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1. Inanswering this question, one assumes that the young person has a steady job,adequate insurance coverage, and sufficient cash reserves. The young individualis in the accumulation phase of the investment life cycle. During this phase,an individual should consider moderately high-risk investments, such as commonstocks, because he/she has a long investment horizon and much earnings abilityover time.
2. Inanswering this question, one assumes that the 63-year-old individual hasadequate insurance coverage and a cash reserve. Depending on her income fromsocial security, she may need some current income from her retirement portfolioto meet living expenses. At the sametime, she will need to protect herself against inflation. Removing money fromher company’s retirement plan and investing it in money market funds and bondfunds would satisfy the investor’s short-term and income needs. But some long-terminvestments, such as common stock mutual funds, are needed to provide theinvestor with needed inflation protection.
3. Typicallyinvestment strategies change during an individual’s lifetime. In theaccumulating phase, the individual is accumulating net worth to satisfyshort-term needs (e.g., house and car purchases) and long-term goals (e.g.,retirement and children's college needs). In this phase, the individual iswilling to invest in moderately high-risk investments in order to achieveabove-average rates of return.
In the consolidating phase, aninvestor has paid off many outstanding debts and typically has earnings thatexceed expenses. In this phase, the investor is becoming more concerned withlong-term needs of retirement or estate planning. Although the investor iswilling to accept moderate portfolio risk, he/she is not willing to jeopardizethe “nest egg.”
In the spending phase, the typical investor is retired or semi-retired.This investor wishes to protect the nominal value of his/her savings, but atthe same time must make some investments for inflation protection.
The gifting phase is oftenconcurrent with the spending phase. The individual believes that the portfoliowill provide sufficient income to meet expenses, plus a reserve foruncertainties. If an investor believes there are excess amounts available inthe portfolio, he/she may decide to make “gifts” to family or friends,institute charitable trusts, or establish trusts to minimize estate taxes.
4.A policy statement is importantfor both the investor and the investment advisor. A policy statement assiststhe investor in establishing realistic investment goals, as well as providing abenchmark by which a portfolio manager’s performance may be measured.
5. Student Exercise
6. The45-year old uncle and 35-year old sister differ in terms of time horizon. However, each has some time before retirement(20 versus 30 years). Each should have a substantial proportion of his/herportfolio invested in equities, with the 35-year old sister possibly havingmore equity investments in small firms or international firms (i.e., cantolerate greater portfolio risk). These investors could also differ in currentliquidity needs (such as children, education expenses, etc.), tax concerns,and/or other unique needs or preferences.
7. Beforeconstructing an investment policy statement, the financial planner needs toclarify the client’s investment objectives (e.g. capital preservation, capitalappreciation, current income or total return) and constraints (e.g. liquidityneeds, time horizon, tax factors, legal and regulatory constraints, and uniqueneeds and preferences). Data on current investments, portfolio returns, andsavings plans (future additions to the portfolio) are helpful, too.
8. Student Exercise
9.CFA Examination III (1993)
9(a). At this point we know (or can reasonablyinfer) that Mr. Franklin is:
·childless
·in good health
·possessed of a large amount of(relatively) liquid wealth intending to leave his estate to a tax-exempt medicalresearch foundation, to whom he is also giving a large current cash gift
·free of debt (not explicitlystated, but neither is the opposite)
·in the highest tax brackets(not explicitly stated, but apparent)
·not skilled in the managementof a large investment portfolio, but also not a complete novice since he ownedsignificant assets of his own prior to his wife’s death
·not burdened by large orspecific needs for current income
·not in need of large orspecific amounts of current liquidity
Taking this knowledge into account,his Investment Policy Statement will reflect these specifics:
Objectives:
Return Requirements: The incidental throw-off of income from Mr. Franklin’s large asset poolshould provide a more than sufficient flow of net spendable income. If not,such a need can easily be met by minor portfolio adjustments. Thus, aninflation-adjusted enhancement of the capital base for the benefit of thefoundation will be the primary return goal (i.e., real growth of capital). Taxminimization will be a continuing collateral goal.
Risk Tolerance: Account circumstances and the long-term return goal suggest that theportfolio can take somewhat above average risk. Mr. Franklin is acquainted withthe nature of investment risk from his prior ownership of stocks and bonds, hehas a still long actuarial life expectancy and is in good current health, andhis heir - the foundation, thanks to his generosity - is already possessed of alarge asset base.
Constraints:
Time Horizon: Even disregarding Mr. Franklin’s still-long actuarial life expectancy,the horizon is long-term because the remainder of his estate, the foundation,has a virtually perpetual life span.
Liquidity Requirement: Given what we know and theexpectation of an ongoing income stream of considerable size, no liquidityneeds that would require specific funding appear to exist.
Taxes: Mr. Franklin is no doubt in the highest tax brackets, and investmentactions should take that fact into account on a continuing basis. Appropriatetax-sheltered investment (standing on their own merits as investments) shouldbe considered. Tax minimization will be a specific investment goal.
Legal and Regulatory: Investments, if under the supervision of an investment management firm(i.e., not managed by Mr. Franklin himself) will be governed by state law andthe Prudent Person rule.
Unique Circumstances: The large asset total, the foundation as their ultimate recipient, andthe great freedom of action enjoyed in this situation (i.e., freedom fromconfining considerations) are important in this situation, if not necessarilyunique.
9(b). Given that stocks have provided (and areexpected to continue to provide) higher risk-adjusted returns than either bondsor cash, and considering that the return goal is for long-term,inflation-protected growth of the capital base, stocks will be allotted themajority position in the portfolio. This is also consistent with Mr. Franklin’sabsence of either specific current income needs (the ongoing cash flow shouldprovide an adequate level for current spending) or specific liquidity needs. Itis likely that income will accumulate to some extent and, if so, willautomatically build a liquid emergency fund for Mr. Franklin as time passes.
Since theinherited warehouse and the personal residence are significant (15%) realestate assets already owned by Mr. Franklin, no further allocation to thisasset class is made. It should be noted that the warehouse is a source of cashflow, a diversifying asset and, probably, a modest inflation hedge. For taxreasons, Mr. Franklin may wish to consider putting some debt on this asset,freeing additional cash for alternative investment use.
Giventhe long-term orientation and the above-average risk tolerance in thissituation, about 70% of total assets can be allocated to equities (includingreal estate) and about 30% to fixed income assets. International securitieswill be included in both areas, primarily for their diversification benefits.Municipal bonds will be included in the fixed income area to minimize incometaxes. There is no need to press for yield in this situation, nor any need todeliberately downgrade the quality of the issues utilized. Venture capitalinvestment can be considered, but any commitment to this (or other“alternative” assets) should be kept small.
The following is one exampleof an appropriate allocation that is consistent with the Investment PolicyStatement and consistent with the historical and expected return and othercharacteristics of the various available asset classes:
Current
Cash/MoneyMarket 0 - 5 0
Non-U.S. Fixed Income 5– 15 10
(Small Cap) 15 – 25 15
Real Estate 10– 15 15*
100
*Includesthe Franklinresidence and warehouse, which together comprise the proportion of total assetsshown.
CHAPTER 2
1. Mostexperts recommend that about 6 month’s worth of living expenses be held in cashreserves. Although these funds are identified as “cash,” it is recommended thatthey be invested in instruments that can easily be converted to cash withlittle chance of loss in value (e.g., money market mutual funds, etc.).
Most experts recommend that an individual should carry life insuranceequal to 7-10 times an individual’s annual salary but final determination needsto include the expected expenses and need’s facing one’s dependents over theirlifetime.. An unmarried individual may not need coverage but should considerpurchasing some insurance while they are “insurable.” A married individual with two children shoulddefinitely have coverage (possibly 9-10 times salary as a starting point, to berefined after consider living expenses of loved ones, desire to provide forcollege education of children, and so on).
$10,000 invested at 8.50percent (assuming annual compounding)
in 5 years: $10,000(FVIF @ 8.50%) = $15,037
in 20 years: $10,000(FVIF@ 8.50%) = $51,120
6. With inflation growing at 3% annually, the above figures need to bedeflated by the following factors:
in 10 years: (1.03)5 = 1.3439
The real values of the answers from 4(a) are: $10,000 invested in 9percent tax-exempt IRA (assuming annual compounding)
in 5 years: $15,386/1.1593 = $13,271.80
in 20 years: $56,044/1.8061 = $31,030.40
The real values of the answers from 5(a) are: $10,000 invested in 10percent tax-exempt IRA (assuming annual compounding)
in 5 years: $16,105/ 1.1593= $13,892.00
in 20 years: $67,275/1.8061 = $37,248.77
Corrections to Solutions Manual PowerPoint Slides Test Bank
1.CHAPTER 1—THE INVESTMENT SETTING Question TF #1 The rate of exchange between certain future dollars and certain current dollarsis known as the pure rate of interest.
2.CHAPTER 1—THE INVESTMENT SETTING Question TF #2 An investment is the current commitment of dollars over time to derive futurepayments to compensate the investor for the time funds are committed, theexpected rate of inflation and the uncertainty of future payments.
3.CHAPTER 1—THE INVESTMENT SETTING Question TF #3 The holding period return (HPR) is equal to the holding period yield (HPY)stated as a percentage.
4.CHAPTER 1—THE INVESTMENT SETTING Question TF #4 The geometric mean of a series of returns is always larger than the arithmeticmean and the difference increases with the volatility of the series.
5.CHAPTER 1—THE INVESTMENT SETTING Question TF #5 The expected return is the average of all possible returns.
6.CHAPTER 1—THE INVESTMENT SETTING Question TF #6 Two measures of the risk premium are the standard deviation and the variance.
7.CHAPTER 1—THE INVESTMENT SETTING Question TF #7 The variance of expected returns is equal to the square root of the expectedreturns.
8.CHAPTER 1—THE INVESTMENT SETTING Question TF #8 The coefficient of variation is the expected return divided by the standarddeviation of the expected return.
9.CHAPTER 1—THE INVESTMENT SETTING Question TF #9 Nominal rates are averages of all possible real rates.
10.CHAPTER 1—THE INVESTMENT SETTING Question TF #10 The risk premium is a function of the volatility of operating earnings, salesvolatility and inflation.
11.CHAPTER 1—THE INVESTMENT SETTING Question TF #11 An individual who selects the investment that offers greater certainty wheneverything else is the same is known as a risk averse investor.
12.CHAPTER 1—THE INVESTMENT SETTING Question TF #12 Investors are willing to forgo current consumption in order to increase futureconsumption for a nominal rate of interest.
13.CHAPTER 1—THE INVESTMENT SETTING Question TF #13 The two most common calculations investors use to measure return performanceare arithmetic means and geometric means.
14.CHAPTER 1—THE INVESTMENT SETTING Question TF #14 The arithmetic mean is a superior measure of the long-term performance becauseit indicates the compound annual rate of return based on the ending value ofthe investment versus its beginning value.
15. CHAPTER 1—THEINVESTMENT SETTING Question MC #1 The basic trade-off in the investment process is
*a. between the anticipated rate of return for a given investmentinstrument and its degree of risk. b. between understanding the nature of a particular investment and having theopportunity to purchase it. c. between high returns available on single instruments and the diversificationof instruments into a portfolio. d. between the desired level of investment and possessing the resourcesnecessary to carry it out. e. None of the above.
16. CHAPTER 1—THEINVESTMENT SETTING Question MC #2 The rate of exchange between future consumption and current consumption is
a. The nominal risk-free rate. b. The coefficient of investment exchange. *c. The pure rate of interest. d. The consumption/investment paradigm. e. The expected rate of return.
17. CHAPTER 1—THEINVESTMENT SETTING Question MC #3 The ____ the variance of returns, everything else remaining constant, the ____the dispersion of expectations and the ____ the risk.
a. Larger, greater, lower b. Larger, smaller, higher *c. Larger, greater, higher d. Smaller, greater, lower e. Smaller, greater, greater
18. CHAPTER 1—THEINVESTMENT SETTING Question MC #4 The coefficient of variation is a measure of
a. Central tendency. b. Absolute variability. c. Absolute dispersion. *d. Relative variability. e. Relative return.
19. CHAPTER 1—THEINVESTMENT SETTING Question MC #5 The nominal risk free rate of interest is a function of
a. The real risk free rate and the investment's variance. b. The prime rate and the rate of inflation. c. The T-bill rate plus the inflation rate. d. The tax free rate plus the rate of inflation. *e. The real risk free rate and the rate of inflation.
20. CHAPTER 1—THEINVESTMENT SETTING Question MC #6 In the phrase 'nominal risk free rate,' nominal means
a. Computed. b. Historical. *c. Market. d. Average. e. Risk adverse.
21. CHAPTER 1—THEINVESTMENT SETTING Question MC #7 If a significant change is noted in the yield of a T-bill, the change is mostlikely attributable to
a. A downturn in the economy. b. A static economy. *c. A change in the expected rate of inflation. d. A change in the real rate of interest. e. A change in risk aversion.
22. CHAPTER 1—THEINVESTMENT SETTING Question MC #8 The real risk-free rate is affected by a two factors;
a. The relative ease or tightness in capital markets and the expectedrate of inflation. b. The expected rate of inflation and the set of investment opportunitiesavailable in the economy. c. The relative ease or tightness in capital markets and the set of investmentopportunities available in the economy. d. Time preference for income consumption and the relative ease or tightness incapital markets. *e. Time preference for income consumption and the set of investmentopportunities available in the economy.
23. CHAPTER 1—THEINVESTMENT SETTING Question MC #9 Which of the following is not acomponent of the risk premium?
a. Business risk b. Financial risk c. Liquidity risk d. Exchange rate risk *e. Unsystematic market risk
24. CHAPTER 1—THEINVESTMENT SETTING Question MC #10 The ability to sell an asset quickly at a fair price is associated with
a. Business risk. *b. Liquidity risk. c. Exchange rate risk. d. Financial risk. e. Market risk.
25. CHAPTER 1—THEINVESTMENT SETTING Question MC #11 The variability of operating earnings is associated with
*a. Business risk. b. Liquidity risk. c. Exchange rate risk. d. Financial risk. e. Market risk.
26. CHAPTER 1—THEINVESTMENT SETTING Question MC #12 The uncertainty of investment returns associated with how a firm finances itsinvestments is known as
a. Business risk. b. Liquidity risk. c. Exchange rate risk. *d. Financial risk. e. Market risk.
27. CHAPTER 1—THEINVESTMENT SETTING Question MC #13 What will happen to the security market line (SML) if the following eventsoccur, other things constant: (1) inflation expectations increase, and (2)investors become more risk averse?
a. Shift up and keep the same slope b. Shift up and have less slope *c. Shift up and have a steeper slope d. Shift down and keep the same slope e. Shift down and have less slope
28. CHAPTER 1—THEINVESTMENT SETTING Question MC #14 A decrease in the market risk premium, all other things constant, will causethe security market line to
a. Shift up b. Shift down c. Have a steeper slope *d. Have a flatter slope e. Remain unchanged
29. CHAPTER 1—THEINVESTMENT SETTING Question MC #15 A decrease in the expected real growth in the economy, all other thingsconstant, will cause the security market line to
a. Shift up *b. Shift down c. Have a steeper slope d. Have a flatter slope e. Remain unchanged
30. CHAPTER 1—THEINVESTMENT SETTING Question MC #16 Unsystematic risk refers to risk that is
a. Undiversifiable *b. Diversifiable c. Due to fundamental risk factors d. Due to market risk e. None of the above
31. CHAPTER 1—THEINVESTMENT SETTING Question MC #17 The security market line (SML) graphs the expected relationship between
a. Business risk and financial risk b. Systematic risk and unsystematic risk *c. Risk and return d. Systematic risk and unsystematic return e. None of the above
32. CHAPTER 1—THEINVESTMENT SETTING Question MC #18 Two factors that influence the nominal risk-free rate are;
*a. The relative ease or tightness in capital markets and the expectedrate of inflation. b. The expected rate of inflation and the set of investment opportunitiesavailable in the economy. c. The relative ease or tightness in capital markets and the set of investmentopportunities available in the economy. d. Time preference for income consumption and the relative ease or tightness incapital markets. e. Time preference for income consumption and the set of investmentopportunities available in the economy.
33. CHAPTER 1—THEINVESTMENT SETTING Question MC #19 Measures of risk for an investment include
a. Variance of returns and business risk b. Coefficient of variation of returns and financial risk c. Business risk and financial risk *d. Variance of returns and coefficient of variation of returns e. All of the above
34. CHAPTER 1—THEINVESTMENT SETTING Question MC #20 Sources of risk for an investment include
a. Variance of returns and business risk b. Coefficient of variation of returns and financial risk *c. Business risk and financial risk d. Variance of returns and coefficient of variation of returns e. All of the above
35. CHAPTER 1—THEINVESTMENT SETTING Question MC #21 Modern portfolio theory assumes that most investors are
*a. Risk averse b. Risk neutral c. Risk seekers d. Risk tolerant e. None of the above
36. CHAPTER 1—THEINVESTMENT SETTING Question MC #22 Which of the following is not a component of the required rate of return?
a. Expected rate of inflation b. Time value of money c. Risk *d. Holding period return e. All of the above are components of the required rate of return
37. CHAPTER 1—THEINVESTMENT SETTING Question MC #23 All of the following are major sources of uncertainty EXCEPT
a. Business risk b. Financial risk *c. Default risk d. Country risk e. Liquidity risk
38. CHAPTER 1—THEINVESTMENT SETTING Question MC #24 The total risk for a security can be measured by its
a. Beta with the market portfolio b. Systematic risk *c. Standard deviation of returns d. Unsystematic risk e. Alpha with the market portfolio
39. CHAPTER 1—THEINVESTMENT SETTING Question MC #25 The increase in yield spreads in late 2008 and early 2009 indicated that
a. Credit risk premiums decreased *b. Market risk premiums increased c. Investors are more confident of the future cash flows of bonds d. Non-investment grade bonds are less risky e. Government bonds are no longer a risk free investment
40. CHAPTER 1—THEINVESTMENT SETTING Question MC #26 Which of the following is least likelyto move a firm's position to the right on the Security Market Line (SML)?
a. An increase in the firm's beta b. Adding more financial debt to the firm's balance sheet relative to equity c. Changing the business strategy to include new product lines with morevolatile expected cash flows d. Investors perceive the stock as being more risky *e. An increase in the risk-free required rate of return.
41. CHAPTER 1—THEINVESTMENT SETTING Question MC #27 Exhibit 1.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Assume you bought 100 shares of NewTech common stock on January 15, 2003 at$50.00 per share and sold it on January 15, 2004 for $40.00 per share. Refer to Exhibit 1.1. What was your holding period return?
42. CHAPTER 1—THEINVESTMENT SETTING Question MC #28 Exhibit 1.1 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Assume you bought 100 shares of NewTech common stock on January 15, 2003 at$50.00 per share and sold it on January 15, 2004 for $40.00 per share. Refer to Exhibit 1.1. What was your holding period yield?
43. CHAPTER 1—THE INVESTMENTSETTING Question MC #29 Exhibit 1.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Suppose you bought a GM corporate bond on January 25, 2001 for $750, on January25, 2004 sold it for $650.00. Refer to Exhibit 1.2. What was your annual holding period return?
44. CHAPTER 1—THEINVESTMENT SETTING Question MC #30 Exhibit 1.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Suppose you bought a GM corporate bond on January 25, 2001 for $750, on January25, 2004 sold it for $650.00. Refer to Exhibit 1.2. What was your annual holding period yield?
45. CHAPTER 1—THEINVESTMENT SETTING Question MC #31 Exhibit 1.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The common stock of XMen Inc. had the following historic prices.
Price of X-Tech
50.00
47.00
76.00
80.00
85.00
90.00
Refer to Exhibit 1.3. What was your holding period return for the time period3/1/1999 to 3/1/2004?
46. CHAPTER 1—THEINVESTMENT SETTING Question MC #32 Exhibit 1.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The common stock of XMen Inc. had the following historic prices.
Price of X-Tech
50.00
47.00
76.00
80.00
85.00
90.00
Refer to Exhibit 1.3. What was your annual holding period yield (Annual HPY)?
47. CHAPTER 1—THEINVESTMENT SETTING Question MC #33 Exhibit 1.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The common stock of XMen Inc. had the following historic prices.
Price of X-Tech
50.00
47.00
76.00
80.00
85.00
90.00
Refer to Exhibit 1.3. What was your arithmetic mean annual yield for theinvestment in XMen Industries.
48. CHAPTER 1—THEINVESTMENT SETTING Question MC #34 Exhibit 1.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The common stock of XMen Inc. had the following historic prices.
Price of X-Tech
50.00
47.00
76.00
80.00
85.00
90.00
Refer to Exhibit 1.3. What was your geometric mean annual yield for theinvestment in XMen?
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