Schweser Printable Answers - PM & EQ 1 - Webs

Schweser Printable Answers - PM & EQ 1

Test ID#: 11

Question 1 - #93495

The standard deviation of the rates of return is 0.25 for Stock J and 0.30 for Stock K. The covariance between the returns of J and K is 0.025. The correlation of the rates of return between J and K is:

Your answer: A was incorrect. The correct answer was C) 0.33.

CovJ,K = (rJ,K)(SDJ)(SDK), where r = correlation coefficient and SDx = standard deviation of stock x

Then, (rJ,K) = CovJ,K / (SDJ × SDK) = 0.025 / (0.25 × 0.30) = 0.333

This question tested from Session 12, Reading 50, LOS d.

Question 2 - #93434

Which of the following is an assumption of capital market theory? All investors:

Your answer: A was incorrect. The correct answer was C) see the same risk/return distribution for a given stock.

All investors select portfolios that lie along the efficient frontier, based on their utility functions. All investors have the same one-period time horizon, and have the same risk/return expectations.

This question tested from Session 12, Reading 51, LOS a, (Part 1).

Question 3 - #96064

If the standard deviation of returns for stock A is 0.60 and for stock B is 0.40 and the covariance between the returns of the two stocks is 0.009 what is the correlation between stocks A and B?

Your answer: A was correct!

CovA,B = (rA,B)(SDA)(SDB), where r = correlation coefficient and SDx = standard deviation of stock x

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A) 0.10.B) 0.20.C) 0.33.

A) select portfolios that lie above the efficient frontier to optimize the risk-return relationship. B) have multiple-period time horizons. C) see the same risk/return distribution for a given stock.

A) 0.0375. B) 0.0020. C) 26.6670.

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Then, (rA,B) = CovA,B / (SDA × SDB) = 0.009 / (0.600 × 0.400) = 0.0375


Question 4 - #93500

An analyst observes the following return behavior between stocks X and Y.

What is the covariance of returns between stocks X and Y?

Your answer: A was incorrect. The correct answer was B) +3.0.

Covariance = {Σ[(ReturnX − MeanX)(ReturnY − MeanY)]} / (n − 1)

MeanX = (7 + 9 + 10 + 10) / 4 = 9; MeanY = (5 + 8 + 11 + 8) / 4 = 8

CovX,Y = [(7 − 9)(5 − 8) + (9 − 9)(8 − 8) + (10 − 9)(11 − 8) + (10 − 9)(8 − 8)] / (4 − 1) = 3.0


Question 5 - #93394

The expected market premium is 8%, with the risk-free rate at 7%. What is the expected rate of return on a stock with a beta of 1.3?

Your answer: A was incorrect. The correct answer was C) 17.4%.

RRStock = Rf + (RMarket − Rf) × BetaStock, where RR = required return, R = return, and Rf = risk-free rate, and (RMarket − Rf) = market premium Here, RRStock = 7 + (8 × 1.3) = 7 + 10.4 = 17.4%.

This question tested from Session 12, Reading 51, LOS e.

Question 6 - #93458

Time Period X's Return Y's Return

1 7 5

2 9 8

3 10 11

4 10 8

A) +1.5.B) +3.0.C) -3.0.

A) 16.3%.B) 10.4%.C) 17.4%.



Which of the following statements about the optimal portfolio is FALSE? The optimal portfolio:

Your answer: A was incorrect. The correct answer was B)

is the portfolio that gives the investor the maximum level of return.

This statement is incorrect because it does not specify that risk must also be considered.

This question tested from Session 12, Reading 50, LOS g.

Question 7 - #93482

The correlation coefficient between stocks A and B is 0.75. The standard deviation of stock A’s returns is 16% and the standard deviation of stock B’s returns is 22%. What is the covariance between stock A and B?


cov1,2 = 0.75 × 0.16 × 0.22 = 0.0264 = covariance between A and B.


Question 8 - #96407

There are benefits to diversification as long as:

Your answer: A was incorrect. The correct answer was C) the correlation coefficient between the assets is less than 1.

There are benefits to diversification as long as the correlation coefficient between the assets is less than 1.


Question 9 - #94343

Which of the following portfolios falls below the Markowitz efficient frontier?

A) lies at the point of tangency between the efficient frontier and the indifference curve with the highest possible utility.

B) is the portfolio that gives the investor the maximum level of return. C) may be different for different investors.

A) 0.3750.B) 0.0352.C) 0.0264.

A) there is perfect positive correlation between the assets.B) there must be perfect negative correlation between the assets.C) the correlation coefficient between the assets is less than 1.

Portfolio Expected Return Expected Standard Deviation



Your answer: A was incorrect. The correct answer was C) Portfolio B.

Portfolio B is inefficient (falls below the efficient frontier) because for the same risk level (8.7%), you could have portfolio C with a higher expected return (15.1% versus 14.2%).

This question tested from Session 12, Reading 50, LOS f.

Question 10 - #93377

In the context of the capital market line (CML), which of the following statements is TRUE?

Your answer: A was incorrect. The correct answer was B) Firm-specific risk can be reduced through diversification.

The other statements are false. Market risk cannot be reduced through diversification; market risk = systematic risk. The two classes of risk are unsystematic risk and systematic risk.

This question tested from Session 12, Reading 51, LOS c.


An investor insists that his portfolio maintain its value in terms of purchasing power and is quite concerned about a loss of value. This investor’s return objective is best described as:


The capital preservation objective is appropriate when a portfolio must earn a return that is at least equal to the inflation rate (maintain its purchasing power) with a very low risk of losing value.



A 12.1% 8.5%

B 14.2% 8.7%

C 15.1% 8.7%

A) Portfolio A.B) Portfolio C.C) Portfolio B.

A) The two classes of risk are market risk and systematic risk.B) Firm-specific risk can be reduced through diversification.C) Market risk can be reduced through diversification.

A) capital preservation.B) total return.C) capital appreciation.



Which of the following statements about the steps in the portfolio management process is FALSE?


Developing an investment strategy is based primarily on an analysis of the current and future financial market and economic conditions. Historical analysis serves to help develop an expectation for future conditions.

This question tested from Session 12, Reading 49, LOS a.


Beta is least accurately described as:

Your answer: A was incorrect. The correct answer was B) a standardized measure of the total risk of a security.

Beta is a standardized measure of the systematic risk of a security. β = Covr,mkt / σ2

mkt. Beta is multiplied by the market risk premium in the CAPM: E(Ri) = RFR + β[E(Rmkt) – RFR].

This question tested from Session 12, Reading 51, LOS d, (Part 1).


Which one of the following statements about portfolio diversification is FALSE?


This statement should read, "The lower the correlation coefficient between the portfolio and a stock, the greater the diversification effect from adding that stock to the portfolio.



A) Developing an investment strategy is based on an analysis of historical performance in financial markets and economic conditions.

B) Rebalancing the investor’s portfolio is done on an as-needed basis, and should be reviewed on a regular schedule.

C) Implementing the plan is based on an analysis of the current and future forecast of financial and economic conditions.

A) a measure of the sensitivity of a security’s return to the market return.B) a standardized measure of the total risk of a security.C) the covariance of a security’s returns with the market return, divided by the variance of market returns.

A) The lower the correlation coefficient between the portfolio and a stock, the lower the diversification effect from adding that stock to the portfolio.

B) In a well diversified portfolio of over 25 stocks market risk will account for over 85% of the portfolio's total risk.

C) As more securities are added to a portfolio total risk falls, but at a decreasing rate.



In a two-asset portfolio, reducing the correlation between the two assets moves the efficient frontier in which direction?


Reducing correlation between the two assets results in the efficient frontier expanding to the left and possibly slightly upward. This reflects the influence of correlation on reducing portfolio risk.



21st Century Investments manages a portfolio, Z, that has zero correlation with the market index and examines the prospects for AMI Enterprises, a manufacturer of laptop batteries. 21st Century Investments derives the following market forecasts:

� Expected return on portfolio Z - 8% � Expected return on the market index - 14% � Risk-free rate - 5% � AMI beta - 1.50

Using the zero-beta form of the capital asset pricing model (CAPM), the equilibrium expected return for AMI is closest to:

Your answer: A was incorrect. The correct answer was B) 17.0%.

The zero beta form of the CAPM replaces the risk-free rate with the return on a zero beta portfolio. Portfolio Z has zero correlation with the market portfolio. Therefore, the beta for portfolio Z also equals zero. Recall the formula for beta:

where covim is the covariance between any asset i and the market index m, σi is the standard deviation of returns for asset i, σm is the standard deviation of returns for the market index, and ρim is the correlation between asset i and the market index. Therefore, the beta will equal zero if the correlation equals zero.

The equation for the zero-beta CAPM is:

E(R) = E(Rz) + β[E(Rm) – E(Rz)] = 0.08 + 1.50[0.14 – 0.08] = 0.17 = 17%


A) The frontier extends to the left, or northwest quadrant representing a reduction in risk while maintaining or enhancing portfolio returns.

B) The efficient frontier is stable unless the asset’s expected volatility changes. This depends on each asset’s standard deviation.

C) The efficient frontier is stable unless return expectations change. If expectations change, the efficient frontier will extend to the upper right with little or no change in risk.

A) 18.5%.B) 17.0%.C) 14.0%.




The slope of the capital market line (CML) is a measure of the level of:

Your answer: A was incorrect. The correct answer was B) excess return per unit of risk.

The slope of the CML indicates the excess return (expected return less the risk-free rate) per unit of risk.



Which of the following statements about risk is FALSE?

Your answer: A was incorrect. The correct answer was C) Total risk = systematic risk - unsystematic risk.

Total risk = systematic risk + unsystematic risk



A security has a 30% chance of producing a 15% return and a 70% chance of producing a -4% return. The variance of the security is closest to:

Your answer: A was incorrect. The correct answer was B) 0.0077.

The variance is the sum of the probability times the difference between the return and the expected return squared. First, find the expected return as: (0.30)(0.15) + (0.70)(–0.04) = 0.017, or 1.7%. Then, the variance is determined as: (0.30)(0.15 – 0.017)2 + (0.70)(–0.04 – 0.017)2 = 0.0077.

This question tested from Session 12, Reading 50, LOS c, (Part 2).


Which of the following is least likely part of the portfolio-management process?

A) expected return over the level of inflation.B) excess return per unit of risk.C) risk over the level of excess return.

A) The market portfolio consists only of systematic risk.B) Unsystematic risk is diversifiable risk.C) Total risk = systematic risk - unsystematic risk.

A) 0.0057.B) 0.0077.C) 7.6.




Limiting the tax liability may be a wise move depending on an investor’s circumstances, but it should not be the primary objective of the portfolio management process. Satisfying the investor’s risk, return, liquidity, and other constraints are primary objectives. Addressing the tax liability should be addressed after the primary objectives have been satisfied. Rebalancing the portfolio is part of the “monitor and update” step. Identifying goals and restraints is part of the “write a policy statement” step.



An investor owns the following portfolio today.

The investor's expected total rate of return (increase in market value) after three years is closest to:


To calculate this result, we first need to calculate the portfolio value, then determine the weights for each stock, and then calculate the expected return. Finally, we determine the compounded rate after three years.

Portfolio Value: = sum of market values = 2,000 + 3,200 + 2,800 = 8,000

Portfolio Weights: WA = 2,000 / 8,000 = 0.25 WB = 3,200 / 8,000 = 0.40 WC = 2,800 / 8,000 = 0.35

Expected Return ERportfolio = Σ[(ERstock)(W% of funds invested in each of the stocks)] ER = wRERR + wSERS + wTERT, where ER = Expected Return and w = % invested in each stock. ER = (0.25 × 17.0) + (0.40 × 8.0) + (0.35 × 13.0) = 12.0%

Expected Return after three years = (1 + return)3 = (1.12)3 − 1 = 1.405 − 1 = 0.405, or 40.5%.


A) limiting the portfolio’s tax liability. B) identifying the investor’s goals and constraints. C) rebalancing the portfolio.

Stock Market Value Expected Annual Return

R $2,000 17%S $3,200 8%T $2,800 13%

A) 40.5%.B) 36.0%.C) 12.0%.




Mike Palm, CFA, is an analyst with a large money management firm. Currently, Palm is considering the risk and return parameters associated with Alux, a small technology firm. After in depth analysis of the firm and the economic outlook, Palm estimates the following return probabilities:

Palm's objective is to quantify the risk/return relationship for Alux.

Given the returns and probability estimates above, what is the expected return for Alux?


ERportfolio = S(ERstock)(W% of funds invested in each of the stocks)

ER = w1ER1 + w2ER2 + w3ER3, where ER = Expected Return and w = % invested in each stock.

ER = (0.3 × -5.0) + (0.50 × 15) + (0.20 × 25) = -1.5 + 7.5 + 5.0 = 11.0%



Which of the following statements about the efficient frontier is FALSE?


This statement should read, "The slope of the efficient frontier decreases steadily as one moves up the curve." The other statements are true.



Which of the following is generally the first general step in the portfolio management process?

Probability (Pi) Return (Ri)

0.3 -5%

0.5 15%

0.2 25%

A) 11%.B) 9%.C) 15%.

A) The slope of the efficient frontier increases steadily as one moves up the curve.B) The efficient frontier line bends backwards due to less than perfect correlation between assets.

C) A portfolio to the left of the efficient frontier is not attainable, while a portfolio to the right of the efficient frontier is inefficient.



Your answer: A was incorrect. The correct answer was C) Write a policy statement.

The policy statement is the foundation of the entire portfolio management process. Here, both risk and return are integrated to determine the investor’s goals and constraints.



A basic assumption of the capital asset pricing model (CAPM) is that there are no transaction costs. If this assumption is relaxed, which of the following would be the least likely to occur?


Each investor can have a unique view of a security market line.

If the assumption of “no transaction cost” is relaxed, then investors will correct mispricing only up to the point where transaction costs begin to offset potential excess return. As a result, all securities will plot within a band around the SML. It also would impact diversification, since at some point the transaction cost will offset the benefits of diversification.



If the standard deviation of stock A is 7.2%, the standard deviation of stock B is 5.4%, and the covariance between the two is -0.0031, what is the correlation coefficient?

Your answer: A was incorrect. The correct answer was C) -0.80.

The formula is: (Covariance of A and B)/[(Standard deviation of A)(Standard Deviation of B)] = (Correlation Coefficient of A and B) = (-0.0031)/[(0.072)(0.054)] = -0.797.



Consider a stock selling for $23 that is expected to increase in price to $27 by the end of the year and pay a $0.50

A) Develop an investment strategy.B) Specify capital market expectations.C) Write a policy statement.

A) All securities will plot very close to the security market line. B) Each investor can have a unique view of a security market line. C) Diversification benefits will be realized up to the point that they offset transactions costs.

A) -0.19.B) -0.64.C) -0.80.



dividend. If the risk-free rate is 4%, the expected return on the market is 8.5%, and the stock’s beta is 1.9, what is the current valuation of the stock? The stock:

Your answer: A was incorrect. The correct answer was C) is undervalued.

The required return based on systematic risk is computed as: ERstock = Rf + (ERM – Rf) × Betastock, or 0.04 + (0.085 – 0.04) × 1.9 = 0.1255, or 12.6%. The expected return is computed as: (P1 – P0 + D1) / P0, or ($27 – $23 + $0.50) / $23 = 0.1957, or 19.6%. The stock is above the security market line ER > RR, so it is undervalued.



In the context of the CML, the market portfolio includes:

Your answer: A was incorrect. The correct answer was B) all existing risky assets.

The market portfolio has to contain all the stocks, bonds, and risky assets in existence. Because this portfolio has all risky assets in it, it represents the ultimate or completely diversified portfolio.

This question tested from Session 12, Reading 51, LOS b.


Which of the following statements regarding the Markowitz model of portfolio theory is FALSE? The model assumes investors:

Your answer: A was incorrect. The correct answer was B) view the mean of the distribution of potential outcomes as the expected risk of an investment.

The following are assumptions associated with Markowitz Portfolio Theory:

� Risk is variability. Investors measure risk as the variance (standard deviation) of expected returns. � Returns distribution. Investors look at each investment opportunity as a probability distribution of expected

returns over a given investment horizon. � Utility maximization. Investors maximize their expected utility over a given investment horizon, and their

indifference curves exhibit diminishing marginal utility of wealth (i.e., they are convex). � Risk/return. Investors make all investment decisions by considering only the risk and return of an

A) is correctly valued.B) is overvalued.C) is undervalued.

A) 12-18 stocks needed to provide maximum diversification.B) all existing risky assets.C) the risk-free asset.

A) estimate a portfolio's risk on the basis of the variability of expected returns.B) view the mean of the distribution of potential outcomes as the expected risk of an investment.

C) evaluate investment opportunities as a probability distribution of expected returns over some time period.



investment opportunity. This means that their utility (indifference) curves are a function of the expected return (mean) and the variance of the returns distribution they envision for each investment.

� Risk aversion. Given two investments with equal expected returns, investors prefer the one with the lower risk. Likewise, given two investments with equal risk, investors prefer the one with the greater expected return.



What is the required rate of return for a stock with a beta of 1.2, when the risk-free rate is 6% and the market is offering 12%?


RRStock = Rf + (RMarket - Rf) × BetaStock, where RR= required return, R = return, and Rf = risk-free rate.

Here, RRStock = 6 + (12 - 6) × 1.2 = 6 + 7.2 = 13.2%.



Luis Green is an investor who uses the security market line to determine whether securities are properly valued. He is evaluating the stocks of two companies, Mia Shoes and Video Systems. The stock of Mia Shoes is currently trading at $15 per share, and the stock of Video Systems is currently trading at $18 per share. Green expects the prices of both stocks to increase by $2 in a year. Neither company pays dividends. Mia Shoes has a beta of 0.9 and Video Systems has a beta of (-0.30). If the market return is 15% and the risk-free rate is 8%, which trading strategy will Green employ?


The required return for Mia Shoes is 0.08 + 0.9 × (0.15-0.08) = 14.3%. The forecast return is $2/$15 = 13.3%. The stock is overvalued and the investor should sell it. The required return for Video Systems is 0.08 - 0.3 × (0.15-0.08) = 5.9%. The forecast return is $2/$18 = 11.1%. The stock is undervalued and the investor should buy it.



An analyst gathered the following data on Stock A and Stock B:

A) 7.2%.B) 6.0%.C) 13.2%.

Mia Shoes Video Systems

A) Sell Buy B) Buy Sell C) Buy Buy



What is the covariance between the returns of Stock A and Stock B?

Your answer: A was incorrect. The correct answer was B) 0.0028.

CovarianceA,B = Σ[(prob)(RA − MeanA)(RB − MeanB)]

Mean A = (0.5)(0.3) + (0.5)(0.15) = 0.225

Mean B = (0.5)(0.15) + (0.5)(0.075) = 0.1125

Covariance = (0.5)(0.3 − 0.225)(0.15 − 0.1125) + (0.5)(0.15 − 0.225)(0.075 − 0.1125) = +0.0028

Note: This is the covariance, it is in return units squared (0.28%2). It is not the correlation coefficient, which is a pure number between +1 and -1.



Given the following data, what is the correlation coefficient between the two stocks and the Beta of stock A?

� standard deviation of returns of Stock A is 10.04% � standard deviation of returns of Stock B is 2.05% � standard deviation of the market is 3.01% � covariance between the two stocks is 0.00109 � covariance between the market and stock A is 0.002


correlation coefficient = 0.00109 / (0.0205)(0.1004) = 0.5296.

beta of stock A = covariance between stock and the market / variance of the market

Beta = 0.002 / 0.03012 = 2.2


Scenario Probability Stock A's return Stock B's return

1 0.5 0.30 0.150

2 0.5 0.15 0.075

A) 0.0876.B) 0.0028.C) 0.0076.

Correlation Coefficient Beta (stock A)

A) 0.5296 2.20

B) 0.6556 2.20

C) 0.5296 0.06




Stock A has a standard deviation of 0.5 and Stock B has a standard deviation of 0.3. Stock A and Stock B are perfectly positively correlated. According to Markowitz portfolio theory how much should be invested in each stock to minimize the portfolio's standard deviation?

Your answer: A was incorrect. The correct answer was C) 100% in Stock B.

Since the stocks are perfectly correlated, there is no benefit from diversification. So, invest in the stock with the lowest risk.



A security has the following expected returns and probabilities of occurrence:

What is the standard deviation of the returns?


The standard deviation is the square root of the variance. The variance is the sum of the probability times the difference between the return and the expected return squared. First, find the expected return as: (0.11)(0.20) + (0.14)(0.50) + (0.15)(0.30) = 0.137, or 13.7%. Then, the variance is determined as: (0.20)(0.11 – 0.137)2 + (0.50)(0.14 – 0.137)2 + (0.30)(0.15 – 0.137)2 = 0.000201. The standard deviation is then: (0.000201)0.5 = 0.0142, or 1.42%.



An analyst wants to determine whether Dover Holdings is overvalued or undervalued, and by how much (expressed as percentage return). The analyst gathers the following information on the stock:

� Market standard deviation = 0.70 � Covariance of Dover with the market = 0.85 � Dover’s current stock price (P0) = $35.00

A) 30% in Stock A and 70% in Stock B.B) 50% in Stock A and 50% in Stock B.C) 100% in Stock B.

Return Probability

11% 20%

14% 50%

15% 30%

A) 1.74%.B) 0.02%.C) 1.42%.



� The expected price in one year (P1) is $39.00 � Expected annual dividend = $1.50 � 3-month Treasury bill yield = 4.50%. � Historical average S&P 500 return = 12.0%.

Dover Holdings stock is:

Your answer: A was incorrect. The correct answer was B) overvalued by approximately 1.8%.

To determine whether a stock is overvalued or undervalued, we need to compare the expected return (or holding period return) and the required return (from Capital Asset Pricing Model, or CAPM).

Step 1: Calculate Expected Return (Holding period return)

The formula for the (one-year) holding period return is: HPR = (D1 + S1 – S0) / S0, where D = dividend and S = stock price. Here, HPR = (1.50 + 39 – 35) / 35 = 15.71%

Step 2: Calculate Required Return

The formula for the required return is from the CAPM: RR = Rf + (ERM – Rf) × Beta

Here, we are given the information we need except for Beta. Remember that Beta can be calculated with: Betastock = [covS,M] / [σ2

M]. Here we are given the numerator and the denominator, so the calculation is: 0.85 / 0.702 = 1.73. RR = 4.50% + (12.0 – 4.50%) × 1.73 = 17.48%.

Step 3: Determine over/under valuation

The required return is greater than the expected return, so the security is overvalued. The amount = 17.48% − 15.71% = 1.77%.



Gregg Goebel and Mason Erikson are studying for the Level I CFA examination. They have just started the section on Portfolio Management and Erikson is having difficulty with the equations for the covariance (cov1,2) and the correlation coefficient (r1,2) for two-stock portfolios. Goebel is confident with the material and creates the following quiz for Erikson. Using the information in the table below, he asks Erickson to fill in the question marks.

A) undervalued by approximately 2.1%.B) overvalued by approximately 1.8%.C) undervalued by approximately 1.8%.

Portfolio J Portfolio K Portfolio L

Number of Stocks 2 2 2

Covariance ? cov1,2 = 0.020 cov1,2 = 0.003

Correlation coefficient r1,2 = 0.750 ? ?

Risk measure Stock 1 Std. Deviation1 = 0.08 Std. Deviation1 = 0.20 Std. Deviation1 = 0.18

Risk measure Stock 2 Std. Deviation2 = 0.18 Std. Deviation2 = 0.12 Variance2 = 0.09



Which of the following choices correctly gives the covariance for Portfolio J and the correlation coefficients for Portfolios K and L?


The calculations are as follows:

Portfolio J covariance = cov1,2 = (r1,2) × (s1) × (s2) = 0.75 × 0.08 × 0.18 = 0.0108, or 0.011.

Portfolio K correlation coefficient = (r1,2) = cov1,2 / [ (s1) × (s2) ] = 0.02 / (0.20 × 0.12) = 0.833.

Portfolio L correlation coefficient = (r1,2) = cov1,2 / [ (s1) × (s2)1/2 ] = 0.003 / (0.18 × 0.091/2) = 0.003 / (0.18 × 0.30) = 0.056.



The basic premise of the risk-return trade-off suggests that risk-averse individuals purchasing investments with higher non-diversifiable risk should expect to earn:

Your answer: A was incorrect. The correct answer was C) higher rates of return.

Investors are risk averse. Given a choice between two assets with equal rates of return, the investor will always select the asset with the lowest level of risk. This means that there is a positive relationship between expected returns (ER) and expected risk (Eσσσσ) and the risk return line (capital market line [CML] and security market line [SML]) is upward sweeping.



Stock A has a standard deviation of 10.00. Stock B also has a standard deviation of 10.00. If the correlation coefficient between these stocks is - 1.00, what is the covariance between these two stocks?

Portfolio J Portfolio K Portfolio L

A) 0.011 0.002 0.076

B) 0.011 0.833 0.056

C) 1.680 0.002 0.076

0.011 0.833 0.056

A) lower rates of return.B) rates of return equal to the market.C) higher rates of return.

A) 1.00.B) 0.00.C) -100.00.




Covariance = correlation coefficient × standard deviationStock 1 × standard deviationStock 2 = (- 1.00)(10.00)(10.00) = - 100.00.



Based on Capital Market Theory, an investor should choose the:


Given the Capital Market Line, the investor chooses the portfolio that maximizes his utility. That portfolio may be exactly the market portfolio or it may be some combination of the risk-free asset and the market portfolio.



Investors who are less risk averse will have what type of utility curves?


Investors who are less risk averse will have flat utility curves, meaning they are willing to take on more risk for a slightly higher return. Investors who are more risk averse require a much higher return to accept more risk, producing a steep utility curve.



The optimal portfolio in the Markowitz framework occurs when an investor achieves the diversified portfolio with the:

Your answer: A was incorrect. The correct answer was B) highest utility.

The optimal portfolio in the Markowitz framework occurs when the investor achieves the diversified portfolio with

A) portfolio that maximizes his utility on the Capital Market Line.B) portfolio with the highest return on the Capital Market Line.C) market portfolio on the Capital Market Line.

A) Flatter.B) Inverted.C) Steeper.

A) highest return.B) highest utility.C) lowest risk.



the highest utility.



Which one of the following statements about correlation is FALSE?

Your answer: A was incorrect. The correct answer was B) If the correlation coefficient were 0, a zero variance portfolio could be constructed.

A correlation coefficient of zero means that there is no relationship between the stock's returns. The other statements are true.



The essence of the capital asset pricing model (CAPM) is embodied in which of the following equations?


The SML equation represents the essence of the CAPM.



The expected rate of return is twice the 12% expected rate of return from the market. What is the beta if the risk-free rate is 6%?

Your answer: A was incorrect. The correct answer was B) 3.

24 = 6 + β (12 − 6)

18 = 6β

A) Potential benefits from diversification arise when correlation is less than +1.B) If the correlation coefficient were 0, a zero variance portfolio could be constructed.C) If the correlation coefficient were -1, a zero variance portfolio could be constructed.

A) The security market line (SML).

B) Both the security market line (SML) and the capital market line (CML) as they are both the same equation.

C) The capital market line (CML).

A) 2.B) 3.C) 4.



β = 3



The expected rate of return is 2.5 times the 12% expected rate of return from the market. What is the beta if the risk-free rate is 6%?

Your answer: A was incorrect. The correct answer was C) 4.

30 = 6 + β (12 - 6) 24 = 6β β = 4



If the standard deviation of asset A is 3.2%, the standard deviation of asset B is 6.8%, and the correlation coefficient is –0.40, what is the covariance between A and B?


The formula is: (correlation)(standard deviation of A)(standard deviation of B) = (–0.40)(0.032)(0.068) = –0.00087.



If two stocks have positive covariance, which of the following statements is TRUE?

Your answer: A was incorrect. The correct answer was B) The rates of return tend to move in the same direction relative to their individual means.

This is a correct description of positive covariance.

If one stock doubles in price, the other will also double in price is true if the correlation coefficient = 1. The two

A) 5.B) 3.C) 4.

A) -0.0021.B) -0.0015.C) -0.0009.

A) The two stocks must be in the same industry.B) The rates of return tend to move in the same direction relative to their individual means.C) If one stock doubles in price, the other will also double in price.



stocks need not be in the same industry.



Which of the following statements about return objectives is TRUE?

Your answer: A was incorrect. The correct answer was C) To achieve the capital appreciation objective, the nominal rate of return must exceed the rate of inflation.

The total return objective considers returns from both capital gains and the reinvestment of current income, but is not net of inflation (net of inflation, this is the real total return).



Which of the following inputs is least likely required for the Markowitz efficient frontier? The:

Your answer: A was incorrect. The correct answer was B) level of risk aversion in the market.

The level of risk aversion in the market is not a required input. The model requires that investors know the expected return and variance of each security as well as the covariance between all securities.



A portfolio to the right of the market portfolio on the capital market line (CML) is created by:


Portfolios that lie to the right of the market portfolio on the capital market line are created by borrowing funds to own more than 100% of the market portfolio (M).

A) The total return objective considers returns from both capital gains and current income, net of expected inflation.

B) To achieve the capital appreciation objective, the real rate of return must exceed the rate of inflation.

C) To achieve the capital appreciation objective, the nominal rate of return must exceed the rate of inflation.

A) covariation between all securities.B) level of risk aversion in the market.C) expected return of all securities.

A) holding more than 100% of the risky asset.B) holding both the risk-free asset and the market portfolio.C) fully diversifying.



The statement, "holding both the risk-free asset and the market portfolio" refers to portfolios that lie to the left of the market portfolio. Portfolios that lie to the left of point M are created by lending funds (or buying the risk free-asset). These investors own less than 100% of both the market portfolio and more than 100% of the risk-free asset. The portfolio at point Rf (intersection of the CML and the y-axis) is created by holding 100% of the risk-free asset. The statement, "fully diversifying" is incorrect because the market portfolio is fully diversified.



An investor’s portfolio currently consists of 100% of stocks that have a mean return of 16.5% and an expected variance of 0.0324. The investor plans to diversify slightly by replacing 20% of her portfolio with U.S. Treasury bills that earn 4.75%. Assuming the investor diversifies, what are the expected return and expected standard deviation of the portfolio?


Since Treasury bills (T-bills) are considered risk-free, we know that the standard deviation of this asset and the correlation between T-bills and the other stocks is 0. Thus, we can calculate the portfolio expected return and standard deviation.

Step 1: Calculate the expected return Expected ReturnPortfolio = (wT-bills × ERT-bills) + (wStocks × ERStocks) = (0.20) × (0.0475) + (1.00-0.20) × (0.165) = 0.1415, or 14.15%.

Step 2: Calculate the expected standard deviation When combining a risk-free asset and a risky asset (or portfolio or risky assets), the equation for the standard deviation, σ1,2 = [(w1

2)(σ12) + (w2

2)(σ22) + 2w1w2 σ1 σ2ρ1,2]1/2, reduces to: σ1,2 = [(wStocks)(σStocks)] = 0.80 ×

0.03241/2 = 0.14400, or 14.40%. (Remember to convert variance to standard deviation).



Mason Snow, CFA, is an analyst with Polari Investments. Snow's manager has instructed him to put only securities that are undervalued on the buy list. Today, Snow is to make a recommendation on the following two stocks: Bahre (with an expected return of 10% and a beta of 1.4) and Cubb (with an expected return of 15% and a beta of 2.0). The risk-free rate is at 7% and the market premium is 4%.

Snow places:

ERPortfolio σPortfolio

A) 14.15% 14.40%

B) 14.15% 2.59%

C) 10.63% 2.59%

A) only Cubb on the list.B) neither security on the list.C) only Bahre on the list.



Your answer: A was incorrect. The correct answer was B) neither security on the list.

In the context of the SML, a security is underpriced if the required return is less than the holding period (or expected) return, is overpriced if the required return is greater the holding period (or expected) return, and is correctly priced if the required return equals the holding period (or expected) return. Here, the holding period (or expected) return is calculated as: (ending price – beginning price + any cash flow or dividends) / beginning price. The required return uses the equation of the SML: risk free rate + Beta × (expected market rate - risk free rate).

� For Bahre: ER = 10% (given), RR = 0.07 + (1.4)(0.11-0.07) = 12.6%. Stock is overpriced - do not put on buy list.

� For Cubb: ER = 15%, (given) RR = 0.07 + (2.0)(0.11-0.07) = 15%. Stock is correctly priced - do not put on buy list (per Snow's manager).



Which of the following statements about investment constraints is least accurate?

Your answer: A was incorrect. The correct answer was B) Investors concerned about time horizon are not likely to worry about liquidity.

Investors with a time horizon constraint may have little time for capital appreciation before they need the money. Need for money in the near term is a liquidity constraint. Time horizon and liquidity constraints often go hand in hand. Diversification often requires the sale of an investment and the purchase of another. Investment sales often trigger tax liability. Younger investors should take advantage of tax deferrals while they have time for the savings to compound, and while they are in their peak earning years. Many retirees have little income and face less tax liability on investment returns.



As the correlation between the returns of two assets becomes lower, the risk reduction potential becomes:

Your answer: A was incorrect. The correct answer was B) greater.

Perfect positive correlation (r = +1) of the returns of two assets offers no risk reduction, whereas perfect negative correlation (r = -1) offers the greatest risk reduction.


A) Diversification efforts can increase tax liability. B) Investors concerned about time horizon are not likely to worry about liquidity. C) Unwillingness to invest in gambling stocks is a constraint.

A) smaller.B) greater.C) decreased by the same level.




Which of the following concerning the steps in the portfolio management process is least accurate?

Your answer: A was incorrect. The correct answer was C)

The implementation process focuses on putting the plan that has been devised to work. The portfolio is constructed and assets are allocated based on the investment strategy and market forecasts. The identification of the risk tolerance should be accomplished during the development of the investor’s policy statement, which should occur prior to the implementation of the investment plan.



All portfolios on the capital market line are:

Your answer: A was incorrect. The correct answer was B) perfectly positively correlated.

The introduction of a risk-free asset changes the Markowitz efficient frontier into a straight line. This straight efficient frontier line is called the capital market line (CML). Since the line is straight, the math implies that any two assets falling on this line will be perfectly, positively correlated with each other. Note: When ra,b = 1, then the equation for risk changes to sport = WAsA + WBsB, which is a straight line.



An investor calculates the following statistics on her two-stock (A and B) portfolio.

� σA = 20%

� σB = 15% � rA,B = 0.32 � WA = 70% � WB = 30%

FOCUS ACTIONS

A) Monitoring Feedback loop Update investor’s needs

B) Investment strategy Short-term and intermediate term market expectations

Construct a strategy based on the policy statement

C) Implementation Current and future market conditions

Identify risk tolerance

Implementation Current and future market conditions

Identify risk tolerance

A) unrelated except that they all contain the risk-free asset.B) perfectly positively correlated.C) distinct from each other.



The portfolio's standard deviation is closest to:


The formula for the standard deviation of a 2-stock portfolio is:

σ = [WA2σA

2 + WB2σB

2 + 2WAWBσAσBrA,B]1/2

σ = [(0.72 × 0.22) + (0.32 × 0.152) +( 2 × 0.7 × 0.3 × 0.2 × 0.15 × 0.32)]1/2 = [0.0196 + 0.002025 + 0.004032]1/2 = 0.02565701/2 = 0.1602, or approximately 16.0%.



An investor believes Stock M will rise from a current price of $20 per share to a price of $26 per share over the next year. The company is not expected to pay a dividend. The following information pertains:

� RF = 8%

� ERM = 16% � Beta = 1.7

Should the investor purchase the stock?


In the context of the SML, a security is underpriced if the required return is less than the holding period (or expected) return, is overpriced if the required return is greater the holding period (or expected) return, and is correctly priced if the required return equals the holding period (or expected) return.

Here, the holding period (or expected) return is calculated as: (ending price – beginning price + any cash flows/dividends) / beginning price. The required return uses the equation of the SML: risk free rate + Beta * (expected market rate - risk free rate).

ER = (26 − 20) / 20 = 0.30 or 30%, RR = 8 + (16 − 8) × 1.7 = 21.6%. The stock is underpriced therefore purchase.



The covariance of the market's returns with the stock's returns is 0.008. The standard deviation of the market's returns is 0.1 and the standard deviation of the stock's returns is 0.2. What is the correlation coefficient between the stock and market returns?

A) 0.1600.B) 0.1832.C) 0.0256.

A) Yes, because it is undervalued.B) No, because it is undervalued.C) No, because it is overvalued.




CovA,B = (rA,B)(SDA)(SDB), where r = correlation coefficient and SDx = standard deviation of stock x

Then, (rA,B) = CovA,B / (SDA × SDB) = 0.008 / (0.100 × 0.200) = 0.400

Remember: The correlation coefficient must be between -1 and 1.



The reaction of stock prices to the announcement of a stock split is covered by which form of the efficient market hypothesis (EMH)?


Semistrong.

The semistrong form of the EMH asserts that security prices fully reflect all publicly available information. Announcement type information such as that related to stock splits is an example of publicly available information.



Which of the following is NOT a rationale for investing in index funds?

Your answer: A was incorrect. The correct answer was C) Minimize risk.

The minimization of risk is not a rationale for investing in index funds.



Which of the following statements about the assumptions of efficient capital markets and the conclusion of the efficient market hypothesis is least accurate?

A) 0.40. B) 0.91. C) 0.00016.

A) Weak. B) Strong. C) Semistrong.

A) Active mutual fund managers underperform index funds.B) Efficient financial markets.C) Minimize risk.




Several strategies have been shown to produce abnormal returns (returns above the market after adjusting for risk). Small firms and firms with low price to earnings (P/E) ratios and high book-to-market values have all been found to produce positive abnormal returns.



Which of the following is a securities market characterized by matching large buy and sell orders on electronic crossing networks?

Your answer: A was incorrect. The correct answer was B) Fourth market.

The fourth market refers to alternative trading systems, including electronic communications networks and electronic crossing networks.



A stock's abnormal rate of return is defined as the:


Abnormal return = Actual return – expected risk-adjusted return

This question tested from Session 13, Reading 54, LOS b, (Part 1).


Which of the following statements regarding secondary markets is least accurate? Secondary markets are important because they provide:

A) Tests of market efficiency have found no strategy that produces excess returns above the market after accounting for transaction costs.

B) If markets are efficient, investors should not trade often.C) In testing for semistrong-form market efficiency, researchers typically adjust for the stock's risk.

A) OTC market.B) Fourth market.C) New York Stock Exchange.

A) actual rate of return less the expected risk-adjusted rate of return. B) rate of return during abnormal price movements. C) expected risk-adjusted rate of return minus the market rate of return.

A) regulators with information about market participants.B) investors with liquidity.




Secondary markets are important because they provide liquidity and continuous information to investors. The liquidity of the secondary markets adds value to both the investor and firm because more investors are willing to buy issues in the primary market, when they know these issues will later become liquid in the secondary market. Therefore, the secondary market makes it easier for firms to raise external capital.



Which of the following statements about securities exchanges is most accurate?

Your answer: A was incorrect. The correct answer was B) Call markets are markets in which the stock is only traded at specific times.

Continuous markets are markets where trades occur at any time the market is open (i.e. they do not need to be open 24 hours per day). Setting one negotiated price is a method used in major continuous markets to set the opening price.



Which of the following statements about securities exchanges is FALSE?

Your answer: A was incorrect. The correct answer was B) In continuous markets, prices are set only by the auction process.

In continuous markets, the price is set by either the auction process or by dealer bid-ask quotes.



Which of the following is a limitation to fully efficient markets?

C) firms with greater access to external capital.

A) Continuous markets are markets where trades occur 24 hours per day.B) Call markets are markets in which the stock is only traded at specific times.

C) Setting a negotiated price to clear the market is a method used to set the closing price in major continuous markets.

A) In call markets, there is only one negotiated price set to clear the market for a given stock.B) In continuous markets, prices are set only by the auction process. C) Securities exchanges may be structured as call markets or continuous markets.

A) There are no limitations to fully efficient markets because the trading actions of fundamental and technical analysts are continuously keeping prices at their intrinsic value.



Your answer: A was incorrect. The correct answer was B) The gains to be earned by information trading can be less than the transaction costs the trading would entail.

Market prices that are not precisely efficient can persist if the gains to be made by information trading are less than the transaction costs such trading would entail.



Which of the following statements about the financial markets is least accurate?


The Federal Reserve sets margin requirements.



Which of the following statements about securities markets is least accurate?

Your answer: A was incorrect. The correct answer was C) Initial public offerings (IPOs) are sold in the secondary market.

IPOs are sold in the primary market.



Which of the following is NOT an assumption that underlies an efficient capital market?

B) The gains to be earned by information trading can be less than the transaction costs the trading would entail.

C) Information is always quickly disseminated and fully embedded in a security’s prices.

A) The New York Stock Exchange sets the initial margin requirements for stocks.B) Exchange listed stocks trading over the counter are called the third market.

C) The National Association of Securities Dealers Automated Quotation system (NASDAQ) is an electronic quotation system for the OTC market.

A) A market that features low transactions costs is said to have internal efficiency.B) In a continuous market, a security can trade any time the market is open.C) Initial public offerings (IPOs) are sold in the secondary market.

A) The expected returns implicitly include risk in the price of the security.

B) New information comes to the market in a random fashion and the timing of the news announcements are independent of each other.

Investors adjust their estimate of security prices slowly to reflect their interpretation of the new




Investors adjust their estimate of security prices slowly to reflect their interpretation of the new information received.

Investors adjust their estimate of security prices rapidly to reflect their interpretation of the new information.



David Farrington is an analyst at Farrington Capital Management. He is aware that many people believe that the capital markets are fully efficient. However, he is not convinced and would like to disprove this claim. Which of the following statements would support Farrington in his effort to demonstrate the limitations to fully efficient markets?

Your answer: A was incorrect. The correct answer was B) Processing new information entails costs and takes at least some time, so security prices are not always immediately affected.

If market prices are efficient there are no returns to the time and effort spent on fundamental analysis. But if no time and effort is spent on fundamental analysis there is no process for making market prices efficient. To resolve this apparent conundrum one can look to the time lag between the release of new value-relevant information and the adjustment of market prices to their new efficient levels. Processing new information entails costs and takes at least some time, which is a limitation of fully efficient markets.



With respect to behavioral finance, the tendency to place too much faith in an earnings forecast is known as:


The tendency to place too much faith in an earnings forecast falls under the heading of overconfidence bias in the context of behavioral finance.



C) information received.

A) Stock prices adjust to their new efficient levels within hours of the release of new information.

B) Processing new information entails costs and takes at least some time, so security prices are not always immediately affected.

C) Technical analysis has been rendered useless by many academics who have shown that analyzing market trends, past volume and trading data will not lead to abnormal returns.

A) overconfidence bias.B) anchoring.C) confirmation bias.



An investor buys 1,000 shares of a non-dividend-paying stock for $18. The initial margin requirement is 40% and the maintenance margin is 30%. After one year the investor sells the stock for $24 per share. The investor's rate of return on this investment (ignoring borrowing and transactions costs and taxes), and the price at which the investor would receive a margin call, are closest to:

Rate of return Margin call


To obtain the result:

Part 1: Calculate Margin Return:

Margin Return % = [((Ending Value - Loan Payoff) / Beginning Equity Position) – 1] * 100 =

= [(([$24 × 1,000] – [$18 × 1,000 × 0.60]) / ($18 × 0.40 × 1,000)) – 1] × 100 =

= 83.33%

Alternative (Check): Calculate the all cash return and multiply by the margin leverage factor.

= [(24,000 – 18,000)/18,000] × [1 / 0.40] = 33.33% × 2.5 = 83.33%

Part 2: Calculate Margin Call Price:

Since the investor is long (purchased the stock), the formula for the margin call price is:

Margin Call = (original price) × (1 – initial margin) / (1 – maintenance margin)

= $18 × (1 – 0.40) / (1 – 0.30) = $15.43

This question tested from Session 13, Reading 52, LOS g, (Part 2).


At a recent seminar on Capital Market Efficiency, David Thorngate, a seasoned arbitrageur wanted to dispel the notion that all arbitrage trades are successful. During his speech, he made the following statements regarding arbitrage and the ability of arbitrageurs to correct market anomalies:

Statement 1: There are limits on the ability of arbitrage to bring about efficient prices. Arbitrage is frequently not riskless. Just because fundamentals indicate that one stock is undervalued or overvalued relative to another does not mean that trading on this information will be profitable.

Statement 2: Even in "pairs trading," where an arbitrageur buys the underpriced security and shorts the overpriced security, significant risk from stock-specific factors remains. So, there is no guarantee that even correctly identified relative mispricings of similar stocks will be corrected in the near term.

Are Statement 1 and Statement 2 as made by Thorngate correct?

A) 83% $15.43 B) 83% $21.00 C) 33% $15.43




There are limits on the ability of arbitrage to bring about efficient prices. Arbitrage is frequently risky. Just because fundamentals indicate that one stock is overpriced relative to another, or absolutely over or underpriced, doesn’t mean that trading based on this information will be profitable. Even in pairs trading, where an arbitrageur buys the underpriced security and shorts the overpriced security, significant risk from stock-specific factors remains. There is no guarantee that even correctly identified relative mispricings of similar stocks will be corrected in the near term.



Which of the following is NOT a reason bond market indexes are more difficult to create than stock market indexes?


Bond deviations tend to be relatively constant.

Bond prices are quite volatile as measured by the bond’s duration.



Which of the following conclusions about the semistrong form of the efficient market hypothesis (EMH) and the strong-form EMH is least accurate?

Your answer: A was incorrect. The correct answer was B) Neglected firms (i.e., those firms with a small number of analysts following them) tend to underperform the market.

Neglected firms tend to outperform the market.

Statement 1 Statement 2

A) Incorrect CorrectB) Correct CorrectC) Correct Incorrect

Correct Correct

A) The universe of bonds is much broader than that of stocks. B) Bond deviations tend to be relatively constant. C) There is a lack of continuous trade data available for bonds.

A) Some tests reject the semistrong form of market efficiency.

B) Neglected firms (i.e., those firms with a small number of analysts following them) tend to underperform the market.

C) If the strong form of market efficiency were true, there would be no need for insider trading laws.





Which of the following statements about securities markets is least accurate?

Your answer: A was incorrect. The correct answer was C) A limit buy order and a stop buy order are both placed below the current market price.

A limit buy is placed below the current market price, but a stop buy order is placed above the current market price (stop buy orders are often placed to protect a short sale from a rising market).

The other choices are true. A well-functioning securities market includes the following characteristics:

� timely and accurate information on price and volume of past transactions. � timely and accurate information on the supply and demand for current transactions.

� liquidity (as indicated by low bid-ask spreads).

� marketability.

� price continuity.

� depth (many buyers and sellers willing to transact above and below the current price).

� internal efficiency (low transaction costs).

� informational/external efficiency (rapidly adjusting prices).



Tests using quarterly earnings reports are tests of which form(s) of the efficient markets hypothesis (EMH)?


The semistrong form of the EMH asserts that security prices fully reflect all publicly available information. Announcement type information such as that related to earnings is an example of publicly available information.



An investor bought a stock on margin. The margin requirement was 60%, the current price of the stock is $80, and

A)Characteristics of a well-functioning securities market include: many buyers and sellers willing to trade at below market price, low bid-ask spreads, timely information on price and volume of past transactions, and accurate information on supply and demand.

B) Secondary markets, such as the over-the-counter (OTC) market, provide liquidity and price continuity.C) A limit buy order and a stop buy order are both placed below the current market price.

A) Semistrong-form. B) They are used to test all three forms. C) Weak-form.



the investor paid $50 for the stock 1 year ago. If margin interest is 5%, how much equity did the investor have in the investment at year-end?


Margin debt = 40% × $50 = $20; Interest = $20 × 0.05 = $1.

Equity % = [Value – (margin debt + interest)] / Value

$80 - $21 / $80 = 73.8%



If an investor buys 100 shares of a $50 stock on margin when the initial margin requirement is 40%, how much money must she borrow from her broker?

Your answer: A was incorrect. The correct answer was B) $3,000.

An initial margin requirement of 40% would mean that the investor must put up 40% of the funds and brokerage firm may lend the 60% balance. Therefore, for this example (100 shares) * ($50) = $5,000 total cost. $5,000 * 0.60 = $3,000.



With regard to stock market indexes, it is least likely that:

Your answer: A was incorrect. The correct answer was B) a value-weighted index must be adjusted for stock splits but not for dividends.

A price-weighted index needs to be adjusted for stock splits, but a value-weighted index does not. Neither type of index considers dividend income.

Price weighting produces a downward bias compared to market weighting because firms that split their stocks (which tend to be the more successful firms) decrease in weight within a price-weighted index. The returns on a

A) 73.8%.B) 67.7%.C) 60.6%.

A) $2,000.B) $3,000.C) $4,000.

A) the use of price weighting versus market value weighting produces a downward bias on the index.B) a value-weighted index must be adjusted for stock splits but not for dividends.

C) buying 100 shares of each stock in a price-weighted index will result in a portfolio that tracks the index quite well.



price-weighted index can be matched by purchasing a portfolio with an equal number of shares of each stock in the index.



An investor can profit from a stock price decline by:


selling short.

Short selling provides a way for an investor to profit from a stock price decline. In order to sell short, the broker borrows the security and then sells it for the short seller. Later, if the investor can replace the borrowed securities by repurchasing them at a lower price, then the investor will profit from the transaction.



An investor buys 200 shares of ABC at the market price of $100 on full margin. The initial margin requirement is 40% and the maintenance margin requirement is 25%.

If the shares of stock later sold for $200 per share, what is the rate of return on the margin transaction?

Your answer: A was incorrect. The correct answer was B) 250%.

One quick (and less than intensive) way to calculate the answer to this on the examination (and it is very important to save time on the examination) is to first calculate the return if all cash, then calculate the margin leverage factor and then finally, multiply the leverage factor times the all cash return to obtain the margin return.

Calculations:

Step 1: Calculate All Cash Return:

Cash Return % = [(Ending Value / Beginning Equity Position) – 1] × 100

= [(($200 × 200) / ($100 × 200)) – 1] × 100 = 100%

Step 2: Calculate Leverage Factor:

Leverage Factor = 1 / Initial Margin % = 1 / 0.40 = 2.50

A) placing a stop buy order. B) purchasing a call option. C) selling short.

A) 400%.B) 250%.C) 100%.



Step 3: Calculate Margin Return:

Margin Transaction Return = All cash return × Leverage Factor = 100% × 2.50 = 250%

Note: You can verify the margin return as follows:

Margin Return % = [((Ending Value − Loan Payoff) / Beginning Equity Position) – 1] × 100

= [(([$200 × 200] – [$100 × 200 × 0.60]) / ($100 × 0.40 × 200)) – 1] × 100

= [ ((40,000 − 12,000) / 8,000) − 1] × 100 = 250%



Which of the following statements about arbitrage and market anomalies is most accurate?

Your answer: A was incorrect. The correct answer was C) In pairs trading, where an arbitrageur purchases the underpriced security and shorts the overpriced security, stock-specific risk remains.

Even in pairs trading, where an arbitrageur buys the underpriced security and shorts the overpriced security, significant risk from stock-specific factors remains.



An investor purchases 200 shares of Merxx on margin. The shares are trading at $40. Initial and maintenance margins are 50% and 25%.

Part 1) If the investor sells the stock when the price rises to $50 at year-end, the return on the investment would be closest to:


Profit = 10,000 – 8,000 = 2,000 Return = 2,000 / 4,000 = 50%


A) If an arbitrageur correctly identifies relative mispricings of similar stocks the correction will take place immediately in the marketplace.

B) Investors of the funds that arbitrageurs and traders use are generally too patient and fail to remove funds in a timely manner when trades go against them.

C) In pairs trading, where an arbitrageur purchases the underpriced security and shorts the overpriced security, stock-specific risk remains.

A) 25.00%.B) 18.75%.C) 50.00%.



An investor purchases 200 shares of Merxx on margin. The shares are trading at $40. Initial and maintenance margins are 50% and 25%.

Part 2) If the company pays a dividend of $0.75, the return on the investment would be closest to:


Dividends income = (0.75) × (200) = $150 Profit = 10,000 – 8,000 + 150 = 2,150 Return = 2,150 / 4,000 = 53.75%



Which of the following is least likely an assumption behind the semistrong-form of the efficient market hypothesis (EMH)?


All information is cost-free and available to everyone at the same time.

The strong-form EMH assumes all information, both public and private, is cost-free and available to all investors at the same time.



Tamber Benz, CFA, recently joined Bay Area Investment Group as a personal financial planner. Today, she has a meeting with a client interested in equity index funds, with a particular interest in learning about the source and direction of biases. In preparation for this meeting, she makes some quick notes (relying on her memory). These notes are listed below. She then finds her well-worn CFA study notes and checks her memory. After reviewing her notes, which of the following choices does she determine is least accurate?

Your answer: A was incorrect. The correct answer was C) An index such as the Valueline Composite Average is

A) 39.55%.B) 53.75%.C) 15.75%.

A) The timing of news announcements are independent of each other. B) A large number of profit-maximizing participants. C) All information is cost-free and available to everyone at the same time.

A) A market value-weighted index, such as the New York Stock Exchange Index, accurately reflects the impact of price changes on wealth.

B) The Dow Jones Industrial Index has a built-in downward bias.

C)An index such as the Valueline Composite Average is constructed by purchasing an equal number of shares of each stock in the index, and will have a downward bias when geometric averaging is used to compute the return.



constructed by purchasing an equal number of shares of each stock in the index, and will have a downward bias when geometric averaging is used to compute the return.

Although the latter part of this statement is correct, the first part is incorrect. The Valueline Composite Average is an unweighted price indicator series, and is constructed by maintaining an equal dollar investment in each stock in the index. The return of an unweighted index is usually calculated using a geometric average. Assuming the existence of volatility, the geometric average will always be lower than the arithmetic average.

The other statements are true. The Dow Jones Industrial Index is a price-weighted index and thus has a built-in downward bias because of the impact of stock splits. After a stock split, the denominator is adjusted downward to keep the index at the same level as before the split. Since high-growth companies tend to announce stock splits more frequently than low-growth companies, the larger, more successful firms lose influence on the index. The NYSE index, as well as the S&P 500 index is a market-value weighted index. One problem with market-value weighted indexes is that firms with greater market capitalization have more impact than other firms. If these firms also have higher returns, the firms can dominate the index.



Which of the following statements regarding growth companies and growth stocks is TRUE? A growth:

Your answer: A was incorrect. The correct answer was C) company has management that has the ability to consistently select projects that earn higher returns than required by their risk.

If the market has identified the company as a growth company and bid up the price, the stock may have below normal returns. The stock price may be more (typically) or less than intrinsic value.



A firm will not pay dividends until four years from now. Starting in year four dividends will be $2.20 per share, the retention ratio will be 40%, and ROE will be 15%. If k = 10%, what should be the value of the stock?

Your answer: A was incorrect. The correct answer was C) $41.32.

g = ROE × retention ratio = ROE × b = 15 × 0.4 = 6%

Based on the growth rate we can calculate the expected price in year 3:

P3 = D4 / (k − g) = 2.2 / (0.10 − 0.06) = $55

A) company will earn above normal returns given its risk. B) stock is one that has a price that is greater than its intrinsic value.

C) company has management that has the ability to consistently select projects that earn higher returns than required by their risk.

A) $55.25.B) $58.89.C) $41.32.



The stock value today is: P0 = PV (55) at 10% for 3 periods = $41.32



When a company’s return on equity (ROE) is 12% and the dividend payout ratio is 60%, what is the implied sustainable growth rate of earnings and dividends?


g = ROE × retention ratio = ROE × (1 – payout ratio) = 12 (0.4) = 4.8%



An analyst gathered the following data:

� An earnings retention rate of 40%. � An ROE of 12%. � The stock's beta is 1.2. � The nominal risk free rate is 6%. � The expected market return is 11%.

Assuming next year's earnings will be $4 per share, the stock’s current value is closest to:


Dividend payout = 1 − earnings retention rate = 1 − 0.4 = 0.6

RS = Rf + β(RM − Rf) = 0.06 + 1.2(0.11 − 0.06) = 0.12

g = (retention rate)(ROE) = (0.4)(0.12) = 0.048

D1 = E1 × payout ratio = $4.00 × 0.60 = $2.40

Price = D1 / (k – g) = $2.40 / (0.12 – 0.048) = $33.32



A) 4.0%.B) 4.8%.C) 7.8%.

A) $33.32.B) $26.67.C) $45.45.



In its latest annual report, a company reported the following:

Based on the sustainable growth model, the most likely forecast of the company’s future earnings growth rate is:

Your answer: A was incorrect. The correct answer was B) 12%.

g = (RR)(ROE)

RR = 1 − dividend payout ratio = 1 − 0.4 = 0.6

ROE = NI / Total Equity = 1,000,000 / 5,000,000 = 1 / 5 = 0.2 Note: This is the "simple" calculation of ROE. Since we are only given these inputs, these are what you should use. Also, if given beginning and ending equity balances, use the average in the denominator.

g = (0.6)(0.2) = 0.12 or 12%



Using the constant growth dividend discount model to value a firm whose growth rate is greater than its required return on equity would result in a value that is:


negative.

For the constant growth DDM to work k must be greater than g.



An increase in a firm’s stock price will, all else equal, cause the price to cash flow (P/CF) ratio to:

Net income = $1,000,000Total equity = $5,000,000Total assets = $10,000,000Dividend payout ratio = 40%

A) 6%.B) 12%.C) 8%.

A) finite but unknown. B) negative. C) infinite.

A) there is insufficient information to tell.B) decrease.C) increase.



Your answer: A was incorrect. The correct answer was C) increase.

An increase in a firm’s stock price will, everything else being equal (i.e., the CF does not change), cause the P/CF ratio to increase.



Which of the following is least likely a risk factor in an equity risk premium for foreign investments?


Technology risk is not considered a relevant risk factor in assessing a country’s equity risk premium. The relevant factors include business risk, financial risk, liquidity risk, exchange rate risk, and country risk.

This question tested from Session 14, Reading 56, LOS e, (Part 2).


Which of the following statements concerning security valuation is least accurate?

Your answer: A was incorrect. The correct answer was B) The retention rate in the dividend discount model is one minus the growth rate.

The retention rate is one minus the dividend payout ratio.



Given the following information, compute price/book value.

� Book value of assets = $550,000 � Total sales = $200,000 � Net income = $20,000 � Dividend payout ratio = 30% � Operating cash flow = $40,000 � Price per share = $100 � Shares outstanding = 1000 � Book value of liabilities = $500,000

A) Technology risk.B) Business risk.C) Exchange rate risk.

A) The top-down approach to security valuation starts with an examination of the economy of each country.

B) The retention rate in the dividend discount model is one minus the growth rate.C) A common stock with no growth in the dividend is valued like preferred stock.



Your answer: A was incorrect. The correct answer was B) 2.0X.

Book value of equity = $550,000 - $500,000 = $50,000

Market value of equity = ($100)(1000) = $100,000

Price/Book = $100,000/$50,000 = 2.0X


Question 100 - #96211

If a stock sells for $50 that has an expected annual dividend of $2 and has a sustainable growth rate of 5%, what is the market discount rate for this stock?


k = [(D1 / P) + g] = [(2/50) + 0.05] = 0.09, or 9.00%.


Question 101 - #96373

Given the following information, compute the price/cash flow ratio for EAV Technology.

� Net income per share = $6 � Price per share = $100 � Depreciation per share = $2 � Interest expense per share = $4 � Marginal tax rate = 25%


Cash Flow = Net income per share + Depreciation per share = $6 + $2 = $8

Price/cash flow = $100 / $8.0X = 12.5X


A) 5.5X.B) 2.0X.C) 2.5X.

A) 9.0%.B) 7.5%.C) 10.0%.

A) 12.5X.B) 8.3X.C) 9.1X.



Question 102 - #96196

If a company can convince its suppliers to offer better terms on their products leading to a higher profit margin, the return on equity (ROE) will most likely:

Your answer: A was incorrect. The correct answer was B) increase and the stock price will increase

Better supplier terms lead to increased profitability. Better profit margins lead to an increase in ROE. This leads to an increase in the dividend growth rate. The difference between the cost of equity and the dividend growth rate will decline, causing the stock price to increase.


Question 103 - #96383

The price to book value ratio (P/BV) is a helpful valuation technique when examining firms:

Your answer: A was incorrect. The correct answer was C) that hold primarily liquid assets.

P/BV analysis works best for firms that hold primarily liquid assets.


Question 104 - #96356

A company has 8 percent preferred stock outstanding with a par value of $100. The required return on the preferred is 5 percent. What is the value of the preferred stock?


The annual dividend on the preferred is $100(.08) = $8.00. The value of the preferred is $8.00/0.05 = $160.00.


Question 105 - #96294

If the risk-free rate is 5%, the market rate is 12%, and the beta of a stock is 0.5, what would happen to the

A) increase and the stock price will decline.B) increase and the stock price will increaseC) decrease and the stock price will increase.

A) with older assets compared to those with newer assets. B) with the same stock prices.C) that hold primarily liquid assets.

A) $160.00. B) $152.81. C) $100.00.



required rate of return if the inflation premium increased by 2%? It would:


k0 = 5 + 0.5(12 – 5) = 8.5; k1 = 7 + 0.5(14 – 7) = 10.5


Question 106 - #96141

Assuming a discount rate of 15%, a preferred stock with a perpetual dividend of $10 is valued at approximately:


The formula for the value of preferred stock with a perpetual dividend is: D / kp, or 10.0 / 0.15 = $66.67.


Question 107 - #96267

A company currently has a required return on equity of 14% and an ROE of 12%. All else equal, if there is an increase in a firm’s dividend payout ratio, the stock's value will most likely:


increase.

Increase in dividend payout/reduction in earnings retention.In this case, an increase in the dividend payout will likely increase the P/E ratio because a decrease in earnings retention will likely increase the P/E ratio. The logic is as follows: Because earnings retention impacts both the numerator (dividend payout) and denominator (g) of the P/E ratio, the impact of a change in earnings retention depends upon the relationship of ke and ROE. If the company is earning a lower rate on new projects than the rate required by the market (ROE < ke), investors will likely prefer that the company pay out earnings rather than investing in lower-yield projects. Since an increase in the dividend payout would decrease earnings retention, the P/E ratio would rise, as investors will value the company higher if it retains a lower percentage of earnings.


A) increase to 10.5. B) increase to 15. C) remain the same.

A) $66.67.B) $1.50.C) $8.70.

A) either increase or decrease. B) increase. C) decrease.



Question 108 - #96247

A firm has a profit margin of 10%, an asset turnover of 1.2, an equity multiplier of 1.3, and an earnings retention ratio of 0.5. What is the firm's internal growth rate?


ROE = (EAT / Sales)(Sales / Total Assets)(Total Assets)

ROE = (0.1)(1.2)(1.3) = 0.156

g = (retention ratio)(ROE) = 0.5(0.156) = 0.078 or 7.8%


Question 109 - #96384

The current price of XYZ, Inc., is $40 per share with 1,000 shares of equity outstanding. Sales are $4,000 and the book value of the firm is $10,000. What is the price/sales ratio of XYZ, Inc.?


The price/sales ratio is (price per share)/(sales per share) = (40)/(4,000/1,000) = 10.0. Alternatively, the price/sales ratio may be thought of as the market value of the company divided by its sales, or (40 × 1,000)/4,000, or 10.0 again.


Question 110 - #96309

If the real risk-free rate is 5%, and the expected rate of inflation is 1%, what is the estimated nominal risk-free rate?


The nominal risk free rate = (1 + Real risk-free rate)(1+ Expected Inflation) – 1, (1.05) x (1.01)-1 = 6.05%.


A) 6.7%.B) 7.8%.C) 4.5%.

A) 0.010.B) 4.000.C) 10.000.

A) 0.02%.B) 6.05%.C) 4.00%.



Question 111 - #96207

All of the following factors affects the firm’s P/E ratio EXCEPT:

Your answer: A was incorrect. The correct answer was B) the expected interest rate on the bonds of the firm.

The factors that affect the P/E ratio are the same factors that affect the value of a firm in the infinite growth dividend discount model. The expected interest rate on the bonds is not a significant factor affecting the P/E ratio.


Question 112 - #96391

Which of the following statements regarding price multiples is most accurate?

Your answer: A was incorrect. The correct answer was B) An advantage of the price/sales ratio is that it is meaningful even for distressed firms.

The P/S ratio is meaningful even for distressed firms, since sales revenue is always positive. This is not the case for the P/E and P/BV ratios, which can be negative.

In the P/BV ratio book value is an appropriate measure of net asset value for firms that primarily hold liquid assets.

Analysts use several different definitions of cash flow (CFO, adjusted CFO, FCFE, EBITDA, etc.) to calculate P/CF ratios.

When earnings are negative, the P/E ratio is meaningless.


Question 113 - #96366



A) the required rate of return.B) the expected interest rate on the bonds of the firm.C) growth rates of dividends.

A) A disadvantage of the price/book value ratio is that it is not an appropriate measure for firms that primarily hold liquid assets.

B) An advantage of the price/sales ratio is that it is meaningful even for distressed firms.C) A rationale for using the price/cash flow ratio is that there is only one clear definition of cash flow.

A) In the investment process, the most important decision is selecting the proper valuation method.B) Firms with abnormally high return on equity (ROE) will probably retain a large portion of their earnings.

C) If the current price of the security is $15 and the analyst using the dividend discount model determines a value of $10, the analyst should issue a sell recommendation.



In the investment process, the most important decision is asset allocation.


Question 114 - #96370

Which of the following statements regarding the value of the firm is most accurate?

Your answer: A was incorrect. The correct answer was C) A company's legal and treasury departments act to reduce the tax rate from 37.5% to 37.0%, the value of the firm will increase.

A decrease in the tax rate would increase the company’s EPS and thus would increase the value of the firm. (The equation for EPS includes the term (1 − t).)

The other statements are incorrect.

Increase in dividend payout/reduction in earnings retention. In this case, an increase in the dividend payout will likely decrease the P/E ratio because a decrease in earnings retention will likely lower the P/E ratio. The logic is as follows: Because earnings retention impacts both the numerator (dividend payout) and denominator (g) of the P/E ratio, the impact of a change in earnings retention depends upon the relationship of ke and ROE. If the company is earning a higher rate on new projects than the rate required by the market (ROE > ke), investors will likely prefer that the company retain more earnings. Since an increase in the dividend payout would decrease earnings retention, the P/E ratio would fall, as investors will value the company lower if it retains a lower percentage of earnings.

Decrease in the expected inflation rate and decrease in the required rate of return. The expected inflation rate is a component of ke (through the nominal risk-free rate). ke can be represented by the following: nominal risk-free rate + stock risk premium, where nominal risk-free rate = [(1 + real risk-free rate) × (1 + expected inflation rate)] – 1.

� If the rate of inflation decreases, the nominal risk-free rate will decrease.

� ke will decrease.

� The spread between ke and g, or the P/E denominator, will decrease.

� P/E ratio will increase.


Question 115 - #96266

Which of the following does NOT directly affect a company’s required return on equity?

A) The board of directors increases the dividend payout ratio, the value of the company will increase.

B) The government engages in a restrictive monetary policy and the expected inflation rate decreases, the P/E ratio will decrease.

C) A company's legal and treasury departments act to reduce the tax rate from 37.5% to 37.0%, the value of the firm will increase.

A) Return on assets.B) The company’s beta.




The formula for the required return is ke = risk free rate + beta × (market rate – risk free rate).


Question 116 - #96289

Which of the following statements regarding an equity risk premium for foreign investments is most accurate?

Your answer: A was incorrect. The correct answer was B) Firms in different countries assume significantly different financial risk.

Country risk arises from unexpected not expected economic and political events. Exchange rate risk must always be taken into account.


Question 117 - #96170

The yield on a company’s 7.5%, $50 par preferred stock is 6%. The value of the preferred stock is closest to:


The preferred dividend is 0.075($50) = $3.75. The value of the preferred = $3.75 / 0.06 = $62.50.


Question 118 - #96193


Your answer: A was incorrect. The correct answer was B) A stock with a dividend last year of $3.25 per share, an

C) Expected market return.

A) Country risk arises from expected economic and political events.B) Firms in different countries assume significantly different financial risk.C) Exchange rate risk is relatively small and can be ignored.

A) $62.50.B) $12.50.C) $50.00.

A) A stock to be held for two years with a year-end dividend of $2.20 per share, an estimated value of $20.00 at the end of two years, and a required return of 15% is estimated to be worth $18.70 currently.

B) A stock with a dividend last year of $3.25 per share, an expected dividend growth rate of 3.5%, and a required return of 12.5% is estimated to be worth $36.11.

C) A stock with an expected dividend payout ratio of 30%, a required return of 8%, an expected dividend growth rate of 4%, and expected earnings of $4.15 per share is estimated to be worth $31.13 currently.



expected dividend growth rate of 3.5%, and a required return of 12.5% is estimated to be worth $36.11.

A stock with a dividend last year of $3.25 per share, an expected dividend growth rate of 3.5%, and a required return of 12.5% is estimated to be worth $37.33 using the DDM where Po = D1 / (k − g). We are given Do = $3.25, g = 3.5%, and k = 12.5%. What we need to find is D1 which equals Do × (1 + g) therefore D1 = $3.25 × 1.035 = $3.36 thus Po = 3.36 / (0.125 − 0.035) = $37.33.

In the answer choice where the stock value is $18.70, discounting the future cash flows back to the present gives the present value of the stock. the future cash flows are the dividend in year 1 plus the dividend and value of the stock in year 2 thus the equation becomes: Vo = 2.2 / 1.15 + (2.2 + 20) / 1.152 = $18.70

For the answer choice where the stock value is $31.13 use the DDM which is Po = D1 / (k − g). We are given k = 0.08, g = 0.04, and what we need to find is next year’s dividend or D1. D1 = Expected earnings × payout ratio = $4.15 × 0.3 = $1.245 thus Po = $1.245 / (0.08 − 0.04) = $31.13


Question 119 - #96282

The equity risk premium for investing in foreign securities considers which of the following types of risk:


The equity risk premium for foreign investments includes business, financial, liquidity, exchange rate, and country risk.


©2009 Kaplan Schweser. All Rights Reserved.

A) exchange rate risk.B) company-specific risk. C) interest rate risk.

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