Lump Sum Amount - Investment Theory - Past Solved Exam , Exams of Investment Management and Portfolio Theory

Download Lump Sum Amount - Investment Theory - Past Solved Exam and more Exams Investment Management and Portfolio Theory in PDF only on Docsity! INVESTMENT THEORY PLEDGE: "On my honor, I have neither given nor received any unauthorized aid on this exam, nor am I aware of anyone giving or receiving any unauthorized aid on this exam." ________________________________________ Signature ________________________________________ Name (Print) MULTIPLE CHOICE QUESTIONS (50 pts, 1 ea) 1. An investor wants to have $1 million when she retires in 20 years. If she can earn a 10 percent annual return, compounded annually, on her investments, the lump-sum amount she would need to invest today to reach her goal is closest to A. $100,000. B. $117,459. C. $148,644. Correct. PV = $1,000,000/(1+0.1)20 D. $161,506. 2. An individual deposits $10,000 at the beginning of each of the next 10 years, starting today, into an account paying 9 percent interest compounded annually. The amount of money in the account at the end of 10 years will be closest to: A. $109,000. B. $143,200. C. $151,900. D. $165,600. Correct. D. N=10, I/Y=9, PV=0, PMT=-10,000, FV= $151,941.32 × 1.09 = $165,616.04 3. The AIMR Code of Ethics specifically addresses all of the following EXCEPT: A. competence. B. integrity and dignity. C. independent judgment. D. importance of contractual obligations. Correct. 4. An analyst gathered the following data about stocks J, K, and L, which together form a value-weighted index: December 31, Year 1 December 31, Year 2 Stock Price Shares Outstanding Price Shares Outstanding J $40 10,000 $50 10,000 K $30 6,000 $20 12,000* L $50 9,000 $40 9,000 *2 for 1 stock split A. The ending value-weighted index (base index = 100) is closest to: 92.3 1. B. 93.64. C. 106.80. Correct. D. 108.33. docsity.com BUS751 Exam Spring 2007, page 2. 5. 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. Correct. 6. 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. Correct. B. has a reverse split. C. pays a cash dividend. D. is removed and replaced. 7. When an AIMR member has a limited number of shares of an initial public offering to distribute, the member would NOT violate the AIMR Standards of Professional Conduct by: A. allocating the shares pro rata to all subscribers for which the issue is appropriate. Correct. B. first filling the orders of individual clients, then filling the orders of institutional clients. C. first filling the orders of clients who have generated the most commissions during the past year. D. first filling the orders of those who have been clients of the investment professional for the longest period of time. 8. According to the AIMR Standards of Practice Handbook, which of the following statements about a member's use of clients' brokerage commission is FALSE? Client brokerage commissions: A. may be directed to pay for the investment manager's operating expenses. Correct. B. should be used by the member to ensure that fairness to the client is maintained. C. should be commensurate with the value of the brokerage and research services received. D. may be used by the member to pay for securities research used in managing the client's portfolio. 9. 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. Correct. D. is the arithmetic mean of the squared deviations from the mean. 10. In the context of capital market theory, unsystematic risk: A. is described as unique risk. Correct. 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. 11. A normal distribution would least likely be described as: A. asymptotic. B. a discrete probability distribution. Correct. C. a symmetrical or bell-shaped distribution. D. a curve that theoretically extends from negative infinity to positive infinity. 12. An investment strategy has an expected return of 12 percent and a standard deviation of 10 percent. If investment returns are normally distributed, the probability of earning a return less than 2 percent is closest to: A. 10%. B. 16%. Correct. docsity.com BUS751 Exam Spring 2007, page 5. 2002 expected common stock shares outstanding 120,000 The company's 2002 expected earnings per share are closest to: A. $3.26. B. $3.72. C. $3.83. Correct. D. $4.17. 25. Graham Industries has two separate divisions: the Farm Equipment Division and the Household Products Division. Each division accounts for about 50 percent of the company's revenues and assets. Managers now want to enter the toy industry. In assessing the attractiveness of investment projects in the toy industry, Graham should use a required rate of return based on: A. a required return computed for the toy industry. Correct. B. the required rate of return on the market portfolio. C. Graham's current weighted-average cost of capital. D. a weighted-average required return computed for the farm equipment, household products, and toy industries. 26. An industry is currently growing at twice the rate of the overall economy. New competitors are entering the industry and the formerly high profit margins have begun to decline. The life cycle stage that best characterizes this industry is: A. mature growth. Correct. B. pioneering development. C. rapid accelerating growth. D. stabilization and market maturity. 27. An analyst applied the DuPont System to the following data for a company. Equity turnover 4.2 Net profit margin 5.5% Total asset turnover 2.0 Dividend payout ratio 31.8% The company's return on equity is closest to: A. 1.3 %. B. 11.0%. C. 23.1 %. Correct. D. 63.6%. 28. Two companies are identical except for substantially different dividend payout ratios. After several years, the company with the lower dividend payout ratio is most likely to have: A. lower stock price. B. higher debt/equity ratio. C. less rapid growth of earnings per share. D. more rapid growth of earnings per share. Correct. 29. Financial leverage differs from operating leverage because financial leverage accounts for a company's: A. use of debt. Correct. B. variability in sales. C. use of plant and equipment. D. variability in fixed operating costs. 30. A company's return on equity is greater than its required rate of return on equity. The earnings multiplier (FI/E) for that company's stock is most likely to be positively related to the: A. risk-free rate. docsity.com BUS751 Exam Spring 2007, page 6. B. market risk premium. C. earnings retention ratio. Correct. D. stock's Capital Asset Pricing Model beta. 31. The traditional single-factor Capital Asset Pricing Model (CAPM) assumes: A. Market risk measures systematic risk. Correct. The CAPM assumes that a single market risk factor, beta, is all that is required to measure systematic risk. B. A nonlinear risk/return trade-off for individual stocks. Incorrect. The CAPM assumes a linear risk/return tradeoff for individual stocks via the Security Market Line (SML). C. A nonlinear relationship between the excess return on individual securities and the overall market at every point in time. Incorrect. The CAPM assumes a linear relationship between the excess return on individual securities and the overall market at every point in time via the Security Characteristic Line (SCL) D. Portfolio risk is tied to market risk, firm size and P/B ratios. Incorrect. The multifactor CAPM model assumes portfolio risk is tied to several risk factors such as market risk, firm size and P/B ratios. 32. The Security Market Line shows: A. The linear risk/return tradeoff for all investment portfolios. Incorrect. The Capital Market Line (CML) shows the linear risk/return tradeoff for all investment portfolios. B. The linear relationship between the return on individual securities and the overall market at every point in time. Incorrect. The linear relationship between the return on individual securities and the overall market at every point in time is the security characteristic line (SCL). C. How expected rates of return can be a simple function of the amount of systematic risk. Correct. The Security Market Line (SML) shows how expected rates of return can be a simple function of the amount of systematic risk. D. The risk premium relative to total risk. Incorrect. Risk premium relative to total risk is the Sharpe Ratio. 33. Systematic risk is the: A. Return volatility tied to the overall market. Correct. Systematic risk is return volatility tied to the overall market. B. Linear relation between the return on individual securities and the overall market at every point in time. Incorrect. The security characteristic line (SCL) is the linear relation between the return on individual securities and the overall market at every point in time. C. Risk-return trade-off for all investment portfolios. Incorrect. The risk-return trade-off for all investment portfolios is the capital market line.(CML). D. Return volatility specific to a particular company. Incorrect. Unsystematic risk is return volatility specific to a particular company. 34. Unsystematic risk is the: A. Return volatility tied to the overall market. Incorrect. Systematic risk is the return volatility tied to the overall market. B. Return volatility specific to a particular company. Correct. Unsystematic risk is return volatility specific to a particular company. C. Nondiversifiable risk. Incorrect. Nondiversifiable risk is another term for systematic risk. D. None of these. Incorrect. Unsystematic risk is return volatility tied to a particular company. 35. Diversifiable risk is: A. Unsystematic risk. Correct. Diversifiable risk is another term for unsystematic risk. B. Systematic risk. Incorrect. Systematic risk is non-diversifiable risk. docsity.com BUS751 Exam Spring 2007, page 7. C. Return volatility tied to the overall market. Incorrect. Return volatility tied to the overall market is nondiversifiable risk. D. The standard deviation of investment returns. Incorrect. The standard deviation of investment returns is the square root of the variance of the annual rate of return on investment. 36. Non-diversifiable risk is: A. Systematic risk. Correct. Another term for systematic risk is non-diversifiable risk. B. Unsystematic risk. Incorrect. Another term for unsystematic risk is diversifiable risk. C. The return volatility tied to an individual company. Incorrect. Return volatility specific to an individual company is diversifiable risk. D. The sensitivity of a security’s returns to the systematic market risk factor. Incorrect. The sensitivity of a security’s return to the systematic market risk factor is beta. 37. Beta is the: A. Unsystematic risk for an individual stock. Incorrect. Unsystematic risk can be diversified away. B. Systematic risk for an investment portfolio. Correct. Beta is a measure of the systematic risk for an individual stock or an investment portfolio. C. Sensitivity of a security’s return to the diversifiable market risk factor. Incorrect. Beta is the sensitivity of a security’s return to the non-diversifiable market risk factor. D. Sensitivity of a security’s return to competitor returns. Incorrect. Beta is the sensitivity of a security’s return to market returns. 38. The security characteristic line (SCL) is the linear: A. Relation between the excess return on individual securities and the overall market at every point in time. Correct. The security characteristic line (SCL) is the linear relation between the excess return on individual securities and the overall market at every point in time. B. Risk/return tradeoff for all investment portfolios. Incorrect. The linear risk/return tradeoff for all investment portfolios is the capital market line (CML). C. Relation between excess return and unsystematic risk only. Incorrect. The security characteristic line (SCL) shows in precise detail how total risk for an individual security consists of both systematic and unsystematic risk. D. General risk/return tradeoff for individual stocks. Incorrect. The linear risk/return tradeoff for individual stocks is the security market line (SML). 39. Excess Return is the: A. Expected return on a portfolio less the risk-free rate of return. Correct. The excess return is a security or portfolio rate of return less the risk-free rate of return. B. Required return on a stock. Incorrect. The required return on a stock is the nominal risk-free rate of return plus the required risk premium. C. Difference between the expected rate of return and the actual rate of return on a security or portfolio. Incorrect. Excess return is a security or portfolio rate of return less the risk-free rate of return. D. Reward for postponing consumption. Incorrect. The reward for postponing consumption is the risk-free rate of return. 40. Abnormal return is any: A. Above-average return. Incorrect. Excess return is the actual return minus the expected return. Abnormal returns can be positive or negative. B. Return less than the risk-free rate of return. Incorrect. Any return less than the risk-free rate of return is a negative abnormal return, but abnormal returns can be positive or negative. C. Return premium over the risk-free rate. Incorrect. Abnormal returns are measured by any risk- adjusted return premium over the risk-free rate. docsity.com BUS751 Exam Spring 2007, page 10. A. The portfolio has positive risk-adjusted performance. Correct. If α > 0 and is statistically significant, the portfolio has returned a positive risk-adjusted performance to its owners. B. Demonstrates above-average unsystematic risk. Incorrect. Alpha is not related to unsystematic risk. C. Demonstrates above-average systematic risk. Incorrect. If β = 1, the portfolio demonstrates above-average systematic risk. D. Demonstrates above-average total risk. Incorrect. Alpha is not related to total risk. 50. Assume the standard deviation for a portfolio is 10%, T-bills yield 3.5%, the market portfolio return is 9%, and the market portfolio standard deviation is 18%. According to the CML, the expected return on the portfolio is: A. 13.4%. Incorrect. Here, risks for the portfolio and market are inverted. E(R p ) = 3.5 + (18% /10%)(9% - 3.5%) = 13.4%. B. 6.58%. Correct. E (R p ) = 3.5 + (10% / 18%) (9% -3.5%) = 6.58%. C. 26%. Incorrect. Here, risks for the portfolio and market are inverted and market returns and the risk-free rate are incorrectly added. E (R p ) = 3.5 + (18% /10%)(9% + 3.5%) = 26%. D. 9.61%. Incorrect. Here, the return for the market portfolio is used instead of market risk. E (R p ) = 3.5 +(10 % / 9%)(9%-3.5%) = 9.61%. SHORT PROBLEMS (ONE PAGE EACH) (50 pts., 5 ea.) 1. Describe the essential difference between the way securities are bought and sold on the floor of the NYSE versus Nasdaq. Solution On the floor of the New York Stock Exchange, a NYSE exchange specialist maintains orderly auction market during 9:30 AM-4:00 PM ET hours. The specialist acts as a broker for member firms, and as a dealer out of own inventory. In contrast, the OTC is a negotiated market in which investors deal directly with market makers. No stringent listing or dealer requirements are present. 2. General Motors (GM) is the world=s largest auto manufacturer. According to The Value Line Investment Survey, dividends are expected to be stable at $2 per share for the foreseeable future. If the stock is fairly priced in an efficient stock market at 36.36, use the constant growth (Gordon) model to calculate the required rate of return for current stockholders. Solution According to the constant growth (Gordon) model, k = D1/P0 + g. If the stock presently sells for 36.36 per share and is expected to pay a $2 dividend indefinitely, the constant growth (Gordon) model estimate of the required rate of for current stockholders is k = D1/P0 + g = 2/36.36 + 0% = 5.5% per year. 3. On March 8, 2005, the Dow Jones Industrial Average closed at 10,805.62 when a divisor of roughly 0.135 was used. At that time, how much would it have cost to form a portfolio comprised of a round lot of each component stock? Would such a portfolio exactly mimic the stock-market performance of the Dow Jones Industrial Average? Solution The DJIA is a price-weighted index of 30 large companies selected by the editors of The Wall Street Journal as indicative of the direction of the overall stock market. As of mid-2005, these 30 companies had a combined market capitalization of $3.8 trillion, and accounted for approximately 25.5% of the $14.9 trillion full market capitalization Dow Jones Wilshire 5000 Composite Index. To construct a portfolio that exactly mimics the stock-market performance of the Dow Jones Industrial Average, an individual investor need only buy an equal number of shares of stock in each of the DJIA 30 stocks. For example, in mid-2005, the DJIA divisor stood at roughly 0.135. This means that the DJIA = 10,805.62 = Σ Prices/0.135, and that Σ Prices = 10,805.62 Η 0.135 = 10,805.62 Η 0.135 = $1,458.76. If an investor then bought 100 shares of stock in each DJIA component, the total amount invested would be $145,876 (= $1,458.76 Η 100 shares), and such a portfolio would exactly mimic the stock-market performance of the DJIA. docsity.com BUS751 Exam Spring 2007, page 11. 4. What is the difference between a firm-price and a best-efforts offering? Solution An investment banker manages syndicate distribution of corporate stocks and bonds on a firm-price (dealer) or best-efforts (broker) basis. In a firm-price offering the investment banker buys and resells the entire issue. In a best-efforts offering, the investment banker merely acts as a broker with no commitment to hold inventory in the event of offering failure. 5. Covariance and correlation indicate the extent to which returns move up or down together. Explain the underlying similarities and differences in detail. Solution Covariance is defined as: where i and j are index or security returns. Correlation is defined as: 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 -4 and +4; correlation is a relative measure of comovement that varies between -1 and +1. 6. Starbucks Corporation (SBUX) is rightly famous for its brewed coffees, Italian-style espresso beverages, cold blended beverages, and a variety of food items. SBUX stock has been a volatile standout performer, rising from a split-adjusted price of 24.97 (on Dec. 31, 2000), to 23.77 (2001), 22.72 (2002), 36.61 (2003), to 54 (2004). Calculate the arithmetic average rate of return on Starbucks Corp. (SBUX) common stock over the 2001-04 period. Explain any differences between the arithmetic average and the geometric mean. Solution To compute the arithmetic average, simple average the annual returns over 4 years. Arithmetic average = (- 4.8% - 4.4% + 61.1% + 47.5%)/4 = 25%. Notice that the arithmetic average of 25% per year substantially exceeds the geometric mean (true return) over this period. The arithmetic average is biased upwards in the case of highly volatile returns because it fails to account for the fact that downside volatility is limited to +100%, but the upside is unlimited. 7. Louise and Christopher Maclin live in London, United Kingdom, and currently rent an apartment in the metropolitan area. During an initial discussion of the Maclins’ financial plans, Christopher Maclin makes the following statements to the Maclins’ financial advisor, Grant Webb: A. “I have used the Internet extensively to research the outlook for the housing market over the next five years, and I believe now is the best time to buy a house.” B. “I do not want to sell any bond in my portfolio for a lower price than I paid for the bond.” C. “I will not sell any of my company stock because I know my company and I believe it has excellent prospects for the future.” Identify the behavioral finance concept most directly exhibited in each of Maclin’s three statements. Explain how each behavioral finance concept is affecting Maclin’s investment decision-making. Solution A. I have used the Internet extensively: N )R-R)(R-R( = Cov jjtiit N =0t ij Σ σσ ji ij ij Cov = r docsity.com BUS751 Exam Spring 2007, page 12. i) Illusion of knowledge: Maclin believes he is an expert on, and can make accurate forecasts about, the real estate market, solely because he has studied housing market data on the Internet. He may have access to a large amount of real estate-related information, but he may not understand how to analyze the information nor have the ability to apply it to a proposed investment. ii) Overconfidence: Overconfidence causes us to misinterpret the accuracy of our information and our skill in analyzing it. Maclin has assumed that the information he collected on the internet is accurate without attempting to verify it or consult other sources. He also assumes he has skill in evaluating and analyzing the real estate-related information he has collected, although there is no information in the question that suggests he posses such ability. B. “I do not want to sell...” i) Reference point: Maclin’s reference point for his bond position is the purchase price, as evidenced by the fact that he will not sell a position for less than he paid for it. This fixation on a reference point, and the subsequent waiting for the price of the security to move above that reference point before selling the security, prevents Maclin from undertaking a risk/return-based analysis of his portfolio position. C. “I will not sell an...” i) Familiarity: Maclin is evaluating his holding of company stock based on his familiarity with the company rather than on sound investment and portfolio principles. Company employees, because of this familiarity, may have a distorted perception of their own company, assuming a “good company” will also be a good investment. Irrational investors believe an investment in a company with which they are familiar will produce higher returns and have less risk than non-familiar investments. ii) Representativeness: Maclin is confusing his company (which may well be a good company) with the company’s stock (which may or may not be an appropriate holding for his portfolio and/or a good investment) and its future performance. This can result in employees overweighting their company stock resulting in an under-diversified portfolio. 8. A necessary condition for stock-market efficiency is that changes in stock prices be random and unpredictable. Is this also a sufficient condition for market efficiency? Solution: No. In the short term, theory and evidence tell us that stock prices are equally apt to rise or fall in an efficient market. However, in an efficient stock market, changes in stock prices are random. Stock prices are not random, as if simply affected by investor psychology, moon spots, or whatever. In an efficient stock market, the price for any given stock effectively represents the expected net present value of all future profits. In this calculation, profits are discounted by using a fair or risk-adjusted rate of return. If the stock market is to be perfectly efficient, there must be a large number of buyers and sellers of essential identical securities, information must be free and readily available, and entry and exit by market players must be uninhibited. 9. Market professionals are bombarded with real-time, historical and descriptive data, analytics and news on markets and securities. On what level(s) is the idea that such data can be used to identify superior investment opportunities a violation of the Efficient Market Hypothesis? Solution: The idea that such data can be used to identify superior investment opportunities a violation of the weak-form and semi-strong forms of the Efficient Market Hypothesis. The weak-form hypothesis involves the easiest or lowest hurdle that must be met for one to argue that the stock market is efficient. According to the weak-form hypothesis, stock and bond prices reflect all prior price and trading volume activity. As such, in an efficient stock market, it would not be possible to earn above-market returns by buying or selling stocks on the premise that they are going up on price momentum, or bound to rise on a quick reversal of Apanic selling.@ In a market that is perfectly efficient, there is no such thing as panic selling, nor panic buying for that matter. All buying and selling are fully informed and unbiased in their assessment of the intrinsic value of the company=s future prospects. The semi-strong form hypothesis is somewhat more strict than the weak-form hypothesis. According to the semi-strong form hypothesis, no investor can obtain an edge by buying or selling stocks on the basis docsity.com