32170621 financial management quiz

Chapter 1 The Investment Environment

Multiple Choice Questions

1. In 2005, ____________ was the most significant real asset of U. S. nonfinancial businesses in terms of total value. A) equipment and software B) inventory C) real estate D) trade credit E) marketable securities

Answer: C [email protected].

2. In 2005, ____________ was the least significant real asset of U. S. nonfinancial businesses in terms of total value. A) equipment and software B) inventory C) real estate D) trade credit E) marketable securities

Answer: B [email protected].

3. In 2005, ____________ was the least significant liability of U. S. nonfinancial businesses in terms of total value. A) bonds and mortgatges B) bank loans C) inventories D) trade debt E) marketable securities


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4. In 2005, ____________ was the most significant financial asset of U. S. nonfinancial businesses in terms of total value. A) cash B) trade credit C) trade debt D) inventory E) marketable securities


5. The material wealth of a society is equal to the sum of _________. A) all financial assets B) all real assets C) all financial and real assets D) all physical assets E) none of the above

Answer: B .Rationale: Financial assets do not directly contribute the productive capacity of the economy.

6. ____________ of an investment bank. A) Citigroup is an example B) Merrill Lynch is an example C) Goldman is an exampleD) B and C are each examplesE) Each of the above is an example

Answer: E .

7. _______ are financial assets. A) Bonds B) Machines C) Stocks D) A and C E) A, B and C

Answer: D .Rationale: Machines are real assets; stocks and bonds are financial assets.

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8. An example of a derivative security is ______. A) a common share of General Motors B) a call option on Mobil stock C) a commodity futures contract D) B and C E) A and B

Answer: D .Rationale: The values of B and C are derived from that of an underlying financial asset; the value of A is based on the value of the firm only.

9. _______ was the first to introduce mortgage pass-through securities. A) Chase Manhattan B) Citicorp C) FNMA D) GNMA E) None of the above

Answer: D .

10. A bond issue is broken up so that some investors will receive only interest payments while others will receive only principal payments, which is an example of ________. A) bundling B) credit enhancement C) unbundling D) financial engineering E) C and D

Answer: E .Rationale: Unbundling is one of many examples of financial engineering that offer more alternatives to the investor.

11. An example of a primitive security is __________. A) a common share of General Motors B) a call option on Mobil stock C) a call option on a stock of a firm based in a Third World country D) a U. S. government bond E) A and D

Answer: E .Rationale: A primitive security's return is based only upon the earning power of the issuing agency, such as stock in General Motors and the U. S. government.

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12. The ____________ refers to the potential conflict between management and shareholders due to management's control of pecuniary rewards as well as the possibility of incompetent performance by managers. A) agency problem B) diversification problem C) liquidity problem D) solvency problem E) regulatory problem

Answer: A .Rationale: The agency problem describes potential conflict between management and shareholders. The other problems are those of firm management only.

13. _________ financial asset(s). A) Buildings are B) Land is a C) Derivatives are D) U. S. Agency bonds are E) C and D

Answer: E .Rationale: A and B are real assets.

14. The value of a derivative security _______. A) depends on the value of the related primitive security B) can only cause increased risk. C) is unrelated to the value of the related primitive security D) has been enhanced due the recent misuse and negative publicity regarding these

instruments E) is worthless today

Answer: A .Rationale: Of the factors cited above, only A affects the value of the derivative and/or is a true statement.

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15. In terms of total value, the most significant liability of U. S. nonfinancial businesses in 2005 was _______. A) bank loans B) bonds and mortgages C) trade debt D) other loans E) marketable securities.


16. Money market funds were a financial innovation partly inspired to circumvent _______. A) Regulation B, which is still in existence B) Regulation D C) DIDMCA D) Regulation M E) Regulation Q, which is no longer in existence

Answer: E .Rationale: Regulation Q limited the amount of interest that banks could pay to depositors; money market funds were not covered by Regulation Q and thus could pay a higher rate of interest. Although Regulation Q no longer exists, money market funds continue to be popular. See page 18.

17. __________ are a way U. S. investor can invest in foreign companies. A) ADRs B) IRAs C) SDRs D) GNMAs E) Krugerrands

Answer: A .Rationale: Only ADRs represent an indirect investment in a foreign company.

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18. _______ are examples of financial intermediaries. A) Commercial banks B) Insurance companies C) Investment companies D) Credit unions E) All of the above

Answer: E .Rationale: All are institutions that bring borrowers and lenders together.

19. Financial intermediaries exist because small investors cannot efficiently ________. A) diversify their portfolios B) gather all relevant information C) assess credit risk of borrowers D) advertise for needed investments E) all of the above.

Answer: E .Rationale: The individual investor cannot efficiently and effectively perform any of the tasks above without more time and knowledge than that available to most individual investors.

20. Firms that specialize in helping companies raise capital by selling securities are called ________. A) commercial banks B) investment banks C) savings banks D) credit unions E) all of the above.

Answer: B .Rationale: An important role of investment banks is to act as middlemen in helping firms place new issues in the market.

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21. Financial assets ______. A) directly contribute to the country's productive capacity B) indirectly contribute to the country's productive capacity C) contribute to the country's productive capacity both directly and indirectly D) do not contribute to the country's productive capacity either directly or indirectly E) are of no value to anyone

Answer: B .Rationale: Financial assets indirectly contribute to the country's productive capacity because these assets permit individuals to invest in firms and governments. This in turn allows firms and governments to increase productive capacity.

22. The sale of a mortgage portfolio by setting up mortgage pass-through securities is an example of ________. A) credit enhancement B) securitization C) unbundling D) derivatives E) none of the above

Answer: B .Rationale: The financial asset is secured by the mortgages backing the instrument.

23. Corporate shareholders are best protected from incompetent management decisions by A) the ability to engage in proxy fights. B) management's control of pecuniary rewards. C) the ability to call shareholder meetings. D) the threat of takeover by other firms. E) one-share / one-vote election rules.

Answer: D [email protected]: Proxy fights are expensive and seldom successful, and management may often control the board or own significant shares. It is the threat of takeover of underperforming firms that has the strongest ability to keep management on their toes.

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24. The national net worth of the U. S. in 2005 was _________. A) $15.411 trillion B) $26.431 trillion C) $42.669 trillion D) $55.651 trillion E) $70.983 trillion

Answer: C [email protected]: See Table 1.2.

25. In 2005, _______ of the assets of U. S. households were financial assets as opposed to tangible assets. A) 20.4% B) 34.2% C) 60.7% D) 71.7% E) 82.5%

Answer: C [email protected]: See Table 1.1.

26. Investment bankers perform the following role(s) ___________. A) market new stock and bond issues for firms B) provide advice to the firms as to market conditions, price, etc C) design securities with desirable properties D) all of the above E) none of the above

Answer: D .Rationale: Investment bankers perform all of the roles described above for their clients.

27. Theoretically, takeovers should result in ___________. A) improved management B) increased stock price C) increased benefits to existing management of taken over firm D) A and B E) A, B, and C

Answer: D .Rationale: Theoretically, when firms are taken over, better managers come in and thus increase the price of the stock; existing management often must either leave the firm, be demoted, or suffer a loss of existing benefits.

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28. Important trends changing the contemporary investment environment are A) globalization. B) securitization. C) information and computer networks. D) financial engineering. E) all of the above

Answer: E .Rationale: All of these are examples of important trends in the contemporary investment environment.

29. The means by which individuals hold their claims on real assets in a well-developed economy are A) investment assets. B) depository assets. C) derivative assets D) financial assets. E) exchange-driven assets

Answer: D .Rationale: Financial assets allocate the wealth of the economy. Book example: it is easier for an individual to own shares of an auto company than to own an auto company directly.

30. Which of the following financial assets makes up the greatest proportion of the financial assets held by U.S. households? A) pension reserves B) life insurance reserves C) mutual fund shares D) debt securities E) personal trusts

Answer: A [email protected]: See Table 1.1.

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31. Which of the following are mechanisms that have evolved to mitigate potential agency problems?

I) compensation in the form of the firm's stock optionsII) hiring bickering family members as corporate spiesIII) underperforming management teams being forced out by boards of

directorsIV) security analysts monitoring the firm closelyV) takeover threats

A) II and V B) I, III, and IV C) I, III, IV, and V D) III, IV, and V E) I, III, and V

Answer: C [email protected]: All but the second option have been used to try to limit agency problems.

32. Commercial banks differ from other businesses in that both their assets and their liabilities are mostly A) illiquid. B) financial. C) real. D) owned by the government. E) regulated.

Answer: B .Rationale: See Table 1.3.

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33. Which of the following is true about GNMA pass-throughs?

I) They aggregate individual home mortgages into heterogeneous pools.II) The purchaser of a GNMA receives monthly interest and principal

payments received from payments made on the pool.III) The banks that originated the mortgages maintain ownership of them.IV) The banks that originated the mortgages continue to service them.

A) II, III, and IV B) I, II, and IV C) II and IV D) I, III, and IV E) I, II, III, and IV

Answer: B [email protected]: III is not correct because the bank no longer owns the mortgage investments.

34. Although derivatives can be used as speculative instruments, businesses most often use them to A) attract customers. B) appease stockholders. C) offset debt. D) hedge. E) enhance their balance sheets.

Answer: D .Rationale: Firms may use forward contracts and futures to protect against currency fluctuations or changes in commodity prices. Interest-rate options help companies control financing costs.

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35. A WEBS security A) limits the diversification potential of investors who hold it. B) may be traded only in the primary market. C) is linked directly to the value of a composite index of futures contracts. D) must be earned as a performance bonus within a corporation rather than

purchased. E) tracks the performance of an index of share returns for a particular country.

Answer: E [email protected]: WEBS (World Equity Benchmark Shares) allow investors to trade portfolios of foreign stocks in a selected country. They can be traded by investors in secondary markets (Amex) and allow U.S. investors to diversify their portfolios of foreign stocks.

36. During the period between 2000 and 2002, a large number of scandals were uncovered. Most of these scandals were related to

I) Manipulation of financial data to misrepresent the actual condition of the firm.

II) Misleading and overly optimistic research reports produced by analysts.III) Allocating IPOs to executives as a quid pro quo for personal favors.IV) Greenmail.

A) II, III, and IV B) I, II, and IV C) II and IV D) I, III, and IV E) I, II, and III

Answer: E [email protected]: I, II, and III are all mentioned as causes of recent scandals.

37. A disadvantage of using stock options to compensate managers is that A) it encourages mangers to undertake projects that will increase stock price. B) it encourages managers to engage in empire building. C) it can create an incentive for mangers to manipulate information to prop up a stock

price temporarily, giving them a chance to cash out before the price returns to a level reflective of the firms true prospects.

D) all of the above. E) none of the above.

Answer: C Rationale: A is a desired characteristic. B is not necessarily a good or bad thing in and

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of itself. C creates an agency problem.

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38. In 2005, ____________ was the most significant real asset of U. S. households in terms of total value. A) consumer durables B) automobiles C) real estate D) mutual fund shares E) bank loans

Answer: C .Rationale: See Table 1.1.

39. The largest component of domestic net worth in 2005 was ____________. A) non-residential real estate B) residential real estate C) inventories D) consumer durables E) equipment and software

Answer: B [email protected]: See Table 1.2.

40. A fixed-income security pays ____________. A) a fixed level of income for the life of the owner B) a fixed level of income for the life of the security C) a variable level of income for owners on a fixed income D) a fixed or variable income stream at the option of the owner E) none of the above

Answer: B .Rationale: Only answer B is correct.

41. Money market securities ____________. A) are short term B) pay a fixed income C) are highly marketable D) generally very low risk E) all of the above

Answer: E .Rationale: All answers are correct.

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42. Financial assets permit all of the following except ____________. A) consumption timing B) allocation of risk C) separation of ownership and control D) elimination of risk E) all of the above

Answer: D [email protected]: Financial assets do not allow risk to be eliminated. However, they do permit allocation of risk, consumption timing, and separation of ownership and control.

43. The Sarbanes-Oxley Act ____________. A) requires corporations to have more independent directors B) requires the firm's CFO to personally vouch for the firm's accounting statements C) prohibits auditing firms from providing other services to clients D) A and B are correct. E) A, B, and C are correct.

Answer: E [email protected]: The Sarbanes-Oxley Act does all of the above.

44. Asset allocation refers to ____________. A) choosing which securities to hold based on their valuation B) investing only in “safe” securities C) the allocation of assets into broad asset classes D) bottom-up analysis E) all of the above

Answer: C [email protected]: Asset allocation refers to the allocation of assets into broad asset classes.

45. Which of the following portfolio construction methods starts with security analysis? A) Top-down B) Bottom-up C) Middle-out D) Buy and hold E) Asset allocation

Answer: B [email protected]: Bottom-up refers to using security analysis to find securities that are attractively priced. Top-down refers to using asset allocation as a starting point.

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46. Which of the following portfolio construction methods starts with asset allocation? A) Top-down B) Bottom-up C) Middle-out D) Buy and hold E) Asset allocation

Answer: A [email protected]: Bottom-up refers to using security analysis to find securities that are attractively priced.

Essay Questions

47. Discuss the agency problem in detail. 48. Discuss the similarities and differences between real and financial assets.

49. Discuss the euro in relation to its impact on globalization. How it currently used and what is are the plans for its future use?

50. Discuss the following ongoing trends as they relate to the field of investments: globalization, financial engineering, securitization, and computer networks


1. Which of the following is not a characteristic of a money market instrument? A) liquidity B) marketability C) long maturity D) liquidity premium E) C and D

Answer: E [email protected]: Money market instruments are short-term instruments with high liquidity and marketability; they do not have long maturities nor pay liquidity premiums.

2. Which one of the following is not a money market instrument? A) a Treasury bill B) a negotiable certificate of deposit C) commercial paper

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D) a Treasury bond E) a Eurodollar account

Answer: D [email protected]: Money market instruments are instruments with maturities of one year or less, which applies to all of the above except Treasury bonds. See Table 2.1.

3. T-bills are financial instruments initially sold by ________ to raise funds. A) commercial banks B) the U. S. government C) state and local governments D) agencies of the federal government E) B and D

Answer: B [email protected]: Only the U. S. government sells T-bills in the primary market.

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4. The bid price of a T-bill in the secondary market is A) the price at which the dealer in T-bills is willing to sell the bill. B) the price at which the dealer in T-bills is willing to buy the bill. C) greater than the asked price of the T-bill. D) the price at which the investor can buy the T-bill. E) never quoted in the financial press.

Answer: B [email protected]: T-bills are sold in the secondary market via dealers; the bid price quoted in the financial press is the price at which the dealer is willing to buy the bill.

5. Commercial paper is a short-term security issued by ________ to raise funds. A) the Federal Reserve Bank B) commercial banks C) large, well-known companies D) the New York Stock Exchange E) state and local governments

Answer: C [email protected]: Commercial paper is short-term unsecured financing issued directly by large, presumably safe corporations.

6. Which one of the following terms best describes Eurodollars: A) dollar-denominated deposits in European banks. B) dollar-denominated deposits at branches of foreign banks in the U. S. C) dollar-denominated deposits at foreign banks and branches of American banks

outside the U. S. D) dollar-denominated deposits at American banks in the U. S. E) dollars that have been exchanged for European currency.

Answer: C [email protected]: Although originally Eurodollars were used to describe dollar-denominated deposits in European banks, today the term has been extended to apply to any dollar-denominated deposit outside the U. S.

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7. Deposits of commercial banks at the Federal Reserve Bank are called __________. A) bankers' acceptances B) repurchase agreements C) time deposits D) federal funds E) reserve requirements

Answer: D [email protected]: The federal funds are required for the bank to meet reserve requirements, which is a way of influencing the money supply. No substitutes for fed funds are permitted.

8. The interest rate charged by banks with excess reserves at a Federal Reserve Bank to banks needing overnight loans to meet reserve requirements is called the_________. A) prime rate B) discount rate C) federal funds rate D) call money rate E) money market rate

Answer: C [email protected]

9. Which of the following statements is (are) true regarding municipal bonds?

I) A municipal bond is a debt obligation issued by state or local governments.

II) A municipal bond is a debt obligation issued by the federal government.

III) The interest income from a municipal bond is exempt from federal income taxation.

IV) The interest income from a municipal bond is exempt from state and local taxation in the issuing state.

A) I and II only B) I and III only C) I, II, and III only D) I, III, and IV only E) I and IV only

Answer: D [email protected]: State and local governments and agencies thereof issue municipal bonds on which the interest income is free from all federal taxes and is exempt from state and local taxation in the issuing state.

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10. Which of the following statements is true regarding a corporate bond? A) A corporate callable bond gives the holder the right to exchange it for a specified

number of the company's common shares. B) A corporate debenture is a secured bond. C) A corporate indenture is a secured bond. D) A corporate convertible bond gives the holder the right to exchange the bond for a

specified number of the company's common shares. E) Holders of corporate bonds have voting rights in the company.

Answer: D [email protected]: Statement D is the only true statement; all other statements describe something other than the term specified.

11. In the event of the firm's bankruptcy A) the most shareholders can lose is their original investment in the firm's stock. B) common shareholders are the first in line to receive their claims on the firm's

assets. C) bondholders have claim to what is left from the liquidation of the firm's assets

after paying the shareholders. D) the claims of preferred shareholders are honored before those of the common

shareholders. E) A and D.

Answer: E [email protected]: Shareholders have limited liability and have residual claims on assets. Bondholders have a priority claim on assets, and preferred shareholders have priority over common shareholders.

12. Which of the following is true regarding a firm's securities? A) Common dividends are paid before preferred dividends. B) Preferred stockholders have voting rights. C) Preferred dividends are usually cumulative. D) Preferred dividends are contractual obligations. E) Common dividends usually can be paid if preferred dividends have been skipped.

Answer: C [email protected]: The only advantages of preferred dividends over common dividends are that preferred dividends must be paid first and any skipped preferred dividends must be paid before common dividends may be paid.

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13. Which of the following is true of the Dow Jones Industrial Average? A) It is a value-weighted average of 30 large industrial stocks. B) It is a price-weighted average of 30 large industrial stocks. C) The divisor must be adjusted for stock splits. D) A and C. E) B and C.

Answer: E [email protected]: The Dow Jones Industrial Average is a price-weighted index of 30 large industrial firms and the divisor must be adjusted when any of the stocks on the index split.

14. Which of the following indices is (are) market-value weighted?

I) The New York Stock Exchange Composite IndexII) The Standard and Poor's 500 Stock IndexIII) The Dow Jones Industrial Average

A) I only B) I and II only C) I and III only D) I, II, and III E) II and III only

Answer: B [email protected]: The Dow Jones Industrial Average is a price-weighted index.

15. The Dow Jones Industrial Average (DJIA) is computed by: A) adding the prices of 30 large "blue-chip" stocks and dividing by 30. B) calculating the total market value of the 30 firms in the index and dividing by 30. C) adding the prices of the 30 stocks in the index and dividing by a divisor. D) adding the prices of the 500 stocks in the index and dividing by a divisor. E) adding the prices of the 30 stocks in the index and dividing by the value of these

stocks as of some base date period.

Answer: C [email protected]: When the DJIA became a 30-stock index, response A was true; however, as stocks on the index have split and been replaced, the divisor has been adjusted. In 2006 the divisor was 0.125.

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Use the following to answer questions 16-18:

Consider the following three stocks:

16. The price-weighted index constructed with the three stocks is A) 30 B) 40 C) 50 D) 60 E) 70

Answer: B [email protected]: ($40 + $70 + $10)/3 = $40.

17. The value-weighted index constructed with the three stocks using a divisor of 100 is A) 1.2 B) 1200 C) 490 D) 4900 E) 49

Answer: C [email protected]: The sum of the value of the three stocks divided by 100 is 490: [($40 x 200) + ($70 x 500) + ($10 x 600)] /100 = 490.

18. Assume at these prices the value-weighted index constructed with the three stocks is 490. What would the index be if stock B is split 2 for 1 and stock C 4 for 1? A) 265 B) 430 C) 355 D) 490 E) 1000

Answer: D [email protected]: Value-weighted indexes are not affected by stock splits.

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19. The price quotations of Treasury bonds in the Wall Street Journal show an ask price of 104:08 and a bid price of 104:04. As a buyer of the bond what is the dollar price you expect to pay? A) $10,480.00 B) $10,425.00 C) $10,440.00 D) $10,412.50 E) $10,404.00

Answer: B [email protected]: You pay the asking price of the dealer, 104 8/32, or 104.25% of $10,000, or $10,425.00.

20. An investor purchases one municipal and one corporate bond that pay rates of return of 8% and 10%, respectively. If the investor is in the 20% marginal tax bracket, his or her after tax rates of return on the municipal and corporate bonds would be ________ and ______, respectively. A) 8% and 10% B) 8% and 8% C) 6.4% and 8% D) 6.4% and 10% E) 10% and 10%

Answer: B [email protected]: rc = 0.10(1 - 0.20) = 0.08, or 8%; rm = 0.08(1 - 0) = 8%.

21. If a Treasury note has a bid price of $975, the quoted bid price in the Wall Street Journal would be A) 97:50. B) 97:16. C) 97:80. D) 94:24. E) 97:75.

Answer: B [email protected]: Treasuries are quoted as a percent of $1,000 and in 1/32s.

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22. In calculating the Standard and Poor's stock price indices, the adjustment for stock split occurs: A) by adjusting the divisor. B) automatically. C) by adjusting the numerator. D) quarterly, on the last trading day of each quarter. E) none of the above.

Answer: B [email protected]: The calculation of the value-weighted S&P indices includes both price and number of shares of each of the stocks in the index. Thus, the effects of stock splits are automatically incorporated into the calculation.

23. Which of the following statements regarding the Dow Jones Industrial Average (DJIA) is false? A) The DJIA is not very representative of the market as a whole. B) The DJIA consists of 30 blue chip stocks. C) The DJIA is affected equally by changes in low and high priced stocks. D) The DJIA divisor needs to be adjusted for stock splits. E) The value of the DJIA is much higher than individual stock prices.

Answer: C [email protected]: The high priced stocks have much more impact on the DJIA than do the lower priced stocks.

24. The index that includes the largest number of actively traded stock is: A) the NASDAQ Composite Index. B) the NYSE Composite Index. C) the Wilshire 5000 Index. D) the Value Line Composite Index. E) the Russell Index.

Answer: C [email protected]: The Wilshire 5000 is the largest readily available stock index, consisting of the stocks traded on the organized exchanges and the OTC stocks.

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25. A 5.5% 20-year municipal bond is currently priced to yield 7.2%. For a taxpayer in the 33% marginal tax bracket, this bond would offer an equivalent taxable yield of: A) 8.20%. B) 10.75%. C) 11.40%. D) 4.82%. E) none of the above.

Answer: B [email protected]: 0.072 = rm (1-t); 0.072 = rm / (0.67); rm = 0.1075 = 10.75%.

26. If the market prices of each of the 30 stocks in the Dow Jones Industrial Average (DJIA) all change by the same percentage amount during a given day, which stock will have the greatest impact on the DJIA? A) The stock trading at the highest dollar price per share. B) The stock with total equity has the higher market value. C) The stock having the greatest amount of equity in its capital structure. D) The stock having the lowest volatility. E) None of the above.

Answer: A [email protected]: Higher priced stocks affect the DJIA more than lower priced stocks; other choices are not relevant.

27. The stocks on the Dow Jones Industrial Average A) have remained unchanged since the creation of the index. B) include most of the stocks traded on the NYSE. C) are changed occasionally as circumstances dictate. D) consist of stocks on which the investor cannot lose money. E) B and C.

Answer: C [email protected]: The stocks on the DJIA are only a small sample of the entire market, have been changed occasionally since the creation of the index, and one can lose money on any stock. See text box on page 50 for a list of DJIA stock changes.

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28. Federally sponsored agency debt A) is legally insured by the U. S. Treasury. B) would probably be backed by the U. S. Treasury in the event of a near-default. C) has a small positive yield spread relative to U. S. Treasuries. D) B and C. E) A and C.

Answer: D [email protected]: Federally sponsored agencies, such as the FHLB, are not government owned. These agencies' debt is not insured by the U.S. Treasury, but probably would be backed by the Treasury in the event of an agency near-default. As a result, the issues are very safe and carry a yield only slightly higher than that of U. S. Treasuries.

29. Brokers' calls A) are funds used by individuals who wish to buy stocks on margin. B) are funds borrowed by the broker from the bank, with the agreement to repay the

bank immediately if requested to do so. C) carry a rate that is usually about one percentage point lower than the rate on U.S.

T-bills. D) A and B. E) A and C.

Answer: D [email protected]: Brokers' calls are funds borrowed from banks by brokers and loaned to investors in margin accounts.

30. A form of short-term borrowing by dealers in government securities is A) reserve requirements. B) repurchase agreements. C) banker's acceptances. D) commercial paper. E) brokers' calls.

Answer: B [email protected]: Repurchase agreements are a form of short-term borrowing where a dealer sells government securities to an investor with an agreement to buy back those same securities at a slightly higher price.

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31. Which of the following securities is a money market instrument? A) Treasury note B) Treasury bond. C) municipal bond. D) commercial paper. E) mortgage security.

Answer: D [email protected]: Only commercial paper is a money market security. The others are capital market instruments.

32. The yield to maturity reported in the financial pages for Treasury securities A) is calculated by compounding the semiannual yield. B) is calculated by doubling the semiannual yield. C) is also called the bond equivalent yield. D) is calculated as the yield-to-call for premium bonds. E) Both B and C are true.

Answer: E [email protected]: The yield to maturity shown in the financial pages is an APR calculated by doubling the semi-annual yield.

33. Which of the following is not a mortgage-related government or government sponsored agency? A) The Federal Home Loan Bank B) The Federal National Mortgage Association C) The U.S. Treasury D) Freddie Mac E) Ginnie Mae

Answer: C [email protected]: Only the U.S. Treasury issues securities that are not mortgage-backed.

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34. In order for you to be indifferent between the after tax returns on a corporate bond paying 8.5% and a tax-exempt municipal bond paying 6.12%, what would your tax bracket need to be? A) 33% B) 72% C) 15% D) 28% E) Cannot tell from the information given

Answer: D [email protected]: .0612 = .085(1-t); (1-t) = 0.72; t = .28

35. What does the term “negotiable” mean with regard to negotiable certificates of deposit? A) The CD can be sold to another investor if the owner needs to cash it in before its

maturity date. B) The rate of interest on the CD is subject to negotiation. C) The CD is automatically reinvested at its maturity date. D) The CD has staggered maturity dates built in. E) The interest rate paid on the CD will vary with a designated market rate.

Answer: A [email protected]

36. Freddie Mac and Ginnie Mae were organized to provide A) a primary market for mortgage transactions. B) liquidity for the mortgage market. C) a primary market for farm loan transactions. D) liquidity for the farm loan market. E) a source of funds for government agencies.

Answer: B [email protected]

37. The type of municipal bond that is used to finance commercial enterprises such as the construction of a new building for a corporation is called A) a corporate courtesy bond. B) a revenue bond. C) a general obligation bond. D) a tax anticipation note. E) an industrial development bond.

Answer: E [email protected]

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38. Suppose an investor is considering a corporate bond with a 7.17% before-tax yield and a municipal bond with a 5.93% before-tax yield. At what marginal tax rate would the investor be indifferent between investing in the corporate and investing in the muni? A) 15.4% B) 23.7% C) 39.5% D) 17.3% E) 12.4%

Answer: D [email protected]: tm = 1-(5.93%/7.17%) = 17.29%

39. Which of the following are characteristics of preferred stock?

I) It pays its holder a fixed amount of income each year, at the discretion of its managers.

II) It gives its holder voting power in the firm.III) Its dividends are usually cumulative.IV) Failure to pay dividends may result in bankruptcy proceedings.

A) I, III, and IV B) I, II, and III C) I and III D) I, II, and IV E) I, II, III, and IV


40. Bond market indexes can be difficult to construct because A) they cannot be based on firms' market values. B) bonds tend to trade infrequently, making price information difficult to obtain. C) there are so many different kinds of bonds. D) prices cannot be obtained for companies that operate in emerging markets. E) corporations are not required to disclose the details of their bond issues.


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41. With regard to a futures contract, the long position is held by A) the trader who bought the contract at the largest discount. B) the trader who has to travel the farthest distance to deliver the commodity. C) the trader who plans to hold the contract open for the lengthiest time period. D) the trader who commits to purchasing the commodity on the delivery date. E) the trader who commits to delivering the commodity on the delivery date.

Answer: D [email protected]


42. Based on the information given, for a price-weighted index of the three stocks calculate: A) the rate of return for the first period (t=0 to t=1). B) the value of the divisor in the second period (t=2). Assume that Stock A had a 2-1

split during this period. C) the rate of return for the second period (t=1 to t=2).

Answer: A Difficulty: Difficult Rationale: A. The price-weighted index at time 0 is (70+85+105)/3 = 86.67. The price-weighted

index at time 1 is (72+81+98)/3 = 83.67. The return on the index is 83.67/86.67 1 = -3.46%.

B. The divisor must change to reflect the stock split. Because nothing else fundamentally changed, the value of the index should remain 83.67. So the new divisor is (36+81+98)/83.67 = 2.57. The index value is (36+81+98)/2.57 = 83.67.

C. The rate of return for the second period is 83.67/83.67-1 = 0.00%

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43. Based on the information given for the three stocks, calculate the first-period rates of return (from t=0 to t=1) on A) a market-value-weighted index. B) an equally-weighted index. C) a geometric index.

Answer: A Difficulty: Difficult Rationale: A. The total market value at time 0 is $70*200 + $85*500 + $105*300 = $88,000.

The total market value at time 1 is $72*200 + $81*500 + $98*300 = $84,300. The return is $84,300/$88,000 1 = -4.20%.

B. The return on Stock A for the first period is $72/$70-1 = 2.86%. The return on Stock B for the first period is $81/$85-1 = -4.71%. The return on Stock C for the first period is $98/$105-1 = -6.67%. The return on an equally weighted index of the three stocks is (2.86%-4.71%-6.67%)/3 = -2.84%.

C. The geometric average return is [(1+.0286)(1-.0471)(1-.0667)](1/3)-1 = [(1.0286)(0.9529)(0.9333)]0.3333 -1 = -2.92%

44. In order for you to be indifferent between the after tax returns on a corporate bond paying 9% and a tax-exempt municipal bond paying 7%, what would your tax bracket need to be? A) 17.6% B) 27% C) 22.2% D) 19.8% E) Cannot tell from the information given

Answer: C [email protected]: .07 = .09(1-t); (1-t) = 0.777; t = .222

45. In order for you to be indifferent between the after tax returns on a corporate bond paying 7% and a tax-exempt municipal bond paying 5.5%, what would your tax bracket need to be? A) 22.6% B) 21.4% C) 26.2% D) 19.8% E) Cannot tell from the information given

Answer: B [email protected]: .055 = .07(1-t); (1-t) = 0.786; t = .214

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46. An investor purchases one municipal and one corporate bond that pay rates of return of 6% and 8%, respectively. If the investor is in the 25% marginal tax bracket, his or her after tax rates of return on the municipal and corporate bonds would be ________ and ______, respectively. A) 6% and 8% B) 4.5% and 6% C) 4.5% and 8% D) 6% and 6% E) None of the above

Answer: D [email protected]: rc = 0.08(1 - 0.25) = 0.06, or 6%; rm = 0.06(1 - 0) = 6%.

47. An investor purchases one municipal and one corporate bond that pay rates of return of 7.2% and 9.1%, respectively. If the investor is in the 15% marginal tax bracket, his or her after tax rates of return on the municipal and corporate bonds would be ________ and ______, respectively. A) 7.2% and 9.1% B) 7.2% and 7.735% C) 6.12% and 7.735% D) 8.471% and 9.1% E) None of the above

Answer: B [email protected]: rc = 0.091(1 - 0.15) = 0.07735, or 7.735%; rm = 0.072(1 - 0) = 7.2%.

48. For a taxpayer in the 25% marginal tax bracket, a 20-year municipal bond currently yielding 5.5% would offer an equivalent taxable yield of: A) 7.33%. B) 10.75%. C) 5.5%. D) 4.125%. E) none of the above.

Answer: A [email protected]: 0.055= rm(1-t); 0.0733 = rm / 0.75).

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49. For a taxpayer in the 15% marginal tax bracket, a 15-year municipal bond currently yielding 6.2% would offer an equivalent taxable yield of: A) 6.2%. B) 5.27%. C) 8.32%. D) 7.29%. E) none of the above.

Answer: D [email protected]: 0.062= rm(1-t); 0.062 = rm / (0.85); rm = 0.0729 = 7.29%.

50. With regard to a futures contract, the short position is held by A) the trader who bought the contract at the largest discount. B) the trader who has to travel the farthest distance to deliver the commodity. C) the trader who plans to hold the contract open for the lengthiest time period. D) the trader who commits to purchasing the commodity on the delivery date. E) the trader who commits to delivering the commodity on the delivery date.


51. A call option allows the buyer to A) sell the underlying asset at the exercise price on or before the expiration date. B) buy the underlying asset at the exercise price on or before the expiration date. C) sell the option in the open market prior to expiration. D) A and C. E) B and C.

Answer: E [email protected]: A call option may be exercised (allowing the holder to buy the underlying asset) on or before expiration; the option contract also may be sold prior to expiration.

52. A put option allows the holder to A) buy the underlying asset at the striking price on or before the expiration date. B) sell the underlying asset at the striking price on or before the expiration date. C) sell the option in the open market prior to expiration. D) B and C. E) A and C.

Answer: D [email protected]: A put option allows the buyer to sell the underlying asset at the striking price on or before the expiration date; the option contract also may be sold prior to expiration.

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53. The ____ index represents the performance of the German stock market. A) DAX B) FTSE C) Nikkei D) Hang Seng E) None of the above


54. The ____ index represents the performance of the Japanese stock market. A) DAX B) FTSE C) Nikkei D) Hang Seng E) None of the above


55. The ____ index represents the performance of the U.K. stock market. A) DAX B) FTSE C) Nikkei D) Hang Seng E) None of the above


56. The ____ index represents the performance of the Hong Kong stock market. A) DAX B) FTSE C) Nikkei D) Hang Seng E) None of the above


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57. The ultimate stock index in the U.S. is the A) Wilshire 5000. B) DJIA. C) S&P 500. D) Russell 2000. E) None of the above.


58. The ____ is an example of a U.S. index of large firms. A) Wilshire 5000 B) DJIA C) DAX D) Russell 2000 E) All of the above


59. The ____ is an example of a U.S. index of small firms. A) S&P 500 B) DJIA C) DAX D) Russell 2000 E) All of the above


60. The largest component of the money market is ____________. A) repurchase agreements B) money market mutual funds C) T-bills D) Eurodollars E) savings deposits


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61. Certificates of deposit are insured by the ____________. A) SPIC B) CFTC C) Lloyds of London D) FDIC E) all of the above


62. Certificates of deposit are insured for up to ____________ in the event of bank insolvency. A) $10,000 B) $100,000 C) $50,000 D) $500,000 E) none of the above


63. The maximum maturity of commercial paper that can be issued without SEC registration is ____________. A) 270 days B) 180 days C) 90 days D) 30 days E) none of the above


64. Which of the following is used extensively in foreign trade when the creditworthiness of one trader is unknown to the trading partner? A) repos B) bankers acceptances C) Eurodollars D) federal funds E) none of the above


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65. A US dollar denominated bond that is sold in Singapore is a ____________. A) Eurobond B) Yankee bond C) Samurai bond D) Bulldog bond E) none of the above


66. A municipal bond issued to finance an airport, hospital, turnpike, or port authority is typically a ____________. A) revenue bond B) general obligation bond C) industrial development bond D) A and B are equally likely E) B and C are equally likely


67. Unsecured bonds are called ____________. A) junk bonds B) debentures C) indentures D) subordinated debentures E) either A or D


68. A bond that can be retired prior to maturity by the issuer is a ____________ bond. A) convertible B) secured C) unsecured D) callable E) Yankee


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69. Corporations can exclude ____________ percent of the dividends received from preferred stock. A) 50 B) 70 C) 20 D) 15 E) 62


Essay Questions

70. Distinguish between U. S. Treasury debt and U. S Agency debt.

[email protected]

71. Discuss the advantages and disadvantages of common stock ownership, relative to other investment alternatives.

[email protected]


1. Which of the following statements regarding risk-averse investors is true? A) They only care about the rate of return. B) They accept investments that are fair games. C) They only accept risky investments that offer risk premiums over the risk-free

rate. D) They are willing to accept lower returns and high risk. E) A and B.


2. Which of the following statements is (are) true?

I) Risk-averse investors reject investments that are fair games.II) Risk-neutral investors judge risky investments only by the expected

returns.

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III) Risk-averse investors judge investments only by their riskiness.IV) Risk-loving investors will not engage in fair games.

A) I only B) II only C) I and II only D) II and III only E) II, III, and IV only

Answer: C [email protected]: Risk-averse investors consider a risky investment only if the investment offers a risk premium. Risk-neutral investors look only at expected returns when making an investment decision.

3. In the mean-standard deviation graph an indifference curve has a ________ slope. A) negative B) zero C) positive D) northeast E) cannot be determined

Answer: C [email protected]: The risk-return trade-off is one in which greater risk is taken if greater returns can be expected, resulting in a positive slope.

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4. In the mean-standard deviation graph, which one of the following statements is true regarding the indifference curve of a risk-averse investor? A) It is the locus of portfolios that have the same expected rates of return and

different standard deviations. B) It is the locus of portfolios that have the same standard deviations and different

rates of return. C) It is the locus of portfolios that offer the same utility according to returns and

standard deviations. D) It connects portfolios that offer increasing utilities according to returns and

standard deviations. E) none of the above.

Answer: C [email protected]: Indifference curves plot trade-off alternatives that provide equal utility to the individual (in this case, the trade-offs are the risk-return characteristics of the portfolios).

5. In a return-standard deviation space, which of the following statements is (are) true for risk-averse investors? (The vertical and horizontal lines are referred to as the expected return-axis and the standard deviation-axis, respectively.)

I) An investor's own indifference curves might intersect.II) Indifference curves have negative slopes.III) In a set of indifference curves, the highest offers the greatest utility.IV) Indifference curves of two investors might intersect.

A) I and II only B) II and III only C) I and IV only D) III and IV only E) none of the above

Answer: D [email protected]: An investor's indifference curves are parallel, and thus cannot intersect and have positive slopes. The highest indifference curve (the one in the most northwestern position) offers the greatest utility. Indifference curves of investors with similar risk-return trade-offs might intersect.

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6. Elias is a risk-averse investor. David is a less risk-averse investor than Elias. Therefore, A) for the same risk, David requires a higher rate of return than Elias. B) for the same return, Elias tolerates higher risk than David. C) for the same risk, Elias requires a lower rate of return than David. D) for the same return, David tolerates higher risk than Elias. E) cannot be determined.

Answer: D [email protected]: The more risk averse the investor, the less risk that is tolerated, given a rate of return.

7. When an investment advisor attempts to determine an investor's risk tolerance, which factor would they be least likely to assess? A) the investor's prior investing experience B) the investor's degree of financial security C) the investor's tendency to make risky or conservative choices D) the level of return the investor prefers E) the investor's feeling about loss



Assume an investor with the following utility function: U = E(r) - 3/2(s2).

8. To maximize her expected utility, she would choose the asset with an expected rate of return of _______ and a standard deviation of ________, respectively. A) 12%; 20% B) 10%; 15% C) 10%; 10% D) 8%; 10% E) none of the above

Answer: C [email protected]: U = 0.10 - 3/2(0.10)2 = 8.5%; highest utility of choices.

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9. To maximize her expected utility, which one of the following investment alternatives would she choose? A) A portfolio that pays 10 percent with a 60 percent probability or 5 percent with 40

percent probability. B) A portfolio that pays 10 percent with 40 percent probability or 5 percent with a 60

percent probability. C) A portfolio that pays 12 percent with 60 percent probability or 5 percent with 40

percent probability. D) A portfolio that pays 12 percent with 40 percent probability or 5 percent with 60

percent probability. E) none of the above.

Answer: C Difficulty: Difficult Rationale: U(c) = 9.02%; highest utility of possibilities.

10. A portfolio has an expected rate of return of 0.15 and a standard deviation of 0.15. The risk-free rate is 6 percent. An investor has the following utility function: U = E(r) - (A/2)s2. Which value of A makes this investor indifferent between the risky portfolio and the risk-free asset? A) 5 B) 6 C) 7 D) 8 E) none of the above

Answer: D Difficulty: Difficult Rationale: 0.06 = 0.15 - A/2(0.15)2; 0.06 - 0.15 = -A/2(0.0225); -0.09 = -0.01125A; A = 8; U = 0.15 - 8/2(0.15)2 = 6%; U(Rf) = 6%.

11. According to the mean-variance criterion, which one of the following investments dominates all others? A) E(r) = 0.15; Variance = 0.20 B) E(r) = 0.10; Variance = 0.20 C) E(r) = 0.10; Variance = 0.25 D) E(r) = 0.15; Variance = 0.25 E) none of these dominates the other alternatives.

Answer: A Difficulty: Difficult Rationale: A gives the highest return with the least risk; return per unit of risk is .75, which dominates the reward-risk ratio for the other choices.

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12. Consider a risky portfolio, A, with an expected rate of return of 0.15 and a standard deviation of 0.15, that lies on a given indifference curve. Which one of the following portfolios might lie on the same indifference curve? A) E(r) = 0.15; Standard deviation = 0.20 B) E(r) = 0.15; Standard deviation = 0.10 C) E(r) = 0.10; Standard deviation = 0.10 D) E(r) = 0.20; Standard deviation = 0.15 E) E(r) = 0.10; Standard deviation = 0.20

Answer: C Difficulty: Difficult Rationale: Portfolio A has a reward to risk ratio of 1.0; portfolio C is the only choice with the same risk-return tradeoff.


13. Based on the utility function above, which investment would you select? A) 1 B) 2 C) 3 D) 4 E) cannot tell from the information given

Answer: C Difficulty: Difficult Rationale: U(c) = 0.21 - 4/2(0.16)2 = 15.88 (highest utility of choices).

14. Which investment would you select if you were risk neutral? A) 1 B) 2 C) 3 D) 4 E) cannot tell from the information given

Answer: D Difficulty: Difficult Rationale: If you are risk neutral, your only concern is with return, not risk.

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15. The variable (A) in the utility function represents the: A) investor's return requirement. B) investor's aversion to risk. C) certainty-equivalent rate of the portfolio. D) minimum required utility of the portfolio. E) none of the above.

Answer: B [email protected]: A is an arbitrary scale factor used to measure investor risk tolerance. The higher the value of A, the more risk averse the investor.

16. The exact indifference curves of different investors A) cannot be known with perfect certainty. B) can be calculated precisely with the use of advanced calculus. C) although not known with perfect certainty, do allow the advisor to create more

suitable portfolios for the client. D) A and C. E) none of the above.

Answer: D [email protected]: Indifference curves cannot be calculated precisely, but the theory does allow for the creation of more suitable portfolios for investors of differing levels of risk tolerance.

17. The riskiness of individual assets A) should be considered for the asset in isolation. B) should be considered in the context of the effect on overall portfolio volatility. C) combined with the riskiness of other individual assets (in the proportions these

assets constitute of the entire portfolio) should be the relevant risk measure. D) B and C. E) none of the above.

Answer: D [email protected]: The relevant risk is portfolio risk; thus, the riskiness of an individual security should be considered in the context of the portfolio as a whole.

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18. A fair game A) will not be undertaken by a risk-averse investor. B) is a risky investment with a zero risk premium. C) is a riskless investment. D) Both A and B are true. E) Both A and C are true.

Answer: D [email protected]: A fair game is a risky investment with a payoff exactly equal to its expected value. Since it offers no risk premium, it will not be acceptable to a risk-averse investor.

19. The presence of risk means that A) investors will lose money. B) more than one outcome is possible. C) the standard deviation of the payoff is larger than its expected value. D) final wealth will be greater than initial wealth. E) terminal wealth will be less than initial wealth.

Answer: B [email protected]: The presence of risk means that more than one outcome is possible.

20. The utility score an investor assigns to a particular portfolio, other things equal, A) will decrease as the rate of return increases. B) will decrease as the standard deviation increases. C) will decrease as the variance increases. D) will increase as the variance increases. E) will increase as the rate of return increases.

Answer: E [email protected]: Utility is enhanced by higher expected returns and diminished by higher risk.

21. The certainty equivalent rate of a portfolio is A) the rate that a risk-free investment would need to offer with certainty to be

considered equally attractive as the risky portfolio. B) the rate that the investor must earn for certain to give up the use of his money. C) the minimum rate guaranteed by institutions such as banks. D) the rate that equates “A” in the utility function with the average risk aversion

coefficient for all risk-averse investors. E) represented by the scaling factor “-.005” in the utility function.


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22. According to the mean-variance criterion, which of the statements below is correct?

A) Investment B dominates Investment A. B) Investment B dominates Investment C. C) Investment D dominates all of the other investments. D) Investment D dominates only Investment B. E) Investment C dominates investment A.

Answer: B [email protected]: This question tests the student's understanding of how to apply the mean-variance criterion.

23. Steve is more risk-averse than Edie. On a graph that shows Steve and Edie's indifference curves, which of the following is true? Assume that the graph shows expected return on the vertical axis and standard deviation on the horizontal axis.

I) Steve and Edie's indifference curves might intersect.II) Steve's indifference curves will have flatter slopes than Edie's.III) Steve's indifference curves will have steeper slopes than Edie's.IV) Steve and Edie's indifference curves will not intersect.V) Steve's indifference curves will be downward sloping and Edie's will be

upward sloping.

A) I and V B) I and III C) III and IV D) I and II E) II and IV

Answer: B [email protected]: This question tests whether the student understands the graphical properties of indifference curves and how they relate to the degree of risk tolerance.

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24. The Capital Allocation Line can be described as the A) investment opportunity set formed with a risky asset and a risk-free asset. B) investment opportunity set formed with two risky assets. C) line on which lie all portfolios that offer the same utility to a particular investor. D) line on which lie all portfolios with the same expected rate of return and different

standard deviations. E) none of the above.

Answer: A [email protected]: The CAL has an intercept equal to the risk-free rate. It is a straight line through the point representing the risk-free asset and the risky portfolio, in expected-return/standard deviation space.

25. Which of the following statements regarding the Capital Allocation Line (CAL) is false? A) The CAL shows risk-return combinations. B) The slope of the CAL equals the increase in the expected return of a risky

portfolio per unit of additional standard deviation. C) The slope of the CAL is also called the reward-to-variability ratio. D) The CAL is also called the efficient frontier of risky assets in the absence of a

risk-free asset. E) Both A and D are true.

Answer: D [email protected]: The CAL consists of combinations of a risky asset and a risk-free asset whose slope is the reward-to-variability ratio; thus, all statements except d are true.

26. Given the capital allocation line, an investor's optimal portfolio is the portfolio that A) maximizes her expected profit. B) maximizes her risk. C) minimizes both her risk and return. D) maximizes her expected utility. E) none of the above.

Answer: D [email protected]: By maximizing expected utility, the investor is obtaining the best risk-return relationships possible and acceptable for her.

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27. An investor invests 30 percent of his wealth in a risky asset with an expected rate of return of 0.15 and a variance of 0.04 and 70 percent in a T-bill that pays 6 percent. His portfolio's expected return and standard deviation are __________ and __________, respectively. A) 0.114; 0.12 B) 0.087;0.06 C) 0.295; 0.12 D) 0.087; 0.12 E) none of the above

Answer: B [email protected]: E(rP) = 0.3(15%) + 0.7(6%) = 8.7%; sP = 0.3(0.04)1/2 = 6%.


You invest $100 in a risky asset with an expected rate of return of 0.12 and a standard deviation of 0.15 and a T-bill with a rate of return of 0.05.

28. What percentages of your money must be invested in the risky asset and the risk-free asset, respectively, to form a portfolio with an expected return of 0.09? A) 85% and 15% B) 75% and 25% C) 67% and 33% D) 57% and 43% E) cannot be determined

Answer: D [email protected]: 9% = w1(12%) + (1 - w1)(5%); 9% = 12%w1 + 5% - 5%w1; 4% = 7%w1; w1

= 0.57; 1 - w1 = 0.43; 0.57(12%) + 0.43(5%) = 8.99%.

29. What percentages of your money must be invested in the risk-free asset and the risky asset, respectively, to form a portfolio with a standard deviation of 0.06? A) 30% and 70% B) 50% and 50% C) 60% and 40% D) 40% and 60% E) cannot be determined

Answer: C [email protected]: 0.06 = x(0.15); x = 40% in risky asset.

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30. A portfolio that has an expected outcome of $115 is formed by A) investing $100 in the risky asset. B) investing $80 in the risky asset and $20 in the risk-free asset. C) borrowing $43 at the risk-free rate and investing the total amount ($143) in the

risky asset. D) investing $43 in the risky asset and $57 in the riskless asset. E) Such a portfolio cannot be formed.

Answer: C Difficulty: Difficult Rationale: For $100, (115-100)/100=15%; .15 = w1(.12) + (1 - w1)(.05); .15 = .12w1

+ .05 - .05w1; 0.10 = 0.07w1; w1 = 1.43($100) = $143; (1 - w1)$100 = -$43.

31. The slope of the Capital Allocation Line formed with the risky asset and the risk-free asset is equal to A) 0.4667. B) 0.8000. C) 2.14. D) 0.41667. E) Cannot be determined.

Answer: A [email protected]: (0.12 - 0.05)/0.15 = 0.4667.

32. Consider a T-bill with a rate of return of 5 percent and the following risky securities:

Security A: E(r) = 0.15; Variance = 0.04Security B: E(r) = 0.10; Variance = 0.0225Security C: E(r) = 0.12; Variance = 0.01Security D: E(r) = 0.13; Variance = 0.0625

From which set of portfolios, formed with the T-bill and any one of the 4 risky securities, would a risk-averse investor always choose his portfolio? A) The set of portfolios formed with the T-bill and security A. B) The set of portfolios formed with the T-bill and security B. C) The set of portfolios formed with the T-bill and security C. D) The set of portfolios formed with the T-bill and security D. E) Cannot be determined.

Answer: C Difficulty: Difficult Rationale: Security C has the highest reward-to-volatility ratio.

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You are considering investing $1,000 in a T-bill that pays 0.05 and a risky portfolio, P, constructed with 2 risky securities, X and Y. The weights of X and Y in P are 0.60 and 0.40, respectively. X has an expected rate of return of 0.14 and variance of 0.01, and Y has an expected rate of return of 0.10 and a variance of 0.0081.

33. If you want to form a portfolio with an expected rate of return of 0.11, what percentages of your money must you invest in the T-bill and P, respectively? A) 0.25; 0.75 B) 0.19; 0.81 C) 0.65; 0.35 D) 0.50; 0.50 E) cannot be determined

Answer: B [email protected]: E(rp) = 0.6(14%) + 0.4(10%) = 12.4%; 11% = 5x + 12.4(1 - x); x = 0.189 (T-bills) (1-x) =0.811 (risky asset).

34. If you want to form a portfolio with an expected rate of return of 0.10, what percentages of your money must you invest in the T-bill, X, and Y, respectively if you keep X and Y in the same proportions to each other as in portfolio P? A) 0.25; 0.45; 0.30 B) 0.19; 0.49; 0.32 C) 0.32; 0.41; 0.27 D) 0.50; 0.30; 0.20 E) cannot be determined

Answer: C Difficulty: Difficult Rationale: E(rp) = .100.10 = 5w + 12.4(1 - w); x = 0.32 (weight of T-bills); As composition of X and Y are .6 and .4 of P, respectively, then for 0.68 weight in P, the respective weights must be 0.41 and 0.27; .6(.68) = 41%; .4(.68) = 27%

35. What would be the dollar values of your positions in X and Y, respectively, if you decide to hold 40% percent of your money in the risky portfolio and 60% in T-bills? A) $240; $360 B) $360; $240 C) $100; $240 D) $240; $160 E) Cannot be determined

Answer: D [email protected]: $400(0.6) = $240 in X; $400(0.4) = $160 in Y.

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36. What would be the dollar value of your positions in X, Y, and the T-bills, respectively, if you decide to hold a portfolio that has an expected outcome of $1,200? A) Cannot be determined B) $54; $568; $378 C) $568; $54; $378 D) $378; $54; $568 E) $108; $514; $378

Answer: B Difficulty: Difficult Rationale: ($1,200 - $1,000)/$1,000 = 12%; (0.6)14% + (0.4)10% = 12.4%; 12% = w5% + 12.4%(1 - w);w=.054; 1-w=.946; w = 0.054($1,000) = $54 (T-bills); 1 - w = 1 - 0.054 = 0.946($1,000) = $946; $946 x 0.6 = $568 in X; $946 x 0.4 = $378 in Y.

37. A reward-to-volatility ratio is useful in: A) measuring the standard deviation of returns. B) understanding how returns increase relative to risk increases. C) analyzing returns on variable rate bonds. D) assessing the effects of inflation. E) none of the above.

Answer: B [email protected]: B is the only choice relevant to the reward-to-volatility ratio (risk and return).

38. The change from a straight to a kinked capital allocation line is a result of: A) reward-to-volatility ratio increasing. B) borrowing rate exceeding lending rate. C) an investor's risk tolerance decreasing. D) increase in the portfolio proportion of the risk-free asset. E) none of the above.

Answer: B Difficulty: Difficult Rationale: The linear capital allocation line assumes that the investor may borrow and lend at the same rate (the risk-free rate), which obviously is not true. Relaxing this assumption and incorporating the higher borrowing rates into the model results in the kinked capital allocation line.

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39. The first major step in asset allocation is: A) assessing risk tolerance. B) analyzing financial statements. C) estimating security betas. D) identifying market anomalies. E) none of the above.

Answer: A [email protected]: A should be the first consideration in asset allocation. B, C, and D refer to security selection.

40. Based on their relative degrees of risk tolerance A) investors will hold varying amounts of the risky asset in their portfolios. B) all investors will have the same portfolio asset allocations. C) investors will hold varying amounts of the risk-free asset in their portfolios. D) A and C. E) none of the above.

Answer: D [email protected]: By determining levels of risk tolerance, investors can select the optimum portfolio for their own needs; these asset allocations will vary between amounts of risk-free and risky assets based on risk tolerance.

41. Asset allocation A) may involve the decision as to the allocation between a risk-free asset and a risky

asset. B) may involve the decision as to the allocation among different risky assets. C) may involve considerable security analysis. D) A and B. E) A and C.

Answer: D [email protected]: A and B are possible steps in asset allocation. C is related to security selection.

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42. In the mean-standard deviation graph, the line that connects the risk-free rate and the optimal risky portfolio, P, is called ______________. A) the Security Market Line B) the Capital Allocation Line C) the Indifference Curve D) the investor's utility line E) none of the above

Answer: B [email protected]: The Capital Allocation Line (CAL) illustrates the possible combinations of a risk-free asset and a risky asset available to the investor.

43. Treasury bills are commonly viewed as risk-free assets because A) their short-term nature makes their values insensitive to interest rate fluctuations. B) the inflation uncertainty over their time to maturity is negligible. C) their term to maturity is identical to most investors' desired holding periods. D) Both A and B are true. E) Both B and C are true.

Answer: D [email protected]: Treasury bills do not exactly match most investor's desired holding periods, but because they mature in only a few weeks or months they are relatively free of interest rate sensitivity and inflation uncertainty.


Your client, Bo Regard, holds a complete portfolio that consists of a portfolio of risky assets (P) and T-Bills. The information below refers to these assets.

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44. What is the expected return on Bo's complete portfolio? A) 10.32% B) 5.28% C) 9.62% D) 8.44% E) 7.58%

Answer: A [email protected]: E(rC) = .8*12.00% + .2*3.6% = 10.32%

45. What is the standard deviation of Bo's complete portfolio? A) 7.20% B) 5.40% C) 6.92% D) 4.98% E) 5.76%

Answer: E [email protected]: Std. Dev. of C = .8*7.20% = 5.76%

46. What is the equation of Bo's Capital Allocation Line? A) E(rC) = 7.2 + 3.6 * Standard Deviation of C B) E(rC) = 3.6 + 1.167 * Standard Deviation of C C) E(rC) = 3.6 + 12.0 * Standard Deviation of C D) E(rC) = 0.2 + 1.167 * Standard Deviation of C E) E(rC) = 3.6 + 0.857 * Standard Deviation of C

Answer: B [email protected]: The intercept is the risk-free rate (3.60%) and the slope is (12.00%-3.60%)/7.20% = 1.167.

47. What are the proportions of Stocks A, B, and C, respectively in Bo's complete portfolio? A) 40%, 25%, 35% B) 8%, 5%, 7% C) 32%, 20%, 28% D) 16%, 10%, 14% E) 20%, 12.5%, 17.5%

Answer: C [email protected]: Proportion in A = .8 * 40% = 32%; proportion in B = .8 * 25% = 20%; proportion in C = .8 * 35% = 28%.

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48. To build an indifference curve we can first find the utility of a portfolio with 100% in the risk-free asset, then A) find the utility of a portfolio with 0% in the risk-free asset. B) change the expected return of the portfolio and equate the utility to the standard

deviation. C) find another utility level with 0% risk. D) change the standard deviation of the portfolio and find the expected return the

investor would require to maintain the same utility level. E) change the risk-free rate and find the utility level that results in the same standard

deviation.

Answer: D Difficulty: Difficult Rationale: This references the procedure described on page 207-208 of the text. The authors describe how to trace out indifference curves using a spreadsheet.

49. The Capital Market Line

I) is a special case of the Capital Allocation Line.II) represents the opportunity set of a passive investment strategy.III) has the one-month T-Bill rate as its intercept.IV) uses a broad index of common stocks as its risky portfolio.

A) I, III, and IV B) II, III, and IV C) III and IV D) I, II, and III E) I, II, III, and IV

Answer: E [email protected]: 'The Capital Market Line is the Capital Allocation Line based on the one-month T-Bill rate and a broad index of common stocks. It applies to an investor pursuing a passive management strategy.

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50. An investor invests 40 percent of his wealth in a risky asset with an expected rate of return of 0.18 and a variance of 0.10 and 60 percent in a T-bill that pays 4 percent. His portfolio's expected return and standard deviation are __________ and __________, respectively. A) 0.114; 0.112 B) 0.087; 0.063 C) 0.096; 0.126 D) 0.087; 0.144 E) none of the above

Answer: C [email protected]: E(rP) = 0.4(18%) + 0.6(4%) = 9.6%; sP = 0.4(0.10)1/2 = 12.6%.

51. An investor invests 70 percent of his wealth in a risky asset with an expected rate of return of 0.11 and a variance of 0.12 and 30 percent in a T-bill that pays 3 percent. His portfolio's expected return and standard deviation are __________ and __________, respectively. A) 0.086; 0.242 B) 0.087; 0.267 C) 0.295; 0.123 D) 0.087; 0.182 E) none of the above

Answer: A [email protected]: E(rP) = 0.7(11%) + 0.3(3%) = 8.6%; sP = 0.7(0.12)1/2 = 24.2%.



52. What percentages of your money must be invested in the risky asset and the risk-free asset, respectively, to form a portfolio with an expected return of 0.08? A) 85% and 15% B) 75% and 25% C) 62.5% and 37.5% D) 57% and 43% E) cannot be determined

Answer: C [email protected]: 8% = w1(11%) + (1 - w1)(3%); 8% = 11%w1 + 3% - 3%w1; 5% = 8%w1; w1

= 0.625; 1 - w1 = 0.375; 0.625(11%) + 0.375(3%) = 8.0%.

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53. What percentages of your money must be invested in the risk-free asset and the risky asset, respectively, to form a portfolio with a standard deviation of 0.08? A) 30% and 70% B) 50% and 50% C) 60% and 40% D) 40% and 60% E) Cannot be determined.

Answer: C [email protected]: 0.08 = x(0.20); x = 40% in risky asset.

54. The slope of the Capital Allocation Line formed with the risky asset and the risk-free asset is equal to A) 0.47 B) 0.80 C) 2.14 D) 0.40 E) Cannot be determined.

Answer: D [email protected]: (0.11 - 0.03)/0.20 = 0.40.



55. What percentages of your money must be invested in the risky asset and the risk-free asset, respectively, to form a portfolio with an expected return of 0.11? A) 53.8% and 46.2% B) 75% and 25% C) 62.5% and 37.5% D) 46.1% and 53.8% E) Cannot be determined.

Answer: A [email protected]: 11% = w1(17%) + (1 - w1)(4%); 11% = 17%w1 + 4% - 4%w1; 7% = 13%w1; w1 = 0.538; 1 - w1 = 0.461; 0.538(17%) + 0.462(4%) = 11.0%.

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56. What percentages of your money must be invested in the risk-free asset and the risky asset, respectively, to form a portfolio with a standard deviation of 0.20? A) 30% and 70% B) 50% and 50% C) 60% and 40% D) 40% and 60% E) Cannot be determined.

Answer: B [email protected]: 0.20 = x(0.40); x = 50% in risky asset.

57. The slope of the Capital Allocation Line formed with the risky asset and the risk-free asset is equal to A) 0.325. B) 0.675. C) 0.912. D) 0.407. E) Cannot be determined.

Answer: A [email protected]: (0.17 - 0.04)/0.40 = 0.325.


1. As diversification increases, the total variance of a portfolio approaches ____________. A) 0 B) 1 C) the variance of the market portfolio D) infinity E) none of the above

Answer: C [email protected]: As more and more securities are added to the portfolio, unsystematic risk decreases and most of the remaining risk is systematic, as measured by the variance of the market portfolio.

2. The index model was first suggested by ____________. A) Graham B) Markowitz

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C) Miller D) Sharpe E) none of the above

Answer: D [email protected]: William Sharpe, building on the work of Harry Markowitz, developed the index model.

3. A single-index model uses __________ as a proxy for the systematic risk factor. A) a market index, such as the S&P 500 B) the current account deficit C) the growth rate in GNP D) the unemployment rate E) none of the above

Answer: A [email protected]: The single-index model uses a market index, such as the S&P 500, as a proxy for the market, and thus for systematic risk.

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4. The Security Risk Evaluation book published by Merrill Lynch relies on the __________ most recent monthly observations to calculate regression parameters. A) 12 B) 36 C) 60 D) 120 E) none of the above

Answer: C [email protected]: Most published betas and other regression parameters, including those published by Merrill Lynch, are based on five years of monthly return data.

5. The Security Risk Evaluation book published by Merrill Lynch uses the __________ as a proxy for the market portfolio. A) Dow Jones Industrial Average B) Dow Jones Transportation Average C) S&P 500 Index D) Wilshire 5000 E) none of the above

Answer: C [email protected]: The Merrill Lynch data (and much of the other published data sets) are based on the S&P 500 index as a market proxy.

6. According to the index model, covariances among security pairs are A) due to the influence of a single common factor represented by the market index

return B) extremely difficult to calculate C) related to industry-specific events D) usually positive E) A and D

Answer: E [email protected]: Most securities move together most of the time, and move with a market index, or market proxy.

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7. The intercept calculated by Merrill Lynch in the regression equations is equal to A) α in the CAPMB) α + rf(1 + β)C) α + rf(1 - β)D) 1 - αE) none of the above

Answer: C [email protected]: The intercept that Merrill Lynch calls alpha is really, using the parameters of the CAPM, an estimate of a + rf (1 - b). The apparent justification for this procedure is that, on a monthly basis, rf(1 - b) is small and is apt to be swamped by the volatility of actual stock returns.

8. Analysts may use regression analysis to estimate the index model for a stock. When doing so, the slope of the regression line is an estimate of ______________. A) the α of the asset B) the β of the asset C) the σ of the asset D) the δ of the asset E) none of the above

Answer: B [email protected]: The slope of the regression line, b, measures the volatility of the stock versus the volatility of the market.

9. In a factor model, the return on a stock in a particular period will be related to _________. A) firm-specific events B) macroeconomic events C) the error term D) both A and B E) neither A nor B

Answer: D [email protected]: The return on a stock is related to both firm-specific and macroeconomic events.

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10. Rosenberg and Guy found that __________ helped to predict a firm's beta. A) the firm's financial characteristics B) the firm's industry group C) firm size D) both A and B E) A, B and C all helped to predict betas.

Answer: E [email protected]: Rosenberg and Guy found that after controlling for the firm's financial characteristics, the firm's industry group was a significant predictor of the firm's beta.

11. If the index model is valid, _________ would be helpful in determining the covariance between assets K and L. A) βk

B) βL

C) σM

D) all of the above E) none of the above

Answer: D [email protected]: If the index model is valid A, B, and C are determinants of the covariance between K and L.

12. Rosenberg and Guy found that ___________ helped to predict firms' betas. A) debt/asset ratios B) market capitalization C) variance of earnings D) all of the above E) none of the above

Answer: D [email protected]: Rosenberg and Guy found that A, B, and C were determinants of firms' betas.

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13. If a firm's beta was calculated as 0.6 in a regression equation, Merrill Lynch would state the adjusted beta at a number A) less than 0.6 but greater than zero. B) between 0.6 and 1.0. C) between 1.0 and 1.6. D) greater than 1.6. E) zero or less.

Answer: B [email protected]: Betas, on average, equal one; thus, betas over time regress toward the mean, or 1. Therefore, if historic betas are less than 1, adjusted betas are between 1 and the calculated beta.

14. The beta of Exxon stock has been estimated as 1.2 by Merrill Lynch using regression analysis on a sample of historical returns. The Merrill Lynch adjusted beta of Exxon stock would be ___________. A) 1.20 B) 1.32 C) 1.13 D) 1.0 E) none of the above

Answer: C [email protected]: Adjusted beta = 2/3 sample beta + 1/3(1); = 2/3(1.2) + 1/3 = 1.13.

15. Assume that stock market returns do not resemble a single-index structure. An investment fund analyzes 100 stocks in order to construct a mean-variance efficient portfolio constrained by 100 investments. They will need to calculate _____________ expected returns and ___________ variances of returns. A) 100, 100 B) 100, 4950 C) 4950, 100 D) 4950, 4950 E) none of the above

Answer: A [email protected]: The expected returns of each of the 100 securities must be calculated. In addition, the 100 variances around these returns must be calculated.

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16. Assume that stock market returns do not resemble a single-index structure. An investment fund analyzes 100 stocks in order to construct a mean-variance efficient portfolio constrained by 100 investments. They will need to calculate ____________ covariances. A) 45 B) 100 C) 4,950 D) 10,000 E) none of the above

Answer: C [email protected]: (n2 - n)/2 = (10,000 - 100)/2 = 4,950 covariances must be calculated.

17. Assume that stock market returns do follow a single-index structure. An investment fund analyzes 200 stocks in order to construct a mean-variance efficient portfolio constrained by 200 investments. They will need to calculate ________ estimates of expected returns and ________ estimates of sensitivity coefficients to the macroeconomic factor. A) 200; 19,900 B) 200; 200 C) 19,900; 200 D) 19,900; 19.900 E) none of the above

Answer: B [email protected]: For a single-index model, n(200), expected returns and n(200) sensitivity coefficients to the macroeconomic factor must be estimated.

18. Assume that stock market returns do follow a single-index structure. An investment fund analyzes 500 stocks in order to construct a mean-variance efficient portfolio constrained by 500 investments. They will need to calculate ________ estimates of firm-specific variances and ________ estimates for the variance of the macroeconomic factor. A) 500; 1 B) 500; 500 C) 124,750; 1 D) 124,750; 500 E) 250,000; 500

Answer: A [email protected]: For the single-index model, n(500) estimates of firm-specific variances must be calculated and 1 estimate for the variance of the common macroeconomic factor.

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19. Consider the single-index model. The alpha of a stock is 0%. The return on the market index is 16%. The risk-free rate of return is 5%. The stock earns a return that exceeds the risk-free rate by 11% and there are no firm-specific events affecting the stock performance. The β of the stock is _______. A) 0.67 B) 0.75 C) 1.0 D) 1.33 E) 1.50

Answer: C [email protected]: 11% = 0% + b(11%); b = 1.0.

20. Suppose you held a well-diversified portfolio with a very large number of securities, and that the single index model holds. If the ó of your portfolio was 0.20 and óM was 0.16, the β of the portfolio would be approximately ________. A) 0.64 B) 0.80 C) 1.25 D) 1.56 E) none of the above

Answer: C Difficulty: Difficult Rationale: s2p / s2m = b2; (0.2)2/(0.16)2 = 1.56; b = 1.25.

21. Suppose the following equation best describes the evolution of β over time:

βt = 0.25 + 0.75βt-1

If a stock had a β of 0.6 last year, you would forecast the β to be _______ in the coming year. A) 0.45 B) 0.60 C) 0.70 D) 0.75 E) none of the above

Answer: C [email protected]: 0.25 + 0.75(0.6) = 0.70.

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22. Merrill Lynch estimates the index model for a stock using regression analysis involving total returns. They estimated the intercept in the regression equation at 6% and the β at 0.5. The risk-free rate of return is 12%. The true β of the stock is ________. A) 0% B) 3% C) 6% D) 9% E) none of the above

Answer: A Difficulty: Difficult Rationale: 6% = a + 12% (1 - 0.5); a = 0%.

23. The index model for stock A has been estimated with the following result:

RA = 0.01 + 0.9RM + eA

If σM = 0.25 and R2A = 0.25, the standard deviation of return of stock A is

_________. A) 0.2025 B) 0.2500 C) 0.4500 D) 0.8100 E) none of the above

Answer: C Difficulty: Difficult Rationale: R2 = b2s2M / s2;0.25 = [(0.81)(0.25)2]/s2; s = 0.4500.

24. The index model for stock B has been estimated with the following result:

RB = 0.01 + 1.1RM + eB

If σM = 0.20 and R2B = 0.50, the standard deviation of the return on stock B is


Answer: C Difficulty: Difficult Rationale: R2 = b2s2M / s2; 0.5 = [(1.1)2(0.2)2]/s2; s = 0.3111.

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25. Suppose you forecast that the market index will earn a return of 15% in the coming year. Treasury bills are yielding 6%. The unadjusted β of Mobil stock is 1.30. A reasonable forecast of the return on Mobil stock for the coming year is _________ if you use Merrill Lynch adjusted betas. A) 15.0% B) 15.5% C) 16.0% D) 16.8% E) none of the above

Answer: D Difficulty: Difficult Rationale: Adjusted beta = 2/3(1.3) + 1/3 = 1.20; E(rM) = 6% + 1.20(9%) = 16.8%.

26. The index model has been estimated for stocks A and B with the following results:

RA = 0.01 + 0.5RM + eA

RB = 0.02 + 1.3RM + eB

σM = 0.25 σ(eA) = 0.20 σ(eB) = 0.10

The covariance between the returns on stocks A and B is ___________. A) 0.0384 B) 0.0406 C) 0.1920 D) 0.0050 E) 0.4000

Answer: B Difficulty: Difficult Rationale: Cov(RA,RB) = bAbBs2M = 0.5(1.3)(0.25)2 = 0.0406.

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RA = 0.01 + 0.8RM + eA

RB = 0.02 + 1.2RM + eB

σM = 0.20 σ(eA) = 0.20 σ (eB) = 0.10

The standard deviation for stock A is __________. A) 0.0656 B) 0.0676 C) 0.2561 D) 0.2600 E) none of the above

Answer: C Difficulty: Difficult Rationale: σA = [(0.8)2(0.2)2 + (0.2)2]1/2 = 0.2561.

28. The index model has been estimated for stock A with the following results:

RA = 0.01 + 0.8RM + eA

σM = 0.20 σ(eA) = 0.10

The standard deviation of the return for stock A is __________. A) 0.0356 B) 0.1886 C) 0.1600 D) 0.6400 E) none of the above

Answer: B Difficulty: Difficult Rationale: σB = [(.8)2(0.2)2 + (0.1)2]1/2 = 0.1886.

29. Security returns A) are based on both macro events and firm-specific events. B) are based on firm-specific events only. C) are usually positively correlated with each other. D) A and B. E) A and C.

Answer: E [email protected]: Stock returns are usually highly positively correlated with each other. Stock returns are affected by both macro economic events and firm-specific events.

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30. The single-index model A) greatly reduces the number of required calculations, relative to those required by

the Markowitz model. B) enhances the understanding of systematic versus nonsystematic risk. C) greatly increases the number of required calculations, relative to those required by

the Markowitz model. D) A and B. E) B and C.

Answer: D [email protected]: The single index model both greatly reduces the number of calculations and enhances the understanding of the relationship between systematic and unsystematic risk on security returns.

31. The Security Characteristic Line (SCL) A) plots the excess return on a security as a function of the excess return on the

market. B) allows one to estimate the beta of the security. C) allows one to estimate the alpha of the security. D) all of the above. E) none of the above.

Answer: D [email protected]: The security characteristic line, which plots the excess return of the security as a function of the excess return of the market allows one to estimate both the alpha and the beta of the security.

32. The expected impact of unanticipated macroeconomic events on a security's return during the period is A) included in the security's expected return. B) zero. C) equal to the risk free rate. D) proportional to the firm's beta. E) infinite.

Answer: B [email protected]: The expected value of unanticipated macroeconomic events is zero, because by definition it must average to zero or it would be incorporated into the expected return.

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33. Covariances between security returns tend to be A) positive because of SEC regulations. B) positive because of Exchange regulations. C) positive because of economic forces that affect many firms. D) negative because of SEC regulations E) negative because of economic forces that affect many firms.

Answer: C [email protected]: Economic forces such as business cycles, interest rates, and technological changes tend to have similar impacts on many firms.

34. In the single-index model represented by the equation ri = E(ri) + βiF + ei, the term ei

represents A) the impact of unanticipated macroeconomic events on security i's return. B) the impact of unanticipated firm-specific events on security i's return. C) the impact of anticipated macroeconomic events on security i's return. D) the impact of anticipated firm-specific events on security i's return. E) the impact of changes in the market on security i's return.

Answer: B [email protected]: The textbook discusses a model in which macroeconomic events are used as a single index for security returns. The ei term represents the impact of unanticipated firm-specific events. The ei term has an expected value of zero. Only unanticipated events would affect the return.

35. Suppose you are doing a portfolio analysis that includes all of the stocks on the NYSE. Using a single-index model rather than the Markowitz model _______ the number of inputs needed from _______ to ________. A) increases, about 1,400, more than 1.4 million B) increases, about 10,000, more than 125,000 C) reduces, more than 125,000, about 10,000 D) reduces, more than 4 million, about 9,000 E) increases, about 150, more than 1,500

Answer: D [email protected]: This example is discussed in the textbook. The main point for the students to remember is that the single-index model drastically reduces the number of inputs required.

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36. One “cost” of the single-index model is that it A) is virtually impossible to apply. B) prohibits specialization of efforts within the security analysis industry. C) requires forecasts of the money supply. D) is legally prohibited by the SEC. E) allows for only two kinds of risk -- macro risk and micro risk.

Answer: E [email protected]: The single-index model discussed in chapter 10 broke risk into macro and micro portions. In this model other factors such as industry effects.

37. The Security Characteristic Line (SCL) associated with the single-index model is a plot of A) the security's returns on the vertical axis and the market index's returns on the

horizontal axis. B) the market index's returns on the vertical axis and the security's returns on the

horizontal axis. C) the security's excess returns on the vertical axis and the market index's excess

returns on the horizontal axis. D) the market index's excess returns on the vertical axis and the security's excess

returns on the horizontal axis. E) the security's returns on the vertical axis and Beta on the horizontal axis.

Answer: C [email protected]: The student needs to remember that it is the excess returns that are plotted and that the security's returns are plotted as a dependent variable.

38. The idea that there is a limit to the reduction of portfolio risk due to diversification is A) contradicted by both the CAPM and the single-index model. B) contradicted by the CAPM. C) contradicted by the single-index model. D) supported in theory, but not supported empirically. E) supported both in theory and by empirical evidence.

Answer: E [email protected]: The benefits of diversification are limited to the level of systematic risk. Figure 8.1 shows this concept graphically.

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39. In their study about predicting beta coefficients, which of the following did Rosenberg and Guy find to be factors that influence beta?

I) industry groupII) variance of cash flowIII) dividend yieldIV) growth in earnings per share

A) I and II B) I and III C) I, II, and III D) I, II, and IV E) I, II, III, and IV

Answer: E [email protected]: All of the factors mentioned, as well as variance of earnings, firm size, and debt-to-asset ratio, were found to help predict betas.

40. If a firm's beta was calculated as 1.6 in a regression equation, Merrill Lynch would state the adjusted beta at a number A) less than 0.6 but greater than zero. B) between 0.6 and 1.0. C) between 1.0 and 1.6. D) greater than 1.6. E) zero or less.

Answer: C [email protected]: Betas, on average, equal one; thus, betas over time regress toward the mean, or 1. Therefore, if historic betas are more than 1, adjusted betas are between 1 and the calculated beta.

41. The beta of a stock has been estimated as 1.8 by Merrill Lynch using regression analysis on a sample of historical returns. The Merrill Lynch adjusted beta of the stock would be ___________. A) 1.20 B) 1.53 C) 1.13 D) 1.0 E) none of the above

Answer: B [email protected]: Adjusted beta = 2/3 sample beta + 1/3(1); = 2/3(1.8) + 1/3 = 1.53.

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42. Assume that stock market returns do not resemble a single-index structure. An investment fund analyzes 40 stocks in order to construct a mean-variance efficient portfolio constrained by 40 investments. They will need to calculate _____________ expected returns and ___________ variances of returns. A) 100, 100 B) 40, 40 C) 4950, 100 D) 4950, 4950 E) none of the above

Answer: B [email protected]: The expected returns of each of the 40 securities must be calculated. In addition, the 40 variances around these returns must be calculated.


Answer: B [email protected]: (n2 - n)/2 = (1,600 - 40)/2 = 780 covariances must be calculated.

44. Assume that stock market returns do follow a single-index structure. An investment fund analyzes 60 stocks in order to construct a mean-variance efficient portfolio constrained by 60 investments. They will need to calculate ________ estimates of expected returns and ________ estimates of sensitivity coefficients to the macroeconomic factor. A) 200; 19,900 B) 200; 200 C) 60; 60 D) 19,900; 19.900 E) none of the above

Answer: C [email protected]: For a single-index model, n(60), expected returns and n(60) sensitivity coefficients to the macroeconomic factor must be estimated.

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Answer: A [email protected]: 7% = 0% + b(11%); b = 0.636.

46. Suppose you held a well-diversified portfolio with a very large number of securities, and that the single index model holds. If the σ of your portfolio was 0.25 and σM was 0.21, the β of the portfolio would be approximately ________. A) 0.64 B) 1.19 C) 1.25 D) 1.56 E) none of the above

Answer: B Difficulty: Difficult Rationale: s2p / s2m = b2; (0.25)2/(0.21)2 = 1.417; b = 1.19.


Answer: C Difficulty: Difficult Rationale: s2p / s2m = b2; (0.18)2/(0.22)2 = 0.669; b = 0.82.

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ât = 0.4 + 0.6βt-1


Answer: D [email protected]: 0.4 + 0.6(0.9) = 0.94.


β t = 0.3 + 0.2βt-1


Answer: A [email protected]: 0.3 + 0.2(0.8) = 0.46.

50. The index model for stock A has been estimated with the following result:

RA = 0.01 + 0.94RM + eA

If σM = 0.30 and R2A = 0.28, the standard deviation of return of stock A is


Answer: D Difficulty: Difficult

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Rationale: R2 = b2s2M / s2; 0.28 = [(0.94) 2(0.30) 2] / .28; s = 0.5329.

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51. 30. A reasonable forecast of the return on Mobil stock for the coming year is _________ if you use Merrill Lynch adjusted betas. A) 15.0% B) 15.5% C) 16.0% D) 14.6% E) none of the above

Answer: D Difficulty: Difficult Rationale: Adjusted beta = 2/3(1.5) + 1/3 = 1.33; E(rM) = 4% + 1.33(8%) = 14.6%.


RA = 0.01 + 0.8RM + eA

RB = 0.02 + 1.1RM + eB

σM = 0.30 σ (eA) = 0.20 σ (eB) = 0.10


Answer: E Difficulty: Difficult Rationale: Cov(RA,RB) = bAbBs2M = 0.8(1.1)(0.30)2 = 0.0792.

53. If a firm's beta was calculated as 1.35 in a regression equation, Merrill Lynch would state the adjusted beta at a number A) less than 1.35 B) between 0.0 and 1.0. C) between 1.0 and 1.35. D) greater than 1.35. E) zero or less.

Answer: C [email protected]: Betas, on average, equal one; thus, betas over time regress toward the mean, or 1. Therefore, if historic betas are less than 1, adjusted betas are between 1 and the calculated beta.

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Answer: A [email protected]: Adjusted beta = 2/3 sample beta + 1/3(1); = 2/3(1.4) + 1/3 = 1.27.


Answer: D [email protected]: Adjusted beta = 2/3 sample beta + 1/3(1); = 2/3(0.85) + 1/3 = 0.90.

56. Assume that stock market returns do not resemble a single-index structure. An investment fund analyzes 125 stocks in order to construct a mean-variance efficient portfolio constrained by 125 investments. They will need to calculate _____________ expected returns and ___________ variances of returns. A) 125, 125 B) 125, 15,625 C) 15,625, 125 D) 15,625, 15,625 E) none of the above

Answer: A [email protected]: The expected returns of each of the 125 securities must be calculated. In addition, the 125 variances around these returns must be calculated.

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Answer: C [email protected]: (n2 - n)/2 = (15,625 - 125)/2 = 7,750 covariances must be calculated.


Answer: D [email protected]: (n2 - n)/2 = (17,424 - 132)/2 = 8,646 covariances must be calculated.

59. Assume that stock market returns do follow a single-index structure. An investment fund analyzes 217 stocks in order to construct a mean-variance efficient portfolio constrained by 217 investments. They will need to calculate ________ estimates of expected returns and ________ estimates of sensitivity coefficients to the macroeconomic factor. A) 217; 47,089 B) 217; 217 C) 47,089; 217 D) 47,089; 47,089 E) none of the above

Answer: B [email protected]: For a single-index model, n(217), expected returns and n(217) sensitivity coefficients to the macroeconomic factor must be estimated.

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60. Assume that stock market returns do follow a single-index structure. An investment fund analyzes 500 stocks in order to construct a mean-variance efficient portfolio constrained by 750 investments. They will need to calculate ________ estimates of firm-specific variances and ________ estimates for the variance of the macroeconomic factor. A) 750; 1 B) 750; 750 C) 124,750; 1 D) 124,750; 750 E) 562,500; 750

Answer: A [email protected]: For the single-index model, n(750) estimates of firm-specific variances must be calculated and 1 estimate for the variance of the common macroeconomic factor.


Answer: C [email protected]: 5% = 0% + b(5%); b = 1.0.

62. Suppose you held a well-diversified portfolio with a very large number of securities, and that the single index model holds. If the ó of your portfolio was 0.24 and σM

was 0.18, the β of the portfolio would be approximately ________. A) 0.64 B) 1.33 C) 1.25 D) 1.56 E) none of the above

Answer: B Difficulty: Difficult Rationale: s2p / s2m = b2; (0.24)2/(0.18)2 = 1.78; b = 1.33.

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Answer: A Difficulty: Difficult Rationale: s2p / s2m = b2; (0.14)2/(0.19)2 = 0.54; b = 0.74.


βt = 0.30 + 0.70βt-1


Answer: D [email protected]: 0.30 + 0.70(0.82) = 0.874.


RA = 0.03 + 0.7RM + eA

RB = 0.01 + 0.9RM + eB

σM = 0.35 σ(eA) = 0.20 σ(eB) = 0.10


Answer: D Difficulty: Difficult

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Rationale: Cov(RA,RB) = bAbBs2M = 0.7(0.9)(0.35)2 = 0.0772.

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1. In the context of the Capital Asset Pricing Model (CAPM) the relevant measure of risk is A) unique risk. B) beta. C) standard deviation of returns. D) variance of returns. E) none of the above.

Answer: B [email protected]: Once, a portfolio is diversified, the only risk remaining is systematic risk, which is measured by beta.

2. According to the Capital Asset Pricing Model (CAPM) a well diversified portfolio's rate of return is a function of A) market risk B) unsystematic risk C) unique risk. D) reinvestment risk. E) none of the above.

Answer: A [email protected]: With a diversified portfolio, the only risk remaining is market, or systematic, risk. This is the only risk that influences return according to the CAPM.

3. The market portfolio has a beta of A) 0. B) 1. C) -1. D) 0.5. E) none of the above

Answer: B [email protected]: By definition, the beta of the market portfolio is 1.

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4. The risk-free rate and the expected market rate of return are 0.06 and 0.12, respectively. According to the capital asset pricing model (CAPM), the expected rate of return on security X with a beta of 1.2 is equal to A) 0.06. B) 0.144. C) 0.12. D) 0.132 E) 0.18

Answer: D [email protected]: E(R) = 6% + 1.2(12 - 6) = 13.2%.

5. The risk-free rate and the expected market rate of return are 0.056 and 0.125, respectively. According to the capital asset pricing model (CAPM), the expected rate of return on a security with a beta of 1.25 is equal to A) 0.1225 B) 0.144. C) 0.153. D) 0.134 E) 0.117

Answer: A [email protected]: E(R) = 5.6% + 1.25(12.5 - 5.6) = 14.225%.

6. Which statement is not true regarding the market portfolio? A) It includes all publicly traded financial assets. B) It lies on the efficient frontier. C) All securities in the market portfolio are held in proportion to their market values. D) It is the tangency point between the capital market line and the indifference curve. E) All of the above are true.

Answer: D [email protected]: The tangency point between the capital market line and the indifference curve is the optimal portfolio for a particular investor.

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7. Which statement is not true regarding the Capital Market Line (CML)? A) The CML is the line from the risk-free rate through the market portfolio. B) The CML is the best attainable capital allocation line. C) The CML is also called the security market line. D) The CML always has a positive slope. E) The risk measure for the CML is standard deviation.

Answer: C [email protected]: Both the Capital Market Line and the Security Market Line depict risk/return relationships. However, the risk measure for the CML is standard deviation and the risk measure for the SML is beta (thus C is not true; the other statements are true).

8. The market risk, beta, of a security is equal to A) the covariance between the security's return and the market return divided by the

variance of the market's returns. B) the covariance between the security and market returns divided by the standard

deviation of the market's returns. C) the variance of the security's returns divided by the covariance between the

security and market returns. D) the variance of the security's returns divided by the variance of the market's

returns. E) none of the above.

Answer: A [email protected]: Beta is a measure of how a security's return covaries with the market returns, normalized by the market variance.

9. According to the Capital Asset Pricing Model (CAPM), the expected rate of return on any security is equal to A) Rf + β [E(RM)].

B) Rf + β [E(RM) - Rf]. C) β [E(RM) - Rf]. D) E(RM) + Rf. E) none of the above.

Answer: B [email protected]: The expected rate of return on any security is equal to the risk free rate plus the systematic risk of the security (beta) times the market risk premium, E(RM - Rf).

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10. The Security Market Line (SML) is A) the line that describes the expected return-beta relationship for well-diversified

portfolios only. B) also called the Capital Allocation Line. C) the line that is tangent to the efficient frontier of all risky assets. D) the line that represents the expected return-beta relationship. E) the line that represents the relationship between an individual security's return and

the market's return.

Answer: D [email protected]: The SML is a measure of expected return per unit of risk, where risk is defined as beta (systematic risk).

11. According to the Capital Asset Pricing Model (CAPM), fairly priced securities A) have positive betas. B) have zero alphas. C) have negative betas. D) have positive alphas. E) none of the above.

Answer: B [email protected]: A zero alpha results when the security is in equilibrium (fairly priced for the level of risk).

12. According to the Capital Asset Pricing Model (CAPM), under priced securities A) have positive betas. B) have zero alphas. C) have negative betas. D) have positive alphas. E) none of the above.


13. According to the Capital Asset Pricing Model (CAPM), over priced securities A) have positive betas. B) have zero alphas. C) have negative betas. D) have positive alphas. E) none of the above.

Answer: C [email protected]: A zero alpha results when the security is in equilibrium (fairly priced for the level of risk).

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14. According to the Capital Asset Pricing Model (CAPM), A) a security with a positive alpha is considered overpriced. B) a security with a zero alpha is considered to be a good buy. C) a security with a negative alpha is considered to be a good buy. D) a security with a positive alpha is considered to be underpriced. E) none of the above.

Answer: D [email protected]: A security with a positive alpha is one that is expected to yield an abnormal positive rate of return, based on the perceived risk of the security, and thus is underpriced.

15. According to the Capital Asset Pricing Model (CAPM), which one of the following statements is false? A) The expected rate of return on a security decreases in direct proportion to a

decrease in the risk-free rate. B) The expected rate of return on a security increases as its beta increases. C) A fairly priced security has an alpha of zero. D) In equilibrium, all securities lie on the security market line. E) All of the above statements are true.

Answer: A [email protected]: Statements B, C, and D are true, but statement A is false.

16. In a well diversified portfolio A) market risk is negligible. B) systematic risk is negligible. C) unsystematic risk is negligible. D) nondiversifiable risk is negligible. E) none of the above.

Answer: C [email protected]: Market, or systematic, or nondiversifiable, risk is present in a diversified portfolio; the unsystematic risk has been eliminated.

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17. Empirical results regarding betas estimated from historical data indicate that A) betas are constant over time. B) betas of all securities are always greater than one. C) betas are always near zero. D) betas appear to regress toward one over time. E) betas are always positive.

Answer: D [email protected]: Betas vary over time, betas may be negative or less than one, betas are not always near zero; however, betas do appear to regress toward one over time.

18. Your personal opinion is that a security has an expected rate of return of 0.11. It has a beta of 1.5. The risk-free rate is 0.05 and the market expected rate of return is 0.09. According to the Capital Asset Pricing Model, this security is A) underpriced. B) overpriced. C) fairly priced. D) cannot be determined from data provided. E) none of the above.

Answer: C [email protected]: 11% = 5% + 1.5(9% - 5%) = 11.0%; therefore, the security is fairly priced.

19. The risk-free rate is 7 percent. The expected market rate of return is 15 percent. If you expect a stock with a beta of 1.3 to offer a rate of return of 12 percent, you should A) buy the stock because it is overpriced. B) sell short the stock because it is overpriced. C) sell the stock short because it is underpriced. D) buy the stock because it is underpriced. E) none of the above, as the stock is fairly priced.

Answer: B [email protected]: 12% < 7% + 1.3(15% - 7%) = 17.40%; therefore, stock is overpriced and should be shorted.

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20. You invest $600 in a security with a beta of 1.2 and $400 in another security with a beta of 0.90. The beta of the resulting portfolio is A) 1.40 B) 1.00 C) 0.36 D) 1.08 E) 0.80

Answer: D [email protected]: 0.6(1.2) + 0.4(0.90) = 1.08.

21. A security has an expected rate of return of 0.10 and a beta of 1.1. The market expected rate of return is 0.08 and the risk-free rate is 0.05. The alpha of the stock is A) 1.7%. B) -1.7%. C) 8.3%. D) 5.5%. E) none of the above.

Answer: A [email protected]: 10% - [5% +1.1(8% - 5%)] = 1.7%.

22. Your opinion is that CSCO has an expected rate of return of 0.13. It has a beta of 1.3. The risk-free rate is 0.04 and the market expected rate of return is 0.115. According to the Capital Asset Pricing Model, this security is A) underpriced. B) overpriced. C) fairly priced. D) cannot be determined from data provided. E) none of the above.

Answer: B [email protected]: 11.5% - 4% + 1.3(11.5% - 4%) = -2.25%; therefore, the security is overpriced.

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Answer: C [email protected]: 13.75% - 4% + 1.3(11.5% - 4%) = 0.0%; therefore, the security is fairly priced.


Answer: A [email protected]: 15% - 4% + 1.3(11.5% - 4%) = 1.25%; therefore, the security is under priced.

25. Your opinion is that Boeing has an expected rate of return of 0.112. It has a beta of 0.92. The risk-free rate is 0.04 and the market expected rate of return is 0.10. According to the Capital Asset Pricing Model, this security is A) underpriced. B) overpriced. C) fairly priced. D) cannot be determined from data provided. E) none of the above.

Answer: A [email protected]: 11.2% - 4% + 0.92(10% - 4%) = 1.68%; therefore, the security is under priced.

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Answer: C [email protected]: 9.52% - 4% + 0.92(10% - 4%) = 0.0%; therefore, the security is fairly priced.


Answer: C [email protected]: 8.0% - 4% + 0.92(10% - 4%) = -1.52%; therefore, the security is overpriced.

28. The risk-free rate is 4 percent. The expected market rate of return is 11 percent. If you expect CAT with a beta of 1.0 to offer a rate of return of 10 percent, you should A) buy stock X because it is overpriced. B) sell short stock X because it is overpriced. C) sell stock short X because it is underpriced. D) buy stock X because it is underpriced. E) none of the above, as the stock is fairly priced.


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Answer: E [email protected]: 11% = 4% + 1.0(11% - 4%) = 11.0%; therefore, stock is fairly priced.


Answer: D [email protected]: 13% > 4% + 1.0(11% - 4%) = 11.0%; therefore, stock is under priced.

31. You invest 55% of your money in security A with a beta of 1.4 and the rest of your money in security B with a beta of 0.9. The beta of the resulting portfolio is A) 1.466 B) 1.157 C) 0.968 D) 1.082 E) 1.175

Answer: E [email protected]: 0.55(1.4) + 0.45(0.90) = 1.175.

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32. Given the following two stocks A and B

If the expected market rate of return is 0.09 and the risk-free rate is 0.05, which security would be considered the better buy and why? A) A because it offers an expected excess return of 1.2%. B) B because it offers an expected excess return of 1.8%. C) A because it offers an expected excess return of 2.2%. D) B because it offers an expected return of 14%. E) B because it has a higher beta.

Answer: C [email protected]: A's excess return is expected to be 12% - [5% + 1.2(9% - 5%)] = 2.2%. B's excess return is expected to be 14% - [5% + 1.8(9% - 5%)] = 1.8%.

33. Capital Asset Pricing Theory asserts that portfolio returns are best explained by: A) economic factors. B) specific risk. C) systematic risk. D) diversification. E) none of the above.

Answer: C [email protected]: The risk remaining in diversified portfolios is systematic risk; thus, portfolio returns are commensurate with systematic risk.

34. According to the CAPM, the risk premium an investor expects to receive on any stock or portfolio increases: A) directly with alpha. B) inversely with alpha. C) directly with beta. D) inversely with beta. E) in proportion to its standard deviation.

Answer: C [email protected]: The market rewards systematic risk, which is measured by beta, and thus, the risk premium on a stock or portfolio varies directly with beta.

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35. What is the expected return of a zero-beta security? A) The market rate of return. B) Zero rate of return. C) A negative rate of return. D) The risk-free rate. E) None of the above.

Answer: D [email protected]: E(RS) = rf + 0(RM - rf) = rf.

36. Standard deviation and beta both measure risk, but they are different in that A) beta measures both systematic and unsystematic risk. B) beta measures only systematic risk while standard deviation is a measure of total

risk. C) beta measures only unsystematic risk while standard deviation is a measure of

total risk. D) beta measures both systematic and unsystematic risk while standard deviation

measures only systematic risk. E) beta measures total risk while standard deviation measures only nonsystematic

risk.

Answer: B [email protected]: B is the only true statement.

37. The expected return-beta relationship A) is the most familiar expression of the CAPM to practitioners. B) refers to the way in which the covariance between the returns on a stock and

returns on the market measures the contribution of the stock to the variance of the market portfolio, which is beta.

C) assumes that investors hold well-diversified portfolios. D) all of the above are true. E) none of the above is true.

Answer: D [email protected]: Statements A, B and C all describe the expected return-beta relationship.

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38. The security market line (SML) A) can be portrayed graphically as the expected return-beta relationship. B) can be portrayed graphically as the expected return-standard deviation of market

returns relationship. C) provides a benchmark for evaluation of investment performance. D) A and C. E) B and C.

Answer: D [email protected]: The SML is a measure of expected return-beta (the CML is a measure of expected return-standard deviation of market returns). The SML provides the expected return-beta relationship for "fairly priced" securities; thus if a portfolio manager selects securities that are underpriced and produces a portfolio with a positive alpha, this portfolio manager would receive a positive evaluation.

39. Research by Jeremy Stein of MIT resolves the dispute over whether beta is a sufficient pricing factor by suggesting that managers should use beta to estimate A) long-term returns but not short-term returns. B) short-term returns but not long-term returns. C) both long- and short-term returns. D) book-to-market ratios. E) None of the above was suggested by Stein.

Answer: A Difficulty: Difficult

40. Studies of liquidity spreads in security markets have shown that A) liquid stocks earn higher returns than illiquid stocks. B) illiquid stocks earn higher returns than liquid stocks. C) both liquid and illiquid stocks earn the same returns. D) illiquid stocks are good investments for frequent, short-term traders. E) None of the above is true.

Answer: B Difficulty: Difficult

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41. An underpriced security will plot A) on the Security Market Line. B) below the Security Market Line. C) above the Security Market Line. D) either above or below the Security Market Line depending on its covariance with

the market. E) either above or below the Security Market Line depending on its standard

deviation.

Answer: C [email protected]: An underpriced security will have a higher expected return than the SML would predict; therefore it will plot above the SML.

42. The risk premium on the market portfolio will be proportional to A) the average degree of risk aversion of the investor population. B) the risk of the market portfolio as measured by its variance. C) the risk of the market portfolio as measured by its beta. D) both A and B are true. E) both A and C are true.

Answer: D [email protected]: The risk premium on the market portfolio is proportional to the average degree of risk aversion of the investor population and the risk of the market portfolio measured by its variance.

43. In equilibrium, the marginal price of risk for a risky security must be A) equal to the marginal price of risk for the market portfolio. B) greater than the marginal price of risk for the market portfolio. C) less than the marginal price of risk for the market portfolio. D) adjusted by its degree of nonsystematic risk. E) none of the above is true.

Answer: A [email protected]: In equilibrium, the marginal price of risk for a risky security must be equal to the marginal price of risk for the market. If not, investors will buy or sell the security until they are equal.

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44. The capital asset pricing model assumes A) all investors are price takers. B) all investors have the same holding period. C) investors pay taxes on capital gains. D) both A and B are true. E) A, B and C are all true.

Answer: D [email protected]: The CAPM assumes that investors are price-takers with the same single holding period and that there are no taxes or transaction costs.

45. If investors do not know their investment horizons for certain A) the CAPM is no longer valid. B) the CAPM underlying assumptions are not violated. C) the implications of the CAPM are not violated as long as investors' liquidity needs

are not priced. D) the implications of the CAPM are no longer useful. E) none of the above is true.

Answer: C [email protected]: This is discussed in the chapter's section about extensions to the CAPM. It examines what the consequences are when the assumptions are removed.

46. The value of the market portfolio equals A) the sum of the values of all equity securities. B) the sum of the values of all equity and fixed income securities. C) the sum the values of all equity, fixed income, and derivative securities. D) the sum of the values of all equity, fixed income, and derivative securities plus the

value of all mutual funds. E) the entire wealth of the economy.

Answer: E [email protected]: The market portfolio includes all assets in existence.

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47. The amount that an investor allocates to the market portfolio is negatively related to

I) the expected return on the market portfolio.II) the investor's risk aversion coefficient.III) the risk-free rate of return.IV) the variance of the market portfolio

A) I and II B) II and III C) II and IV D) II, III, and IV E) I, III, and IV

Answer: D [email protected]: The optimal proportion is given by y = (E(RM)-rf)/(.01xAσ2

M). This amount will decrease as rf, A, and σ2

M decrease.

48. One of the assumptions of the CAPM is that investors exhibit myopic behavior. What does this mean? A) They plan for one identical holding period. B) They are price-takers who can't affect market prices through their trades. C) They are mean-variance optimizers. D) They have the same economic view of the world. E) They pay no taxes or transactions costs.

Answer: A [email protected]: Myopic behavior is shortsighted, with no concern for medium-term or long-term implications.

49. The CAPM applies to A) portfolios of securities only. B) individual securities only. C) efficient portfolios of securities only. D) efficient portfolios and efficient individual securities only. E) all portfolios and individual securities.

Answer: E [email protected]: The CAPM is an equilibrium model for all assets. Each asset's risk premium is a function of its beta coefficient and the risk premium on the market portfolio.

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50. Which of the following statements about the mutual fund theorem is true?

I) It is similar to the separation property.II) It implies that a passive investment strategy can be efficient.III) It implies that efficient portfolios can be formed only through active

strategies.IV) It means that professional managers have superior security selection

strategies.

A) I and IV B) I, II, and IV C) I and II D) III and IV E) II and IV

Answer: C [email protected]: The mutual fund theorem is similar to the separation property. The technical task of creating mutual funds can be delegated to professional managers; then individuals combine the mutual funds with risk-free assets according to their preferences. The passive strategy of investing in a market index fund is efficient.

51. The expected return -- beta relationship of the CAPM is graphically represented by A) the security market line. B) the capital market line. C) the capital allocation line. D) the efficient frontier with a risk-free asset. E) the efficient frontier without a risk-free asset.

Answer: A [email protected]: The security market line shows expected return on the vertical axis and beta on the horizontal axis. It has an intercept of rf and a slope of E(RM) - rf.

52. A “fairly priced” asset lies A) above the security market line. B) on the security market line. C) on the capital market line. D) above the capital market line. E) below the security market line.

Answer: B [email protected]: Securities that lie on the SML earn exactly the expected return generated by the CAPM. Their prices are proportional to their beta coefficients and they have alphas equal to zero.

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53. For the CAPM that examines illiquidity premiums, if there is correlation among assets due to common systematic risk factors, the illiquidity premium on asset i is a function of A) the market's volatility. B) asset i's volatility. C) the trading costs of security i. D) the risk-free rate. E) the money supply.

Answer: C [email protected]: The formula for this extension to the CAPM relaxes the assumption that trading is costless.

54. Your opinion is that security A has an expected rate of return of 0.145. It has a beta of 1.5. The risk-free rate is 0.04 and the market expected rate of return is 0.11. According to the Capital Asset Pricing Model, this security is A) underpriced. B) overpriced. C) fairly priced. D) cannot be determined from data provided. E) none of the above.

Answer: C [email protected]: 14.5% = 4% + 1.5(11% - 4%) = 14.5%; therefore, the security is fairly priced.

55. Your opinion is that security C has an expected rate of return of 0.106. It has a beta of 1.1. The risk-free rate is 0.04 and the market expected rate of return is 0.10. According to the Capital Asset Pricing Model, this security is A) underpriced. B) overpriced. C) fairly priced. D) cannot be determined from data provided. E) none of the above.

Answer: A [email protected]: 4% + 1.1(10% - 4%) = 10.6%; therefore, the security is fairly priced.

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56. The risk-free rate is 4 percent. The expected market rate of return is 12 percent. If you expect stock X with a beta of 1.0 to offer a rate of return of 10 percent, you should A) buy stock X because it is overpriced. B) sell short stock X because it is overpriced. C) sell stock short X because it is underpriced. D) buy stock X because it is underpriced. E) none of the above, as the stock is fairly priced.


57. The risk-free rate is 5 percent. The expected market rate of return is 11 percent. If you expect stock X with a beta of 2.1 to offer a rate of return of 15 percent, you should A) buy stock X because it is overpriced. B) sell short stock X because it is overpriced. C) sell stock short X because it is underpriced. D) buy stock X because it is underpriced. E) none of the above, as the stock is fairly priced.


58. You invest 50% of your money in security A with a beta of 1.6 and the rest of your money in security B with a beta of 0.7. The beta of the resulting portfolio is A) 1.40 B) 1.15 C) 0.36 D) 1.08 E) 0.80

Answer: B [email protected]: 0.5(1.6) + 0.5(0.70) = 1.15.

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59. You invest $200 in security A with a beta of 1.4 and $800 in security B with a beta of 0.3. The beta of the resulting portfolio is A. 1.40 A) 1.00 B) 0.52 C) 1.08 D) 0.80

Answer: C [email protected]: 0.2(1.4) + 0.8(0.3) = 0.52.

60. Security A has an expected rate of return of 0.10 and a beta of 1.3. The market expected rate of return is 0.10 and the risk-free rate is 0.04. The alpha of the stock is A) 1.7%. B) -1.8%. C) 8.3%. D) 5.5%. E) none of the above.

Answer: B [email protected]: 10% - [4% +1.3(10% - 4%)] = -1.8%.

61. A security has an expected rate of return of 0.15 and a beta of 1.25. The market expected rate of return is 0.10 and the risk-free rate is 0.04. The alpha of the stock is A) 1.7%. B) -1.7%. C) 8.3%. D) 3.5%. E) none of the above.

Answer: D [email protected]: 15% - [4% +1.25(10% - 4%)] = 3.5%.

62. A security has an expected rate of return of 0.13 and a beta of 2.1. The market expected rate of return is 0.09 and the risk-free rate is 0.045. The alpha of the stock is A) -0.95%. B) -1.7%. C) 8.3%. D) 5.5%. E) none of the above.

Answer: A [email protected]: 13% - [4.5% +2.1(9% - 4.5%)] = -0.95%.

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63. Assume that a security is fairly priced and has an expected rate of return of 0.13. The market expected rate of return is 0.13 and the risk-free rate is 0.04. The beta of the stock is ___? A) 1.25 B) 1.7 C) 1 D) 0.95 E) none of the above.

Answer: C [email protected]: 13% = [4% +β(13% - 4%)]; 9% = β(9%); β = 1.

64. Assume that a security is fairly priced and has an expected rate of return of 0.17. The market expected rate of return is 0.11 and the risk-free rate is 0.04. The beta of the stock is ___? A) 1.25 B) 1.86 C) 1 D) 0.95 E) none of the above.

Answer: B [email protected]: 17% = [4% +β(11% - 4%)]; 13% = β(7%); β = 1.86.

Essay Questions

65. Discuss the differences between the capital market line and the security market line.


1. ___________ a relationship between expected return and risk. A) APT stipulates B) CAPM stipulates C) Both CAPM and APT stipulate D) Neither CAPM nor APT stipulate E) No pricing model has found

Answer: C [email protected]: Both models attempt to explain asset pricing based on risk/return relationships.

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2. Which pricing model provides no guidance concerning the determination of the risk premium on factor portfolios? A) The CAPM B) The multifactor APT C) Both the CAPM and the multifactor APT D) Neither the CAPM nor the multifactor APT E) None of the above is a true statement.

Answer: B [email protected]: The multifactor APT provides no guidance as to the determination of the risk premium on the various factors. The CAPM assumes that the excess market return over the risk-free rate is the market premium in the single factor CAPM.

3. An arbitrage opportunity exists if an investor can construct a __________ investment portfolio that will yield a sure profit. A) positive B) negative C) zero D) all of the above E) none of the above

Answer: C [email protected]: If the investor can construct a portfolio without the use of the investor's own funds and the portfolio yields a positive profit, arbitrage opportunities exist.

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4. The APT was developed in 1976 by ____________. A) Lintner B) Modigliani and Miller C) Ross D) Sharpe E) none of the above

Answer: C [email protected]: Ross developed this model in 1976.

5. A _________ portfolio is a well-diversified portfolio constructed to have a beta of 1 on one of the factors and a beta of 0 on any other factor. A) factor B) market C) index D) A and B E) A, B, and C

Answer: A [email protected]: A factor model portfolio has a beta of 1 one factor, with zero betas on other factors.

6. The exploitation of security mispricing in such a way that risk-free economic profits may be earned is called ___________. A) arbitrage B) capital asset pricing C) factoring D) fundamental analysis E) none of the above

Answer: A [email protected]: Arbitrage is earning of positive profits with a zero (risk-free) investment.

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7. In developing the APT, Ross assumed that uncertainty in asset returns was a result of A) a common macroeconomic factor B) firm-specific factors C) pricing error D) neither A nor B E) both A and B

Answer: E [email protected]: Total risk (uncertainty) is assumed to be composed of both macroeconomic and firm-specific factors.

8. The ____________ provides an unequivocal statement on the expected return-beta relationship for all assets, whereas the _____________ implies that this relationship holds for all but perhaps a small number of securities. A) APT, CAPM B) APT, OPM C) CAPM, APT D) CAPM, OPM E) none of the above

Answer: C [email protected]: The CAPM is an asset-pricing model based on the risk/return relationship of all assets. The APT implies that this relationship holds for all well-diversified portfolios, and for all but perhaps a few individual securities.

9. Consider a single factor APT. Portfolio A has a beta of 1.0 and an expected return of 16%. Portfolio B has a beta of 0.8 and an expected return of 12%. The risk-free rate of return is 6%. If you wanted to take advantage of an arbitrage opportunity, you should take a short position in portfolio __________ and a long position in portfolio _______. A) A, A B) A, B C) B, A D) B, B E) A, the riskless asset

Answer: C [email protected]: A: 16% = 1.0F + 6%; F = 10%; B: 12% = 0.8F + 6%: F = 7.5%; thus, short B and take a long position in A.

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10. Consider the single factor APT. Portfolio A has a beta of 0.2 and an expected return of 13%. Portfolio B has a beta of 0.4 and an expected return of 15%. The risk-free rate of return is 10%. If you wanted to take advantage of an arbitrage opportunity, you should take a short position in portfolio _________ and a long position in portfolio _________. A) A, A B) A, B C) B, A D) B, B E) none of the above

Answer: C [email protected]: A: 13% = 10% + 0.2F; F = 15%; B: 15% = 10% + 0.4F; F = 12.5%; therefore, short B and take a long position in A.

11. Consider the one-factor APT. The variance of returns on the factor portfolio is 6%. The beta of a well-diversified portfolio on the factor is 1.1. The variance of returns on the well-diversified portfolio is approximately __________. A) 3.6% B) 6.0% C) 7.3% D) 10.1% E) none of the above

Answer: C [email protected]: s2

P = (1.1)2(6%) = 7.26%.

12. Consider the one-factor APT. The standard deviation of returns on a well-diversified portfolio is 18%. The standard deviation on the factor portfolio is 16%. The beta of the well-diversified portfolio is approximately __________. A) 0.80 B) 1.13 C) 1.25 D) 1.56 E) none of the above

Answer: B [email protected]: (18%)2 = (16%)2 b2; b = 1.125.

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13. Consider the single-factor APT. Stocks A and B have expected returns of 15% and 18%, respectively. The risk-free rate of return is 6%. Stock B has a beta of 1.0. If arbitrage opportunities are ruled out, stock A has a beta of __________. A) 0.67 B) 1.00 C) 1.30 D) 1.69 E) none of the above

Answer: E [email protected]: A: 15% = 6% + bF; B: 8% = 6% + 1.0F; F = 12%; thus, beta of A = 9/12 = 0.75.

14. Consider the multifactor APT with two factors. Stock A has an expected return of 16.4%, a beta of 1.4 on factor 1 and a beta of .8 on factor 2. The risk premium on the factor 1 portfolio is 3%. The risk-free rate of return is 6%. What is the risk-premium on factor 2 if no arbitrage opportunities exit? A) 2% B) 3% C) 4% D) 7.75% E) none of the above

Answer: D [email protected]: 16.4% = 1.4(3%) + .8x + 6%; x = 7.75.

15. Consider the multifactor model APT with two factors. Portfolio A has a beta of 0.75 on factor 1 and a beta of 1.25 on factor 2. The risk premiums on the factor 1 and factor 2 portfolios are 1% and 7%, respectively. The risk-free rate of return is 7%. The expected return on portfolio A is __________if no arbitrage opportunities exist. A) 13.5% B) 15.0% C) 16.5% D) 23.0% E) none of the above

Answer: C [email protected]: 7% + 0.75(1%) + 1.25(7%) = 16.5%.

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16. Consider the multifactor APT with two factors. The risk premiums on the factor 1 and factor 2 portfolios are 5% and 6%, respectively. Stock A has a beta of 1.2 on factor 1, and a beta of 0.7 on factor 2. The expected return on stock A is 17%. If no arbitrage opportunities exist, the risk-free rate of return is ___________. A) 6.0% B) 6.5% C) 6.8% D) 7.4% E) none of the above

Answer: C [email protected]: 17% = x% + 1.2(5%) + 0.7(6%); x = 6.8%.

17. Consider a one-factor economy. Portfolio A has a beta of 1.0 on the factor and portfolio B has a beta of 2.0 on the factor. The expected returns on portfolios A and B are 11% and 17%, respectively. Assume that the risk-free rate is 6% and that arbitrage opportunities exist. Suppose you invested $100,000 in the risk-free asset, $100,000 in portfolio B, and sold short $200,000 of portfolio A. Your expected profit from this strategy would be ______________. A) -$1,000 B) $0 C) $1,000 D) $2,000 E) none of the above

Answer: C [email protected]: $100,000(0.06) = $6,000 (risk-free position); $100,000(0.17) = $17,000 (portfolio B); -$200,000(0.11) = -$22,000 (short position, portfolio A); 1,000 profit.

18. Consider the one-factor APT. Assume that two portfolios, A and B, are well diversified. The betas of portfolios A and B are 1.0 and 1.5, respectively. The expected returns on portfolios A and B are 19% and 24%, respectively. Assuming no arbitrage opportunities exist, the risk-free rate of return must be ____________. A) 4.0% B) 9.0% C) 14.0% D) 16.5% E) none of the above

Answer: B [email protected]: A: 19% = rf + 1(F); B:24% = rf + 1.5(F); 5% = .5(F); F = 10%; 24% = rf + 1.5(10); ff = 9%.

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19. Consider the multifactor APT. The risk premiums on the factor 1 and factor 2 portfolios are 5% and 3%, respectively. The risk-free rate of return is 10%. Stock A has an expected return of 19% and a beta on factor 1 of 0.8. Stock A has a beta on factor 2 of ________. A) 1.33 B) 1.50 C) 1.67 D) 2.00 E) none of the above

Answer: C [email protected]: 19% = 10% + 5%(0.8) + 3%(x); x = 1.67.

20. Consider the single factor APT. Portfolios A and B have expected returns of 14% and 18%, respectively. The risk-free rate of return is 7%. Portfolio A has a beta of 0.7. If arbitrage opportunities are ruled out, portfolio B must have a beta of __________. A) 0.45 B) 1.00 C) 1.10 D) 1.22 E) none of the above

Answer: C [email protected]: A: 14% = 7% + 0.7F; F = 10; B: 18% = 7% + 10b; b = 1.10.


There are three stocks, A, B, and C. You can either invest in these stocks or short sell them. There are three possible states of nature for economic growth in the upcoming year; economic growth may be strong, moderate, or weak. The returns for the upcoming year on stocks A, B, and C for each of these states of nature are given below:

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21. If you invested in an equally weighted portfolio of stocks A and B, your portfolio return would be ___________ if economic growth were moderate. A) 3.0% B) 14.5% C) 15.5% D) 16.0% E) none of the above

Answer: D [email protected]: E(Rp) = 0.5(17%) + 0.5(15%) = 16%.

22. If you invested in an equally weighted portfolio of stocks A and C, your portfolio return would be ____________ if economic growth was strong. A) 17.0% B) 22.5% C) 30.0% D) 30.5% E) none of the above

Answer: B [email protected]: 0.5(39%) + 0.5(6%) = 22.5%.

23. If you invested in an equally weighted portfolio of stocks B and C, your portfolio return would be _____________ if economic growth was weak. A) -2.5% B) 0.5% C) 3.0% D) 11.0% E) none of the above

Answer: D [email protected]: 0.5(0%) + 0.5(22%) = 11%.

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24. If you wanted to take advantage of a risk-free arbitrage opportunity, you should take a short position in _________ and a long position in an equally weighted portfolio of _______. A) A, B and C B) B, A and C C) C, A and B D) A and B, C E) none of the above, none of the above

Answer: C [email protected]: E(RA) = (39% + 17% - 5%)/3 = 17%; E(RB) = (30% + 15% + 0%)/3 = 15%; E(RC) = (22% + 14% + 6%)/3 = 14%; E(RP) = -0.5(14%) + 0.5[(17% + 15%)/2]; -7.0% + 8.0% = 1.0%.


Consider the multifactor APT. There are two independent economic factors, F1 and F2. The risk-free rate of return is 6%. The following information is available about two well-diversified portfolios:

25. Assuming no arbitrage opportunities exist, the risk premium on the factor F1 portfolio should be __________. A) 3% B) 4% C) 5% D) 6% E) none of the above

Answer: A [email protected]: 2A: 38% = 12% + 2.0(RP1) + 4.0(RP2); B: 12% = 6% + 2.0(RP1) + 0.0(RP2); 26% = 6% + 4.0(RP2); RP2 = 5; A: 19% = 6% + RP1 + 2.0(5); RP1 = 3%.

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26. Assuming no arbitrage opportunities exist, the risk premium on the factor F2 portfolio should be ___________. A) 3% B) 4% C) 5% D) 6% E) none of the above

Answer: C [email protected]: See solution to previous problem.

27. A zero-investment portfolio with a positive expected return arises when _________. A) an investor has downside risk only B) the law of prices is not violated C) the opportunity set is not tangent to the capital allocation line D) a risk-free arbitrage opportunity exists E) none of the above

Answer: D [email protected]: When an investor can create a zero-investment portfolio (by using none of the investor's own funds) with a possibility of a positive profit, a risk-free arbitrage opportunity exists.

28. An investor will take as large a position as possible when an equilibrium price relationship is violated. This is an example of _________. A) a dominance argument B) the mean-variance efficiency frontier C) a risk-free arbitrage D) the capital asset pricing model E) none of the above

Answer: C [email protected]: When the equilibrium price is violated, the investor will buy the lower priced asset and simultaneously place an order to sell the higher priced asset. Such transactions result in risk-free arbitrage. The larger the positions, the greater the risk-free arbitrage profits.

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29. The APT differs from the CAPM because the APT _________. A) places more emphasis on market risk B) minimizes the importance of diversification C) recognizes multiple unsystematic risk factors D) recognizes multiple systematic risk factors E) none of the above

Answer: D [email protected]: The CAPM assumes that market returns represent systematic risk. The APT recognizes that other macroeconomic factors may be systematic risk factors.

30. The feature of the APT that offers the greatest potential advantage over the CAPM is the ______________. A) use of several factors instead of a single market index to explain the risk-return

relationship B) identification of anticipated changes in production, inflation and term structure as

key factors in explaining the risk-return relationship C) superior measurement of the risk-free rate of return over historical time periods D) variability of coefficients of sensitivity to the APT factors for a given asset over

time E) none of the above

Answer: A [email protected]: The advantage of the APT is the use of multiple factors, rather than a single market index, to explain the risk-return relationship. However, APT does not identify the specific factors.

31. In terms of the risk/return relationship A) only factor risk commands a risk premium in market equilibrium. B) only systematic risk is related to expected returns. C) only nonsystematic risk is related to expected returns. D) A and B. E) A and C.

Answer: D [email protected]: Nonfactor risk may be diversified away; thus, only factor risk commands a risk premium in market equilibrium. Nonsystematic risk across firms cancels out in well-diversified portfolios; thus, only systematic risk is related to expected returns.

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32. The following factors might affect stock returns: A) the business cycle. B) interest rate fluctuations. C) inflation rates. D) all of the above. E) none of the above.

Answer: D [email protected]: A, B, and C all are likely to affect stock returns.

33. Advantage(s) of the APT is(are) A) that the model provides specific guidance concerning the determination of the risk

premiums on the factor portfolios. B) that the model does not require a specific benchmark market portfolio. C) that risk need not be considered. D) A and B. E) B and C.

Answer: B [email protected]: The APT provides no guidance concerning the determination of the risk premiums on the factor portfolios. Risk must considered in both the CAPM and APT. A major advantage of APT over the CAPM is that a specific benchmark market portfolio is not required.

34. Portfolio A has expected return of 10% and standard deviation of 19%. Portfolio B has expected return of 12% and standard deviation of 17%. Rational investors will A) Borrow at the risk free rate and buy A. B) Sell A short and buy B. C) Sell B short and buy A. D) Borrow at the risk free rate and buy B. E) Lend at the risk free rate and buy B.

Answer: B [email protected]: Rational investors will arbitrage by selling A and buying B.

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35. An important difference between CAPM and APT is A) CAPM depends on risk-return dominance; APT depends on a no arbitrage

condition. B) CAPM assumes many small changes are required to bring the market back to

equilibrium; APT assumes a few large changes are required to bring the market back to equilibrium.

C) implications for prices derived from CAPM arguments are stronger than prices derived from APT arguments.

D) all of the above are true. E) both A and B are true.

Answer: E [email protected]: Under the risk-return dominance argument of CAPM, when an equilibrium price is violated many investors will make small portfolio changes, depending on their risk tolerance, until equilibrium is restored. Under the no-arbitrage argument of APT, each investor will take as large a position as possible so only a few investors must act to restore equilibrium. Implications derived from APT are much stronger than those derived from CAPM, making C an incorrect statement.

36. A professional who searches for mispriced securities in specific areas such as merger-target stocks, rather than one who seeks strict (risk-free) arbitrage opportunities is engaged in A) pure arbitrage. B) risk arbitrage. C) option arbitrage. D) equilibrium arbitrage. E) none of the above.

Answer: B [email protected]: Risk arbitrage involves searching for mispricings based on speculative information that may or may not materialize.

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37. In the context of the Arbitrage Pricing Theory, as a well-diversified portfolio becomes larger its nonsystematic risk approaches A) one. B) infinity. C) zero. D) negative one. E) none of the above.

Answer: C [email protected]: As the number of securities, n, increases, the nonsystematic risk of a well-diversified portfolio approaches zero.

38. A well-diversified portfolio is defined as A) one that is diversified over a large enough number of securities that the

nonsystematic variance is essentially zero. B) one that contains securities from at least three different industry sectors. C) a portfolio whose factor beta equals 1.0. D) a portfolio that is equally weighted. E) all of the above.

Answer: A [email protected]: A well-diversified portfolio is one that contains a large number of securities, each having a small (but not necessarily equal) weight, so that nonsystematic variance is negligible.

39. The APT requires a benchmark portfolio A) that is equal to the true market portfolio. B) that contains all securities in proportion to their market values. C) that need not be well-diversified. D) that is well-diversified and lies on the SML. E) that is unobservable.

Answer: D [email protected]: Any well-diversified portfolio lying on the SML can serve as the benchmark portfolio for the APT. The true (and unobservable) market portfolio is only a requirement for the CAPM.

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40. Imposing the no-arbitrage condition on a single-factor security market implies which of the following statements?

I) the expected return-beta relationship is maintained for all but a small number of well-diversified portfolios.

II) the expected return-beta relationship is maintained for all well-diversified portfolios.

III) the expected return-beta relationship is maintained for all but a small number of individual securities.

IV) the expected return-beta relationship is maintained for all individual securities.

A) I and III are correct. B) I and IV are correct. C) II and III are correct. D) II and IV are correct. E) Only I is correct.

Answer: C [email protected]: The expected return-beta relationship must hold for all well-diversified portfolios and for all but a few individual securities; otherwise arbitrage opportunities will be available.

41. Consider a well-diversified portfolio, A, in a two-factor economy. The risk-free rate is 6%, the risk premium on the first factor portfolio is 4% and the risk premium on the second factor portfolio is 3%. If portfolio A has a beta of 1.2 on the first factor and .8 on the second factor, what is its expected return? A) 7.0% B) 8.0% C) 9.2% D) 13.0% E) 13.2%

Answer: E [email protected]: .06 + 1.2 (.04) + .8 (.03) = .132

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42. The term “arbitrage” refers to A) buying low and selling high. B) short selling high and buying low. C) earning risk-free economic profits. D) negotiating for favorable brokerage fees. E) hedging your portfolio through the use of options.

Answer: C [email protected]: Arbitrage is exploiting security mispricings by the simultaneous purchase and sale to gain economic profits without taking any risk. A capital market in equilibrium rules out arbitrage opportunities.

43. To take advantage of an arbitrage opportunity, an investor would

I) construct a zero investment portfolio that will yield a sure profit.II) construct a zero beta investment portfolio that will yield a sure profit.III) make simultaneous trades in two markets without any net investment.IV) short sell the asset in the low-priced market and buy it in the high-

priced market.

A) I and IV B) I and III C) II and III D) I, III, and IV E) II, III, and IV

Answer: B [email protected]: Only I and III are correct. II is incorrect because the beta of the portfolio does not need to be zero. IV is incorrect because the opposite is true.

44. The factor F in the APT model represents A) firm-specific risk. B) the sensitivity of the firm to that factor. C) a factor that affects all security returns. D) the deviation from its expected value of a factor that affects all security returns. E) a random amount of return attributable to firm events.

Answer: D [email protected]: F measures the unanticipated portion of a factor that is common to all security returns.

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45. In the APT model, what is the nonsystematic standard deviation of an equally-weighted portfolio that has an average value of ó(ei) equal to 25% and 50 securities? A) 12.5% B) 625% C) 0.5% D) 3.54% E) 14.59%


Rationale: ( ) %54.35.12)(,5.1225

50

1)(

1)( 222 ===== pip een

e σσσ

46. Which of the following is true about the security market line (SML) derived from the APT? A) The SML has a downward slope. B) The SML for the APT shows expected return in relation to portfolio standard

deviation. C) The SML for the APT has an intercept equal to the expected return on the market

portfolio. D) The benchmark portfolio for the SML may be any well-diversified portfolio. E) The SML is not relevant for the APT.

Answer: D [email protected]: The benchmark portfolio does not need to be the (unobservable) market portfolio under the APT, but can be any well-diversified portfolio. The intercept still equals the risk-free rate.

47. If arbitrage opportunities are to be ruled out, each well-diversified portfolio's expected excess return must be A) inversely proportional to the risk-free rate. B) inversely proportional to its standard deviation. C) proportional to its weight in the market portfolio. D) proportional to its standard deviation. E) proportional to its beta coefficient.

Answer: E [email protected]: For each well-diversified portfolio (P and Q, for example), it must be true that [E(rp)-rf]/βp = [E(rQ)-rf]/ βQ.

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48. Suppose you are working with two factor portfolios, Portfolio 1 and Portfolio 2. The portfolios have expected returns of 15% and 6%, respectively. Based on this information, what would be the expected return on well-diversified portfolio A, if A has a beta of 0.80 on the first factor and 0.50 on the second factor? The risk-free rate is 3%. A) 15.2% B) 14.1% C) 13.3% D) 10.7% E) 8.4%

Answer: B [email protected]: E(RA) = 3 +0.8*(15-3) + 0.5*(6-3) = 14.1.

49. Which of the following is (are) true regarding the APT?

I) The Security Market Line does not apply to the APT.II) More than one factor can be important in determining returns.III) Almost all individual securities satisfy the APT relationship.IV) It doesn't rely on the market portfolio that contains all assets.

A) II, III, and IV B) II and IV C) II and III D) I, II, and IV E) I, II, III, and IV

Answer: A [email protected]: All except the first item are true. There is a Security Market Line associated with the APT.

50. In a factor model, the return on a stock in a particular period will be related to A) factor risk. B) non-factor risk. C) standard deviation of returns. D) both A and B are true. E) none of the above is true.

Answer: D [email protected]: Factor models explain firm returns based on both factor risk and non-factor risk.

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51. Which of the following factors did Chen, Roll and Ross not include in their multifactor model? A) Change in industrial production B) Change in expected inflation C) Change in unanticipated inflation D) Excess return of long-term government bonds over T-bills E) All of the above factors were included in their model.

Answer: E [email protected]: Chen, Roll and Ross included the four listed factors as well as the excess return of long-term corporate bonds over long-term government bonds in their model.

52. Which of the following factors were used by Fama and French in their multi-factor model? A) Return on the market index B) Excess return of small stocks over large stocks. C) Excess return of high book-to-market stocks over low book-to-market stocks. D) All of the above factors were included in their model. E) None of the above factors was included in their model.

Answer: D [email protected]: Fama and French included all three of the factors listed.

53. Which of the following factors did Merton not suggest as a likely source of uncertainty that might affect security returns? A) uncertainties in labor income. B) prices of important consumption goods. C) book-to-market ratios. D) changes in future investment opportunities. E) All of the above are sources of uncertainty affecting security returns.

Answer: C [email protected]: Merton did not suggest book-to-market ratios as an ICAPM pricing factor; the other three were suggested.

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54. Black argues that past risk premiums on firm-characteristic variables, such as those described by Fama and French, are problematic because. A) they may result from data snooping. B) they are sources of systematic risk. C) they can be explained by security characteristic lines. D) they are more appropriate for a single-factor model. E) they are macroeconomic factors.


55. Multifactor models seek to improve the performance of the single-index model by A) modeling the systematic component of firm returns in greater detail. B) incorporating firm-specific components into the pricing model. C) allowing for multiple economic factors to have differential effects D) all of the above are true. E) none of the above is true.


56. Multifactor models such as the one constructed by Chen, Roll, and Ross, can better describe assets' returns by A) expanding beyond one factor to represent sources of systematic risk. B) using variables that are easier to forecast ex ante. C) calculating beta coefficients by an alternative method. D) using only stocks with relatively stable returns. E) ignoring firm-specific risk.

Answer: A [email protected]: The study used five different factors to explain security returns, allowing for several sources of risk to affect the returns.

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57. Consider the multifactor model APT with three factors. Portfolio A has a beta of 0.8 on factor 1, a beta of 1.1 on factor 2, and a beta of 1.25 on factor 3. The risk premiums on the factor 1, factor 2, and factor 3 are 3%, 5% and 2%, respectively. The risk-free rate of return is 3%. The expected return on portfolio A is __________if no arbitrage opportunities exist. A) 13.5% B) 13.4% C) 16.5% D) 23.0% E) none of the above

Answer: B [email protected]: 3% + 0.8(3%) + 1.1(5%) + 1.25(2%) = 13.4%.

58. Consider the multifactor APT. The risk premiums on the factor 1 and factor 2 portfolios are 6% and 4%, respectively. The risk-free rate of return is 4%. Stock A has an expected return of 16% and a beta on factor 1 of 1.3. Stock A has a beta on factor 2 of ________. A) 1.33 B) 1.05 C) 1.67 D) 2.00 E) none of the above

Answer: B [email protected]: 16% = 4% + 6%(1.3) + 4%(x); x = 1.05.

59. Consider a well-diversified portfolio, A, in a two-factor economy. The risk-free rate is 5%, the risk premium on the first factor portfolio is 4% and the risk premium on the second factor portfolio is 6%. If portfolio A has a beta of 0.6 on the first factor and 1.8 on the second factor, what is its expected return? A) 7.0% B) 8.0% C) 18.2% D) 13.0% E) 13.2%

Answer: C [email protected]: .05 + .6 (.04) + 1.8 (.06) = .182

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60. Consider a single factor APT. Portfolio A has a beta of 2.0 and an expected return of 22%. Portfolio B has a beta of 1.5 and an expected return of 17%. The risk-free rate of return is 4%. If you wanted to take advantage of an arbitrage opportunity, you should take a short position in portfolio __________ and a long position in portfolio _______. A) A, A B) A, B C) B, A D) B, B E) A, the riskless asset

Answer: C [email protected]: A: 22% = 2.0F + 4%; F = 9%; B: 17% = 1.5F + 4%: F = 8.67%; thus, short B and take a long position in A.

61. Consider the single factor APT. Portfolio A has a beta of 0.5 and an expected return of 12%. Portfolio B has a beta of 0.4 and an expected return of 13%. The risk-free rate of return is 5%. If you wanted to take advantage of an arbitrage opportunity, you should take a short position in portfolio _________ and a long position in portfolio _________. A) A, A B) A, B C) B, A D) B, B E) none of the above

Answer: B [email protected]: A: 12% = 5% + 0.5F; F = 14%; B: 13% = 5% + 0.4F; F = 20%; therefore, short A and take a long position in B.

62. Consider the one-factor APT. The variance of returns on the factor portfolio is 9%. The beta of a well-diversified portfolio on the factor is 1.25. The variance of returns on the well-diversified portfolio is approximately __________. A) 3.6% B) 6.0% C) 7.3% D) 14.1% E) none of the above

Answer: D [email protected]: s2

P = (1.25)2(9%) = 14.06%.

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63. Consider the one-factor APT. The standard deviation of returns on a well-diversified portfolio is 22%. The standard deviation on the factor portfolio is 14%. The beta of the well-diversified portfolio is approximately __________. A) 0.80 B) 1.13 C) 1.25 D) 1.57 E) none of the above

Answer: D [email protected]: (22%)2 = (14%)2b2; b = 1.57.

64. Consider the single-factor APT. Stocks A and B have expected returns of 12% and 14%, respectively. The risk-free rate of return is 5%. Stock B has a beta of 1.2. If arbitrage opportunities are ruled out, stock A has a beta of __________. A) 0.67 B) 0.93 C) 1.30 D) 1.69 E) none of the above

Answer: B [email protected]: A: 12% = 5% + bF; B: 14% = 5% + 1.2F; F = 7.5%; Thus, beta of A = 7/7.5 = 0.93.

65. Consider the multifactor APT with two factors. Stock A has an expected return of 17.6%, a beta of 1.45 on factor 1 and a beta of .86 on factor 2. The risk premium on the factor 1 portfolio is 3.2%. The risk-free rate of return is 5%. What is the risk-premium on factor 2 if no arbitrage opportunities exit? A) 9.26% B) 3% C) 4% D) 7.75% E) none of the above

Answer: A [email protected]: 17.6% = 1.45(3.2%) + .86x + 5%; x = 9.26.

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1. The current yield on a bond is equal to ________. A) annual interest divided by the current market price B) the yield to maturity C) annual interest divided by the par value D) the internal rate of return E) none of the above

Answer: A [email protected]: A is current yield and is quoted as such in the financial press.

2. If a 7% coupon bond is trading for $975.00, it has a current yield of ____________ percent. A) 7.00 B) 6.53 C) 7.24 D) 8.53 E) 7.18

Answer: E [email protected]: 70/975 = 7.18.

3. If a 6% coupon bond is trading for $950.00, it has a current yield of ____________ percent. A) 6.5 B) 6.3 C) 6.1 D) 6.0 E) 6.6

Answer: B [email protected]: 60/950 = 6.3.

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4. If an 8% coupon bond is trading for $1025.00, it has a current yield of ____________ percent. A) 7.8 B) 8.7 C) 7.6 D) 7.9 E) 8.1

Answer: A [email protected]: 80/1025 = 7.8.

5. If a 7.5% coupon bond is trading for $1050.00, it has a current yield of ____________ percent. A) 7.0 B) 7.4 C) 7.1 D) 6.9 E) 6.7

Answer: C [email protected]: 75/1050 = 7.1.

6. A coupon bond pays annual interest, has a par value of $1,000, matures in 4 years, has a coupon rate of 10%, and has a yield to maturity of 12%. The current yield on this bond is ___________. A) 10.65% B) 10.45% C) 10.95% D) 10.52% E) none of the above

Answer: A Difficulty: Moderate Rationale: FV = 1000, n = 4, PMT = 100, i = 12, PV= 939.25; $100 / $939.25 = 10.65%.

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7. A coupon bond pays annual interest, has a par value of $1,000, matures in 12 years, has a coupon rate of 11%, and has a yield to maturity of 12%. The current yield on this bond is ___________. A) 10.39% B) 10.43% C) 10.58% D) 10.66% E) none of the above

Answer: D Difficulty: Moderate Rationale: FV = 1000, n = 12, PMT = 110, i = 12, PV= 938.06; $100 / $938.06 = 10.66%.

8. Of the following four investments, ________ is considered the safest. A) commercial paper B) corporate bonds C) U. S. Agency issues D) Treasury bonds E) Treasury bills

Answer: E [email protected]: Only Treasury issues are insured by the U. S. government; the shorter-term the instrument, the safer the instrument.

9. To earn a high rating from the bond rating agencies, a firm should have A) a low times interest earned ratio B) a low debt to equity ratio C) a high quick ratio D) B and C E) A and C

Answer: D [email protected]: High values for the times interest and quick ratios and a low debt to equity ratio are desirable indicators of safety.

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10. At issue, coupon bonds typically sell ________. A) above par value B) below par C) at or near par value D) at a value unrelated to par E) none of the above

Answer: C [email protected]: If the investment banker has appraised the market and the quality of the bond correctly, the bond will sell at or near par (unless interest rates have changed very dramatically and very quickly around the time of issuance).

11. Accrued interest A) is quoted in the bond price in the financial press. B) must be paid by the buyer of the bond and remitted to the seller of the bond. C) must be paid to the broker for the inconvenience of selling bonds between

maturity dates. D) A and B. E) A and C.

Answer: B Difficulty: Moderate Rationale: Accrued interest must be paid by the buyer, but is not included in the quotations page price.

12. The invoice price of a bond that a buyer would pay is equal to A) the asked price plus accrued interest. B) the asked price less accrued interest. C) the bid price plus accrued interest. D) the bid price less accrued interest. E) the bid price.

Answer: A [email protected]: The buyer of a bond will buy at the asked price and will also be invoiced for any accrued interest due to the seller.

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13. An 8% coupon U. S. Treasury note pays interest on May 30 and November 30 and is traded for settlement on August 15. The accrued interest on the $100,000 face value of this note is _________. A) $491.80 B) $800.00 C) $983.61 D) $1,661.20 E) none of the above

Answer: D Difficulty: Moderate Rationale: 76/183($4,000) = $1,661.20. Approximation: .08/12*100,000=666.67 per month. 666.67/month * 2.5 months = 1.666.67.

14. A coupon bond is reported as having an ask price of 113% of the $1,000 par value in the Wall Street Journal. If the last interest payment was made two months ago and the coupon rate is 12%, the invoice price of the bond will be ____________. A) $1,100 B) $1,110 C) $1,150 D) $1,160 E) none of the above

Answer: C Difficulty: Moderate Rationale: $1,130 + $20 (accrued interest) = $1,150.

15. The bonds of Ford Motor Company have received a rating of "D" by Moody's. The "D" rating indicates A) the bonds are insured B) the bonds are junk bonds C) the bonds are referred to as "high yield" bonds D) A and B E) B and C

Answer: E [email protected]: D ratings are risky bonds, often called junk bonds (or high yield bonds by those marketing such bonds).

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16. The bond market A) can be quite "thin". B) primarily consists of a network of bond dealers in the over the counter market. C) consists of many investors on any given day. D) A and B. E) B and C.

Answer: D [email protected]: The bond market, unlike the stock market, can be a very thinly traded market. In addition, most bonds are traded by dealers.

17. Ceteris paribus, the price and yield on a bond areA) positively related. B) negatively related. C) sometimes positively and sometimes negatively related. E) not related. E) indefinitely related.

Answer: B [email protected]: Bond prices and yields are inversely related.

18. The ______ is a measure of the average rate of return an investor will earn if the investor buys the bond now and holds until maturity. A) current yield B) dividend yield C) P/E ratio D) yield to maturity E) discount yield

Answer: D [email protected]: The current yield is the annual interest as a percent of current market price; the other choices do not apply to bonds.

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19. The _________ gives the number of shares for which each convertible bond can be exchanged. A) conversion ratio B) current ratio C) P/E ratio D) conversion premium E) convertible floor

Answer: A [email protected]: The conversion premium is the amount for which the bond sells above conversion value; the price of bond as a straight bond provides the floor. The other terms are not specifically relevant to convertible bonds.

20. A coupon bond is a bond that _________. A) pays interest on a regular basis (typically every six months) B) does not pay interest on a regular basis but pays a lump sum at maturity C) can always be converted into a specific number of shares of common stock in the

issuing company D) always sells at par E) none of the above

Answer: A [email protected]: A coupon bond will pay the coupon rate of interest on a semiannual basis unless the firm defaults on the bond. Convertible bonds are specific types of bonds.

21. A ___________ bond is a bond where the bondholder has the right to cash in the bond before maturity at a specified price after a specific date. A) callable B) coupon C) put D) Treasury E) zero-coupon

Answer: C [email protected]: Any bond may be redeemed prior to maturity, but all bonds other than put bonds are redeemed at a price determined by the prevailing interest rates.

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22. Callable bonds A) are called when interest rates decline appreciably. B) have a call price that declines as time passes. C) are called when interest rates increase appreciably. D) A and B. E) B and C.

Answer: D [email protected]: Callable bonds often are refunded (called) when interest rates decline appreciably. The call price of the bond (approximately par and one year's coupon payment) declines to par as time passes and maturity is reached.

23. A Treasury bond due in one year has a yield of 5.7%; a Treasury bond due in 5 years has a yield of 6.2%. A bond issued by Ford Motor Company due in 5 years has a yield of 7.5%; a bond issued by Shell Oil due in one year has a yield of 6.5%. The default risk premiums on the bonds issued by Shell and Ford, respectively, are A) 1.0% and 1.2% B) 0.7% and 1.5% C) 1.2% and 1.0% D) 0.8% and 1.3% E) none of the above

Answer: D Difficulty: Moderate Rationale: Shell: 6.5% - 5.7% = .8%; Ford: 7.5% - 6.2% = 1.3%.

24. A Treasury bond due in one year has a yield of 4.6%; a Treasury bond due in 5 years has a yield of 5.6%. A bond issued by Lucent Technologies due in 5 years has a yield of 8.9%; a bond issued by Mobil due in one year has a yield of 6.2%. The default risk premiums on the bonds issued by Mobil and Lucent Technologies, respectively, are: A) 1.6% and 3.3% B) 0.5% and .7% C) 3.3% and 1.6% D) 0.7% and 0.5% E) none of the above

Answer: A Difficulty: Moderate Rationale: Mobil: 6.2% - 4.6% = 1.6%; Lucent Technologies: 8.9% - 5.6% = 3.3%.

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25. A Treasury bond due in one year has a yield of 6.2%; a Treasury bond due in 5 years has a yield of 6.7%. A bond issued by Xerox due in 5 years has a yield of 7.9%; a bond issued by Exxon due in one year has a yield of 7.2%. The default risk premiums on the bonds issued by Exxon and Xerox, respectively, are A) 1.0% and 1.2% B) 0.5% and .7% C) 1.2% and 1.0% D) 0.7% and 0.5% E) none of the above

Answer: A Difficulty: Moderate Rationale: Exxon: 7.2% - 6.2% = 1.0%; Xerox: 7. 9% - 6.7% = 1.2%.

26. Floating-rate bonds are designed to ___________ while convertible bonds are designed to __________. A) minimize the holders' interest rate risk; give the investor the ability to share in the

price appreciation of the company's stock B) maximize the holders' interest rate risk; give the investor the ability to share in the

price appreciation of the company's stock C) minimize the holders' interest rate risk; give the investor the ability to benefit from

interest rate changes D) maximize the holders' interest rate risk; give investor the ability to share in the

profits of the issuing company E) none of the above

Answer: A Difficulty: Moderate Rationale: Floating rate bonds allow the investor to earn a rate of interest income tied to current interest rates, thus negating one of the major disadvantages of fixed income investments. Convertible bonds allow the investor to benefit from the appreciation of the stock price, either by converting to stock or holding the bond, which will increase in price as the stock price increases.

27. A coupon bond that pays interest annually is selling at par value of $1,000, matures in 5 years, and has a coupon rate of 9%. The yield to maturity on this bond is: A) 8.0% B) 8.3% C) 9.0% D) 10.0% E) none of the above

Answer: C [email protected]: When a bond sells at par value, the coupon rate is equal to the yield to maturity.

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28. A coupon bond that pays interest annually has a par value of $1,000, matures in 5 years, and has a yield to maturity of 10%. The intrinsic value of the bond today will be ______ if the coupon rate is 7%. A) $712.99 B) $620.92 C) $1,123.01 D) $886.28 E) $1,000.00

Answer: D Difficulty: Moderate Rationale: FV = 1000, PMT = 70, n = 5, i = 10, PV = 886.28.

29. A coupon bond that pays interest annually, has a par value of $1,000, matures in 5 years, and has a yield to maturity of 10%. The intrinsic value of the bond today will be _________ if the coupon rate is 12%. A) $922.77 B) $924.16 C) $1,075.82 D) $1,077.20 E) none of the above

Answer: C Difficulty: Moderate Rationale: FV = 1000, PMT = 120, n = 5, i = 10, PV = 1075.82

30. A coupon bond that pays interest semi-annually has a par value of $1,000, matures in 5 years, and has a yield to maturity of 10%. The intrinsic value of the bond today will be __________ if the coupon rate is 8%. A) $922.78 B) $924.16 C) $1,075.80 D) $1,077.20 E) none of the above

Answer: A Difficulty: Moderate Rationale: FV = 1000, PMT = 40, n = 10, i = 5, PV = 922.78

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31. A coupon bond that pays interest semi-annually has a par value of $1,000, matures in 5 years, and has a yield to maturity of 10%. The intrinsic value of the bond today will be ________ if the coupon rate is 12%. A) $922.77 B) $924.16 C) $1,075.80 D) $1,077.22 E) none of the above

Answer: D Difficulty: Moderate Rationale: FV = 1000, PMT = 60, n = 10, i = 5, PV = 1077.22

32. A coupon bond that pays interest of $100 annually has a par value of $1,000, matures in 5 years, and is selling today at a $72 discount from par value. The yield to maturity on this bond is __________. A) 6.00% B) 8.33% C) 12.00% D) 60.00% E) none of the above

Answer: C Difficulty: Moderate Rationale: FV = 1000, PMT = 100, n = 5, PV = -928, i = 11.997%

33. You purchased an annual interest coupon bond one year ago that now has 6 years remaining until maturity. The coupon rate of interest was 10% and par value was $1,000. At the time you purchased the bond, the yield to maturity was 8%. The amount you paid for this bond one year ago was A) $1,057.50. B) $1,075.50. C) $1,088.50. D) $1.092.46. E) $1,104.13.

Answer: E Difficulty: Moderate Rationale: FV = 1000, PMT = 100, n = 7, i = 8, PV = 1104.13

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34. You purchased an annual interest coupon bond one year ago that had 6 years remaining to maturity at that time. The coupon interest rate was 10% and the par value was $1,000. At the time you purchased the bond, the yield to maturity was 8%. If you sold the bond after receiving the first interest payment and the yield to maturity continued to be 8%, your annual total rate of return on holding the bond for that year would have been _________. A) 7.00% B) 7.82% C) 8.00% D) 11.95% E) none of the above

Answer: C [email protected]: FV = 1000, PMT = 100, n = 6, i = 8, PV = 1092.46; FV = 1000, PMT = 100, n = 5, i = 8, PV = 1079.85; HPR = (1079.85 - 1092.46 + 100) / 1092.46 = 8%

35. Consider two bonds, A and B. Both bonds presently are selling at their par value of $1,000. Each pays interest of $120 annually. Bond A will mature in 5 years while bond B will mature in 6 years. If the yields to maturity on the two bonds change from 12% to 10%, ____________. A) both bonds will increase in value, but bond A will increase more than bond B B) both bonds will increase in value, but bond B will increase more than bond A C) both bonds will decrease in value, but bond A will decrease more than bond B D) both bonds will decrease in value, but bond B will decrease more than bond A E) none of the above

Answer: B Difficulty: Moderate Rationale: The longer the maturity, the greater the price change when interest rates change.

36. A zero-coupon bond has a yield to maturity of 9% and a par value of $1,000. If the bond matures in 8 years, the bond should sell for a price of _______ today. A) 422.41 B) $501.87 C) $513.16 D) $483.49 E) none of the above

Answer: B Difficulty: Moderate Rationale: $1,000/(1.09)8 = $501.87

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37. You have just purchased a 10-year zero-coupon bond with a yield to maturity of 10% and a par value of $1,000. What would your rate of return at the end of the year be if you sell the bond? Assume the yield to maturity on the bond is 11% at the time you sell. A) 10.00% B) 20.42% C) 13.8% D) 1.4% E) none of the above

Answer: D Difficulty: Moderate Rationale: $1,000/(1.10)10 = $385.54; $1,000/(1.11)9 = $390.92; ($390.92 - $385.54)/$385.54 = 1.4%.

38. A Treasury bill with a par value of $100,000 due one month from now is selling today for $99,010. The effective annual yield is __________. A) 12.40% B) 12.55% C) 12.62% D) 12.68% E) none of the above

Answer: D Difficulty: Moderate Rationale: $990/$99,010 = 0.01; (1.01)12 - 1.0 = 12.68%.

39. A Treasury bill with a par value of $100,000 due two months from now is selling today for $98,039, with an effective annual yield of _________. A) 12.40% B) 12.55% C) 12.62% D) 12.68% E) none of the above

Answer: C Difficulty: Moderate Rationale: $1,961/$98,039 = 0.02; (1.02)6 - 1 = 12.62%.

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40. A Treasury bill with a par value of $100,000 due three months from now is selling today for $97,087, with an effective annual yield of _________. A) 12.40% B) 12.55% C) 12.62% D) 12.68% E) none of the above

Answer: B Difficulty: Moderate Rationale: $2,913/$97,087 = 0.03; (1.03)4 - 1.00 = 12.55%.

41. A coupon bond pays interest semi-annually, matures in 5 years, has a par value of $1,000 and a coupon rate of 12%, and an effective annual yield to maturity of 10.25%. The price the bond should sell for today is ________. A) $922.77 B) $924.16 C) $1,075.80 D) $1,077.20 E) none of the above

Answer: D Difficulty: Moderate Rationale: (1.1025)1/2 - 1 = 5%, N=10, I=5%, PMT=60, FV=1000, PV=1,077.22.

42. A convertible bond has a par value of $1,000 and a current market price of $850. The current price of the issuing firm's stock is $29 and the conversion ratio is 30 shares. The bond's market conversion value is ______. A) $729 B) $810 C) $870 D) $1,000 E) none of the above

Answer: C [email protected]: 30 shares X $29/share = $870.

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43. A convertible bond has a par value of $1,000 and a current market value of $850. The current price of the issuing firm's stock is $27 and the conversion ratio is 30 shares. The bond's conversion premium is _________. A) $40 B) $150 C) $190 D) $200 E) none of the above

Answer: A Difficulty: Moderate Rationale: $850 - $810 = $40.


Consider the following $1,000 par value zero-coupon bonds:

44. The yield to maturity on bond A is ____________. A) 10% B) 11% C) 12% D) 14% E) none of the above

Answer: A Difficulty: Moderate Rationale: ($1,000 - $909.09)/$909.09 = 10%.

45. The yield to maturity on bond B is _________. A) 10% B) 11% C) 12% D) 14% E) none of the above

Answer: B Difficulty: Moderate Rationale: ($1,000 - $811.62)/$811.62 = 0.2321; (1.2321)1/2 - 1.0 = 11%.

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46. The yield to maturity on bond C is ____________. A) 10% B) 11% C) 12% D) 14% E) none of the above

Answer: C Difficulty: Moderate Rationale: ($1,000 - $711.78)/$711.78 = 0.404928; (1.404928)1/3 - 1.0 = 12%.

47. The yield to maturity on bond D is _______. A) 10% B) 11% C) 12% D) 14% E) none of the above

Answer: C Difficulty: Moderate Rationale: ($1,000 - $635.52)/$635.52 = 0.573515; (1.573515)1/4 - 1.0 = 12%.

48. A 10% coupon bond, annual payments, 10 years to maturity is callable in 3 years at a call price of $1,100. If the bond is selling today for $975, the yield to call is _________. A) 10.26% B) 10.00% C) 9.25% D) 13.98% E) none of the above

Answer: D Difficulty: Moderate Rationale: FV = 1100, n = 3, PMT = 100, PV = -975, i = 13.98%.

49. A 12% coupon bond, semiannual payments, is callable in 5 years. The call price is $1,120; if the bond is selling today for $1,110, what is the yield to call? A) 12.03%. B) 10.86%. C) 10.95%. D) 9.14%. E) none of the above.

Answer: C Difficulty: Moderate Rationale: YTC = FV = 1120, n = 10, PMT = 60, PV = -1,110m i = 5.48%, 5.48*2=10.95

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50. A 10% coupon, annual payments, bond maturing in 10 years, is expected to make all coupon payments, but to pay only 50% of par value at maturity. What is the expected yield on this bond if the bond is purchased for $975? A) 10.00%. B) 6.68%. C) 11.00%. D) 8.68%. E) none of the above.

Answer: B Difficulty: Moderate Rationale: FV = 500, PMT = 100, n = 10, PV = -975, i = 6.68%

51. You purchased an annual interest coupon bond one year ago with 6 years remaining to maturity at the time of purchase. The coupon interest rate is 10% and par value is $1,000. At the time you purchased the bond, the yield to maturity was 8%. If you sold the bond after receiving the first interest payment and the bond's yield to maturity had changed to 7%, your annual total rate of return on holding the bond for that year would have been _________. A) 7.00% B) 8.00% C) 9.95% D) 11.95% E) none of the above

Answer: D [email protected]: FV = 1000, PMT = 100, n = 6, i = 8, PV = 1092.46; FV = 1000, PMT = 100, n = 5, i = 7, PV = 1123.01; HPR = (1123.01 - 1092.46 + 100) / 1092.46 = 11.95%.

52. The ________ is used to calculate the present value of a bond. A) nominal yield B) current yield C) yield to maturity D) yield to call E) none of the above

Answer: C [email protected]: Yield to maturity is the discount rate used in the bond valuation formula. For callable bonds, yield to call is sometimes the more appropriate calculation for the investor (if interest rates are expected to decrease).

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53. The yield to maturity on a bond is ________. A) below the coupon rate when the bond sells at a discount, and equal to the coupon

rate when the bond sells at a premium. B) the discount rate that will set the present value of the payments equal to the bond

price. C) based on the assumption that any payments received are reinvested at the coupon

rate. D) none of the above. E) A, B, and C.

Answer: B [email protected]: The reverse of A is true; for C to be true payments must be reinvested at the yield to maturity.

54. A bond will sell at a discount when __________. A) the coupon rate is greater than the current yield and the current yield is greater

than yield to maturity B) the coupon rate is greater than yield to maturity C) the coupon rate is less than the current yield and the current yield is greater than

the yield to maturity D) the coupon rate is less than the current yield and the current yield is less than yield

to maturity E) none of the above is true.

Answer: D Difficulty: Moderate Rationale: In order for the investor to earn more than the current yield the bond must be selling for a discount. Yield to maturity will be greater than current yield as investor will have purchased the bond at discount and will be receiving the coupon payments over the life of the bond.

55. Consider a 5-year bond with a 10% coupon that has a present yield to maturity of 8%. If interest rates remain constant, one year from now the price of this bond will be _______. A) higher B) lower C) the same D) cannot be determined E) $1,000

Answer: B Difficulty: Moderate Rationale: This bond is a premium bond as interest rates have declined since the bond was issued. If interest rates remain constant, the price of a premium bond declines as the bond approaches maturity.

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56. A bond has a par value of $1,000, a time to maturity of 20 years, a coupon rate of 10% with interest paid annually, a current price of $850 and a yield to maturity of 12%. Intuitively and without the use calculations, if interest payments are reinvested at 10%, the realized compound yield on this bond must be ________. A) 10.00% B) 10.9% C) 12.0% D) 12.4% E) none of the above

Answer: B [email protected]: In order to earn yield to maturity, the coupons must be reinvested at the yield to maturity. However, as the bond is selling at discount the yield must be higher than the coupon rate. Therefore, B is the only possible answer.

57. A bond with a 12% coupon, 10 years to maturity and selling at 88 has a yield to maturity of _______. A) over 14% B) between 13% and 14% C) between 12% and 13% D) between 10% and 12% E) less than 12%

Answer: A Difficulty: Moderate Rationale: YTM = 14.33%.

58. Using semiannual compounding, a 15-year zero coupon bond that has a par value of $1,000 and a required return of 8% would be priced at approximately ______. A) $308 B) $315 C) $464 D) $555 E) none of the above

Answer: A Difficulty: Moderate Rationale: FV = 1000, n = 30, I = 4, PV = 308.32

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59. The yield to maturity of a 20-year zero coupon bond that is selling for $372.50 with a value at maturity of $1,000 is ________. A) 5.1% B) 8.8% C) 10.8% D) 13.4% E) none of the above

Answer: A Difficulty: Moderate Rationale: [$1,000/($372.50]1/20 - 1 = 5.1%.

60. Which one of the following statements about convertibles is true? A) The longer the call protection on a convertible, the less the security is worth. B) The more volatile the underlying stock, the greater the value of the conversion

feature. C) The smaller the spread between the dividend yield on the stock and the yield-to-

maturity on the bond, the more the convertible is worth. D) The collateral that is used to secure a convertible bond is one reason convertibles

are more attractive than the underlying stock. E) Convertibles are not callable.

Answer: B Difficulty: Moderate Rationale: The longer the call protection the more attractive the bond. The smaller the spread (c), the less the bond is worth. Convertibles are debentures (unsecured bonds). All convertibles are callable at the option of the issuer.

61. Consider a $1,000 par value 20-year zero coupon bond issued at a yield to maturity of 10%. If you buy that bond when it is issued and continue to hold the bond as yields decline to 9%, the imputed interest income for the first year of that bond is A) zero. B) $14.87. C) $45.85. D) $7.44. E) none of the above.

Answer: B Difficulty: Moderate Rationale: $1,000/(1.10)20 = $148.64; $1,000/(1.10)19 = $163.51; $194.49 - $148.64 = $14.87.

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62. The bond indenture includes A) the coupon rate of the bond. B) the par value of the bond. C) the maturity date of the bond. D) all of the above. E) none of the above.

Answer: D [email protected]: The bond indenture includes the coupon rate, par value and maturity date of the bond as well as any other contractual features.

63. A Treasury bond quoted at 107:16 107:18 has a bid price of _______ and an asked price of _____. A) $107.16, $107.18 B) $1,071.60, $1,071.80 C) $1,075.00, $1,075.63 D) $1,071.80, $1,071.60 E) $1,070.50, $1,070.56

Answer: C Difficulty: Moderate Rationale: Treasury bonds are quoted as a percentage of par value ($1,000) with the number after the colon representing the fractions of a point in 32nds. The bid price is quoted first and is the lower of the two.

64. Bearer bonds are A) bonds traded without any record of ownership. B) helpful to tax authorities in the enforcement of tax collection. C) rare in the United States today. D) all of the above. E) both A and C.

Answer: E Difficulty: Moderate Rationale: Bearer bonds are not registered so there is no record of ownership. They are rare in the United States today. Tax authorities find registered bonds helpful in tax enforcement but not bearer bonds.

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65. Most corporate bonds are traded A) on a formal exchange operated by the New York Stock Exchange. B) by the issuing corporation. C) over the counter by bond dealers linked by a computer quotation system. D) on a formal exchange operated by the American Stock Exchange. E) on a formal exchange operated by the Philadelphia Stock Exchange.

Answer: C Difficulty: Moderate Rationale: Most corporate bonds are traded in a loosely organized network of bond dealers linked by a computer quote system. Only a small proportion is traded on the New York Exchange.

66. The process of retiring high-coupon debt and issuing new bonds at a lower coupon to reduce interest payments is called A) deferral. B) reissue. C) repurchase. D) refunding. E) none of the above.

Answer: D Difficulty: Moderate Rationale: The process of refunding refers to calling high-coupon bonds and issuing new, lower coupon debt.

67. Convertible bonds A) give their holders the ability to share in price appreciation of the underlying stock. B) offer lower coupon rates than similar nonconvertible bonds. C) offer higher coupon rates than similar nonconvertible bonds. D) both A and B are true. E) both A and C are true.

Answer: D Difficulty: Moderate Rationale: Convertible bonds offer appreciation potential through the ability to share in price appreciation of the underlying stock but offer a lower coupon and yield than similar nonconvertible bonds.

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68. TIPS are A) securities formed from the coupon payments only of government bonds. B) securities formed from the principal payments only of government bonds. C) government bonds with par value linked to the general level of prices. D) government bonds with coupon rate linked to the general level of prices. E) zero-coupon government bonds.

Answer: C Difficulty: Moderate Rationale: Treasury Inflation Protected Securities (TIPS) are bonds whose par value adjusts according to the general level of prices. This changes coupon payments, but not the stated coupon rate.

69. Altman's Z scores are assigned based on a firm's financial characteristics and are used to predict A) required coupon rates for new bond issues. B) bankruptcy risk. C) the likelihood of a firm becoming a takeover target. D) the probability of a bond issue being called. E) none of the above.

Answer: B [email protected]: Z-scores are used to predict significant bankruptcy risk.

70. When a bond indenture includes a sinking fund provision A) firms must establish a cash fund for future bond redemption. B) bondholders always benefit, because principal repayment on the scheduled

maturity date is guaranteed. C) bondholders may lose because their bonds can be repurchased by the corporation

at below-market prices. D) both A and B are true. E) none of the above is true.

Answer: C Difficulty: Moderate Rationale: A sinking fund provisions requires the firm to redeem bonds over several years, either by open market purchase or at a special call price from bondholders. This can result in repurchase in advance of scheduled maturity at below-market prices.

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71. Subordination clauses in bond indentures A) may restrict the amount of additional borrowing the firm can undertake. B) are sometimes referred to as "me-first" rules. C) provide higher priority to senior creditors in the event of bankruptcy. D) all of the above are true. E) both B and C are true.

Answer: D [email protected]: All of the statements correctly describe subordination clauses.

72. Collateralized bonds A) rely on the general earning power of the firm for the bond's safety. B) are backed by specific assets of the issuing firm. C) are considered the safest assets of the firm. D) all of the above are true. E) both B and C are true.

Answer: E [email protected]: Collateralized bonds are considered the safest assets of the firm because they are backed by specific assets of the firm, rather than relying on the firm's general earning power.

73. Debt securities are often called fixed-income securities because A) the government fixes the maximum rate that can be paid on bonds. B) they are held predominantly by older people who are living on fixed incomes. C) they pay a fixed amount at maturity. D) they promise either a fixed stream of income or a stream of income determined by

a specific formula. E) they were the first type of investment offered to the public, which allowed them to

“fix” their income at a higher level by investing in bonds.

Answer: D [email protected]: This definition is given in the chapter's introduction. It helps the student understand the nature of bonds.

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74. A zero-coupon bond is one that A) effectively has a zero percent coupon rate. B) pays interest to the investor based on the general level of interest rates, rather than

at a specified coupon rate. C) pays interest to the investor without requiring the actual coupon to be mailed to

the corporation. D) is issued by state governments because they don't have to pay interest. E) is analyzed primarily by focusing (“zeroing in”) on the coupon rate.

Answer: A Difficulty: Moderate Rationale: Zero-coupon bonds pay no interest. Investors receive the face value at maturity.

75. Swingin' Soiree, Inc. is a firm that has its main office on the Right Bank in Paris. The firm just issued bonds with a final payment amount that depends on whether the Seine River floods. This type of bond is known as A) a contingency bond B) a catastrophe bond C) an emergency bond D) an incident bond E) an eventuality bond

Answer: B [email protected]: Catastrophe bonds are used to transfer risk from the firm to the capital markets.

76. One year ago, you purchased a newly issued TIPS bond that has a 6% coupon rate, five years to maturity, and a par value of $1,000. The average inflation rate over the year was 4.2%. What is the amount of the coupon payment you will receive and what is the current face value of the bond? A) $60.00, $1,000 B) $42.00, $1,042 C) $60.00, $1,042 D) $62.52, $1,042 E) $102.00, $1,000

Answer: D Difficulty: Moderate Rationale: The bond price, which is indexed to the inflation rate, becomes $1,000*1.042 = $1,042. The interest payment is based on the coupon rate and the new face value. The interest amount equals $1,042*.06 = $62.52.

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77. Bond analysts might be more interested in a bond's yield to call if A) the bond's yield to maturity is insufficient. B) the firm has called some of its bonds in the past. C) the investor only plans to hold the bond until its first call date. D) interest rates are expected to rise. E) interest rates are expected to fall.

Answer: E [email protected]: If interest rates fall the firm is more likely to call the issue and refinance at lower rates. This is similar to an individual refinancing a home. The student has to think through each of the reasons given and make the connection between falling rates and the motivation to refinance.

78. What is the relationship between the price of a straight bond and the price of a callable bond? A) The straight bond's price will be higher than the callable bond's price for low

interest rates. B) The straight bond's price will be lower than the callable bond's price for low

interest rates. C) The straight bond's price will change as interest rates change, but the callable

bond's price will stay the same. D) The straight bond and the callable bond will have the same price. E) There is no consistent relationship between the two types of bonds.

Answer: A Difficulty: Moderate Rationale: For low interest rates, the price difference is due to the value of the firm's option to call the bond at the call price. The firm is more likely to call the issue at low interest rates, so the option is valuable. At higher interest rates the firm is less likely to call and this option loses value. The prices converge for high interest rates. A graphical representation is shown in Figure 14.4, page 463.

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79. Three years ago you purchased a bond for $974.69. The bond had three years to maturity, a coupon rate of 8%, paid annually, and a face value of $1,000. Each year you reinvested all coupon interest at the prevailing reinvestment rate shown in the table below. Today is the bond's maturity date. What is your realized compound yield on the bond?

A) 6.43% B) 7.96% C) 8.23% D) 8.97% E) 9.13%

Answer: D [email protected]: The investment grows to a total future value of $80*(1.072)*(1.094) + $80*(1.094) + $1,080 = $1,261.34 over the three year period. The realized compound yield is the yield that will compound the original investment to yield the same future value: $974.69*(1+rcy)3 = $1,261.34, (1+rcy)3 = 1.29409, 1+rcy = 1.0897, rcy = 8.97%.

80. Which of the following is not a type of international bond? A) Samurai bonds B) Yankee bonds C) bulldog bonds D) Elton bonds E) All of the above are international bonds.

Answer: D [email protected]: Samurai bonds, Yankee bonds, and bulldog bonds are mentioned in the textbook.

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81. A coupon bond that pays interest annually has a par value of $1,000, matures in 6 years, and has a yield to maturity of 11%. The intrinsic value of the bond today will be ______ if the coupon rate is 7.5%. A) $712.99 B) $851.93 C) $1,123.01 D) $886.28 E) $1,000.00

Answer: B Difficulty: Moderate Rationale: FV = 1000, PMT = 75, n = 6, i = 11, PV = 851.93.

82. A coupon bond that pays interest annually has a par value of $1,000, matures in 8 years, and has a yield to maturity of 9%. The intrinsic value of the bond today will be ______ if the coupon rate is 6%. A) $833.96 B) $620.92 C) $1,123.01 D) $886.28 E) $1,000.00

Answer: A Difficulty: Moderate Rationale: FV = 1000, PMT = 60, n = 8, i = 9, PV = 833.96

83. A coupon bond that pays interest semi-annually has a par value of $1,000, matures in 6 years, and has a yield to maturity of 9%. The intrinsic value of the bond today will be __________ if the coupon rate is 9%. A) $922.78 B) $924.16 C) $1,075.80 D) $1,000.00 E) none of the above

Answer: D Difficulty: Moderate Rationale: FV = 1000, PMT = 45, n = 12, i = 4.5, PV = 1000.00

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84. A coupon bond that pays interest semi-annually has a par value of $1,000, matures in 7 years, and has a yield to maturity of 11%. The intrinsic value of the bond today will be __________ if the coupon rate is 8.8%. A) $922.78 B) $894.51 C) $1,075.80 D) $1,077.20 E) none of the above

Answer: B Difficulty: Moderate Rationale: FV = 1000, PMT = 44, n = 14, i = 5.5, PV = 894.51

85. A coupon bond that pays interest of $90 annually has a par value of $1,000, matures in 9 years, and is selling today at a $66 discount from par value. The yield to maturity on this bond is __________. A) 9.00% B) 10.15% C) 11.25% D) 12.32% E) none of the above


86. A coupon bond that pays interest of $40 semi annually has a par value of $1,000, matures in 4 years, and is selling today at a $36 discount from par value. The yield to maturity on this bond is __________. A) 8.69% B) 9.09% C) 10.43% D) 9.76% E) none of the above


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87. You purchased an annual interest coupon bond one year ago that now has 18 years remaining until maturity. The coupon rate of interest was 11% and par value was $1,000. At the time you purchased the bond, the yield to maturity was 10%. The amount you paid for this bond one year ago was A) $1,057.50 B) $1,075.50 C) $1,083.65 D) $1.092.46 E) $1,104.13

Answer: C Difficulty: Moderate Rationale: FV = 1000, PMT = 110, n = 19, i = 10, PV = 1,083.65

88. You purchased an annual interest coupon bond one year ago that had 9 years remaining to maturity at that time. The coupon interest rate was 10% and the par value was $1,000. At the time you purchased the bond, the yield to maturity was 8%. If you sold the bond after receiving the first interest payment and the yield to maturity continued to be 8%, your annual total rate of return on holding the bond for that year would have been _________. A) 8.00% B) 7.82% C) 7.00% D) 11.95% E) none of the above

Answer: A [email protected]: FV = 1000, PMT = 100, n = 9, i = 8, PV = 1124.94; FV = 1000, PMT = 100, n = 8, i = 8, PV = 1114.93; HPR = (1114.93 - 1124.94 + 100) / 1124.94 = 8%

89. Consider two bonds, F and G. Both bonds presently are selling at their par value of $1,000. Each pays interest of $90 annually. Bond F will mature in 15 years while bond G will mature in 26 years. If the yields to maturity on the two bonds change from 9% to 10%, ____________. A) both bonds will increase in value, but bond F will increase more than bond G B) both bonds will increase in value, but bond G will increase more than bond F C) both bonds will decrease in value, but bond F will decrease more than bond G D) both bonds will decrease in value, but bond G will decrease more than bond F E) none of the above

Answer: D Difficulty: Moderate Rationale: The longer the maturity, the greater the price change when interest rates change.

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90. A zero-coupon bond has a yield to maturity of 12% and a par value of $1,000. If the bond matures in 18 years, the bond should sell for a price of _______ today. A) 422.41 B) $501.87 C) $513.16 D) $130.04 E) none of the above

Answer: D Difficulty: Moderate Rationale: $1,000/(1.12)18 = $130.04

91. A zero-coupon bond has a yield to maturity of 11% and a par value of $1,000. If the bond matures in 27 years, the bond should sell for a price of _______ today. A) $59.74 B) $501.87 C) $513.16 D) $483.49 E) none of the above

Answer: A Difficulty: Moderate Rationale: $1,000/(1.11)27 = $59.74

92. You have just purchased a 12-year zero-coupon bond with a yield to maturity of 9% and a par value of $1,000. What would your rate of return at the end of the year be if you sell the bond? Assume the yield to maturity on the bond is 10% at the time you sell. A) 10.00% B) 20.42% C) -1.4% D) 1.4% E) none of the above

Answer: C Difficulty: Moderate Rationale: $1,000/(1.09)12 = $355.53; $1,000/(1.10)11 = $350.49; ($350.49 - $355.53)/$355.53 = -1.4%.

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93. You have just purchased a 7-year zero-coupon bond with a yield to maturity of 11% and a par value of $1,000. What would your rate of return at the end of the year be if you sell the bond? Assume the yield to maturity on the bond is 9% at the time you sell. A) 10.00% B) 23.8% C) 13.8% D) 1.4% E) none of the above

Answer: B Difficulty: Moderate Rationale: $1,000/(1.11)7 = $481.66; $1,000/(1.09)6 = $596.27; ($596.27 - $481.66)/$481.66 = 23.8%.


Answer: B [email protected]: 22 shares X $42/share = $924.


Answer: A [email protected]: 35 shares X $20/share = $700.

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Answer: B Difficulty: Moderate Rationale: $950 - $880 = $70.


Answer: C Difficulty: Moderate Rationale: $1150 - $975 = $175.

98. If a 7% coupon bond that pays interest every 182 days paid interest 32 days ago, the accrued interest would be A) 5.67 B) 7.35 C) 6.35 D) 6.15 E) 7.12

Answer: D [email protected]: $35*(32/182) = $6.15

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99. If a 7.5% coupon bond that pays interest every 182 days paid interest 62 days ago, the accrued interest would be A) 11.67 B) 12.35 C) 12.77 D) 11.98 E) 12.15

Answer: C [email protected]: $37.5*(62/182) = $12.77

100. If a 9% coupon bond that pays interest every 182 days paid interest 112 days ago, the accrued interest would be A) 27.69 B) 27.35 C) 26.77 D) 27.98 E) 28.15

Answer: A [email protected]: $45*(112/182) = $27.69

101. A 7% coupon bond with an ask price of 100:00 pays interest every 182 days. If the bond paid interest 32 days ago, the invoice price of the bond would be A) 1,005.67 B) 1,007.35 C) 1,006.35 D) 1,006.15 E) 1,007.12

Answer: D [email protected]: $1000 + [35*(32/182)] = $1006.15

102. A 7.5% coupon bond with an ask price of 100:00 pays interest every 182 days. If the bond paid interest 62 days ago, the invoice price of the bond would be A) 1,011.67 B) 1,012.35 C) 1,012.77 D) 1,011.98 E) 1,012.15

Answer: C [email protected]: $1000 + [37.5*(62/182)] = $1012.77

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103. A 9% coupon bond with an ask price of 100:00 pays interest every 182 days. If the bind paid interest 112 days ago, the invoice price of the bond would be A) 1,027.69 B) 1,027.35 C) 1,026.77 D) 1,027.98 E) 1,028.15

Answer: A [email protected]: $1,000 + [45*(112/182)] = $1,027.69


Answer: E Difficulty: Moderate Rationale: The bond price, which is indexed to the inflation rate, becomes $1,000*1.032 = $1,032. The interest payment is based on the coupon rate and the new face value. The interest amount equals $1,032*.05 = $51.60.


Answer: B Difficulty: Moderate Rationale: The bond price, which is indexed to the inflation rate, becomes $1,000*1.036 = $1,036. The interest payment is based on the coupon rate and the new face value. The interest amount equals $1,036*.04 = $41.44.

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109. You purchased a zero-coupon bond that has a face value of $1,000, five years to maturity and a yield to maturity of 7.3%. It is one year later and similar bonds are offering a yield to maturity of 8.1%. You will sell the bond now. You have a tax rate of 40% on regular income and 15% on capital gains. Calculate the following for this bond.• the purchase price of the bond• the current price of the bond• the imputed interest income• the capital gain (or loss) on the bond• the before-tax rate of return on this investment• the after-tax rate of return on this investment

[email protected]

Answer: Calculations are shown in the table below.

Purchase Price of the BondN=5 I=7.3 PMT=0 FV=1000 CPT PV=703.07

Current Price of the BondN=4 I=8.1 PMT=0 FV=1000 CPT PV=732.31

Imputed Interest Income Find price at original YTM

N=4 I=7.3 PMT=0 FV=1000 CPT PV=754.40Change in price at original YTM = imputed interest income= $754.40 - $703.07 = $51.33

Capital Gain (Loss)Change in price due to interest rate change = $732.31-754.40=-$22.09

Note: total change in price=imputed interest income + capital gain (loss)$732.31-703.07=$29.24=$51.33-22.09

Before-tax Rate of Return($732.31-703.07)/$703.07=4.16%

After-tax Rate of Returntax on imputed interest income=$51.33*.4=$20.53tax on capital gain (loss)=-$22.09*.15=-$3.31 (savings due to capital loss)After-tax return=($732.31-703.07-20.53+3.31)/$703.07=1.71%

This question tests the depth of the student's understanding of the concepts and mechanics of zero-coupon bonds.

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1. The duration of a bond is a function of the bond's A) coupon rate. B) yield to maturity. C) time to maturity. D) all of the above. E) none of the above.

Answer: D [email protected]: Duration is calculated by discounting the bond's cash flows at the bond's yield to maturity and, except for zero-coupon bonds, is always less than time to maturity.

2. Ceteris paribus, the duration of a bond is positively correlated with the bond's A) time to maturity. B) coupon rate. C) yield to maturity. D) all of the above. E) none of the above.

Answer: A [email protected]: Duration is negatively correlated with coupon rate and yield to maturity.

3. Holding other factors constant, the interest-rate risk of a coupon bond is higher when the bond's: A) term-to-maturity is lower. B) coupon rate is higher. C) yield to maturity is lower. D) current yield is higher. E) none of the above.

Answer: C [email protected]: The longer the maturity, the greater the interest-rate risk. The lower the coupon rate, the greater the interest-rate risk. The lower the yield to maturity, the greater the interest-rate risk. These concepts are reflected in the duration rules; duration is a measure of bond price sensitivity to interest rate changes (interest-rate risk).

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4. The "modified duration" used by practitioners is equal to the Macaulay duration A) times the change in interest rate. B) times (one plus the bond's yield to maturity). C) divided by (one minus the bond's yield to maturity). D) divided by (one plus the bond's yield to maturity). E) none of the above.

Answer: D [email protected]: D* = D/(1 + y)

5. Given the time to maturity, the duration of a zero-coupon bond is higher when the discount rate is A) higher. B) lower. C) equal to the risk free rate. D) The bond's duration is independent of the discount rate. E) none of the above.

Answer: D [email protected]: The duration of a zero-coupon bond is equal to the maturity of the bond.

6. The interest-rate risk of a bond is A) the risk related to the possibility of bankruptcy of the bond's issuer. B) the risk that arises from the uncertainty of the bond's return caused by changes in

interest rates. C) the unsystematic risk caused by factors unique in the bond. D) A and B above. E) A, B, and C above.

Answer: B [email protected]: Changing interest rates change the bond's return, both in terms of the price of the bond and the reinvestment of coupon payments.

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7. Which of the following two bonds is more price sensitive to changes in interest rates?

1) A par value bond, X, with a 5-year-to-maturity and a 10% coupon rate.2) A zero-coupon bond, Y, with a 5-year-to-maturity and a 10% yield-to-maturity.

A) Bond X because of the higher yield to maturity. B) Bond X because of the longer time to maturity. C) Bond Y because of the longer duration. D) Both have the same sensitivity because both have the same yield to maturity. E) None of the above

Answer: C [email protected]: Duration is the best measure of bond price sensitivity; the longer the duration the higher the price sensitivity.

8. Holding other factors constant, which one of the following bonds has the smallest price volatility? A) 5-year, 0% coupon bond B) 5-year, 12% coupon bond C) 5 year, 14% coupon bond D) 5-year, 10% coupon bond E) Cannot tell from the information given.

Answer: C [email protected]: Duration (and thus price volatility) is lower when the coupon rates are higher.

9. Which of the following is not true? A) Holding other things constant, the duration of a bond increases with time to

maturity. B) Given time to maturity, the duration of a zero-coupon decreases with yield to

maturity. C) Given time to maturity and yield to maturity, the duration of a bond is higher

when the coupon rate is lower. D) Duration is a better measure of price sensitivity to interest rate changes than is

time to maturity. E) All of the above.

Answer: B [email protected]: The duration of a zero-coupon bond is equal to time to maturity, and is independent of yield to maturity.

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10. The duration of a 5-year zero-coupon bond is A) smaller than 5. B) larger than 5. C) equal to 5. D) equal to that of a 5-year 10% coupon bond. E) none of the above.

Answer: C [email protected]: Duration of a zero-coupon bond equals the bond's maturity.

11. The basic purpose of immunization is to A) eliminate default risk. B) produce a zero net interest-rate risk. C) offset price and reinvestment risk. D) A and B. E) B and C.

Answer: E [email protected]: When a portfolio is immunized, price risk and reinvestment risk exactly offset each other resulting in zero net interest-rate risk.

12. The duration of a par value bond with a coupon rate of 8% and a remaining time to maturity of 5 years is A) 5 years. B) 5.4 years. C) 4.17 years. D) 4.31 years. E) none of the above.

Answer: D [email protected]: Calculations are shown below.Yr. CF PV of CF@08% Weight * Yr.1 $80 $80/1.08 = $74.07 0.0741 * 1 = 0.07412 $80 $80/(1.08)2 = $68.59 0.0686 * 2 = 0.13723 $80 $80/(1.08)3 = $63.51 0.0635 * 3 = 0.19054 $80 $80/(1.08)4 = $58.80 0.0588 * 4 = 0.23525 $1,08

0$1,080/(1.08)5 = $735.03 0.7350 * 5 = 3.6750

Sum $1000.00 4.3120 yrs. (duration)

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13. The duration of a perpetuity with a yield of 8% is A) 13.50 years. B) 12.11 years. C) 6.66 years. D) cannot be determined. E) none of the above.

Answer: A [email protected]: D = 1.08/0.08 = 13.50 years.

14. A seven-year par value bond has a coupon rate of 9% and a modified duration of A) 7 years. B) 5.49 years. C) 5.03 years. D) 4.87 years. E) none of the above.

Answer: C Difficulty: Difficult Rationale: Calculations are shown below.

Yr. CF PV of CF@9% Weight * Yr.1 $90 $82.57 0.0826 X 1 = 0.08262 $90 $75.75 0.0758 X 2 = 0.15163 $90 $69.50 0.0695 X 3 = 0.20854 $90 $63.76 0.0638 X 4 = 0.25525 $90 $58.49 0.0585 X 5 = 0.29256 $90 $53.66 0.0537 X 6 = 0.32227 $1,090 $596.26 0.5963 X 7 = 4.1741

Sum $1000.00 5.4867 years (duration)

modified duration = 5.4867 years/1.09 = 5.03 years.

15. Par value bond XYZ has a modified duration of 6. Which one of the following statements regarding the bond is true? A) If the market yield increases by 1% the bond's price will decrease by $60. B) If the market yield increases by 1% the bond's price will increase by $50. C) If the market yield increases by 1% the bond's price will decrease by $50. D) If the market yield increases by 1% the bond's price will increase by $60. E) None of the above.

Answer: A [email protected]: = -D*-$60 = -6(0.01) X $1,000

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16. Which of the following bonds has the longest duration? A) An 8-year maturity, 0% coupon bond. B) An 8-year maturity, 5% coupon bond. C) A 10-year maturity, 5% coupon bond. D) A 10-year maturity, 0% coupon bond. E) Cannot tell from the information given.

Answer: D [email protected]: The longer the maturity and the lower the coupon, the greater the duration

17. Which one of the following par value 12% coupon bonds experiences a price change of $23 when the market yield changes by 50 basis points? A) The bond with a duration of 6 years. B) The bond with a duration of 5 years. C) The bond with a duration of 2.7 years. D) The bond with a duration of 5.15 years. E) None of the above.

Answer: D Difficulty: Difficult Rationale: DP/P = -D X [D(1+y) / (1+y)]; -.023 = -D X [.005 / 1.12]; D = 5.15.

18. Which one of the following statements is true concerning the duration of a perpetuity? A) The duration of 15% yield perpetuity that pays $100 annually is longer than that of

a 15% yield perpetuity that pays $200 annually. B) The duration of a 15% yield perpetuity that pays $100 annually is shorter than that

of a 15% yield perpetuity that pays $200 annually. C) The duration of a 15% yield perpetuity that pays $100 annually is equal to that of

15% yield perpetuity that pays $200 annually. D) the duration of a perpetuity cannot be calculated. E) None of the above.

Answer: C [email protected]: Duration of a perpetuity = (1 + y)/y; thus, the duration of a perpetuity is determined by the yield and is independent of the cash flow.

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19. The two components of interest-rate risk are A) price risk and default risk. B) reinvestment risk and systematic risk. C) call risk and price risk. D) price risk and reinvestment risk. E) none of the above.

Answer: D [email protected]: Default, systematic, and call risks are not part of interest-rate risk. Only price and reinvestment risks are part of interest-rate risk.

20. The duration of a coupon bond A) does not change after the bond is issued. B) can accurately predict the price change of the bond for any interest rate change. C) will decrease as the yield to maturity decreases. D) all of the above are true. E) none of the above is true.

Answer: E [email protected]: Duration changes as interest rates and time to maturity change, can only predict price changes accurately for small interest rate changes, and increases as the yield to maturity decreases.

21. Indexing of bond portfolios is difficult because A) the number of bonds included in the major indexes is so large that it would be

difficult to purchase them in the proper proportions. B) many bonds are thinly traded so it is difficult to purchase them at a fair market

price. C) the composition of bond indexes is constantly changing. D) all of the above are true. E) both A and B are true.

Answer: D [email protected]: All of the above are true statements about bond indexes.

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22. You have an obligation to pay $1,488 in four years and 2 months. In which bond would you invest your $1,000 to accumulate this amount, with relative certainty, even if the yield on the bond declines to 9.5% immediately after you purchase the bond? A) a 6-year; 10% coupon par value bond B) a 5-year; 10% coupon par value bond C) a 5-year; zero-coupon bond D) a 4-year; 10% coupon par value bond E) none of the above

Answer: B Difficulty: Difficult Rationale: When duration = horizon date, one is immunized, or protected, against one interest rate change. The zero has D = 5. Since the other bonds have the same coupon and yield, solve for the closest value of T that gives D = 4.2 years. 4.2 = (1.10))/.10 - [(1.10) + T(.10-.10)] / = 1.1; .68 (1.10) T - .68 + .68 = 1.1; .68 (1.10) T = 1.1; (1.10) T = 1.6176; T [ln (1.10)] = ln (1.6176); T = 5.05 years, so choose the 5-year 10% coupon bond.

23. Duration measures A) weighted average time until a bond's half-life. B) weighted average time until cash flow payment. C) the time required to recoup one's investment, assuming the bond was purchased

for $1,000. D) A and C. E) B and C.

Answer: E [email protected]: B and C are true, as one receives coupon payments throughout the life of the bond (for coupon bonds); thus, duration is less than time to maturity (except for zeros).

24. Duration A) assesses the time element of bonds in terms of both coupon and term to maturity. B) allows structuring a portfolio to avoid interest-rate risk. C) is a direct comparison between bond issues with different levels of risk. D) A and B. E) A and C.

Answer: D [email protected]: Duration is a weighted average of when the cash flows of a bond are received; thus both coupon and time to maturity are considered. If the duration of the portfolio equals the investor's horizon date, the investor is protected against interest rate changes.

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25. Identify the bond that has the longest duration (no calculations necessary). A) 20-year maturity with an 8% coupon. B) 20-year maturity with a 12% coupon. C) 15-year maturity with a 0% coupon. D) 10-year maturity with a 15% coupon. E) 12-year maturity with a 12% coupon.

Answer: C [email protected]: The lower the coupon, the longer the duration. The zero-coupon bond is the ultimate low coupon bond, and thus would have the longest duration.

26. When interest rates decline, the duration of a 10-year bond selling at a premium A) increases. B) decreases. C) remains the same. D) increases at first, then declines. E) decreases at first, then increases.

Answer: A [email protected]: The relationship between interest rates and duration is an inverse one.

27. An 8%, 30-year corporate bond was recently being priced to yield 10%. The Macaulay duration for the bond is 10.20 years. Given this information, the bond's modified duration would be________. A) 8.05 B) 9.44 C) 9.27 D) 11.22 E) none of the above

Answer: C [email protected]: D* = D/(1 + y); D* = 10.2/(1.1) = 9.27

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28. An 8%, 15-year bond has a yield to maturity of 10% and duration of 8.05 years. If the market yield changes by 25 basis points, how much change will there be in the bond's price? A) 1.85% B) 2.01% C) 3.27% D) 6.44% E) none of the above

Answer: A [email protected]: ΔP/P = (-8.05 X 0.0025)/1.1 = 1.85%

29. One way that banks can reduce the duration of their asset portfolios is through the use of A) fixed rate mortgages. B) adjustable rate mortgages. C) certificates of deposit. D) short-term borrowing. E) none of the above.

Answer: B [email protected]: One of the gap management strategies practiced by banks is the issuance of adjustable rate mortgages, which reduce the interest rate sensitivity of their asset portfolios.

30. The duration of a bond normally increases with an increase in A) term to maturity. B) yield to maturity. C) coupon rate. D) all of the above. E) none of the above.

Answer: A [email protected]: The relationship between duration and term to maturity is a direct one; the relationship between duration and yield to maturity and to coupon rate is negative.

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31. Which one of the following is an incorrect statement concerning duration? A) The higher the yield to maturity, the greater the duration B) The higher the coupon, the shorter the duration. C) The difference in duration is small between two bonds with different coupons each

maturing in more than 15 years. D) The duration is the same as term to maturity only in the case of zero-coupon

bonds. E) All of the statements are correct.

Answer: A [email protected]: The relationship between duration and yield to maturity is an inverse one; as is the relationship between duration and coupon rate. The difference in the durations of longer-term bonds of varying coupons (high coupon vs. zero) is considerable. Duration equals term to maturity only with zeros.

32. Immunization is not a strictly passive strategy because A) it requires choosing an asset portfolio that matches an index. B) there is likely to be a gap between the values of assets and liabilities in most

portfolios. C) it requires frequent rebalancing as maturities and interest rates change. D) durations of assets and liabilities fall at the same rate. E) none of the above.

Answer: C [email protected]: As time passes the durations of assets and liabilities fall at different rates, requiring portfolio rebalancing. Further, every change in interest rates creates changes in the durations of portfolio assets and liabilities.

33. Contingent immunization A) is a mixed-active passive bond portfolio management strategy. B) is a strategy whereby the portfolio may or may not be immunized. C) is a strategy whereby if and when some trigger point value of the portfolio is

reached, the portfolio is immunized to insure an minimum required return. D) A and B. E) A, B, and C.

Answer: E [email protected]: Contingent immunization insures a minimum average rate of return over time by immunizing the portfolio if and when the value of the portfolio reaches the trigger point required to insure that rate of return. Thus, the strategy is a combination active/passive strategy; but the portfolio will be immunized only if necessary.

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34. Some of the problems with immunization are A) duration assumes that the yield curve is flat. B) duration assumes that if shifts in the yield curve occur, these shifts are parallel. C) immunization is valid for one interest rate change only. D) durations and horizon dates change by the same amounts with the passage of time. E) A, B, and C.

Answer: E [email protected]: Durations and horizon dates change with the passage of time, but not by the same amounts.

35. If a bond portfolio manager believes A) in market efficiency, he or she is likely to be a passive portfolio manager. B) that he or she can accurately predict interest rate changes, he or she is likely to be

an active portfolio manager. C) that he or she can identify bond market anomalies, he or she is likely to be a

passive portfolio manager. D) A and B. E) A, B, and C.

Answer: D [email protected]: If one believes that one can predict bond market anomalies, one is likely to be an active portfolio manager.

36. According to experts, most pension funds are underfunded because A) their liabilities are of shorter duration than their assets. B) their assets are of shorter duration than their liabilities. C) they continually adjust the duration of their liabilities. D) they continually adjust the duration of their assets. E) they are too heavily invested in stocks.


37. Cash flow matching on a multiperiod basis is referred to as a A) immunization. B) contingent immunization. C) dedication. D) duration matching. E) rebalancing.

Answer: C [email protected]: Cash flow matching on a multiperiod basis is referred to as a dedication strategy.

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38. Immunization through duration matching of assets and liabilities may be ineffective or inappropriate because A) conventional duration strategies assume a flat yield curve. B) duration matching can only immunize portfolios from parallel shifts in the yield

curve. C) immunization only protects the nominal value of terminal liabilities and does not

allow for inflation adjustment. D) both A and C are true. E) all of the above are true.

Answer: E [email protected]: All of the above are correct statements about the limitations of immunization through duration matching.

39. The curvature of the price-yield curve for a given bond is referred to as the bond's A) modified duration. B) immunization. C) sensitivity. D) convexity. E) tangency.

Answer: D [email protected]: Convexity measures the rate of change of the slope of the price-yield curve, expressed as a fraction of the bond's price.

40. Consider a bond selling at par with modified duration of 10.6 years and convexity of 210. A 2 percent decrease in yield would cause the price to increase by 21.2%, according to the duration rule. What would be the percentage price change according to the duration-with-convexity rule? A) 21.2% B) 25.4% C) 17.0% D) 10.6% E) none of the above.

Answer: B Difficulty: Difficult Rationale: ∆ P/P = -D*∆ y + (1/2) * Convexity * (∆ y)2; = -10.6 * -.02 + (1/2) * 210 * (.02)2 = .212 + .042 = .254 (25.4%)

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41. A substitution swap is an exchange of bonds undertaken to A) change the credit risk of a portfolio. B) extend the duration of a portfolio. C) reduce the duration of a portfolio. D) profit from apparent mispricing between two bonds. E) adjust for differences in the yield spread.

Answer: D [email protected]: A substitution swap is an example of bond price arbitrage, undertaken when the portfolio manager attempts to profit from apparent mispricing.

42. A rate anticipation swap is an exchange of bonds undertaken to A) shift portfolio duration in response to an anticipated change in interest rates. B) shift between corporate and government bonds when the yield spread is out of line

with historical values. C) profit from apparent mispricing between two bonds. D) change the credit risk of the portfolio. E) increase return by shifting into higher yield bonds.

Answer: A [email protected]: A rate anticipation swap is pegged to interest rate forecasting, and involves increasing duration when rates are expected to fall and vice-versa.

43. An analyst who selects a particular holding period and predicts the yield curve at the end of that holding period is engaging in A) a rate anticipation swap. B) immunization. C) horizon analysis. D) an intermarket spread swap. E) none of the above.

Answer: C [email protected]: Horizon analysis involves selecting a particular holding period and predicting the yield curve at the end of that holding period. The holding period return for the bond can then be predicted.

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44. The process of unbundling and repackaging the cash flows from one or more bonds into new securities is called A) speculation. B) immunization. C) reverse hedging. D) interest rate arbitrage. E) financial engineering.

Answer: E [email protected]: The process of financial engineering in the bond market creates derivative securities with different durations and interest rate sensitivities.

45. An active investment strategy A) implies that market prices are fairly set. B) attempts to achieve returns greater than those commensurate with the risk borne. C) attempts to achieve the proper return that is commensurate with the risk borne. D) requires portfolio managers, while a passive investment strategy does not. E) occurs when bond portfolio managers are hyperactive.

Answer: B [email protected]: An active strategy implies that there are mispricings in the markets, which can be exploited to earn superior returns.

46. Interest-rate risk is important to A) active bond portfolio managers. B) passive bond portfolio managers. C) both active and passive bond portfolio managers. D) neither active nor passive bond portfolio managers. E) obsessive bond portfolio managers.

Answer: C [email protected]: Active managers try to identify interest rate trends so they can move in the right direction before the changes. Passive managers try to minimize interest-rate risk by offsetting it with price changes in strategies such as immunization.

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47. Which of the following are true about the interest-rate sensitivity of bonds?

I) Bond prices and yields are inversely related.II) Prices of long-term bonds tend to be more sensitive to interest rate

changes than prices of short-term bonds.III) Interest-rate risk is directly related to the bond's coupon rate.IV) The sensitivity of a bond's price to a change in its yield to maturity is

inversely related to the yield to maturity at which the bond is currently selling.

A) I and II B) I and III C) I, II, and IV D) II, III, and IV E) I, II, III, and IV

Answer: C [email protected]: Number III is incorrect because interest-rate risk is inversely related to the bond's coupon rate.

48. Which of the following researchers have contributed significantly to bond portfolio management theory?

I) Sidney HomerII) Harry MarkowitzIII) Burton MalkielIV) Martin LiebowitzV) Frederick Macaulay

A) I and II B) III and V C) III, IV, and V D) I, III, IV, and V E) I, II, III, IV, and V

Answer: D [email protected]: Harry Markowitz developed the mean-variance criterion but not a theory of bond portfolio management.

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49. According to the duration concept A) only coupon payments matter. B) only maturity value matters. C) the coupon payments made prior to maturity make the effective maturity of the

bond greater than its actual time to maturity. D) the coupon payments made prior to maturity make the effective maturity of the

bond less than its actual time to maturity. E) discount rates don't matter.

Answer: D [email protected]: Duration considers that some of the cash flows are received prior to maturity and this effectively makes the maturity less than the actual time to maturity.

50. Duration is important in bond portfolio management because

I) it can be used in immunization strategies.II) it provides a gauge of the effective average maturity of the portfolio.III) it is related to the interest rate sensitivity of the portfolio.IV) it is a good predictor of interest rate changes.

A) I and II B) I and III C) III and IV D) I, II, and III E) I, II, III, and IV

Answer: D [email protected]: Duration can be used to calculate the approximate effect of interest rate changes on prices, but is not used to forecast interest rates.

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51. Two bonds are selling at par value and each has 17 years to maturity. The first bond has a coupon rate of 6% and the second bond has a coupon rate of 13%. Which of the following is true about the durations of these bonds? A) The duration of the higher-coupon bond will be higher. B) The duration of the lower-coupon bond will be higher. C) The duration of the higher-coupon bond will equal the duration of the lower-

coupon bond. D) There is no consistent statement that can be made about the durations of the bonds. E) The bond's durations cannot be determined without knowing the prices of the

bonds.

Answer: B Difficulty: Difficult Rationale: In general, duration is negatively related to coupon rate. The greater the cash flows from coupon interest, the lower the duration will be. Since the bonds have the same time to maturity, that isn't a factor. The duration of the 6% coupon bond equals (1.06/.06)*(1-(1/1.0617)) = 11.10. The duration of the 13% coupon bond equals (1.13/.13)*(1-(1/1.1317)) = 7.60.

52. Which of the following offers a bond index? A) Merrill Lynch B) Salomon Smith Barney C) Lehman D) All of the above E) All but Merrill Lynch

Answer: D [email protected]: All of these are mentioned in the text's discussion of bond indexes.

53. Which of the following two bonds is more price sensitive to changes in interest rates?1) A par value bond, A, with a 12-year-to-maturity and a 12% coupon rate.2) A zero-coupon bond, B, with a 12-year-to-maturity and a 12% yield-to-maturity. A) Bond A because of the higher yield to maturity. B) Bond A because of the longer time to maturity. C) Bond B because of the longer duration. D) Both have the same sensitivity because both have the same yield to maturity. E) None of the above

Answer: C [email protected]: Duration is the best measure of bond price sensitivity; the longer the duration the higher the price sensitivity.

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54. Which of the following two bonds is more price sensitive to changes in interest rates?

1) A par value bond, D, with a 2-year-to-maturity and a 8% coupon rate.2) A zero-coupon bond, E, with a 2-year-to-maturity and a 8% yield-to-maturity.

A) Bond D because of the higher yield to maturity. B) Bond E because of the longer duration C) Bond D because of the longer time to maturity. D) Both have the same sensitivity because both have the same yield to maturity. E) None of the above

Answer: B [email protected]: Duration is the best measure of bond price sensitivity; the longer the duration the higher the price sensitivity.


Answer: C [email protected]: Duration (and thus price volatility) is lower when the coupon rates are higher.


Answer: D [email protected]: Duration (and thus price volatility) is lower when the coupon rates are higher.

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57. The duration of a 15-year zero-coupon bond is A) smaller than 15. B) larger than 15. C) equal to 15. D) equal to that of a 15-year 10% coupon bond E) none of the above.

Answer: C [email protected]: Duration of a zero-coupon bonds equals the bond's maturity.

58. The duration of a 20-year zero-coupon bond is A) equal to smaller than 20. B) larger than 20. C) smaller than 20. D) equal to that of a 20-year 10% coupon bond E) none of the above.

Answer: A [email protected]: Duration of a zero-coupon bonds equals the bond's maturity.

59. The duration of a perpetuity with a yield of 10% is A) 13.50 years. B) 11 years. C) 6.66 years. D) cannot be determined. E) none of the above.

Answer: B [email protected]: D = 1.10/0.10 = 11 years.

60. The duration of a perpetuity with a yield of 6% is A) 13.50 years. B) 12.11 years. C) 17.67 years. D) cannot be determined. E) none of the above.

Answer: C [email protected]: D = 1.06/0.06 = 17.67 years.

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61. Par value bond F has a modified duration of 9. Which one of the following statements regarding the bond is true? A) If the market yield increases by 1% the bond's price will decrease by $90. B) If the market yield increases by 1% the bond's price will increase by $90. C) If the market yield increases by 1% the bond's price will decrease by $60. D) If the market yield decreases by 1% the bond's price will increase by $60. E) None of the above.

Answer: A [email protected]: ΔP/P = -D*Δy; -$90 = -9(0.01) X $1,000

62. Par value bond GE has a modified duration of 11. Which one of the following statements regarding the bond is true? A) If the market yield increases by 1% the bond's price will decrease by $55. B) If the market yield increases by 1% the bond's price will increase by $55. C) If the market yield increases by 1% the bond's price will decrease by $110. D) If the market yield increases by 1% the bond's price will increase by $110. E) None of the above.

Answer: C [email protected]: ΔP/P = -D*Δy; -$110 = -11(0.01) X $1,000

63. Which of the following bonds has the longest duration? A) A 15-year maturity, 0% coupon bond. B) A 15-year maturity, 9% coupon bond. C) A 20-year maturity, 9% coupon bond. D) A 20-year maturity, 0% coupon bond. E) Cannot tell from the information given.

Answer: D [email protected]: The longer the maturity and the lower the coupon, the greater the duration

64. Which of the following bonds has the longest duration? A) A 12-year maturity, 0% coupon bond. B) A 12-year maturity, 8% coupon bond. C) A 4-year maturity, 8% coupon bond. D) A 4-year maturity, 0% coupon bond. E) Cannot tell from the information given.

Answer: A [email protected]: The longer the maturity and the lower the coupon, the greater the duration

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65. A 10%, 30-year corporate bond was recently being priced to yield 12%. The Macaulay duration for the bond is 11.3 years. Given this information, the bond's modified duration would be A) 8.05 B) 10.09 C) 9.27 D) 11.22 E) none of the above

Answer: B [email protected]: D* = D/(1 + y); D* = 11.3/(1.12) = 10.09

66. A 6%, 30-year corporate bond was recently being priced to yield 8%. The Macaulay duration for the bond is 8.4 years. Given this information, the bond's modified duration would be A) 8.05 B) 9.44 C) 9.27 D) 7.78 E) none of the above

Answer: D [email protected]: D* = D/(1 + y); D* = 8.4/(1.08) = 7.78

67. A 9%, 16-year bond has a yield to maturity of 11% and duration of 9.25 years. If the market yield changes by 32 basis points, how much change will there be in the bond's price? A) 1.85% B) 2.01% C) 2.67% D) 6.44% E) none of the above

Answer: C [email protected]: ΔP/P = (-9.25 X 0.0032)/1.11 = 2.67%

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68. A 7%, 14-year bond has a yield to maturity of 6% and duration of 7 years. If the market yield changes by 44 basis points, how much change will there be in the bond's price? A) 1.85% B) 2.91% C) 3.27% D) 6.44% E) none of the above

Answer: B [email protected]: ΔP/P = (-7 X 0.0044)/1.06 = 2.91%

69. Consider a bond selling at par with modified duration of 12 years and convexity of 265. A 1 percent decrease in yield would cause the price to increase by 12%, according to the duration rule. What would be the percentage price change according to the duration-with-convexity rule? A) 21.2% B) 25.4% C) 17.0% D) 13.3% E) none of the above.

Answer: D Difficulty: Difficult Rationale: ∆ P/P = -D*∆ y + (1/2) * Convexity * (∆ y)2; = -12 * -.01 + (1/2) * 265 * (.01)2 = .12 + .01325 = .13325 or (13.3%)

70. Consider a bond selling at par with modified duration of 22-years and convexity of 415. A 2 percent decrease in yield would cause the price to increase by 44%, according to the duration rule. What would be the percentage price change according to the duration-with-convexity rule? A) 21.2% B) 25.4% C) 17.0% D) 52.3% E) none of the above.

Answer: D Difficulty: Difficult Rationale: ∆ P/P = -D*∆ y + (1/2) * Convexity * (∆ y)2; = -22 * -.02 + (1/2) * 415* (.02)2 = .44 + .083 = .523 or (52.3%)

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71. The duration of a par value bond with a coupon rate of 6.5% and a remaining time to maturity of 4 years is A) 3.65 years. B) 3.45 years. C) 3.85 years. D) 4.00 years. E) none of the above.

Answer: A [email protected]: Calculations are shown below.

Yr. CF PV of [email protected]% Weight * Yr.1 $65 $65/1.065 = $61.03 0.0610 * 1 = 0.06102 $65 $65/(1.065)2 = $57.31 0.0573 * 2 = 0.11463 $65 $65/(1.065)3 = $53.81 0.0538 * 3 = 0.16144 $1,06

5$1,065/(1.065)4 = $827.85 0.8279 * 4 = 3.3116


72. The duration of a par value bond with a coupon rate of 7% and a remaining time to maturity of 3 years is A) 3 years. B) 2.71years. C) 2.81 years. D) 2.91 years. E) none of the above.

Answer: C [email protected]: Calculations are shown below.

Yr. CF PV of CF@7% Weight * Yr.1 $70 $70/1.07 = $65.42 0.0654 * 1 = 0.06542 $70 $70/(1.07)2 = $61.14 0.0611 * 2 = 0.12223 $1,07

0$1,070/(1.07)3 = $873.44 0.8734 * 3 = 2.6202


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73. The duration of a par value bond with a coupon rate of 8.7% and a remaining time to maturity of 6 years is A) 6.0 years. B) 5.1 years. C) 4.27 years. D) 3.95 years. E) none of the above.

Answer: D [email protected]: Calculations are shown below.

Yr. CF PV of [email protected]% Weight * Yr.1 $87 $87/1.087 = $80.04 0.0804 * 1 = 0.08042 $87 $87/(1.087)2 = $73.63 0.0736 * 2 = 0.14723 $87 $87/(1.087)3 = $67.74 0.0677 * 3 = 0.20314 $87 $87/(1.087)4 = $62.32 0.0623 * 4 = 0.24925 $87 $87/(1.087)5 = $57.33 0.0573 * 5 = 0.28656 1,08

71,087/(1.087)6 = $658.95 0.6590 * 6 = 3.9540


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32170621 financial management quiz

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