Series-65-Deck-1 Cerifi PETE

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Series 65

1

Registered Investment Adviser Representative

Class Agenda

2

a

Chapter 1Day

1

Chapters 2 & 3Day 2

Chapter 4 Day

3

Series 65 Exam

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Passing Score:

• 72% or higher (94 out of 130 questions)

Number of questions:

• 130, plus 10 “experimental” questions

Time Allowed:

• 180 minutes

Format:

• Multiple choice• Including Roman Numeral and Except Questions

Prometric will provide you with

• Dry erase board and markers• Calculator

Series 65 Exam Breakdown

4

Economic Factors and Business Information – 20 questionsChapter 1

Laws, Regulations, and Guidelines Including Prohibition on Unethical Business Practices – 39 questionsChapter 4

Investment Vehicle Characteristics – 32 questionsChapter 2

Client Investment Recommendations and Strategies – 39 questionsChapter 3

EQUITY VALUATIONSPortfolio Basics

5 6

Equity Analysis

FUNDAMENTAL

Use of public info about the company to make investment decisions

1. Balance sheet • assets – liabilities = net worth (snapshot right

now)

2. Income statement

• sales(rev) – expenses = net income (based on past timeframe)

3. Cash flow statement

• how cash balance changes due to change in balance sheet and income statement

TECHNICAL

Use of past price patterns in the market to make investment decision

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BALANCE SHEET

Current Assets

Cash $20,000Mkt Sec 10,000Acct Rec 30,000Inventory 10,000

Current Assets Total: 70,000

Fixed AssetsVehicles 4,000Real Estate 400,000Depreciation ‐300,000Intangible Assets / Goodwill 800,000Logos 20,000

Fixed Assets Total: 924,000

Total 994,000

Current Liabilities

Acct Payable 4,000Wages 2,000Dividends payable 4,000Note Payable 5,000Interest Payable 2,000

Current Liabilities Total: 17,000

Long Term Liabilities

Mortgage Payable 100,000

Stockholder’s Equity

Common at Par 40,000Paid in Surplus 500,000Retained Earnings 337,000Stockholder’s Equity Total: 877,000

Total 994,000

7

CURRENT

ASSETS

CURRENT

LIABILITIES

LONG

TERM

ASSETS

LONG

TERM

LIABILITIES

Portfolio / Fixed Income Basics

STOCKHOLDERS

EQUITY

Net Worth = Total Assets – Total Liabilities

994 - 117877 =

123

Liquidity Measure’sHow Quickly The Company Can Turn Assets In Cash To Pay Bills Coming Due

Formula

1) Net Working Capital Current assets – current liabilities

2) Current Ratio Current assets / current liabilities

3) Quick Ratio (Acid Test) ‐ best measure Current assets ‐ (inventory and prepaid) / current liabilities

Current Assets –convert into cash 1yr Current Liabilities ‐ payable within 1 year

C ‐ Cash W – wages payable

M – marketable securities (stocks/bonds) A – accounts payable

A ‐ accounts receivable I – interest payable

I ‐ inventory N – notes payable

P – pre‐paid expenses T – taxes payable

Which item is used when computing a corporation's Current Ratio?

A. Net Working Capital B. Long Term Debt C. Inventory D. Sales

Portfolio / Fixed Income Basics 9

Which of the following would be evaluated to measure a company’s liquidity?

A. Accounts receivableB. Income statementC. Cash and inventoryD. Balance sheet


Debt/Equity Ratio

11

• Sources of long‐term capital ✔Common stockholders (Common at Par + Capital in Excess of Par + Retained

Earnings)✔Preferred stockholders ✔Bondholders

• Stockholder’s Equity consists of capital contributed by both common stockholders and preferred stockholders

• Shows how highly “leveraged” a corporation is, and thus, how susceptible it is to defaulting

• Debt/Equity Ratio =Debt

Stockholder’s Equity

What ratio would be used to evaluate a company’s ability to pay off its short term debt?

A. Debt / Equity RatioB. Current Ratio C. Price / Earnings RatioD. Dividend Payout Ratio


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The Statement of Financial Condition for ABC Corporation shows the following:

Current Assets Current Liabilities

Cash: $1,000,000 Wages Payable: $2,000,000Accounts Receivable: $2,000,000 Accounts Payable: $1,000,000Inventory: $2,000,000 Taxes Payable: $1,000,000Prepaid Expenses: $1,000,000

Long Term Assets Long Term Liabilities

Furniture / Fixtures: $1,000,000 Notes Payable: $2,000,000Real Estate: $2,000,000Goodwill: $1,000,000 Stockholder's Equity

Common Equity: $4,000,000

Total Liabilities andTotal Assets: $10,000,000 Stockholders' Equity: $10,000,000

The Current Ratio for ABC Corporation is:

A. 1:1B. 2:1C. 3:2D. 5:2

What is "financial leverage?"

A. Assets minus liabilitiesB. Debt as a percentage of equity C. Operating income as a percentage of bond

interestD. Current assets - current liabilities



ABC Corporation Income StatementFor the year ending 12-31-XX

($000)

Gross Sales 4,000

Expenses 2,000

Operating Income 2,000

Bond Interest 200

Net Income Before Tax 1,800

Taxes 800

Net Income After Tax 1,000

Preferred Dividend 100

Earnings for Common 900

Common Dividend 500

Retained Earnings 400

"GONNER""EBTPC" = Every Body Trades Puts and Calls

Dividend Measures

17

• Dividend Payout Ratio =

✔Measures how much of a company’s earnings are paid to the common shareholders as a dividend

• Dividend Yield =

✔Shows a common stock’s return on money invested looking at dividends only

Common Dividend Paid

Earnings For Common

Annual Dividend

Market Price

Question

18

Which of the following is (are) included in the computation of stockholder's equity?

I. Cash

II. Treasury Stock

III. Retained Earnings

IV. Additional Paid‐In Capital

A. I onlyB. II and III C. II, III, IV D. I, II, III, IV


A company has net income after tax of $4MM. The company pays a $1MM preferred dividend; and a $1MM common dividend. What is the dividend payout ratio?

A. 25%B. 33% C. 50%D. 75%

= 1MM3MM

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Dividend Discount ModelFind The “Present Value” Of The Future Dividend Payments

Dividend discount model –if you want to buy a stock that’s paying a current .50 quarterly dividend. You require an 11% Rate of return on your money and the dividend is expected to grow by 5% each year(based on history of the company).

The “theoretical” price of the stock =

next years dividend / (1 + discount rate – 1+ growth rate)

= $2 / (1.11 – 1.05)

= $2 / .06

= $33.33

The dividend discount model can be used to value:

A. start-up companies B. growth companies C. mature companies D. all companies


Discounted Cash Flows

24

• Find out how attractive the stock (investment) price is compared to the present value of future cash flow

• Use the estimated future cash flows of the company and discount them to todays value (present value)

• The “discount rate” used will be your required rate of return (stable investments use a smaller discount rate and growth co. use a higher rate)

Assumption

1) Growth rate – guesstimate of how much growth in the cash flows

Present Value= future cash flow / 1 + discount rate T

Financial Statements

25

10K

• Annual corporate audited financial statements filed with the SEC

10Q

• Quarterly corporate unaudited financial statements

Once filed with the SEC, these are public documents for investor scrutiny

Footnotes

• Revenue recognition• Inventory valuation method (LIFO or FIFO)• Long term debt maturities• Lease obligations• Pension obligations• Pending litigation

Details of the dollar amount of a corporation’s estimated future legal liability would be found in the:

A. footnotes of the company’s financial statements

B. company’s FOCUS reportC. Blue Sheets filed by the companyD. income statement of the company

Portfolio / Fixed Income Basics 26 27

Economics

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Basic Economics

28

Gross Domestic Product – sum of all goods and services produced IN the U.S.

Real GDP has the inflation factor stripped out

GDP

Consumer Spending

Government Spending

Business Investments

Series #65 Economics / Analysis 29

GDP consists of all of the following EXCEPT:

A. Consumer spendingB. Government spendingC. Foreign Government spendingD. Fixed investment


Gross Domestic Product measures the:

A. price of goods and services in the United StatesB. level of output of goods and services in the

United StatesC. level of consumption of goods and services in

the United StatesD. inflation rate of prices of goods and services in

the United States


What economic indicator shows, on a national basis, buying and investment?

A. GNP B. GDP C. CPI D. BOP

Recession / Depression

32

Recession is a mild downturn in business over 2 quarters (6 month period)

Depression is a downturn in business over 6 quarters (18 month period) & Public fear

Inflation / Deflation

33

Inflation –prices go up/ Interest rates go up more dollars chasing the same goods –

Disinflation – reduction in inflation over a specific period of time

Deflation – prices go down/Interest rates go down fewer dollars chasing the same goods

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Inflation

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Real Interest Rate

• This is the rate of interest being paid minus the inflation rate. The Treasury likes to keep the RIR on their products at around 3% but the Interest rate fluctuates due to inflation, so:

1992 2012

RIR 3% 3%

Inflation 7% 1%

Interest Rate 10% 4%

Question

35

A bond has an interest rate of 12% and the inflation rate is 4%. The Real Interest Rate is:

A. 3%

B. 4%

C. 8%

D. 12%

Question

36

A customer buys a business in 2020 for $100,000. In 2021 they sell the business for $120,000, for a profit of $ 20,000. The interest rate for Treasury Bonds over that same period was 7% and the risk free rate of return was 5%. The inflation rate over this period was 4%. What was the customer’s real rate of return?

A. 3%

B. 12%

C. 16%

D. 20%

Economics: Business Cycle

37

Expansion

• Business Grows

Prosperity

• Peak

Recession

• Contraction

Recovery

• Beginning of a new expansion


Which of the following occurs between a recession and a recovery?

A. expansionB. depressionC. troughD. prosperity


The usual order of the economic cycle is:

A. expansion, recession, recovery, peak B. recession, recovery, peak, expansion C. expansion, peak, recession, recovery D. peak, recession, expansion, recovery

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During which phase of the economic cycle would one most likely find monetary "inflation" starting to occur?

A. Expansion B. Prosperity C. Recession D. Recovery


A six month mild decline in economic activity is a(n):

A. recession B. depression C. correction D. expansion

Economics: Fiscal and Monetary Policy

42

Fiscal Policy Monetary Policy

• Used by the President and Congress

• Government Spending

• Taxes

• Used by the Federal Reserve

o Money Supply

o Interest Rates

o D.O.R.M.

❑ Discount Rate

❑ Open Market Operations

❑ Reserve Requirement

❑ Margin Requirement


Fiscal Policy is set by:

A. Supreme Court decisions B. Congressional action C. Presidential edict D. Federal Reserve action


To stimulate the economy using Fiscal Policy which of the following actions could be taken?

I Tax rates could be reduced II Tax rates could be increased III Government spending could be reduced IV Government spending could be increased

A. I and III B. I and IV C. II and III D. II and IV

Role of the Federal Reserve - DORM

45

• Sets the Discount Rate (window rate)

• Federal Open Market Operations

• Sets the Reserve Requirement for Banks

• Sets the Margin Rate ( Reg T )

• Money Rates set by BANKS

• Prime Rate ‐ to best corporate client

• Broker’s Loan Call Rate ‐ to broker’s for customer margin securities

• Federal ( Fed ) Funds Rate – to another bank

• Fed uses moral suasion✔Dovish tone to talk rates down / hawkish tone to talk rates up

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Open Market Operations – Monetary Policy

46

Ease Money Tighten Money

• Fed reserve board buys back treasuries from banks…

• Bank receives money

• The more money a bank has the less it costs to borrow

• Interest rates go down

• repo

• Fed reserve board sells treasuries to bank…

• Bank pays out money to the fed

• The less money a bank has the more it will cost for consumers to borrow

• Interest rates go up

• Reverse repo


Which of the following rates is the highest?

A. Prime Rate

B. Broker Rate

C. Federal Funds Rate

D. Discount Rate


Which of the following rates is the lowest?

A. Prime Rate

B. Broker Rate


D. Discount Rate


All of the following rates are set by banks EXCEPT:

A. Prime Rate

B. Broker Rate


D. Discount Rate

= bank TO best corporate client

= bank TO broker

= bank TO bank

Volatility/ Beta

50

• Beta measures a security’s volatility when compared to the market as a whole (S&P 500)✔Security with a beta = 1 directly correlated to the market or in sync with the market

✔Security with a beta more than 1 = more volatile than the overall market✔Security with a negative beta = inverse relationship with the market as a whole

• Defensive (Low Beta – below 1)

• Speculative (High Beta – above 1)

Portfolio Construction

51

• Younger companies that don’t have a proven track record, have low or no dividend payout but have above average growth ratesGrowth

• High quality companies with a long track record of increasing earnings and dividend payments, thus increasing the stock price over time

Blue Chip

• No track record, no dividend record, but high potential growthEmerging Growth

• Mature companies that have little growth potential but which pay a very high dividend rate, like utilitiesIncome

• Tracks the business cycle• “Big ticket” items such as cars, houses, major appliances, etc.Cyclical

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Portfolio Construction

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• Does well in a down economy• Credit collection companies, gold stocks, pawn shopsCounter-cyclical

• Unaffected by the business cycle, including pharmaceuticals, food, tobacco, etc.Defensive

• Extremely susceptible to the business cycle or to changes in consumer sentiment

• High flying company one day and a crashing company the next daySpeculative

• Takeover or bankruptcy that is likely to “turn around” producing large capital gainsSpecial Situations

Question

53

Growth stocks would have all of the following characteristics EXCEPT:

A. High price‐earnings ratios

B. High price to book value ratios

C. High dividend payout ratios

D. High retained earnings ratios

Investing Decisions

54

Top-Down Investing• Pick the industry, then the stocks• First looks at the market sectors that are likely to outperform the overall market;

then focuses on the specific sector; and then finally picks the companies in that sector as an investment

Bottom-Up Investing

• Pick the specific companies, regardless of industry sector• Evaluates individual companies within an industry focusing on the company's

business model, management, product lines, growth prospects, and historical performance

• After this, a decision is made for the best investment

Question

55

An analyst evaluates a company’s market prospects, sales growth, product line, profitability, cash flow, capital structure, price/earnings ratio and dividend yield and then compares these to other companies that are in the same economic sector to decide which company is the superior investment. This is an example of:

A. capital rationing

B. bottom up investment approachC. top down investment approach

D. strategic asset allocation

An investment adviser that uses a "top down" approach to portfolio management will:

A. select the key index that he or she believes will outperform other sectors

B. analyze the entire economic outlook to sort out the areas for higher growth potential

C. look for emerging markets that are likely to outperform mature markets

D. select investments based on the size of each issue's market capitalization from largest to smallest


Performance Measurements

57

How? Why?

ROI (Sum of cash flows / Years) / initial investment If the ROI > RRR = invest

Total return Income + Growth / Initial investment Compare returns on all investments

Holding period Return

Same as above Calculates your total return based on the time investment was held

Annualized return (1+ holding period return)1/time ‐ 1 Annualizes the total return Equities are more volatile in short term

After tax yield(tax free equivalent)

Taxable yield * (100% ‐ bracket) How well your investment did considering taxes paid

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AFTER‐TAX YIELD• Computes the rate of return after taxes are paid and is dependent on each

individual’s tax bracket

• When we talk about muni bond interest, we look at the interest as being exempt from Fed. tax

– if you're in the 20% tax bracket and you purchase an 10% corporate, what is the equivalent tax‐free (municipal) yield?

• 10% X $1,000 = $100 annual interest

• tax is 20% or ‐$20 tax

– After tax return = $80; thus 8% Muni = 10% Corp. given a 20% T.B.

After‐Tax Yield = Taxable Yield x (100% ‐ Tax Bracket%)


A customer invests $1,000 on an investment that is expected to generate $100 in the first year, $150 in the second year, and $350 in the third year at which time, the original $1,000 original investment will be returned. What is the Return on Investment (ROI)?

A. 10% B. 20% C. 30% D. 60%


(100 + 150 + 350) / 3 1,000

= 20%

Question

60

Total Return is an appropriate measure of performance for:

I. Common stocks

II. Preferred stocks

III. Bonds

A. I onlyB. I and II

C. II and III

D. I, II, III

A customer has made an investment that pays $20 of interest during its first year and that has appreciated by $250, for a year-end value of $1,300. The customer’s total return is:

A. 1.91%B. 2.38%C. 23.80%D. 25.71%


$20 + 250 = $1,050

25.71%

A trader would buy a security if the expected rate of return was greater than the:

A. required rate of return B. average rate of returnC. risk-free rate of returnD. total rate of return


The “hurdle rate” is the same thing as the:

A. expected rate of returnB. required rate of returnC. risk free rate of returnD. real rate of return


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Which of the following alternate investment choices is most suitable for a customer in a 30% tax bracket who desires the highest rate of return?

A. 6%; 20 year; AAA corporate bondB. 6%; 20 year; Treasury bondC. 6%; 20 year; Municipal bond D. 6%; 20 year; Agency bond


Risk-Free Rate Of Return

67

This is the average return on the safest security – short term Treasuries

• The average return over the last 50 years has been 3%• The last 12 years of near zero interest rates is atypical (NOT NORMAL!!)

The risk free rate of return is the return provided by which of the following investments?

A. Municipals B. Agencies C. Common stocks D. Treasuries


An investment in Treasury Bills has:

A. interest rate risk B. purchasing power risk C. credit risk D. no risk


Comparison Returns

70

How? Why?

Risk adjusted return (risk premium)

Total return – risk free rate

• Where the risk‐free rate is a t‐billHow much excess (incremental) return did you get for taking on more risk

Real rate of return(inflation adjusted return)

Total return – inflation

• Where inflation is measured via CPIHow much excess return are you getting over inflation

Active rate of return Total return – benchmark• Where the benchmark is an equivalent

index

How much excess return are you getting for using an active portfolio manager (are they worth the added fees)

Passive rate of return Benchmark index (beware of tracking error on the index fund)

Use index funds to generate market returns for lower annual fees

The risk premium is the rate of return on an investment over the:

A. holding period returnB. stock dividend rateC. current yieldD. money market return


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A portfolio manager generates a 10% rate of return on a "small cap" portfolio, compared to an 8% rate of return on the benchmark portfolio and a 6% rate of return on the Standard and Poor's 500 index over the same period. The passive rate of return on the portfolio is:

A. 2% B. 6%C. 8% D. 10%


A portfolio manager generates a 10% rate of return on a "small cap" portfolio, compared to an 8% rate of return on the benchmark portfolio and a 6% rate of return on the Standard and Poor's 500 index over the same period. The active rate of return on the portfolio is:

A. 2% B. 4% C. 6% D. 10%


A U.S. based customer has purchased a Treasury Bond at par with a 6.50% coupon. Inflation is 2.25%. If the U.S. dollar declines by 10% against the Euro, the investor's real rate of return is:

A. 2.25%B. 3.60%C. 4.25% D. 6.50%


6.50% nominal rate ‐ 2.25% inflation rate

Statistical Measures

76

• Average returnMean

• Center returnMedian

• Return occurring most oftenMode

• Difference between highest and lowest numberRange


STATISTICAL MEASURES• Mean: Average Return

4% 6% 12% 8% 10% 13% 10%

7

9% average

• Median: Center return

4% 6% 8% 10% 10% 12% 13%

• Mode: Most frequent return

4% 6% 8% 10% 10% 12% 13%

• Range: Difference between the highest and lowest number

13 and 4 = 9

Consider the following returns:

Year 1: 4%Year 2: 6%Year 3: 12%Year 4: 8%Year 5: 10%Year 6: 13%Year 7: 10%

All of the following are measures of central tendency EXCEPT:

A. meanB. medianC. modeD. range


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An investment generates the following annual returns:

Year 1: 6%Year 2: 4%Year 3: 2%Year 4: 6%Year 5: 8%

The mode return is:

A. 2%B. 4%C. 6% D. 8%


Given the set of the following numbers - 5, 4, 11, 6, 8, 5, 12, 13 - what is the range?

A. 8B. 9 C. 10D. 13


ARITHMETIC vs GEOMETRIC MEAN

• Arithmeticmean return is the average annual return; geometricmean return is the compounded annual return

• A $100 investment generates the following returns:– Year 1: +20%– Year 2: ‐10%– Year 3: +20%

– Arithmeticmean return calculation: (+20% ‐ 10% + 20%) / 3 = 10%– Geometric mean return calculation:

• Gaining 20% in Year 1 = $100 x 1.2 = $120• Losing 10% in Year 2 = $120 x .9 = $108• Gaining 20% in Year 3 = $108 x 1.2 = $129.60• Geometric mean return = 9% (100 x 1.09 x 1.09 x 1.09 = $129.50)

• Arithmetic mean return of 10% slightly overstates the actual compound (geometric) return of 9%


The rate of return that considers compounding of returns of the time horizon of an investment is:

A. arithmetic rate of returnB. geometric rate of returnC. expected rate of returnD. annualized rate of return


The essential difference between the arithmetic mean return and the geometric mean return is:

A. arithmetic mean return considers compounding while geometric mean return does not

B. geometric mean return considers compounding while arithmetic mean return does not

C. arithmetic mean return considers probability while geometric mean return does not

D. geometric mean return considers probability while arithmetic mean return does not


Volatility Measures

84

How? Why?

Standard Deviation Something about the sum of the square root of the variance of the individual numbers from the mean (never ask you to calculate it!!!!!)

Volatility of portfolio returns vs the average return(the mean)Higher SD = more risk (more volatility)

Sharpe Ratio Risk adjusted return / standard deviation Higher Sharpe = more incremental reward for risk (vol) taken

Beta Portfolio beta of 2Mkt index return is 10%Portfolio anticipated return 20%

Volatile of the investment in relation to the overall marketHigher Beta = more volatile than the market

Duration Present value of a bond’s future cash flows (cpn and princ), weighted by the length of time to receipt / current market value

Measures bond price volatility due to a change in interest rates‐‐long term‐low coupon bonds are most volatileHigher DURATION = more volatility in bond price

Delta Volatility of options premium due to change in mkt price of the underlying

Why we call options Derivatives

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An investment adviser representative has been reviewing the likelihood that an equity investment will produce the desired return. He has determined that the mean return on the investment is 20%, with a 15% standard deviation, and a 95% probability of occurrence. This means that he would expect the range of returns to be approximately:

A. 5.00% - 35.00%B. 17.00% - 21.10%C. 4.75% - 33.25%D. 16.15% - 20.05%


Question

86

The Sharpe Ratio is a measure of:

A. Volatility

B. Risk‐adjusted return

C. Risk‐free return

D. Required return

Planning Tools

88

How? Why?

Expected Return Sum of (expected return * probability of occurrence) The weighted average of expected returns based on probabilities of occurrence

CAPM – capital asset pricing model

Risk free rate + Risk premiumWhere risk premium = beta * (expected return ‐risk free rate)Assumes investors are risk averse

The expected return including the risk free rate and the risk premium (find most “Efficient investments”)

Future value FV = PV * (1+ expected rate)T Value of asset at a later date assuming a

constant rate of compounding

EXPECTED RATE OF RETURN• Assigns a probability percentage to each of a variety of

investment outcomes and adds them up

Probability of Occurrence Projected Return Expected Return

50% X 4% =

50% X 8% =

Expected Return =

Probability of Occurrence Projected Return Expected Return

20% X -5% =

30% X 10% =

50% X 8% =

Expected Return =


+2%+4%+6%

-1%+3%+4%

+6%

Question

90

The portfolio return measure that calculates a mean rate of return from a probability distribution of all potential rates of return is:

A. Total return

B. Expected return

C. Internal rate of return

D. Holding period return

A trader would buy a security if the expected rate of return was greater than the:

A. required rate of return B. average rate of returnC. risk-free rate of returnD. total rate of return


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COMPOUND VALUE OF A SUM (a.k.a. FUTURE VALUE)

• How much an investment today will be worth at a future date, assuming it compounds at a stated rate of return

– For example, $1,000 today will be worth $1,331 in 3 years if it compounds at a 10% annual interest rate

• $1,000 x 1.1 (Year 1) x 1.1 (Year 2) x 1.1 (Year 3) = $1,331


Year 1: 110% X 1000 – the value is $1100Year 2: 110% X 1100 – the value is $1210Year 3: 110% X 1210 – the value is $1331

Question

93

To find the future value of an investment, the annual investment returns must be:

A. Discounted

B. Compounded

C. Amortized

D. Accreted

What does "X" refer to in the following formula:

X = P ( 1 + i)n

A. Net Present ValueB. Internal Rate of ReturnC. Yield to MaturityD. Compound Value of an Amount


The “hurdle rate” is the same thing as the:

A. expected rate of returnB. required rate of returnC. risk free rate of returnD. real rate of return


Capital Asset Pricing Model

96

• The most efficient investments are found using CAPM – the Capital Asset Pricing Model✔ABCD stock has a Beta = +2✔Expected Market Return = 7%✔Risk‐Free Rate of Return = 1%✔Question: What is ABCD’s Expected Return using CAPM?✔Answer:

• Risk Premium is 2 x (7% – 1%) = 12%• Expected Return = 1% Risk Free Return + 12% Risk Premium = 13%

Question

97

CAPM is used to calculate the:

A. Risk‐free rate of return

B. Expected rate of return

C. Geometric rate of return

D. Total rate of return

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All of the following are components of the Capital Asset Pricing Model EXCEPT:

A. Risk-Free Rate of ReturnB. AlphaC. BetaD. Expected Market Rate of Return


PORTFOLIO RISKS• Systematic Risk

– Risk of the market as a whole and the risk that cannot be diversified away

• Non‐Systematic Risk– Risk of a specific security. As more and more securities are added to a portfolio, the non‐systematic risk is

diversified away, leaving the portfolio only with systematic risk

• Timing Risk– Risk of buying high or selling low because the trades were done at the wrong time

• Capital Risk– Risk of not recovering invested capital due to a poor investment choice

• Value at Risk (VAR)– Measure of how much portfolio value could be lost based on historical reference

– If a portfolio has a 90% value at risk of $1MM, then it is expected that the portfolio cannot lose more than $1MM, 90% of the time

– Determined by Monte Carlo simulations ‐ computer simulations that predict returns based on a broad array of economic variables, with thousands of potential outcomes


Monte Carlo simulation:

A. is used to determine the expected value of an investment's return based on the probability of a specific result occurring

B. establishes a frequency distribution of investment returns over a range of different conditions

C. predicts the variability of return that can occur relative to the mean or median return

D. establishes the asset allocation percentages applied to each asset class based upon an investor's objectives, risk tolerance, and time horizon


Monte Carlo simulation analyzes potential portfolio returns achieved based upon which of the following varying factors?

I interest rates II inflation ratesIII equity returns

A. I onlyB. III onlyC. I and IID. I, II, III


Alpha

103

Not the same alpha that you learned on Series #7!

The excess return offered by a high beta investment as compared to the market return, adjusted up to that investment’s risk level (as measured by beta)

Used to evaluate a hedge fund that takes risky positions to measure the manager’s true investment performance

Alpha Computation

104

• “Beta up” the benchmark return to the same risk level as the chosen investment and compare them✔Assume the S&P 500 index is up 10% (beta of 1)✔Assume XYZ stock is up 25% (beta of 2)✔Assume the risk‐free rate of return is 0✔Alpha calculation:

• XYZ return in excess of risk‐free rate of return = 25%• Risk‐adjusted benchmark return = 10% x 2 = 20% • Alpha of XYZ stock = 25% investment return in excess of risk‐free rate – 20% risk‐adjusted

benchmark return = 5%

✔Alpha = 0, the investment is no better than the market on a risk‐adjusted basis✔Alpha > 0, the investment outperformed the market on a risk‐adjusted basis✔An Alpha < 0, the investment underperformed the market on a risk‐adjusted basis

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An active portfolio manager generates a return of 18.80% on her equity portfolio that has a beta of 1.40. The expected return of the benchmark market index (beta of 1) is 12%. Assuming that the risk-free rate of return is zero, what is the alpha achieved by the manager?

A. +2% B. -2%C. +6%D. -6%


12% * 1.4 = 16.8%

18.8% – 16.8% = +2%

106

During a given period of time, the overall stock market, which has a Beta of 1, is up 8% in value. XYZ stock, which has a Beta of 1.25, is up 11% during the same period. Assuming that the risk-free rate of return is "0," the "alpha" of XYZ stock is:

A. 0% B. 1% C. 10% D. 11%

8% * 1.25 = 10%

11% – 10% = +1%


Efficient Market Theory

107

• General theory – the “market” is efficient at pricing investments (nothing is under/over valued. Bob Barker theory!)

• Using analysis is pointless ‐‐ just Buy ETF’s/Index funds/Passive

3 VERSIONS

What can be used to find undervalued investments (info not reflected in price)

What is already reflected in the market price?

Weak All public information (fundamental) Past price patterns (technical)

Semi‐Strong Inside info Public information and past price patterns

Strong Nothing! Everything

Question

108

Which form of efficient market theory would be used by those who believe that future prices cannot be predicted by past performance?

A. Weak Form

B. Semi‐Weak Form

C. Semi‐Strong Form

D. Strong Form

Fixed Income ValuationsFixed Income Valuations

109

Bond Basics

110

Bonds are generally issued at par with the interest rate set at the current market rate of interest

The interest rate is based up on the bond’s risk level and maturity

Interest payments are made semi-annually

At maturity the bond will be redeemed at par

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Question

111

A $1,000 par bond is issued with 5 years to maturity. The coupon rate on the bond is 3.50%. If the inflation rate for the next 5 years is 2.50%, the bond will be worth how much in 5 years?

A. $1,000

B. $1,131

C. $1,188

D. $1,338

Bond Pricing

112

Bond is a fixed income security

Price is established by the coupon rate as compared to the market interest rate for that security

• Par if coupon rate = market interest rate• Discount if coupon rate < market interest rate• Premium if coupon rate > market interest rate

The actual price is determined by discounting the cash flows to today’s present value (PV) using the market rate of interest as the discount factor

DISCOUNTED CASH FLOWS(same as stock analysis)

Stocks – using cash flow generated by business/assumptionsBonds – using coupon and principal

Bond Pricing Using PV

113

• Example: A 3‐year bond is issued with a 10% coupon rate when the market rate of interest is 12% ✔End of Year 1, the holder will have received $100 (interest only)✔End of Year 2, the holder will receive another $100 (interest only)✔End of Year 3, the holder will receive $1,100 (interest and principal)

• $100 received in Year 1: PV = $100/1.12 = $89.29• $100 received in Year 2: PV = $100/ (1.12 x 1.12) = $79.72• $1,100 received in Year 3: PV = $1,100/ (1.12 x 1.12 x 1.12) = $782.96• The PV of the cash flows is: $89.29 + $79.72 + $782.96 = $951.97. This is the

price of the bond

• Note that this math is not required for the exam – only the concept must be known

• Example: A 2‐year $1,000 par bond is issued with a 10% coupon rate when the market rate of interest is 8%

• By the end of Year 1, the holder will have received $100 (interest only).

• By the end of Year 2, the holder will receive $1,100 (interest and principal).

• $100 received in Year 1 is worth $100/1.08 = $92.59 now

• $1,100 received in Year 2 is worth $1,100/ (1.08 X 1.08) = $943.07 now

• The NPV of the cash flows is: $92.59 + $943.07 = $1,035.66. This is the price of the bond.

NET PRESENT VALUE

114Portfolio / Fixed Income Basics

NET PRESENT VALUE


• Example: A 2‐year $1,000 par bond is issued with a 10% coupon rate when the market rate of interest is 10%

• By the end of Year 1, the holder will have received $100 (interest only).

• By the end of Year 2, the holder will receive $1,100 (interest and principal).

• $100 received in Year 1 is worth $100/1.10 = $90.91 now

• $1,100 received in Year 2 is worth $1,100/ (1.10 X 1.10) = $909.09 now

• The NPV of the cash flows is: $90.91 + $909.09 = $1,000. This is the price of the bond.

NET PRESENT VALUE

• Example: A 2 year zero coupon $1,000 par bond is issued when the market rate of interest is 10%

• By the end of Year 2, the holder will receive $1,000

• $1,000 is worth $1,000/ (1.10 X 1.10) = $826.45 now

• The NPV of the cash flows is: $826.45. This is the price of the bond now.


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Question

117

The “Present Value” of a fixed income security is based on the:

A. Original price paid by the investor

B. Sum of all expected future payments to be made by the issuer of the security

C. Discounting of all expected future payments to be made by the issuer of the security

D. Current price of the security in the market

Which of the following is NOT included in the calculation of net present value of a 10-year fixed rate non-callable bond?

A. Coupon rateB. Par valueC. Volatility D. Purchase price



If the market rate of interest is 10%, the net present value of $1,000 to be received 2 years from now is:

A. less than $1,000B. more than $1,000C. $1,000D. more or less than $1,000, depending on

market demand

$826.44 x 1.1 = $909.09 value after 1 year$909.09 x 1.1 = $1,000 value after 2 years

Which of the following will equal the face value of a bond?

A. The present value of the payments to be received from the issuer discounted by the bond coupon rate

B. The present value of the payments to be received from the issuer discounted by the market rate of interest

C. The future value of the payments to be received from the issuer discounted by the bond coupon rate

D. The future value of the payments to be received from the issuer discounted by the market rate of interest



NPV ‐ INVESTMENT DECISIONS

• A 3‐year $1,000 investment generates the following cash flows when the RRR is 8%– Yr 0: ‐1,000– Yr 1: 100– Yr 2: 100– Yr 3: 1,100

• A 3‐year $1,000 investment generates the following cash flows when the RRR is 14%– Yr 0: ‐1,000– Yr 1: 100– Yr 2: 100– Yr 3: 1,100

$100 received in Year 1 is worth $100/1.08 = $92.59 now$100 received in Year 2 is worth $100/ (1.08 x1.08) = $85.73 now$1,100 received in Year 3 is worth $1,100/ (1.08x1.08x1.08) = $873.22 nowThe PV of the cash flows is $1,051.54By subtracting the initial investment, the NPV is +$51.54 (more than the initial investment), indicating a good investment

$100 received in Year 1 is worth $100/1.14 = $87.72 now$100 received in Year 2 is worth $100/ (1.14 x1.14) = $76.95 now$1,100 received in Year 3 is worth $1,100/ (1.14x1.14x1.14) = $742.47 nowThe PV of the cash flows is: $907.14By subtracting the initial investment, the NPV is ‐$92.86 (less than the initial investment), indicating a bad investment

The Net Present Value of an investment is lower than "0." This means that the:

A. rate of return from the investment is greater than the discount rate used in the computation

B. rate of return from the investment is lower than the discount rate used in the computation

C. investment will produce a return that is greater than the rate of inflation

D. investment will produce a return that is lower than the rate of inflation


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A bond is issued with an 8% coupon rate. If the Net Present Value (NPV) of the cash flows generated by the investment equals "0," then the price of the bond:

A. will be at parB. will be at a discountC. will be at a premiumD. cannot be determined


Bond Price Volatility

124

Long-term bond prices are more volatile than short-term bond prices

Low-coupon bonds are more volatile than high-coupon bonds

• Long-term zero coupon bonds are the most volatile• Short-term high coupon bonds are the least volatile•

The formal measure of bond price volatility is called “Duration”

125

Bond Price Volatility

Large PremiumSmall Premium

Large DiscountSmall Discount

PremiumDiscount

High CouponLow Coupon

Long MaturityShort Maturity

Portfolio / Fixed Income Basics Portfolio / Fixed Income Basics 126

DURATION (MACAULAY)• Computes the time required for a bond to return its original investment

– Note that this math is not required for the exam – only the concept must be known

• Examples:

• The higher the duration number, the greater the bond price volatility • Bonds with the greatest duration will be those with long terms and/or low coupons

• The smaller the duration number, the lower the bond price volatility – Bonds with the lowest duration will be those with short terms and/or high coupons

• Note that for a zero‐coupon bond, duration is the time to maturity (because all money is received at maturity)

Bond Duration5 year; 0% coupon 5.005 year; 6% coupon 4.395 year; 9% coupon 4.19

Bond Duration5 year; 6% coupon 4.3920 year; 6% coupon 11.90


Duration is a measure of a bond's:

A. income yieldB. price volatility C. credit qualityD. risk of early redemption


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Question

129

Which of the following bonds would have the greatest duration?

A. 15‐year Treasury Inflation Protection Security with a 2% coupon

B. 15‐year Zero Coupon bond with no stated coupon rate

C. 15‐year Corporate Debenture with a 7% coupon

D.15‐year Treasury Bond with a 4% coupon

Interest Rate Volatility

130

Do not confuse bond price volatility with interest rate volatility

Short term interest rate movements are more volatile than long term interest rate movements, since they are directly influenced by Federal Reserve monetary actions

For a given change in interest rates for a specific maturity, bond prices will move inversely

YIELD CURVE

• EXAMPLE: If The Federal Reserve Conducts Reverse Repurchase Agreements With The Primary Dealers, Then This Tightens Credit And Short Term Interest Rates Will Rise And The Yield Curve Will Shift As Follows:


YIELD CURVE

• Yield Curve Flattens As Fed Tightening Raises Short Term Rates

• Long Term Rates Don't Move Much Since They Are Determined By Long Term Expectations Of Inflation And Economic Output


YIELD CURVE

• EXAMPLE (Cont.): If The Federal Reserve Keeps Tightening, Then Short Term Rates Will Be Pushed Higher Than Long Term Rates And The Yield Curve Inverts


YIELD CURVE

• Expecting where the economy is going by looking at the yield curve begins to make some sense – When The Curve Is Inverted:

• This Shows That The Fed Is Tightening To Slow Down The Economy (Maybe Sending It Into A Recession)

– From This Point, Things Can Only Get Better (Meaning Rates Will Drop As The Fed Starts To Loosen)

– When The Curve Is Ascending:• This Shows That The Fed Is Pursuing A Loose Money Policy Done To Stimulate The Economy

– From This Point, Things Can Only Get Worse (Meaning Rates Will Rise As The Fed Starts To Tighten)


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YIELDS VS PRICES

• Thus, while long term bond prices are more volatile, short term YIELDS are more volatile than long term yields– Long term bond prices are more volatile because bonds represent a series of cash‐flows (interest payments) over time plus a final big principal payment at maturity

• Since long bonds have more interest payments over time AND a final big principal payment at the end, there is a bigger change to the value of the bond when interest rates are changed

– Short term yields are more volatile because the fed actions affect the “short end” of the yield curve more than the “long end” (to prevent things like inflation)


Which statements are true regarding interest rate movements?

I. Actions of the Federal Reserve tend to affect short-term rates more than long-term rates

II. Actions of the Federal Reserve tend to affect long-term rates more than short-term rates

III. Short-term rates are more volatile than long-term rates

IV. Long-term rates are more volatile than short-term rates

A. I and III B. I and IVC. II and IIID. II and IV


Bond A has a 5% coupon and 5 years to maturity. Bond B has a 5% coupon and 10 years to maturity. If market interest rates rise by 1%:

A. the value of both bonds is unaffectedB. Bond A's value will decline more than Bond

B's valueC. Bond B's value will decline more than Bond

A's valueD. the value of both Bond A and Bond 8 will fall

by equal amounts


What investment held in an investment portfolio would be subject to the greatest negative impact from an increase in market interest rates?

A. Common stockB. Preferred stockC. Mutual fundD. REITs


Yield Measures

139

• Nominal Yield (NY)

✔Annual percentage return based upon buying the bond at par

• Current Yield (CY)

✔Annual percentage return based upon buying the bond at current market price• Discount bond, CY > NY

• Premium bond, CY < NY

• Yield To Maturity (YTM) ✔Annual percentage return based upon buying the bond at current market price and also includes annual pro‐

rated gain if the bond is bought at a discount; or annual pro‐rated loss if the bond is bought at a premium

• Discount bond, YTM > CY

• Premium bond, YTM < CY

• Yield To Call (YTC)

✔Same as YTM, but increases annual gain if a discount bond is called early; or increases annual loss if a premium bond is called early

• Discount bond, YTC > YTM

• Premium bond, YTC < YTM

140

EFFECTS OF INTEREST RATE MOVEMENTS ON BOND PRICES

• DISCOUNT BOND

• PREMIUM BOND

• PAR BOND


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Yield Measures

141

Market discount bond, the yields from lowest to highest are:

• Nominal Yield• Current Yield• Yield To Maturity• Yield To Call

Market premium bond, the yields from lowest to highest are:

• Yield To Call• Yield To Maturity• Current Yield• Nominal Yield

Basis Quotes

142

Dealers, many times, quote bonds on a yield basis rather than a dollar price

In this instance, bonds must be priced “worst case scenario”, that is, the lowest yield the investor could obtain

Premium bonds must be priced YTC, that is, to the near term call date (the very first time the bond could be called)

Discounts bonds must be priced YTM

Question

143

A customer buys a premium bond with 20 years to maturity that is callable at par at any time during its life. In which situation will the customer earn the lowest yield on the bond?

A. If the bond is called in 5 years

B. If the bond is called in 10 years

C. If the bond is called in 15 yearsD. If the bond is redeemed by the issuer at maturity

A customer buys a discount bond with 20 years to maturity that is callable at par at any time during its life. In which situation will the customer earn the lowest yield on the bond?

A. If the bond is called in 5 years B. If the bond is called in 10 yearsC. If the bond is called in 15 yearsD. If the bond is redeemed by the issuer at

maturity


For bonds trading at a discount, rank the yield measures from lowest to highest?

A. Nominal; Current; Yield to Maturity; Yield to Call B. Yield to Call; Yield to Maturity; Current; NominalC. Yield to Maturity; Nominal; Yield to Call; CurrentD. Current; Nominal; Yield to Call; Yield to Maturity


A 20-year, 6% bond is quoted by a dealer on a 5% basis. The bond is callable in 10 years at par. To calculate the dollar price for the bond, the dealer would use the:

A. redemption date to find the number of years over which the discount would be earned

B. call date to find the number of years over which the discount would be earned

C. redemption date to find the number of years over which the premium would be lost

D. call date to find the number of years over which the premium would be lost


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Internal Rate Of Return (IRR)

147

True yield to maturity of a bond

Finds the yield (IRR) that discounts the cash flows to today’s price

• IRR assumes all cash flows are reinvested at the IRR

To find IRR requires a bond calculator, so only the concept is tested

Question

148

The IRR (Internal Rate of Return) of an investment assumes that:

A. cash flows generated by the investment are not reinvested

B. cash flows generated by the investment are reinvested at the risk‐free rate of return

C. cash flows generated by the investment are reinvested at the internal rate of return

D. cash flows generated by the investment are reinvested at the total rate of return

The Internal Rate of Return of an investment is the:

A. return which discounts the net cash flows to a present value of "0"

B. current yield of the investmentC. excess of return over the risk-free rate of

returnD. expected return based on probability of

investment outcomes


If the Required Rate of Return (RRR) on a security is less than the Internal Rate of Return (IRR) on that security, then the:

A. security should be purchased for investment B. security should not be purchased for investmentC. security has a positive risk premiumD. security has a negative risk premium


Bond Risks

151

• Risk that the issuer’s credit rating is dropped due to deteriorating business conditions (for corporate bonds)

• Only risk rated by Moody’s and Standard and Poor’s

Credit Risk (a.k.a. Business Risk)

• Risk that market interest rates rise, forcing bond prices down• Long term and low coupon bonds are most susceptible

Market Risk (a.k.a. Interest Rate Risk)

• Risk that there will be no “market” for the security when the owner wishes to sell• This is a serious risk for junk bondsMarketability Risk

• Risk that selling the security will incur large transaction costs - variation on marketability risk (and often confused with it)

• There is a “market” for the issue, however it is very expensive to tradeLiquidity Risk

Bond Risks

152

• Risk that the issuer will call in the issue if market interest rates fall after issuance, allowing the issuer to “refund” the issue at lower current market rates

• Bonds with high coupons and low call premiums are most susceptibleCall Risk

• Risk that, over a long-term investment time horizon, market rates are dropping and the holder of a bond that makes semi-annual interest payments will be forced to “reinvest” these payments at lower and lower rates

• Zero-coupon bonds avoid this risk

Reinvestment Risk

• Risk that as the rate of inflation increases, it will cause market interest rates to rise in tandem

• As interest rates rise, bond prices will fall

Purchasing Power Risk (a.k.a. Inflation

Risk)

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Bond Risks

153

• Risk that as the rate of inflation increases, it will cause market interest rates to rise in tandem

• As interest rates rise, bond prices will fall

• Inflation contractually embedded in the economy is “inertial inflation” – Union/Government employment contracts that have Cost Of Living Adjustments (COLAs) automatically increasing wages as inflation increases can lead to spiraling inflation which causes the value of long-term and low coupon bonds to fall dramatically

Purchasing Power Risk (a.k.a. Inflation Risk)

Inertial inflation is:

A. demand drivenB. money supply basedC. contractually basedD. employment driven


Bond Risks

155

• Risk of a tax law change negatively affecting a security’s valueLegislative Risk

(a.k.a. Regulatory Risk)

• Risk of investing in other countries that have weak political systems, so investors have little legal protection if an issuer or government attempts to “hurt” them

• This is mainly a risk of investing in 3rd world countries

Political Risk

All of the following risks are essentially equivalent for long term corporate bonds EXCEPT:

A. Interest rate riskB. Market riskC. Default riskD. Inflation risk


A company’s profits decline because it lost a government contract. This company has been exposed to:

A. political riskB. business risk C. regulatory riskD. market risk


An individual buys a multiple dwelling apartment house for investment purposes. He is hoping that the real estate market will increase in value; however, real estate prices decline by 20% due to an unfavorable tax ruling. This is an example of:

A. market riskB. political riskC. regulatory riskD. business risk


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TIME VALUE OF MONEY

• $100 today is worth more than $100 tomorrow

• The potential to earn interest on money affects its relative value

• The productivity of money is known as its time value

159Portfolio / Fixed Income Basics Portfolio / Fixed Income Basics 160

An individual is given the choice of receiving $1,000,000 today; or of receiving $100,000 per year for the next 15 years, for a total of $1,500,000 to be received. The difference of $500,000 between the 2 amounts is due to the:

A. risk premiumB. time value of moneyC. opportunity costD. net present value of a sum

The "time value of money" is the:

A. potential to earn interest on money which affects its relative value

B. after tax return of an investmentC. original principal amount plus any interest

accrued during a specific time periodD. incremental return of an investment over the

return of a risk free security


Opportunity Cost

162

The risk that after a bond is purchased, market rates are rising and the holder earns a lower than market rate of return on that investment

• The difference between the lower rate earned and the higher current market rate is the “opportunity cost” – the cost of a “lost” investment opportunity

Question

163

A Registered Investment Adviser has a client with $100,000 in a 3% savings account. The RIA recommends leaving $20,000 in the account and placing $80,000 in an equity fund expected to yield 10% for the year. The client rejects the proposal. The opportunity cost of the decision is:

A. 0

B. $5,600

C. $7,000

D. $10,000

Portfolio Management Strategies, Styles and Techniques

Portfolio Management Strategies, Styles and Techniques

164

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Portfolio Balance

165

Portfolio composition must be broadly balanced between:

• Equity holdings; and

• Bond holdings.

As a “rule of thumb,” the investment percentage allocated to bonds is the customer’s age

• A 20-year old customer would have 20% of assets in bonds and 80% in equities• A 80-year old customer would have 80% of assets in bonds and 20% in equities

Note young customers still get a bond % allocation for safety; and older customers still get an equity % allocation for growth

Portfolio Strategy

166

• Choose the target % of each asset class based on suitability

Strategic Asset Allocation

Choose the min/max % (variance) of each asset class based on short term market conditions

Tactical Asset Allocation

• Chooses the % of each asset class based on what fits the current market condition

Dynamic Asset Allocation

Question

167

An individual who is 25 years from retirement has $500,000 to invest today. He is risk tolerant and is looking to withdraw $80,000 per year once he retires. Which asset allocation is BEST for this client?

A. 25% Stocks / 25% Bonds / 25% REITs / 25% Money Markets

B. 50% Stocks / 40% Bonds/ 10% Cash

C. 100% BondsD.100% Stocks

A 25-year old man receives $50,000 and wants to retire at age 65 with an income of $1,500 per month from his investment portfolio. The adviser should invest:

A. 100% in bonds and 0% in stocksB. 65% in bonds and 35% in stocksC. 25% in bonds and 75% in stocks D. 0% in bonds and 100% in stocks


Investment Time Horizon

169

Because of the variability of equity returns, as compared to more stable bond returns, investors with:

• Short-term investment time horizons should shift their allocation more into bonds or money market instruments; and

• Long-term investment time horizons should shift their allocation more into equities with higher growth potential.

A customer has just received a $100,000 inheritance and wants to know what to do with the money until he decides how to use it. He thinks that he will make his decisions on what to do with the funds within 3 months. The BEST recommendation is for the customer to buy:

A. Treasury Bills B. Treasury NotesC. Investment Grade Preferred StockD. Certificates of Deposit


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Question

171

A customer has a term loan that is maturing in 3 years in the amount of $100,000. The customer has the cash now, and wants to know the best investment to make for the 3 years until the loan payment is due. The BEST recommendation is to buy:

A. Blue chip stocks

B. AA rated debentures with a 3 year maturity

C. Treasury notes maturing in 3 years

D.AA general obligation bonds maturing in 3 years

Asset Classes

172

The generally recognized asset classes are:

• Equities• Fixed income• Cash• Real estate • Commodities

Within these asset classes are investment vehicles which are subsets of these asset class

• Growth stocks would be a subset within the equities asset class • High yield debt (i.e. junk bonds) would be a subset within the fixed income class

Which of the following is an asset class?

A. Diamonds and precious jewelsB. Real estate C. AnnuityD. S & P 500 Index


Which of the following investments is an "asset class"?

A. Real estate B. Gold coinsC. Mutual fundD. Jewelry


Asset Allocation

175

• Formalizes the portfolio balance equation by defining a broad range of investment vehicles

• Typical investment vehicles, from safest to most risky are:1. Money Market Instruments2. U.S. Governments3. AAA Corporate and Foreign Government Bonds4. Large Capitalization Stocks (Blue Chips)5. Mid‐Capitalization Stocks6. Small‐Capitalization Stocks7. International Stocks8. Micro‐Cap Stocks

• Strategic Asset Allocation: Defines the “investment strategy” to be used based on suitability and sets percentage allocations to each investment vehicle within the defined asset class✔ A younger investor will have greater strategic allocations of the more risky asset classes✔ An older investor will have greater strategic allocations of the safer asset classes

Adding an asset class of foreign securities to a portfolio's structure:

A. increases riskB. decreases risk C. has no effect on riskD. is a prohibited practice


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The use of multiple asset classes when constructing a portfolio reduces:

A. regulatory riskB. market risk C. interest rate riskD. purchasing power risk


Equity Asset Class Breakdown

178

• Capitalization of less than $300MM Micro-Cap

• Capitalization of $300MM up to $2BSmall-Cap

• Capitalization of $2B to $10BMid-Cap

• Capitalization $10B or moreLarge-Cap

A company that has a market capitalization of between $2 billion and $10 billion is considered to be:

A. Small CapB. Mid CapC. Large CapD. Nano Cap

179

A corporation that has a market capitalization of $400,000,000 would be an appropriate investment for a:

A. Micro Cap Mutual FundB. Small Cap Mutual Fund C. Mid Cap Mutual FundD. Large Cap Mutual Fund

180

Indexes

181

Dow Jones Industrial Average • 30 large cap. issues, chosen to mirror the U.S. economy

Standard and Poor's 500 Average • 500 largest market cap. companies headquartered in the U.S.

Wilshire Index • All NYSE, AMEX (now renamed NYSE-MKT) and NASDAQ stocks (about 3,600 stocks)

Russell 2000 Index • 2,000 small cap. issues, mainly NASDAQ and non-NASDAQ OTC issues

EAFE – Europe, Australasia, Far East Index• Largest market cap companies based outside North America• Oldest international stock index, started in 1969

Question

182

A customer is invested in a diversified portfolio of small‐cap, mid‐cap and large‐cap stocks of companies based in the United States. Which index fund could the customer use to further diversify this portfolio?

A. S & P 500

B. Russell 2000

C. DJIA

D. EAFE

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A client of an investment adviser wishes to invest in an index which consists of small capitalization issues. The investment adviser would recommend the:

A. Dow Jones AveragesB. Standard & Poor’s 500C. Wilshire IndexD. Russell 2000

183

Investing Styles

184

Growth investing• Selecting equity investments in asset classes ignoring fundamental factors. Instead, selection is based on technical

factors such as historical earnings or stock price growth

Value investing• Selecting equity investments in asset classes by finding securities that are fundamentally undervalued• These are companies that are out-of-favor with low P/E ratios

Momentum investing• Selecting equity investments based upon an upward or downward trending price• Stocks that show positive earnings momentum are likely to continue this trend leading to higher stock prices• Stocks that show negative earnings momentum are likely to continue this trend leading to lower stock prices

Socially/ethically responsible investing• Avoiding companies such as tobacco, alcohol, fossil fuels,...

Question

185

A value investor looks for stock where the:

A. Share price does not reflect a positive outlook for the company

B. Share price has been increasing on ever‐higher trading volumes

C. Quality of the company’s earnings, balance sheet. management and market positioning are uniformly high

D. Company’s earnings are growing at a rapid rate, supporting ever higher stock prices

Question

186

A registered investment adviser has a close friend that recently passed away from lung cancer. When the adviser is screening stock groups using a proprietary computer model as part of his portfolio allocation decision‐making, he identifies that tobacco stocks appear to be undervalued and are likely to outperform the market in the coming months. The adviser decides not to invest in these stocks. This is an example of:

A. Computer modeling investing

B. Strategic / tactical investing

C. Ethical / socially responsible investing

D. Fundamental investment analysis

Portfolio Rebalancing

187

Buy and hold• A strategy where no change is made to the portfolio composition• No annual portfolio rebalancing between asset classes• At the end of a bull market, the portfolio will be over-exposed to stocks and is much more

susceptible to loss in a market downturn• At the end of a bear market, the portfolio will be under-exposed to stocks and will not enjoy as

large a market gain in a market rebound

Rebalancing• Typically portfolios are rebalanced annually• As an example, if the strategic allocation is 50% stocks and 50% bonds; and at year end the

portfolio now has 60% stocks and 40% bonds; then stocks are sold with the proceeds invested in bonds to restore the balance to 50%-50%

• Periodic rebalancing restores the allocations to the desired percentages

An example of a passive long term bond investment strategy is:

A. buy and hold B. a barbellC. a ladderD. interest rate anticipation


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Portfolio Management Techniques

189

Passive Portfolio Rebalancing• Continuous automatic rebalancing from over-performing asset classes to under-performing asset

classes to maintain the desired percentage allocations as values move

Active Portfolio Rebalancing• The manager reallocates funds from over-performing or market-performing asset classes to those

classes that the manager thinks will do better over the coming time frame - dynamic asset allocation can produce higher returns irrespective of market indices

• This is “tactical” portfolio rebalancing• 1st is the rebalancing frequency; 2nd is in what is being invested

Sector Rotation• A type of active portfolio rebalancing, sector rotation recognizes that the economy operates in cycles

and at various points in the cycle, there are certain business sectors that perform better than other ones

PORTFOLIO MANAGEMENT TECHNIQUES


Tactical asset allocation requires that:

A. a laddered equity portfolio be created B. a buy and hold strategy be employed C. more frequent trading be used to rebalance

the portfolio D. neutral cash positions are dominant in the

portfolio

191

An investor employing sector rotation is using a:

A. timing strategyB. momentum strategyC. contrarian strategyD. value strategy

192

193

A portfolio that is rebalanced monthly is considered to be:

A. ActiveB. PassiveC. Fixed D. Strategic


A portfolio invested in index funds that is rebalanced annually is considered to be:

A. Active/ActiveB. Passive/PassiveC. Active/Passive D. Passive/Active


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195

A portfolio invested in actively managed funds that is rebalanced annually is considered to be:



1st2nd

196

A portfolio invested in index funds that is rebalanced monthly is considered to be:



1st2nd

197

Regular balancing of a portfolio is considered:

A. PassiveB. Index investingC. Strategic asset allocationD. Dynamic asset allocation

An investor who rebalances his portfolio annually to bring the asset allocations to the percentages established in that investor's IPS is practicing:

A. strategic asset allocationB. tactical asset allocationC. value investingD. momentum investing


An investor who uses a sector timing strategy is practicing:

A. strategic asset allocationB. tactical asset allocationC. value investingD. passive asset allocation


When describing a mutual fund manager, the term management tenure is the:

A. length of time that the individual has been in the securities industry

B. length of time that the individual has been managing that mutual fund

C. length of time that the mutual fund has been in existence

D. length of time that the mutual fund has been managed by a registered investment adviser


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Question

201

An adviser to a mutual fund foresees an economic slowdown and believes that sit‐down chain restaurants are going to underperform. The adviser sells those stocks out of the fund’s portfolio and holds the proceeds as cash, pending reinvestment. This is an example:

A. strategic asset allocation

B. rebalancing

C. diversification

D. tactical asset allocation

Question

202

A trader uses a predetermined strategy where investment funds are moved from one sector to another based on a calendar schedule, using the following sectors as the asset classes: utilities, retailers, consumer staples, technology, and transportation stocks. This is an example of:

A. portfolio rebalancing

B. tactical asset allocation

C. rotational investing strategy

D. strategic asset allocation

Question

203

Which is a passive investment?

A.Making investments in an Individual Retirement Account

B.Making investments in a 401(k) Account

C.Investing in 100 shares each of 10 different companies

D.Investing in shares of a S & P 500 Index fund

Funding Techniques

204

Lump Sum Funding• Funding an asset allocation strategy 100% over a very short time frame• The risk is that the strategy is funded at a market “top” – called timing

risk

Dollar Cost Averaging (DCA)• Spreading the cost of funding an asset allocation strategy over a long-

time frame – say 1-2 years, by making monthly investments over that time period

• This minimizes timing risk

Question

205

An example of Dollar Cost Averaging is buying:

A. Stocks when prices rise above their 200‐day moving averageB. $150 of a Standard and Poor’s 500 Index mutual fund every month

C. 200 shares of ABC ETF each month, regardless of its price

D. Smaller dollar amounts of stock when prices are high and larger dollar amounts of stock when prices are high

Financial Leverage

206

The use of borrowed money can increase the return as long as the borrowed money is at a lower interest rate than the return on the investment made with borrowed funds

• If you borrow at 4% and use the money for an investment yielding 5%, there is 1% positive financial leverage

• If you borrow at 5% to make an investment yielding 4%, this is a 1% negative financial leverage (and the investment should not be made)

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Question

207

A company whose profits have increased at a rate greater than the rate of interest charged on the borrowed funds that produced those profits has:

A. Miscalculated its cost of funds

B. Been successful in an arbitrage transaction

C. Been successful in applying leverage

D. Reduced its ROI (Return On Investment)

Investment Policy Statement (IPS)

208

• Details the investment strategy created for the client and allowed tactical variation

• Based upon the customer suitability determination, the IPS details the:✔Percentage allocation to each asset class (strategic asset allocation);✔Investment vehicles chosen within that asset class

• If index funds are chosen = passive asset allocation (low management fees)• If manager selects specific investments = active asset allocation (high management fees)

• Shows the permitted tactical variation within each asset class and/or investment vehicle, allowing the manager to tactically overweight investments that are likely to outperform (market timing)

• Details the expected portfolio return and standard deviation as compared to a relevant benchmark

No FEEs

Question

209

Under ERISA rules, the IPS for a qualified retirement plan does which of the following?

A. The IPS establishes the plan’s investment objectives, asset allocations, performance projections and risk limitations

B. The IPS identifies the transactions that are prohibited under the plan’s investment policies

C. The IPS identifies anyone who is a party‐in‐interest and related prohibitions on self‐dealing using plan assets

D. The IPS identifies the investment alternatives offered under Rule 404(c) that, when combined with each other, tend to minimize risk through diversification

Which 2 of the following investments are passively managed?

I Index fundsII Sector fundsIII Growth fundsIV Unit investment trusts

A. I and IIIB. I and IVC. II and IIID. II and IV


Portfolio Immunization

211

• Bond Portfolio Immunization✔A strategy used to fund a known future liability✔Here the portfolio is managed to make it worth a specific amount at a stated date in the future

✔The intent is to eliminate interest rate risk• Thus, making an investment in a 10‐year T‐STRIP (zero coupon bond) with a $1000 par if $1000 is needed in 10 years would work

• However, buying a 30‐year T‐Bond (coupon paying bond) wouldn’t meet this obligation especially if interest rates dropped

✔Hence, the duration of the bonds used must match the length of time until the liability must be paid

Portfolio Immunization

212

• Bond Contingent Portfolio Immunization✔This is an “active management” strategy where the manager selects bonds that will outperform a benchmark index

✔However, if the portfolio drops below a predetermined value, the manager shifts to a defensive strategy by buying high credit quality issues with a lower return to assure at least a minimum rate of return is earned

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An investor knows that he must pay back the principal of a $50,000 loan that he got from a close relative to buy a house. The loan matures in 10 years. To make sure that the client has the funds to pay back the loan in 10 years, you recommend that the customer buy 50M of 10-year Treasury STRIPS. This is an example of:

A. portfolio immunizationB. portfolio diversificationC. portfolio rebalancingD. portfolio hedging


Documents

Series-65-Deck-1 Cerifi PETE