using Treasury bond futures contracts which each represent $100,000. Current Value − July 2004 Bond Rate Dec. 2004 Treasury Bonds Estimated Values − Nov. 2004 Bond Rate Dec. 2004 Treasury Bonds
Case 1
Case 2
8.5% 87.75
8.5% 87.75
9.5% 85.60
7.5% 91.65
25. Refer to Exhibit 21.2. How you would go about hedging the bond issue? a. Buy 5,000 contracts b. Buy 50,000 contracts c. Sell 5,000,000 contracts d. Sell 5,000 contracts e. None of the above ANS: D
A short hedge is appropriate in this case. So, assuming a 1:1 hedge ratio, sell 5,000 $100,000 contracts. PTS: 1
OBJ: Multiple Choice Problem
26. Refer to Exhibit 21.2. What is the dollar gain or loss assuming that future conditions described in Case 1 actually occur? (Ignore commissions and margin costs, and assume a naive hedge ratio.) a. $47,316,683.00 gain b. $36,566,683.00 loss c. $10,750,000.00 gain d. $10,750,000.00 loss e. None of the above ANS: B Payoff on futures position: $100,000(0.8875 − 0.8560) = $2,150 per contract Times 5,000 contracts = $10,750,000 gain Annual interest increase = (9.5 − 8.5) = 1% per year Or $500,000,000(0.01) = $5,000,000 per year Present value of increased interest at 8.5% for 20 years = $47,316,683 Net loss = $47,316,683 − $10,750,000 = $36,566,683 PTS: 1
OBJ: Multiple Choice Problem
27. Refer to Exhibit 21.2. What is the dollar gain or loss assuming that future conditions described in Case 2 actually occur? (Ignore commissions and margin costs, and assume a naive hedge ratio.) a. $19,500,000.00 gain b. $27,816,683.04 gain c. $27,816,683.04 loss d. $19,500,000.00 loss e. None of the above ANS: B Payoff on futures position: $100,000(0.8875 − 0.9165) = $3,900 per contract Times 5,000 contracts = $19,500,000 gain Annual interest savings = (8.5 − 7.5) = 1% per year Or $500,000,000(.01) = $5,000,000 per year Present value of interest savings at 8.5% for 20 years = $47,316,683 Net gain = $47,316,683 + (19,500,000) = $27,816,683.04 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 21.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
As a relationship officer for a money-center commercial bank, one of your corporate accounts has just approached you about a one-year loan for $3,000,000. The customer would pay a quarterly interest expense based on the prevailing level of LIBOR at the beginning of each quarter. As is the bank's convention on all such loans, the amount of the interest payment would then be paid at the end of the quarterly cycle when the new rate for the next cycle is determined. You observe the following LIBOR yield curve in the cash market: 90-day LIBOR 180-day LIBOR 270-day LIBOR 360-day LIBOR
4.70% 4.85% 5.10% 5.40%
28. Refer to Exhibit 21.3. If 90-day LIBOR rises to the levels "predicted" by the implied forward rates, what will the dollar level of the bank's interest receipt be at the end of the first quarter? a. $35,250.00 b. $36,375.00 c. $38,250.00 d. $40,500.00 e. None of the above ANS: A 3,000,000 0.047(90/360) = $35,250.00 PTS: 1
OBJ: Multiple Choice Problem
29. Refer to Exhibit 21.3. What is the implied 90-day forward rate at the beginning of the second quarter? a. 4.70% b. 4.85% c. 4.60% d. 4.94% e. None of the above ANS: D BIFRA = [((B AYB) − (A AYA))/(B − A)] [1 + (AYA)(A/360)] where: BIFRA = the implied forward rate at time A over the period from time A to B AYB = the add-on yield for an instrument with B days to maturity. AYA = the add-on yield for an instrument with A days to maturity. 180IFR90
PTS: 1
= [((180)(0.0485) − (90)(0.047))/(180−90)] [1 + (0.047)(90/360)] = 0.049419 or 4.94% OBJ: Multiple Choice Problem
30. Refer to Exhibit 21.3. If 90-day LIBOR rises to the levels "predicted" by the implied forward rates, what will the dollar level of the bank's interest receipt be at the end of the second quarter? a. $40,500.00 b. $38,250.00 c. $35,250.00 d. $37,064.25 e. None of the above ANS: D $3,000,000 (.049419)(90/360) = $37,064.25
PTS: 1
OBJ: Multiple Choice Problem
31. Refer to Exhibit 21.3. What is the implied 90-day forward rate at the beginning of the third quarter? a. 5.10% b. 5.47% c. 4.70% d. 4.85% e. None of the above ANS: B BIFRA = [((B AYB) − (A AYA))/(B − A)] [1 + (AYA)(A/360)] where: BIFRA = the implied forward rate at time A over the period from time A to B AYB = the add-on yield for an instrument with B days to maturity. AYA = the add-on yield for an instrument with A days to maturity. 270IFR180
PTS: 1
= [((270)(0.0510) − (180)(0.0485))/(270 − 180)] [1 + (0.0485)(180/360)] = 0.054674 or 5.47% OBJ: Multiple Choice Problem
32. Refer to Exhibit 21.3. If 90-day LIBOR rises to the levels "predicted" by the implied forward rates, what will the dollar level of the bank's interest receipt be at the end of the third quarter? a. $35,250.00 b. $36,375.00 c. $38,250.00 d. $41,005.50 e. None of the above ANS: D $3,000,000 (.054674/360)(90) = $41,005.50 PTS: 1
OBJ: Multiple Choice Problem
33. Refer to Exhibit 21.3. What is the implied 90-day forward rate at the beginning of the fourth quarter? a. 6.19% b. 5.10% c. 6.07% d. 5.68% e. None of the above ANS: C BIFRA = [((B AYB) − (A AYA))/(B − A)] [1 + (AYA)(A/360)] where: BIFRA = the implied forward rate at time A over the period from time A to B AYB = the add-on yield for an instrument with B days to maturity. AYA = the add-on yield for an instrument with A days to maturity. 360IFR270
PTS: 1
= [((360)(0.054) − (270)(0.051))/(360 − 270)] [1 + (0.051)(270/360)] = 0.060679 or 6.07% OBJ: Multiple Choice Problem
34. Refer to Exhibit 21.3. If 90-day LIBOR rises to the levels "predicted" by the implied forward rates, what will the dollar level of the bank's interest receipt be at the end of the fourth quarter? a. $36,223.50 b. $40,500.00 c. $38,250.00 d. $36,375.00 e. None of the above ANS: A $3,000,000 .048298(90/360) = $36,223.50 PTS: 1
OBJ: Multiple Choice Problem
35. Refer to Exhibit 21.3. If the bank wanted to hedge its exposure to falling LIBOR on this loan commitment, describe the sequence of transactions in the futures markets it could undertake. a. Buy 3 Eurodollar futures contracts that expire at the end of the first quarter. b. Buy 3 Eurodollar futures contracts that expire at the end of the first quarter, 3 that expire at the end of the second quarter, and 3 that expire at the end of the third quarter. c. Sell 3 Eurodollar futures contracts that expire at the end of the year. d. Sell one Eurodollar futures contract that expires at the end of the first quarter, one that expires at the end of the second quarter, and one that expires at the end of the third quarter. e. Buy 3 Eurodollar futures contracts that expire at the end of the year. ANS: B
PTS: 1
OBJ: Multiple Choice Concept
36. Refer to Exhibit 21.3. Assuming the yields inferred from the Eurodollar futures contract prices for the next three settlement periods are equal to the implied forward rates, calculate the dollar value of the annuity that would leave the bank indifferent between making the floating-rate loan and hedging it in the futures market, and making a one-year fixed-rate loan. a. $49,312.36 b. $35,120.62 c. $39,036.45 d. $44,452.36 e. None of the above ANS: C 35,250.00/(1 + 0.047(90/360)) + 34,875.00/(1 + 0.0485(180/360)) + 35,534.72/(1 + 0.0510(270/360)) + 50,818.16/(1 + 0.0540(360/360)) $151,330.10 Annuity PTS: 1
= Annuity/(1 + 0.047(90/360)) + Annuity/(1 + 0.0485(180/360)) + Annuity/(1 + 0.0510(270/360)) + Annuity/(1 + 0.0540(360/360)) = 3.876636 Annuity = $39,036.45
OBJ: Multiple Choice Problem
37. Refer to Exhibit 21.3. Assuming the yields inferred from the Eurodollar futures contract prices for the next three settlement periods are equal to the implied forward rates, calculate in annual (360-day) percentage terms, the annuity that would leave the bank indifferent between making the floating-rate loan and hedging it in the futures market, and making a one-year fixed-rate loan. a. 20.86% b. 5.10% c. 4.91% d. 5.20% e. None of the above
ANS: D (Annuity/3,000,000)(360/90) = ($39,036.45/3,000,000) 4 = 0.0520 or 5.20% PTS: 1
OBJ: Multiple Choice Problem
38. A bond portfolio manager expects a cash inflow of $12,000,000. The manager plans to hedge potential risk with a Treasury futures contract with a value of $105,215. The conversion factor between the CTD and the bond specified in the Treasury futures contract is 0.85. The duration of bond portfolio is 8 years, and the duration of the CTD bond is 6.5 years. Indicate the number of contracts required and whether the position to be taken is short or long. a. 114 contracts short b. 114 contracts long c. 119 contract short d. 119 contracts long e. None of the above ANS: D Number of contracts = (12000000/105215)(0.85)(8/6.5) = 119.32 119 contracts long PTS: 1
OBJ: Multiple Choice Problem
39. A bond portfolio manager expects a cash outflow of $35,000,000. The manager plans to hedge potential risk with a Treasury futures contract with a value of $105,215. The conversion factor between the CTD and the bond specified in the Treasury futures contract is 0.85. The duration of bond portfolio is 8 years, and the duration of the CTD bond is 6.5 years. Indicate the number of contracts required and whether the position to be taken is short or long. a. 333 contracts short b. 333 contracts long c. 348 contract short d. 348 contracts long e. None of the above ANS: C Number of contracts
= (35000000/105215)(0.85)(8/6.5) = 348.01
348 contracts short PTS: 1
OBJ: Multiple Choice Problem
40. Assume that you manage a $50 million equity portfolio. The portfolio beta is 0.85. You anticipate a cash inflow of $5 million into the portfolio. Calculate the number of contracts you would need to hedge your position and indicate whether you would go short or long. Assume that the price of the S&P 500 futures contract is 1062 and the multiplier is 250. a. 25 contracts short b. 18 contracts short c. 16 contracts long d. 19 contracts short e. None of the above ANS: C Number of contracts = [5,000,000/(250)(1062)](0.85) = 16
Since you wish to lock in the purchase price you go long. PTS: 1
OBJ: Multiple Choice Problem
41. Assume that you manage an equity portfolio. The portfolio beta is 1.15. You anticipate a decline in equity values and wish to hedge $500 million of the portfolio. Calculate the number of contracts you would need to hedge your position and indicate whether you would go short or long. Assume that the price of the S&P 500 futures contract is 1105 and the multiplier is 250. a. 2500 contracts short b. 1810 contracts short c. 1810 contracts long d. 2081 contracts short e. 2081 contracts long ANS: D Number of contracts
= [500,000,000/(250)(1105)](1.15) = 2081
Since you expect a decline in prices you go short. PTS: 1
OBJ: Multiple Choice Problem
42. Assume that you manage an equity portfolio. The portfolio beta is 1.15. You anticipate a rise in equity values and wish to increase equity exposure on $500 million of the portfolio. Calculate the number of contracts you would need to hedge your position and indicate whether you would go short or long. Assume that the price of the S&P 500 futures contract is 1105 and the multiplier is 250. a. 2500 contracts short b. 1810 contracts short c. 1810 contracts long d. 2081 contracts short e. 2081 contracts long ANS: E Number of contracts
= [500,000,000/(250)(1105)](1.15) = 2081
Since you expect a rise in prices you go long. PTS: 1
OBJ: Multiple Choice Problem
Exhibit 21.4 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) A 3-month T-bond futures contract (maturity 20 years, coupon 6%, face $100,000) currently trades at $98,781.25 (implied yield 6.11%). A 3-month T-note futures contract (maturity 10 years, coupon 6%, face $100,000) currently trades at $101,468.80 (implied yield 5.80%). Assume semiannual compounding. 43. Refer to Exhibit 21.4. If you expected the yield curve to steepen, the appropriate NOB futures spread strategy would be a. Go long the T-bond and short the T-note b. Go short the T-bond and long the T-note c. Go long the T-bond and long the T-note d. Go short the T-bond and short the T-note
e. None of the above ANS: B If you expected the yield curve to steepen, the appropriate NOB futures spread strategy would be go short the T-bond and long the T-note. PTS: 1
OBJ: Multiple Choice Problem
44. Refer to Exhibit 21.4. If you expected the yield curve to flatten, the appropriate NOB futures spread strategy would be a. Go long the T-bond and short the T-note b. Go short the T-bond and long the T-note c. Go long the T-bond and long the T-note d. Go short the T-bond and short the T-note e. None of the above ANS: A If you expected the yield curve to flatten, the appropriate NOB futures spread strategy would be go long the T-bond and short the T-note. PTS: 1
OBJ: Multiple Choice Problem
45. Refer to Exhibit 21.4. Suppose the yield curve changed so the that the new yield on the T-bond contract rose to 6.5% and the new yield on the T-note contract fell to 5.5%. Calculate the profit on the NOB futures spread. (Assume coupons are paid semiannually) a. −$5850.92 b. −$6,671.42 c. $6,671.42 d. $5850.92 e. None of the above ANS: C First calculate the new prices of the T-bond and T-notes contracts using bond valuation formulas with semi-annual compounding. T-bond price = $94,447.89. T-note price = $103,806.81. NOB profit = (98,781.25 − 94,447.89) + (103,806.81 − 101,468.80) = $6,671.42
PTS: 1
OBJ: Multiple Choice Problem
Exhibit 21.5 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
The S&P 500 stock index is at 1100. The annualized interest rate is 3.5% and the annualized dividend is 2%. 46. Refer to Exhibit 21.5. Calculate the price of the futures contract now. a. 1108.59 b. 1102.75 c. 1139.79 d. 1123.19 e. None of the above ANS: B F(0, T) = 1100 + 1100(.00533 − .0033) = 1102.75 PTS: 1
OBJ: Multiple Choice Problem
47. Refer to Exhibit 21.5. If the futures contract was currently available for 1250, indicate the appropriate strategy that would earn an arbitrage profit. a. Long futures, and short the index. b. Short futures and long the index. c. Long futures and long the index. d. Short futures and short the index. e. None of the above. ANS: B Since the futures contract is trading above its theoretical value the appropriate strategy would be to short the futures contract and go long the index. PTS: 1
OBJ: Multiple Choice Problem
48. Refer to Exhibit 21.5. If the futures contract was currently available for 1050, indicate the appropriate strategy that would earn an arbitrage profit. a. Long futures, and short the index. b. Short futures and long the index. c. Long futures and long the index. d. Short futures and short the index. e. None of the above. ANS: A Since the futures contract is trading below its theoretical value the appropriate strategy would be to go long the futures contract and short the index. PTS: 1
OBJ: Multiple Choice Problem
49. Refer to Exhibit 21.5. If the futures contract was currently available for 1250, calculate the arbitrage profit. a. $0 b. $133.41 c. −$133.41 d. $147.25 e. −$147.25 ANS: D You should short futures at $1250. Borrow at the rate of 0.5833% (3.5%/(360/60)) to buy the index at $1100. Hold for 60 days, then collect dividends and repay loan.
The net profit = 1250 − 1100 − 1100(.005833 − .0033) = $147.25 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 21.6 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Assume that you observe the following prices in the T-Bill and Eurodollar futures markets
September
T-Bill 93.25
Eurodollar 92.35
50. Refer to Exhibit 21.6. If you expected the TED spread to widen over the next month then an appropriate strategy would be to a. Go long T-Bill futures and long Eurodollar futures. b. Go short T-Bill futures and short Eurodollar futures. c. Go long T-Bill futures and short Eurodollar futures. d. Go short T-Bill futures and long Eurodollar futures. e. None of the above. ANS: C If the spread is expected to widen then go long T-Bill futures and short Eurodollar futures. PTS: 1
OBJ: Multiple Choice Problem
51. Refer to Exhibit 21.6. Assume that a month later the price of the September T-Bill future is 93 and the price of the Eurodollar future is 90.25. Calculate the profit on the T-Bill futures position. a. 25 basis points. b. 110 basis points. c. −25 basis points. d. −110 basis points. e. 50 basis points. ANS: C Profit on long T-Bill futures position = 93 − 93.25 = −.25 = −25 basis points. PTS: 1
OBJ: Multiple Choice Problem
52. Refer to Exhibit 21.6. Assume that a month later the price of the September T-Bill future is 93 and the price of the Eurodollar future is 90.25. Calculate the profit on the Eurodollar futures position. a. 190 basis points. b. 210 basis points. c. −190 basis points. d. −210 basis points. e. 100 basis points. ANS: B Profit on short Eurodollar futures position = 92.35 − 90.25 = 2.1 = 210 basis points. PTS: 1
OBJ: Multiple Choice Problem
Exhibit 21.7 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Assume that you observe the following prices in the T-Bill and Eurodollar futures markets
September
T-Bill 95.24
Eurodollar 94.6
53. Refer to Exhibit 21.7. If you expected the TED spread to narrow over the next month then an appropriate strategy would be to a. Go long T-Bill futures and long Eurodollar futures. b. Go short T-Bill futures and short Eurodollar futures. c. Go long T-Bill futures and short Eurodollar futures. d. Go short T-Bill futures and long Eurodollar futures. e. None of the above. ANS: D If the spread is expected to narrow then go short T-Bill futures and long Eurodollar futures. PTS: 1
OBJ: Multiple Choice Problem
54. Refer to Exhibit 21.7. Assume that a month later the price of the September T-Bill future is 96.25 and the price of the Eurodollar future is 95.9. Calculate the profit on the T-Bill futures position. a. 101 basis points. b. 130 basis points. c. −101 basis points. d. −130 basis points. e. 29 basis points. ANS: C Profit on short T-Bill futures position = 95.24 − 96.25 = −1.01 = −101 basis points. PTS: 1
OBJ: Multiple Choice Problem
55. Refer to Exhibit 21.7. Assume that a month later the price of the September T-Bill future is 96.25 and the price of the Eurodollar future is 95.9. Calculate the profit on the Eurodollar futures position. a. 101 basis points. b. 130 basis points. c. −101 basis points. d. −130 basis points. e. 29 basis points. ANS: B Profit on long Eurodollar futures position = 95.9 − 94.6 = 1.3 = 130 basis points. PTS: 1
OBJ: Multiple Choice Problem
Exhibit 21.8 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Consider a portfolio manager with a $20,500,000 equity portfolio under management. The manager wishes to hedge against a decline in share values using stock index futures. Currently a stock index future is priced at 1250 and has a multiplier of 250. The portfolio beta is 1.25. 56. Refer to Exhibit 21.8. Calculate the number of contract required to hedge the risk exposure and indicate whether the manager should be short or long. a. 100 contracts long.
b. c. d. e.
82 contracts short. 82 contracts long. 100 contract short. None of the above.
ANS: B Since you are long the equity portfolio you should be short the stock index futures contract. The number of contracts = [(20,500,000/(1250)(250))] 1.25 = 82 contracts PTS: 1
OBJ: Multiple Choice Problem
57. Refer to Exhibit 21.8. Assume that a month later the equity portfolio has a market value of $20,000,000 and the stock index future is priced at 1150 with a multiplier of 250. Calculate the profit on the equity position. a. $100,000 b. −$200,000 c. $600,000 d. −$500,000 e. $400,000 ANS: D Profit on the equity portfolio = 20,000,000 − 20,500,000 = −$500,000 PTS: 1
OBJ: Multiple Choice Problem
58. Refer to Exhibit 21.8. Assume that a month later the equity portfolio has a market value of $20,000,000 and the stock index future is priced at 1150 with a multiplier of 250. Calculate the profit on the stock index futures position. a. $1,550,000 b. −$2,000,000 c. $2,050,000 d. −$5,000,000 e. $2,400,000 ANS: C Profit on the stock index future = [(1250)(250) − (1150)(250)] 82 = $2,050,000 PTS: 1
OBJ: Multiple Choice Problem
59. Refer to Exhibit 21.8. Calculate the overall profit. a. $1,550,000 b. −$2,000,000 c. $2,050,000 d. −$5,000,000 e. $2,400,000 ANS: A Overall profit = 2,050,000 − 500,000 = $1,550,000 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 21.9 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
As a portfolio manager, you are responsible for a $150 million portfolio, 90 percent of which is invested in equities, with a portfolio beta of 1.25. You are utilizing the S&P 500 as your passive benchmark. Currently the S&P 500 is valued at 1202. The value of the S&P 500 futures contract is equal to $250 times the value of the index. The beta of the futures contract is 1.0. 60. Refer to Exhibit 21.9. If you anticipate a cash inflow of $2 million next week, how many futures contracts should you buy or sell in order to mitigate the effect of this inflow on the portfolio's performance (rounded to the nearest integer)? a. Sell 6 contracts b. Buy 6 contracts c. Sell 8 contracts d. Buy 8 contracts e. None of the above ANS: B Value of S&P 500 futures contract = $250 1202 = $300,500 Number of contracts = (2,000,000/300,500)(1.25) = 5.99 6 contracts should be purchased to hedge cash inflow. PTS: 1
OBJ: Multiple Choice Problem
61. Refer to Exhibit 21.9. If you anticipate a cash outflow of $5 million next week, how many futures contracts should you buy or sell in order to mitigate the effect of this outflow on the portfolio's performance (rounded to the nearest integer)? a. Sell 21 contracts b. Buy 21 contracts c. Sell 17 contracts d. Buy 17 contracts e. None of the above ANS: A Value of S&P 500 futures contract = $300,500 Number of contracts = (5,000,000/300,500)(1.25) = 20.80 20.80 contracts should be sold to hedge cash outflow. PTS: 1
OBJ: Multiple Choice Problem
62. Refer to Exhibit 21.9. How many contracts should you buy or sell in order to increase the portfolio beta to 1.30 (rounded to the nearest integer)? a. Sell 70 contracts b. Buy 70 contracts c. Buy 87 contracts d. Buy 98 contracts e. None of the above ANS: C 1.3 = (0.90)(1.25) + [(F)(300,500)/150,000,000](1.0) 87.35 = F (87 contracts should be purchased) PTS: 1
OBJ: Multiple Choice Problem
63. Refer to Exhibit 21.9. How many contracts should you buy or sell in order to reduce the portfolio beta to 0.80 (rounded to the nearest integer)?
a. b. c. d. e.
Sell 162 contracts Buy 162 contracts Sell 324 contracts Buy 324 contracts None of the above
ANS: A 0.8 = (0.90)(1.25) + [(F)(300,500)/150,000,000](1.0) −162.23 = F (162 contracts should be sold) PTS: 1
OBJ: Multiple Choice Problem
Exhibit 21.10 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The S&P 500 stock index is at 1300. The annualized interest rate is 4.0% and the annualized dividend is 2%. You are currently considering purchasing a 2-month futures contract for your portfolio. 64. Refer to Exhibit 21.10. Calculate the current price of the futures contract. a. 1295.66 b. 1304.34 c. 1342.75 d. 1379.29 e. 1393.49 ANS: B F(0, T)
PTS: 1
= 1300 + 1300(4%/(360/60) − 2%/(360/60)) = 1300 + 1300(.00667 − .00333) = 1304.34 OBJ: Multiple Choice Problem
65. Refer to Exhibit 21.10. If the futures contract was currently available for 1280, indicate the appropriate strategy that would earn an arbitrage profit. a. Long futures, and short the index. b. Short futures and long the index. c. Long futures and long the index. d. Short futures and short the index. e. None of the above. ANS: A Since the futures contract is trading below its theoretical value the appropriate strategy would be to go long the futures contract and short the index. PTS: 1
OBJ: Multiple Choice Problem
66. Refer to Exhibit 21.10. If the futures contract was currently available for 1350, calculate the arbitrage profit. a. $8.33 b. $28.45 c. $45.67 d. $50.00 e. $54.33 ANS: C
You should short futures at $1350. Borrow at the rate of 0.6667% (4%/(360/60)) to buy the index at $1300. Hold for 60 days, then collect dividends and repay loan. The net profit = 1350 − 1300 − 1300(.006667 − .003333) = $45.67 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 21.11 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Consider a portfolio manager with a $10,000,000 equity portfolio under management. The manager wishes to hedge against a decline in share values using stock index futures. Currently a stock index future is priced at 1350 and has a multiplier of 250. The portfolio beta is 1.50. 67. Refer to Exhibit 21.11. Calculate the number of contract required to hedge the risk exposure and indicate whether the manager should be short or long. a. 100 contracts long. b. 44 contracts long. c. 44 contracts short. d. 100 contract short. e. None of the above. ANS: C Since you are long the equity portfolio you should be short the stock index futures contract. The number of contracts = [(10,000,000/(1350)(250))] 1.5 = 44.44 contracts PTS: 1
OBJ: Multiple Choice Problem
68. Refer to Exhibit 21.11. Assume that a month later the equity portfolio has a market value of $9,500,000 and the stock index future is priced at 1300 with a multiplier of 250. Calculate the profit on the equity position. a. $100,000 b. $200,000 c. −$200,000 d. −$500,000 e. −$600,000 ANS: D Profit on the equity portfolio = 9,500,000 − 10,000,000 = −$500,000 PTS: 1
OBJ: Multiple Choice Problem
69. Refer to Exhibit 21.11. Assume that a month later the equity portfolio has a market value of $10,000,000 and the stock index future is priced at 1300 with a multiplier of 250. Calculate the profit (loss) on the stock index futures position. a. −$1,050,000 b. −$550,000 c. −$50,000 d. $550,000 e. $1,050,000 ANS: D Profit on the stock index future = [(1300)(250) − (1350)(250)] −44 = $550,000
PTS: 1
OBJ: Multiple Choice Problem
70. Refer to Exhibit 21.11. Calculate the overall profit. a. −$50,000 b. −$150,000 c. $50,000 d. $150,000 e. $550,000 ANS: C Overall profit = 550,000 − 500,000 = $50,000 PTS: 1
OBJ: Multiple Choice Problem
71. In late January 2011, Starlight Corporation is considering the sale of $50 million in 10-year debentures rated AAA. The issue will most likely be registered and sold some time in April. Therefore, Starlight Corporation desires to hedge the pending issue using Treasury bond futures contracts each representing $100,000. Explain how you would go about hedging the bond issue? a. Sell 500 contracts b. Buy 500 contracts c. Sell 50 contracts d. Buy 50 contracts e. None of the above ANS: A A short hedge is appropriate in this case. So, assuming a 1:1 hedge ratio, sell 500 $100,000 contracts. PTS: 1
OBJ: Multiple Choice Problem
Exhibit 21.12 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Suppose you are a loan officer for a commercial bank and one of your clients has just approached you about a one-year loan for $4,000,000. Interest on the new loan will be paid at the end of each quarter based on the prevailing level of LIBOR at the beginning of each quarter. The LIBOR yield curve in the cash market is as follows: 90-day LIBOR 180-day LIBOR 270-day LIBOR 360-day LIBOR
2.70% 2.85% 3.10% 3.40%
72. Refer to Exhibit 21.12. What will the dollar level of the bank's interest receipt be at the end of the first quarter? a. $26,500 b. $27,000 c. $28,500 d. $108,000 e. None of the above ANS: B 4,000,000 0.027(90/360) = $27,000
PTS: 1
OBJ: Multiple Choice Problem
73. Refer to Exhibit 21.12. What is the implied 90-day forward rate at the beginning of the second quarter? a. 2.70% b. 2.85% c. 2.98% d. 3.15% e. 3.32% ANS: C BIFRA = [((B AYB) − (A AYA))/(B − A)] [1 + (AYA)(A/360)] where: BIFRA = the implied forward rate at time A over the period from time A to B AYB = the add-on yield for an instrument with B days to maturity. AYA = the add-on yield for an instrument with A days to maturity. 180IFR90
PTS: 1
= [((180)(0.0285) − (90)(0.027))/(180 − 90)] [1 + (0.027)(90/360)] = [(5.13 − 2.43)/90] [1 + 0.00675] = [0.03] [1.00675] = 0.0298 or 2.98% OBJ: Multiple Choice Problem
74. Refer to Exhibit 21.12. What is the implied 90-day forward rate at the beginning of the third quarter? a. 2.97% b. 3.05% c. 3.34% d. 3.55% e. 3.76% ANS: D BIFRA = [((B AYB) − (A AYA))/(B − A)] [1 + (AYA)(A/360)] where: BIFRA = the implied forward rate at time A over the period from time A to B AYB = the add-on yield for an instrument with B days to maturity. AYA = the add-on yield for an instrument with A days to maturity. 270IFR180
PTS: 1
= [((270)(0.0310) − (180)(0.0285))/(270 − 180)] [1 + (0.0285)(180/360)] = [(8.37 − 5.13)/90] [1 + 0.01425] = [0.036] [1.01425] = 0.03549 or 3.55% OBJ: Multiple Choice Problem
75. Refer to Exhibit 21.12. A bond portfolio manager expects a cash inflow of $10,000,000. The manager plans to hedge potential risk with a Treasury futures contract with a value of $102,150. The conversion factor between the CTD and the bond specified in the Treasury futures contract is 0.88. The duration of bond portfolio is 6 years, and the duration of the CTD bond is 4.5 years. Indicate the number of contracts required and whether the position to be taken is short or long. a. 114 contracts short b. 114 contracts long c. 60 contract short d. 60 contracts long e. None of the above
ANS: B Number of contracts = (10,000,000/102,150)(0.88)(6/4.5) = 114.86 114 contracts long PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 22—OPTION CONTRACTS TRUE/FALSE 1. The Chicago Board Options Exchange has the largest share of stock option trading. ANS: T
PTS: 1
2. Index options are settled by delivery of the stocks that make up the index. ANS: F
PTS: 1
3. In index options, the aggregate market takes the place of the individual stock issues being traded, as in stock options. ANS: T
PTS: 1
4. Risk management is the driving force behind the futures options market. ANS: F
PTS: 1
5. The longer the time to expiration, the greater the value of a call option. ANS: T
PTS: 1
6. There is an inverse relationship between the market interest rate and the value of a call option. ANS: F
PTS: 1
7. Credit risk in the options market is only a concern to the option seller. ANS: F
PTS: 1
8. The standardization of option contracts and the creation of the Options Clearing Corporation are two important results of the opening of the Chicago Board of Options Exchange. ANS: T
PTS: 1
9. Stock options expire on the Sunday following the third Saturday of the designated month. ANS: F
PTS: 1
10. A price spread (or vertical spread) involves buying and selling an option for the same stock and expiration date but with different exercise prices. ANS: T
PTS: 1
11. A portfolio containing a share of stock and a put option will have the same value as a portfolio containing a call option and the risk-free discount bond. ANS: T
PTS: 1
12. A strip is a call option on a stock that is written by someone that owns the stock. ANS: F
PTS: 1
13. The buyer of a straddle expects stock prices to move strongly in either direction. ANS: T
PTS: 1
14. A long strip position indicates that an investor is bullish but conservative. ANS: T
PTS: 1
15. Index options can only be settled in cash. ANS: T
PTS: 1
16. Unlike stock options, futures options require the holder to enter into a futures contract. ANS: F
PTS: 1
17. It is a violation of the securities laws to combine option contracts to achieve a customized payoff. ANS: F
PTS: 1
18. European options can only be exercised on the expiration date. ANS: T
PTS: 1
19. The owner of a call option on a futures contract has the obligation to buy the futures contract at a predetermined strike price during a specified time period. ANS: F
PTS: 1
20. Options on futures expire at the same time the futures contract expires. ANS: F
PTS: 1
21. The underlying stock price and the value of the put option are factors that impact the value of an American call option. ANS: F
PTS: 1
22. The binomial option pricing model approximates the price of an option obtained using the Black-Scholes option pricing model as the number of subintervals increases. ANS: T
PTS: 1
23. Investors should purchase market index put options if they anticipate an increase in the index value. ANS: F
PTS: 1
24. The Options Clearing Corporation (OCC) acts as the guarantor of each Chicago Board Options Exchange (CBOE) traded contract.
ANS: T
PTS: 1
25. It is always theoretically possible to use options as a perfect hedge against fluctuations in value of the underlying asset. ANS: T
PTS: 1
26. The most important input the investor must provide in determining option values is the strike price. ANS: F
PTS: 1
27. The binomial model is a continuous method for valuing options. ANS: F
PTS: 1
28. In a binomial option pricing model the initial value of the call can be determined by working backward through the tree and solving for each of the remaining intermediate option values. ANS: T
PTS: 1
29. The binomial option pricing model and the Black and Scholes model are similar because they are both discrete models. ANS: F
PTS: 1
30. The delta in the Black-Scholes model is simply the slope of a line tangent to the call option price curve. ANS: T
PTS: 1
MULTIPLE CHOICE 1. The creation of the CBOE led to all the following innovations in options except a. The creation of a central marketplace. b. The introduction of a clearing corporation. c. The standardization of expiration dates. d. The creation of a primary market. e. The creation of a secondary market. ANS: D
PTS: 1
OBJ: Multiple Choice
2. A calendar spread requires the purchase and sale of two calls or two puts in the same stock with a. The same expiration date but different exercise prices. b. The same exercise price but different expiration dates. c. Different exercise prices and different expiration dates. d. The same exercise price and the same expiration month. e. Traded in different markets. ANS: B
PTS: 1
OBJ: Multiple Choice
3. In a money spread, an investor would a. Buy two in-the-money call options on the same stock with different exercise dates. b. Buy two out-of-the-money call options on the same stock with different exercise dates. c. Sell two in-the-money call options on the same stock with different exercise dates.
d. Sell an out-of-the-money call and purchase an in-the-money call on the same stock with the same exercise date. e. Sell two out-of-the-money call options on the same stock with different exercise dates. ANS: B
PTS: 1
OBJ: Multiple Choice
4. A money spread involves buying and selling call options in the same stock with a. The same time period and exercise price. b. The same time period but different exercise price. c. A different time period but same exercise price. d. A different time period and different exercise price. e. Options in different markets. ANS: B
PTS: 1
OBJ: Multiple Choice
5. If you were to purchase an October option with an exercise price of 50 for 8 and simultaneously sell an October option with an exercise price of 60 for 2, you would be a. Bullish and taking a high risk. b. Bullish and conservative. c. Bearish and taking a high risk. d. Bearish and conservative. e. Neutral. ANS: B
PTS: 1
OBJ: Multiple Choice
6. You own a stock that has risen from $10 per share to $32 per share. You wish to delay taking the profit but you are troubled about the short run behavior of the stock market. An effective action on your part would be to a. Purchase a put. b. Purchase a call. c. Purchase an index option. d. Utilize a bearish spread. e. Utilize a bullish spread. ANS: A
PTS: 1
OBJ: Multiple Choice
7. If you were to purchase an October option with an exercise price of 50 for $8 and simultaneously sell an October option with an exercise price of 60 for $2, you would be a. Bullish and taking a high risk. b. Bullish and conservative. c. Bearish and taking a high risk. d. Bearish and conservative. e. Neutral. ANS: B
PTS: 1
OBJ: Multiple Choice
8. A vertical spread involves buying and selling call options in the same stock with a. The same time period and price. b. The same time period but different price. c. A different time period but same price. d. A different time period and different price. e. Options in different markets. ANS: B
PTS: 1
OBJ: Multiple Choice
9. Which of the following is not a factor needed to calculate the value of an American call option?
a. b. c. d. e.
The stock price The exercise price The exchange on which the option is listed The volatility of the underlying stock The interest rate
ANS: C
PTS: 1
OBJ: Multiple Choice
10. Buying a bear spread is equivalent to a. Selling a bull spread. b. Buying an out-of-the-money call and selling an in-the-money call on the same stock with the same exercise date. c. Selling an out-of-the-money call and buying an in-the-money call on the same stock with a different exercise price. d. Choices a and b only. e. None of the above ANS: A
PTS: 1
OBJ: Multiple Choice
11. A currency call is like being ____ in the currency futures. a. Out-of-the-money b. In-the-money c. Long d. Short e. At-the-money ANS: C
PTS: 1
OBJ: Multiple Choice
12. A straddle is the simultaneous purchase (or sale) of a put and call option with the same underlying asset, a. Same exercise price, and expiration date. b. Same exercise price but different expiration date. c. Same expiration date but different exercise price. d. Either choices b or c. e. None of the above. ANS: A
PTS: 1
OBJ: Multiple Choice
13. In the Black-Scholes option pricing model, an increase in security price (S) will cause a. An increase in call value and an increase in put value b. An increase in call value and a decrease in put value c. A decrease in call value and an increase in put value d. A decrease in call value and a decrease in put value e. An increase in call value and an increase or decrease in put value ANS: B
PTS: 1
OBJ: Multiple Choice
14. In the Black-Scholes option pricing model, an increase in exercise price (X) will cause a. An increase in call value and an increase in put value b. An increase in call value and a decrease in put value c. A decrease in call value and an increase in put value d. A decrease in call value and a decrease in put value e. An increase in call value and an increase or decrease in put value ANS: C
PTS: 1
OBJ: Multiple Choice
15. In the Black-Scholes option pricing model, an increase in time to expiration (T) will cause a. An increase in call value and an increase in put value b. An increase in call value and a decrease in put value c. A decrease in call value and an increase in put value d. A decrease in call value and a decrease in put value e. An increase in call value and an increase or decrease in put value ANS: E
PTS: 1
OBJ: Multiple Choice
16. In the Black-Scholes option pricing model, an increase in the risk free rate (RFR) will cause a. An increase in call value and an increase in put value b. An increase in call value and a decrease in put value c. A decrease in call value and an increase in put value d. A decrease in call value and a decrease in put value e. An increase in call value and an increase or decrease in put value ANS: B
PTS: 1
OBJ: Multiple Choice
17. In the Black-Scholes option pricing model, an increase in security volatility () will cause a. An increase in call value and an increase in put value b. An increase in call value and a decrease in put value c. A decrease in call value and an increase in put value d. A decrease in call value and a decrease in put value e. An increase in call value and an increase or decrease in put value ANS: A
PTS: 1
OBJ: Multiple Choice
18. The value of a call option is positively related to: a. Underlying stock price. b. Time to expiration c. Exercise price. d. a and b e. b and c ANS: D
PTS: 1
OBJ: Multiple Choice
19. The value of a call option is inversely related to: a. Underlying stock price. b. Time to expiration c. Exercise price. d. a and b e. b and c ANS: C
PTS: 1
OBJ: Multiple Choice
20. If the hedge ratio is 0.50, this indicates that the portfolio should hold a. Two shares of stock for every call option written. b. One share of stock for every two call options written. c. Two shares of stock for every call option purchased. d. One share of stock for every two call options purchased. e. Two call options for every put option written. ANS: B
PTS: 1
OBJ: Multiple Choice
21. Options can be used to a. Modify an equity portfolio's systematic risk.
b. c. d. e.
Modify an equity portfolio's unsystematic risk. Manage currency exposures in international equity portfolios. Change a portfolio's exposure to a particular asset All of the above
ANS: E
PTS: 1
OBJ: Multiple Choice
22. The Black-Scholes model assumes that stock price movements can be described by a. Geometric moving averages. b. Arithmetic moving averages. c. Regression towards the mean. d. Geometric Brownian motion. e. Stochastic time lags. ANS: D
PTS: 1
OBJ: Multiple Choice
23. Which of the following is not a variable required to determine an option's value in the Black-Scholes valuation model? a. Future security price. b. Exercise price. c. Time to expiration. d. Risk-free rate. e. Security price volatility. ANS: A
PTS: 1
OBJ: Multiple Choice
24. In the Black-Scholes model N(d1) represents the a. Hedge ratio. b. Partial derivative of the call's value with respect to the stock price. c. Change in the option's value given a one dollar change in the underlying security's price. d. Option's delta. e. All of the above. ANS: E
PTS: 1
OBJ: Multiple Choice
25. The calculation of a weighted average of the implied volatility estimates from options on the Standard & Poor's 500 index using a wide range of exercise prices is known as a. Spider. b. QQQ. c. VIX. d. CIN. e. VOL. ANS: C
PTS: 1
OBJ: Multiple Choice
26. The entity that acts as the guarantor of each CBOE-traded contract is the a. Federal government b. Securities and exchange commission c. CBOE d. Options clearing corporation e. Federal reserve bank ANS: D
PTS: 1
OBJ: Multiple Choice
27. A foreign currency option contract traded on U.S. exchanges allows for the sale or purchase of a set amount of
a. b. c. d. e.
U.S. currency at a floating exchange rate U.S. currency at a fixed exchange rate Foreign currency at a floating exchange rate Foreign currency at a fixed exchange rate None of the above
ANS: D
PTS: 1
OBJ: Multiple Choice
28. Options on futures contracts are very popular because a. They require the holder to purchase at a future date b. Of their ability to create leverage c. The seller of the futures contract is under no obligation d. The amount of the underlying commodity is negotiable e. None of the above ANS: B
PTS: 1
OBJ: Multiple Choice
Exhibit 22.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Option Type Contract Size Expiry Strike $0.815 $0.820
Currency 50000 April Call $0.0118
Canadian dollar Canadian dollars
Put $0.0068
29. Refer to Exhibit 22.1. How much must an investor pay for one call option contract? a. $680 b. $815 c. $625 d. $590 e. $340 ANS: D (US$/Can$)(0.0118)(50,000 Can$) = $590 PTS: 1
OBJ: Multiple Choice Problem
30. Refer to Exhibit 22.1. How much must an investor pay for one put option contract? a. $680 b. $815 c. $340 d. $625 e. $590 ANS: C (US$/Can$)(0.0068)(50,000 Can$) = $340 PTS: 1
OBJ: Multiple Choice Problem
31. Refer to Exhibit 22.1. If the spot rate at expiration is $0.90 and the call option was purchased, what is the dollar gain or loss?
a. b. c. d. e.
$0 $3750 gain $3660 gain $4650 loss $2680 loss
ANS: C Cost = $590 Net gain = (0.90 − 0.815)(50,000) − 590 = $3,660 PTS: 1
OBJ: Multiple Choice Problem
32. Refer to Exhibit 22.1. If the spot rate at expiration is $0.80 and the call option was purchased, what is the dollar gain or loss? a. $123 gain b. $590 loss c. $312 gain d. $237 gain e. $0 ANS: B Cost = $590 Payoff = (0) − 590 = −$590 (Option expires worthless) PTS: 1
OBJ: Multiple Choice Problem
33. Refer to Exhibit 22.1. If the spot rate at expiration is $0.85 and the put option was purchased, what is the dollar gain or loss? a. $340 loss b. $125 gain c. $750 gain d. $750 loss e. $200 loss ANS: A Cost = $340 Payoff = (0) − 340 = −$340 (Option expires worthless) PTS: 1
OBJ: Multiple Choice Problem
34. Refer to Exhibit 22.1. If the spot rate at expiration is $0.75 and the put option was purchased, what is the dollar gain or loss? a. $0 b. $200 loss c. $200 gain d. $3160 gain e. $1187 loss ANS: D Cost = $340 Payoff = (0.82 − 0.75)(50,000) − $340 = $3160 PTS: 1 Exhibit 22.2
OBJ: Multiple Choice Problem
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) XYZ CORP Exercise Calls
Puts
Date OCT OCT OCT OCT OCT OCT
Price 85 90 95 85 90 95
Price 16 3/4 12 7 5/8 1/8 3/8 13/16
NYSE Close 101 11/16 101 11/16 101 11/16 101 11/16 101 11/16 101 11/16
35. Refer to Exhibit 22.2. If you establish a long straddle using the options with an 85 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16? a. $18.75 loss b. $18.75 gain c. $1,668.75 gain d. $1,668.75 loss e. $1,687.50 loss ANS: A Long straddle: purchase one OCT 85 put and one OCT 85 call Cost of one call = 16 3/4(100) = Cost of one put = 1/8(100) = Total cost =
$
$1,675.00 12.50 $1,687.50
Payoff on one call = 100(101 11/16 − 85) = $1,668.75 Payoff on one put = 0, expires out of the money Net gain/loss = $1,668.75 − $1,687.50 = $18.75 loss PTS: 1
OBJ: Multiple Choice Problem
36. Refer to Exhibit 22.2. If you establish a long strap using the options with an 85 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16? a. $1,687.50 loss b. $3,362.50 loss c. $3,675.50 gain d. $13.00 gain e. $13.00 loss ANS: D Long strap: purchase two OCT 85 calls and one OCT 85 put Cost of 2 calls = 2(16.75(100) = Cost of one put = 1/8(100) = Total cost =
$
$3,350.00 12.50 $3,362.50
Payoff on 2 calls = 2(100)(101 11/16 − 85) = $3,375.00 Payoff on one put = 0, expires out of the money Net gain/loss = $3,375.50 − $3,362.50 = $13.00 gain PTS: 1
OBJ: Multiple Choice Problem
37. Refer to Exhibit 22.2. If you establish a long strip using the options with an 85 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16? a. $1,668.75 gain b. $1,700.00 gain c. $1,700.00 loss d. $31.25 gain e. $31.25 loss ANS: E Long strip: purchase one OCT 85 call and two OCT 85 puts Cost of one call = 16 3/4(100) = Cost of two puts = 2(1/8)(100) = Total cost =
$
$1,675.00 25.00 $1,700.00
Payoff on one call = 100(101 11/16 − 85) = $1,668.75 Payoff on two puts = 0, expires out of the money Net gain/loss = $1,668.75 − $1,700.00 = $31.25 loss PTS: 1
OBJ: Multiple Choice Problem
38. Refer to Exhibit 22.2. If you establish a long straddle using the options with a 90 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16? a. $68.75 loss b. $68.75 gain c. $37.50 loss d. $1,200.00 loss e. $1,200.00 gain ANS: A Long straddle: purchase one OCT 90 put and one OCT 90 call Cost of one call = 12(100) = Cost of one put = 3/8(100) = Total cost =
$1,200.00 $ 37.50 $1,237.50
Payoff on one call = 100(101 11/16 − 90) = $1,168.75 Payoff on one put = 0, expires out of the money Net gain/loss = $1,168.75 − $1,237.50 = $68.75 loss PTS: 1
OBJ: Multiple Choice Problem
39. Refer to Exhibit 22.2. If you establish a long strap using the options with a 90 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16? a. $37.50 loss b. $37.50 gain c. $100.00 loss d. $100.00 gain e. $2,437.50 loss ANS: C Long strap: purchase two OCT 90 calls and one OCT 90 put Cost of 2 calls = 2(12.00(100) =
$2,400.00
Cost of one put = 3/8(100) = Total cost =
$
37.50 $2,437.50
Payoff on 2 calls = 2(100)(101 11/16 − 90) = $2,337.50 Payoff on one put = 0, expires out of the money Net gain/loss = $2,337.50 − $2,437.50 = $100.00 loss PTS: 1
OBJ: Multiple Choice Problem
40. Refer to Exhibit 22.2. If you establish a long strip using the options with a 90 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16? a. $106.25 gain b. $106.25 loss c. $1,275.00 loss d. $1,275.00 gain e. $75.00 loss ANS: B Long strip: purchase one 90 call and two OCT 90 puts Cost of one call = 12(100) = Cost of two puts = 2(3/8)(100) = Total cost =
$
$1,200.00 75.00 $1,275.00
Payoff on one call = 100(101 11/16 − 90) = $1,168.75 Payoff on two puts = 0, expires out of the money Net gain/loss = $1,168.75 − $1,275.00 = $106.25 loss PTS: 1
OBJ: Multiple Choice Problem
41. Refer to Exhibit 22.2. If you establish a long straddle using the options with a 95 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16? a. $668.75 gain b. $668.75 loss c. $94.56 gain d. $94.56 loss e. $81.25 loss ANS: D Long straddle: purchase one OCT 95 put and one OCT 95 call Cost of one call = 7 5/8(100) = Cost of one put = 13/16(100) = Total cost =
$762.50 $ 81.25 $763.31
Payoff on one call = 100(101 11/16 − 95) = $668.75 Payoff on one put = 0, expires out of the money Net gain/loss = $668.75 − $763.31 = $94.56 loss PTS: 1
OBJ: Multiple Choice Problem
42. Refer to Exhibit 22.2. If you establish a long strap using the options with a 95 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16? a. $81.25 loss
b. c. d. e.
$1,606.25 gain $1,606.25 loss $268.75 loss $268.75 gain
ANS: D Long strap: purchase two OCT 95 calls and one OCT 95 put Cost of 2 calls = 2(7 5/8)(100) = Cost of one put = 13/16(100) = Total cost =
$
$1,525.00 81.25 $1,606.25
Payoff on 2 calls = 2(100)(101 11/16 − 95) = $1,337.50 Payoff on one put = 0, expires out of the money Net gain/loss = $1,337.50 − $1,606.25 = $268.75 loss PTS: 1
OBJ: Multiple Choice Problem
43. Refer to Exhibit 22.2. If you establish a long strip using the options with a 95 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16? a. $256.25 loss b. $256.25 gain c. $925.00 loss d. $668.75 gain e. $668.75 loss ANS: A Long strip: purchase one 95 call and two OCT 95 puts Cost of one call = 7 5/8(100) = Cost of two puts = 2(13/16)(100) = Total cost =
$762.50 $162.50 $925.00
Payoff on one call = 100(101 11/16 − 95) = $668.75 Payoff on two puts = 0, expires out of the money Net gain/loss = $668.75 − $925.00 = $256.25 loss PTS: 1
OBJ: Multiple Choice Problem
44. Refer to Exhibit 22.2. If XYZ were trading at $90/share and you formed a bull money spread, what is your profit if XYZ is trading at $110 at expiration? a. $912.50 loss b. $87.50 gain c. $87.50 loss d. $1,000.00 gain e. $1,000.00 loss ANS: B Bull money spread = buy the in-the-money call, i.e., OCT 85 and sell the out-of-the-money call, i.e., OCT 95 Cost of buying OCT 85 call = 100(16 3/4) = Proceeds from selling OCT 95 call = 100(7 5/8) = Net cost
$1,675.00 $ 762.50 $ 912.50
Payoff on OCT 85 call = 100(110 − 85) = $2,500.00 Payoff on OCT 95 call = 100(110 − 95) = ($1,500.00) Net payoff = $2,500.00 − 1,500.00 = $1,000.00 Total gain/loss = $1,000.00 − 912.50 = $87.50 gain PTS: 1
OBJ: Multiple Choice Problem
Exhibit 22.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) A stock currently trades for $130 per share. Options on the stock are available with a strike price of $125. The options expire in 10 days. The risk free rate is 3% over this time period, and the expected volatility is 0.35. 45. Refer to Exhibit 22.3. Use the Black-Scholes option pricing model to calculate the price of a call option. a. $5.19 b. $4.35 c. $3.93 d. $6.19 e. $8.17 ANS: D Price using the B-S option pricing model d1
= ln(130/125) + [(.03 + 5(.352))(.0833)]/(.35(.02778.5)) = 0.715807
d2
= 0.715807 − (.35(.02778.5)) = 0.657474
N(d1) = 0.762945 N(d2) = 0.744562 Call price = Pc
PTS: 1
= 120[0.762945 − 125(e −.03(.02778))( 0.744562] = $6.19 OBJ: Multiple Choice Problem
46. Refer to Exhibit 22.3. Calculate the price of the put option. a. $1.086 b. $0.862 c. $6.234 d. $0.623 e. $2.317 ANS: A Put price = 6.19 + 125(e −.03(.02778)) − 130 = $1.086 PTS: 1
OBJ: Multiple Choice Problem
47. Assume that you have just sold a stock for a loss at a price of $75, for tax purposes. You still wish to maintain exposure to the sold stock. Suppose that you buy a call with a strike price of $70 and a price of $6.75. Calculate the effective price paid to repurchase the stock if the price after 35 days is $65.
a. b. c. d. e.
$71.75 $76.75 $58.25 $81.75 None of the above
ANS: A The effective price is 65 + 6.75 = $71.75 The option expires worthless so your effective price is the current price plus the option premium. PTS: 1
OBJ: Multiple Choice Problem
48. Assume that you have just sold a stock for a loss at a price of $75, for tax purposes. You still wish to maintain exposure to the sold stock. Suppose that you buy a call with a strike price of $70 and a price of $6.75. Calculate the effective price paid to repurchase the stock if the price after 35 days is $80. a. $81.75 b. $73.25 c. $86.75 d. $76.75 e. None of the above ANS: D The effective price is 70 + 6.75 = $76.75 The option is exercised so your effective price is the strike price plus the option premium. PTS: 1
OBJ: Multiple Choice Problem
49. Assume that you have just sold a stock for a loss at a price of $75, for tax purposes. You still wish to maintain exposure to the sold stock. Suppose that you sell a put with a strike price of $80 and a price of $7.25. Calculate the effective price paid to repurchase the stock if the price after 35 days is $70. a. $77.75 b. $87.25 c. $82.25 d. $72.75 e. None of the above ANS: D The effective price is 80 − 7.25 = $72.75 The option is exercised so your effective price is the strike price less the option premium. PTS: 1
OBJ: Multiple Choice Problem
50. Assume that you have just sold a stock for a loss at a price of $75, for tax purposes. You still wish to maintain exposure to the sold stock. Suppose that you sell a put with a strike price of $80 and a price of $7.25. Calculate the effective price paid to repurchase the stock if the price after 35 days is $85. a. $77.75 b. $87.25 c. $82.25 d. $72.75 e. None of the above. ANS: A
The effective price is 85 − 7.25 = $77.75 The option expires worthless so your effective price is the current price less the option premium. PTS: 1
OBJ: Multiple Choice Problem
Exhibit 22.4 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Consider the following information on put and call options for Citigroup Strike Price $32.50
Put Price $2.85
Call Price $1.65
51. Refer to Exhibit 22.4. Calculate the net value of a protective put position at a stock price at expiration of $20, and a stock price at expiration of $45. a. $6.35, $18.85 b. $29.65, $42.15 c. $21.65, $34.15 d. $8, $8 e. −$8, −$8 ANS: B At S = 20 Net value of protective put = (32.5 − 20) − 2.85 + 20 = 29.65 At S = 45 Net value of protective put = −2.85 + 45 = 42.15 PTS: 1
OBJ: Multiple Choice Problem
52. Refer to Exhibit 22.4. A protective put is an appropriate strategy if a. An investor wishes to generate additional income. b. An investor wished to insure against a decline in share values. c. An investor expected share prices to be volatile. d. An investor expected share prices to remain in a trading range. e. An investor expected share prices to be volatile, but was inclined to be bullish. ANS: B This strategy is appropriate if an investor wished to insure against a decline in share values. PTS: 1
OBJ: Multiple Choice Problem
53. Refer to Exhibit 22.4. Calculate the net value of a covered call position at a stock price at expiration of $20, and a stock price at expiration of $45. a. $6.35, $18.85 b. $29.65, $42.15 c. $21.65, $34.15 d. $8, $8 e. −$8, −$8 ANS: C At S = 20 Net value of covered call = 1.65 + 20 = 21.65
At S = 45 Net value of covered call = −(45 − 32.5) + 1.65 + 45 = 34.15 PTS: 1
OBJ: Multiple Choice Problem
54. Refer to Exhibit 22.4. A covered call is an appropriate strategy if a. An investor wishes to generate additional income. b. An investor wished to insure against a decline in share values. c. An investor expected share prices to be volatile. d. An investor expected share prices to remain in a trading range. e. An investor expected share prices to be volatile, but was inclined to be bullish. ANS: A This strategy is appropriate if an investor wished to generate additional income. PTS: 1
OBJ: Multiple Choice Problem
55. Refer to Exhibit 22.4. Calculate the payoffs of a long straddle at a stock price at expiration of $20 and a stock price at expiration of $45. a. $6.35, $18.85 b. $29.65, $42.15 c. $21.65, $34.15 d. $8, $8 e. −$8, −$8 ANS: D At S = 20 Net payoff on a long straddle = (32.5 − 20) − 1.65 − 2.85 = 8 At S = 45 Net payoff on a long straddle = (45 − 32.5) − 1.65 − 2.85 = 8 PTS: 1
OBJ: Multiple Choice Problem
56. Refer to Exhibit 22.4. A long straddle is an appropriate strategy if a. An investor wishes to generate additional income. b. An investor wished to insure against a decline in share values. c. An investor expected share prices to be volatile. d. An investor expected share prices to remain in a trading range. e. An investor expected share prices to be volatile, but was inclined to be bullish. ANS: C This strategy is appropriate if an investor expected share prices to be volatile. PTS: 1
OBJ: Multiple Choice Problem
57. Refer to Exhibit 22.4. Calculate the payoffs of a short straddle at a stock price at expiration of $20 and a stock price at expiration of $45. a. $6.35, $18.85 b. $29.65, $42.15 c. $21.65, $34.15 d. $8, $8 e. −$8, −$8
ANS: E At S = 20 Net payoff on a short straddle = −(32.5 − 20) + 1.65 + 2.85 = −8 At S = 45 Net payoff on a long straddle = −(45 − 32.5) + 1.65 + 2.85 = −8 PTS: 1
OBJ: Multiple Choice Problem
58. Refer to Exhibit 22.4. A short straddle is an appropriate strategy if a. An investor wishes to generate additional income. b. An investor wished to insure against a decline in share values. c. An investor expected share prices to be volatile. d. An investor expected share prices to remain in a trading range. e. An investor expected share prices to be volatile, but was inclined to be bullish. ANS: D This strategy is appropriate if an investor expected share prices to remain in a trading range. PTS: 1
OBJ: Multiple Choice Problem
59. Refer to Exhibit 22.4. Calculate the payoffs of a long strap at a stock price at expiration of $20 and a stock price at expiration of $45. a. $6.35, $18.85 b. $29.65, $42.15 c. $21.65, $34.15 d. $8, $8 e. −$8, −$8 ANS: A At S = 20 Net payoff on a long strap = (32.5 − 20) − (2)(1.65) − 2.85 = 6.35 At S = 45 Net payoff on a long strap = (2)(45 − 32.5) − (2)(1.65) − 2.85 = 18.85 PTS: 1
OBJ: Multiple Choice Problem
60. Refer to Exhibit 22.4. A long strap is an appropriate strategy if a. An investor wishes to generate additional income. b. An investor wished to insure against a decline in share values. c. An investor expected share prices to be volatile. d. An investor expected share prices to remain in a trading range. e. An investor expected share prices to be volatile, but was inclined to be bullish. ANS: E This strategy is appropriate if an investor expected share prices to be volatile. PTS: 1
OBJ: Multiple Choice Problem
Exhibit 22.5 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
The information provided is relevant in the context of a one period (one year) binomial option pricing model. A stock currently trades at $50 per share, a call option on the stock has an exercise price of $45. The stock is equally likely to rise by 25% or fall by 25%. The one-year risk free rate is 2%. 61. Refer to Exhibit 22.5. Calculate the possible prices of the stock one year from today. a. $37.50 or $17.50. b. $62.50 or $37.50. c. $62.50 or $17.50. d. $50 or $45. e. None of the above. ANS: B If the stock rises the price one year for now will be = 50(1 + 0.25) = $62.50 If the stock falls the price one year for now will be = 50(1 − 0.25) = $37.50 PTS: 1
OBJ: Multiple Choice Problem
62. Refer to Exhibit 22.5. Estimate n, the number of call options that must be written. a. −1.4286 b. −2.9286 c. −2.8571 d. −2.5714 e. −1.1111 ANS: A Current stock price = $50 Exercise price = $45 Risk free rate = 2% Price in one year if stock rises = 50(1.25) = $62.50 Price in one year if stock declines = 50(1.25) = $37.50 Intrinsic value of call option if stock rises to $62.50 = Max[0, 62.50 − 45] = $17.50 Intrinsic value of call option if stock falls to $37.50 = Max[0, 37.50 − 45] = $0 Estimate the number calls needed by setting: The hedge portfolio will consist of one share of stock held long plus some number of call options written. Value of hedge portfolio if stock rises = Value of hedge portfolio if stock falls 62.50 + (17.5)(n) = 37.50 + (0)(n) n = −1.4286 PTS: 1
OBJ: Multiple Choice Problem
63. Refer to Exhibit 22.5. Calculate the price of the call option today (C0). a. $7.56 b. $17.48 c. $9.26 d. $5.0 e. $17.15 ANS: C Value of hedge portfolio today = 50 − (1.4286)(C0) = 37.5/(1.02)
C0 = $9.26 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 22.6 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The following information is provided in the context of a two period (two six month periods) binomial option pricing model. A stock currently trades at $60 per share, a call option on the stock has an exercise price of $65. The stock is equally likely to rise by 15% or fall by 15% during each six month period. The one-year risk free rate is 3%. 64. Refer to Exhibit 22.6. Calculate the possible prices of the stock at the end of one year. a. $69, $51, $79.35 b. $51, $79.35, $58.65 c. $79.35, $58.65, $43.35 d. $58.65, $43.35, $14.35 e. None of the above ANS: C Current stock price = $60 Price in one year if stock rises 15% per six month period = 60(1.15)(1.15) = $79.35 Price in one year if stock rises 15%, then falls 15% = 60(1.15)(0.85) = $58.65 Price in one year if stock declines 15% per period = 60(0.85)(0.85) = $43.35 PTS: 1
OBJ: Multiple Choice Problem
65. Refer to Exhibit 22.6. Calculate the price of the call option after the stock price has already moved up in value once (Cu). a. $7.77 b. $14.35 c. $0 d. $4.21 e. $6.44 ANS: A Current stock price = $60 Exercise price = $65 Risk free rate = 3% or 1.49% per six month period = (1.03)0.5 − 1 = 0.0149 Price in six months if stock rises 15% = 60(1.15) = $69 Price in six month if stock falls 15% = 60(0.85) = $51 Price in one year if stock rises 15% per six month period = 60(1.15)(1.15) = $79.35 Price in one year if stock rises 15%, then falls 15% = 60(1.15)(0.85) = $58.65 Price in one year if stock declines 15% per period = 60(0.85)(0.85) = $43.35 Intrinsic value of call option if stock rises to $79.35 = Max[0, 79.35 − 65] = $14.35 Intrinsic value of call option if stock falls to $58.65 = Max[0, 58.65 − 65] = $0 Intrinsic value of call option if stock falls to $43.35 = Max[0, 43.35 − 65] = $0 Estimate the number calls needed by constructing a hedge portfolio. The hedge portfolio will consist of one share of stock held long plus some number of call options written. At the end of the first six month period:
Value of hedge portfolio if stock rises = Value of hedge portfolio if stock falls 79.35 + (14.35)(n) = 58.65 + (0)(n) n = −1.44251 Value of hedge portfolio at the end of first six months = 69 − (1.44251)(Cu) = 58.65/(1.0149) Cu = $7.7719 PTS: 1
OBJ: Multiple Choice Problem
66. Refer to Exhibit 22.6. Calculate the price of the call option after the stock price has already moved down in value once (Cd). a. $7.77 b. $14.35 c. $0 d. $4.21 e. $6.44 ANS: C Cd = 0. Since the ending stock prices of $58.65 and $43.35 are both below the exercise price. PTS: 1
OBJ: Multiple Choice Problem
67. Refer to Exhibit 22.6. Calculate the price of the call option today (C0). a. $7.77 b. $14.35 c. $0 d. $4.21 e. $6.44 ANS: D To solve for the value of the call today (C0), first determine the number of calls by constructing a hedge portfolio where: Right now: Value of hedge portfolio if stock rises = Value of hedge portfolio if stock falls 69 + (7.7719)(n) = 51 + (0)(n) n = −2.31603 Value of hedge portfolio now = 60 − (2.31603)(C0) = 51/(1.0149) C0 = $4.2092 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 22.7 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) GE Corporation has a put option selling for $2.90 and a call option selling for $1.95, both with a strike price of $29.00. 68. Refer to Exhibit 22.7. What would the net value of a protective put position be if the stock price at expiration is $35?
a. b. c. d. e.
$3.10 $30.15 $32.10 $34.05 $35.00
ANS: C Net value of protective put = −2.90 + 35 = $32.10 PTS: 1
OBJ: Multiple Choice Problem
69. Refer to Exhibit 22.7. What would the net value of a covered call position be if the stock price at expiration is $35? a. $29.00 b. $30.65 c. $33.55 d. $36.00 e. $36.65 ANS: B Net value of covered call = −(35 − 29) + 1.65 + 35 = 30.65 PTS: 1
OBJ: Multiple Choice Problem
70. Refer to Exhibit 22.7. What would the net value of a long straddle position be if the stock price at expiration is $35? a. −7.15 b. −$1.15 c. $1.15 d. $7.15 e. $36.15 ANS: C Net payoff on a long straddle = (35 − 29) − 2.9 − 1.95 = 1.15 PTS: 1
OBJ: Multiple Choice Problem
71. Refer to Exhibit 22.7. What would the net value of a short straddle position be if the stock price at expiration is $35? a. −36.15 b. −7.15 c. −$1.15 d. $1.15 e. $7.15 ANS: C Net payoff on a long straddle = −(35 − 29) + 2.90 + 1.95 = −1.15 PTS: 1
OBJ: Multiple Choice Problem
72. Refer to Exhibit 22.7. What would the net value of a long strap position be if the stock price at expiration is $35? a. −$1.15 b. −$2.30
c. $1.15 d. $2.30 e. $5.20 ANS: E Net payoff on a long strap = (2)(35 − 29) − (2)(1.95) − 2.90 = 5.20 PTS: 1
OBJ: Multiple Choice Problem
73. Refer to Exhibit 22.7. Which strategy is most appropriate for an investor who expects share prices to be volatile, but was inclined to be bullish? a. protective put b. covered call c. long straddle d. short straddle e. long strap ANS: E
PTS: 1
OBJ: Multiple Choice Problem
Exhibit 22.8 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Consider the following information on put and call options for a common stock Strike Price $22.50
Put Price $2.65
Call Price $1.85
74. Refer to Exhibit 22.8. Calculate the net value of a protective put position at an expiration stock price of $20. a. $2.85 b. $17.15 c. $19.85 d. $21.65 e. $22.85 ANS: C At S = 20 the Net value of protective put = (22.5 − 20) − 2.65 + 20 = 19.85 PTS: 1
OBJ: Multiple Choice Problem
75. Refer to Exhibit 22.8. Calculate the net value of a covered call position at an expiration stock price of $20. a. $1.85 b. $4.45 c. $18.15 d. $21.85 e. $24.35 ANS: D At S = 20 the Net value of covered call = 1.85 + 20 = 21.85 PTS: 1
OBJ: Multiple Choice Problem
76. Refer to Exhibit 22.8. Calculate the payoff of a long straddle at an expiration stock price of $20. a. −$4.50
b. c. d. e.
−$2.00 $2.00 $4.50 $20.50
ANS: C At S = 20 the Net payoff on a long straddle = (22.5 − 20) − 2.65 − 1.85 = 2 PTS: 1
OBJ: Multiple Choice Problem
77. Refer to Exhibit 22.8. Calculate the payoff of a short straddle at an expiration stock price of $20. a. −$4.50 b. −$2.00 c. $2.00 d. $4.50 e. $20.50 ANS: B At S = 20 the Net payoff on a short straddle = −(22.5 − 20) + 2.65 + 1.85 = −2 PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 23—SWAP CONTRACTS, CONVERTIBLE SECURITIES, AND OTHER EMBEDDED DERIVATIVES TRUE/FALSE 1. A warrant is an option to buy a stated number of shares of common stock at a specified price at any time during the life of the warrant. ANS: T
PTS: 1
2. A major difference between a call option and a warrant is that call options are issued by the company so that any proceeds from the sale of stock go to the issuing firm. ANS: F
PTS: 1
3. Risk management strategies involving interest rate agreements can be classified as forward-based or option-based. ANS: T
PTS: 1
4. Forward rate agreements usually require substantial collateral. ANS: F
PTS: 1
5. The forward rate agreement is the most complicated of the OTC interest rate contracts. ANS: F
PTS: 1
6. If interest rates fall, an interest rate cap would expire unexercised. ANS: T
PTS: 1
7. In an interest rate swap, the fixed rate payer profits if interest rates fall. ANS: F
PTS: 1
8. While LIBOR is usually used with forward rate agreements it is rarely used with other interest rate agreements. ANS: F
PTS: 1
9. The issuance of convertibles will ultimately lead to greater dilution than an initial issue of stock. ANS: T
PTS: 1
10. Convertibles provide the upside potential of common stock and the downside protection of a bond. ANS: T
PTS: 1
11. The intrinsic value of a warrant = (Market price of common stock + Warrant exercise price) Number of shares specified by the warrant.
ANS: F
PTS: 1
12. By attaching a convertible feature to a bond issue a firm can often get a lower rate of interest on its debt. ANS: T
PTS: 1
13. The investment value of a convertible bond is the price which it would be expected to sell as a straight debt instrument. ANS: T
PTS: 1
14. The conversion parity price is equal to the par value of a convertible bond divided by the number of shares into which it can be converted. ANS: F
PTS: 1
15. In a forward rate agreement (FRA) two parties agree today to a future exchange of cash flows based on two different interest rates. ANS: T
PTS: 1
16. A floor agreement is a series of cash settlement interest rate options, typically based on LIBOR. ANS: F
PTS: 1
17. An interest rate collar is a combination of a long position in either a cap or floor with a short position in the other. ANS: T
PTS: 1
18. On the settlement date for a forward rate agreement (FRA) contract, the difference between the two interest rates is multiplied by the FRA's par value and prorated by the length of the holding period. ANS: F
PTS: 1
19. A plain vanilla swap agreement is used in similar situations as a forward rate agreement. ANS: T
PTS: 1
MULTIPLE CHOICE 1. Which of the following is not true about interest rate swaps? a. Payments are based on a notional principal. b. Floating rate payers profit if interest rates fall. c. Payments can be quarterly as well as semi-annually. d. Parities exchange debt obligations. e. Default risk is a possibility in the swaps market. ANS: D
PTS: 1
OBJ: Multiple Choice
2. A ____ contract can be viewed as a prepackaged series of forward rate agreements to buy or sell LIBOR at the same fixed rate.
a. b. c. d. e.
Swap Cap Floor Collar None of the above
ANS: A
PTS: 1
OBJ: Multiple Choice
3. An interest rate ____ is a combination of a cap and a floor. a. Swap b. FRA c. LIBOR d. Collar e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
4. A pay-fixed interest rate swap can be viewed as equivalent to a. A long position in a par valued FRN and a long position in a par valued fixed rate note. b. A long position in a par valued FRN and a short position in a par valued fixed rate note. c. A short position in a par valued FRN and a long position in a par valued fixed rate note. d. A short position in a par valued FRN and a short position in a par valued fixed rate note. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
5. The writer of a ____ agreement makes settlement payments when LIBOR is greater than the striking rate of the agreement. a. Swap b. Cap c. Floor d. Collar e. None of the above ANS: B
PTS: 1
OBJ: Multiple Choice
6. The writer of a ____ agreement makes settlement payments when LIBOR is less than the striking rate of the agreement. a. Swap b. Cap c. Floor d. Collar e. None of the above ANS: C
PTS: 1
OBJ: Multiple Choice
7. Which of the following is not a characteristic of warrants? a. They are sweeteners added to other security issues. b. After the initial sale, warrants are detachable. c. They pay no dividends. d. They provide no voting rights. e. No dilution protection is offered in the event of stock dividends or stock splits. ANS: E
PTS: 1
OBJ: Multiple Choice
8. An investor considering investment in warrants as part of an overall program, should consider which of the following? a. Diversification b. Cutting losses short, and letting profits run c. A low intrinsic value d. Viewing warrant selection as a portion of the total investment process e. All of the above ANS: E
PTS: 1
OBJ: Multiple Choice
9. All of the following are normal characteristics of a convertible bond, except a. Conversion at the option of the issuer. b. Conversion into a fixed number of shares of common stock. c. A conversion price initially above the market price of the common stock. d. An interest rate lower than that on straight debentures. e. Subordination. ANS: A
PTS: 1
OBJ: Multiple Choice
10. Which of the following is not a typical characteristic of a convertible preferred stock? a. They are cumulative but not participating. b. The conversion privilege normally expires before maturity. c. They have no sinking fund or purchase fund. d. They have a fixed conversion rate. e. There is generally no waiting period before conversion can take place. ANS: B
PTS: 1
OBJ: Multiple Choice
11. ____ are debt instruments that have their principal or coupon payments tied to some other underlying variable. a. Structured notes b. Variable rate notes c. Systematic notes d. Embedded notes e. PC bonds ANS: A
PTS: 1
OBJ: Multiple Choice
12. ____ has coupons denominated in a currency other than that of their principal. a. Eurodollar bonds b. Dual currency bonds c. Euromarket bonds d. Bi-currency bonds e. Forward currency bonds ANS: C
PTS: 1
OBJ: Multiple Choice
13. An example of a commodity-linked fixed income security is a a. Cap and floor note. b. Cash and debit. c. Commodity debenture. d. Bull and bear note. e. Derivative commodity note. ANS: D
PTS: 1
OBJ: Multiple Choice
14. A(n) ____ contract is an arrangement whereby the coupon rate on a note moves in the opposite direction of some variable rate index. a. Inverse floating rate b. Reverse floating rate c. Backward floating rate d. Opposing floating rate e. Defensive floating rate ANS: B
PTS: 1
OBJ: Multiple Choice
15. Consider a pension fund manager that wishes to convert $10 million from notes paying LIBOR to stocks, using an equity swap. The equity swap should be structured so that a. Pension fund receives LIBOR and pays an equity return based on notional principal of $5 million. b. Pension fund pays LIBOR and receives an equity return based on notional principal of $5 million. c. Pension fund receives LIBOR and pays an equity return based on notional principal of $10 million. d. Pension fund pays LIBOR and receives an equity return based on notional principal of $10 million. e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
16. A real option is a reference to a. Options on physical assets. b. Options on commodity futures. c. The value of flexibility embedded in a real asset. d. a and b. e. b and c. ANS: C
PTS: 1
OBJ: Multiple Choice
17. The intrinsic value of a warrant is calculated as: a. (Market price of common stock + Warrant exercise price) Number of shares specified by warrant. b. (Market price of common stock − Warrant exercise price) Number of shares specified by warrant. c. (Market price of common stock + Warrant exercise price)/Number of shares specified by warrant. d. (Market price of common stock − Warrant exercise price)/Number of shares specified by warrant. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
18. An advantage of convertible bonds is a. Investors get the upside potential of a bond. b. Investors get the upside potential of a stock. c. Issuing firms can get a lower rate of interest on its debt. d. a and b. e. b and c. ANS: E
PTS: 1
OBJ: Multiple Choice
19. Warrants differ from options in a number of ways. Which of the following statements about warrants and options is false? a. When originally issued, the life of a warrant is usually much longer than that of a call option. b. Warrants are usually issued by the company on whose stock the warrant is written. c. Warrants are often used by companies as sweeteners to make new issues of debt or equity more attractive. d. Warrant holders have voting rights while option holders do not. e. None of the above (that is, all statements are true) ANS: D
PTS: 1
OBJ: Multiple Choice
20. All of the following are normal characteristics of a convertible bond, except a. Conversion at the option of the issuer. b. Conversion into a fixed number of shares of common stock. c. A conversion price initially above the market price of the common stock. d. An interest rate lower than that on straight debentures. e. Subordination. ANS: A
PTS: 1
OBJ: Multiple Choice
21. The minimum price of a convertible bond is a. Min (Bond Value, Conversion Value). b. Max (Bond Value, Conversion Value). c. Min (Stock Value, Conversion Value). d. Max (Stock Value, Conversion Value). e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
22. The conversion premium for a convertible bond is calculated as: a. (Market Price + Minimum Value)/Minimum Value. b. (Market Price/Minimum Value) Minimum Value. c. (Market Price + Minimum Value) Minimum Value. d. (Market Price − Minimum Value)/Minimum Value. e. (Market Price Minimum Value)/Minimum Value. ANS: D
PTS: 1
OBJ: Multiple Choice
23. The conversion price parity for a convertible bond is defined as: a. Market Price of Convertible Bond/Conversion Ration. b. Market Price of Convertible Bond Conversion Ration. c. Market Price of Convertible Bond − Conversion Ration. d. Market Price of Convertible Bond + Conversion Ration. e. None of the above. ANS: A
PTS: 1
OBJ: Multiple Choice
24. An equity call option issued directly by the company whose stock serves as the underlying asset is known as a a. Collar. b. Cap. c. Floor. d. Warrant. e. Swap.
ANS: D
PTS: 1
OBJ: Multiple Choice
25. The payment of any compensation for loss is contingent on the actual occurrence of a credit-related event under a a. Total return swap. b. Credit default swap. c. Collar. d. Forward rate agreement. e. Swap agreement. ANS: B
PTS: 1
OBJ: Multiple Choice
26. Options embedded in real assets owned by firms are known as a. Asset options. b. Binomial options. c. Company options. d. Warrant options. e. Real options. ANS: E
PTS: 1
OBJ: Multiple Choice
27. In convertible bonds, the value of the common stock price upon immediate conversion is the a. Put-call parity price. b. Conversion parity price. c. Cash equivalent price. d. Convertible price. e. Redemption price. ANS: B
PTS: 1
OBJ: Multiple Choice
28. Suppose a corporation desires to borrow financial capital for six months, with two three-month installments. The firm is concerned that interest rates may rise over this period of time. To eliminate interest rate exposure the firm could acquire a a. 3 6 Forward Rate Agreement b. 3 month "floating-for-fixed" Swap c. 3 month Bond-Index Linked Swap d. 3 month Warrant e. All of the above ANS: A
PTS: 1
OBJ: Multiple Choice
29. Suppose the premium on a three year, four percent floor is equal to the premium on a three year, eight percent cap. This combination is referred to as a. Zero-cost warrant b. Zero-premium strap c. Zero-cost collar d. Zero-premium swap e. Zero-cost FRA ANS: C
PTS: 1
OBJ: Multiple Choice
30. The following are all advantages of having an equity swap market except a. These agreements allow investors to take advantage of overall price movements in a specific country's stock market. b. Creating a direct equity investment in a foreign country may be difficult for some
investors where it is prohibited by law. c. These agreements eliminate the need for a counterparty because they are traded on the NYSE. d. An investment fund wanting to accumulate foreign index returns denominated in their domestic currency may not be legally permitted to obtain sufficient exchange-traded derivative contracts to hedge a direct equity investment. e. All of the above are advantages of an equity swap market ANS: C
PTS: 1
OBJ: Multiple Choice
Exhibit 23.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) A company buys an interest rate cap that pays the difference between LIBOR and 8% if LIBOR exceeds 8%. Current LIBOR is 7%. The amount of the option is $2,500,000, and the settlement is every 6 months. Assume a 360 day year. 31. Refer to Exhibit 23.1. Find the payoff if LIBOR closes at 7.8%. a. $0.00 b. $25,000.00 c. $50,000.00 d. −$25,000.00 e. −$50,000.00 ANS: A Payoff = $2,500,000 (180/360) Max(0, 0.078 − 0.08) = 0 PTS: 1
OBJ: Multiple Choice Problem
32. Refer to Exhibit 23.1. Find the payoff if LIBOR closes at 8.2%. a. $0.00 b. $25,000.00 c. $50,000.00 d. −$25,000.00 e. −$50,000.00 ANS: B Payoff
PTS: 1
= $2,500,000 (180/360) Max(0, 0.082 − 0.08) = 2,500,000 0.5 0.02 = $25,000.00 OBJ: Multiple Choice Problem
Exhibit 23.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Darden Industries has decided to borrow $25,000,000.00 for six months in two three-month issues. As the Treasurer, you are concerned that interest rates will rise over the next three months and the rate upon which the second payment will be based will be undesirable. (The amount of Darden's first payment will be known at origination.) To reduce the company's interest rate exposure, you decide to purchase a 3 6 FRA whereby you pay the dealer's quoted fixed rate of 4.5% in exchange for receiving 3-month LIBOR at the settlement date. In order to hedge her exposure, the dealer buys LIBOR from McIntire Industries at its bid rate of 4%. (Assume a notional principal of $25,000,000.00 and that there are 60 days between month 3 and month 6.)
33. Refer to Exhibit 23.2. Assuming that 3-month LIBOR is 5.00% on the rate determination day, and the contract specified settlement in arrears at month 6, describe the transaction that occurs between the dealer and Darden. a. The dealer is obligated to pay Darden $19,500 b. The dealer is obligated to pay Darden $31,250 c. Darden is obligated to pay the dealer $19,500 d. Darden is obligated to pay the dealer $31,250 e. None of the above ANS: B (25,000,000)(0.050 − 0.045) (90/360) = $31,250 The dealer is obligated to pay Darden $31,250 PTS: 1
OBJ: Multiple Choice Problem
34. Refer to Exhibit 23.2. Assuming that 3-month LIBOR is 5.00% on the rate determination day, and the contract specified settlement in advance, describe the transaction that occurs between the dealer and Darden. a. The dealer is obligated to pay Darden $30,864.20. b. The dealer is obligated to pay Darden $19,359.61. c. Darden is obligated to pay the dealer $19,359.61. d. Darden is obligated to pay the dealer $30,864.20. e. None of the above ANS: A (25,000,000)(0.050 − 0.045) (90/360) (1 + (0.050)(90)/360) = $30,864.20 The dealer must pay Darden $30,864.20 PTS: 1
OBJ: Multiple Choice Problem
35. Refer to Exhibit 23.2. Assuming that 3-month LIBOR is 5.00% on the rate determination day, and the contract specified settlement in arrears at month 6, describe the transaction that occurs between the dealer and McIntire. a. The dealer is obligated to pay McIntire $62,500. b. The dealer is obligated to pay McIntire $57,500. c. McIntire is obligated to pay the dealer $62,500. d. McIntire is obligated to pay the dealer $57,500. e. None of the above ANS: C (25,000,000)(0.050 − 0.04) (90/360) = $62,500 McIntire must pay the dealer $62,500 PTS: 1
OBJ: Multiple Choice Problem
36. Refer to Exhibit 23.2. Assuming that 3-month LIBOR is 5.00% on the rate determination day, and the contract specified settlement in advance, describe the transaction that occurs between the dealer and McIntire. a. The dealer is obligated to pay McIntire $61,728.40. b. The dealer is obligated to pay McIntire $56,389.16. c. McIntire is obligated to pay the dealer $56,389.16. d. McIntire is obligated to pay the dealer $61,728.40. e. None of the above ANS: D
(25,000,000)(0.050 − 0.04) (90/360) (1 + (0.05)(90)/360) = $61,728.40 McIntire must pay the dealer $61,728.40. PTS: 1
OBJ: Multiple Choice Problem
37. Refer to Exhibit 23.2. How much compensation does the dealer receive for transaction costs, credit risk and other costs associated with matching the FRA's? a. $31,250 b. $21,350 c. $41,000 d. $48,150 e. None of the above ANS: A Spread = 4.5 − 4 = .5% Spread Notional Principal = (.005)(90/360)(25,000,000) = $31,250 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 23.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Chimichango Industries has decided to borrow $50,000,000.00 for six months in two three-month issues. As the Treasurer, you are concerned that interest rates will rise over the next three months and the rate upon which the second payment will be based will be undesirable. (The amount of Chimichango's first payment will be known at origination.) To reduce the company's interest rate exposure, you decide to purchase a 3 6 FRA whereby you pay the dealer's quoted fixed rate of 5.91% in exchange for receiving 3-month LIBOR at the settlement date. In order to hedge her exposure, the dealer buys LIBOR from Megabuks Industries at its bid rate of 5.85%. (Assume a notional principal of $50,000,000.00 and that there are 60 days between month 3 and month 6.) 38. Refer to Exhibit 23.3. Assuming that 3-month LIBOR is 5.6% on the rate determination day, and the contract specified settlement in arrears at month 6, describe the transaction that occurs between the dealer and Chimichango. a. The dealer is obligated to pay Chimichango $38,750. b. The dealer is obligated to pay Chimichango $31,250. c. Chimichango is obligated to pay the dealer $38,750. d. Chimichango is obligated to pay the dealer $31,250. e. None of the above. ANS: C (50,000,000)(0.056 − 0.0591) (90/360) = ($38,750.00) Chimichango must pay the dealer $38,750. PTS: 1
OBJ: Multiple Choice Problem
39. Refer to Exhibit 23.3. Assuming that 3-month LIBOR is 5.6% on the rate determination day, and the contract specified settlement in advance, describe the transaction that occurs between the dealer and Chimichango. a. The dealer is obligated to pay Chimichango $38,215.00 b. The dealer is obligated to pay Chimichango $30,818.54. c. Chimichango is obligated to pay the dealer $31,818.54. d. Chimichango is obligated to pay the dealer $38,215.00 e. None of the above.
ANS: D (50,000,000)(0.056 − 0.0591) (90/360) (1 + (0.056)(90)/360) = ($38,215.00). Chimichango must pay the dealer $38,215. PTS: 1
OBJ: Multiple Choice Problem
40. Refer to Exhibit 23.3. Assuming that 3-month LIBOR is 5.6% on the rate determination day, and the contract specified settlement in arrears at month 6, describe the transaction that occurs between the dealer and Megabuks. a. The dealer is obligated to pay Megabuks $38,750. b. The dealer is obligated to pay Megabuks $31,250. c. Megabuks is obligated to pay the dealer $38,750. d. Megabuks is obligated to pay the dealer $31,250. e. None of the above. ANS: B (50,000,000)(0.056 − 0.0585) (90/360) = ($31,250.00) The dealer must pay the Megabuks $31,250. PTS: 1
OBJ: Multiple Choice Problem
41. Refer to Exhibit 23.3. Assuming that 3-month LIBOR is 5.6% on the rate determination day, and the contract specified settlement in advance, describe the transaction that occurs between the dealer and Megabuks. a. The dealer is obligated to pay Megabuks $38,215.00 b. Megabuks is obligated to pay the dealer $31,818. 54. c. Megabuks is obligated to pay the dealer $38,215.00 d. The dealer is obligated to pay Megabuks $30,818.54. e. None of the above ANS: D (50,000,000)(0.056 − 0.0585) (90/360) (1 + (0.056)(90)/360) = ($30,818.54). The dealer must pay the Megabuks $30,818.54. PTS: 1
OBJ: Multiple Choice Problem
42. Refer to Exhibit 23.3. How much compensation does the dealer receive for transaction costs, credit risk and other costs associated with matching the FRA's? a. $30,000 b. $31,250 c. $7,500 d. $5,000 e. None of the above ANS: C Spread = 5.91 − 5.85 = .06% Spread Notional Principal = (.0006)(90/360)(50,000,000) = $7,500 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 23.4 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Black Gold Industries (BGI) is an independent oil producer with production capacity of 500,000 barrels per month. Due to the cost structure of the business, BGI needs to receive $56.50 per barrel in order to remain solvent. On the other side of this situation is Petrochemicals Unlimited (PU) which uses an average of 500,000 barrels of West Texas crude oil in its normal production operations. The nature of PU's business is such that they will financially suffer if they have to pay more than an average of $57.80 per barrel for oil over the next six years. To hedge against their exposure to volatile oil prices, BI and PU contact a swap dealer to arrange the six-year oil swap described below: − − − − − − −
Settlement is made monthly. The notional principal is for 500,000 barrels per month. The monthly WTI index value is determined as the average of the daily settlement prices for the crude oil futures contract traded on the New York Mercantile Exchange (NYMEX). The swap dealer pays BGI $57.00 per barrel. BGI pays the swap dealer the average NYMEX Oil futures price per barrel. PU pays the swap dealer $57.50 per barrel. The swap dealer pays PU dealer the average NYMEX Oil futures price per barrel.
43. Refer to Exhibit 23.4. Describe the transaction that occurs between BGI and the swap dealer if the monthly average oil futures settlement price is $58.45. a. BGI pays the swap dealer $725,000. b. The swap dealer pays BGI $725,000. c. BGI pays the swap dealer $675,000. d. The swap dealer pays BGI $675,000. e. None of the above. ANS: A (58.45 − 57.00)500,000 = $725,000 At a future settlement price of $58.45 per barrel, BGI must pay the swap dealer $725,000 PTS: 1
OBJ: Multiple Choice Problem
44. Refer to Exhibit 23.4. Describe the transaction that occurs between PU and the swap dealer if the monthly average oil futures settlement price is $58.45. a. PU pays the swap dealer $725,000. b. The swap dealer pays PU $725,000. c. PU pays the swap dealer $475,000. d. The swap dealer pays PU $475,000. e. None of the above. ANS: D (58.45 − 57.50)500,000 = $475,000 At a settlement price of $58.45 per barrel, the swap dealer must pay PU $475,000 PTS: 1
OBJ: Multiple Choice Problem
45. Refer to Exhibit 23.4. Describe the transaction that occurs between BGI and the swap dealer if the monthly average oil futures settlement price is $55.50. a. BGI pays the swap dealer $750,000. b. The swap dealer pays BGI $800,000. c. BGI pays the swap dealer $800,000. d. The swap dealer pays BGI $750,000. e. None of the above. ANS: D
(55.50 − 57.00)500,000 = $750,000 At a future settlement price of $55.50 per barrel, the swap dealer must pay BGI $750,000 PTS: 1
OBJ: Multiple Choice Problem
46. Refer to Exhibit 23.4. Describe the transaction that occurs between PU and the swap dealer if the monthly average oil futures settlement price is $55.50. a. PU pays the swap dealer $850,000. b. The swap dealer pays PU $1,000,000. c. PU pays the swap dealer $1,000,000. d. The swap dealer pays PU $850,000. e. None of the above. ANS: C (55.50 − 57.50)500,000 = $1,000,000 At a settlement price of $55.50 per barrel, PU must pay the swap dealer $1,000,000 PTS: 1
OBJ: Multiple Choice Problem
47. Refer to Exhibit 23.4. Barring default by PU or BGI, how much compensation does the swap dealer receive each month? a. $150,000 b. $210,000 c. $175,000 d. $250,000 e. None of the above ANS: D The swap dealer has no exposure to oil prices so she collects the spread of 500,000(57.50 − 57.00) = $250,000 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 23.5 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Exclusive Industries has debentures outstanding (par value $1,000.00) convertible into exclusive's common stock at $30. The coupon rate is 11% payable semiannually and they mature in 10 years. 48. Refer to Exhibit 23.5. Calculate the conversion value if the stock price is $24.00 per share. a. $600.00 b. $700.00 c. $800.00 d. $900.00 e. $1,000.00 ANS: C The bond is convertible into 33.333 shares of common stock since $1000/$30 = 33.333 shares. The conversion value is 33.333 $24 = $800.00 PTS: 1
OBJ: Multiple Choice Problem
49. Refer to Exhibit 23.5. Calculate the straight-bond value assuming that bonds of equivalent risk and maturity are yielding 13% per year compounded semiannually. a. $942.65 b. $902.65 c. $889.82 d. $796.83 e. $757.37 ANS: C P = 55(PVIFA6.5%,20) + 1000(PVIF6.5%,20) P = 55 (11.0185) + 1000 (.2838) = $889.82 where 11.0185 is the present value of annuity factor and .2838 is the present value factor both calculated for 20 periods at an interest rate of 6.5% per period. PTS: 1
OBJ: Multiple Choice Problem
Exhibit 23.6 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) BioTech Industries has debentures outstanding (par value $1,000) convertible into the company's common stock at $30. The coupon rate is 11 percent payable semiannually and they mature in 10 years. 50. Refer to Exhibit 23.6. Calculate the conversion value of the bond if the stock price is $27.00 per share. a. $600.00 b. $700.00 c. $800.00 d. $900.00 e. $1,000.00 ANS: D The bond is convertible into 33.333 shares of common stock since $1000.00/$30.00 = 33.333 shares. The conversion value is 33.333 $27.00 = $900.00 PTS: 1
OBJ: Multiple Choice Problem
51. Refer to Exhibit 23.6. Calculate the straight-bond value assuming that bonds of equivalent risk and maturity are yielding 14 percent per year compounded semiannually. a. $757.37 b. $796.83 c. $841.07 d. $889.82 e. $902.65 ANS: C P = 55(PVIFA7%,20) + 1000(PVIFA7%,20) P = 55(10.5940) + 1000(0.2584) = $841.07 PTS: 1
OBJ: Multiple Choice Problem
52. Refer to Exhibit 23.6. At present, what would be the minimum value of the bond? a. $600.00 b. $796.83
c. $889.82 d. $900.00 e. $1000.00 ANS: D The minimum value of the bond would be at least the greater of the two values, the straight-debt value or the conversion value. In this case, the minimum value is $900.00 (its conversion value). PTS: 1
OBJ: Multiple Choice Problem
53. The common stock of BioTech Industries pays a dividend of $1 per share and has a current market price of $27 per share. The convertible bond is selling for $1100. The payback or breakeven time for the bond is a. 1.75 years. b. 2.89 years. c. 3.20 years. d. 3.60 years. e. 4.32 years. ANS: B Bond Price Conversion Value Bond Income Stock Income
PTS: 1
$1100.00 $ 900.00 $ 110.00 $1/27 = .0370 $1100 = $40.70
OBJ: Multiple Choice Problem
54. The exercise price of The American Dairy Company is $17. You purchase the warrants for $4.00 each when American Dairy's stock price is $20.00 a share. Each warrant entitles you to purchase one share of ADC stock. Calculate your percentage gain assuming the warrant premium drops by 50% and you sell your warrants when the stock reaches $30.00 per share. a. 37.5% b. 87.5% c. 137.5% d. 237.5% e. 337.5% ANS: D V = ($20.00 − $17.00) = $3.00 theoretical value $4.00 − $3.00 = $1.00 premium V = ($30.00 − $17.00) = $13.00 theoretical value V = $13.00 + $0.50 = $13.50 actual value (13.50 − 4)/4 = 9.50/4 = 237.5% PTS: 1 Exhibit 23.7
OBJ: Multiple Choice Problem
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The WallMal Company has entered into a 4-year interest rate swap, with semiannual settlement, to pay a fixed rate of 8% per year and receive 6-month LIBOR. The notional principal is $50,000,000. 55. Refer to Exhibit 23.7. Assume that one year later the fixed rate on a new 3-year receive fixed pay floating LIBOR swap has fallen to 7% per year. Settlement is on a semiannual basis. Calculate the market value of the FRN based on $100 face value. a. $102.66 b. $100.00 c. $95.56 d. $89.63 e. $70.77 ANS: B The market value of a FRN is its par value = $100 PTS: 1
OBJ: Multiple Choice Problem
56. Refer to Exhibit 23.7. Assuming that one year after the swap was initiated the fixed rate on a new 3-year receive fixed pay floating LIBOR swap has fallen to 7% per year, calculate the market value of the 8% fixed rate bond based on $100 face value. Settlement is on a semiannual basis. a. $102.66 b. $100.00 c. $95.56 d. $89.63 e. $70.77 ANS: A
PTS: 1
OBJ: Multiple Choice Problem
57. Refer to Exhibit 23.7. Indicate the market value of the swap to the WallMal Company. a. $3,525,120 b. −$3,500,000 c. $1,332,150 d. −$1,332,150 e. $1,026,600 ANS: D The company pays the dealer = (102.6643 − 100)(50,000,000) = $1,332,150 PTS: 1
OBJ: Multiple Choice Problem
58. Refer to Exhibit 23.7. Assume that one year later the fixed rate on a new 3-year receive fixed pay floating LIBOR swap has risen to 9% per year. Settlement is on a semiannual basis. Calculate the market value of the FRN based on $100 face value. a. $97.42 b. $100.00
c. $92.56 d. $99.63 e. $75.77 ANS: B The market value of a FRN is its par value = $100 PTS: 1
OBJ: Multiple Choice Problem
59. Refer to Exhibit 23.7. Assume that one year after the swap was initiated the fixed rate on a new 3-year receive fixed pay floating LIBOR swap has risen to 9% per year, calculate the market value of the 8% fixed rate bond based on $100 face value. Settlement is on a semiannual basis. a. $76.45 b. $101.24 c. $100.0 d. $97.42 e. $70.77 ANS: D
PTS: 1
OBJ: Multiple Choice Problem
60. Refer to Exhibit 23.7. Indicate the market value of the swap to the WallMal Company. a. $5,786,345 b. −$3,575,987 c. $1,289,450 d. −$1,514,900 e. $1,250,075 ANS: C The dealer pays the company = (100 −97.4211)(50,000,000) = $1,289,450 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 23.8 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) An international investment firm buys an interest rate cap that pays the difference between LIBOR and 6% if LIBOR exceeds 6%. Current LIBOR is 5%. The amount of the option is $1,500,000, and the settlement is every 3 months. Assume a 360 day year. 61. Refer to Exhibit 23.8. Find the payoff if LIBOR closes at 4.7%. a. −$45,000 b. −$11,250 c. $0 d. $11,250 e. $45,000 ANS: C
Payoff = $1,500,000 (90/360) Max(0, 0.047 − 0.06) = 0 PTS: 1
OBJ: Multiple Choice Problem
62. Refer to Exhibit 23.8. Find the payoff if LIBOR closes at 6.3%. a. −$45,000 b. −$11,250 c. $0 d. $11,250 e. $45,000 ANS: D Payoff = $1,500,000 (90/360) Max(0, 0.063 − 0.06) = 1,500,000 0.25 0.03 = $11,250 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 23.9 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The Skalmory Corporation has entered into a 3-year interest rate swap, with semiannual settlement, to pay a fixed rate of 7.5% per year and receive 6-month LIBOR. The notional principal is $10,000,000. 63. Refer to Exhibit 23.9. Assume that one year later the fixed rate on a new 2-year receive fixed pay floating LIBOR swap has fallen to 7% per year. Settlement is on a semiannual basis. Calculate the market value of the FRN based on $100 face value. a. $101.33 b. $100.58 c. $100.00 d. $98.67 e. $95.83 ANS: C The market value of a FRN is the par value = $100 PTS: 1
OBJ: Multiple Choice Problem
64. Refer to Exhibit 23.9. Assuming that one year after the swap was initiated the fixed rate on a new 2-year receive fixed pay floating LIBOR swap has fallen to 7% per year, calculate the market value of the 7.5% fixed rate bond based on $100 face value. Settlement is on a semiannual basis. a. $101.33 b. $100.92 c. $100.00 d. $98.67 e. $95.83 ANS: B
PTS: 1
OBJ: Multiple Choice Problem
65. Refer to Exhibit 23.9. What is the market value of the swap to the Skalmory Corporation? a. −$9,000,000 b. −$1,804,000 c. −$87,654 d. $91,830 e. $7,620,000 ANS: D The company pays the dealer = (1.009183 − 1.00)(10,000,000) = $91,830 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 23.10 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) TexMex Corporation has decided to borrow $50,000,000 for six months in two three-month issues. The corporation is concerned that interest rates will rise over the next three months. Thus, the corporation purchases a 3 6 FRA whereby the corporation pays the dealer's quoted fixed rate of 3.5% in exchange for receiving 3-month LIBOR at the settlement date. In order to hedge her exposure, the dealer buys LIBOR from Newport Inc. at its bid rate of 3%. The notional principal is $50,000,000 and that there are 60 days between month 3 and month 6. 66. Refer to Exhibit 23.10. Suppose that 3-month LIBOR is 4.0% on the rate determination day, and the contract specified settlement in arrears at month 6, describe the transaction that occurs between the dealer and TexMex. a. The dealer is obligated to pay TexMex $61,881. b. The dealer is obligated to pay TexMex $61,500. c. TexMex is obligated to pay the dealer $247,524. d. TexMex is obligated to pay the dealer $246,000. e. None of the above ANS: B (50,000,000)(0.04 − 0.035) (90/360) = $62,500 The dealer is obligated to pay TexMex $62,500 PTS: 1
OBJ: Multiple Choice Problem
67. Refer to Exhibit 23.10. Suppose that 3-month LIBOR is 4.0% on the rate determination day, and the contract specified settlement in advance, describe the transaction that occurs between the dealer and TexMex. a. The dealer is obligated to pay TexMex $61,881. b. The dealer is obligated to pay TexMex $61,500. c. TexMex is obligated to pay the dealer $247,524. d. TexMex is obligated to pay the dealer $246,000. e. None of the above ANS: A (50,000,000)(0.040 − 0.035) (90/360) (1 + (0.04)(90)/360) = $61,881.19 The dealer must pay TexMex $61,881.19 PTS: 1
OBJ: Multiple Choice Problem
68. Refer to Exhibit 23.10. Suppose that 3-month LIBOR is 4.0% on the rate determination day, and the contract specified settlement in arrears at month 6, describe the transaction that occurs between the dealer and Newport. a. The dealer is obligated to pay Newport $125,000. b. The dealer is obligated to pay Newport $115,000. c. Newport is obligated to pay the dealer $125,000. d. Newport is obligated to pay the dealer $115,000. e. None of the above ANS: C (50,000,000)(0.04 − 0.03) (90/360) = $125,000 Newport must pay the dealer $125,000 PTS: 1
OBJ: Multiple Choice Problem
69. Refer to Exhibit 23.10. Suppose that 3-month LIBOR is 4.00% on the rate determination day, and the contract specified settlement in advance, describe the transaction that occurs between the dealer and Newport. a. The dealer is obligated to pay Newport $123,762. b. The dealer is obligated to pay Newport $125,000. c. Newport is obligated to pay the dealer $125,000. d. Newport is obligated to pay the dealer $123,762. e. None of the above ANS: D (50,000,000)(0.04 − 0.03) (90/360) (1 + (0.04)(90)/360) = $123,762.38 Newport must pay the dealer $123,762.38. PTS: 1
OBJ: Multiple Choice Problem
70. Refer to Exhibit 23.10. How much compensation does the dealer receive for transaction costs, credit risk and other costs associated with matching the FRA's? a. $42,700 b. $62,500 c. $82,000 d. $96,300 e. None of the above ANS: B Spread = 3.5 − 3 = .5% Spread Notional Principal = (.005)(90/360)(50,000,000) = $62,500 PTS: 1
OBJ: Multiple Choice Problem
CHAPTER 24—PROFESSIONAL MONEY MANAGEMENT, ALTERNATIVE ASSETS, AND INDUSTRY ETHICS TRUE/FALSE 1. Management and advisory firms can advise clients on how to structure their own portfolios. ANS: T
PTS: 1
2. In an investment company, the invested funds belong to many individuals. ANS: T
PTS: 1
3. The total market value of all assets of a mutual fund divided by the number of shares of the fund is known as the net asset value. ANS: T
PTS: 1
4. A portfolio is generally managed by the board of directors of an investment company. ANS: F
PTS: 1
5. A closed-end investment company is normally referred to as a mutual fund. ANS: F
PTS: 1
6. The market price of shares of a closed-end fund is typically determined by supply and demand. ANS: F
PTS: 1
7. An open-end investment company differs from a closed-end investment company by the way they operate after the initial public offering. ANS: T
PTS: 1
8. Open-end investment companies continue to sell and repurchase shares after their initial public offering. ANS: T
PTS: 1
9. A no-load fund imposes a substantial sales charge and sells shares at their NAV. ANS: F
PTS: 1
10. All investment firms charge annual management fees to compensate the professional manager of the fund. ANS: T
PTS: 1
11. Hedge funds are far less liquid than mutual fund shares. ANS: T
PTS: 1
12. The primary purpose of government regulations and voluntary standards in the professional asset management industry is to ensure that managers deal with all investors fairly and equitably and that information about investment performance is accurately reported. ANS: T
PTS: 1
13. Hedge funds have no limitations on when and how often capital can be contributed or removed from the partnership. ANS: F
PTS: 1
14. The returns received by the average individual investor on funds managed by investment companies will probably be superior to the average results for a specific U.S. or international market. ANS: F
PTS: 1
15. An investor should be cautious when selecting a fund based solely on the manager's past performance, since past performance may not be repeated in the future. ANS: T
PTS: 1
16. Diversifying a portfolio to eliminate unsystematic risk is one of the major benefits of investing in mutual funds. ANS: T
PTS: 1
17. High Portfolio turnover lowers mutual fund costs. ANS: F
PTS: 1
18. The total market value of all assets of a mutual fund divided by the number of shares of the fund is known as the net asset value. ANS: T
PTS: 1
19. Income distributions and capital gains distributions are the only source of returns for mutual funds. ANS: F
PTS: 1
20. The market price of shares of a closed-end fund is typically determined by supply and demand. ANS: T
PTS: 1
21. Closed-end investment companies never sell at discounts to their NAV. ANS: F
PTS: 1
22. Market index funds attempt to match the composition and performance of a specified market indicator series. ANS: T
PTS: 1
23. Open-end and closed-end investment companies are similar in that both companies will repurchase shares on demand. ANS: F
PTS: 1
24. When securities are held in an investment company the appropriate way to value a client's investment is by net asset value (NAV). ANS: T
PTS: 1
25. An open-end investment company functions like any other public firm. ANS: F
PTS: 1
26. The offering price for a share of a load fund equals the net asset value of the share. ANS: F
PTS: 1
27. Fund of funds give investors access to hedge fund managers that might otherwise be unavailable to them. ANS: T
PTS: 1
28. A common hedge fund strategy known as long-short equity is a type of arbitrage strategy. ANS: F
PTS: 1
29. Convertible arbitrage hedge funds profit from disparities in the relationship between prices for convertible bonds and fixed-income bonds. ANS: F
PTS: 1
MULTIPLE CHOICE 1. Which of the following is an approach to asset management? a. Management and advisory firms b. Investment companies c. Strategic management d. Choices a and b only e. All of the above ANS: D
PTS: 1
OBJ: Multiple Choice
2. An open-end investment company is commonly referred to as a(n) a. Balanced fund. b. Mutual fund. c. Money market fund. d. Accessible fund. e. Unit trust. ANS: B
PTS: 1
OBJ: Multiple Choice
3. The main difference between a closed-end fund and an open-end fund is a. The way each is traded after the initial public offering.
b. c. d. e.
There is no significant difference. The minimum initial investment. The type of allowable investments. The way in which each is regulated by the SEC.
ANS: A
PTS: 1
OBJ: Multiple Choice
4. Net asset value (NAV) is determined by a. The total market value of all its assets multiplied by the number of fund shares outstanding. b. The total market value of all its assets divided by the number of fund shares outstanding. c. The total market value of all its assets divided by the number of shareholders. d. Supply and demand for the investment company stock in the secondary market. e. Supply and demand for the investment company stock in the primary market. ANS: B
PTS: 1
OBJ: Multiple Choice
5. The market price of a closed-end investment company has generally been a. 5 to 20 percent below the NAV. b. 25 to 35 percent below the NAV. c. Equal to the NAV (within a 2 percent range). d. 5 to 20 percent above the NAV. e. 25 to 35 percent above the NAV. ANS: A
PTS: 1
OBJ: Multiple Choice
6. The closed-end fund index is a. Value weighted and based on market values. b. Value weighted and based on NAVs. c. Price weighted and based on market values. d. Price weighted and based on NAVs. e. Equally weighted and based on market values. ANS: C
PTS: 1
OBJ: Multiple Choice
7. Open-end mutual funds that charge a sales fee when the fund is initially offered to the investor are known as a. 12b-1. b. Americus trusts. c. Unit investment trusts. d. Load funds. e. Contingency funds. ANS: D
PTS: 1
OBJ: Multiple Choice
8. A 12b-1 plan allows funds to a. Charge a redemption fee. b. Deduct 7 to 8 percent commission at the initial offering. c. Deduct .75 percent of the average net assets per year. d. Charge a contingent deferred sales load. e. Switch from closed-end to open-end. ANS: C
PTS: 1
OBJ: Multiple Choice
9. When the offer price and the NAV of a mutual fund are equal it is an indication that a. The fund's assets are in equilibrium.
b. c. d. e.
The fund is trading at par. It is strictly a coincidence. The fund has no initial fee. The fund is backloaded.
ANS: D
PTS: 1
OBJ: Multiple Choice
10. All investment companies charge an annual a. 12b-1 fee. b. Marketing and distribution. c. Management fee. d. Maintenance fee. e. Market adjustment. ANS: C
PTS: 1
OBJ: Multiple Choice
11. The offering price of a load fund equals the NAV of the fund a. Less an initial requirement. b. Plus a sales charge. c. Plus a sales charge and an administrative fee. d. Less a negotiated discount. e. At its stated value. ANS: B
PTS: 1
OBJ: Multiple Choice
12. Funds that normally contain a combination of common stock and fixed income securities are known as a. Section 401(k) plans. b. Balanced funds. c. Contractual plans. d. Income funds. e. Flexible funds. ANS: B
PTS: 1
OBJ: Multiple Choice
13. Funds that attempt to provide current income, safety of principal and liquidity are known as a. Balanced funds. b. Flexible funds. c. Income funds. d. Money market funds. e. Index funds. ANS: D
PTS: 1
OBJ: Multiple Choice
14. A money market fund would be likely to invest in a portfolio containing all of the following except a. Commercial paper. b. Banker's acceptances. c. U.S. Treasury bills. d. Bank certificates of deposit. e. U.S. Treasury notes. ANS: E
PTS: 1
OBJ: Multiple Choice
15. A mutual fund typically performs all of the following functions, except a. Provides alternative risk-return options. b. Eliminates unsystematic risk. c. Provides diversification.
d. Derives a risk-adjusted performance that is consistently superior to risk-adjusted net return of the aggregate market. e. Administers the account, keeps records and provides timely information. ANS: D
PTS: 1
OBJ: Multiple Choice
16. Mutual fund performance studies have shown that most funds a. Have risks and returns that are inconsistent with their stated objectives. b. Have risks and returns that are consistent with their stated objectives. c. Do not have stated objectives. d. Have experienced risk-adjusted returns above the market. e. Have changed their objectives over time. ANS: B
PTS: 1
OBJ: Multiple Choice
17. The text offers a number of suggestions for investing in mutual funds. Which of the following is not such a suggestion? a. Choose only those mutual funds which are consistent with your objectives and constraints. b. Invest in no-load funds whenever possible. c. Avoid investing in index funds. d. Use a dollar cost average strategy. e. None of the above (that is, all are valid suggestions for investing in mutual funds) ANS: C
PTS: 1
OBJ: Multiple Choice
18. The gross return of closed-end investments companies has typically been a. 10-20 percent less than their NAV. b. 10-15 percent less than their NAV. c. Less than the net return. d. About the same as the net return. e. None of the above ANS: E
PTS: 1
OBJ: Multiple Choice
19. A major question in modern finance regarding closed-end investment companies is a. Why do these funds sell at discounts? b. Why do the discounts differ between funds? c. What are the returns available to investors from funds that sell at a large discount? d. Choices a and b only e. All of the above ANS: E
PTS: 1
OBJ: Multiple Choice
20. A portfolio manager should be able to perform all of the following functions, except a. Determine risk-return preferences. b. Eliminate systematic risk. c. Maintain diversification ensuring a stabilized risk class. d. Attempt to derive a risk-adjusted performance that is superior to the market. e. Administer the account, keep records and provide timely information. ANS: B
PTS: 1
OBJ: Multiple Choice
21. An investment company is a. A corporation that handles the administrative functions for a fund. b. A corporation that has its major assets in a portfolio of securities. c. A corporation that invests in financial services firms.
d. a and b. e. a and c. ANS: B
PTS: 1
OBJ: Multiple Choice
22. An investment management company is a. A corporation that handles the administrative functions for a fund. b. A corporation that has its major assets in a portfolio of securities. c. A corporation that invests in financial services firms. d. a and b. e. a and c. ANS: A
PTS: 1
OBJ: Multiple Choice
23. In the case of private management firms a. Investors deal with a fund company and do not have separate accounts tailored to their specific needs. b. Investors deal with a fund company and have separate accounts tailored to their specific needs. c. Investors deal with an asset manager and do not have separate accounts tailored to their specific needs. d. Investors deal with an asset manager have separate accounts tailored to their specific needs. e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
24. In the case of investment companies a. Investors deal with a fund company and do not have separate accounts tailored to their specific needs. b. Investors deal with a fund company and have separate accounts tailored to their specific needs. c. Investors deal with an asset manager and do not have separate accounts tailored to their specific needs. d. Investors deal with an asset manager have separate accounts tailored to their specific needs. e. None of the above. ANS: A
PTS: 1
OBJ: Multiple Choice
25. In the case of open-end investment companies, shares of the company a. Trade on the secondary market. b. Can be bought from or sold to the investment company at the NAV. c. Are determined by supply and demand. d. a and c. e. b and c. ANS: E
PTS: 1
OBJ: Multiple Choice
26. In the case of closed-end investment companies, shares of the company a. Trade on the secondary market. b. Can be bought from or sold to the investment company at the NAV. c. Are determined by supply and demand. d. a and c. e. b and c.
ANS: D
PTS: 1
OBJ: Multiple Choice
27. The following are examples of mutual fund companies a. Common stock funds. b. Bond funds. c. Hedge funds. d. a and b. e. a, b and c ANS: D
PTS: 1
OBJ: Multiple Choice
28. An example of an international fund would be one that consisted of investments in securities from a. The U.S., Germany, and Japan. b. Germany, Italy, and the U.K. c. The U.S., Korea, and Argentina. d. All of the above. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
29. The Investment Company Act of 1940 a. Contains various anti-fraud provisions and record keeping and reporting requirements for fund advisors. b. Regulates broker-dealers. c. Requires federal registration of all public offerings of securities. d. Regulates the structure and operations of mutual funds. e. Contains a code of ethics and standards of professional conduct. ANS: D
PTS: 1
OBJ: Multiple Choice
30. The Securities Act of 1933 a. Contains various anti-fraud provisions and record keeping and reporting requirements for fund advisors. b. Regulates broker-dealers. c. Requires federal registration of all public offerings of securities. d. Regulates the structure and operations of mutual funds. e. Contains a code of ethics and standards of professional conduct. ANS: C
PTS: 1
OBJ: Multiple Choice
31. The Securities Exchange Act of 1934 a. Contains various anti-fraud provisions and record keeping and reporting requirements for fund advisors. b. Regulates broker-dealers. c. Requires federal registration of all public offerings of securities. d. Regulates the structure and operations of mutual funds. e. Contains a code of ethics and standards of professional conduct. ANS: B
PTS: 1
OBJ: Multiple Choice
32. The Investment Advisors Act of 1940 a. Contains various anti-fraud provisions and record keeping and reporting requirements for fund advisors. b. Regulates broker-dealers. c. Requires federal registration of all public offerings of securities.
d. Regulates the structure and operations of mutual funds. e. Contains a code of ethics and standards of professional conduct. ANS: A
PTS: 1
OBJ: Multiple Choice
33. Soft dollars are generated when a. A manager commits to paying a higher than normal brokerage fee in exchange for additional bundled services. b. A manager commits to paying a higher than normal brokerage fee in exchange for secretarial services. c. A manager commits to paying a higher than normal brokerage fee in exchange for office equipment. d. All of the above. e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
34. Which of the following is a characteristic of hedge funds? a. They are generally less restricted in how and where they can make investments. b. They are more liquid than mutual fund shares. c. They have no limitations on when and how often investment capital can be contributed or removed. d. All of the above. e. None of the above. ANS: A
PTS: 1
OBJ: Multiple Choice
35. In a long short-short hedge fund strategy a. Managers take long positions in undervalued stocks and short positions in overvalued stocks. b. Managers take short positions in undervalued stocks and long positions in overvalued stocks. c. Managers take offsetting risk positions on the long and short side. d. All of the above. e. None of the above. ANS: A
PTS: 1
OBJ: Multiple Choice
36. In a convertible arbitrage strategy hedge fund managers attempt to a. Generate profits by taking advantage of convertible bond pricing disparities caused by changing market events. b. Generate profits by taking advantage of disparities in the relationship between prices for convertible bonds and the underlying common stock. c. Generate profits by taking advantage of disparities in the relationship between prices for convertible bonds and the underlying common stock option. d. All of the above. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
37. Ethical conflicts may arise as a result of a. Incentive compensation schemes. b. Soft dollar arrangements. c. Marketing investment management services. d. All of the above.
e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
38. Which of the following are guiding principles for ethical behavior in the asset management industry as put forward by the CFA Center for Financial Market Integrity? a. The interests of investment professional come first. b. The preferred method for promoting fair and efficient markets is to set up a central oversight board. c. Financial markets in various countries should develop high-quality standards for reporting financial information that reflect local customs. d. Financial statements should be reported from the perspective of firm shareholders. e. All of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
39. Which of the following are functions that a portfolio manager should perform for clients? a. Determine investment objectives and constraints, diversify the portfolio, eliminate tax payments. b. Determine investment objectives, diversify the portfolio, maintain ethical standards and eliminate tax payments. c. Determine investment objectives and constraints, diversify the portfolio, and maintain ethical standards. d. Determine constraints, diversify the portfolio, eliminate tax payments. e. Determine investment objectives and constraints, diversify the portfolio, eliminate tax payments, and achieve risk adjusted return superior to the relevant benchmark. ANS: C
PTS: 1
OBJ: Multiple Choice
40. The 12b-1 plan permits funds to deduct as much as ____ percent of average net asset per year to cover distribution costs, brokers' commissions, and general marketing expenses. a. 0.25 b. 0.50 c. 0.75 d. 1.00 e. 1.50 ANS: C
PTS: 1
OBJ: Multiple Choice
41. What type of funds are typically no-load funds that impose no penalty for early withdrawal and generally allow holders to write checks against their account? a. Mutual funds b. Open-end funds c. Closed-end funds d. Money market funds e. Balanced funds ANS: D
PTS: 1
OBJ: Multiple Choice
42. Which of the following is not an example of an alternative asset class? a. Hedge funds b. Private equity c. Real estate d. Commodities e. All of the above are examples of alternative asset classes.
ANS: E
PTS: 1
OBJ: Multiple Choice
43. When alternative assets of investors are pooled together into a single pool of assets a. The collection of assets is formed as a limited partnership. b. One or more general partners are responsible for running the organization. c. The limited partners are only liable to the extent of their investments. d. Both a and c. e. All of the above. ANS: E
PTS: 1
OBJ: Multiple Choice
44. Investing in emerging markets can be viewed as a global application of a. Fixed-income arbitrage. b. Convertible arbitrage. c. Merger arbitrage. d. Distressed opportunistic strategies. e. Equity market neutral. ANS: D
PTS: 1
OBJ: Multiple Choice
45. An investment vehicle that acts like a mutual fund of hedge funds, and allows investors access to managers that might otherwise be unavailable is known as a. Managed futures funds b. Long-short equity funds c. Fund of funds d. Private equity funds e. Leveraged Buyouts (LBOs) ANS: C
PTS: 1
OBJ: Multiple Choice
46. Which of the following statements regarding the closed-end investment company's net asset value (NAV) is false? a. NAV is computed throughout the day based on prevailing market prices for the portfolio of securities b. The market price of the shares is determined by how they trade on the exchange c. NAV and market price of a closed-end fund are almost never the same d. No new investment dollars are available for the investment company unless it makes another public sale of securities e. All of the above are true ANS: E
PTS: 1
OBJ: Multiple Choice
47. Investment companies or mutual funds that continue to sell and repurchase shares after their initial public offerings are referred to as a. Closed-end b. Open-end c. No-load d. Load e. None of the above ANS: B
PTS: 1
OBJ: Multiple Choice
48. Funds that adjust the asset allocation weights in the portfolio to match the needs of an investor who is nearing retirement are known as a. Balanced funds
b. c. d. e.
Flexible portfolio funds Lifetime funds Money market funds Target date funds
ANS: E
PTS: 1
OBJ: Multiple Choice
49. Hedge funds that are organized as a limited partnership a. Are less restricted in how they make investments than general partnership hedge funds b. Typically have larger abnormal returns than general partnership hedge funds c. Are usually less correlated with traditional asset class investments than general partnership hedge funds d. Have less liquid investments than mutual funds e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
Exhibit 24.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Suppose ABC Mutual fund owned only 4 stocks as follows: Stock W X Y Z
Shares 2500 2100 2700 1900
Price $11 14 23 15
50. Refer to Exhibit 24.1. The fund originated by selling $100,000 of stock at $10.00 per share. What is its current NAV? a. $1.47 b. $14.75 c. $16.03 d. $27.62 e. $234.12 ANS: B Original number of shares = $100,000/$10 = 10,000
W X Y Z TOTAL
Shares 2500 2100 2700 1900
Price $11 14 23 15
MV $ 27,500 $ 29,400 $ 62,100 $ 28,500 $147,500
NAV = $147,500/10,000 = $14.75 PTS: 1
OBJ: Multiple Choice Problem
51. Refer to Exhibit 24.1. What is the offering price for the fund if the NAV is $25.25 and the load is 6 percent? a. $26.19 b. $23.74
c. $25.25 d. $26.77 e. $24.13 ANS: D Offering price
PTS: 1
= NAV + NAV Load percentage = $25.25 + 25.25(0.06) = $26.77 OBJ: Multiple Choice Problem
52. Suppose Mega Mutual Fund owns only the 4 stocks shown below with no liabilities. Stock A B C D
Shares 1800 2200 2300 1900
Price 15 11 9 18
The fund originated by selling $300,000 of stock at $30.00 per share. What is its current NAV? a. $106.10 b. $12.94 c. $129.40 d. $10.61 e. None of the above ANS: D Original number of shares = $300,000 $30 = 10,000 Stock A B C D
Shares 1800 2200 2300 1900
Price 15 11 9 18 Total =
Market Price 27,000 24,200 20,700 34,200 106,100
NAV = $106,100 10,000 = $10.61 PTS: 1
OBJ: Multiple Choice Problem
53. Suppose Under Mutual Fund owns only the 3 stocks shown below with no liabilities. Stock A B C
Shares 2900 3100 3200
Price 15 14 12
The fund originated by selling $500,000 of stock at $50.00 per share. What is its current NAV? a. $12.53 b. $15.29 c. $152.90 d. $125.30 e. None of the above
ANS: A Original number of shares = $500,000 $50 = 10,000 Stock AA BB CC
Shares 2900 3100 3200
Price 15 14 12 Total =
Market Price 43,500 43,400 38,400 125,300
NAV = $125,300 10,000 = $12.53 PTS: 1
OBJ: Multiple Choice Problem
54. Suppose you consider investing $1,000 in a load fund which charges a fee of 2%, and you expect the fund to earn 14% over the next year. Alternatively, you could invest in a no-load fund with similar risk that is expected to earn 9% and charges a 1/2 percent redemption fee. Which is better and by how much? a. Funds are equal b. Load fund by $32.65 c. Load fund by $50.55 d. No-load fund by $64.55 e. No-load fund by $44.30 ANS: B Load Fund:
$1,000 (1.00 − 0.02) (1.14) = $1117.20
No-Load Fund:
$1,000 (1.09)(1.00 − 0.005) = $1084.55
The difference is 1117.20 − 1084.55 = $32.65 Load fund is better. PTS: 1
OBJ: Multiple Choice Problem
55. Suppose you consider investing $1,000 in a load fund which charges a fee of 2%, and you expect the fund to earn 11% over the next year. Alternatively, you could invest in a no-load fund with similar risk that is expected to earn 7% and charges a 1/2 percent redemption fee. Which is better and by how much? a. Funds are equal b. No-load fund by $36.98 c. Load fund by $45.25 d. Load fund by $23.15 e. No-load fund by $15.52 ANS: D Load Fund:
$1,000 (1.00 − 0.02) (1.11) = $1087.80
No-Load Fund:
$1,000 (1.07)(1.00 − 0.005) = $1064.65
The difference is $1087.80 − $1064.65= $23.15 Load fund is better. PTS: 1
OBJ: Multiple Choice Problem
56. Suppose you consider investing $15,000 in a load fund from which a fee of 5% is deducted and you expect the fund to earn 12% over the next year. Alternatively, you could invest in a no load fund which is expected to earn 10% and which takes a 1/2 percent redemption fee. Which is better and by how much? a. Load fund by $318.45 b. No load fund by $457.50 c. Funds are equal d. Load fund by $415.10 e. No load fund by $211.51 ANS: B Load Fund:
$15,000 (1.00 − 0.05) (1.12) = $15960
No-Load Fund:
$15,000 (1.10) (1.00 − .005) = $16417.50
The difference is $16417.50 − $15960 = $457.50 No-Load fund is better. PTS: 1
OBJ: Multiple Choice Problem
57. Suppose you consider investing $10,000 in a load fund from which a fee of 3% is deducted and you expect the fund to earn 12% over the next year. Alternatively, you could invest in a no load fund which is expected to earn 10% and which takes a 0 percent redemption fee. Which is better and by how much? a. Load fund by $151 b. No load fund by $136 c. Funds are equal d. No load fund by $421 e. Load fund by $115 ANS: B Load Fund:
$10,000 (1.00 − 0.03) (1.12) = $10864
No-Load Fund:
$10,000 (1.10) = $11000
The difference is $11000 − $10864 = $136 No-Load fund is better. PTS: 1
OBJ: Multiple Choice Problem
58. Suppose you consider investing $5,000 in a load fund from which a fee of 8% is deducted and you expect the fund to earn 12% over the next year. Alternatively, you could invest in a no load fund which is expected to earn 10% and which takes a 1/2 percent redemption fee. Which is better and by how much? a. Load fund by $320.50 b. Load fund by $575.50 c. Funds are equal d. No load fund by $320.50 e. No load fund by $575.50 ANS: D
Load Fund:
$5,000 (1.00 − 0.08) (1.12) = $5152.00
No-Load Fund:
$5,000 (1.10) (1.00 − .005) = $5472.50
The difference is $5152.00 − $5472.50 = −$320.50 No-Load fund is better. PTS: 1
OBJ: Multiple Choice Problem
59. On January 2, 2003, you invest $10,000 in Megabucks Mutual Fund, a load fund that charges a fee of 2%. The fund's returns were 13% in 2003, 11% in 2004, 8% in 2005. On December 31, 2005 you redeem all your shares. The dollar value is a. $13,600.00 b. $13,275.51 c. $13,297.67 d. $13,995.75 e. $10,000.00 ANS: B Dollar value = $10,000 (1.13)(1.11)(1.08)(1.00 − 0.02) = $13275.51 PTS: 1
OBJ: Multiple Choice Problem
60. On January 2, 2003, you invest $50,000 in the Lizbiz Mutual Fund, a load fund that charges a fee of 5%. The fund's returns were 14.6% in 2003, −6.4% in 2004, 15.2% in 2005. On December 31, 2005 you redeem all your shares. The dollar value is a. $66,722.27 b. $15,200.00 c. $58,695.74 d. $33,366.25 e. $10,000.00 ANS: C Dollar value = $50,000 (1.146)(0.936)(1.152)(1.00 − 0.05) = $58695.74 PTS: 1
OBJ: Multiple Choice Problem
61. On January 2, 2003, you invest $100,000 in the Jeffers Mutual Fund, a load fund that charges a fee of 5%. The fund's returns were −14.6% in 2003, −6.4% in 2004, 35% in 2005. On December 31, 2005 you redeem all your shares. The dollar value is: a. $95,600.57 b. $102,515.90 c. $83,297.75 d. $133,995.75 e. $100,000.00 ANS: B Dollar value = $100,000 (0.854)(0.936)(1.35)(1.00 − 0.05) = $102515.90 PTS: 1
OBJ: Multiple Choice Problem
62. On January 2, 2003, you invest $10,000 in the Tiger Fund, a load fund that charges a fee of 6%. The fund's returns were 25% in 2003, 35% in 2004, −5% in 2005. On December 31, 2005 you redeem all your shares of Tiger. The dollar value is a. $5,200.89 b. $13,345.89 c. $7,931.25 d. $15,896.34 e. $8,646.91 ANS: C Dollar value = $10,000 (1.25)(1.35)(0.5)(1.00 − 0.06) = $7931.25 PTS: 1
OBJ: Multiple Choice Problem
63. On January 2, 2003, you invest $10,000 in the W.O.W. Mutual Fund, a load fund that charges a fee of 5%. The fund's returns were 13.6% in 2003, 12.2% in 2004, 8.3% in 2005. On December 31, 2005 you redeem all your W.O.W. shares. The dollar value is a. $13,600.00 b. $13,664.13 c. $10,000.00 d. $131,136.40 e. $13,113.64 ANS: E Dollar value = $10,000 (1.136)(1.122)(1.083)(1.00 − 0.05) = $13,113.64 PTS: 1
OBJ: Multiple Choice Problem
64. On January 2, 2003, you invest $10,000 in the Dog Mutual Fund, a load fund that charges a fee of 7%. The fund's returns were 12.8% in 2003, 13.9% in 2004, 7.9% in 2005. On December 31, 2005 you redeem all your shares. The dollar value is a. $12,800.00 b. $12,892.50 c. $100,000.00 d. $128,925.00 e. $10,000.00 ANS: B Dollar value = $10,000 (1.128)(1.139)(1.079)(1.00 − 0.07) = $12,892.50 PTS: 1
OBJ: Multiple Choice Problem
65. On January 2, 2003, you invest $50,000 in A Mutual Fund, a load fund that charges a fee of 7%. The fund's returns were 12.8% in 2003, 13.9% in 2004, 7.9% in 2005. On December 31, 2005 you redeem all your shares in A. The dollar value is a. $64,462.57 b. $644,625.70 c. $50,000.00 d. $6,446.25 e. $10,000.00 ANS: A Dollar value = $50,000 (1.128)(1.139)(1.079)(1.00 − 0.07) = $64,462.51 PTS: 1
OBJ: Multiple Choice Problem
66. On January 2, 2003, you invest $100,000 in Righteous, a load fund that charges a fee of 7%. The fund's returns were 12.8% in 2003, 13.9% in 2004, 7.9% in 2005. On December 31, 2005 you redeem all your Righteous shares. The dollar value is a. $12,800.00 b. $12,892.50 c. $100,000.00 d. $128,925.00 e. $10,000.00 ANS: D Dollar value = $100,000 (1.128)(1.139)(1.079)(1.00 − 0.07) = $128,925.02 PTS: 1
OBJ: Multiple Choice Problem
67. Consider the Defiance Bond Fund that consists of the 3 bonds shown below and has no liabilities. Company Komko Hijack Mitsue
Current Bond Value 980 1010 1200
# Bonds 120 150 100
If initially the value of the fund was $250,000 and the original shares were offered to the public with a NAV of $25 per share, what is the current NAV of the fund? a. $25.00 b. $38.91 c. $39.81 d. $31.98 e. $39.91 ANS: B Original # of shares = 250,000 25 = 10,000 NAV = 389,000 10,000 = $38.91 PTS: 1
OBJ: Multiple Choice Problem
68. Consider X Bond Fund which consists of the 5 bonds shown below with no liabilities. Company Komko Hijack Mitsue Smitsu Jones
Current Bond Value 980 1010 1200 800 600
# Bonds 120 150 100 120 150
If initially the value of the fund was $1,000,000 and the original shares were offered to the public with a NAV of $25 per share, what is the current NAV of the fund? a. $25.00 b. $27.68 c. $25.68 d. $28.76 e. $26.78 ANS: D
Original # of shares = 500,000 25 = 20,000 NAV = 575,100 20,000 = $28.76 PTS: 1
OBJ: Multiple Choice Problem
69. Consider the Compliance Bond Fund that consists of the 7 bonds shown below and has no liabilities. Company Komko Hijack Mitsue Smitsu Jones GMM ATP
Current Bond Value 980 1010 1200 800 600 1000 950
# Bonds 120 150 100 120 150 150 150
If initially the value of the fund was $2,500,000 and the original shares were offered to the public with a NAV of $25 per share, what is the current NAV of the fund? a. $27.11 b. $25.00 c. $26.11 d. $21.67 e. $26.27 ANS: A Original # of shares = 800,000 25 = 32,000 NAV = 867,600 32,000 = $27.11 PTS: 1
OBJ: Multiple Choice Problem
70. Given the following fees and expected returns for fund X, assuming an initial investment of $1000 calculate the value of the investment at the end of 5 years. Investment X a. b. c. d. e.
E(Return) 10%
Load 2.5%
12b-1 fee 0.25%
Rear-end load 0%
Years 5 years
$1069.82 $1550.77 $1042.36 $1689.95 $1389.95
ANS: B $1000(1 − 0.025)(1 + .10)5(1 − 0.0025)5 = $1,550.77 PTS: 1
OBJ: Multiple Choice Problem
71. Given the following fees and expected returns for fund Y, assuming an initial investment of $1000 calculate the value of the investment at the end of 5 years Investment Y a. $1069.82
E(Return) 8%
Load 0%
12b-1 fee 0.50%
Rear-end load 3%
Years 5 years
b. c. d. e.
$1550.77 $1642.36 $1389.95 $1362.59
ANS: D $1000(1 + 0.08)5(1 − 0.005)5(1 − .03) = $1,389.95 PTS: 1
OBJ: Multiple Choice Problem
72. Calculate the annual rate of return for a mutual fund with the following fees and expected returns Investment Mutual Fund a. b. c. d. e.
E(Return) 7%
Load 4%
12b-1 fee 0.50%
Years Held 7 years
4.95% 5.0% 5.85% 2.5% 6.55%
ANS: C $1(1 − 0.04)(1 + 0.07)7(1 − 0.005)7 = $1.4884 Annual return = 1.48841/7 − 1 = 0.05845 = 5.85% PTS: 1
OBJ: Multiple Choice Problem
73. If the Micro mutual fund was originated by selling $250,000 of stock at $10.00 per share. Calculate its current NAV if the fund consists of the following four stocks. Stock Q R S T a. b. c. d. e.
Shares 9,500 7,200 4,500 6,800
Price $10.75 $13.90 $22.25 $14.75
$5.78 $10.00 $12.43 $16.11 $19.21
ANS: D Original number of shares = $250,000/$10 = 25,000 Market value of fund = 10.75(9500) + 13.70(7200) + 22.25(4500) + 14.75(6800) = 102,125 + 100,080 + 100,125 + 100,300 = 402,630 NAV = $402,630/25,000 = $16.105 PTS: 1
OBJ: Multiple Choice Problem
74. What is the offering price for a mutual fund with a NAV of $22.50 and a load of 5 percent? a. $21.38
b. c. d. e.
$21.79 $22.50 $23.63 $27.50
ANS: D Offering price
PTS: 1
= NAV + NAV Load percentage = $22.50 + 22.50(0.05) = $23.625 OBJ: Multiple Choice Problem
75. You are considering investing $50,000 in two mutual funds. The first fund is a load fund with a fee of 6% and you expect the fund to earn 11% over the next year. Alternatively, you could invest in a no load fund that is expected to earn 8% and has a 0.5 percent redemption fee. What fund has a higher return and how much more value will it have after the first year? a. Load fund by $1,360 b. Load fund by $580 c. No load fund by $580 d. No load fund by $1,560 e. No load fund by $1,820 ANS: D Load Fund:
$50,000 (1.00 − 0.06) (1.11) = $52,170
No-Load Fund:
$50,000 (1.08) (1.00 − .005) = $53,730
No-Load Fund is preferred. The value difference is $53,730 − $52,170 = $1,560 PTS: 1
OBJ: Multiple Choice Problem
76. On January 1, 2005, you invest $20,000 in Libby Mutual Fund, a load fund that charges a fee of 2.5%. The fund's returns were 9% in 2005, 8% in 2006, 3% in 2007. If you redeem all your shares on December 31, 2007, what is the dollar value? a. $24,250.32 b. $24,000.32 c. $23,644.06 d. $23,195.17 e. $21,501.80 ANS: C Dollar value = $20,000 (1.09)(1.08)(1.03)(1.00 − 0.025) = $23,644.06 PTS: 1
OBJ: Multiple Choice Problem
77. Suppose NBT Mutual Fund has no liabilities and owns only three stocks with the following number of shares and respective market prices. Stock X Y Z
Shares 7900 8100 9200
Price 16 15 12
The fund originated by selling $500,000 of stock at $100.00 per share. What is its current NAV? a. $0.72
b. c. d. e.
$14.33 $15.21 $71.66 None of the above
ANS: D Original number of shares = $500,000 $100 = 5,000 Stock X Y Z
Shares 7900 8100 9200
Price 16 15 12 Total =
Market Price 126,400 121,500 110,400 358,300
NAV = $358,300 5,000 = $71.66 PTS: 1
OBJ: Multiple Choice Problem
78. You are considering investing $1,000 in a load fund which charges a fee of 2.5%, with an expected return of 12% over the next year. Alternatively, you could invest in a no-load fund with similar risk that is expected to earn 8% and charges a 1/2 percent redemption fee. Which is better and by how much? a. Load fund by $12.00 b. Load fund by $15.32 c. Load fund by $17.40 d. No-load fund by $6.55 e. No-load fund by $1.30 ANS: C Load Fund:
$1,000 (1.00 − 0.025) (1.12) = $1092.00
No-Load Fund:
$1,000 (1.08)(1.00 − 0.005) = $1074.60
The difference is 1092.00 − 1074.60 = $17.40 Load fund is better by $17.40. PTS: 1
OBJ: Multiple Choice Problem
79. What is the offering price for a mutual fund with a NAV of $36.50 and a load of 4 percent? a. $34.78 b. $35.51 c. $35.77 d. $36.50 e. $37.96 ANS: E Offering price
PTS: 1
= NAV + NAV Load percentage = $36.50 + 36.50(0.04) = $37.96 OBJ: Multiple Choice Problem
CHAPTER 25—EVALUATION OF PORTFOLIO PERFORMANCE TRUE/FALSE 1. Investors want their portfolio managers to completely diversify their portfolio, that is, eliminate all systematic risk. ANS: F
PTS: 1
2. A peer group comparison collects the returns produced by a representative universe of investors over a specific period of time and displays them in a simple boxplot format. ANS: T
PTS: 1
3. The typical proxy for the market portfolio is the S&P 500 Index because it is diversified and price weighted. ANS: F
PTS: 1
4. Treynor's performance measure implicitly assumes a completely diversified portfolio. ANS: T
PTS: 1
5. A negative Treynor measure (negative T) for a portfolio always indicates that the portfolio would plot below the SML. ANS: F
PTS: 1
6. Sharpe's performance assumes that all portfolios are completely diversified. ANS: T
PTS: 1
7. The Sharpe measure examines the risk premium per unit of systematic risk. ANS: F
PTS: 1
8. The Sharpe and Treynor measures complement each other and thus both should be used to measure portfolio performance. ANS: T
PTS: 1
9. The Sharpe and Treynor measures always give different rankings. ANS: F
PTS: 1
10. Overall performance is the total return above the risk free rate. ANS: T
PTS: 1
11. The Jensen measure requires that each period's rates of return and risk-free rate be measured, rather than using the long-term averages as in the Treynor and Sharpe measures.
ANS: T
PTS: 1
12. The ranking differences between the Sharpe, Treynor and Jensen performance measures occur because of the differences in diversification. ANS: T
PTS: 1
13. Funds with low levels of diversification tend to "beat the market." ANS: F
PTS: 1
14. The portfolio performance measure that can be most affected by a benchmark error is the Sharpe measure. ANS: F
PTS: 1
15. Attribution analysis separates a portfolio manager's performance into an allocation effect and selection effect. ANS: T
PTS: 1
16. An appropriate composite risk measure that indicates the relative price volatility for a bond compared to interest rate changes is the bond's yield to maturity. ANS: F
PTS: 1
17. In evaluating bond performance, the Lehman Brothers Index is an appropriate risk measure. ANS: F
PTS: 1
18. The policy effect is a difference in bond portfolio performance from that of a benchmark index due to a difference in duration. ANS: T
PTS: 1
19. Duration is considered a good measure of risk for a bond portfolio because it indicates the relative volatility of the bond or portfolio due to interest rate changes and also the rating of the bonds. ANS: F
PTS: 1
20. A test of bond performance over time indicated that bond portfolio managers are more consistent over time than equity managers. ANS: F
PTS: 1
21. A portfolio manager should be evaluated many times and in a variety of market environments before a final judgment is reached regarding his/her strengths and weaknesses. ANS: T
PTS: 1
22. Two desirable attributes of a portfolio manager's performance are the ability to derive above-average returns for a given risk class and the ability to time the market. ANS: F
PTS: 1
23. The most common manner of evaluating portfolio managers is a peer group comparison. ANS: T
PTS: 1
24. Treynor developed the first composite measure of portfolio performance by introducing the capital market line, which defines the relationship between the return of a portfolio over time and the return for the market portfolio. ANS: F
PTS: 1
25. The Sharpe measure of portfolio performance divides the portfolio's risk premium by the portfolio's beta. ANS: F
PTS: 1
26. The market rewards investors for bearing total risk. ANS: F
PTS: 1
27. The information ratio permits only relative assessments of performance for different portfolios in a style class. ANS: T
PTS: 1
28. When applying the Jensen's alpha measure the alpha level and significance can vary greatly depending on the specification of the return-generating model. ANS: T
PTS: 1
MULTIPLE CHOICE 1. The major requirements of a portfolio manager include the following, except a. Follow the client's policy statement. b. Completely diversify the portfolio to eliminate all unsystematic risk. c. The ability to derive above-average risk adjusted returns. d. Completely diversify the portfolio to eliminate all systematic risk. e. None of the above (that is, all are requirements of a portfolio manager) ANS: D
PTS: 1
OBJ: Multiple Choice
2. Portfolio managers who anticipate an increase in interest rates should a. Act to keep the duration constant. b. Decrease the portfolio duration. c. Increase the portfolio duration. d. Assume higher risk in the market. e. Invest in junk bonds. ANS: B
PTS: 1
OBJ: Multiple Choice
3. Treynor showed that rational, risk averse investors always prefer portfolio possibility lines that have a. Zero slopes. b. Slightly negative slopes. c. Highly negative slopes.
d. Slightly positive slopes. e. Highly positive slopes. ANS: E
PTS: 1
OBJ: Multiple Choice
4. The measure of performance which divides the portfolio's risk premium by the portfolio's beta is the a. Sharpe measure. b. Jensen measure. c. Fama measure. d. Alternative components model (MCV). e. Treynor measure. ANS: E
PTS: 1
OBJ: Multiple Choice
5. Sharpe's performance measure divides the portfolio's risk premium by the a. Standard deviation of the rate of return. b. Variance of the rate of return. c. Slope of the fund's characteristic line. d. Beta. e. Risk free rate. ANS: A
PTS: 1
OBJ: Multiple Choice
6. Which measure of portfolio performance allows analysts to determine the statistical significance of abnormal returns? a. Sharpe measure b. Jensen measure c. Fama measure d. Alternative components model (MCV) e. Treynor measure ANS: B
PTS: 1
OBJ: Multiple Choice
7. Selectivity measures how well a portfolio performed relative to a a. Market portfolio (S&P 400). b. Portfolio of the same securities in the previous period. c. Naively selected portfolio of equal risk. d. Naively selected portfolio of equal return. e. World market portfolio. ANS: C
PTS: 1
OBJ: Multiple Choice
8. A portfolio performance measurement technique that decomposes the return of a manager's holdings to a predetermined benchmark's returns and separates the difference into an allocation and selection is called a. Immunization analysis. b. Performance attribution analysis. c. Tactical rankings. d. Convexity utilization. e. Duration matching attrition. ANS: B
PTS: 1
OBJ: Multiple Choice
9. Under the performance attribution analysis method, the ____ measures the manager's decision to overor underweight a particular market segment in terms of that segment's return performance relative to the overall return to the benchmark.
a. b. c. d. e.
Selection effect Allocation effect Distribution effect Diversification effect Attribution effect
ANS: B
PTS: 1
OBJ: Multiple Choice
10. Under the performance attribution analysis method, the ____ measures the manager's ability to form specific market segment portfolios that generate superior returns relative to the way in which the comparable market segment is defined in the benchmark portfolio weighted by the manager's actual market segment investment proportions. a. Selection effect b. Allocation effect c. Distribution effect d. Diversification effect e. Attribution effect ANS: A
PTS: 1
OBJ: Multiple Choice
11. If the return increases as more global investments with low correlation are added to the market portfolio, the efficient frontier moves a. Up and right. b. Up and left. c. Down and right. d. Down and left. e. Up only. ANS: B
PTS: 1
OBJ: Multiple Choice
12. Wagner and Tito suggested that a bond portfolio return differing from the return from the Lehman Brothers Index can be divided into four components. Which of the following is not included? a. Policy effect b. Rate anticipation effect c. Sector/Quality effect d. Analysis effect e. Trading effect ANS: C
PTS: 1
OBJ: Multiple Choice
13. Information ratio portfolio performance measures a. Adjust portfolio risk to match benchmark risk. b. Compare portfolio returns to expected returns under CAPM. c. Evaluate portfolio performance on the basis of return per unit of risk. d. Indicate historic average differential return per unit of historic variability of differential return. e. None of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
14. Relative return portfolio performance measures a. Adjust portfolio risk to match benchmark risk. b. Compare portfolio returns to expected returns under CAPM. c. Evaluate portfolio performance on the basis of return per unit of risk. d. Indicate historic average differential return per unit of historic variability of differential
return. e. None of the above. ANS: C
PTS: 1
OBJ: Multiple Choice
15. Excess return portfolio performance measures a. Adjust portfolio risk to match benchmark risk. b. Compare portfolio returns to expected returns under CAPM. c. Evaluate portfolio performance on the basis of return per unit of risk. d. Indicate historic average differential return per unit of historic variability of differential return. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
16. For a poorly diversified portfolio the appropriate measure of portfolio performance would be a. The Treynor measure because it evaluates portfolio performance on the basis of return and diversification. b. The Sharpe measure because it evaluates portfolio performance on the basis of return and diversification. c. The Treynor measure because it uses standard deviation as the risk measure. d. The Sharpe measure because it uses beta as the risk measure. e. None of the above. ANS: B
PTS: 1
OBJ: Multiple Choice
17. Components of overall portfolio performance include a. Selectivity. b. Manager's risk. c. Security risk. d. a and b. e. a, b and c. ANS: D
PTS: 1
OBJ: Multiple Choice
18. A portfolio's gross selectivity is made up of a. Manager's risk. b. Net selectivity. c. Diversification. d. a and b. e. b and c. ANS: E
PTS: 1
OBJ: Multiple Choice
19. Bailey, Richards, and Tierney maintain that any useful benchmark should have the following characteristics: a. Measurable. b. Investable. c. Value-weighted. d. a and b. e. a, b and c. ANS: D
PTS: 1
OBJ: Multiple Choice
20. Which of the following statements concerning performance measures is false? a. The Sharpe measure examines both unsystematic and systematic risk.
b. c. d. e.
The Treynor measure examines systematic risk. The Jensen measure examines systematic risk. All three measures examine both unsystematic and systematic risk. None of the above (that is, all statements are true)
ANS: D
PTS: 1
OBJ: Multiple Choice
21. Which of the following statements about returns-based analysis or effective mix analysis is true? a. This analysis compares the historical return pattern of the portfolio in question with the historical returns of various well-specified indexes. b. This analysis uses sophisticated quadratic programming techniques to indicate what styles or style combinations were most similar to the portfolio's actual historical returns. c. This analysis is based on the belief that the portfolio's current make-up will be a good predictor for the next period's returns. d. Choices a and b e. All of the above statements describe returns-based analysis or effective mix analysis ANS: D
PTS: 1
OBJ: Multiple Choice
22. A manager's superior returns could have occurred due to: a. an insightful asset allocation strategy, over weighting an asset class that earned high returns. b. investing in undervalued sectors. c. selecting individual securities that earned above average returns. d. Choices a and c e. All of the above ANS: E
PTS: 1
OBJ: Multiple Choice
23. In the evaluation of bond portfolio performance, the policy effect refers to a. The difference in portfolio duration and index duration. b. The extra return attributable to acquiring bonds that are temporarily mispriced relative to risk. c. Short-run changes in the portfolio during a specific period. d. The differential return from changing duration of the portfolio during a specific period. e. None of the above. ANS: A
PTS: 1
OBJ: Multiple Choice
24. In the evaluation of bond portfolio performance, the interest rate anticipation effect refers to a. The difference in portfolio duration and index duration. b. The extra return attributable to acquiring bonds that are temporarily mispriced relative to risk. c. Short-run changes in the portfolio during a specific period. d. The differential return from changing duration of the portfolio during a specific period. e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
25. In the evaluation of bond portfolio performance, the analysis effect refers to a. The difference in portfolio duration and index duration. b. The extra return attributable to acquiring bonds that are temporarily mispriced relative to risk. c. Short-run changes in the portfolio during a specific period. d. The differential return from changing duration of the portfolio during a specific period.
e. None of the above ANS: B
PTS: 1
OBJ: Multiple Choice
26. In the Grinblatt-Titman (GT) performance measure, a. Portfolio performance is measured by assessing the quality of services provided by money managers by looking at adjustments made to the content of their portfolios. b. Portfolio performance is measured by examining both unsystematic and systematic risk. c. Portfolio performance is measured by comparing the returns of each stock in the portfolio to the return of a benchmark portfolio. With the same aggregate investment characteristics as the security in question. d. Portfolio performance is measured on the basis of return per unit of risk. e. Portfolio performance is measured on the basis of historic average differential return per unit of historic variability of differential return. ANS: A
PTS: 1
OBJ: Multiple Choice
27. In the Characteristic Selectivity (CS) performance measure, a. Portfolio performance is measured by assessing the quality of services provided by money managers by looking at adjustments made to the content of their portfolios. b. Portfolio performance is measured by examining both unsystematic and systematic risk. c. Portfolio performance is measured by comparing the returns of each stock in the portfolio to the return of a benchmark portfolio. With the same aggregate investment characteristics as the security in question. d. Portfolio performance is measured on the basis of return per unit of risk. e. Portfolio performance is measured on the basis of historic average differential return per unit of historic variability of differential return. ANS: C
PTS: 1
OBJ: Multiple Choice
28. A more recent adjustment to the Sharpe measurement for portfolio evaluation is a. To divide the portfolio risk premium by total risk rather than the portfolio's beta. b. To divide the portfolio risk premium by standard deviation rather than the portfolio's beta. c. To divide the portfolio risk premium by the excess portfolio return rather than total risk. d. To divide the excess portfolio return by the portfolio's standard deviation. e. To divide the excess portfolio return by the portfolio's beta. ANS: C
PTS: 1
OBJ: Multiple Choice
29. Which portfolio measurement uses the mean excess return in the numerator divided by the amount of residual risk that the investor incurred in pursuit of those excess returns? a. Jensen measure. b. Fama measure. c. Sharpe measure. d. Treynor ratio. e. Information ratio. ANS: E
PTS: 1
OBJ: Multiple Choice
30. The cost of active management is the coefficient ER and it is sometimes referred to as a. Market timing. b. Reward for risk. c. Excess reward. d. Excess risk. e. Tracking error.
ANS: E
PTS: 1
OBJ: Multiple Choice
31. A disadvantage of the Treynor and Sharpe measures is that a. They produce absolute performance rankings. b. The beta and standard deviation are static. c. They are both difficult to compute. d. They produce relative performance rankings. e. They give very different measurements for well-diversified portfolios. ANS: D
PTS: 1
OBJ: Multiple Choice
32. The Sortino measure differs from the Sharpe ratio in that a. It measures the portfolio's average return in excess of a user-selected minimum acceptable return threshold. b. It measures the downside risk in a portfolio. c. Higher values of the Sortino measure are not desirable, while higher values in the Sharpe ratio are desirable. d. Both a and b. e. All of the above. ANS: D
PTS: 1
OBJ: Multiple Choice
33. Portfolio managers are often evaluated using a boxplot of returns for a universe of investors over a specific period of time which is known as a(n) a. Return adjusted comparison b. Efficient frontier comparison c. Time plot comparison d. Peer group comparison e. None of the above ANS: D
PTS: 1
OBJ: Multiple Choice
34. Suppose the expected return for the market portfolio and risk-free rate are 13% and 3% respectively. Stocks A, B, and C have Treynor measures of 0.24, 0.16, and 0.11, respectively. Based on this information an investor should a. Buy stocks A, B, and C b. Buy stocks A and B and sell stock C c. Buy stock A and sell stocks B and C d. Sell stocks A, B, and C e. Hold stocks A, B, and C ANS: A
PTS: 1
OBJ: Multiple Choice
35. Which of the following performance measures is the most rigorous risk-adjustment process separating systematic and unsystematic risk? a. Treynor ratio b. Sharpe ratio c. Jensen's Alpha d. Information ratio e. None of the above ANS: C
PTS: 1
OBJ: Multiple Choice
Exhibit 25.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
The portfolios identified below are being considered for investment. During the period under consideration Rf = .03. Portfolio A B C D
Return 0.16 0.22 0.11 0.18
Beta 1.0 1.5 0.6 1.1
0.15 0.10 0.08 0.12
36. Refer to Exhibit 25.1. Using the Sharpe Measure, which portfolio performed best? a. A b. B c. C d. D e. Two portfolios are tied ANS: B (A) (0.16 − 0.03) 0.15 = 0.87 (B)
(0.22 − 0.03) 0.10 = 1.90
(C)
(0.11 − 0.03) 0.08 = 1.0
(D)
(0.18 − 0.03) 0.12 = 1.25
Portfolio B has the best performance using the Sharpe Measure. PTS: 1
OBJ: Multiple Choice Problem
37. Refer to Exhibit 25.1. According to the Treynor Measure, which portfolio performed best? a. A b. B c. C d. D e. Two portfolios are tied ANS: D (A) (0.16 − 0.03) 1.00 = 0.13 (B)
(0.22 − 0.03) 1.50 = 0.127
(C)
(0.11 − 0.03) 0.60 = 0.133
(D)
(0.18 − 0.03) 1.10 = 0.136
Portfolio D has the best performance using the Treynor Measure. PTS: 1
OBJ: Multiple Choice Problem
Exhibit 25.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
The portfolios identified below are being considered for investment. Assume that during the period under consideration Rf = .04. Portfolio W X Y Z
Return 0.18 0.21 0.13 0.16
Beta 1.8 0.9 0.7 1.5
0.06 0.10 0.03 0.07
38. Refer to Exhibit 25.2. Using the Sharpe Measure, which portfolio performed best? a. W b. X c. Y d. Z e. Two portfolios are tied ANS: C (W) (0.18 − 0.04) 0.06 = 2.33 (X)
(0.21 − 0.04) 0.10 = 1.70
(Y)
(0.13 − 0.04) 0.03 = 3.00
(Z)
(0.16 − 0.04) 0.07 = 1.71
Portfolio Y has the best performance using the Sharpe Measure. PTS: 1
OBJ: Multiple Choice Problem
39. Refer to Exhibit 25.2. According to the Treynor Measure, which portfolio performed best? a. W b. X c. Y d. Z e. Two portfolios are tied ANS: B (W) (0.18 − 0.04) 1.8 = 0.078 (X)
(0.21 − 0.04) 0.9 = 0.189
(Y)
(0.13 − 0.04) 0.7 = 0.129
(Z)
(0.16 − 0.04) 1.5 = 0.08
Portfolio X has the best performance using the Treynor Measure. PTS: 1
OBJ: Multiple Choice Problem
Exhibit 25.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Consider the data presented below on three mutual funds and the market.
Fund AAA BBB CCC Market
Beta 0.75 1.05 0.89 1.00
Standard Deviation (%) 7.0 5.0 8.0 8.0
Return (%) 14 18 20 12
Rf (%) 3 3 3 3
40. Refer to Exhibit 25.3. Compute the Sharpe Measure for the AAA fund. a. 4.49 b. 2.74 c. 1.57 d. 1.70 e. 1.27 ANS: C (14 − 3) 7 = 1.57 PTS: 1
OBJ: Multiple Choice Problem
41. Refer to Exhibit 25.3. Compute the Jensen Measure for the BBB fund. a. 4.49 b. 2.74 c. 4.25 d. 5.55 e. 8.99 ANS: D (18 − 3) − [1.05 (12.0 − 3.0)] = 5.55 PTS: 1
OBJ: Multiple Choice Problem
42. Refer to Exhibit 25.3. Compute the Treynor Measure for the CCC fund. a. 14.7 b. 15.3 c. 19.1 d. 17.0 e. 12.7 ANS: A (20 − 3) 0.89 = 14.7 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 25.4 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The data presented below has been collected at this point in time.
Fund AAA BBB CCC Market
Beta 1.05 1.00 0.92 1.00
Standard Deviation (%) 4.98 4.04 3.13 3.75
Return (%) 16 15 11 13
Rf (%) 6 6 6 6
43. Refer to Exhibit 25.4. Compute the Sharpe Measure for the AAA fund. a. 2.01 b. 2.74 c. 2.91 d. 5.43 e. 1.72 ANS: A (16 − 6) 4.98 = 2.01 PTS: 1
OBJ: Multiple Choice Problem
44. Refer to Exhibit 25.4. Compute the Jensen Measure for the BBB fund. a. 2.10 b. 2.74 c. 5.43 d. 2.00 e. 1.65 ANS: D (15 − 6) − [1.00 (13.0 − 6.0)] = 2.00 PTS: 1
OBJ: Multiple Choice Problem
45. Refer to Exhibit 25.4. Compute the Treynor Measure for the CCC fund. a. 5.43 b. 2.74 c. 2.19 d. 2.00 e. 1.65 ANS: A (11 − 6) 0.92 = 5.43 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 25.5 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The data presented below has been collected at this point in time.
Fund XXX YYY ZZZ Market
Beta 1.07 1.02 0.86 1.00
Standard Deviation (%) 5.13 4.28 3.52 3.80
Return (%) 19 17 12 13
46. Refer to Exhibit 25.5. Compute the Sharpe Measure for the XXX fund. a. 6.98 b. 2.35 c. 2.53 d. 3.86
Rf (%) 6 6 6 6
e. 1.72 ANS: C (19 − 6) 5.13 = 2.53 PTS: 1
OBJ: Multiple Choice Problem
47. Refer to Exhibit 25.5. Compute the Jensen Measure for the YYY fund. a. 6.98 b. 2.35 c. 2.53 d. 3.86 e. 1.72 ANS: D (17 − 6) − [1.02 (13.0 − 6.0)] = 3.86 PTS: 1
OBJ: Multiple Choice Problem
48. Refer to Exhibit 25.5. Compute the Treynor Measure for the ZZZ fund. a. 6.98 b. 2.35 c. 2.53 d. 3.86 e. 1.72 ANS: A (12 − 6) 0.86 = 6.98 PTS: 1
OBJ: Multiple Choice Problem
49. What is the Sharpe measure for the S&P 500 over the last ten years if the standard deviation was 8% and the return was 14%? a. 1.55 b. 1.69 c. 1.75 d. 1.99 e. 2.09 ANS: C 14 8 = 1.75 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 25.6 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Given the following information evaluate the performance of Cloud Incorporated (CI). RCI = 0.17
BCI = 1.05
Rf = 0.07
Rm = 0.12
50. Refer to Exhibit 25.6. Calculate CI's overall performance. a. 0.1225 b. 0.1000 c. 0.0525
d. 0.0475 e. 0.0325 ANS: B Overall Performance = RCI − Rf = 0.17 − 0.07 = 0.10 PTS: 1
OBJ: Multiple Choice Problem
51. Refer to Exhibit 25.6. Calculate CI's selectivity. a. 0.1225 b. 0.1000 c. 0.0525 d. 0.0475 e. 0.0325 ANS: D Selectivity = RCI − Rx(Ba) where Rx(Ba) = Rf + BCI(Rm − Rf) = 0.07 + 1.05(0.12 − 0.07) = 0.1225 Selectivity = 0.17 − 0.1225 = 0.0475 PTS: 1
OBJ: Multiple Choice Problem
52. Refer to Exhibit 25.6. Calculate CI's risk. a. 0.1225 b. 0.1000 c. 0.0525 d. 0.0475 e. 0.0325 ANS: C Risk = Rx(Ba) − Rf = 0.1225 − 0.07 = 0.0525 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 25.7 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Given the following information evaluate the performance of Tyler Incorporated (TI). RTI = 0.18
BTI = 1.06
Rf = 0.06
Rm = 0.11
53. Refer to Exhibit 25.7. Calculate TI's overall performance. a. 0.0113 b. 0.1200 c. 0.0670 d. 0.0530 e. 0.0696 ANS: B Overall Performance = RTI − Rf = 0.18 − 0.06 = 0.12 PTS: 1
OBJ: Multiple Choice Problem
54. Refer to Exhibit 25.7. Calculate TI's selectivity. a. 0.0113
b. c. d. e.
0.1200 0.0687 0.0530 0.0696
ANS: C Selectivity = RTI − Rx(Ba) where Rx(Ba) = Rf + BTI(Rm − Rf) = 0.06 + 1.06(0.11 − 0.06) = 0.113 Selectivity = 0.18 − 0.113 = 0.0687 PTS: 1
OBJ: Multiple Choice Problem
55. Refer to Exhibit 25.7. Calculate TI's risk. a. 0.0113 b. 0.1200 c. 0.0670 d. 0.0530 e. 0.0696 ANS: D Risk = Rx(Ba) − Rf = 0.113 − 0.06 = 0.053 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 25.8 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Weights Policy 50% stocks 50% bonds
Actual 60% stocks 40% bonds
Returns Index 8% stocks 5% bonds
Actual 9% stocks 7% bonds
56. Refer to Exhibit 25.8. Which of the following statements is true? a. The portfolio manager earned an extra 0.3% because of a shift in allocation out of bonds and into stocks. b. The portfolio manager earned an extra 0.3% because of a shift in allocation out of stocks and into bonds. c. The portfolio manager earned an extra 6.5% because of a shift in allocation out of bonds and into stocks. d. The portfolio manager earned an extra 6.5% because of a shift in allocation out of stocks and into bonds. e. None of the above is a true statement. ANS: A Policy allocation, index return = (.50)(8%) + (.50)(5%) = 6.5% Actual allocation, index return = (.60)(8%) + (.40)(5%) = 6.8% The manager earned an extra 0.3% because of a shift in allocation during a time period when equity market outperformed bond market.
PTS: 1
OBJ: Multiple Choice Problem
57. Refer to Exhibit 25.8. Which of the following statements is true? a. Sector/security selection hurt the portfolio performance; returns were 1.4% less than if the manager invested the funds in stocks and bond indexes. b. Sector/security selection improved the port-folio performance by 1.4%; each sector return was higher than for index value. c. Sector/security selection hurt the portfolio performance; returns were 6.8% less than if the manager invested the funds in stocks and bond indexes. d. Sector/security selection improved the port-folio performance by 6.8%; each sector return was higher than for index return. e. None of the above is a true statement. ANS: B Actual allocation, actual return = (.60)(9%) + (.40)(7%) = 8.2% Actual allocation, index return = (.60)(8%) + (.40)(5%) = 6.8% Sector/security selection improved the portfolio's performance by 1.4%; each sector return was higher than for index value. Overall, the manager made a good allocation decision (which increased return by 0.3%) and a good sector/security selection (which increased returns by 1.4%). PTS: 1
OBJ: Multiple Choice Problem
Exhibit 25.9 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Consider the following information for four portfolios, the market and the risk free rate (RFR): Portfolio A1 A2 A3 A4 Market RFR
Return 0.15 0.1 0.12 0.08 0.11 0.03
Beta 1.25 0.9 1.1 0.8 1 0
SD 0.182 0.223 0.138 0.125 0.2 0
58. Refer to Exhibit 25.9. Calculate the Sharpe Measure for each portfolio. a. A1 = 0.40, A2 = 0.31, A3 = 0.65, A4 = 0.66 b. A1 = 0.31, A2 = 0.66, A3 = 0.65, A4 = 0.40 c. A1 = 0.66, A2 = 0.65, A3 = 0.31, A4 = 0.40 d. A1 = 0.66, A2 = 0.31, A3 = 0.65, A4 = 0.40 e. None of the above ANS: D Portfolio
Return
Beta
SD
Sharpe
Rank
Treynor
Rank
Jensen a
Rank
A1 A2 A3 A4 Market RFR
0.15 0.1 0.12 0.08 0.11 0.03
1.25 0.9 1.1 0.8 1 0
0.182 0.223 0.138 0.125 0.2 0
0.66 0.31 0.65 0.4 0.4
1 4 2 3
0.096 0.077778 0.081818 0.0625 0.08
1 3 2 4
0.02 −0.002 0.002 −0.014 0
1 3 2 4
PTS: 1
OBJ: Multiple Choice Problem
59. Refer to Exhibit 25.9. Calculate the Jensen alpha Measure for each portfolio. a. A1 = 0.014, A2 = −0.002, A3 = 0.002, A4 = −0.02 b. A1 = 0.002, A2 = −0.02, A3 = 0.002, A4 = −0.014 c. A1 = 0.02, A2 = −0.002, A3 = 0.002, A4 = −0.014 d. A1 = 0.02, A2 = −0.002, A3 = 0.02, A4 = −0.14 e. None of the above ANS: C Portfolio
Return
Beta
SD
Sharpe
Rank
Treynor
Rank
Jensen a
Rank
A1 A2 A3 A4 Market RFR
0.15 0.1 0.12 0.08 0.11 0.03
1.25 0.9 1.1 0.8 1 0
0.182 0.223 0.138 0.125 0.2 0
0.66 0.31 0.65 0.4 0.4
1 4 2 3
0.096 0.077778 0.081818 0.0625 0.08
1 3 2 4
0.02 −0.002 0.002 −0.014 0
1 3 2 4
PTS: 1
OBJ: Multiple Choice Problem
60. Refer to Exhibit 25.9. Calculate the Treynor Measure for each portfolio. a. A1 = 0.0625, A2 = 0.0778, A3 = 0.0818, A4 = 0.096 b. A1 = 0.096, A2 = 0.0778, A3 = 0.0818, A4 = 0.0625 c. A1 = 0.096, A2 = 0.0818, A3 = 0.0778, A4 = 0.0625 d. A1 = 0.0778, A2 = 0.096, A3 = 0.0818, A4 = 0.0625 e. None of the above ANS: B Portfolio
Return
Beta
SD
Sharpe
Rank
Treynor
Rank
Jensen a
Rank
A1 A2 A3 A4 Market RFR
0.15 0.1 0.12 0.08 0.11 0.03
1.25 0.9 1.1 0.8 1 0
0.182 0.223 0.138 0.125 0.2 0
0.66 0.31 0.65 0.4 0.4
1 4 2 3
0.096 0.077778 0.081818 0.0625 0.08
1 3 2 4
0.02 −0.002 0.002 −0.014 0
1 3 2 4
PTS: 1
OBJ: Multiple Choice Problem
Exhibit 25.10 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Consider the following information for a portfolio manager:
Stocks Bonds Cash
Policy Weight 0.65 0.3 0.05
Actual Weight 0.7 0.25 0.05
Index Returns 0.11 0.07 0.03
Actual Returns 0.12 0.08 0.025
61. Refer to Exhibit 25.10. Calculate the percentage return that can be attributed to the asset allocation decision. a. 0.105%
b. c. d. e.
0.925% 0.20% 0.96% 0.94%
ANS: C
Stocks Bonds Cash
Policy Weight 0.65 0.3 0.05
Asset Allocation Policy index Actual index
Index Returns 0.11 0.07 0.03
Actual Returns 0.12 0.08 0.025
0.094 0.096 0.002
Security Selection Actual Actual Actual index
PTS: 1
Actual Weight 0.7 0.25 0.05
0.10525 0.096 0.00925 OBJ: Multiple Choice Problem
62. Refer to Exhibit 25.10. Calculate the percentage return that can be attributed to the security selection decision. a. 0.105% b. 0.925% c. 0.20% d. 0.96% e. 0.94% ANS: B
Stocks Bonds Cash Asset Allocation Policy index Actual index
Security Selection Actual Actual Actual index
PTS: 1
Policy Weight 0.65 0.3 0.05
Actual Weight 0.7 0.25 0.05
Index Returns 0.11 0.07 0.03
Actual Returns 0.12 0.08 0.025
0.094 0.096 0.002
0.10525 0.096 0.00925 OBJ: Multiple Choice Problem
63. A portfolio manager has the following sequence of cash flows over a two year period:
Time outflows inflows
0 −$2,000
1 −$500 $50
2 $3,090
Calculate the portfolio manager's dollar weighted return. a. 13.56% b. 11.48% c. 15.50% d. 8.75% e. 10.67% ANS: A Time outflows inflows
0 −$2,000
Net
−$2,000
1 −$500 $50 −$450
Dollar weighted return
2 $90 $3,000 $3,090
13.56%
To calculate dollar weighted return solve for r in the following equation
PTS: 1
OBJ: Multiple Choice Problem
64. A portfolio manager has the following sequence of cash flows over a two year period:
Time 0 1 2
Market Value before cash flow $ 0 $3,200 $6,000
Cash In $3,000 $1,950 −$ 90
Market Value after cash flow $3,000 $5,150 $5,910
Calculate the portfolio manager's time weighted return. a. 13.56% b. 11.48% c. 15.50% d. 8.75% e. 10.67% ANS: B Time 0 1 2
MV before cash flow $ 0 $3,200 $6,000
Time weighted return
Cash In $3,000 $1,950 −$ 90 11.48%
Period 1 return = 1 − (3200/3000) = 0.0667 Period 2 return = 1 − (6000/5150) = .165
MV after Cash flow $3,000 $5,150 $5,910
Return 6.67% 16.50%
Time weighted return = [(1 + 0.0667)(1 + 0.165)]0.5 − 1 = 0.1148 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 25.11 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The last year's performance for four mutual funds is presented below. The market return was 10.70%, last year with a standard deviation of 13.1% and the risk-free rate of return was 5%.
Fund A B C D
Beta 1.50 1.20 0.90 0.50
Standard Deviation (%) 18.95 12.41 9.30 8.10
Return (%) 12.5 13.0 11.2 9.5
65. Refer to Exhibit 25.11. Compute the Sharpe Measure for the A fund. a. 0.012 b. 0.040 c. 0.069 d. 0.396 e. 1.142 ANS: D Sharpe for A: (.125 − .05) .1895 = 0.396 PTS: 1
OBJ: Multiple Choice Problem
66. Refer to Exhibit 25.11. Compute the Jensen Measure for the B fund. a. 1.16% b. 2.31% c. 6.90% d. 9.60% e. 10.13% ANS: A Jensen for B: (.13 − .05) − [1.20 (.107 − .05)] = .08 − .0684 = .0116 PTS: 1
OBJ: Multiple Choice Problem
67. Refer to Exhibit 25.11. Compute the Treynor Measure for the C fund. a. 0.012 b. 0.040 c. 0.069 d. 0.396 e. 1.142 ANS: C Treynor for C: (.112 − .05) 0.90 = .0688 PTS: 1
OBJ: Multiple Choice Problem
68. Refer to Exhibit 25.11. Based on the Sharpe Measure which portfolio preformed best? a. A b. B c. C d. D e. Market ANS: C Sharpe for A: (.125 − .05) .1895 = 0.396 Sharpe for B: (.130 − .05) .1241 = 0.645 Sharpe for C: (.112 − .05) .0930 = 0.667 Sharpe for D: (.095 − .05) .0810 = 0.556 Sharpe for Market: (.107 − .05) .131 = 0.435 PTS: 1
OBJ: Multiple Choice Problem
69. Refer to Exhibit 25.11. Based on the Treynor Measure which portfolio preformed best? a. A b. B c. C d. D e. Market ANS: D Treynor for A: (.125 − .05) 1.5 = 0.050 Treynor for B: (.130 − .05) 1.2 = 0.067 Treynor for C: (.112 − .05) 0.9 = 0.069 Treynor for D: (.095 − .05) 0.5 = 0.090 Treynor for Market: (.107 − .05) 1.0 = 0.057 PTS: 1
OBJ: Multiple Choice Problem
Exhibit 25.12 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) An analyst is considering investing in funds A, B, C, and D. The market portfolio, M, is expected to be 11% next period and the risk-free rate of return is 3%. The market portfolio had a standard deviation over the past ten years of 0.20. The analyst gathered the following information on the four funds. Stock A B C D
Return 17% 20% 10% 15%
Beta 1.7 2.1 0.9 1.2
.21 .25 .12 .16
70. Refer to Exhibit 25.12. Rank the four funds and market portfolio in order from highest to lowest based on their Treynor performance measures. a. A, B, C, D, M b. B, C, M, D, A c. C, A, M, D, B d. D, A, B, M, C e. D, B, A, C, M ANS: D The Treynor measures for the four funds are computed as follows: A = (.17 − .03)/1.7 = 0.082 B = (.20 − .03)/2.1 = 0.081 C = (.10 − .03)/0.9 = 0.078 D = (.15 − .03)/1.2 = 0.100 M = (.11 − .03)/1.0 = 0.080 Ranking the funds and market portfolio from highest to lowest: D, A, B, M, C PTS: 1
OBJ: Multiple Choice Problem
71. Refer to Exhibit 25.12. Rank the four funds and market portfolio in order from highest to lowest based on their Sharpe measures. a. A, B, C, D, M b. B, C, M, D, A c. C, A, M, D, B d. D, A, B, M, C e. D, B, A, C, M ANS: E The Sharpe measures for the four stocks are computed as follows: A = (.17 − .03)/.21 = 0.667 B = (.20 − .03)/.25 = 0.680 C = (.10 − .03)/.12 = 0.583 D = (.15 − .03)/.16 = 0.750 M = (.11 − .03)/.20 = 0.400 Ranking the funds and market portfolio from highest to lowest: D, B, A, C, M PTS: 1
OBJ: Multiple Choice Problem
72. Refer to Exhibit 25.12. Compute the Jensen Measure for the C fund. a. 0.16% b. 1.80% c. 7.20% d. 9.00% e. 9.13% ANS: B Jensen for C: (.12 − .03) − [0.9 (.11 − .03)] = .09 − .072 = .018 or 1.8% PTS: 1
OBJ: Multiple Choice Problem