FIN352. Review Questions for Midterm Exam

Review questions for midterm exam 1. The nominal risk-free rate of interest is a function of a) The real risk-free rate plus the investment's variance. b) The prime rate and the rate of inflation. c) The T-bill rate plus the inflation rate. d) The real risk-free rate and the expected rate of inflation.* 2. At the beginning of the year an investor purchased 100 shares of common stock from ABC Corporation at $10 per share. During the year, the firm paid dividends of $1 per share. At the end of the year, the investor sold the 100 shares at $11 per share. What is the HPR? a) b) c) d) 1.20% 5.50% 12.00% 20.00% * 3. Given the following returns and return relatives over the past four years, compute the arithmetic mean (AM) and geometric mean (GM) rates of return. Period t1 t2 t3 t4 1.05 0.90 1.11 0.98 Return Relative Return Relative 0.05 -0.10 0.11 -0.02 a) AM = 4.000%, GM = 1.010% b) AM = 1.000%, GM = 0.692% * c) AM = 0.692%, GM = 4.000% d) AM = 1.000%, GM = 1.0692% USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS 7. The member of the New York Stock Exchange who acts as a dealer on assigned stocks is known as a a) b) c) d) Registered trader. Commission broker. Registered dealer. Specialist. * 9. An order placed specifying the buy or sell price a) b) c) d) Limit order. * Short sale. Market order. Priced order. is a 10. A pure auction market is one in which a) b) c) d) Dealers provide liquidity by buying and selling shares of stock for themselves. Dealers compete against each other to provide the highest bid and lowest asking prices. Buyers submit bid prices to sellers. Buyers and sellers submit bid and ask prices to a central location to be matched. * USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS Jack has a margin account and deposits $25,000. If the margin requirement is 40 percent, commissions are ignored, and Irish Industries is currently selling at $45 per share: 11. What is the value of stock that Jack can acquire? a) b) c) d) $41,667 $62,500 * $75,000 $87,500 12. What is Jack's profit if the price of Irish Industries rises to $55? a) b) c) d) $ 5,555 $ 9,259 $13,895 * $23,598 13. If the maintenance margin is 20 percent, to what price can Irish Industries fall before Jack receives a margin call? a) b) c) d) $21.75 $23.75 $33.75 * $35.75 14. Under a defined-benefit retirement plan, employees are promised: > a. b. c. d. 15. Portfolio theory tells us that diversification has the potential to: > a. b. c. d. a fixed lump sum amount at retirement. employer matching of employee retirement plan contributions. a variable amount at retirement, depending upon retirement plan performance. a fixed retirement income. 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. 16. A stock broker may improperly buy and sell the securities in a customer’s account to generate commissions. This is known as ____________ . > 17. > a. b. c. d. enhancement insider trading indexing churning Annual accounting information is filed with the SEC on the: a. 10K report. b. 10Q report. c. 13D report. d. Form 144. 18. Warren Buffett seeks to buy firms that have a low P/E ratio have consistently low return on equity are rapidly growing all of the above > a. b. c. d. 19. Finance professionals who work with individual investors and institutions in executing orders for individual common stocks or bonds are called: > a. b. c. d. 20. Finance professionals primarily involved with the distribution of securities from issuing corporations to the general public are called: > a. b. c. d. brokers. portfolio managers. analysts. certified financial planners. security analysts. technicians. investment bankers. chief financial officers. 21. Correlation is: > a) b) c) d) an absolute measure of comovement that varies between -1 and +1. a relative measure of comovement that varies between -1 and +1. an absolute measure of comovement that varies between -∞ and +∞. a relative measure of comovement that varies between -∞ and +∞. 22. The optimal portfolio: > 23. a) b) c) d) maximizes utility derived from non-monetary and monetary rewards. has the lowest level of risk for a given expected return. is always the market portfolio. none of the above. Investors often have difficulty in thinking about their investments from the portfolio perspective because: > a) b) c) d) of the house money effect. mental accounting tends to ignore the interaction between individual investments. a myopic focus keeps investors looking at the long-term. risk is considered an absolute measure. 24. A risk-averse investor is one who will: > a) b) c) d) assume risk only with adequate compensation. sometimes assume risk for its own sake. not assume risk. not assume large risk. 25. If a portfolio has two stocks; GE and DIS weighted as 60% and 40%, respectively. If the expected annual return for GE is 12% while for DIS is 10%, what is the expected return of this portfolio? > a) 10.4% b) 10.8% c) 11.0% d) 11.2% 26. The New York Stock Exchange is the: sole trading forum for all companies listed on the NYSE. home of securities with a total market capitalization of roughly $50 trillion. second largest equities marketplace in the world. largest U.S. securities market in terms of the value of companies listed and the dollar value of trading activity. > a) b) c) d) 27. The National Association of Securities Dealers (NASD) is a: > a) b) c) d) self-regulatory organization with particular responsibility for the regulation of options markets. self-regulatory organization with particular responsibility for the regulation of OTC markets. regulatory arm of the SEC. self-regulatory organization with particular responsibility for the regulation of futures markets. 28. Nasdaq is a negotiated market in which investors deal directly with: > a) b) c) d) 29. The S&P 500: > a) b) c) d) market maker dealers. exchange specialists. floor brokers. other investors in a trading pit. dates from 1896. is comprised mainly of Nasdaq stocks.. accounts for roughly 30% of the market capitalization of the overall stock market. a market cap weighted index. 30. Which stock index is a good benchmark for determining the performance of small companies? > a. b. c. a. Whilshire 4500 Nikkei 225 Index Russell 2000 NASDAQ 100 31.The Chicago Board Options Exchange is not a forum for trading: > a) b) c) d) interest rate options. stocks. stock options. put options. 32. Short sales with 50% initial margin trigger a 30% maintenance margin call following a: > a. b. c. d. 50% rise in price. 15.4% rise in price. 20% rise in price. 22.9% fall in price. Solution: consider that the investor shorts one share of a $100 with $50 of borrowed money. To trigger a 30% margin call, the price would have to change to 0.3 = (100+50-P) / P, solving for P = $115.38, which represents a 15.4% increase in price. 33. If the initial margin requirement is 40%, an investor buying 100 shares at $100 per share must furnish equity of: > a) b) c) d) $4,000. $6,000. $10,000. $100. Solution: equity = 40% × 100 × $100 = $4,000 34.Limit orders: > 35. a. b. c. d. specify a certain price at which a market order takes effect. specify a particular price to be met or bettered. are executed at the best price available. are orders entered for a particular day. Primary markets: a. b. c. involve the organized trading of outstanding securities on exchanges. involve the organized trading of outstanding securities in the over-the-counter market. involve the organized trading of outstanding securities on exchanges and over-the-counter markets. are where new issues (IPOs) are sold by corporations to raise new capital. > d. 36. The role of investment banker does not include: > a. b. c. d. giving companies advice on the price, amount and timing of an IPO. a commitment to maintain a continuous primary market for listed issues. managing a syndicate for distribution on a firm-price (dealer) or best-efforts (broker) basis. helping maintain an after market for OTC issues. 37. An investor buys $10,000 worth of stock using 50% margin. If the stock price increases by 20%, what return does the investor earn? (ignore transaction costs and interest fees) a. 10% > b. c. d. 20% 30% 40% Solution: return = 20%×$10,000 / (50% × $10,000) = 0.4 or 40% 38. If an investor would like to sell short shares originally valued at $20,000 in which his/her cash contribution is $10,000, what is the stock value when the investor receives a margin call if the maintenance margin 30%? > a) The current stock value decreases to $24,615 b) The current stock value decreases to $14,000 c) The current stock value increases to $24,615 d) The current stock value increases to $26,000 0.30 = Solution: $20, 000 + $18, 000 − Current Stock Value Current Stock Value Current stock value = $24,615 39. Highly volatile cyclical stocks tend to have: > a) b) c) d) α > 0. β = 0. β > 1. β < 1. 40. Total risk for common stocks is: > a) b) c) d) measured by beta. the sum of systematic risk and diversifiable risk. the sum of market risk and systematic risk. the sum of diversifiable risk and unsystematic risk. 41.The slope of the CML is: > a) b) c) d) the market price of risk for efficient portfolios. the amount of return expected for bearing the risk of an individual portfolio. the market price of risk for any given security. none of the above. 42. The Sharpe Ratio is the: > a) b) c) d) return above the risk-free rate. systematic risk per unit of excess return. return above the risk-free rate relative to the risk-free rate. excess return per unit of total risk. 43. An R2 = 25.13% in the stock-price beta estimation for the Coca-Cola Company implies that 25.13% of the variation in the: > a) S&P Index can be explained by variation in the Coca-Cola stock return. b) Coca-Cola stock price can be explained by variation in the S&P Index. c) return on Coca-Cola can be explained by variation in the S&P Index return. d) S&P Index can be explained by variation in the Coca-Cola stock price. 44. An intercept estimate of 0 in the stock-price beta estimation for the Coca-Cola Company implies: zero excess returns on Coca-Cola during the estimation period. zero total return on Coca-Cola during the estimation period. β = 1. α = 1. > a) b) c) d) 45. In comparing the Sharpe Ratio and the Treynor Measure, it is important to remember that: > a) b) c) d) Treynor is based on total risk while Sharpe is based on systematic risk. Sharpe is based on total risk while Treynor is based on systematic risk. Sharpe is based on unsystematic risk while Treynor is based on systematic risk. Treynor is based on unsystematic risk while Sharpe is based on total risk. 46. If RF = 6%, RM = 12%, ß = 2, portfolio performance of 18% is: > a) b) c) d) 6% inferior. 12% inferior. 6% superior. consistent with the risk taken. Solution: expected return = 6% + 2×(12%-6%) = 18% 47. The SML is: > a) b) c) d) an upward sloping straight line. an upward sloping curved line. a downward sloping curved line. a downward sloping straight line. 48. . What is the portfolio beta if such a portfolio has two stocks; GM with a beta of 1.7 and WMT with a beta of 0.6? The portfolio is divided into GM (35%) and WMT (65%). > a) 1.31 b) 1.41 c) 1.51 d) 1.61 Solution: The portfolio beta = 1.7×0.6 + 0.6×0.65 = 1.41 49. A portfolio has an average monthly return of 1.5% and a standard deviation of 1.2%. If the risk-free rate is 0.25%, what is Sharpe ratio? > a) 0.21 b) 0.30 c) 0.95 d) 1.25 Solution: Sharpe ratio = RP − RF 1.5% − 0.25% = = 0.21 SD( RP ) 1.2% 50. An investment company whose shares trade on a stock exchange is known as: > a) a closed-end fund. b) c) d) an index fund. a dual-purpose fund. a unit investment trust. 51. In an efficient market, what percentage of mutual funds would outperform the market averages? > a) 50% before expenses. b) 50% after expenses. c) 0% before expenses. d) 0% after expenses. 52. > The average equity fund typically underperforms the S&P 500 because of a) excessive risk taking. b) insufficient cash balances. c) excessive portfolio turnover. d) insufficient diversification. 53. An investor buys a mutual fund with a 3% front-end load and a NAV of $15.93. One year later, the investor sells at a NAV of $16.75. What was the investor’s return? > a) 4.90% b) 2.08% c) 5.15% d) 2.35% Solution: ($16.75 - 1.03×$15.93) / 1.03×$15.93 = 0.0208 54.Exchange traded funds are useful for a) implementing an indexing strategy. b) obtaining international exposure in a portfolio. c) obtaining high diversification with low cost. > d) all of the above 55. > An advantage of buying a no-load fund relative to a load fund is that: a) b) c) d) the management fee is avoided. no-load funds can sometimes be bought at a discount. the sales charge is avoided. administrative fees and transaction costs are avoided. 56. When a closed end fund trades at a discount, the shares a) are overvalued relative to NAV. b) are split 2 for 1 by the fund. c) are traded at a fixed percentage of NAV. > d) trade at a price that is lower then NAV. 57. If an investor would like to invest $10,000 in a load mutual fund. The mutual fund has a load of 3% and the NAV is $32.64. What is the number of shares bought? > a) 326.40 b) 316.61 c) 305.28 d) 297.18 Solution: $10,000 X 0.97 = $9,700, # of shares bought = $97,000 / 32.64 = 297.18 Answers to the text questions from Learning Objectives slide Chapter 2 2.1 An analyst gathered the following data about stocks J, K, and L, which together form a valueweighted index: December 31, Year 1 Stock Price Shares Outstanding J $40 10,000 K $30 6,000 L $50 9,000 *2 for 1 stock split December 31, Year 2 Price Shares Outstanding $50 10,000 $20 12,000* $40 9,000 The ending value-weighted index (base index = 100) is closest to: A. 92.3 1. B. 93.64. C. 106.80. D. 108.33. Answer: C 2.2 The divisor for the Dow Jones Industrial Average (DJIA) is most likely to decrease when a stock in the DJIA: A. has a stock split. B. has a reverse split. C. pays a cash dividend. D. is removed and replaced. Answer: A Chapter 3 Q3.1 Explain the meaning of market depth for a common stock. Q3.1 ANSWER Market depth is a term used to describe the size of the market for a security at or near the market price. The size, or depth, of the market at or near the market price is indicated by the bid size and ask size. Large bid size and ask size near the market price indicate significant market depth. This would mean that individual or institutional investors could buy or sell a considerable amount of stock near the market price. Market depth is a measure of liquidity. Q3.2 What is the difference between a market order and a limit order? What are the advantages and disadvantages of each type of order? Q3.2 ANSWER A market order is an instruction to immediately buy a security at the current ask price or to sell a security at the current bid price. This contrasts with a limit order, whereby the customer specifies a price at which to execute a buy or sell decision. A limit order can be executed only if the market price reaches at least the specified price target. With a buy limit order, securities may be bought at or below the specified price target. With a sell limit order, securities may be sold at or above the specified price target. Some investors prefer limit orders because they give investors more control over the execution of their transactions and provide a method of protecting themselves from market fluctuations. Market orders guarantee execution but do not guarantee a price. Limit orders guarantee a price, but do not guarantee execution. Q3.3 What is a buy-stop order, and what type of trader commonly employs them? Q3.3 ANSWER A stop order is a market order to buy or sell a certain quantity of a security if a specified price (the stop price) is reached or passed. A position is said to be stopped out when the position is offset by the execution of a stop order. A buy stop order is a buy order that is to be held until the market price rises to a specified stop price, at which point it becomes a market order. Buy stop orders are often used by short sellers who wish to limit their risk exposure but are not permitted for over-the-counter trading. Q3.4 What is the bid-ask spread? Q3.4 ANSWER The bid-ask spread is the gap between the bid price and the ask price. It is the price markup faced by investors, and the profit margin earned by the exchange specialist or Nasdaq market maker. The quoted bid is the highest price an investor is willing to pay to buy a security. Practically speaking, this is the highest currently available price at which an investor can sell shares of stock or any other security. The quoted ask is the lowest price an investor will accept to sell a stock. Practically speaking, this is the quoted offer at which an investor can presently buy shares of stock. Q3.5 How can investors benefit from dollar-cost averaging? Q3.5 ANSWER Dollar-cost averaging is a simple mechanical means by which an individual investor can benefit from market volatility. This method involves a simple investment strategy of investing a fixed amount in a particular security at regular intervals. Because the amount invested remains constant, the investor buys more shares when the price is low but fewer shares when the price is high. As a result, the average dollar amount paid, or the average cost per share, is always lower than the average price per share. Dollar-cost averaging will result in the greatest discount from the average share price in the most volatile market environments. Therefore, dollar-cost averaging is an attractive means for long-term investing because it allows regular long-term investors to reduce the effects of market risk by acquiring more shares when share prices are at their lowest. Q3.6 Compare and contrast the relative tax advantages of earning investment returns from capital gains versus dividends. Q3.6 ANSWER The advantage of earning capital gains is that the investor does not have to pay the tax until the security is sold. Therefore, the tax can be deferred by simply not selling the stock. This gives the investor some ability to time when capital gains are taken and the tax paid. The advantage of dividend income was obvious when the Bush Administration lowered the dividend tax rate to15%, which is lower than the 20% tax rate on capital gains. Q3.7 Explain how traditional IRAs and Roth IRAs allow investors to defer taxes. Under what conditions will traditional IRAs and Roth IRAs give the same tax savings? Q3.7 ANSWER Investors who do not exceed gross adjusted income limitations may make tax-deductible contributions to a traditional IRA. Profits earned on these contributions are not taxed until withdrawals are made from the IRA. Withdrawals made after the depositor has reached an age of 59½ years are taxed as ordinary income. Contributions to Roth IRAs are taxed, but profits made on those contributions and withdrawals after age 59 ½ are not taxed. Clearly, there are substantial tax deferral-benefits to be gained from investing in IRAs. From Table 4.3, one can see that a tax-deferred $2,000 annual investment compounds to $167,151 more than a taxable $2,000 annual investment. Tax-deferred investments result in much more interest-on-interest compounding than taxable investments. The advantage of tax deferral lies in the fact that it allows a larger sum to accumulate prior to the payment of taxes. When income tax rates are higher during working years, a traditional IRA is preferred. When income tax rates are higher during retirement years, a Roth IRA is preferred. When income tax rates are the same during working and retirement years, traditional IRAs and Roth IRAs give the same tax savings. Q3.8 What is the difference between a primary offering and a secondary offering? Q3.8 ANSWER The fundamental difference between primary and secondary offerings is that the issuing corporation receives the proceeds of primary offerings, but the issuing corporation does not receive any sale proceeds in a secondary offering. A primary offering is the sale of a newly issued security of a corporation seeking outside equity capital and a public market for its stock. Secondary offerings are the public sale of previously issued securities held by large investors, corporations, or institutional investors. Chapter 4 Q4.1 Investors often wrongly focus on arithmetic average return when judging portfolio performance. Explain why the arithmetic average return is upward biased and cannot be used to depict the return on investment over time. Q4.1 ANSWER There is a simple mathematical problem with computing investment returns using arithmetic averages. Because positive returns can exceed 100% but the downside is limited to -100%, arithmetic average returns are biased to the upside. The problem lies in the way investors see simple arithmetic average returns. If a stock appreciates by 100% and then falls by 50%, the arithmetic average return for two periods is 25% per year (= [100% - 50%]/2). In fact, no net profit is made. If a $10 stock jumps to $20 (up 100%) and then falls back to $10 (declines by 50%), it has fallen back to its initial price. The actual investment return is 0% per year over the two-year holding period. Accurate measurement of annual investment returns requires calculation of the geometric mean return. The geometric mean return is the appropriate measure of the compound rate of return earned on investment over time. Q4.2 Over the long run, common stocks provide higher rates of return than corporate bonds. Is this just a statistical regularity, or is there also an underlying economic rationale? Explain. Q4.2 ANSWER Common stocks provide higher rates of return than corporate bonds. More than just a statistical regularity, there is a simple underlying economic rationale. First of all, on a day to day basis common stocks display higher variation in prices and returns than is true with corporate bonds. Common stockholders demand a risk premium to compensate them for the added volatility of holding equities, and this added risk premium results in higher expected rates of return for common stocks versus corporate bonds. Second, corporate bonds are sold by corporations who invest the proceeds in plant and equipment. The expected rate of return on these investment projects exceeds the rate of interest paid on corporate bonds, thereby providing issuers with an expected profit margin plus a needed margin of safety. On average, investment projects must pay more than financing costs or companies would be unable to make principle and interest payments to corporate bond holders. As residual claimants on the value of the firm, common stockholders enjoy the profits earned on projects funded with corporate debt. Just as banks always charge more for loans than the amount of interest paid on savings accounts, corporations always must make more on investment projects that the cost of funds used to provide them with financing. Q4.3 Describe three main determinants of the required rate of return and four primary determinants of common stock risk. Q4.3 ANSWER The determinants of required return are the: 1. real (after inflation) risk-free rate 2. expected inflation rate 3. required risk premium. Common stock risk is derived from: 1. General economic factors, like changes in GDP, interest rates, value of the dollar, etc., are responsible for roughly 30% of stock price variance. 2. Market sector factors tied to cyclical, stable growth, emerging growth characteristics of the market cause roughly 15% of stock price variance. 3. Industry factors tied to domestic rivalry, import competition, and regulatory characteristics cause roughly 10% of stock-price variance. 4. Firm-specific factors reflecting management quality and corporate governance, operating and financial leverage, product quality, and so on, cause roughly 45% of stock-price variance. Q4.4 Explain the characteristics of firm-specific risk. How might an investor limit his or her exposure to this type of risk? Q4.4 ANSWER Firm-specific risk is the risk that problems with an individual company will reduce the value of investments. Factors that affect firm-specific risk include things like the quality of management, operating and financial leverage, and changes in product quality. Such factors have been shown to account for slightly less than one-half of the volatility in common stock prices. An investor may limit exposure to firm-specific risk by owning many stocks. Diversification reduces the chance that the adverse performance of a single firm within a portfolio will result in significant capital loss. Q4.5 What is valuation risk? Did market P/E ratios in March 2000 signify high valuation risk? Q4.5 ANSWER Valuation risk is the risk of loss due to relatively high stock prices. In the case of P/E ratios, valuation risk refers to the risk that current P/E ratios relative to historical norms are too high. In March of 2000, P/E ratios were far above average for major market indices like the DJIA, S&P 500 and Nasdaq. Q4.6 Covariance and correlation indicate the extent to which returns move up or down together. Explain underlying similarities and differences. Q4.6 ANSWER Covariance and correlation are both measures of comovement that offer insight concerning the volatility of securities. Covariance is an absolute measure of comovement that varies between -∞ and +∞; correlation is a relative measure of comovement that varies between -1 and +1. CFA4.1 Which of the following statements about standard deviation is TRUE? Standard deviation: A. is the square of the variance. B. can be a positive or a negative number. C. is denominated in the same units as the original data. D. is the arithmetic mean of the squared deviations from the mean. Answer: C CFA4.2 A stock with a coefficient of variation of 0.50 has a(n): A. variance equal to half the stock's expected return. B. expected return equal to half the stock's variance C. expected return equal to half the stock's standard deviation D. standard deviation equal to half the stock's expected return. Answer: D CFA4.3 Which of the following is least likely to affect the required rate of return on an investment? A. Real risk free rate. B. Asset risk premium. C. Expected rate of inflation. D. Investors' composite propensity to consume. Answer: D CFA4.4The Markowitz efficient frontier is best described as the set of portfolios that has: A. the minimum risk for every level of return. B. proportionally equal units of risk and return. C. the maximum excess rate of return for every given level of risk. D. the highest return for each level of beta based on the capital asset pricing model. Answer: A CFA4.5 An investor is considering adding another investment to a portfolio. To achieve the maximum diversification benefits, the investor should add an investment that has a correlation coefficient with the existing portfolio closest to: A. -1.0 B. -0.5 C. 0.0 D. 1.0 Answer: A Chapter 5 P5.1 The Value Line Investment Survey reports that β = 1.05 for chemical giant EI DuPont de Nemours & Co. (DD).Calculate the expected rate of return for the market and for DD during the coming year if the risk-free rate is anticipated to be 4% and the market risk premium is expected to be 5%. Is DD more or less risky than the overall market? P5.1 SOLUTION The expected returns for the market and DD are: E(RDD) = = E(RM) = = 4% + 1.05(5%) 9.25% 4% + 1.00(5%) 9.00% P5.9 With a βDD = 1.05 > 1.00, DD is slightly more risky than the overall market. Given these three assets, which one is inferior to the other two? Why? A B C E(R) 12% 12% 16% SD 20% 30% 30% P5.9 SOLUTION Comparing assets A and B, A is preferred because both have the same expected return but B is riskier. Between B and C, C is preferred because it offers a higher expected return for the same level of risk. Therefore, asset B is inferior and is dominated by A and C. P5.15 Suppose an investor has an investment portfolio comprised of 1,000 shares of LEH (Beta = 2.04) at 31.40, 100 FSLR (Beta = 0.03) at 288.50, and 5,000 of EFTC (Beta = 1.09) at 3.95. Calculate the beta of this three-stock portfolio. 5.15 SOLUTION The amount invested is $31,400 (= 1,000 × 31.40) in LEH, $28,850 (= 100 × 288.50) in FSLR, and $19,750 (= 5,000 × 3.95) in ETFC. Thus, the value of the entire portfolio is $80,000 (= $31,400 + $28,850 + $19,750). The weights of each stock in the portfolio are: LEH weight = $31,400/ $80,000 = 39.2% FSLR weight = $28,850/$80,000 = 36.1% ETFC weight = $19,750/$80,000 = 24.7% Portfolio beta = 0.392(2.04) + 0.361(0.03) + 0.247(1.09) = 1.08 (signifying above-market risk) P5.16 From 1988-2007, the S&P 500 earned an average 13.9% per year with a standard deviation of 15.1%. If the risk-free rate is 4%, calculate and interpret the Sharpe Ratio and Treynor Index for the overall market. P5.16 SOLUTION The Sharpe Ratio shows the amount of risk premium earned relative to total risk, where total risk is measured by standard deviation: Sharpe Ratio = [E(RP) – RF]/SD(RP) = (13.9% - 4%)/15.1% = 0.66 The market as a whole provided 0.66% additional risk premium for every 1% of portfolio risk (standard deviation). The Treynor Index shows the amount of risk premium earned relative to systematic risk, where risk is measured by beta (systematic risk): Treynor Index = [E(RP) – RF]/ βM = (13.9% - 4%)/1.0 = 9.90 The market as a whole paid 9.90% in additional risk premium for every one unit of portfolio risk (systematic risk). P5.17 Assume the following information: Your Portfolio Expected return Standard deviation 20% Beta The Market 15% Expected return Standard deviation 12% 1.3 Beta 14% 1.0 If the risk-free rate is 5%, calculate and compare the Sharpe Ratio and the Treynor Index for both Your Portfolio and The Market. Did your portfolio beat the market on a risk-adjusted basis? P5.17 SOLUTION Your Portfolio The Market Sharpe = R P − R F 15% − 5% = = 0.50 20% SD( R P ) Sharpe = R P − R F 14% − 5% = = 0.75 12% SD( R P ) Treynor = RP − RF = 15% − 5% = 7.69 1.3 βP R − R F 14% − 5% Treynor = P = = 9.00 1.0 βP No. Because the Sharpe Ratio is lower than that for the overall market, your portfolio is unattractive in that it offers a smaller risk premium per unit of risk (standard deviation). Your portfolio is also unattractive in that it has a smaller Treynor Index than the overall market, and thus offers a smaller risk premium per unit of systematic risk (beta). P5.19 Suppose a mutual fund has earned an 11% annual return, the fund’s β = 1.4, the market return RM = 9%, and the risk-free rate RF = 4%. Calculate the mutual fund’s alpha (αMF). On a riskadjusted basis, did the fund beat the market? P5.19 SOLUTION αMF = (RM - RF) – βMF((RM - RF) = (11% - 4%) – 1.4(9% -4%) = 0% Because the mutual fund’s alpha αMF = 0, the fund earned exactly the expected return given the level of risk taken. Therefore, on a risk-adjusted basis, the fund failed to beat the market. CFA5.1 In the context of the security market line (SML), which of the following statements best characterizes the relationship between risk and the required rate of return for an investment? A. The slope of the SML indicates the risk per unit of return for a given individual investor. B. A parallel shift in the SML occurs in response to a change in the attitudes of investors toward risk. C. A movement along the SML shows a change in the risk characteristics of a specific investment, such as a change in its business risk or financial risk. D. A change in the slope of the SML reflects a change in market conditions, such as ease or tightness of monetary policy or a change in the expected rate of inflation. Answer: C CFA5.2 Arbitrage pricing theory (APT) and the capital asset pricing model (CAPM) are most similar with respect to their assumption that: A. security returns are normally distributed. B. a mean-variance efficient market portfolio exists and contains all risky assets. C. an asset's price is primarily determined by its covariance with one dominant factor. D. unique risk factors are independent and will be diversified away in a large portfolio. Answer: D CFA5.3 In the context of capital market theory, unsystematic risk: A. is described as unique risk. B. refers to nondiversifiable risk. C. remains in the market portfolio. D. refers to the variability in all risky assets caused by macroeconomic and other aggregate market-related variables Answer: A Chapter 16 Q16.2 Which investment benchmark is most commonly used to judge the investment performance of large-cap equity mutual funds? Explain the concept and how it is employed. Q16.2 ANSWER By far and away the most commonly accepted investment benchmark, or reference point for investment performance, for large-cap equity mutual funds is the S&P 500 Index. As a value-weighted index of 500 major companies chosen to be broadly representative of U.S. industry, the S&P 500 satisfies the need for a widely understood and comprehensive standard for investment performance. It is difficult to measure the success of professional investment management unless an appropriate investment benchmark, or investment standard, for expected investment risk and return is established. If the overall market rose 25%, the performance of an investment advisor would hardly be judged as spectacular if the advisor’s portfolio returned a meager 15% rate of return. However, it would be cause for celebration if the overall market fell 10% and that same professional money manager earned 15%. Of course, it is not only necessary to consider investment performance relative to the overall market or an appropriate benchmark. It also is necessary to consider relative risk. For example, a professional investor that outperforms the overall market only by taking on above-market risk might very well fail to provide superior risk-adjusted performance. Any such investor could scarcely be described as beating the market. Beating the market requires superior rates of return for the same level of risk, or market-like returns from a portfolio with belowmarket risk. Q16.3 How does a closed-end mutual fund differ from an open-end mutual fund? Which is more popular, and why? Q16.3 ANSWER Both closed-end and open-end mutual funds offer managed portfolios of stocks and bonds for the benefit of individual investors, but there are many important differences. The original form of mutual fund, a closed-end fund is a mutual fund investment company that issues a fixed number of shares at a specific point in time. An open-end fund issues a flexible number of shares depending upon investor supply and demand. The publicly-traded price of closed-end fund shares can and does tend to vary from the underlying net asset value (NAV) per share. Most closed-end funds sell at a significant discount to NAV. When open-end mutual fund shareholders want to redeem their shares, the open-end mutual fund stands ready to do so at NAV. Like Exchange Traded Funds (ETFs), closed-end mutual funds are publicly traded throughout the trading day on an exchange or the Nasdaq stock market. Openend mutual funds are bought and sold through a broker or directly through the fund based upon the daily closing NAV as of 4:00pm ET. Because closed-end mutual funds are publicly traded throughout the trading day, they can be bought on margin and sold short. Some closed-end funds also have options associated with them. Open-end funds bought through a broker, like eTrade, can also be bought on margin and sold short, but open-end funds bought directly from fund companies cannot typically be bought on margin or sold short. The willingness to redeem open-end mutual fund shares at NAV has made open-end mutual funds much more popular than closed-end funds. There are literally thousands of money market, bond, and equity funds of the open-end variety. Only a few hundred closed-end funds are available to investors. Q16.4 What is the difference between an open-end mutual fund and an exchange traded fund? Are exchange-traded funds open-end or closed-end funds? Q16.3 ANSWER Shares of an open-end mutual fund are bought and sold directly by the mutual fund firm. Shares are traded at the NAV, unless there is a load. The open-end mutual fund also charges management fees, 12b-1 charges, and other costs. Most open-end mutual funds are actively managed. ETFs are bought and sold on a stock exchange (mostly the American Stock Exchange). The price the shares trade for may not be equal to the NAV, but are usually very close to the NAV. Investors can exchange ETF shares for NAV with the investment advisor. Most ETFs are passive portfolios that mimic an index. Q16.5 Describe the important investment characteristics and composition of the QQQQs. What trading characteristics make the QQQQs a favorite tool of speculators? Q16.5 ANSWER Exchange-traded funds (EFTs) are tradable shares in baskets of stocks that closely track broad market averages, market sectors, or major stock markets from around the world. Among the most popular EFTs are the QQQQs which track the Nasdaq 100 Index. The NASDAQ-100 Index includes 100 of the largest domestic and international non-financial companies listed on The Nasdaq Stock Market based on market capitalization. As a value-weighted adjusted index, the QQQQs emphasize the largest nonfinancial Nasdaq companies in terms of market capitalization. Prominently featured are Microsoft Corporation, QUALCOMM Incorporated, and Intel Corp., among other Nasdaq giants. Given the composition of Nasdaq companies, the QQQQs are largely a tech-dominated index. Generally speaking, 75-80% of the QQQQs are comprised of tech stock investment (e.g., Information Technology Hardware, Computer Software/Services, and Pharmaceuticals & Biotechnology, among others. In contrast with mutual funds, the QQQQs can be bought and sold throughout the trading day, and short selling on down ticks is allowed. Buying on margin and hedging with options is also allowed. Interestingly, the QQQQs are a favorite trading tool of speculators; the average holding period for QQQQ investors averages as little as 5 trading days or less. Q16.6 What is the difference between no-load and load mutual funds? Q16.6 ANSWER Load funds are purchased through retail brokers and investment professionals and involve significant upfront sales commissions of 1%-3% of the amount invested in low-load mutual funds, to 4%-8 1/2% of the amount invested in full-load mutual funds. Sometimes, mutual fund commissions are deferred until the point of redemption. In either case, sales commissions dramatically cut the total return earned by mutual fund shareholders. By contrast, no-load funds are sold directly to investors by mutual fund management companies without commissions. Q16.7 Does effective diversification require one to invest in a large number of different mutual funds? How can an investor easily and cheaply achieve broad diversification? Q16.7 ANSWER No, diversification does not require one to invest in a large number of different mutual funds. Even a modest amount of diversification amongst uncorrelated investment vehicles will greatly reduce portfolio risk. In fact, a single investment vehicle, such as an index fund, can provide effective diversification within an asset class. With this in mind, in order to construct a broadly diversified portfolio, an investor need only invest in three mutual funds: a common stock index fund, a bond market fund, and a money market fund. When low-cost index funds are relied on, the costs of broad diversification can be minimal. Furthermore, it is often easy to change your portfolio mix. Additionally, diversification within a particular asset type can be achieved by investing in index funds. A single common stock index fund, for example, greatly reduces the risks associated with investing in common stocks. Q16.11 Describe four distinctive ways in which hedge funds differ from mutual funds. Q16.11 ANSWER Hedge funds differ from mutual funds in a number of important ways: (1) Only sophisticated, high net worth investors are eligible to invest in hedge funds. The typical investor is a wealthy individual or an institution such as an endowment or foundation. A minimum investment of $1 million or more is required. (2) Hedge fund investors often pay a portfolio management fee of 1% to 2% of net assets, plus a performance-based fee that can run as high as 10% per year, depending upon performance. Fees are not subject to specific regulatory limits. (3) Leveraging strategies are hallmarks of hedge funds. Investment policies do not have to be disclosed, even to investors in the fund. (4) There are no specific rules on valuation or pricing. As a result, hedge fund investors may be unable to determine the value of their investment at any given time. In addition, new investors typically must pledge to keep their money in a hedge fund for at least one year.