Investments

Question 1

What is the equation for margin position?

Answer 1

Margin Position = Equity / Fair Market Value

Equity = Stock Price - Loan

So …

1. Determine the amount loaned, based on the original stock price.
2. Subtract the loan amount from the current price.
3. Divide the result by the current price.

Question 2

What is the margin call formula?

Answer 2

So …

1. Determine the loan amount.
2. Divide it by 1 minus the maintenance margin.

Question 3

Lisa purchased 500 shares of XYZ stock trading at $40 per share, with an initial margin requirement of 60% and a maintenance margin of 30%. At what price would Lisa receive a margin call?

a) $20.00
b) $22.86
c) $57.14
d) $80.00

Answer 3

Answer: B

Price to receive a margin call = Loan / 1 - maintenance margin

$40 x (1 - 0.60) / 1 - 0.30

= $16 / 0.70

= $22.86

Question 4

Laureen purchased 1,000 shares of CWC stock for $80 per share with an initial margin requirement of 65% and a maintenance margin of 40%. Assume the stock price falls to $30 per share, how much equity must Laureen contribute?

a) $2 per share
b) $8 per share
c) $10 per share
d) $12 per share

Answer 4

Answer: C

[see attached image]

Debt = $80 x (1 - .65)

= $28 per share

Laureen must contribute $10 per share. Required Equity - Actual Equity ($12-$2)

Question 5

What do Value Line and Morningstar rank, what are the rankings, and what do the rankings indicate?

Answer 5

Value Line ranks stocks and Morningstar ranks primarily mutual funds.

Value Line.

• Ranks stocks on a scale of 1 to 5 for timeliness and safety.
• A ranking of 1 represents the highest rating for timeliness and safety (signal to buy).
• A ranking of 5 represents their lowest ranking (signal to sell).

Morningstar.

• Ranks mutual funds, stocks, and bonds using 1 to 5 stars.
• 1 star represents the lowest ranking; 5 stars represents the highest ranking.

Question 6

When must one purchase a stock by to receive the dividend?

Answer 6

To receive the dividend, an investor must purchase the stock prior to the ex-dividend date or 2 business days before the date of record.

Question 7

MSFT declared a dividend payable to shareholders on the record date of Wednesday, May 15th. Which is the last possible date an investor could purchase the stock and still receive the dividend?

a) Stock purchased on May 13th.
b) Stock purchased on May 12th.
c) Stock purchased on May 11th.
d) Stock purchased on May 10th.

Answer 7

Answer: A

The investor would have to purchase the stock on Monday, May 13th as the last possible date. Recall the ex-dividend date would be Tuesday, May 14th. An investor would have to purchase prior to the ex-dividend date to receive the dividend.

Question 8

If June 4 is the date of record, when must Joe purchase the stock in order to receive the dividend?

a) June 1.
b) June 2.
c) June 3.
d) June 4.
e) May 31.

Answer 8

Answer: B

Date of Record minus 2 business days.

Question 9

What does each of the following regulate?

• Securities Act of 1933
• Securities Act of 1934
• Investment Company Act of 1940
• Investment Advisers Act of 1940
• Securities Investors Protection Act of 1970
• Insider Trading and Securities Fraud Enforcement Act of 1988

Answer 9

• Securities Act of 1933
  
  • Regulates the issuance of new securities (Primary Market).
  • Requires new issues are accompanied with a prospectus before being purchased.
• Securities Act of 1934
  
  • Regulates the secondary market and trading of securities.
  • Created the SEC to enforce compliance with security regulations and laws.
• Investment Company Act of 1940
  
  • Authorized the SEC to regulate investment companies.
  • Three types of investment companies: Open, Closed, Unit Investment Trusts.
• Investment Advisers Act of 1940
  
  • Required investment advisors to register with the SEC or state.
• Securities Investors Protection Act of 1970
  
  • Established SIPC to protect investors for losses resulting from brokerage firm failures.
  • Does not protect investors from incompetence or bad investment decisions.
  • Protects accounts member firms open for clients, regardless of the client’s citizenship.
• Insider Trading and Securities Fraud Enforcement Act of 1988 -
  
  • Defines an insider as anyone with information that is not available to the public.
  • Insiders cannot trade on that information

Question 10

What are the types of money market securities, and when does each mature?

Answer 10

Treasury Bills

• Issued in varying maturities up to 52 weeks.
• Denominations in $100 increments through Treasury Direct up to $5 million per auction. Larger amounts available through a competitive bid.

Commercial Paper

• Short-term loans between corporations.
• Maturities of 270 days or less and it does not have to register with the SEC.
• Commercial paper has denominations of $100,000 and are sold at a discount.

Bankers Acceptance

• Facilitates imports/exports.
• Maturities of 9 months or less.
• Can be held until maturity or traded.

Eurodollars

• Deposits in foreign banks that are denominated in US dollars.

Question 11

What does the IPS establish?

Answer 11

RR (objectives) TTLLU (constraints) –> Risk, Return, Taxes (Whether the investments are being held in a taxable, tax-deferred or tax-free account.), Time-line/horizon, Liquidity, Legal (laws and regulations), and Unique circumstances

Question 12

What’s the difference between price-weighted average and value-weighted index?

Answer 12

Price-weighted average:

Assume there are three stocks in our ABC average and their values are $44, $60, and $100. Our price average would be ($44 + $60 + $100) / 3 = $68. Therefore, our price-weighted average would be $68.

Value-weighted:

Takes into account the percent allocation of the position within the portfolio.

Question 13

You are interviewing James Smith, CFP® to manage your investments and provide financial guidance in other areas of your life. James states that his investment philosophy is as a contrar-ian; he buys securities that are losing favor and sells securities that are gaining favor. You review his previous track record, which is about equal with the market. His investments are typ-ically in a security that has lost at least 10% from its most recent high. What type of bias is James exhibiting?

a) Anchoring
b) Herding
c) Overconfidence
d) Hindsight Bias

Answer 13

Answer: A

He is subject to anchoring. His belief is a stock that falls 10% from its high is likely to return to that high. He is fixated on that high price.

Question 14

Kevin has subscribed to various investment magazines and data resources, which he religiously reads and analyzes. Kevin utilizes this analysis to make shifts in his high beta portfolio on a daily basis. Which behavioral finance bias is Kevin subject to?

a) Hindsight bias
b) Overconfidence
c) Regret avoidance
d) Herd mentality

Answer 14

Answer: B

This is a classic example of overconfidence. Kevin believes that his information is perfect, that his analysis is perfect, so he trades too often and has a very risky portfolio (high beta).

Question 15

Tip!

Question 16

What are the standard deviation percentages?

Answer 16

Memorize the 68, 95 & 99% depending on if the return is +/-1, 2 or 3 standard deviations away from the average.

Question 17

What is the formula for Coefficient of Variation (CV), and what information does it provide?

Answer 17

• Coefficient of variation is useful in determining which investment has more relative risk when investments have different average returns.
• Coefficient of variation tells us the probability of actually experiencing a return close to the average return.
• The higher the coefficient of variation the more risky an investment per unit of return.

Question 18

What is Kurtosis, and what do leptokurtic and platykurtic distributions indicate?

Answer 18

Kurtosis refers to variation of returns. If there is little variation of returns, the distribution will have a high peak. Treasuries have little variation of returns, have a high peak, and, therefore, have a positive kurtosis. If returns are widely dispersed, the peak of the curve will be low and have a negative kurtosis.

• Leptokurtic = high peak and fat tails (higher chance of extreme events)
• Platykurtic = low peak and thin tails (lower chance of extreme events)

Question 19

Conrad has noticed that the stock she purchased tends to have a very tight distribution around the mean but there seems to be a high probability of “outliers” (multi-deviation returns). This is most indicative of what type of curve?

a) Positive skewness
b) Leptokurtosis
c) Normal
d) Lognormal

Answer 19

Answer: B

Leptokurtic distribution reflects the tendency of observations to fall closely around the mean creating a peaked distribution at the mean with thicker tails. If historical returns indicate lepto-kurtosis then there is much more reserved variation in periodic returns but higher probability of large multi-sigma deviations (i.e. “fat tails”).

Question 20

What are the characteristics of Monte Carlo simulation?

Answer 20

Monte Carlo simulation is a spreadsheet simulation that gives a probabilistic distribution of events occurring. For example, what is the probability of running out of money in retirement with a client who has a withdrawal rate of 3%, 4% or 5%. Monte Carlo simulation then adjusts assumptions and returns the probability of an event occurring depending upon the assumption.

Question 21

What is Covariance, what are the inputs necessary to calculate it, and where is its formula located on the provided formula sheet?

Answer 21

Covariance is the measure of two securities combined and their interactive risk. In other words, how price movements between two securities are related to each other.

• Covariance is a measure of relative risk.
• If the correlation coefficient is known, or a given, covariance is calculated as the deviation of investment ‘A’ times the deviation of investment ‘B’ times the correlation of investment ‘A’ to investment ‘B.’

Inputs:

• σ_A = Standard deviation of Asset A.
• σ_B = Standard deviation of Asset B.
• þ_AB= Correlation coefficient of Assets A and B.

You may need to calculate COV, if you are given the correlation coefficient and need to calculate the standard deviation of a two-asset portfolio.

Second formula on left side of list on sheet.

Question 22

What is Correlation/Correlation Coefficient, what are the inputs necessary to calculate it, and where is its formula located on the provided formula sheet?

Answer 22

Correlation and the covariance measure movement of one security relative to that of another. Covariance and correlation coefficient are both relative measures. The correlation coefficient is represented by the Greek letter Rho or r.

Inputs:

• σ_A = Standard deviation of Asset A.
• σ_B = Standard deviation of Asset B.
• þ_AB= Correlation coefficient of Assets A and B.

Correlation ranges from +1 to -1 and provides the investor with insight as to the strength and direction two assets move relative to each other.

• A correlation of +1 denotes that two assets are perfectly positively correlated.
• A correlation of 0 denotes that assets are completely uncorrelated.
• A correlation of -1 denotes a perfectly negative correlation.
• Diversification benefits (risk is reduced) begin anytime correlation is less than 1.

This is not a provided formula. It is the algebraic equivalent of the Covariance formula (provided).

You won’t have to calculate correlation using the formula, but you need a thorough understanding of the concepts related to correlation.

Question 23

When combining asset classes, an investor begins to receive diversification benefits when correlation is:

a) Equals -1.
b) Less than 1.
c) Less than 0.
d) Less than or equal to 1.
e) Equals 0.

Answer 23

Answer: B

When the correlation coefficient is less than 1, an investor begins to receive diversification benefits. In other words, variability of returns is reduced. The most diversification benefits are received when correlation is equal to -1, but diversification benefits begin when correlation is less than 1.

Question 24

What is Beta, what are the inputs necessary to calculate it, and where is its formula located on the provided formula sheet?

Answer 24

• The beta coefficient is a measure of an individual security’s volatility relative to that of the market.
• Beta is best used to measure the volatility of a diversified portfolio.
• It measures systematic risk dependent on the volatility of the security relative to that of the market.
  
  • The beta of the market is 1.
  • A stock with a beta of 1 will be expected to mirror the market in terms of direction, return, and fluctuation.
  • A stock beta higher than 1 means the stock fluctuates more than the market and greater risk is associated with that particular security.
  • A stock beta of less than one indicates that the security fluctuates less relative to market movements.
• It should also be noted that the greater the beta coefficient of a given security, the greater the systematic risk associated with that particular security.
• Beta is also a measure of systematic risk or market risk, whereas standard deviation is a measure of total risk.
• Beta is the slope of the line that represents a security’s return when plotted relative to market returns.

Inputs:

• COVim= σ_i σ_m σ_im
• σ_i = Standard deviation of the individual security.
• σ_m = Standard deviation of the market.
• σ_m² = Variance of the market.
• þ_im = Correlation coefficient between the individual security and the market.

Beta may also be calculated by dividing the security risk premium by the market risk premium.

The formula is the third in the left column.

Question 25

When considering a diversified portfolio, which of the following is an appropriate measure of risk?

a) Standard deviation.
b) Beta.
c) Covariance.
d) Coefficient of determination.
e) Correlation coefficient.

Answer 25

Answer: B

Beta is an appropriate measure of risk for a diversified portfolio (one that has a high r²). Standard deviation is an appropriate measure of total risk for a nondiversified portfolio.

Question 26

What is the Coefficient of Determination or R-Squared, and what are the inputs necessary to calculate it?

Answer 26

• R-squared is a measure of how much return is due to the market or what percentage of a security’s return is due to the market.
• Calculate r-squared (r²) by squaring the correlation coefficient.
• If mutual fund XYZ has a correlation coefficient of 0.80, then its r² is 0.64, which means 64% of fund XYZ’s return is due to the market.
• R-squared (r²) also provides the investor insight into how well-diversified a portfolio is, because the higher the r-squared, the higher percentage of return from the market (systematic risk) and the less from unsystematic risk.
• R-squared also tells the investor if Beta is an appropriate measure of risk.
• If r-squared is greater than or equal to 0.70, then Beta is an appropriate measure of total risk. If r-squared is less than 0.70, then Beta is not an appropriate measure of total risk and standard deviation should be used to measure total risk.

Question 27

Mutual fund XYZ has a 5-year return of 12%, with a standard deviation of 15%. Fund XYZ has a Beta of 1.4, with a correlation of 0.90 to the S&P 500. What percent of the return from fund XYZ is due to the S&P 500?

a) 90%.
b) 81%.
c) 19%.
d) 10%.

Answer 27

Answer: B

Correlation = 0.90, therefore, r-squared = 0.81. 81% of the return is due to the market and 19% is due to unsystematic risk.

Question 28

Which of the following indices is the most appropriate benchmark for Sam to measure his portfolio against?

[see attached image]

a) Index 1.
b) Index 2.
c) Index 3.
d) Index 1 and 2.
e) Index 1 and 3.

Answer 28

Answer: C

Index 3 is the appropriate benchmark to measure the performance of Sam’s portfolio against because Index 3 accounts for 95% (r-squared) of the return in Sam’s portfolio.

Question 29

What is Standard Deviation of a Portfolio, what are the inputs necessary to calculate it, and where is its formula located on the provided formula sheet?

Answer 29

• The risk of a portfolio can be measured through determination of the interactivity of the standard deviation and covariance of securities in the portfolio.
• The process also utilizes the weight of both securities involved, the deviations of the respective securities, and the correlation coefficient of the two securities.
• This formula is also known as Portfolio Deviation Formula or Standard Deviation of a Two Asset Portfolio

Inputs:

• w_A = Weight of Asset A.
• σ_A = The standard deviation of Asset A.
• w_B = Weight of Asset B.
• σ_B = The standard deviation of Asset B.
• COV_AB = Covariance formula (on CFP® Exam formula sheet).

Second formula in right column.

Formula is on the CFP® Exam formula sheet, but it may not be necessary to use the formula: Can take (σ_A x weight) + (σ_B x weight) and adjust downward to compensate for the correlation between the assets.

Question 30

What is Systematic Risk, and what are the types of systematic risk?

Answer 30

Systematic risk is the lowest level of risk one could expect in a fully diversified portfolio. It is inherent in the “system” as a result of the unknown element existing in securities that have no guarantees.

PRIME

• Purchasing Power Risk.*
  
  • Purchasing power risk is the risk that
    
    • (1) inflation will erode the amount of goods and services that can be purchased, and
    • (2) a dollar today cannot purchase the same amount of goods and services tomorrow or the day after.
  • Purchasing power risk impacts both equities and bonds
• Reinvestment Rate Risk.*
  
  • Reinvestment rate risk is the risk that an investor will not be able to reinvest at the same rate of return that is currently being received.
  • Reinvestment rate risk mostly impacts bonds.
• Interest Rate Risk.*
  
  • Interest rate risk is the risk that changes in interest rates will impact the price of both equities and bonds.
  • There is an inverse relationship between interest rates and both equities and bonds.
• Market Risk.
  
  • Market risk impacts all securities in the short term because the short-term ups and downs of the market tend to take all securities in the same direction.
• Exchange Rate Risk.
  
  • Exchange rate risk is the risk that a change in exchange rates will impact the price of international securities.

* = most likely to be tested

Question 31

What is Unsystematic Risk, and what are the types of unsystematic risk?

Answer 31

Unsystematic risk is the risk that exists in a specific firm or investment that can be eliminated through diversification. Through ownership of a number of different securities or investments, the investor can eliminate this risk and insulate their investments.

ABCDEFG

• Accounting Risk
  
  • Accounting risk is the risk associated with an audit firm being too closely tied to the management of a company, for example: Arthur Andersen and Enron.
• Business Risk**
  
  • Business risk is the inherent risk a company faces by operating in a particular industry. For example, Halliburton faces much different risks in the oil industry than Microsoft does, which is primarily selling intellectual property and protecting copyrights.
• Country Risk**
  
  • Country risk is the risk a company faces by doing business in a particular country. For example, Halliburton faces unique risks doing business in Iraq.
• Default Risk**
  
  • Default risk is the risk of a company defaulting on their debt payments. Default risk can be thought of as the likelihood of a firm being able to satisfy its debt obligations on time.
• Executive Risk
  
  • Executive risk is the risk associated with the moral and ethical character of the management running the company.
• Financial Risk**
  
  • Financial risk is the amount of financial leverage deployed by the firm. Financial leverage is the ratio of debt versus equity the firm has deployed, or the financial structure. The higher the percentage of debt deployed by the firm, the more risky.
• Government/Regulation Risk**
  
  • Government or regulation risk is the risk that tariffs or restrictions may be placed on an industry or firm that may impact the firm’s ability to effectively compete in an industry.

** = most likely to be tested

Question 32

Stock index funds and exchange-traded funds that track market indices are subject to which of the following risks?

a) Financial risk.
b) Business risk.
c) Systematic risk.
d) Unsystematic risk.
e) Diversifiable risk.

Answer 32

Answer: C

Stock index funds and ETFs that track market indices are subject to systematic risk or market risk, since they attempt to achieve market-type returns. All others are examples of unsystematic, or diversifiable, risk.

Question 33

Which of the following are nondiversifiable risk (CFP® Certification Examination, released 3/ 95)?

1. Business risk.
2. Management risk.
3. Company or industry risk.
4. Market risk.
5. Interest rate risk.
6. Purchasing power risk.

a) 4, 5 and 6.
b) 1, 2, and 3.
c) 5, 6 and 2.
d) 1, 3 and 4.
e) 1, 4, and 6.

Answer 33

Answer: A

Nondiversifiable risks are systematic risk. Recall the mnemonic for systematic risk: PRIME risks.

Question 34

What is Modern Portfolio Theory?

Answer 34

The acceptance by an investor of a given level of risk while maximizing expected return objectives.

Question 35

What is the Efficient Frontier?

Answer 35

The curve which illustrates the best possible returns that could be expected from all possible portfolios.

• No portfolio on the efficient frontier is better than any other portfolio that lies on the efficient frontier. It actually depends on the investor’s risk tolerance when determining which portfolio is preferred on the efficient frontier.
• The efficient frontier represents the most “efficient” portfolios in terms of the risk-reward relationship. An investor cannot achieve a portfolio that has a higher return for each level of risk.
• Portfolios that lie beneath the efficient frontier are “inefficient” because there is a portfolio that provides more return for that level of risk.
• The area above the efficient frontier is considered “unattainable.”

Question 36

What are Indifference Curves?

Answer 36

Constructed using selections made based on this highest level of return given an acceptable level of risk.

• An indifference curve represents how much return an investor needs to take on risk.
• If an investor is risk-averse, this investor will have a very steep indifference curve. This means the investor requires significantly more return to take on just a little more risk.
• Alternatively, if an investor is risk-seeking, they will have a relatively flat indifference curve. This means the investor will not require a significant amount of return to take on more risk.

Question 37

What is an Efficient Portfolio?

Answer 37

Occurs when an investor’s indifference curve is tangent to the efficient frontier.

Question 38

What is an Optimal Portfolio?

Answer 38

The one selected from all efficient portfolios.

• The point at which an investor’s indifference curve is tangent to the efficient frontier represents that investor’s optimal portfolio.

Question 39

You, a CFP® professional, have been instructed to provide your client with the most appropriate portfolio for her needs. She is 76 years old and does not have many assets. You have requested an intern to put together several hypothetical portfolios for this client for you to choose from later. The intern has provided you with the attached. Which of the portfolios above is most likely on the efficient frontier?

a) A and C
b) B and C
c) B and D
d) D and E

Answer 39

Answer: B

A and B are both the same level of risk but B has a higher return. This leads one to believe that B is on the efficient frontier or at least more efficient than A. C and D both have the same level of return but C is less risky than D. Therefore C is more likely to be on the efficient frontier than is D.

Question 40

Modern asset allocation is based upon the model developed by Harry Markowitz. Which of the following statements is/are correctly identified with this model? (CFP® Certification Examination, released 3/95)

1. The risk, return, and covariance of assets are important input variables in creating portfolios.
2. Negatively correlated assets are necessary to reduce the risk of portfolios.
3. In creating a portfolio, diversifying across asset types (e.g., stocks and bonds) is less effective than diversifying within an asset type.
4. The efficient frontier is relatively insensitive to the input variable.

a) 1 and 2.
b) 1, 2 and 3.
c) 1 only.
d) 2 and 4.
e) 1, 2, and 4.

Answer 40

Answer: C

When designing a portfolio the most important variables are risk, return and covariance (how asset classes move relative to each other). Negatively correlated assets are not necessary to reduce risk; simply, assets with a correlation less than 1 are necessary. Diversifying across asset types is more effective by combining stocks and bonds. The efficient frontier is very sensitive to the risk and return input variables.

Question 41

What is the Capital Market Line, and what are its inputs?

Answer 41

• The Capital Market Line (CML) is the macro aspect of the Capital Asset Pricing Model (CAPM). It specifies the relationship between risk and return in all possible portfolios.
• The CML becomes the new efficient frontier, mixing in the risk-free asset with a diversified portfolio.
• A portfolio’s returns should be on the CML.
• Inefficient portfolios are below the CML.
• The CML is not used to evaluate the performance of a single security.

Inputs:

• r_p = Required portfolio rate of return.
• r_f = Risk-free rate of return.
• r_m = Return on the market.
• σ_m = Standard deviation of the market.
• σ_p = Standard deviation of the portfolio.

The CML formula is no longer on the formula sheet. You may be asked what measure of risk the CML uses, which is standard deviation.

• The CML intersects the Y-axis at the risk-free rate because an investor with 100% of his assets in the risk-free asset will yield a return but experience no variability (standard deviation).
• The CML runs tangent (touches in only one spot) with the efficient frontier at the “optimal portfolio” or the “tangency portfolio.”
• Before the CML touches the efficient frontier the investor is said to have a security allocation made up of the optimal portfolio mix and is lending a portion of uninvested assets at the risk-free rate.
• At the optimal portfolio, the investor is fully invested in that portfolio—he does not lend anything at the risk-free rate or borrow at that rate.
• To the right of the optimal portfolio, the investor is said to have borrowed at the risk-free rate to fully invest all capital and borrowed funds in that portfolio.
• As always, any portfolio above the efficient frontier/CML is unobtainable and any below is inefficient.

Question 42

What is the Capital Asset Pricing Model, what are its inputs, and where is it located on the formula sheet?

Answer 42

• The Capital Asset Pricing Model (CAPM) calculates the relationship of risk and return of an individual security using the Beta (b) as its measure for risk.
• The CAPM formula is often referred to as the Security Market Line (SML) equation because its inputs and results are used to construct the SML.
• The difference between the (r_m - r_f) is considered the market risk premium, that is how much an investor should be compensated to take on a market portfolio versus a risk-free asset.

Inputs:

• r_i = Required or expected rate of return.
• r_f = Risk-free rate of return.
• ß_i = Beta, which is a measure of the systematic risk associated with a particular portfolio.
• r_m = Return of the market.
• r_m - r_f = Market risk premium.

You may be given the market risk premium rather than the return of the market. Be sure to remember that the market risk premium is (r_m - r_f).

Fourth formula in the right column.

Question 43

If the risk-free rate of return is 3%, the beta of a security is 1.5, and the market risk premium is 9%, what is the expected return?

a) 13.5%.
b) 12.5%.
c) 16.5%.
d) 12.0%.
e) 13.0%.

Answer 43

Answer: C

r_i = r_f + (rm - rf)ßi

= 0.03 + (0.09)1.5

= 16.5%

Note: The risk premium is given in the question facts (r_m - r_f). We do not need to calculate it.

Question 44

What is the Security Market Line?

Answer 44

• The relationship between risk and return as defined by the CAPM and graphically plotted results in the Security Market Line (SML).
• Both the CAPM and SML assume an investor should earn a rate of return at least equal to the risk-free rate of return.
• The SML intersects the y-axis at the risk-free rate of return.
• The SML uses Beta as its measure of risk, whereas the CML uses Standard Deviation as its measure of risk.
• If a portfolio provides a return above the SML, it would be considered undervalued and should be purchased.
• If a portfolio provides a return below the SML, it would be considered overvalued and should not be purchased.
• The SML may also be used with individual securities.

Question 45

What is the intersection on the y-axis of the CML/SML?

a) Risk-free rate of return.
b) Market portfolio.
c) Undervalued asset.
d) Overvalued asset.
e) Indeterminable.

Answer 45

Answer: A

The starting point on the CML/SML is a risk-free rate of return.

Question 46

What is the Information Ratio, what are its inputs, and where is it located on the formula sheet?

Answer 46

• A relative risk-adjusted performance measure.
• Measures the excess return and the consistency provided by a fund manager, relative to a benchmark.
• The higher the excess return (or Information Ratio) the better.
• Excess return can be positive or negative depending on the fund’s performance relative to its benchmark.

Inputs:

• R_p = The portfolio’s actual return.
• R_b = The return of the benchmark.
• R_p – R_b = excess return
• σ_A = Tracking error of active return (standard deviation of the difference between portfolio returns and index returns).

Seventh formula in left column.

Question 47

What is the Treynor Index, what are its inputs, and where is it located on the formula sheet?

Answer 47

A risk-adjusted performance measure. It’s also a “relative” risk-adjusted-performance indicator, meaning one Treynor ratio needs to be compared to another Treynor ratio to provide meaning.

• The Treynor Index uses the beta of a portfolio as its denominator, and the difference between the portfolio return and the risk-free return as the numerator.
• It’s a measure of how much return was achieved for each unit of risk. The higher the Treynor ratio, the better because that means more return was provided for each unit of risk.
• It measures the reward achieved relative to the level of systematic risk (as defined by beta).
• Accomplished by standardizing portfolio returns for volatility.
• Treynor justifies use of the model on the assumption that in a well-diversified portfolio, the unsystematic risk is already close to zero.
• Treynor Index doesn’t indicate whether a portfolio manager has outperformed or underperformed the market.

Inputs:

• r_p = The realized return on the portfolio.
• r_f = The risk-free rate of return.
• ß_p = The beta of the portfolio.

Fifth formula in the right column.

Question 48

John is considering the two mutual funds below, but is uncertain which performed better over the past year. Growth Fund has a beta of 1.2 relative to the market. The risk-free rate of return was 3%. Which fund would you recommend based on the Treynor ratio?

Growth Fund: Actual Return 12%
Index Fund: Actual Return of 9%

a) Growth Fund.
b) Index Fund.
c) Growth and Index Fund have the same risk-adjusted returns.
d) None of the Above.

Answer 48

Answer: A

Select the Growth Fund because it has a higher Treynor ratio.

• Growth Fund Treynor = (0.12 - 0.03) / 1.2 = 0.075
• Index Fund Treynor = (0.09 - 0.03) / 1 = 0.06

Note the Index Fund Beta is 1 because it tracks the market.

Question 49

What is the Sharpe Index, what are its inputs, and where is it located on the formula sheet?

Answer 49

Sharpe provides a measure of portfolio performance using a risk-adjusted measure that standardizes returns for their variability. The model measures reward to total variability, or total risk.

Inputs:

• r_p = realized return on the portfolio.
• r_f = risk-free rate of return.
• σ_p = standard deviation of the portfolio.

The Sharpe Index is:

• A risk-adjusted performance measure. It’s also a “relative” risk-adjusted-performance indicator, meaning one Sharpe ratio needs to be compared to another Sharpe ratio to provide meaning.
• A measure of how much return was achieved for each unit of risk. The higher the Sharpe ratio, the better because that means more return was provided for each unit of risk.
• Sharpe Index measures risk premiums of the portfolio relative to the total amount of risk in the portfolio.
• The formula does not measure a portfolio manager’s performance against that of the market.

Ninth formula in the left column (second to last)

Question 50

Craig is evaluating two sector mutual funds that are not well-diversified. How would you recommend that Craig evaluate the funds on a risk-adjusted return basis?

a) Calculate the Treynor ratio and select the fund with the highest Treynor.
b) Calculate the Sharpe ratio and select the fund with the highest Sharpe.
c) Calculate the Treynor ratio and select the fund with the lowest Treynor.
d) Calculate the Sharpe ratio and select the fund with the lowest Sharpe.

Answer 50

Answer: B

Because sector funds are not well-diversified the most appropriate risk measure to use is standard deviation. Recall the standard deviation is used for nondiversified portfolios and Beta is used for well-diversified portfolios. When evaluating both Sharpe and Treynor ratios, always select the fund that provides the highest Sharpe or Treynor ratio. The higher the Sharpe or Treynor, the more return for each unit of risk.

Question 51

What is Jensen’s Model or Jensen’s Alpha, what are its inputs, and where is it located on the formula sheet?

Answer 51

• The Jensen Index or Jensen’s Alpha is significantly different from Sharpe and Treynor in that the Jensen’s Alpha is capable of distinguishing a manager’s performance relative to that of the market and determining differences between realized or actual returns and required returns as specified by CAPM.
• Treynor and Sharpe are calculations for providing a measure and ranking of relative performance. Jensen’s model attempts to construct a measure of absolute performance on a risk-adjusted basis.
• An absolute performance measure simply means that looking at Jensen’s Alpha tells you something.
  
  • A positive Alpha indicates that the fund manager provided more return than was expected for the risk undertaken.
  • A negative Alpha indicates that the fund manager provided less return than was expected for the risk that was undertaken.
  • An Alpha of zero indicates that the fund manager provided a return equal to the return that was expected for the risk that was undertaken.

Inputs:

• r_p = realized portfolio return.
• r_f = risk-free rate of return.
• a_p = alpha, an intercept that measures the manager’s contribution to the portfolio return.
• ßp = beta of the portfolio. rm = expected return on the market.

Fifth formula in the left column.

Question 52

Christos is evaluating two mutual funds to purchase. Which fund would you recommend?

• Fund A: Standard Deviation = 12%, R-squared = 0.92, Alpha = 2.0, Sharpe = 1.2
• Fund B: Standard Deviation = 13%, R-squared = 0.90, Alpha = 1.8, Sharpe = 1.5

a) Fund A because it has a higher Alpha.
b) Fund A because it has a lower standard deviation.
c) Fund B because it has a higher Sharpe.
d) Fund B because it has a higher standard deviation.

Answer 52

Answer: A

Since both portfolios are well-diversified, as indicated by r-squared, then evaluate the funds based on the risk-adjusted performance indicator that uses Beta. Since Alpha uses Beta as its measure of risk, the fund with the higher Alpha should be selected.

Note: If the r-squared was less than 0.70, the funds would not be well-diversified, so standard deviation should be the risk measure. Only Sharpe uses standard deviation as its risk measure. Then fund B would have been appropriate.

Question 53

Donna’s mutual fund returned 19% last year, with a beta of 2. The risk-free rate of return was 3%, the market return was 8%. The standard deviation is 18%. What would you tell Donna regarding the performance of her mutual fund?

a) The standard deviation was too high; therefore, Donna was undercompensated for the risk of her fund.
b) The Sharpe ratio is 1, which means Donna earned an adequate risk-adjusted return.
c) The Sharpe ratio is 1, which means Donna earned a return less than was required on a risk-adjusted basis.
d) The market outperformed the mutual fund on a risk-adjusted basis.
e) The alpha is 6%, which means the fund manager returned a higher rate of return than was expected on a risk-adjusted basis.

Answer 53

Answer: E

Standard deviation is a measure of volatility and variability. Standard deviation by itself is not a risk-adjusted performance indicator. For Sharpe to be meaningful, one Sharpe ratio needs to be compared to another Sharpe ratio. The Alpha ratio is calculated below:

a_p = r_p - [r_f + (r_m - r_f)ßp]

a_p = 0.19 - [0.03 + (0.08 - 0.03)2]

0.19 - 0.13 = 0.06 or 6%

Question 54

Prince Albert is reviewing his investment statement with you, his CFP® practitioner. You two are going through his investment performance and he points out that the All American Total Market fund beat the market by 2%. Having seen this you point out that this investment, you recommended of course, has an alpha of 2%. Under what circumstances is this comment true?

a) Always, as it meets the definition of alpha.
b) Only if the risk-free rate of return is zero.
c) Only if the beta of the fund is one.
d) Only if the correlation is positive.

Answer 54

Answer: C

The calculation for alpha is the actual return of the fund less the expected return on the fund. The only time the alpha will equal the amount the fund beat the market is if the beta is one.

Let’s just make up some numbers. Return on the portfolio is 8%, return on the market is 6%, the risk-free return is 2%, and beta is 1.

a_p = r_p - [r_f + (r_m - r_f)ßp]

a_p = 0.08 - [0.02 + (0.06 - 0.02)1]

0.08 - 0.06 = 0.02 or 2%

Question 55

Alpha, Jenson, and Treynor: Which risk-adjusted performance measurement is appropriate to use and when?

Answer 55

• Both Treynor and Alpha use Beta as the measure of risk; therefore, Treynor and Alpha are appropriate risk-adjusted performance indicators when considering a diversified portfolio.
• A portfolio is considered diversified when r-squared is greater than or equal to 0.70. If r-squared is greater than or equal to 0.70 then Beta is a reliable measure of total risk; therefore, Treynor and Alpha are appropriate risk-adjusted performance measures.
• A portfolio is considered not well-diversified when r-squared is less than 0.70. If r-squared is less than 0.70, then Beta is not an appropriate measure of total risk; therefore, standard deviation is an appropriate risk measurement. If standard deviation is an appropriate measure of risk, then using Sharpe as a risk-adjusted measurement is appropriate because Sharpe uses standard deviation as its measure of risk.
• Sharpe and Treynor are relative performance measures. Relative means that you must compare one Sharpe or one Treynor to another. The higher the Sharpe or Treynor, the more return for each unit of risk. Always select the higher Sharpe or Treynor ratio.
• When determining which fund performed better on a risk-adjusted basis, always rank the Sharpe or Treynor ratios, then select the highest.
• Alpha is an absolute performance measure. A positive Alpha is good; a negative Alpha is bad.
• Select which risk-adjusted performance measures to use based on r-squared.
• If r-squared is > 0.70, use Treynor and Alpha because both use Beta and a r-squared > 0.70 indicates the portfolio is well-diversified and Beta is an appropriate measure of total risk.
• If r-squared is < 0.70, then the portfolio is not well-diversified so use Sharpe because it uses standard deviation as its measure of risk. Standard deviation is appropriate for portfolios that are not well-diversified.
• If r-squared is too low, they are using wrong benchmark. Therefore IR doesn’t hold as true measure.

Question 56

If mutual fund ABC has a correlation of 0.80 to the S&P 500, which of the following risk-adjusted performance measures would be appropriate to measure the performance of fund ABC?

a) Treynor.
b) Jensen.
c) Sharpe.
d) Treynor and Sharpe.
e) Treynor and Jensen.

Answer 56

Answer: C

Because the correlation is 0.80, the r-squared is 0.64. Only 64% of the return for fund ABC is due to the S&P 500. Therefore, 36% is due to unsystematic risk. Since Beta only measures market (systematic risk), too much return is due to unsystematic risk; therefore, Beta is not appropriate. Rule out Treynor and Jensen since both use Beta. Sharpe uses standard deviation, which measures total risk market (systematic) and unsystematic.

Question 57

What is the Holding Period Return formula?

Answer 57

This formula is not on the provided formulas sheet.

Question 58

What is the Effective Annual Rate, what are its inputs, and where is it located on the exam formula sheet?

Answer 58

This formula calculates the effective annual interest rate earned on an investment when the compounding occurs more often than once per year.

Inputs:

• i = i = stated annual interest rate
• n = number of compounding periods

Seventh formula on the right (EAR).

Question 59

What is the Arithmetic Average, what are its inputs, and where is it located on the formula sheet?

Answer 59

The arithmetic average (or mean) is also known as the simple average. It is the sum of all numbers divided by the number of observations.

Eighth formula on the right (under EAR).

Or, enter each value followed by the sigma plus key Σ+. once all are entered, downshift 7 (x, y)

Question 60

What is the Geometric Mean, what are its inputs, where is it located on the formula sheet, and how is it calculated?

Answer 60

This is the standard formula for finding the geometric mean for a set of observations, where a1, a2, a3, etc may represent a set of given stock prices over a period of time.

Last formula on the right.

Or, enter each number and multiply it by the following number. Once all are entered, downshift multiply (y^x), enter the number of values just multipled, downshift divide (1/x), =.

A negative value under the radical makes the formula unusable, as we cannot take the n^th root of a negative number. A zero return also creates issues.

Question 61

What is the Weighted Average, and how is it calculated?

Answer 61

Multiply the price of each share by the number of shares at that price. Add the total for each type of share together. Divide by total number of shares.

Question 62

Tip!

Answer 62

You may not have to calculate dollar-weighted or time-weighted return, but you must know that mutual funds report on a time-weighted basis.

Question 63

What is Arbitrage Pricing Theory (APT)?

Answer 63

• APT asserts that pricing imbalances cannot exist for any significant period of time; otherwise investors will exploit the price imbalance until the market prices are back to equilibrium.
• APT is a multi-factor model that attempts to explain return based on factors. Anytime a factor has a value of zero, then that factor has no impact on return.
• APT attempts to take advantage of pricing imbalances.
• Inputs are factors (F) such as inflation, risk premium, and expected returns and their sensitivity (b) to those factors.
• Standard deviation and beta are not inputs to the APT.
• r_i = a₁ + b₁F₁ + b₂F₂ + b₃F₃ + e
• Don’t memorize the formula, but do memorize the keywords: multi-factor model, sensitivity to those factors, and STD and Beta are not inputs.

Question 64

Tip! Dividend Discount Model

Answer 64

Be sure to use next year’s dividend when determining the value of stock using the constant growth dividend formula.

D₁ is the next expected dividend. It is calculated using the current dividend and dividend growth rate as follows:

D₁=D₀(1 + g)

Question 65

Tip!

Answer 65

If the required rate of return decreases, the stock price will increase.

If the dividend is expected to increase, the stock price will increase.

If the required rate of return increases, the stock price will decrease.

If the dividend is expected to decrease, the stock price will decrease.

Question 66

What is the Dividend Payout Ratio?

Answer 66

The relationship between the amount of earnings paid to shareholders in the form of a dividend, relative to earnings per share.

• Typically, the higher the dividend payout ratio, the more mature the company.
• A high dividend payout ratio may also indicate the possibility of the dividend being reduced.
• A low dividend payout ratio may indicate that the dividend may increase, thereby increasing the stock price.

Question 67

What is Return on Equity?

Answer 67

Measures the overall profitability of a company. There is a direct relationship between ROE, earnings and dividend growth.

Question 68

What do technicians consider in their analysis?

Answer 68

• Charting
• Market Volume
• Short Interest
• Odd Lot Trading
• The Dow Theory
• Breadth of the Market
• Advance Decline Line

Question 69

What does Fundamental Analysis consider?

Answer 69

• Financial statement analysis
• Economic data

Question 70

What are the three forms of the Efficient Market Hypothesis, and what does each support or reject?

Answer 70

Question 71

The current annual dividend of ABC Corporate is $2.00 per share. Five years ago the dividend was $1.36 per share. The firm expects dividends to grow in the future at the same compound annual rate as they grew during the past five years. The required rate of return on the firm’s common stock is 12%. The expected return on the market portfolio is 14%. What is the value of a share of common stock of ABC corporation using the constant dividend growth model? (CFP® Certification Examination, released 3/95)

a) $11.
b) $17.
c) $25.
d) $36.
e) $54.

Answer 71

Answer: E

Step 1: Calculate growth

N = 5
I = solve for = 8.02
PV = \<1.36\>
PMT = 0
FV = 2.00

Step 2: Use constant growth dividend formula.

($2.00 x 1.0802) / (0.12 - 0.0802)

$54

Question 72

Shilo is invested in an MLP that has just paid an annual dividend. The energy, oil, and gas industry is really booming so she expects the company will increase dividends by 7% for 3 years, 5% for 2 years, and will hold it stable at 3% from then on. The company’s recent financial statements show earnings per share of $12 and a retention ratio of 60%. If Shilo requires at least an 8% rate of return on her investment, what is the value?

a) $112.97
b) $114.04
c) $115.63
d) $116.22

Answer 72

Answer: B

This question throws a few tricks at you. First you have to determine the amount of Shilo’s most recent dividend to extrapolate the dividends into the future. Next, you have this MLP investment. What’s that? Doesn’t matter. It is not relevant to the problem! Lastly, there are 3 different growth periods to contend with.

Div0 = EPS x (1 – Retention) = $12 x 0.40 = $4.80 
Div1 = $4.80 x 1.07 = $5.14;
Div2 = $5.14 x 1.07 = $5.50;
Div3 = $5.50 x 1.07 = $5.89;
Div4 = $5.89 x 1.05 = $6.18;
Div5 = $6.18 x 1.05 = $6.49;
Div6 = $6.49 x 1.03 = $6.68

V = $6.68 / (0.08 – 0.03) = $133.60

[Orange Shift]
[C All]
0 [CFj]
5.14 [CFj]
5.5 [CFj]
5.89 [CFj]
6.18 [CFj]
6.49 + 133.6 = [CFj]
8 [I/YR]
[Orange Shift] [NPV]

Answer: $114.04

Question 73

Cole’s Cars Inc. has the following information, what is the return on equity?

EPS: $2.00
C/S Dividend: $1.00
P/S Dividend: $0.50
Sales: $5,000,000
Shares Outstanding: 1,000,000
Total Equity: $7,000,000

a) 15%
b) 20%
c) 25%
d) 28.5%

Answer 73

Answer: D

ROE = $2.00 / ($7,000,000 / 1,000,000)

28.5%

Question 74

Which of the following companies (attached) is most likely to increase its dividend?

a) Company A.
b) Company B.
c) Company C.
d) Company D.
e) None of the Above.

Answer 74

Answer: D

Calculate the dividend for each company using the dividend yield formula, then compare the dividend to earnings per share.

Dividend Yield = Dividend / Stock Price

Dividend = Stock Price x Dividend Yield

Company A = $20 x 10% = $2.00 vs. $2.00 in EPS
Company B = $50 x 5% = $2.50 vs. $2.50 in EPS
Company C = $30 x 8% = $2.40 vs. $2.40 in EPS
Company D = $40 x 12% = $4.80 vs. $5.00 in EPS Room to increase the dividend!

Question 75

Which of the following forms of the efficient market hypothesis supports technical analysis?

a) Strong.
b) Semi-Strong.
c) Weak.
d) All of the above.
e) None of the above.

Answer 75

Answer: E

All three forms suggest that technical analysis will not help you achieve above-average market returns.

Question 76

If an investor is a proponent of index funds, which of the following forms of the efficient market hypothesis is the investor advocating?

a) Strong.
b) Semi-Strong.
c) Weak.
d) All of the above.
e) None of the above.

Answer 76

Answer: A

The EMH asserts that investors cannot achieve above-average market returns; therefore, investors should take a passive investment strategy. Semi-strong does also reject fundamental and technical analysis, but does believe inside information will help out perform the market. Strong is the better choice in this question.

Question 77

Lindsay is your client, and she believes that you can help her improve her returns by assisting her with her investment selections. What type of method is appropriate?

a) Laddered bonds and UITs.
b) Strategic asset allocation.
c) Passive investment in ETFs.
d) Dollar-cost averaging in index funds.

Answer 77

Answer: B

Strategic asset allocation is the only active investment strategy.

Question 78

Are Series E Bonds marketable?

Answer 78

No, EE Bonds are NOT marketable securities.

Question 79

Which of the following bonds mitigate against purchasing power risk?

a) TIPS and STRIPS.
b) STRIPS and EE Bonds.
c) TIPS and EE Bonds.
d) I Bonds and TIPS.
e) I Bonds and EE Bonds.

Answer 79

Answer: D

I bonds adjust the interest paid for inflation, and TIPS adjust the par value for inflation. All other bonds provide no purchasing power risk protection.

Question 80

Which federal agency bond is the exception to the rule and why?

Answer 80

Agency Bonds are not backed by the full faith and credit of the US government. GNMA is the exception to the rule: These bonds are backed by the full faith and credit of the US government.

Question 81

What are the three types of municipal bonds, and what are the two muni bond insurers?

Answer 81

1. General Obligation Bonds.
2. Revenue Bonds.
3. Private Activity Bonds.

General Obligation Bonds

• General obligation bonds are backed by the full faith, credit, and taxing authority of the municipality that issued the bond.

Revenue Bonds

• Revenue bonds are backed by the revenue of a specific project.
• Revenue bonds are NOT backed by the full faith, credit, and taxing authority of the entity that issued the bond.

Private Activity Bonds

• Private activity bonds are used to finance construction of stadiums.

Insured Municipal Bonds

• The following companies insure municipal bonds:
  
  • American Municipal Bond Assurance Corp. (AMBAC)
  • Municipal Bond Insurance Association Corp. (MBIA)
• If an insured municipal bond is in default, the insurance company will pay the interest and principal amounts.

Question 82

What are the risks inherent in U.S. government and corporate bonds?

Answer 82

The primary difference between Corporate Bond Risk and U.S. Government Bond Risk is that U.S. government bonds are not subject to default risk. Municipal bonds can be considered to have default risk unless they are insured.

Corporate Bond Risk

• Default Risk.
• Reinvestment Rate Risk.
• Interest Rate Risk.
• Purchasing Power Risk.

US Government Bond Risk

• Reinvestment Rate Risk.
• Interest Rate Risk.
• Purchasing Power Risk.

Question 83

What is the Tax Exempt Yield, what are its inputs, and where is it located on the exam formula sheet?

Answer 83

• The “Tax-Equivalent Yield” (T.E.Y.) is the yield a taxable corporate bond would need to pay for the yield on a tax-exempt muni to be equivalent to a taxable corporate bond.
• The “Tax-Exempt Yield” is the after-tax rate of return a taxable corporate bond pays.
• If a bond is double or triple-tax-free, simply combine the federal, state, and local income tax rate. This is then used for the marginal tax rate in the formula.
  
  • To be double-tax-free, the bond holder must live in the state that issued the municipal bond.
  • To be triple-tax-free, the bond holder must live in the local municipality that issued the bond.

Eighth down on the left (TEY).

Inputs:

• r = tax exempt yield
• t = marginal tax rate

We can restate the formula:

Tax-Exempt Yield = Corporate Rate x (1 - Marginal Tax Rate)

This formula is not provided on the formula sheet, but is the algebraic equivalent to the TEY formula provided

Question 84

William lives in a state with a 5% state income tax and itemizes deductions on his federal tax return. His marginal federal tax rate is 35%. His local municipality issues a 4.5% municipal bond. What is the taxable equivalent yield based on this information?

a) 6.9%.
b) 8.3%
c) 7.3%.
d) 4.5%
e) 9.7%

Answer 84

Answer: C

TEY = 0.045 / (1 - 0.3825) = .0729 or 7.3%

What if William does not itemize deductions, how would the answer change?

TEY = 0.045 / [1 - (0.35 + 0.05)] = .075 or 7.5%

Question 85

What is the taxable equivalent yield on a treasury security paying 3.5% if the marginal federal tax rate is 35% and the state income tax rate is 5%?

a) 5.8%
b) 3.7%
c) 5.1%
d) 4.8%

Answer 85

Answer: B

0.035 / (1 - .05) = 3.68%

US Treasuries are exempt from state and local taxes only. Use the taxes you save in the equation.

Question 86

If the yield ratio is Rtf(tax-free) / Rt(taxable), how does a higher ratio affect the attractiveness of municipal bonds?

a) The higher the ratio, the more appealing.
b) The lower the ratio, the more appealing.
c) Both A and B.
d) Neither A or B.
e) Investors are indifferent to the ratio.

Answer 86

Answer: A

As the tax-free return increases, the ratio becomes bigger. If investors are able to earn a tax-free return that is very close to a taxable return, investors will always choose the tax-free return.

Question 87

Paul is considering buying a bond with a current yield of 8% and selling for $900. Assuming the bond pays an annual coupon, what is the coupon rate of this bond?

a) 5.5%
b) 6.0%
c) 7.2%
d) 8.2%
e) 9.0%

Answer 87

Answer: C

Current Yield = Coupon Payment / Price of the Bond

0.08 = x / $900

$900 x 8% = $72

Coupon Rate Coupon Payment Par = 7.2%

Question 88

What is the yield to maturity of a bond that is selling at a 5% discount to par, paying 11.25% interest, and maturing in 7 years?

a) 11.23%.
b) 12.34%.
c) 13.10%.
d) 13.79%.

Answer 88

Answer: B

5% discount to par = $1,000 par x 0.95 = $950
N = 7 x 2 = 14
i = ?
PV = <950>
PMT = (1,000 x 0.1125) / 2 = 56.25
FV = 1,000

solving -> 6.16 x 2 = 12.34% on an annual basis

Question 89

Joe purchased a bond for $880 with a 9% coupon. He sold the bond after one year when it was paying him a current yield of 10%. What is the holding period return?

a) 9.0%.
b) 9.5%.
c) 10.0%.
d) 11.0%.
e) 12.5%.

Answer 89

Answer: E

Step 1: Calculate Selling Price

Current Yield = Coupon Payment / Price of the Bond
0.10 = $90 / Price
Price = $90 / 0.10 = $900

Step 2: Calculate Holding Period Return

HPR = (Sales Price - Purcahse Price +/- Cash Flows) / Purchase Price
($900 - $880 + 90) / $880 = 12.5%

Question 90

What is the yield to call of a bond that is selling at a $1,200, paying 12% interest, semi-annually, and maturing in 10 years, if the bond is callable in 5 years at $1,050?

a) 3.96%.
b) 7.91%.
c) 10%.
d) 12.91%.

Answer 90

Answer: B

N = 5 x 2
i = ? solving -> 3.96 x 2 = 7.91% on an annual basis
PV =
PMT = ($1,000 x 0.12) / 2
FV = $1,050

Question 91

What is the relationship between Coupon, Current Yield, YTM, and YTC?

Answer 91

Remember that when shopping, if you see a Discount “Call Mom’s Cell Now!” -> Discounts (from highest to lowest) is yield to CALL, yield to Maturity, Current yield, and Nominal yield.

Question 92

Treasury zero coupon bonds are particularly suited to which of the following types of accounts? (CFP Certification Examination, released 2004)

a) IRA.
b) Trust.
c) Corporate.
d) Joint.

Answer 92

Answer: A

Zero coupons generate phantom income. Held in an IRA avoids current taxation.

Question 93

What is the Unbiased Expectations Theory, what are its inputs, and where is it located on the formula sheet?

Answer 93

The unbiased expectations theory is related to the term structure of interest rates. The theory holds that today’s longer-term interest rates have embedded in them expectations about future short-term interest rates. More specifically, long-term rates are geometric averages of current and expected future shorter-term interest rates.

iR<sub>N</sub> = Actual N-period rate today 
N = term to maturity, N = 1, 2, 3, ...
<sub>1</sub>R<sub>1</sub> = Current one-year rate today
E(<sub>i</sub>R<sub>1</sub>) = expected one-year rate at period i, where i = 1 to N. For example the one-year rate expected at year three would be: E(3r1)

Ninth on the right.

The easier way to approach this formula is …

PV = -1 (for the -1 at the end of the formula)
N = # of periods
PV = (1 + return 1) x (1 + return 2) x … (1 + return n)
Solve for I/YR

Question 94

What is Bond Duration, what are its inputs, and where is it located on the formula sheet?

Answer 94

Duration is the weighted average maturity of all cash flows.

• The bigger the duration, the more price-sensitive or volatile the bond is to interest rate changes.
• Duration is the moment in time the investor is immunized from interest rate risk and reinvestment rate risk.
• Modified Duration is a bond’s price sensitivity to changes in interest rates.
• A bond portfolio should have a duration equal to the investor’s time horizon to be effectively immunized.

A zero-coupon bond will always have a duration equal to its maturity.

As the coupon rate increases, the duration decreases.

There is a direct relationship between duration and the term of a bond. As term increases or decreases, duration will increase or decrease. There is an inverse relationship between the coupon rate/yield to maturity and duration. Remember, coupon rate and yield to maturity are INterest rates and there is an INverse relationship. The IN should help keep it straight.

Sixth on the left.

Inputs:

• y = Yield to Maturity of the Bond.
• c = Coupon Rate of the Bond.
• t = Number of Periods to Maturity.

Note - adjust the y, c and t if compounding is semiannual. Simply divide y and c by 2 and multiply t by 2.

Question 95

Where is the formula for estimating bond price on the formula sheet, and what are its inputs?

Answer 95

Inputs:

• D = Duration.
• y = Yield to Maturity.
• Ay = Change in Interest Rates.
• AP / P = % Price Change

A = Delta symbol

Sixth on the right.

Question 96

Mike is saving for his child’s education, which is approximately 4 years from now. Which of the following bonds should Mike invest in to immunize his portfolio?

Bond A: AAA rate, 5-year maturity, 3.86 duration, 11% coupon, selling for $954.
Bond B: AA rated, 4-year maturity, 3.2 duration, 12.5% coupon selling for $982.
Bond C: A rated, zero-coupon, 5 year maturity, selling for $575.

a) Bond B, because its maturity matches the goal time frame.
b) Bond A, because it has a higher credit rating than Bond A.
c) Bond C, because it’s a zero coupon, its duration is 5 years.
d) Bond C, because it has a greater discount than Bond A
e) Bond A, because its duration matches the goal time frame.

Answer 96

Answer: E

To immunize a portfolio, the duration must equal the time horizon. Bond B’s duration is too low and does not match the investor’s time horizon. Bond C is too long. The best answer is bond A.

Question 97

John has determined that he will need cash at the end of 8 years. Which of the following bonds may initially immunize his portfolio?

a) A 10-year maturity coupon bond.
b) A 8-year maturity coupon bond.
c) A series of Treasury bills.
d) A 15-year zero-coupon bond.

Answer 97

Answer: A

Answer A is the best answer because the 8-year maturity coupon bond will have a duration of less than 8 years, whereas the 10-year bond will be closer to 8 years. A 15-year zero-coupon bond will have a duration equal to 15 years.

Question 98

If an investor expects interest rates to increase, which type of bond would the investor prefer?

• Bond A: AAA rate, 10-year maturity, 8.86 duration, 11% coupon, selling for $954.
• Bond B: AA rated, 5-year maturity, 4.2 duration, 12.5% coupon selling for $982.
• Bond C: AA rated, zero-coupon, 30 year maturity, selling for $575.

a) Bond A.
b) Bond B.
c) Bond C.

Answer 98

Answer: B

The bond with the smallest duration will be the least sensitive to changes in interest rates. The bond with the smallest duration will have the shortest term and highest coupon/YTM.

Question 99

An investor expects interest rates to decrease, which type of bond would the investor prefer if the investor wants to maximize his capital gains?

• Bond A: AAA rate, 10-year maturity, 8.86 duration, 11% coupon, selling for $954.
• Bond B: AA rated, 5-year maturity, 4.2 duration, 12.5% coupon selling for $982.
• Bond C: AA rated, zero-coupon, 30-year maturity, selling for $575.

a) Bond A.
b) Bond B.
c) Bond C.

Answer 99

Answer: C

The bigger duration of a bond, the more sensitive to changes in interest rates. By choosing the bond with the biggest duration, an investor will experience the biggest capital gain. The bond with the longest term and smallest coupon/YTM.

Question 100

Which one of the following types of investor benefits most from the tax advantages of preferred stocks? (CFP Certification Examination, released 3/95)

a) Government.
b) Individual.
c) Corporate.
d) Mutual Funds.
e) Nonprofit institutional.

Answer 100

Answer: C

Corporations receive a 50 or 65% deduction of dividends (preferred and common stock) based on percentage of ownership of the company paying the dividends (covered in tax) for tax years beginning after December 31, 2017.

Question 101

What is the formula for Convertible Bonds, and what are its inputs?

Answer 101

CV = (PAR / CP) x Ps

• Ps is the price of the common stock.
• CP is the conversion price.
• (1,000 / CP) is the conversion ratio or the number of shares the convertible can be converted into.

Question 102

William purchased a bond for $1,050. The conversion price is $40 and the market price of the common stock is $35. What is the conversion value of the bond?

a) $300
b) $400
c) $875
d) $1,050

Answer 102

Answer: C

CV = (1,000 / $40) x $35

CV = $875

Question 103

What is the formula for Property Valuation, and what variables are used to calculate net operating income (NOI)?

Answer 103

Cash operating expenses does not include depreciation or amortization, which are not cash expenses. It also excludes payments on debt service since this is a financing expense, not an operating one.

Simply take net income and add back depreciation and financing activities.

Question 104

Trippy owns 20 condominiums on the Gulf Coast of Florida. The condominiums rent for $9,167 per month. Trippy has a 10% vacancy rate and his total expenses for the year are $1,500,000. He pays $250,000 on his mortgage where $50,000 represents the interest. Assuming a 10% required rate of return, how much would an investor be willing to pay for the property?

a) $1,000,000
b) $5,300,720
c) $6,300,720
d) $7,300,720

Answer 104

Answer: B

Question 105

What is the Net Asset Value (NAV) formula?

Answer 105

NAV = (Assets - Liabilities) / Shares Outstanding

Question 106

Tip!

Answer 106

Unit Investment Trusts (UITs) are passively managed and self-liquidating.

Question 107

A client has a growth objective but requires a large percentage of the return to be tax-efficient. Which of the following products would be most appropriate for this client? (CFP® Certification Examination, released 2004)

a) Non-leveraged equipment leasing.
b) Balanced mutual fund.
c) Preferred stock mutual fund.
d) Stock index fund.

Answer 107

Answer: D

Stock index funds are tax-efficient because they have a low turnover ratio. Stocks are not frequently added or removed from an index, which leads to low turnover and infrequent capital gains distributions.

Question 108

Tip!

Answer 108

American Depository Receipts (ADRs) do not eliminate exchange rate risk.

Question 109

American depository receipts (ADRs) are used to: (CFP® Certification Examination, released 3/95)

1. Finance foreign exports.
2. Eliminate currency risk.
3. Sell US securities in overseas markets.
4. Trade foreign securities in US markets.

a) 1 and 3.
b) 1 and 4.
c) 2 and 4.
d) 4 only.
e) 1, 2, and 4.

Answer 109

Answer: D

Answer C is tempting, but not correct. ADRs trade in US dollars on the US markets, but the actual foreign shares are held in a domestic bank’s foreign branch and the exchange of currency happens there, so currency risk is still relevant.

Question 110

Which option will provide the investor with the maximum gains if the stock price appreciates?

Answer 110

Buying a Call.

Question 111

Which option will allow the investor to maximize gains if the stock price falls?

Answer 111

Buying a Put.

Question 112

How do you calculate the intrinsic value of a call and put option?

Answer 112

Intrinsic Value

• Call Option: Stock Price – Strike Price.
• Put Option: Strike Price – Stock Price.

Intrinsic value cannot be less than 0.

It’s also critical to remember that intrinsic value cannot be less than zero.

Question 113

Holly purchases a call option on Starbucks. The strike price is $50 and the stock is trading at $53. The call expires in two months and the premium is $5. What is the intrinsic value of her call option?

a) $2
b) $3
c) $4
d) $5

Answer 113

Answer: B

Call Option Intrinsic Value: Stock Price – Strike Price

Intrinsic Value = $53 – $50

Intrinsic Value = $3

Time Component = $5 – $3 = $2

Question 114

Holly purchases a put option on Starbucks. The strike price is $50 and the stock is trading at $40. The put expires in two months and the premium is $13. What is the intrinsic value of her put option?

a) $2
b) $3
c) $10

d)

Answer 114

Answer: C

Put Option Intrinsic Value: Strike Price – Stock Price

Intrinsic Value = $50 – $40

Intrinsic Value = $10 Time

Component = $13 – $10 = $3

Question 115

Walter purchases 2 call options on ABC with a strike price of $50, for a $3 premium. At expiration, the stock is trading for $27. What is Walter’s gain or loss on the transaction?

a) $600 Gain
b) $600 Loss
c) $300 Gain
d) $300 Loss

Answer 115

Answer: B

St: He doesn’t own the underlying stock, no gain or loss on the stock.

O: Intrinsic value = Stock Price - Strike = $27 - $50 = $0 (Cannot have a negative intrinsic value)

P: Premium paid =

S: Shares = 200 Gain or Loss Equals: (0 + ) x 200 = $600 Loss.

Question 116

Harold purchases 3 put options on XYZ with a strike price of $30, for a $1 premium. The stock is trading at $35 when Harold purchases the put option. At expiration, the stock is trading for $27. What is Harold’s gain or loss on the transaction?

a) $600 Gain
b) $600 Loss
c) $300 Gain
d) $300 Loss

Answer 116

Answer: A

St: He doesn’t own the underlying stock, no gain or loss on the stock.

O: Intrinsic value = Strike - Stock Price = $30 - $27 = $3

P: Premium paid =

S: Shares = 300 Gain or Loss Equals: ($3 + ) x 300 = $600 Gain.

Question 117

Tom sells 5 call options on ACME with a strike price of $20, for a $1 premium. The stock is trading at $18 when Tom sells the call options. At expiration, the stock is trading for $27. What is Tom’s gain or loss on the transaction?

a) $3,000 Gain
b) $3,000 Loss
c) $7,000 Gain
d) $7,000 Loss

Answer 117

Answer: B

St: He doesn’t own the underlying stock, no gain or loss on the stock.

O: Intrinsic value = Stock Price - Strike = $27 - $20 = $7 (IMPORTANT NOTE - When SELLING a call, the investor would have to buy the call option to close out the position. You must calculate this as a LOSS of $7 per share because he would have to buy the option back.)

P: Premium Received = $1

S: Shares = 500 Gain or Loss Equals: (+ $1) x 500 = $3,000 Loss.

Question 118

Sherri sells 10 put options on ABC Inc. with a strike price of $50, for a $3 premium. The stock is trading at $52 when Sherri sells the put options. At expiration, the stock is trading for $30. What is Sherri’s gain or loss on the transaction?

a) $20,000 Gain
b) $20,000 Loss
c) $17,000 Gain
d) $17,000 Loss

Answer 118

Answer: D

St: She doesn’t own the underlying stock, no gain or loss on the stock.

O: Intrinsic value = Strike - Stock Price = $50 - $30 = $20 (IMPORTANT NOTE - When SELLING a put, the investor would have to buy the put option to close out the position. You must calculate this as a LOSS of $20 per share because she would have to buy the option back.)

P: Premium Received = $3

S: Shares = 1,000 Gain or Loss Equals: ( + $3) x 1,000 = $17,000 Loss.

Question 119

How do you “protect profits” or “lock-in gains” using options?

Answer 119

Buying a put. This is true whether it’s a put on a single stock or an index to protect a diversified portfolio of common stocks.

Question 120

What is the Black Scholes pricing model, and what variables does it consider?

Answer 120

The Black Scholes Model is used to determine the value of a CALL option.

• The Black Scholes Model considers the following variables:
  
  • Current price of the underlying asset.
  • Time until expiration.
  • The risk-free rate of return.
  • Volatility of the underlying asset
• All variables have a direct relationship on the price of the option, except the strike price. As the strike price increases, the option decreases in value.

Question 121

What is the Put/Call Parity pricing model?

Answer 121

Attempts to value a PUT option based upon a call option.

Question 122

What is the Binomial Pricing Model?

Answer 122

Explains prices based upon the underlying asset price moving in two directions.

Question 123

How are options taxed?

Answer 123

If the contract expires without being exercised, the premium paid is a short-term loss and the premium received is a short-term gain

Question 124

A call option with a strike price of $110 is selling for $3.50 when the market price of the under-lying stock is $108. The intrinsic value of the call is: (CFP Certification Examination, released 3/95)

a) $0.
b) $1.50.
c) $2.
d) $3.50.
e) -$2.

Answer 124

Answer: A

Call = Stock Price - Strike Price

Call = $108 - $110

Call is out of the money, therefore, zero intrinsic value. Remember, intrinsic value cannot be less than zero. The $3.50 premium represents the time premium only.

Question 125

A client purchased 100 shares of Yahoo at $30. Yahoo is now trading at $42. The client buys a put option with a strike price of $40 for $1. How much would the client make (in total) if the stock was trading at $35 on the expiration date?

a) $500.
b) $600.
c) $700.
d) $800.
e) $900.

Answer 125

Answer: E

St: $35 - $30 = $5 per share

O: Strike - Stock = $40 - $35 = $5

P: premium paid

S: 100

Gain or Loss: ($5 + $5 + ) x 100 = $900.

Question 126

A client purchased one call option with a strike price of $50 and a premium of $6. A client also purchased one put option with a strike price of $40 and a premium of $8.

What is the client’s gain or loss (per share) if the stock closes at $45 on expiration?

a) $2 Loss Per Share.
b) $2 Gain Per Share.
c) $6 Gain Per Share.
d) $14 Loss Per Share.

Answer 126

Answer: D

Call Option:

St: $0 (doesn’t own the underlying stock)

O: (Stock Price - Strike Price) = $45 - $50 = $0 (cannot have negative intrinsic value)

P: premium paid

S: N/A - Question asks about per share gain or loss

Call Gain or Loss = $0 + $0 + =

Put Option:

St: $0 (doesn’t own the underlying stock)

O: (Strike Price - Stock Price) = $40 - $45 = $0 (cannot have negative intrinsic value)

P: premium paid

S: N/A - Question asks about per share gain or loss Put Gain or Loss = $0 + $0 + =

Question 127

A client purchased one call option with a strike price of $50 and a premium of $6. A client also purchased one put option with a strike price of $40 and a premium of $8.

What is the client’s gain or loss (per share) if the stock closes at $60 per share on expiration?

a) $2 Loss Per Share
b) $4 Loss Per Share
c) $8 Gain Per Share
d) $14 Gain Per Share

Answer 127

Answer: B

Call Option:

St: $0 (doesn’t own the underlying stock)

O: (Stock Price - Strike Price) = $60 - $50 = $10

P: premium paid

S: N/A - Question asks about per share gain or loss

Call Gain or Loss = $0 + $10 + = $4

Put Option:

St: $0 (doesn’t own the underlying stock)

O: (Strike Price - Stock Price) = $40 - $60 = $0 (cannot have negative intrinsic value)

P: premium paid

S: N/A - Question asks about per share gain or loss

Put Gain or Loss = $0 + $0 + =

Total Gain or Loss = Call Gain of $4 + Put Loss of $8 = $4 per share loss

Question 128

A client purchased one call option with a strike price of $50 and a premium of $6. A client also purchased one put option with a strike price of $40 and a premium of $8.

What is the client gain or loss (per share) if the stock closes at $30 per share on expiration?

a) $2 Loss Per Share
b) $4 Loss Per Share
c) $8 Gain Per Share
d) $14 Gain Per Share

Answer 128

Answer: B

Call Option:

St: $0 - Doesn’t own the underlying stock

O: (Stock - Strike) = $30 - $50 = $0 (cannot have a negative intrinsic value)

P: Premium paid

S: N/A - Question asks about per share gain or loss

Call Gain or Loss = $0 + $0 + =

Put Option:

St: $0 - Doesn’t own the underlying stock

O: Strike - Stock = $40 - $30 = $10

P: Premium paid

S: N/A - Question asks about per share gain or loss

Put Gain or Loss = $0 + $10 + = $2

Total Gain or Loss = Call Loss of + Put Gain of $2 = $4 Loss Per Share

Question 129

Theresa sells a call option for a premium of $5. The call has an exercise price of $50. Which of the following statements is true?

a) Theresa’s maximum gain potential is $50.
b) Theresa’s maximum loss potential is $45.
c) Theresa’s maximum gain potential is unlimited.
d) Theresa’s maximum loss potential is unlimited.

Answer 129

Answer: D

By selling a call option, Theresa has given the buyer the right to buy a stock from her for $50 per share. Theoretically, the stock could go to infinity; therefore, Theresa would have to buy the stock at that price and then sell it to the option buyer at $50 per share. Therefore, Theresa’s loss potential is unlimited.

Question 130

With the same dollar investment, which of the following strategies can cause the investor to experience the greatest loss? (CFP Certification Examination, released 3/95)

a) Selling a naked put option.
b) Selling a naked call option.
c) Writing a covered call.
d) Buying a call option.
e) Buying the underlying security.

Answer 130

Answer: B

Selling a naked call has the greatest loss potential. When selling a naked put, the most an investor could lose is the strike price because the stock could fall to zero and the investor would be forced to buy the stock at the strike price. Writing a covered call is relatively conservative because the option seller owns the underlying asset. Anytime an investor buys an option, the maximum loss is limited to the premium paid. When buying the underlying security, the maximum loss is the stock price paid.

Question 131

A money fund manager in the United Kingdom is concerned about a decrease in the British Pound. What should the fund manager do?

a) Purchase a futures contract on the British Pound.
b) Buy a futures contract on the US Dollar.
c) Sell a futures contract on the US Dollar.
d) Sell a futures contract on the British Pound.

Answer 131

Answer: D

The fund manager is inherently long on the British Pound. To hedge the fund manager’s risk, the manager should enter into an opposite position. The opposite position would be to short the British Pound. This is accomplished by selling a futures contract.