Investments - Quiz and Case Study Flashcards. 3 Chapters down

Which of the following is an assumption of Modern Portfolio Theory?

Modern Portfolio Theory maintains markets are efficient, investors have full knowledge and are rational and risk averse and prefer portfolios with the highest return for a given level of risk, lying on the Efficient Frontier curve.

Which of the following is a key difference between equities and fixed-income investments?

Equities represent ownership in the company while fixed income investment represents a loan to the company without any ownership in the company.

be classified as an Investment Adviser under SEC regulations?

Remember the "ABC" rule: he or she is providing advice, is in the business of providing advice and for compensation.

IPO

An IPO is the first time shares of the company are offered for sale to the public.

In a monopolistic competition market structure, firms typically:

Monopolistic competition features many firms selling similar but differentiated products, allowing each firm some pricing power through product differentiation.

The primary market is distinguished from the secondary market in that the primary market:

Involves the initial issuance of securities directly from the issuer to investors

Which of the following are the five basic types of market structures?

perfect competition, monopolistic competition, oligopoly, monopoly, and monopsony

The Securities and Exchange Commission (SEC) was created to:

Enforce federal securities laws, regulate securities markets, and protect investors

The stock market crash of 1929 and subsequent Great Depression led Congress to pass which landmark securities legislation?

The Securities Act of 1933 and the Securities Exchange Act of 1934

These two acts formed the foundation of modern securities regulation, requiring disclosure in new offerings (1933) and regulating secondary market trading (1934).

Under federal securities law, an investment adviser is defined as a person or firm that:

The Investment Advisers Act of 1940 defines an investment adviser as someone who, for compensation, engages in the business of advising others about securities investments. This definition is relevant to CFP® professionals who provide investment advice. All three portions of the definition are required to be considered an investment adviser or financial adviser, thus governed by the fiduciary standard.

Which statement correctly describes the risk-return relationship across asset classes?

Higher potential returns are generally associated with higher levels of risk

Ranking asset classes from generally lowest to highest risk, the correct order is:

Cash equivalents, fixed income, equities

The primary risk associated with investing in cash equivalents is:

Inflation risk, as returns may not keep pace with rising prices

Cash equivalents offer stability and liquidity but typically provide returns that barely exceed or may fall below inflation, eroding purchasing power.

holding period return

Holding period return = (ending value – beginning value +/- cash flows) / beginning value

arithmetic mean return

look it up in chapter 3

How is the real return calculated?

Total return divided by the inflation rate

Remember the formula (1+investment return/1+ inflation rate) - 1 x 100.

What does the beta of 0.3 for Bond B indicate?

The bond is less volatile than the market. 

The market beta is 1
Any security with a beta of less than 1 has less price volatility less than the market; any security with a beta of greater than 1 has price volatility greater than the market.

learn how to solve IRR

IRR

A portfolio manager reports a time-weighted return of 12% while the dollar-weighted return is 8%. What does this suggest?

Cash flows were added when performance was strong and withdrawn when performance was weak
When dollar-weighted return is lower than time-weighted return, it indicates that cash flows occurred at inopportune times (buying high, selling low), which hurts the investor's personal return.

An investment produces returns of +15%, +8%, and -5% over three years. What is the arithmetic mean return?

Arithmetic mean = (15% + 8% + (-5%))/3 = 18%/3 = 6.0%

Systematic risk and examples

Systematic risk (market risk) cannot be eliminated through diversification and affects all securities.
Changes in tax policy, Inflation rate changes, Recession affecting corporate earnings, The Federal Reserve raises interest rates

Unsystematic risk

Diversification across many stocks and industries reduces unsystematic (firm-specific) risk, as company-specific events tend to offset each other.

Standard deviation measures which type of risk?

standard deviation measures total risk, which includes both systematic (market) risk and unsystematic (firm-specific) risk.

Stock A has a standard deviation of 15% and Stock B has a standard deviation of 30%. What can you conclude?

Stock B's higher standard deviation (30% vs. 15%) indicates its returns fluctuate more widely around the mean, making it more volatile.

Which statement about beta is correct?

A negative beta indicates the stock moves in the opposite direction of the market
A negative beta indicates an inverse relationship with the market; when the market rises, the stock tends to fall, and vice versa.

A stock has a beta of 1.5. If the market return increases by 10%, what is the expected change in the stock's return?

15%
Expected change = Beta × Market change = 1.5 × 10% = 15%. The stock is expected to move 1.5 times as much as the market.

Why is geometric mean return always less than or equal to arithmetic mean return (except when all returns are identical)?

Geometric mean accounts for compounding effects and volatility drag

An investor held a bond for 18 months, during which it generated a total return of 9%. What is the annualized holding period return?

6%
Annualized HPR = (1 + 0.09)^(12/18) - 1 = (1.09)^(0.6667) - 1 ≈ 0.06 or 6.0%

A portfolio consists of 60% Stock X (beta = 1.2) and 40% Stock Y (beta = 0.8). What is the portfolio's beta?

1.04
Portfolio beta = (0.60 × 1.2) + (0.40 × 0.8) = 0.72 + 0.32 = 1.04

If Portfolio A has 60% U.S. stocks with an expected return of 8% and 15% standard deviation, 20% international stocks with an expected return of 10% and 20% standard deviation, 15% bonds with an expected return of 4% and 5% standard deviation, and 5% real estate with an expected return of 6% and 10% standard deviation, what is the portfolio’s expected return?

The portfolio's expected return is a weighted average of the holdings multiplied by their respective returns.  (.60) x (.08) + (.20) x (.10) +(.15) x (.04) + (.05) x (.06) = 7.7%.  Standard deviations are not part of this calculation of expected return.

What does the efficient frontier represent in modern portfolio theory?

The set of portfolios that provide the highest return for a given level of risk.

How does the Capital Market Line (CML) differ from the Security Market Line (SML)?

The CML represents the risk-return trade-off of efficient portfolios, while the SML represents the risk-return trade-off of individual securities. 

What is a primary component of an Investment Policy Statement (IPS)?

The client's investment objectives and asset allocation strategy. 

Breakeven effect

The breakeven effect describes investors' tendency to take increased risk to avoid realizing losses, often holding declining investments in hopes of getting back to even.

How does the anchoring bias typically affect investment decisions?

Investors give too much weight to an initial reference point when evaluating subsequent information

endowment effect

The endowment effect causes people to assign higher value to assets they already own compared to identical assets they don't own.

An investor creates a portfolio with 70% in Asset M (expected return = 14%, standard deviation = 22%) and 30% in Asset N (expected return = 6%, standard deviation = 10%). If the correlation is 0.2, which statement is correct?

The portfolio's expected return is 11.4% and its risk is less than 18.2%
Expected return = (0.70 × 14%) + (0.30 × 6%) = 9.8% + 1.8% = 11.6%. The weighted average standard deviation would be 18.4%, (.7 x .22) + (.3 x .10) but with correlation of 0.2 (less than 1.0), actual portfolio risk will be less than this weighted average. It will be 15.88% ( formula: square root of .7 squared x .22 squared + .3 squared x .10 squared + 2 x .70 x .30 x .22 x .10 x .2)

How does behavioral finance challenge the Efficient Market Hypothesis?

It demonstrates that systematic cognitive biases prevent investors from always acting rationally, leading to persistent market inefficiencies

According to modern portfolio theory, an optimal portfolio is located:

At the point where the efficient frontier is tangent to the investor's highest indifference curve

An Investment Policy Statement should be reviewed and potentially updated when:

The client experiences significant life changes such as retirement, inheritance, or change in risk tolerance

Which of the following is most suitable for evaluating a company's intrinsic value based on its future cash flows?

Discounted cash flow models estimate the intrinsic value of an asset by calculating the present value of all future cash flows the asset is expected to generate.  

The Sharpe ratio is primarily used to:

Assess the risk-adjusted return of a portfolio 

style drift

Style drift occurs when a fund is invested in assets outside of its stated investment objectives, found in its prospectus, including market cap, PE ratio range, estimated risk and return. This will happen if the fund shifts its investment strategy. 

Which rebalancing strategy involves adjusting the portfolio in response to significant market changes rather than on a fixed schedule?

Tactical rebalancing involved short term changes to the portfolio in response to market changes

A portfolio has a Sharpe ratio of 0.45 and a Treynor ratio of 7.5. What can you conclude?

The portfolio has unsystematic risk since the Sharpe ratio (using total risk) is lower relative to the Treynor ratio (using systematic risk)
When comparing the same portfolio, a relatively lower Sharpe ratio suggests the portfolio contains unsystematic risk that increases total risk (standard deviation) beyond systematic risk (beta).

Which characteristic is important for an appropriate benchmark portfolio?

The benchmark should be specified in advance, investable and replicable, reflect the investment style and objectives

Attribution analysis is best defined as:

The process of identifying the sources of portfolio returns and comparing them to a benchmark

A portfolio manager's performance should be considered superior to the benchmark when:

The portfolio's risk-adjusted return exceeds the benchmark's risk-adjusted return

Technical analysis differs from fundamental analysis in that technical analysis:

Focuses on price patterns, trends, and trading volume rather than financial statements

Relative value analysis involves comparing securities using:

Valuation multiples such as P/E ratios, P/B ratios, and EV/EBITDA

A bond attribution analysis typically includes all of the following components

	Trading activity and transaction costs
	rate anticipation effects from interest rate positioning
	Policy decisions regarding duration and credit quality

In attribution analysis as described by Brinson, Hood, and Beebower (BHB), performance is divided into:

Allocation effect and selection effect

Which of the following short-term debt securities is typically backed by the full faith and credit of the U.S. government?

Treasury bills

Treasury Inflation-Protected Securities (TIPS) differ from traditional Treasury notes because they:

Provide protection against inflation. 
cost of living component that increases as the CPI increases and offers some protection against inflation. 

Which of the following is a primary risk associated with investing in municipal bonds?

Credit risk

Which tranche of a CMO is generally considered the least risky?

Senior tranche

Fixed income securities

muni bond, t note, corp. bond

Floating-rate notes differ from fixed-rate bonds in that floating-rate notes:

Have coupon rates that adjust periodically based on a reference rate

A bond with 2 years remaining until maturity would be classified as:

short term
Bonds with maturities under 3 years are considered short-term, offering lower interest rate risk but typically lower yields.

An investor purchases a 20-year STRIP. Compared to a 20-year Treasury bond with coupons, the STRIP will have:

Higher duration and greater interest rate sensitivity
Zero-coupon bonds have duration equal to their maturity, while coupon bonds have lower duration, making STRIPS more sensitive to interest rate changes.

The primary disadvantage of investing in STRIPS is:

Annual taxation on imputed interest despite receiving no cash until maturity

Private activity municipal bonds differ from general municipal bonds in that they:

May be subject to the alternative minimum tax (AMT)

The tax-equivalent yield formula is used to:

Compare tax-exempt municipal bond yields with taxable bond yields

When interest rates decline significantly, mortgage-backed securities investors face:

Increased prepayment risk as homeowners refinance, returning principal early

The weighted average maturity (WAM) of a mortgage-backed security:

Estimates the average time until principal is repaid, considering expected prepayments

If the duration of the Green Valley municipal bonds is 7.5 years, how would a 1% increase in interest rates likely impact the bond's price?

The price would decrease by approximately 7.5%.
Generally, the price of a bond is inversely related to the level of interest rates. Duration provides a measure of a bond's volatility and estimates the change in the price of a bond based on changes in interest rates. Duration provides a time-weighted measure of a fixed income security's cash flow in terms of payback period. A 1% increase in interest rates will have the effect of reducing the bond's trading price by the amount of its duration; a 2% increase will reduce the price by twice its duration, etc.

Which of the following best describes a passive bond portfolio management strategy?

Holding bonds to maturity and minimizing transaction costs. 

Default risk is best measured by:

Credit ratings from agencies like S&P and Moody's

Which risk is unique to callable bonds compared to non-callable bonds?

Call risk—the risk that the bond will be redeemed before maturity

Convexity is valuable to bond investors because:

It causes bonds to gain more in value when rates fall than they lose when rates rise by the same amount

A bond portfolio manager expecting a flattening yield curve (long-term rates falling relative to short-term rates) should:

Increase exposure to long-term bonds

When the Federal Reserve raises short-term interest rates, bond prices typically:

Decrease across all maturities, with longer-term bonds declining more

The liquidity preference theory explains upward-sloping yield curves by:

Investors requiring higher yields to compensate for the greater risk of long-term bonds

Market segmentation theory suggests that:

Yields in different maturity segments are determined independently by supply and demand in each segment