Equity Investment - Questions

Question 1

Which of the following statements about a security market index is most accurate?

A)
If an index increases by 5% in one year, the market return for the year is 5%.

B)
An index must use actual prices from market transactions.

C)
An index may reflect dividends paid by its constituent securities.

Answer 1

C
(c)An index that is designed to measure total return will include dividends in its calculation.
(b)Some security market indices use estimated prices when actual prices are not available.
(a)The percent change in a security market index is the return on a portfolio of its constituent securities. Whether this represents an estimate of the market return depends on the nature and purpose of the index (for example, a security market index may be designed to represent a particular industry or asset class).

(Module 37.1, LOS 37.a)

Question 2

When using a security market index to represent a market’s performance, the performance of that market over a period of time is best represented by:

A)
the index value.

B)
the change in the index value.

C)
the percent change in the index value.

Answer 2

+ C
Explanation
Percentage changes in the value of a security market index over time represent the performance of the market, segment, or asset class from which the securities are chosen.

Question 3

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

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

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

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

Answer 3

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

Question 4

An analyst with Guffman Investments has developed a stock selection model based on earnings announcements made by companies with high P/E stocks. The model predicts that investing in companies with P/E ratios twice that of their industry average that make positive earnings announcements will generate significant excess return. If the analyst has consistently made superior risk-adjusted returns using this strategy, which form of the efficient market hypothesis has been violated?

A)
Semistrong and strong forms only.

B)
Strong, semistrong, and weak forms.

C)
Weak form only.

Answer 4

A:
Explanation
The semistrong form of EMH states that security prices rapidly adjust to reflect all publicly available information. If the analyst can use his model, which is based on publicly available information, to earn above average returns, the semistrong form of the EMH has been violated. If the semistrong form of EMH is violated, the strong form of EMH is also violated.

(Module 38.1, LOS 38.e)

Question 5

The idea that uninformed traders, when faced with unclear information, observe the actions of informed traders to make decisions, is referred to as:

A)
herding behavior.

B)
information cascades.

C)
narrow framing.

Answer 5

B
“Information cascades” refers to uninformed traders watching the actions of informed traders when making investment decisions. Herding behavior is when trading occurs in clusters, not necessarily driven by information. Narrow framing refers to investors viewing events in isolation.

Question 6

An increase in which of the following factors would most likely improve a market’s efficiency?

A)
Bid-ask spreads.
Incorrect Answer
B)
Restrictions on short selling.
Incorrect Answer

Answer 6

C)
Number of participants.
Correct Answer
Explanation
As the number of market participants increases, the speed at which markets adjust to new information is likely to increase. Restrictions on short selling limit the ability of arbitrage to correct pricing anomalies. (!)High bid-ask spreads increase transaction costs and decrease efficiency.

Question 7

Octagon Advisors believes that the market is semi-strong efficient. The firm’s portfolio managers most likely will use:

A)
active portfolio management strategies.

B)
passive portfolio management strategies.

C)
an enhanced indexing strategy that relies on trading patterns.

Answer 7

B
Explanation
If the market is semi-strong efficient, portfolio managers should use passive management because neither technical analysis nor fundamental analysis will generate positive abnormal returns on average over time.

(Module 38.1, LOS 38.e)

Question 8

The type of securities market index that has a bias toward value stocks is an index with weights based on:

A)
earnings.

B)
security prices.

C)
market capitalization

Answer 8

A
Explanation
Fundamental-weighted indexes, such as those weighted on earnings, dividends, or book values, tend to weight value stocks more heavily than growth stocks.
(Module 37.1, LOS 37.d)

Question 9

(!new) James Investments is calculating an equally weighted index on a four stock portfolio.

Stock N of Shares Cost 0 Cost 1
W 100 5.00 5.00
X 1,000 10.00 12.50
Y 500 7.50. 10.00
Z 1500 5.00 8.00
If the initial index value is 100, the current index is closest to:

A)
142.6.

B)
129.5.

C)
137.9.

Answer 9

B
First calculate the return relatives and then find the mean of the relatives. The number of shares is irrelevant in this question.

5/5 = 1

12.5/10 = 1.25

10/7.50 = 1.33

8/5 = 1.60

(1 + 1.25 + 1.33 + 1.60) / 4 = 1.295

100 × 1.295 = 129.5

(Module 37.1, LOS 37.e)

Question 10

When a security is added to a widely followed market index, the security’s price is most likely to:

A)
be unaffected.

B)
decrease.

C)
increase.

Answer 10

C
Explanation
Adding a security to a market index typically causes an increase in that security’s price as portfolio managers who track the index purchase the security.

Question 11

Which of the following would be inconsistent with an efficient market?

A)
Price adjustments are biased.

B)
Price changes are independent.

C)
Stock prices adjust rapidly to new information.

Answer 11

A
Explanation
Market efficiency assumes that investors adjust their estimates of security prices rapidly to reflect their unbiased interpretation of the new information. New information arrives randomly and independently. Therefore, price changes are independent.

Question 12

(!) Which of the efficient market theory?

A)
All investors have learned to exploit signals related to future performance.

B)
Low P/E stocks tend to have positive abnormal returns over the long run.

C)
Trend analysis is worthless in determining stock prices.

Answer 12

B
Explanation
P/E information is publicly available information and therefore this test relates to the semistrong-form EMH. Trend analysis is based on historical information and therefore relates to the weak-form EMH. In an efficient market one would expect 50% of pension fund managers to do better than average and 50% of pension fund managers to do worse than average. If all investors exploit the same information no excess returns are possible.

Question 13

If the momentum effect persists over time, it would provide evidence against which of the following forms of market efficiency?

A)
Weak form only.

B)
Semistrong form only.

C)
Both weak form and semistrong form.

Answer 13

C

The momentum effect suggests it is possible to earn abnormal returns using market data. All three forms of market efficiency (weak form, semistrong form, and strong form) assume that market prices fully reflect market data.

(Module 38.1, LOS 38.f)

Question 14

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

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

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

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

Answer 14

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

Question 15

Which of the following statements best describes the overreaction effect?

A)
High returns over a one-year period are followed by high returns over the following year.

B)
High returns over a one-year period are followed by low returns over the following three years.

C)
Low returns over a three-year period are followed by high returns over the following three years.

Answer 15

С
Explanation
The overreaction effect refers to stocks with poor returns over three to five-year periods that had higher subsequent performance than stocks with high returns in the prior period. The result is attributed to overreaction in stock prices that reverses over longer periods of time. Stocks with high previous short-term returns that have high subsequent returns show a momentum effect.

Question 16

Participating preference shares most likely:

A)
receive extra dividends if firm profits exceed a predetermined threshold.
Correct Answer
B)
give the shareholder the right to sell the shares back to the firm at a specific price.
Incorrect Answer
C)
can be exchanged for common stock at a ratio determined at issuance.
Incorrect Answer

Answer 16

a
Explanation
Participating preference shares receive extra dividends if firm profits exceed a predetermined threshold. Convertible preference shares can be exchanged for common stock at a conversion ratio determined at issuance. Putable common shares give the shareholder the right to sell the shares back to the firm at a specific price.

(Module 39.1, LOS 39.a)

Question 17

With which of the following types of equity shares does the investor typically have the greatest voting power?

A)
Common shares.

B)
Participating preference shares.

C)
Unsponsored depository receipts.

Answer 17

A
Explanation
While common shares have voting rights, preference shares typically do not. With unsponsored depository receipts, the depository bank retains the right to vote the shares.

Question 18

Private equity investment securities are issued:

A)
only by private firms.

B)
by both public and private firms.

C)
by public firms but not by private firms.

Answer 18

B
Explanation
Private equity securities are not registered for public trading but may be issued by firms that have issued publicly traded common stock (public firms) as well as firms that do not have any publicly traded securities (private firms). A private investment in public equity (PIPE) is an example of private equity securities issued by a public company.

(Module 39.1, LOS 39.c)

Question 19

When analyzing an industry characterized by increasing book values of equity, return on equity for a period is most appropriately calculated based on:

A)
average book value.

B)
beginning book value.

C)
ending book value.

Answer 19

F
Explanation
When book values are not stable, analysts should calculate ROE based on the average book value for the period. When book values are more stable, beginning book value is appropriate.

Question 20

Dividends on non-participating preference shares are typically:

A)
a contractual obligation of the company.

B)
a fixed percentage of par value.

C)
lower than the dividends on common shares.

Answer 20

B
Explanation
Similar to the interest payments on a debt security, dividends on non-participating preference shares (preferred stock) are typically fixed. Unlike the interest payments on a debt security, the company is not contractually obligated to pay preferred dividends. Preferred dividends are typically higher than a firm’s common dividends.

Question 21

(new)A U.S. investor purchases ADRs of a Japanese company, while a Japanese investor purchases the same value of the company’s common stock. Compared to the Japanese investor, the U.S. investor will most likely:

A)
benefit from greater transparency.

B)
realize different returns.

C)
face the same risk.

Answer 21

B
Explanation
The return to the U.S. investor is affected by the return on the shares in Japanese yen and by the dollar/yen exchange rate. The U.S. investor therefore faces additional currency risk, which will most likely result in returns that differ from those a Japanese investor would realize. ADRs do not necessarily offer greater transparency to foreign investors than that which is available to domestic investors.

Question 22

Private equity securities most likely:

A)
are issued to individual investors.

B)
are illiquid and do not have quoted prices.

C)
trade in over-the-counter dealer markets.

Answer 22

B
Explanation
Private equity securities are illiquid and do not trade in public securities markets. Holders of private equity must negotiate with other investors to sell the securities. Private equity securities are typically issued to qualified institutional investors.

(Module 39.1, LOS 39.c)

Question 23

High return on invested capital and high pricing power are most likely to be associated with an industry that has:

A)
high concentration.

B)
low barriers to entry.

C)
high capacity.

Answer 23

a
Explanation
High return on invested capital and high pricing power are associated with high industry concentration (i.e., small number of firms), high barriers to entry, and low industry capacity.

(Module 40.2, LOS 40.h)

*
High industry concentration refers to a situation where a small number of companies or a single dominant company hold a significant share of the total market within a specific industry. It indicates that a large portion of the industry’s market share is controlled by a limited number of firms.