Investment Management. Final Exam Preparatory Questions

FIN352 Investments Final exam preparatory questions 1. Portfolio theory tells us that diversification has the potential to: a. b. c. d. increase anticipated risk for a given expected return. reduce expected return for a given anticipated risk. reduce anticipated risk for a given expected return. * reduce transaction costs. 2. The expected value is the: a. b. c. d. inverse of the standard deviation correlation between a security’s risk and return. weighted average of all possible outcomes. * same as the discrete probability distribution. 3. Given the following probability distribution, calculate the expected return of security XYZ. Security XYZ's Potential return 20% 30% -40% 50% 10% a. b. c. d. 16 percent 22 percent 25 percent 18 percent 0.3 0.2 0.1 0.1 0.3 Probability Solution: E(R) = ΣRipri = (20)(0.3) + (30)(0.2) + (- 40)(0.1) + (50)(0.1) + = (10)(0.3) = 22 percent 4. Two stocks with perfect negative correlation will have a correlation coefficient of: a. b. c. d. +1.0 +2.0 0 –1.0 * 1 5. Which of the following is true regarding random diversification? a. b. c. d. Investment characteristics are considered important in random diversification. The net benefit of random diversification eventually disappears as more securities are added. * Random diversification, if done correctly, can eliminate all risk in a portfolio. Random diversification eventually removes all company specific risk from a portfolio. 6. Company specific risk is also known as: a. b. c. d. market risk. systematic risk. non-diversifiable risk. diversifiable risk. * 7. The relevant risk for a well-diversified portfolio is: a. b. c. d. interest rate risk. inflation risk. business risk. market risk. * 8. Which of the following statements regarding portfolio risk and number of is generally true? a. b. c. d. stocks Adding more stocks increases risk. Adding more stocks decreases risk, but does not eliminate it. * Adding more stocks has no effect on risk. Adding more stocks decreases only systematic risk. 9. Markowitz's main contribution to portfolio theory is: a. b. c. d. that risk is the same for each type of financial asset. that risk is a function of credit, liquidity and market factors. risk is not quantifiable. insight about the relative importance of variances and covariances in determining portfolio risk. * 2 10. The major problem with the Markowitz model is its: a. b. c. lack of accuracy. predictability flaws. complexity. * d. inability to handle large number of inputs 11. The efficient set of portfolios represents: a. b. c. d. investor preferences, whereas indifference curves reflect portfolio possibilities. portfolio possibilities, whereas indifference curves reflect investor preferences. * investor risk, whereas indifference curves reflect portfolio return. portfolio return, whereas indifference curves reflect investor preferences. 12. According to the Markowitz model, an efficient portfolio is one that has the: a. b. c. d. largest expected return for the smallest level of risk. largest expected return and zero risk. largest expected return for a given level of risk. * smallest level of risk. 13. Portfolios lying on the upper right portion of the efficient frontier are likely to be chosen by: a. b. c. d. aggressive investors. * conservative investors. risk-averse investors. defensive investors. 14. Which of the following is not one of the assumptions of the Capital Market Theory? a. b. c. d. All investors have the same one-period time horizon. There are no personal income taxes. There is no interest rate charged on borrowing. * There are no transaction costs. 15. A portfolio which lies below the efficient frontier is described as: a. b. c. d. optimal. unattainable. dominant. dominated. * 3 16. The optimal portfolio is the efficient portfolio with the a. b. c. d. lowest risk. highest risk. highest utility. * least investment. 17 Different investors estimate the inputs to the Markowitz model differently because: a. b. c. d. every investor has his/her own risk/return preferences. every investor has access to different information about securities. there is an inherent uncertainty in security analysis. * there is a random selection process used by individual investors. 18. As a measure of market risk, the beta for the S&P 500 is generally considered to be: a. b. c. d. -1.0. 1.0. * 0. impossible to determine. 19. Asset allocation is one of the most widely used applications of: a. b. c. d. the Capital Asset Pricing Model. random diversification. passive portfolio approach. modern portfolio theory. * 20. The only asset class to provide systematic protection against inflation is: a. b. c. d. bonds. real estate. foreign stocks. TIPS. * 21. Which of the following statements about diversification is most accurate? The purpose of diversification is to: a. b. c. d. increase a portfolio’s expected return. reduce a portfolio’s non-diversifiable risk. reduce a portfolio’s systematic risk. reduce a portfolio’s total risk. * 4 22. Gordon holds a portfolio of U.S. equities and is considering adding several alternative ETFs that are tied to different asset classes. Adding which of the following ETFs would produce the largest reduction in the risk of Gordon’s portfolio? a. b. c. d. A real estate ETF An emerging markets ETF An EAFE ETF A U.S. bond ETF * 23. Based on the historic evidence, which of the following is the most supported reason for adding gold to a portfolio of U.S. stocks? a. b. c. d. To increase the portfolio’s expected return. To reduce the portfolio’s risk. * To increase the portfolio’s expected return and reduce its risk. To increase the portfolio’s expected return and maintain its risk. 24. The Capital Asset Pricing Model: a. b. c. d. has serious flaws because of its complexity. shows the relationship between risk and expected return. * was developed by Markowitz in the 1930s. is a discounted-cash-flow valuation model. 25.. Select the INCORRECT statement regarding the CML. a. b. c. d. The CML is an equilibrium relationship for efficient portfolios and individual securities. * The CML represents the risk-return tradeoff in equilibrium for efficient portfolios. The intercept of the CML is the reward per unit of time available to investors for deferring consumption. Standard deviation is the measure of risk which determines a portfolio's equilibrium return. 26. If markets are truly efficient and in equilibrium a. b. c. d. all securities would lie on the SML. any security that plots below the SML would be considered undervalued. any security that lies above the SML would be considered overvalued. no security would lie on the SML.. 27. Select the correct statement regarding the market portfolio. It: a. b. c. is readily and precisely observable. is a risky portfolio. * is the lowest point of tangency between the risk-free rate and the efficient 5 d. frontier. should be composed of stocks or bonds. 28. Select the INCORRECT statement regarding the CML. a. b. c. d. The CML is an equilibrium relationship for efficient portfolios and individual securities.* The CML represents the risk-return tradeoff in equilibrium for efficient portfolios. The intercept of the CML is the reward per unit of time available to investors for deferring consumption. Standard deviation is the measure of risk which determines a portfolio's equilibrium return. 29. Which of the following statements about the difference between the SML and the CML is true? a. b. c. d. The intercept of the CML is the origin, whereas the intercept of the SML is RF. The CML applies to efficient portfolios, whereas the SML applies to all portfolios or securities. * The CML can be downward sloping, whereas that is impossible for the SML. The CML and the SML are essentially the same except for the price of risk. 30. Select the incorrect statement regarding the CML. a. b. c. d. The CML is an equilibrium relationship for efficient portfolios and individual securities. * The CML represents the risk-return tradeoff for efficient portfolios. The intercept of the CML is the reward to investors for deferring consumption. The CML relies on standard deviation as the measure of risk. 31. The expected return on the market for next period is 11 percent. The risk-free rate is 4 percent, and Alpha Company has a beta of 1.1. The market risk premium is: a. b. c. d. 7.7 percent. 7 percent. * 11 percent. 12.1 percent. 32..The relative valuation measure that is most heavily utilized by market participants today is: a. b. c. d. P/E ratio. * Price/book value ratio Price/sales ratio E/P ratio 6 33. The estimated value of common stock is the: a. b. c. d. present value of all expected cash flows. * present value of all capital gains. future value of all dividend payments. present value of all dividend payments. 34.What is the estimated value of a stock with a required rate of return of 12 percent, a projected constant growth rate of dividends of 7 percent and expected dividend of $3.00 a. $12 b. c. d. $60 $150 $5 Solution: P0 = D1/(k – g) = 3/(.12 - .07) = $60 35. Charlie is valuing a common stock with forecast dividends as shown below. He thinks that 10% is an appropriate discount rate. What is the most he should pay for the stock? D1 $2.00 a. b. c. d. D2 $2.40 D3 $2.76 D4 $3.17 Later 6% growth $60.20 $63.25 $65.42 * $84.01 36. Which of the following statements is most correct? a. The stock valuation model, P0 = D1/(ks - g), cannot be used for firms which have negative growth rates. b. If a stock pays $1 as dividend (D 0=$1), has a required rate of return ks = 15 percent, and its dividend grows at a constant rate of 5 percent, this implies that the stock’s intrinsic value is $21. c. If a stock pays $1 as dividend (D 0=$1), has a required rate of return ks = 15 percent, and its dividend grows at a constant rate of 5 percent, this implies that the stock’s intrinsic value is $10.5. * d. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate. 7 37. The last dividend paid by Tyco was $1.00. Tyco’s growth rate is expected to be a constant 5 percent for 2 years, after which dividends are expected to grow at a rate of 8 percent forever. Tyco’s required rate of return on equity (ks) is 12 percent. What is the approximate current price of Tyco’s common stock? a. $30 b. $32 c. $36 d. $26 * 38. What are two major approaches used to value stocks? a. b. c. d. Discounted cash flow techniques and absolute valuation techniques Discounted cash flow techniques and relative valuation techniques * Compound free cash flow techniques and relative valuation techniques Markowitz diversification techniques and relative valuation techniques 39. Which of the following statements regarding intrinsic value and market price is true? a. If intrinsic value is greater than the current market price, the stock should be avoided or, if already held, sold. b. If intrinsic value is less than the current market price, the stock is undervalued. c. If intrinsic value is equal to the current market price, the stock is correctly valued. * d. If the intrinsic value is greater than the current market price, the stock is considered speculative. 40. Which of the following variables has an inverse relationship with the P/E ratio? a. b. c. d. payout ratio expected growth rate of dividends expected growth rate of earnings required rate of return * 41. On a company’s balance sheet, shareholder’s equity is nearly always described by its? a. Book value * 8 b. c. d. Market value Current value Stock value 42. If the dividend growth rate increases for a firm, its P/E will ---------, other things the same. a. b. c. d. increase * stay the same decrease increase or decrease but not stay the same 43. Which of the following is TRUE regarding the risk premium? The risk premium a. must reflect all the uncertainty involved in the asset. * b. does not apply to low beta stocks. c. is directly related to changes in the interest rate. d. reflects only the financial risk of a security. 44. If security markets are totally efficient, the best common stock strategy to take is: a. b. c. d. an asset allocation approach. the modern portfolio theory. an active strategy. a passive strategy. * 45. The central focus of a security analyst’s job is to: a. b. c. d. ascertain the accuracy of financial statements of selected companies. find growth stocks. forecast a specific company’s return. * determine the market demand for a specific company’s stock. 46. An analyst employed by a pension fund to search for stocks for the fund to invest in would be referred to as: a. b. a sell-side analyst. a buy-side analyst. * 9 c. d. an institutional analyst. a money manager. 47.Which of the following statements regarding defensive stocks is true? a. b. c. d. They are often expected to have above-average future growth. They often have high P/E multiples. They are expected to be adversely affected by high interest rates. They often produce necessary items such as food and prescription drugs. * 48.Historically, sell-side equity research has typically been _________to the target company? a. b. c. d. very unfavorable unfavorable favorable * neutral 49. ____________ funds are especially popular with momentum investors. a. b. c. d. Index. Managed Global Sector * 50. A fast growing company paid a dividend this year of $1.25, which is expected to grow at 20% for two years. Afterwards, the growth rate will be 9%. If the required is 12%, what is the value of this stock? a. $41.67 b. $15.62 > c. $65.40 d. $54.91 Solution: D1 = $1.25×1.20 = $1.50, D2= $1.50×1.20 = $1.80, D3 = $1.25×1.202×1.09 = $1.962, then price in year 2 will be 1.962/(0.12-0.09) = $65.40, so PV = 1.50/1.12 + (1.80+65.40)/1.122 = $54.91 51. High P/E ratios are typically associated with stocks that display: a) b) c) d) below-average risk. below-average dividend payout ratios. * below-average historical returns. below-average historical EPS growth. 10 52.Put and call options on equity securities are considered: a. b. c. d. Commodity derivatives Financial derivatives * Forward contracts Futures contracts 53 One important reason for the existence of derivatives is that they: a. b. c. d. help lower transactions costs. have valuable tax benefits. contribute to market completeness. * are risk-free. 54. A major difference between new shares being sold by a corporation and sold under a call option is that: a. b. c. d. there is no profit or loss under the shares sold under the call. there is no risk to the investor with the call. there is no increase in the shares outstanding with the call. * there is no commission to the investor with the call. 55. Which of the following statements is true regarding a call writer: a. b. c. d. The call writer expects the stock to move upward. The call writer expects the stock to remain the same or move down.* The call writer expects the stock to split. The call writer expects to sell the stock prior to expiration of the option. 56. Options sold on exchanges are protected against a. b. c. d. stock dividends and splits. * cash dividends. interest rate movements. inflation. shares 57. If the price of the common stock exceeds the exercise price of a call for the holder the call is said to be a. b. c. naked. out of the money. in the money. * 11 d. covered. 58. Which of the following is true regarding option pricing: a. b. c. d. the longer the maturity of the option, the higher the premium. * the more volatile the underlying stock, the lower the premium. option prices are less volatile than equity prices. the shorter the maturity of the option, the lower the premium. 59.A stock is at $68. A two-month put (strike price = $70) is available at a $5 premium.. The intrinsic value is ___ and the time value is ____. a. b. c. d. $5 . . . $0. $0 . . . $5. $3 . . . $2. $2 . . . $3. * 60. "Open interest" is the number of option contracts: a) b) c) d) bought during a given day of trading. sold during a give day of trading. created during a given day of trading. none of these. * 61. Out-of-the-money call options have an exercise price that: a) exceeds the current market price of the underlying common stock. * b) exceeds the strike price. c) is less than the current market price of the underlying common stock. d) is less than the strike price. 62. The writer of a put option is said to have a: a) b) c) d) long position. short position. * covered position. uncovered position. 63. An investor bought one ABC $25 (exercise price is $25) call contract for a premium of $5 per share. At the maturity (expiration), ABC stock price is $30. Which is the net profit/loss of this investment? a) $500 b) $0 * 12 c) -$500 d) $100 64. An investor sold one ABC $25 (exercise price is $25) call contract for a premium of $5 per share. At the maturity (expiration), ABC stock price is $40. Which is the net profit/loss of this investment? a) $1000 b) $0 c) -$1000 * d) -$500 65. Gwen wrote a put option with a $15 strike price on RDX stock when the stock price was $16 per share. The option premium was $3. What is the maximum loss (per share) that Gwen could experience on her option position? a. b. c. d. $3 $12 * $14 $15 66. Carl purchased a call option on Apex stock that had a premium of $4, an exercise price of $25, and six-months to expiration. When he purchased the option, Apex was selling at $27 per share. What profit (per share) would Carl earn on his option transaction if Apex sells at $31 per share at expiration? a. b. c. d. $0 $2 * $4 $6 13