Exam q's Flashcards
The typical small investor would be unlikely to make a trade in which Market?
1,2,3 or 4
The fourth market is direct trades between investors. Because of the expense of trading in this market, only large institutions trade here.
Maturity and minimum denomination of the following:
Commercial Paper
Negotiable CD’s
Bankers Acceptances
Commercial Paper - maximum maturity is 270 days and the minimum denomination is usually $100,000, it can be lower but most institutional investors prefer to deal in minimums of $1M.
Negotiable CDs - usually short term matuirty used by money markets, banks will sell negotiable CDs with a minimum denomination of $100,000. However, trades in negotiable CDs have a minimum denomination of $1 million.
Bankers Acceptances - Usually trade in multiples of $100,000.
Series EE bonds carry a fixed-rate and are investments that are guaranteed to double in value over ….. years. The newer Series I bonds have both a fixed rate and a variable rate to keep up with …….?
Series EE savings bonds double in 20 years
Series I savings bonds have a fixed and variable rate to keep up with inflation
Mortgage Pass-Throughs
Pass through: In a mortgage pass-through, the issuer of the pass-through security collects the payments
from the borrowers, deducts a service charge, and then distributes the payments to the holders of the pass-through security. FNMA and FHLMC are the agencies that issue these securities.
Collateralized Mortgage Obligations
Collateralized mortgage obligations (CMOs) are similar to a pass-through, with one key difference. The issuer of a CMO sequences the securities. These sequences are called tranches. In a traditional CMO (known as a sequential pay CMO), interest will be paid on all of the tranches as promised, but the initial principal payments are directed to paying off only the first tranche. Once the first tranche has been paid in full, then the principal payments are directed to the owners of the second tranche. The holders of the first tranche
have a relatively short-term, low risk security. The holders of the last tranche own a security that has substantial credit risk and risk as to the timing of payments
With regard to collateralized mortgage obligations, which answer below is correct:
(A) The different tranches are of relatively equal safety.
(B) The maturity is fixed, just as with other bond-like instruments.
(C) The issuer is responsible for servicing these instruments.
(D) The principal received each period is relatively certain, the interest income is not.
The answer is (C). (A) is incorrect because although the first tranche is relatively safe, the later tranches can be quite risky. (B) is incorrect because the maturity is dependent upon when the borrowers pay off their mortgages. (D) is incorrect as interest and principal payments both depend on payments made by the mortgage borrowers, both are uncertain.
If the return on a security is normally distributed with an arithmetic mean of 6 percent and a standard deviation of 3 percent, then the probability of earning more than 12 percent is approximately? (A) 5 percent (B) 2½ percent (C) 1 percent (D) ½ percent
The answer is (B). The 12 percent is two standard deviations above the expected rate of return of 6 percent. The probability of a return more than two standard deviations from the expected return is 5 percent. However, this 5 percent is split equally between the upside and downside.
Approximately 68 percent of the time, the actual return will be within one standard deviation of the expected return
One of the most important things to remember about a normal distribution is that approximately 68 percent of the time, the actual return will be within …… standard deviation of the expected return and about 95 percent of the time the actual return will be within …… standard deviations of the expected return.
One of the most important things to remember about a normal distribution is that approximately 68 percent of the time, the actual return will be within one standard deviation of the expected return and about 95 percent of the time the actual return will be within two standard deviations of the expected return.
If the return on a security is normally distributed with an arithmetic mean of 6 percent and a standard deviation of 3 percent, then the probability of earning more than 12 percent is approximately (A) 5 percent (B) 2½ percent (C) 1 percent (D) ½ percent
The answer is (B). The 12 percent is two standard deviations above the expected rate of return of 6 percent. The probability of a return more than two standard deviations from the expected return is 5 percent. However, this 5 percent is split equally between the upside and downside.
You just bought a bond for 105 ($1,050). The bond will pay $70 in coupon payments annually. You plan to hold it to maturity in 10 years, and you believe you will be able to reinvest the coupons at a 5 percent rate of return. What would be your realized compound yield to maturity? (A) 5 percent (B) 5.5 percent (C) 6 percent (D) 6.5 percent
The answer is (C). The keystrokes for the realized compound yield to maturity are: SHIFT, C ALL; 10, N; 5, I/YR; 70, PMT; FV {Display: –880.45}; SHIFT, C ALL; 10, N; 1050, +/-, PV; 1880.45, FV; I/YR {Display: 6.00}
For a bond that pays $35 interest annually, trades at a price of 85 (i.e., $850), has a par value of $1,000, and a term to maturity of 8 years, the yield to maturity is
The answer is (B). The keystrokes for the yield to maturity are: SHIFT, C ALL; 8, N; 850, +/-, PV; 35, PMT; 1000, FV; I/YR {Display 5.91%}
Which of the following is correct with respect to what are known as alternative investments?
(A) a problem with trading collectibles is that there are no price indexes to get a sense of their change in value
(B) the depletion allowance for growing timber is an attractive tax incentive for investors
(C) the prices of collectibles are primarily a function of the demand curve
(D) gold jewelry is a good alternative investment as its value will move with the price of gold
The answer is (C). (A) is incorrect because both Barron’s and Forbes report the Sotheby index for prices of certain collectibles. (B) is incorrect because the depletion allowance applies to mineral rights, not timber. (D) is incorrect because although the price of jewelry will reflect, to some extent, the content of any precious metal such as gold, the price is mainly a function of the exquisiteness of the design and the currency of the style.
Suppose stocks X and Y have standard deviations of 5 percent and 10 percent and a covariance of 0. If 40 percent of a portfolio is invested in X and 60 percent in Y, what is the standard deviation of this two-security portfolio? (A) 6.3 percent (B) 7.5 percent (C) 8.0 percent (D) 40.0 percent
The answer is (A). The answer is calculated as follows:
Variance = (.402 x 52) + (.602 x 102) + (2 x .40 x .60 x 0) = 4 + 36 + 0 = 40
Standard deviation = Square root of 40 or 6.3 percent
Keystrokes: SHIFT, C ALL; .4, x, .4, x, 5, x, 5, =, M+; .6, x, .6, x, 10, x, 10, =, M+; 2, x, .4, x, .6, x, 0, =, M+; RM; SHIFT, yx, .5, = {Display: 6.3}
Which of the following statements concerning betas is correct?
(A) Stocks with negative betas have the least amount of risk.
(B) A stock with a beta equal to 1 has no risk.
(C) A stock with a beta of 0 is expected to provide a rate of return equal to the market portfolio.
(D) A stock with a beta greater than 1 is expected to be more volatile than the market portfolio.
The answer is (D). (A) is incorrect because a stock with a negative beta only means it moves opposite to the general market, not that it has the least risk. (B) is incorrect because a stock with a beta of 1 should move about the same as the overall market. (C) is incorrect because a stock with a beta of 0 would provide a rate of return about the same as the risk-free rate.
What is Modern Portfolio Theory and why is it important to understand?
Modern portfolio theory (MPT) is a theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward. According to the theory, it’s possible to construct an “efficient frontier” of optimal portfolios offering the maximum possible expected return for a given level of risk.
It is important to understand because it is the basis for how most professionals think about the market.
Which of the following is a feature of the S&P 500 Index?
(A) it is the most commonly quoted index
(B) the index includes common stocks, preferred stocks, and warrants, but not rights
(C) the adjustment for dividends paid in shares of stock (i.e., stock dividends) is always complicated
(D) it is a value-weighted index
The answer is (D). (A) is incorrect because the most commonly quoted index is the Dow Jones Industrial Average. (B) is incorrect because the index includes only common stocks. (C) is incorrect because, as a value-weighted index, dividends paid in shares of stock do not alter the market capitalization’s of any of the companies.
Market capitalization is
Market capitalization is equal to the share price multiplied by the number of shares outstanding.
The volatility of a bond’s price when interest rates change is greater
(A) when the term to maturity is shorter.
(B) when the coupon rate is higher.
(C) when its duration statistic is smaller.
(D) when the yield to maturity is lower.
The answer is (D). (A), (B) and (C) are associated with reduced volatility in a bond’s price when interest rates change.
Which of the following is a violation of the wash sale rule?
(A) You sell 27 shares of an S&P 500 index fund at a loss. Then, 15 days later, you buy 42 shares of a Russell 3000 index fund.
(B) You have brokerage accounts at two firms. At the first firm you buy 100 shares of PQR stock. Then, 22 days later, you sell 100 shares of PQR stock, bought the prior year, for a loss in your account at the other firm.
(C) Your spouse buys 200 shares of UK stock. Then, 31 days later, you sell 100 shares of the same stock, bought 43 days earlier, at a slight loss.
(D) You sell 100 shares of UK stock at a slight gain. Then, 4 days later, your spouse buys 200 shares of the same stock.
The answer is (B). (A) is incorrect because the two indices are sufficiently different. (C) is incorrect because the purchase is more than 30 days prior to the sale. (D) is incorrect because the stock is sold at a gain.
Growth investing in stocks typically means investing in which of the following?
(A) above-average-P/E stocks
(B) below-average-P/E stocks
(C) stocks with recent large jumps in their dividend payments
(D) stocks with large recent price increases
The answer is (A). (B) is incorrect because it is the definition of value investing. (C) and (D) are incorrect because they are meaningless as descriptions of investment styles.
Which statement best describes the relationship between the overall economy and the stock market?
(A) There is no discernible relationship between the two.
(B) The stock market typically leads the overall economy.
(C) The stock market typically moves with the overall economy.
(D) The stock market typically lags behind the overall economy.
The answer is (B). The stock market is one of the leading indicators identified by the National Bureau of Economic Research (NBER).
Which of the following is correct with regard to measuring a company’s profitability?
(A) a firm with a weak ROA could still have an average or better ROE if its equity multiplier is large enough
(B) ROE indicates the profits earned relative to the amount of total assets owned by the firm
(C) if two firms in the same industry have the same ROE, then it really doesn’t matter what their ROA ratios are
(D) the equity multiplier is one of the more effective profitability ratios
The answer is (A). (B) is incorrect because ROE is profits relative to equity, not total assets. (C) is incorrect because as ROE = ROA x Equity Multiplier, which means a firm with a weak ROA that uses extensive debt financing (and this has a large equity multiplier), is much weaker than a firm with a strong ROA and little use of debt financing. (D) is incorrect because the equity multiplier is a financial leverage ratio, not a profitability ratio.
Which of the following statements regarding duration is correct?
(A) The higher the coupon rate, the larger the duration statistic.
(B) The duration of a zero-coupon bond equals its term to maturity.
(C) Usually, the longer the term to maturity, the shorter the duration statistic.
(D) The higher the yield to maturity, the larger the duration statistic.
The answer is (B). (A) and (D) are incorrect because duration is inversely related to the coupon rate and yield to maturity. (C) is incorrect because duration is normally directly related to term to maturity.
Duration: It is analogous to the beta statistic for a stock, wherein the higher the beta, the more volatile
the price of the asset for a given change in the market portfolio.
If a standard call on MM stock with a strike price of $20 is purchased for $3 per share, the buyer exercises at the close of trading on the expiration date, and the stock closes at $30 per share, then what is the buyer's profit before taxes and commissions (A) $700 (B) $1,000 (C) $2,000 (D) $2,300
The answer is (A). A standard call option is for 100 shares. If the stock closes at $30 and the strike price is $20, the buyer of the call has a gain of $10 per share, or $1,000 on the stock itself. However, the buyer paid $300 for the option, so the buyer’s net gain is $700 ($1,000 – $300).
Which of the following statements concerning warrants is correct?
(A) The exercise of warrants involves the issuance of new shares by the company.
(B) They typically have a longer term to expiration than rights, but a shorter term to expiration than LEAPS®.
(C) Companies sell them with the hope that they will expire worthless.
(D) When they are issued in conjunction with a bond offering, the bond’s coupon rate is normally higher.
The answer is (A). (B) is incorrect because, not only do warrants have longer terms to expiration than rights, they also typically have longer terms to expiration than LEAPS®. (C) is incorrect because companies issue warrants with the hope that they will be exercised in the future, thus allowing the company to sell stock at a price greater than the current price. (D) is incorrect because attaching the warrants to a bond allows a lower coupon rate to be provided due to the extra benefit of the warrants.
Long-term Equity Anticipation SecuritiesSM (LEAPS®)
Puts and calls are normally written for relatively short periods (9 months is typically the longest available); however, a 1990 innovation in the options market called Long-term Equity Anticipation Securities SM (LEAPS®)—were introduced on the CBOE and the AMEX and they are now traded on all the options exchanges. There are no differences in the terminology or strategy used with LEAPS® as with regular options, other than that LEAPS® can have a substantially longer time to expiration. There are two types of LEAPS®: Equity LEAPS® and Index LEAPS®. Equity LEAPS® have expiration dates as long as 3 years from the date of initial listing. Index LEAPS® may have expiration dates as long as 5 years from the date of the initial listing.
For a bond that pays $55 interest annually, trades at a price of 90 (i.e., $900), has a par value of $1,000, is callable in 5 years at a price of $1,055, and matures in 10 years, the yield to maturity is
6.92%.
The keystrokes for the yield to maturity are: SHIFT, C ALL; 10, N; 900, +/-, PV; 55, PMT; 1000, FV; I/YR {Display: 6.92%}
A cereal manufacturer needs 50,000 bushels of corn next month. The spot (cash market) price for corn is $5 per bushel, and the futures contract with delivery next month has a price of $5.50 per bushel. The manufacturer goes long contracts for 50,000 bushels. Which of the following statements is correct?
(A) The current basis is $.50.
(B) If the basis does not change, the manufacturer will effectively buy the corn for $275,000.
(C) If the basis does not change and the spot price of corn falls, the manufacturer will be glad it hedged with the futures contract.
(D) If the basis decreases (i.e., becomes more negative), the manufacturer will actually make a profit on its hedge.
The answer is (D). (A) is incorrect because the basis is the cash price minus futures price, which, in this case, is –$.50. (B) is incorrect because the manufacturer will buy the corn at the current spot price, or $250,000 ($5 x 50,000 bushels) if the basis does not change. (C) is incorrect because the manufacturer will realize it could have bought the corn for a cheaper price if it had not hedged.
Which of the following statements about financial futures contracts is correct?
(A) A person expecting interest rates to rise and who wants to speculate on that expectation might go long an interest rate futures contract.
(B) The futures contract on 10-year T-notes requires delivery of a T-note with a maturity of 10 years.
(C) Stock market index futures contracts only exist for the S&P 500 index.
(D) The S&P 500 futures contract is worth 250 times the S&P 500 index.
The answer is (D). (A) is incorrect because if interest rates rise, the price of the underlying bond would fall, and the price of the interest rate futures contract would also most likely fall. (B) is incorrect because any T-note with a maturity greater than 6 1/2 years may be delivered. (C) is incorrect because there are at least six different indexes covered by futures contracts.
Which of the following accurately describes tactical asset allocation decisions?
(A) These decisions are made for the purpose of establishing the risk exposure of the portfolio.
(B) These decisions are made only occasionally.
(C) These decisions may include more asset categories than are found in strategic asset allocation decisions.
(D) In an organization, these decisions are made at the highest level.
The answer is (C). (A), (B), and (D) are incorrect because they describe strategic asset allocation decisions.
The main difference between strategic and tactical asset allocation is that tactical asset allocation is used to make changes to an investor’s asset allocation based primarily on short-term capital market expectations. In contrast, strategic asset allocation focuses only on long-term capital market expectations. Tactical asset allocation is used to try to beat the market. Strategic asset allocation is used to assure the riskiness of the portfolio matches the investor’s risk tolerance.
Which of the following statements regarding the psychological issues of investing is correct?
(A) People are more likely to invest when given more choices.
(B) There is a natural tendency for people to see patterns where none exist.
(C) People who check the value of their investments more frequently tend to do better.
(D) Experienced investors usually hold more diversified portfolios.
The answer is (B). (A) is incorrect because more choices typically confuse people and they are less likely to invest. (C) is incorrect because people who check their values more frequently tend to trade unnecessarily. (D) is incorrect because experienced investors tend to be overconfident about their investment selections, and concentrate their holdings.
- Which of the following is (are) correct about corporate bankruptcy?
I. Chapter VII bankruptcy involves the company obtaining court protection while it reorganizes.
II. Any of several parties can initiate a bankruptcy proceeding.
II only
I is incorrect because Chapter VII is for liquidation, Chapter XI is for reorganization.
VII = 7 (liquidating) XI = 11 (reorganizing)
What is a Red Herring?
To initiate a public offering, the issuing firm and its investment banker compose a registration statement. This is submitted to the Securities and Exchange Commission (SEC) for review. During the review period, the investment banker may distribute this registration statement in an effort to drum up initial interest in the offering. Because the front page of the statement contains a paragraph in red ink indicating that the company is not attempting to sell its shares before the SEC approves the registration, the statement is known as a red herring. Red herrings are sometimes revised several times before the issue is ready for sale to the public.
Which of the following statements about investment banking is (are) correct?
I. When a red herring is issued, it means the investment banker is signaling the offering is highly speculative.
II. In a firm commitment, the underwriter buys the securities for resale to the public.
II only.
I is incorrect because a red herring is a preliminary prospectus used to drum up interest in an offering.
Which of the following statements concerning specialists is (are) correct?
I. Specialists make a market in listed stocks.
II. Specialists maintain a book of limit orders to be executed.
Both I and II
A year ago, Sally bought some stock for $40. During the year, she received $2 in dividends, which she took as cash. Now, at the end of the year, her stock is worth $48. Which of the following statements is (are) correct?
I. Her holding period return (HPR) is 5 percent because she has not yet sold the stock and the ending value is therefore speculative.
II. Her holding period return relative (HPRR) is 1.20 percent because return relatives do not include dividends or interest.
Neither I nor II
I is incorrect because the HPR is 25 percent ([8 + 2] / 40); it is immaterial whether or not the holding is actually sold. II is incorrect because the HPRR is then 1.25 (1 plus the HPR).
Which of the following statements regarding short sales is (are) correct?
I. The lender of the stock for a short sale loses any dividends that would otherwise accrue.
II. These transactions can be made only after a downtick.
Neither I nor II
I is incorrect because the borrower of the stock must make good any dividends the lender would have received. II is incorrect because, except under special conditions, short sales may take place anytime.
Which of the following statements about the capital market line (CML) is (are) correct?
I. The CML defines the expected return for any security or portfolio.
II. The CML is defined by combinations of a risk-free asset and the market portfolio.
II only
I is incorrect because the CML is relevant only for fully diversified portfolios.
Capital market line (CML) is a graph that reflects the expected return of a portfolio consisting of all possible proportions between the market portfolio and a risk-free asset.
You have the following holdings with the associated beta values:
Stock Market Value Beta
ABC Co. $30,000 2.0
XYZ Ltd. $30,000 1.4
WJW Inc. $60,000 .9
Which of the following is (are) correct?
I. The portfolio's beta is 1.3. II. The most volatile stock in the portfolio is the ABC Co.
Both I and II are correct.
To compute the portfolio’s beta, first determine the percentage allocation to each asset, then multiply those percentage allocation by the associated betas, and then sum the products. The calculation is:
Name Weight Beta Product
ABC Co. .25 2.0 .5
XYZ Ltd. .25 1.4 .35
WJW Inc. .5 .9 .45
Sum 1.3
Over the last 3 months, a portfolio has rates of return of 8 percent, 4 percent, and –2 percent. Which of the following is (are) correct about its performance?
I. the rate of return for the entire quarter is 10.07 percent
II. the geometric mean monthly rate of return is 3.25 percent
Both I and II
To compute the rate of return for the entire quarter, first convert the per period returns to return relatives, then multiply them together, and then subtract one. The computation is: 1.08 x 1.04 x .98 – 1 = .1007 or 10.07%. To compute the geometric mean return, first convert the per period returns to return relatives, then multiply them together, take the cube root (because there are three time periods), and then subtract one. The computation is: (1.08 x 1.04 x .98)1/3 – 1 = .0325 or 3.25%
The Normandy Fund had a return of 14 percent, a standard deviation of 12 percent, and a beta of 1.2. During the same period, the market had a return of 12 percent and a standard deviation of 8 percent. The risk-free rate was 6 percent. Which of the following statements concerning Normandy’s performance is (are) correct?
I. Normandy’s Sharpe ratio was 0.67.
II. Normandy’s “Jensen’s alpha” was 0.008, or .8 percent.
Both I and II
Sharpe ratio . 14 . 06
. 12
0.67 p f
p
Jensen’s alpha = Rp − [Rf + βp(RM − Rf)]
= .14 − [.06 + 1.2(.12 − .06)]
= .14 − .132
= 0.008 or .8%
Which of the following statements is (are) correct with respect to common stock?
I. Class A common stock would always be preferred to Class B common stock.
II. When voting by proxies, investors can always vote for or against the recommendation of the Board of Directors.
I only
I is incorrect because there are no legal definitions as to what is meant by a Class A or Class B share. Depending on the terms of the shares for a particular company, some investors may prefer Class A and others may prefer Class B.
Which of the following is (are) correct with respect to time-weighted rates of return?
I. A time-weighted rate of return is always less than a dollar-weighted rate of return over the same time period.
II. If a portfolio earns 20% in the first year and loses 20% in the second year, the time-weighted rate of return is –2.02%.
II only
I is incorrect because, depending on when the cash inflows and outflows occurred, a time-weighted rate of return could be higher or lower than a dollar-weighted rate of return.
According to the textbook, when selecting a mutual fund, advisors should, along with other criteria, look for funds:
I. with the best historical performance in terms of total returns.
II. with the lowest fees.
II only
I is incorrect because there is no significant correlation between past and future performance, other than for the worst performing funds, past performance should not be a significant factor in the selection of a fund.
Which of the following statements is (are) correct with respect to the mechanics of paying a dividend?
I. The ex-dividend date precedes the record date.
II. Firms typically increase their dividends in the same quarter of each year, whichever quarter that is.
Both I and II are correct.
Decoration date –> Ex-dividend date –> Record date –> payment date
Ex dividend date is set by the exchange and need to buy shares before this date if you want to receive a dividend.
Which of the following statements about monetary policy is (are) correct?
I. Open market operations are used by the Federal Reserve Board on a daily basis to influence the level of bank reserves.
II. The Federal Reserve Board adjusts reserve requirements almost as frequently as it adjusts its discount rate.
I only
II is incorrect because the Federal Reserve Board rarely changes the reserve requirements; such changes are potentially quite disruptive to the banking industry.
You just received a margin call for $5,000. You can meet the margin call in which of the following ways, assuming a 25% maintenance margin rate?
I. Sell $5,000 worth of stock.
II. Deposit $5,000 in cash.
II only
If you sell $5,000 worth of stock, the loan balance goes down by $5,000, but the market value of your account also goes down by $5,000. For example, suppose you had a $40,000 debit balance and your account balance fell to $46,666. In this case, your margin call would be $5,000.
Margin call = loan – [MV x (1 – MMR)] = $40,000 – [$46,666 x (1 – .25)] = $40,000 – 35,000 = $5,000
If you sell $5,000 in stock and pay down the loan, your loan balance is then $35,000 and the market value of your account is $41,666. You would still be subject to the following margin call: $35,000 – [$41,666 x (1 – .25)] = $35,000 – $31,249.50 = $3,750.50. In other words, you need to sell a lot more stock to meet a margin call than just what the amount of the call is.
Which of the following statements concerning a bond’s yield to maturity is (are) correct?
I. It is the discount rate that causes the present value of the coupon payments and the par value to equal the price of the bond.
II. It is normally found by dividing a bond’s coupon rate by its current market price.
I only
II is incorrect because the coupon rate divided by the current price is the definition of the current yield.
Which of the following statements regarding bond swaps is (are) correct?
I. An example of a tax swap is if an investor sells a bond at a loss and immediately buys a similar but not substantially identical bond.
II. Selling a bond and replacing it with a similar bond that has a higher current yield is a pure-yield pick-up swap.
Both I and II are correct.
Which of the following statements concerning cost basis is (are) correct?
I. Commissions are deductible expenses, not part of the cost basis.
II. Any accrued interest paid on the purchase of a bond is offset against other interest income.
II only
Commissions are added to the cost basis of any asset purchased.
An investment has a 40 percent probability of a 20 percent rate of return, a 35 percent probability of a 0 percent rate of return, and a 25 percent probability of a -10 percent rate of return. Which of the following is (are) correct?
I. The expected rate of return is 5.5 percent.
II. The returns approximate a symmetrical, bell-shaped distribution.
I only
II is incorrect because in this example the highest probability is associated with the highest rate of return and the lowest probability with the lowest rate of return. If one draws a histogram, one will see that the distribution is negatively skewed.
Even though funds, on average, underperform market indices, they can still be good investments for which of the following reasons?
I. Any mutual fund investment is guaranteed to provide adequate diversification.
II. For smaller accounts, they may provide the only effective vehicle for diversification.
II only
I is incorrect because some mutual funds concentrate on stocks from just one sector, industry, or country.
Which of the following statements regarding the Black-Scholes option pricing model is (are) correct?
I. As the risk-free interest rate increases, a call option becomes more valuable.
II. The longer the time to expiration, the more valuable the call option is.
Both I and II
Which of the following statements concerning convertible bonds is (are) correct?
I. They provide an inexpensive way to buy stock.
II. They provide a lower yield than do straight bonds of comparable credit risk and maturity because of the attractiveness of the conversion feature.
II Only
I is incorrect because convertible bonds normally trade at a premium to conversion value. Thus, buying a convertible bond and then converting provides an investor with fewer shares of stock than if the investor had just bought the stock directly to start with.
Which of the following statements concerning futures contracts is (are) correct?
I. Whether one is taking a long or short position, a futures contract requires a deposit analogous to earnest money; no margin loans are involved.
II. Futures contracts can be used for hedging, although hedging limits the potential of windfall gains from favorable price movements.
Both I and II
With regard to the concept of immunizing a bond portfolio, which of the following statements is (are) correct?
I. One of the main goals of immunization is to minimize the variability of the prices of the bonds in the portfolio.
II. Perfect immunization is possible only if there is a one-time-only change in interest rates.
II only
I is incorrect because an immunized portfolio may still have price variability. The goal of immunization is only to lock in the yield to maturity for one’s desired holding period.
Price risk: The risk of an existing bond’s price changing when market interest rates change. If rates increase, the bond’s price decreases, and if rates decrease, the bond’s price increases.Reinvestment rate risk: The risk associated with reinvesting coupon payments as market interest rates change. If rates increase, the coupons
are reinvested at higher rates than previously expected, and if rates decrease, the coupons are reinvested at lower rates than previously expected. A portfolio is immunized when the expected gains from one of these changes exactly off set the expected losses
from the other change.
Which of the following statements regarding the taxation of options is (are) correct?
I. The writer of an option must declare the premium as a capital gain at the time of writing.
II. If the owner of a call exercises the option, the option premium is subtracted from the strike price and commissions paid in determining the investor’s basis on the acquired stock.
Neither I nor II
I is incorrect because the tax treatment of a premium is not determined until the option position is closed out. Hence, at the time of writing, there is no tax recognition of the premium received. II is incorrect because when the owner of a call exercises the option, he or she is buying the stock. Hence, the cost basis of the stock is the premium PLUS the exercise price plus the commissions paid.
